7

Carter, Volcker, and the Conquest of Inflation

At a certain point in the inflationary process, public opinion will support strong policies to restore stability even though those policies seem to entail a harsh short-term cost.

—PAUL VOLCKER, “THE TRIUMPH OF CENTRAL BANKING” (1990)

Chapter 6 was a sojourn into the history of doctrine, which is sometimes necessary to understand the history of policy. But the history of politics typically has far more bearing on economic policy.

Jimmy Carter took office as president of the United States in January 1977. When he moved into the White House, the U.S. economy had recently come through the rough stagflationary episode detailed in chapter 5, but it was clearly heading uphill. The U.S. body politic had perhaps come through an even rougher patch, given the disquieting Watergate hearings, Richard Nixon’s resignation (to avoid impeachment) in August 1974, and Gerald Ford’s controversial pardon of Nixon a month later.

So, when Americans went to the polls in November 1976, the country was ready for change and for someone who seemed both placid and honest—not for a continuation of the Nixon administration, which is how Carter tried to paint Ford in the campaign. Carter filled the I’m-not-Nixon bill superbly. His campaign mantra, “I’ll never lie to you,” was perfect for the times, and he won in a tight race: by about 2 percentage points in the popular vote and by a 297–240 margin in the electoral college.

Economic Tumult Begins

When Carter arrived in Washington, inflation as measured by the Consumer Price Index (CPI) on a twelve-month basis was down to 5.2 percent, which looked pretty good compared to the double-digit readings that had prevailed from February 1974 through April 1975. Inflation jumped above 6 percent in February 1977, however, and remained in the 6–7 percent range for the remainder of the year. No one knew it at the time, but inflation and Iran’s Ayatollah Ruhollah Khomeini would prove to be the two banes of Carter’s presidential existence.

In terms of real growth, the recovery from the deep recession of 1973–1975 was proceeding apace, with a robust 4.5 percent growth rate of real GDP between 1976:1 and 1977:1. Nonetheless, many Americans still felt like their economy was in recession.¹ The unemployment rate in January 1977 remained high, at 7.5 percent. It would never dip much below 6 percent during Carter’s presidency.

To lead his economic team, Carter chose W. Michael Blumenthal, a prominent and highly successful corporate CEO—one of the few CEOs of the day who was a Democrat—as his secretary of the treasury and Charles Schultze, a deeply respected economist from Brookings, as his Council of Economic Advisers chair. Both had PhDs in economics and substantial prior Washington experience, but they were destined to clash. Like most professional economists, Schultze was data- and model-driven; Blumenthal, an experienced businessman, worried more about psychological factors that models ignored. He was also more hawkish on inflation than Schultze was. For director of the Office of Management and Budget Carter tapped Bert Lance, a businessman buddy from Georgia. That appointment raised eyebrows at the time,² and Lance did not last a year.³

Carter’s most unconventional economic appointment, however, came about a year later when he nominated G. William Miller to replace Arthur Burns as chair of the Federal Reserve. Like Blumenthal, Miller had been a successful CEO. But unlike Blumenthal, he had no training in economics. Nor, it soon became apparent, did Miller have much understanding of how the Federal Reserve operates, a handicap Miller himself understood and had warned Carter about (Meltzer 2009a, 923). Miller’s tenure as Fed chair was destined to be brief and less than successful.

Early in his presidency, Carter proposed and Congress passed a modest fiscal stimulus—amounting to roughly 1 percent of GDP—that was focused on job creation. It included several hundred thousand public service jobs and a novel tax credit for expanding employment (see just below). Carter’s original stimulus proposal had been larger, including a $50 per capita rebate of 1976 taxes. But the rebate proved to be a political loser, derided by, for example, Senator Russell Long (D-LA), then chair of the Senate Finance Committee, as “throwing $50 bills off the top of the Washington Monument” (Eizenstat 2018, 292).

One reason the stimulus package was trimmed was that the federal budget deficit was already running at about 2.5 percent of GDP, which seems puny given what happened once Reagan succeeded Carter. But the balanced budget ideology was alive and well in 1977, at least at the level of lip service. The slimmed-down stimulus bill passed both the House and the Senate by overwhelming votes of 326–87 and 63–15, respectively, and Carter signed it into law on May 13, less than four months into his presidency.

