Down the ages there has been no shortage of central bankers intent on squeezing inflation out of the system, but Paul Volcker is in a class of his own.
Appointed by Jimmy Carter in 1979 when the US annual inflation rate was well into double digits, Volcker administered brutal shock treatment to the world’s biggest economy, at one point pushing official interest rates above 20%. Fans of the 6ft 7in (2.04m) chairman of the Federal Reserve continue to be in awe of his single-minded approach to price stability. Volcker is the inflation hawks’ hawk.
Judged by its own lights, the strategy worked. Inflation peaked in 1980, and was one of the reasons Carter lost the presidency to Ronald Reagan that year, but then started to fall rapidly as sky-high interest rates led to business failures and mass job losses. The US inflation rate is currently 6.8%, its highest for 39 years, but in 1982 it was coming down not going up.
Inevitably, comparisons have been drawn between Volcker’s no-nonsense approach to inflation and that of the current Fed chairman, Jerome Powell. Official interest rates in the US have been pegged at close to zero since the start of the pandemic almost two years ago, even though the economy is likely to grow by about 6% this year and unemployment has been falling fast.
Powell is a Republican but many in his own party think the removal of the stimulus provided by the Fed in early 2020 is long overdue. It is about time, according to his critics, he started to emulate Volcker since otherwise US inflation will continue to spiral higher.
The jury’s out on that because while the Omicron strain of Covid-19 will add to supply bottlenecks and so push up the price of goods, it has already led to a fall in the cost of crude oil, which will mean Americans have to pay less to fill up at the pumps. As things stand, it looks as if the headline rate of US inflation might have peaked but the core rate – which excludes energy and food – is likely to remain stubbornly high.
Even so, Powell is not remotely considering becoming Volcker redux – and nor could he do so without triggering a monumental financial crisis, not just in the US but in the rest of the developed world and in emerging economies as well.
Volcker was a big man in every sense of the word but his get-tough approach to tackling inflation had some unfortunate side-effects, of which four are worth mentioning here.
For a start, as anybody who listens to the music of Bruce Springsteen from the early 1980s can testify, bringing inflation down so quickly had a devastating impact on America’s manufacturing sector. Many communities in the Mid-West were one-company towns and they were hollowed out when those business closed or moved their operations overseas to countries with cheaper labour costs. All sorts of problems – physical and mental – resulted from this de-industrialisation. Political problems too, because without the wipeout of industry in Ohio and Pennsylvania Donald Trump would never have made it to the White House.
Some of the American companies that survived Volcker’s monetarism moved their operations south to Mexico, but many others outsourced across the Pacific to China, where the economic reform programme under Deng Xiaoping was just getting under way. It could be argued that it was only a matter of time before China emerged as a manufacturing superpower but there is no doubt Volckerism gave Beijing a helping hand. Few among the American policy establishment would have imagined four decades ago that China would have moved so rapidly from low-cost manufacturing to a position where it is a rival to the US in hi-tech sectors such as artificial intelligence. Nobody sees China as a backwater these days, and the economic threat it poses to a century-long US hegemony is a cause of growing geopolitical tension.
The third side-effect of crushing US inflation in the early 1980s was the Latin American debt crisis. Countries that borrowed heavily in dollars from US banks in the late 1970s found the loans unpayable when American interest rates rocketed and the global recession that resulted choked off their exports. Many developing countries are in an analogous position today: they have borrowed in dollars at the low interest rates that have prevailed since the global financial crisis and have used future export earnings as collateral. The International Monetary Fund says up to 40 of the world’s lowest-income countries are either in debt distress or at risk of it, so a Volcker-like increase in interest would be ruinous for them.
Last, but not least, the Volcker era altered the balance of the US economy, making industry weaker and finance stronger. From the late 1970s and early 80s onwards, the driving force behind the American economy has not been its still-significant manufacturing sector but its banks.
As the economy has become increasingly “financialised” so Wall Street has ceased to be a conduit for providing capital to growing businesses but instead has come to serve nobody but itself. Keynes once said the job was unlikely to be well done if speculation was the primary focus of financial markets, and his words have never been truer.
Financialisation has gone so far in the US that the Federal Reserve now cannot take the sort of action Volcker deployed 40 years ago because it would lead to a crash just as severe – and perhaps worse – than that of 1929.
Powell is therefore trapped. He has to respond slowly and carefully or risk a full-blown sell-off. Wall Street has the whip hand these days, not the Federal Reserve. And for that, despite his reputation, Volcker is partly to blame.