The Fed About to Repeat Volcker’s Tight Money Mistake? It Did Not Reduce Inflation, Only Led to Exploding Budget and Trade Deficits.

It is a total myth that Paul Volcker’s tight money in the early 1980’s “slayed the dragon of inflation”. Incredibly, that myth survives to this day, as Fed Chairman Powell and much of Wall Street have just praised Volcker’s approach to fighting inflation. That myth is the result of bafflingly flawed logic and disregard for the facts. Rigorous logic and attention to the facts lead to the conclusion that just as spiking oil prices worldwide (from $12 a barrel to $42) caused a massive cost-push inflation in the early 1980’s, stabilizing oil prices due to free market forces caused the eventual decline in inflation. In other words, the sharp rise and fall in inflation had all to do with oil prices, and nothing to do with monetary policy. It would be absurd to claim that soaring world oil prices in the late 1970’s and early 1980’s were due to a loose American monetary policy, rather than to a sudden major reduction in OPEC oil production following the arrival of Ayatollah Khomeini in Iran and the breakout of the Iran-Iraq War.

Similarly, the first energy crisis of 1973 was caused by OPEC’s nationalization of its oil and the consequent price decontrol, leading to world oil prices jumping from $2 a barrel to $12 overnight. Oil being a very important cost factor, the knock-on effects led to a jump in inflation, leading to the new phenomenon of “stagflation”, a combination of inflation and economic decline. It should be obvious that the jump in world oil prices had nothing to do with U.S. monetary policy, and that a restrictive monetary policy response was totally inappropriate and counterproductive. In fact, since the jump in oil prices was not due to increased oil consumption but to sudden price decontrol, the correct policy response would have been to stimulate investment in non-OPEC oil production and in energy efficiency. High interest rates would clearly hinder such investments, making them more expensive to finance and requiring a higher return on investment threshold.

The reason the Federal Reserve and the economics profession failed to properly understand the oil induced inflation and “stagflation” following the 1973–74 and 1979–80 energy crises, is that the elementary distinction between cost-push and demand-pull inflation was forgotten. That distinction was forgotten because historically most inflation had been of the demand-pull variety, i.e., due to a booming economy with excess aggregate demand. Clearly, a tighter monetary policy is logical when there is demand-pull inflation, but it is nonsensical and counterproductive when there is cost-push inflation. The proper policy response to cost-push inflation is to address the reasons why costs are rising, not to reduce consumer demand and cause a recession.

Today’s global inflation spike is of the “cost-push” variety. It is clearly not due to a jump in American consumer demand, but to global supply-chain disruptions due to the Covid pandemic, subsequently aggravated by Russia’s invasion of Ukraine and the consequent reduction of Russian oil and gas supplies in the West for political reasons. Just as American monetary policy has not been the cause of our domestic inflation, it cannot be the solution. Tightening monetary policy will do nothing to resolve global supply-chain disruptions or spiking oil prices; it will only serve to significantly slow economic growth, resulting in our third bout of “stagflation”.

It is important to understand that Volcker’s tight money had very deleterious effects, apart from doing nothing to reduce inflation. Not only did high interest rates slow investments in domestic oil production and energy efficiency/conservation, they served to explode American public and private indebtedness. Our budget deficits soared not only for cyclical reasons (lower tax revenues and higher social outlays) due to the recession worsened by tight money. They also soared as federal interest expense skyrocketed: maturing Treasury debt with 7% coupons was rolled over into new Treasury debt with 16% coupons, piling on to newly issued Treasury bonds with historically high coupons. Thanks to Volcker, the fed funds rate reached 21% in 1983–84, while inflation was below 10%, meaning that the real overnight interest rate (with no future inflation risk!) was an absurd 10%+. Not only did those absurdly high nominal and real interest rates cause our public and private debt to surge, they caused the dollar exchange rate to double, leading to record trade deficits and high unemployment.

Fed Chairman Powell was probably just giving lip service to the calls for a Volcker-like response to the current cost-push inflation, since he has shown a deeper understanding of economics than most economists, and a logical desire to not uselessly cause a recession. He will probably go slow with small fed funds rate hikes and with Fed balance sheet reductions (quantitative tightening) which are totally inappropriate given that the economy still has slack. In fact, tighter monetary policy is only justified when there is no slack, i.e., no unemployment and no unused production capacity. Most likely, inflation will gradually subside in tandem with diminishing supply-chain problems and stabilizing, if not lower, oil prices.

Apart from finally understanding the difference between the two varieties of inflation requiring different policy responses, Americans must also understand the real causes of our large, record federal indebtedness. One major cause is totally avoidable recessions caused by excessively tight monetary policy and high interest rates, leading to a big cyclical drop in tax revenues and a big cyclical increase in social expenditures. Eliminate all our recessions engineered by the Fed with high interest rates since 1974, and the outstanding federal debt shrinks to very low levels.

A second major cause of our heavy federal indebtedness is the fact that due to all too many mediocre public schools with deficient curriculums, half of our citizenry is undereducated with low earnings power. A flimsy basic high school education also has negative consequences for many college graduates, whose education remains very narrow. For an economically and socially prosperous society, the following high school courses must be included in the curriculum: 1) psychology (taught in conjunction with group therapy and good parenting workshops); 2) 20th Century history; 3) economics/finance/investing; 4) history of art/architecture/design; 5) history of music; 6) the United Nations’ Charter and its Universal Declaration of Human Rights; 7) the world history of human rights violations; 8) comparative religion studied through direct readings of the holy books; 9) logic and critical thinking; 10) ethics and empathy; 11) foreign languages and cultures; 12) the major mistakes in economic, social, and foreign policy of the past 100 years.

If all our public schools were truly excellent, with an enlightened curriculum, strict class discipline, lots of homework, and providing individual attention to students having academic or psychological problems, we would have practically no poverty, no welfare, no violence of any kind, no addiction, no crime, no rampant dishonesty, no abusiveness. We would have very few mentally disturbed citizens, hardly any mass shootings, very few high school dropouts, and very few unwanted pregnancies/abortions. Our budget deficits would disappear. Our tax rates would drop dramatically. Capital gains and estate taxes would be eliminated. All our social, economic, and political problems would be solved. Our politicians would be much better educated. We would avoid very costly foreign policy mistakes. We would also undoubtedly see the wisdom of requiring all our political candidates to be truly qualified before being allowed to run. There would be specialized, very advanced graduate school programs for political candidates, ensuring that at a minimum they would each be able to list off the top of their head all the major mistakes in economic, social, and foreign policy over the past 100 years and knowledgeably discuss which would have been the correct policies. It’s all doable, it should have been done many decades ago.

© Edward Sonnino 2022

April 12, 2022


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Edward Sonnino

Edward Sonnino

Born and raised in New York City. Best course in college: history of art. Profession: economic forecaster and portfolio manager. Fluent in French and Italian.