A giant is dead. Paul Volcker died this week, aged 92. At 6ft 7in, he was, according to the New York Times obituary, one inch too tall for military service.
But he is best known as the man who tamed US inflation. When President Jimmy Carter put in him in charge of the US Federal Reserve Bank in August 1979, inflation was running at 1% a month.
In October 1979 Volcker held a major press conference. He announced the Fed was going to “slay the inflationary dragon.” Indeed, it did.
Instead of putting up controlled interest rates by a few miserly percentage points he set about controlling the growth in the money supply. That left markets to determine how high to set interest rates.
By presidential election day in 1980, the market had set the prime bank lending rate in US at 21.5%. In time that did the trick for inflation but the timing was not good for Carter’s re-election prospects. He lost to a pleased Ronald Reagan.
In November 1982, the US rate of unemployment peaked at 10.8%. Annual inflation was down to 4% in 1983 and Reagan reappointed Volcker for a second term.
Reagan became less pleased as the date for the 1985 presidential election approached. Volcker did not support continuing US government deficit spending under Reagan; nor did he support what he saw as excessive banking deregulation.
Much earlier, in the 1960s, the US government under President Lyndon Johnson resorted to deficit spending to jointly finance the Vietnam War and the “War on Poverty.” The “Great Society” deficit spending continued into the 1970s. The double-digit inflation of the 1970s was one consequence.
To the best of my knowledge, Volcker never visited New Zealand in an official capacity but his work affected policy making in New Zealand regardless.
I was a Treasury official in New Zealand in 1982 when our prime minister returned from a meeting in Paris of member countries of the Organisation of Economic Cooperation and Development. There he encountered the stories of the successes of the UK and the US in getting inflation down by orthodox means but in conjunction with distressingly high unemployment.
New Zealand was also experiencing high inflation and chronic deficit spending, albeit from different origins. Double-digit inflation commenced in New Zealand soon after the major 19.45% devaluation of the New Zealand dollar in 1967 and the much-decried nil general wage order in 1968. Employers and unions quickly agreed to large wage increases, an act then-finance minister Robert Muldoon soon decried as an unholy alliance. However, his government allowed monetary policy to accommodate the inflationary effects of these events and thereby entrench inflation.
The quadrupling of world oil prices in the mid-1970s saw the third Labour government resort to large-scale deficit spending. Our national net external indebtedness today is a legacy of that borrowing.
So, when Muldoon returned from the OECD in 1982, he knew about the high unemployment in the US (and in the UK under Margaret Thatcher) from orthodox tight monetary policy. He wanted to get inflation down without incurring high rates of unemployment. I suspect in this he was motivated by a mixture of hard-headed political thinking, a soft heart and wishful thinking.
So, in the hope of avoiding Volcker-type disinflation and unemployment, he put New Zealand into a comprehensive wage, price, interest rate, rent and exchange-rate freeze. To buy worker support he cut taxes to preserve after-tax worker incomes. That aggravated the deficit-spending problem. Meanwhile the accruing losses from government guarantees for risky major energy projects would soon dramatically compound the spiralling public debt problem.
By 1984 that set of policies all but put New Zealand’s economic management into the hands of the International Monetary Fund. The Reserve Bank did not have enough foreign exchange to defend the value of the New Zealand dollar on the first trading day after the 1984 general election.
That situation led inexorably to a return to prudent orthodoxy. To resume international trade and currency exchange, there had to be a devaluation. To defend the devalued dollar there had to be a return to market-determined interest rates. Government stock yields, frozen by Muldoon at 11% a year, jumped to 16% in the first post-election government bond tender. To stop the public debt spiral there had to measures to reduce deficit spending. For example, subsidies to farmers were all but eliminated, user charges were increased, new taxes were introduced.
Farmers aside, it all looked pretty good for a while. The Higher Salaries Commission gave the top of public service huge wage increases on the ending of the wage and price freeze. The stock market roared away on the back of a commercial property and investment company boom. The Treasury reported in 1987 that economic growth since 1984 had exceeded its 1984 expectations.
Everything turned to custard after the October 1987 share market crash and the 1987 general election, which Labour won handsomely only to collapse in an internal civil war. Only then did New Zealand experience a recession comparable to the nastiness of the US experience in Volcker’s day.
New Zealand’s nadir came in March 1992 when the unemployment rate peaked at 11.4%. The net public debt peaked in the same year at 49% of gross domestic product. It was a long haul out of that hole.
Different people can take different lessons out of these experiences. For me the lesson is that no one has yet found a reliable path for avoiding the pain from past profligacy. Volcker, the US giant, imposed far greater pain than he expected would be needed. He would have felt that deeply.
His successor, Alan Greenspan, hoped to find a sliver path with the “Greenspan put” that assured financial markets that profits were underwritten by the Fed. The disastrous US-led global financial crisis from 2007-2008 destroyed that hope.
Those calling today for the minister of finance to increase the public debt to defer the onset of the next recession seem little different from those who were lauding Muldoon’s deficit spending. They may defer the day of reckoning but only by making it worse.
Before his death Paul Volcker lamented a US in which respect for its key institutions the government, the Supreme Court and the presidency was “all gone.”
It is not for us to know who the next giants will be to restore what has been lost. But expect it to be painful. In the US today the government’s financial liabilities exceeded its assets by 84% of GDP. Back in Volcker’s 1982 it was ‘only’ 29%.
Volcker took tough decisions knowing he would cop the blame. That takes rare but sorely needed courage. I, for one, am happy to pay my respects.