One interesting historical footnote was buried in the 1977 stimulus bill: the New Jobs Tax Credit. Doubtless reflecting economists’ desires to provide incentives at the margin rather than waste money subsidizing activities that would happen anyway, the tax credit offered firms a wage subsidy of 50 percent of the first $4,200 in wages for increases in employment of at least 2 percent over the previous year, the latter being a crude but practical way to focus the subsidy on marginal hiring.

Though it was a small-scale policy innovation, the New Jobs Tax Credit is generally considered to have been a success (Perloff and Wachter 1979). When I served on President Bill Clinton’s Council of Economic Advisers in 1993, we convinced him of the virtues of making investment incentives marginal in a similar manner, but Congress rejected the idea. The New Jobs Tax Credit idea popped up again in 2009 when the Obama administration was searching for ideas to boost job creation, and something resembling it became part of the Hiring Incentives to Restore Employment Act of 2010.

But Carter’s efforts to apply expansionary fiscal policy did not end with the 1977 stimulus package. Later that year the new president, who had (accurately) dubbed the existing tax code “a disgrace to the human race” in his campaign, was back to Congress with another tax bill. This one was intended to be more tax reform than tax cut, but as it worked its way through Congress the former morphed into the latter. Remember, the chair of the Senate Finance Committee at the time was the aforementioned Russell Long, whose famous aphorism for tax reform was “Don’t tax you; don’t tax me; tax that fellow behind the tree.”

Long greatly admired many of those trees. So, by the time the bill passed the House and Senate by overwhelming majorities in October 1978, almost all of Carter’s reform proposals had been stripped out. Instead, tax rates were trimmed, brackets were widened, the standard deduction was increased, and the maximum tax rate on capital gains was cut from 35 percent to 28 percent. By sheer coincidence, I imagine, the net tax cut in the Revenue Act of 1978 was roughly the same magnitude as the original 1977 stimulus, so the fiscal stimulus was effectively doubled. Carter, a fiscal conservative, was tempted to veto the bill, but his advisers and members of Congress talked him out of it (Eizenstat 2018, 316). Looking back on those two bills forty years later, Stuart Eizenstat, Carter’s domestic policy guru, wrote that “given what we knew as we came into office early in 1977, it is difficult to argue that we were mistaken in putting forward a stimulus plan for the stalled economy. But it is equally difficult to defend the second jolt that we proposed late in the same year” (Eizenstat 2018, 314). In brief, there is something to the charge that fiscal policy became too expansionary in 1977–1978. The economy, growing nicely, didn’t need it.

The year 1977 also saw the beginnings of what came to be seen as a “dollar crisis.” Floating exchange rates were still new then and not entirely trusted. Since the U.S. dollar remained the linchpin of the international monetary system (as it still is), a falling dollar was considered a very big deal at the time both in the United States and abroad.

At an Organisation for Economic Co-operation and Development meeting in June 1977, Secretary Blumenthal made a mild remark that exchange rate adjustments should “play their appropriate role” in international macroeconomic adjustments. Under floating exchange rates, that thought comes close to being a tautology. Nonetheless, Blumenthal was accused of trying to boost U.S. growth and simultaneously slow down foreign growth by “talking down” the dollar, a charge he denied (Solomon 1982, 346). Regardless, secretaries of the treasury from then on studiously avoided saving anything that might evoke memories of “the Blumenthal dollar”—until Secretary Steven Mnuchin broke the taboo in January 2018 by stating, quite forthrightly, that a weak dollar was good for U.S. trade (Ball 2018). In fact, President Donald Trump had gone there before him (Chandler 2017).

Inflation was rising in 1977, and the Federal Open Market Committee’s (FOMC) comparatively easy monetary policy may have weighed more heavily on the dollar than Blumenthal’s banal remark did. Regardless of the cause(s), the dollar continued to fall into 1978. By October it was down 14 percent from its January 1977 level, as measured against the Fed’s trade-weighted average of major foreign currencies. Its declines against the deutsche mark and the Japanese yen were particularly dramatic. A deutsche mark was worth just under 42 cents in January 1977 but cost over 54 cents by October 1978. The Japanese yen went from 291 to the dollar to just 184.

