Confidence in a crisis

Volcker: The Triumph of Persistence, by William Silber, Bloomsbury RRP£25/RRP$30, 448 pages

The economy suffers a malaise. A fiscal deficit yawns but government is paralysed. The only agency that can act is the US Federal Reserve. It all sounds very familiar.

Paul Volcker was chairman of the Fed from 1979 to 1987. His foe was inflation – the opposite of the high unemployment fought by Ben Bernanke today. But the pressures on the two men from purist academics and interfering politicians are eerily similar.

That makes this fine new biography especially timely. William Silber’s theme is the tension between monetary and fiscal policy, between the ascetic central bankers and the wilful politicians, and how one must check the other.

Silber, a professor of finance and economics at New York University’s Stern School of Business, argues that Volcker’s achievements went beyond taming inflation; by keeping interest rates high, he also forced Ronald Reagan to rein in the budget deficit. That is relevant to today’s debate, which pits supporters of the Fed against Republican critics who say that by striving to push down long-term interest rates, the central bank is relieving market pressure on politicians to tackle the public finances.

Most of Silber’s account is devoted to the three main policy episodes of Volcker’s career: his role in ending the link between the dollar and gold at the US Treasury in 1971; in fighting inflation at the Fed a decade later; and in proposing the “Volcker rule”, which restricts commercial banks from speculating, in 2010.

Volcker, still influential at 85, comes across in this book as determined and principled but also pragmatic. He misses out on early chances to become Fed chairman or Treasury secretary because presidents Lyndon Johnson and Richard Nixon do not trust him to do what he is told. When a crisis unfolds, however, he does what is needed – even when that means bailing out the creditors of Continental Illinois in 1984, and thus establishing the idea that some banks are too big to fail.

It is for his fight against inflation at the Fed that Volcker is best known. Throughout the 1970s, under the chairmanship of Arthur Burns, the central bank was quick to cut interest rates whenever unemployment seemed likely to increase. By the end of the decade prices were rising by close to 15 per cent a year.

Volcker changed the regime at the Fed and targeted the money supply (although never to the satisfaction of monetarist economists). Short-term interest rates rose as high as 19 per cent, the economy fell into recession, but inflation was crushed. As Silber notes, the price of gold fell and the dollar rose once Volcker was in charge, suggesting markets believed he would avoid inflation. But interest rates on treasuries stayed high as Reagan’s tax cuts led the government to borrow more and more.

In early 1982, the Fed raised interest rates again by 2 percentage points in the teeth of recession. Silber argues that it was the knowledge that the private sector would get no relief on interest rates unless the government reined back that pushed the Reagan administration to raise taxes later that year, and led to further deficit reduction in 1985.

It is interesting to compare that situation with the present day. Now, short-term interest rates are close to zero, inflation is low and inflation-protected bonds do not imply an investor fear of runaway price rises. But with 10-year Treasury bonds yielding just 1.62 per cent at the time of writing, investors seem happy to lend to the government, despite high deficits.

Instead, all the facts indicate that there is little private demand to borrow, in which case the Fed could raise interest rates and still put little pressure on Congress to tackle the deficit. Indeed, it might well have the opposite effect. Silber recognises that, but in a final chapter titled “Trust” he argues that the Fed may at some point have to raise interest rates pre-emptively, and in an economy weakened by recession and unemployment it “may not have the public support that it needs”.

What Volcker’s experience shows is that when a central bank is forced to keep rates high by a profligate government, then politicians will threaten its independence. Jimmy Carter appointed Volcker in 1979 and the resulting high interest rates may have cost him re-election in 1980. Volcker’s reappointment by Reagan in 1983 was touch-and-go. In 1986, Volcker was outvoted 4-3 on the Fed board by four Reagan appointees, who wanted to lower rates. He almost resigned but the matter was smoothed over.

In January 2014, Bernanke’s term at the Fed will end, and whoever is president will have to appoint a replacement. This book suggests that the most important thing is to choose somebody wise, stubborn and, above all, independent.

Robin Harding is the FT’s US economics editor

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