Misunderstanding Volcker

Paul Volcker, the former Federal Reserve chairman often called “Tall Paul” for his 6’7″ stature, is dead at 92. Volcker played an outsized role in shifting the prevailing economic model from one dominated by labor to one dominated by capital. As Mark Blyth put it in a recent talk, the late 1970s and early 1980s, the rise of the “independent” central banker, which Volcker exemplified, was a core element in the economic regime change after the moneyed classes saw workers as being too empowered and revolted. His fixation with reducing inflation favored investors over workers, and lowered labor’s wage share of GDP. As as we’ll see, Volcker sought to achieve that end.

It took me quite some time to get a better perspective on Volcker. I was imprinted by the Wall Street of 1981, when Volcker was in the midst of implementing what he’d billed as a money supply experiment in order to wring inflation out of the system. The Fed money supply figures were announced every Thursday at 4:00 PM, after the market had closed (then at 3:00 PM). Even on the investment banking floors, someone would inevitably hover around the Quotron machine and would broadcast the latest money supply increases, and whatever the hot takes there were on what it meant.

At the peak of his money supply experiment, banks were hemorrhaging losses on their credit card portfolios, which yielded only 19% when it cost 22% to fund them. The economy went into a steep slide, the worst since the Great Depression. Securities firms like Goldman were also suffering. The institutional sales force, both equities and fixed income, was crying for lucrative new issues. But few companies who didn’t have to wanted to sell shares in the “death of equities” era, nor did they want to issue bonds at prevailing rates of 13% to 15%. Structures with tax advantages like zero coupon bonds and debt for equity swaps became popular.

Volcker relented in August 1982. I recall the word going through the firm like lightening that the Fed was going to ease up. There was no news announcement; primary deals apparently got the signal from the New York Fed’s trading desk. Later write-ups of this era suggested that Volcker wanted to persist even longer, but that the Latin American sovereign debt crisis, and the very real risk of US bank failures (recall that that serial near bankrupt Citibank was looking wobbly) stayed his hand.

That August was the beginning of long disinflationary period that ended in May 2007. It gave a huge tailwind to financial asset prices and helped make the new neoliberal model, of denying workers real income gains but letting them binge on debt as a way to increase their standard of living, palatable. It was also a major driving force for financialization, which is increasingly decried by economists as a negative for growth. No wonder bankers revere Volcker.

Ironically, economists have deemed the Volcker and parallel Thatcher money supply experiments to be failures. Contrary to the persistent myth-making of Milton Friedman, money supply changes (and lagged ones) correlated with no macroeconomic variable. So it may not come as a surprise that William Grieder found, in his classic The Secrets of the Temple, that Volcker may have suspected as much. Greider provided evidence that Volcker was using money supply targets as an a cover to let interest rates rise vastly higher than would have been deemed sane he had stuck with the traditional central bank approach of targeting interest rates.

Another telling Greider tidbit was that during the time when Volcker was driving interest rates to the moon, Volcker would keep a notecard in a jacket pocket that tracked weekly construction wages. Volcker saw getting them to decline as a key metric that his policies were succeeding. He intoned: “I want unions to get the message.”

Some experts, such as Warren Mosler, point out that the underlying inflationary trends were dissipating even before Volcker launched his money jihad, as shown by oil prices peaking in 1979. Recall that Volcker became Fed chairman in 1979 and started implementing the “Volcker shock” of constraining money supply in March 1980. Thus there is a case to be made that inflation would have abated, particularly since the key practice that had helped reinforce it, widespread formal and informal cost of living adjustments, had been abandoned or weakened.

The suddenness of Volcker turning off his “kill the economy to save it” initiative wound up seriously damaging US manufacturers. Mind you, they had been feeling considerable heat from Germany and Japan in the 1970s. I recall a sense of despair and even desperation in the business press and among my business school colleagues (I went to HBS from 1979 to 1981) about the decline of US competitiveness. Some of it was that many US manufacturers, particularly automakers, were saddled with old plant that was less efficient than that of the foreign upstarts. Germany and Japan also had better infrastructure thanks to post-World-War II reconstruction.