The Carter administration responded with a comprehensive “dollar rescue package” that included emergency sales of gold and borrowing from the International Monetary Fund for the only time in U.S. history. Even more drastically, the U.S. Treasury sold some debt securities denominated in deutsche marks and Swiss francs. They were dubbed “Carter bonds,” a nickname not meant as a compliment. (The Treasury never issued foreign currency denominated bonds again.) It all looked a bit panicky.

The falling dollar was not the big problem, however. Rising inflation was.⁴ The twelve-month CPI inflation rate rose from 5.2 percent in January 1977 to 9 percent in December 1978 and eventually to over 14 percent in 1980. Some of that increase, especially in 1979 and 1980, was due to the Organization of the Petroleum Exporting Countries’ “OPEC II” shock, as detailed in chapter 5. But even core inflation, after hovering in the 6–6.5 percent range during 1977, was up to 8.5 percent by December 1978 and topped 13 percent for a few months in 1980.⁵ Inflation was clearly the major problem of the day, topping even unemployment. And that, not the cheap dollar, was the big blot on the reputations of Carter and Miller.

Origins of the Dual Mandate

Another sequence of events in the early Carter years gets far less attention, but it is worth noting here for its importance to U.S. monetary history and to monetary policy even today. The little-known Federal Reserve Reform Act of 1977 was signed into law by President Carter in November 1977. Its focus was on increasing the Fed’s accountability, including a legal requirement to report to Congress “concerning the ranges of monetary and credit aggregates for the upcoming 12 months”⁶ and beginning to hold separate Senate confirmation hearings for the Federal Reserve Board’s chair and vice chair. Prior to that, while all Fed governors had to be confirmed, the president simply designated one of them as chair and another as vice chair.

Most significantly, however, the 1977 act established what we now call the Fed’s dual mandate: to “promote maximum employment, production, and price stability.” This mandate, which distinguishes the Federal Reserve from most other central banks by placing employment on an equal footing with inflation, is often falsely attributed to the Humphrey-Hawkins Act (the Full Employment and Balanced Growth Act), which Congress passed and Carter signed about a year later.

The Humphrey-Hawkins Act gets far more attention because it set a (probably unrealistic) numerical goal for the unemployment rate (4%) and established semiannual Humphrey-Hawkins hearings at which the Fed chair would explain the central bank’s actions to Congress. The act also made a modest change to the wording of the monetary mandate to “maximum employment, stable prices, and moderate long-term interest rates.” Because economists consider the last of these three to be redundant (if prices are stable, nominal interest rates will be low), this is called the Fed’s dual mandate. But that mandate dates from the 1977 act, not the 1978 act.

Prior to 1977, the entire U.S. government was, of course, committed by the Employment Act of 1946 to pursuing “conditions under which there will be afforded useful employment for those able, willing, and seeking to work.” This vague but important commitment was passed with the memory of the Great Depression still fresh in legislators’ minds. However, Congress was not yet willing to embrace the title that had been proposed earlier, “Full Employment Act.” Importantly, the Employment Act was not directed at the Fed; people in 1946 simply did not think the Fed was that important. In fact, the act, which also created the Council of Economic Advisers in the White House, required an annual Economic Report of the President. It asked for no such report from the Federal Reserve.

So, the 1977 and 1978 amendments to the Federal Reserve Act really were landmarks for monetary policy even if that was not realized at the time. I find it amazing that Allan Meltzer’s monumental A History of the Federal Reserve (2009a, b), which leaves out approximately nothing, barely mentions the 1977 act and does not even mention its dual mandate provision.

