Paul Volcker (1927-2019): the man who ushered in the era of independent central banks

The reputation of central bankers is a fickle thing. Mervyn King’s stock fell when the financial crisis revealed the former Bank of England governor’s blind spot about the risks building up in British banks in the early years of this century. Alan Greenspan bowed out as head of the US Federal Reserve shortly before that crisis erupted, but his standing took a tumble as the once-feted maestro was criticised for monetary and supervisory misjudgments that contributed to the near-death experience of Wall Street and the City in the autumn of 2008. But if anything the reputation of his predecessor, Paul Volcker, who died on Sunday at the age of 92, has risen since his stint at America’s central bank ended in 1987.

Volcker remained in the public eye long after then, not least for his advocacy of a tough approach to regulating banks in the wake of the financial crisis. But it was his time as America’s top central banker that secured his place in history. Even though he was in charge of the Fed for a much shorter time—eight years in all—than Greenspan, who was there for almost two decades, his impact was immense, both in America and globally. When this literally towering figure (he was six foot seven inches tall) took over in August 1979, inflation appeared to be out of control, not just in America but in other advanced economies.  Volcker’s decisive actions tamed the scourge of the post-war world. The monetarist methods that he used did not last. But his legacy endured because he had proved that a genuinely independent central bank could contain inflation.

Volcker took over the reins at the Fed when monetarism was in its heyday, as the post-war Keynesian consensus that had played down the role of monetary policy crumbled and inflation was blamed on excessive growth of money. The new dictum was that of the economist Milton Friedman, who said in 1970 that inflation was “always and everywhere a monetary phenomenon.” In Britain, where he had made that celebrated remark, inflation subsequently reached 27 per cent in August 1975, prompting the Labour government to adopt monetary targeting, a policy pursued with greater zeal after Margaret Thatcher’s Conservatives won power in 1979.

Volcker was thus following a trend when he adopted a narrower form of monetary targeting at a crucial meeting of the Fed in October 1979. But it was one thing for the Bank of England to pursue a policy under instruction from the Treasury, quite another when America’s far more influential central bank did so of its own accord. By restricting the money supply, Volcker allowed interest rates to soar to an extent that would not have been possible if the Fed had still been setting rates directly. The harsh measures clobbered the American economy, which suffered two successive recessions in the early 1980s.

At great cost and after an agonising lag, Volcker prevailed. Inflation subsided in America and more generally around the world. But was this really a victory for monetarism? Though the Fed’s measures were undeniably monetarist in form, in substance they operated through the impact of viciously higher interest rates on demand. Much the same was true in Britain. And it was not long before it became apparent that trying to steer the economy according to the monetarist lodestar was a doomed venture. When the measures of money were narrow, as in America, they generated unwelcome sharp fluctuations in interest rates. When they were broad, they had a life of their own, making them false friends for policymakers trying to gauge their likely effect on inflation.

One by one countries abandoned monetarism. The most apt epitaph was that of Gerald Bouey, governor of the Bank of Canada between 1973 and 1987, who said after dropping its target for the monetary aggregate, labelled M1: “We didn’t abandon M1. M1 abandoned us.” What endured was the influence of central banks themselves. Volcker had shown that a tough-minded central bank left to its own devices could conquer inflation. Monetary policy could cut through the vicious circle that had driven inflation up over time as people came to expect progressively higher inflation, an expectation that turned into reality as they bargained wages and set prices. A credible central bank could generate a virtuous circle in which firms and unions instead came to expect lower inflation.

Rather than target money which was loosely linked to inflation, central banks would target inflation itself. That in turn could be controlled by moving interest rates up and down, something which the central bank could control precisely at the short end as the monopoly supplier of reserves held by commercial banks. And since longer rates reflect what is expected to happen to shorter rates they also came under the sway of the rate-setters.

This approach to monetary policy hinged on the independence of central banks. If politicians were at the helm they would always be tempted to manipulate interest rates to favour their short-term electoral prospects, creating a bias to easy money and higher inflation. That was after all what had happened to the Fed before Volcker took over. Though notionally independent since an “accord” with the US Treasury in 1951, it bowed to political pressure when Arthur Burns was in charge during the 1970s and did too little to curb inflation in the 1960s under William McChesney Martin, despite his famous adage that the Fed’s role was to remove the punch bowl just as the party gets going.

Volcker turned the Fed’s notional independence into the real thing. That inspired plagiarism. Until then the German Bundesbank had been a rarity in enjoying genuine independence from political control. But Volcker’s success made the case for other countries to follow suit, taking monetary policy out of the hands of politicians and putting it in those of independent technocrats chosen for their economic and financial competence. When European leaders negotiated the Maastricht treaty in the early 1990s, the template they chose for the European Central Bank was that of a strictly independent central bank. In 1997 the Labour government transformed economic policymaking by making the Bank of England free to set interest rates, releasing it from its former subservience to the Treasury.

Volcker has died when that hard-won independence is under threat from populist politicians, most notably in America where President Trump rarely misses an opportunity to vent his frustration that interest rates are too high. Under Jerome Powell, the Fed is having to walk a tightrope to set rates as it should and would without barracking from the White House. More generally, central banks have lost credibility as inflation remains stubbornly stuck below their targets. The central banker who demonstrated the muscle of monetary policy to curb inflation has died at a time when his successors appear increasingly impotent in their capacity to raise it.