That isn’t to say that far too many US companies were also afflicted with sclerotic management. There are famous stories from that era of GM execs having no idea how bad the company’s cars were because they’d be babied every day by mechanics while they were at the office. Big US manufacturers also often saw themselves as victims of unions who protected slough-off workers. That picture was challenges when Toyota, in a famed joint venture with General Motors called NUMMI, took over the operation of GM’s worst factory, which it had shuttered in 1982. Its workers had regularly called in sick or showed up drunk. Toyota re-hired the 85% of the former employees and let the union play a role in choosing managers. Toyota got the factory’s output to the average quality level of (then widely recognized as way better) Toyota plants.

But the aftershocks of the Volcker experiment put floundering US manufacturers on a faster decline, from which most never recovered. The dollar strengthened considerably and rapidly, which gave foreign manufactures a price advantage. In the 30 months of the super-strong dollar, US automakers lost market share sharply, and they never got it back. The impact was so strong that even the supposed free marketer Reagan Administration was able to secure the Plaza Accord of 1985, a coordinated G-5 effort to push the dollar down and in particular, the yen up.

Volcker remained an uber-inflation hawk, arguing for decades after his leadership of the Fed for zero inflation, an idea that would have most orthodox economists’ eyes rolling. Even though economists dislike inflation, they loathe deflation. If you accept the premise that the central bank is using interest rates to manipulate growth, zero gives you nowhere to go if you think you need to drop rates in a crisis (the US, unlike Europe, remains allergic to the idea of negative interest rates, and we’ve explained elsewhere why this is a sound view).

Mind you, MMT advocates also favor zero interest rates, but their approach is radically different. They don’t want money to play a role in managing the economy; they want to use a Job Guarantee to provide a floor for labor prices and help assure sound development, and use fiscal spending to further regulate activity. By contrast, Volcker was also adamantly opposed to deficit spending.

Volcker also stood for skepticism of bankers and his belief in the need for strong regulation, particularly of consumer products. He was vehemently opposed to money market funds, recognizing (as the crisis demonstrated to be correct) that consumers would incorrectly treat them as equivalent to government-guaranteed deposits. He also didn’t like that money market funds made it harder for the Fed to control credit (money market funds are big holders of commercial paper, which provide short term funding for corporations and later, off balance sheet vehicles). He also pooh-poohed financial services claims of adding special value, saying that the last innovation he’d seen in banking was the ATM.

Volcker’s brand image as a strict regulator led Obama to include him in campaign events in his 2008 run, leading many to assume that Obama would make Volcker his Treasury secretary (one scenario was that Volcker would serve only for a year until the financial system was stabilized and then hand off the job). Obama’s bait and switch with Geithner showed where the incoming President stood on bank. And if you had any doubts, Obama added insult to injury by relegating Volcker to heading a “do nearly nothing” committee.

But the idea that Volcker was actually tough on banks is considerably exaggerated. Consider, for instance, our write-up of a 2010 Volcker speech widely depicted as “blistering”:

Unfortunately, the reactions to Volcker’s speech say far more about politics and PR in the US than they do about what he actually said. Volcker’s comments were delivered in a moderate, occasionally perplexed tone. He was often candid and descriptive, far from “blistering.” And despite the Wall Street Journal headline, “Volcker Spares No One in Broad Critique,” in fact he left many targets untouched (bank pay, accounting chicanery, “free market” ideology, cognitive capture of regulators and the revolving door between regulatory positions and lucrative private sector roles, predatory behavior by financial firms). In fact, Volcker was a defender of traditional commercial banks, noting that they have special role via acting as depositaries and payment services, and complaining of how money market funds were encroaching on their turf and providing similar functions without having the same degree of oversight and capital requirements. He also spent a fair bit of his talk extolling the Fed as the logical party to serve as the lead financial regulator, while somehow missing that the central bank did a horrific job in the runup to the crisis and is chock full of monetary economists who have no interest in financial firms’ inner workings.

Indeed, Volcker actually said (and I am not making this up), that the mess in the economy was NOT the result of the financial crisis. His formulation is rather astonishing. He depicts the financial crisis as the result of real economy imbalances, as opposed to the build up of speculative excesses in a grossly undercaptialized, tightly coupled financial system (starts at 9:30).

But in saying that I don’t mean to blame the crisis on the regulators or even on the market. I mean, this crisis got so serious, it’s so difficult to get out of this recession because of disequilibrium in the real economy. You know the story…when the bubble in housing burst, then the financial system came under great pressure, you don’t blame it for originating the crisis, in fact, under pressure, it broke.

Huh? The idea that the real economy distortions produced the crisis. as opposed to deregulation led to excessive leverage in financial firms and were the primary cause of distortions in the real economy, is barmy. Contrast Volcker’s take with that of Meryvn King, Governor of the Bank of England in a 2009 speech:

Two years ago Scotland was home to two of the largest and most respected international banks. Both are now largely state-owned. Sir Walter Scott would have been mortified by these events. Writing in 1826, under the pseudonym of Malachi Malagrowther, he observed that:

“Not only did the Banks dispersed throughout Scotland afford the means of bringing the country to an unexpected and almost marvellous degree of prosperity, but in no considerable instance, save one [the Ayr Bank], have their own over-speculating undertakings been the means of interrupting that prosperity”.

Banking has not been good for the wealth of the Scottish – and, it should be said, almost any other – nation recently. Over the past year, almost six million jobs have been lost in the United States, over 2 ½ million in the euro area, and over half a million in the United Kingdom. Our national debt is rising rapidly, not least as the consequence of support to the banking system. We shall all be paying for the impact of this crisis on the public finances for a generation.

To put none too fine a point on it, King is the top central banker an a country where financial services constitutes a bigger proportion of GDP than the US, yet he does not hesitate to place blame for the crisis where it belongs, on the banks (and he is willing to eat crow for regulatory lapses). Volcker, by contrast, offers a critique which is hardly controversial, yet gives the industry a pass.

Similarly, Volcker was hauled out of mothballs to press for what is now called the Volcker Rule only after the Administration was on the back foot as a result of losing the old Ted Kennedy seat in Massachusetts to Scott Brown, ending the Democrats’ filibuster-proof majority. The Administration wasn’t keen to have him give even comparatively mild criticism of financiers while it was laboring mightily to bail them out while not reforming them.

And the Geithner Treasury was not all that happy with the narrow restriction of the Volcker Rule.

Volcker’s idea of limiting bank proprietary trading was sound, but as we discussed at length at the time, trying to separate customer trading from other trades was a flawed way to go about it. A financial firm will often take on a large position from a customer because it can do so at a good price; if it flattens its position relatively quickly, which is what the Volcker Rule would want it to do, it’s perverse to look favorably to selling to customers as opposed to other professional traders. We argued, based on input from former in-house risk managers, that this was one place where the notorious Value at Risk model would give regulators a good handle on whether a financial firm was holding unduly large, as in presumed speculative, positions.

Part of Volcker’s stature was due to his famously modest (one might even say cheap) habits and his personal integrity. He stayed at the Fed even though he was nursing a wife dying of cancer. People on Wall Street at the time thought he might quit because the chairman’s salary wouldn’t buy much in the way of nursing care.

Volcker was also slow to cash out, and even when he did, he became the Chairman of the boutique investment bank Wolfensohn & Co., headed by former Salomon Brothers partner, later World Bank head James Wolfensohn. I have no doubt he could have landed a much more lucrative post had he wanted to.

I met Volcker first on an over 90 degree day, when I was in a T-shirt and jeans in a vegetable market around the corner from my apartment. He was wearing a suit and tie and carrying a very worn denim bag. I approached him and told him I remembered from my days at Goldman how everyone had hung on the money supply announcement. He seemed pleased to have been recognized and politely said I was too young for that. I didn’t keep him much longer.

I next saw him at one of Amar Bhide’s book parties, a very small gathering. Volcker was expected to make only a brief appearance but stayed for about half an hour. Oddly, he wound up seated alone for a stretch with no one talking to him. I went over a chatted him up, feeling it was wrong for him to be neglected like that. We discussed some recent news, although for the life of me I can’t recall what precisely.

I ran into him again at some INET conferences, and engaged him briefly at each, and also saw him speak an the Atlantic Economy summit (this when one of the budget debates was a hot topic) and Volcker moralized about the horrors of debt spending. I had gotten sufficiently better versed in macroeconomics to be disappointed.

Volcker’s starchy manner, lack of pretentiousness, and skepticism of bank claims of virtue made him old school. But he played a central role in ushering a Brave New World that was nevertheless better for financiers and rentiers than everyone else.