Supply Shocks Strike Again

While all this was happening legislatively, food prices began to climb all over the world, and inflation once again became economic issue number one. In the United States, the growth rate of the food and beverages component of the CPI, which had dropped to a low of 1 percent (seasonally adjusted annual rate) in December 1976 began rising, eventually peaking at about 13 percent in February 1979 (figure 7.1). With a relative importance in the index of about 18 percent, these rising food prices alone contributed 2 percentage points to overall CPI inflation in 1978 and 1.75 points in both 1979 and 1980 (Blinder and Rudd 2013, 141).⁷ Carter and Miller absorbed much of the blame even though, as Blinder and Rudd remarked, “we are deeply skeptical that agricultural diseases, bad weather, and the hog cycle were lagged effects of monetary policy” (142).⁸

That said, oil prices, not food prices, dominated the headlines in 1979 and 1980. What we now call OPEC II struck when the Iranian Revolution of 1978–1979, followed by Iraq’s invasion of Iran, sent crude oil prices skyrocketing. The pass-through into consumer prices was quick and dramatic. The CPI energy component, which registered just 7 percent inflation (seasonally adjusted annual rate) in November 1978, soared to 47 percent by March 1980 (figure 7.2). No, that is not a typo. Forty-seven percent.

FIGURE 7.1. U.S. food price inflation, 1975–1980.

Source: Bureau of Labor Statistics.

FIGURE 7.2. U.S. energy price inflation, 1975–1980.

Source: Bureau of Labor Statistics.

Once again, as Rudd and I observed, “it should be obvious that both OPEC shocks were set in motion by geopolitical events that cannot possibly be attributed to, say, money growth in the United States or even to world economic growth” (Blinder and Rudd 2013, 140). Nonetheless, monetarists seem not to have found this obvious at all at the time. For example, Milton Friedman’s rhetorical question in a 1975 Newsweek column—“Why should the average level of prices be affected significantly by changes in the price of some things relative to others?”—was supposed to answer itself (Friedman 1975b, 73). Some of Friedman’s intellectual heirs remain unconvinced even to this day.⁹ One reason, of course, is that core inflation soared at the same time—up from the 6 percent range in early 1978 to as high as 13.5 percent in mid-1980. Why?

Part of the explanation is that supply shocks, even temporary ones, leave some pass-through into core prices in their wake. Blinder and Rudd (2013, 146) estimated that this pass-through amounted to about 2 percentage points of additional core inflation in the 1978–1980 period. Nonetheless, even with this addition, the entire inflation story of 1978–1980 cannot be pinned on supply shocks.

One obvious additional cause of higher inflation was excessive growth of aggregate demand that pushed the economy beyond full employment. Indeed, the growth rates of real GDP over the four quarters of 1977 and 1978 were 5 percent and 6.7 percent, respectively—both well above trend. Consistent with that, the unemployment rate tracked downward steadily, with only small exceptions, from its recession high of 9 percent in May 1975 to a low of 5.6 percent in May 1979.

This rapid growth was due in part to the aforementioned fiscal stimulus. But monetary policy also played a role. For example, the growth rate of M2 (from twelve months earlier) remained in double digits from mid-1975 until the start of 1978. You don’t have to be a monetarist to wonder whether money growth rates such as that might be inflationary. In any case, the combination of rapid money growth, rapid GDP growth, and rising inflation led many critics to blame the Miller Fed for losing control of inflation. They had a point. The Fed’s official history website put it this way: “Unlike some of his predecessors, Miller was less focused on combating inflation, but rather was intent on promoting economic growth even if it resulted in inflation. Miller believed that inflation was caused by many factors beyond the Board’s control.”¹⁰ That last sentence is redolent of Arthur Burns.

Many of Miller’s critics on Wall Street were far less measured. For example, journalist Steven Beckner wrote (slightly hysterically perhaps) that “if Nixon appointee Burns lit the fire, Miller poured the gasoline on it during the administration of President Jimmy Carter” (Beckner 1996, 22). But before we embrace the excess demand explanation too uncritically, we should note that the unemployment rate never dropped below 5.8 percent during 1977 and 1978. Given the Congressional Budget Office’s current estimate of the natural rate of unemployment at that time, which was around 6.2 percent (contemporaneous estimates were a bit lower), the overshoot was modest. You don’t get much of an increase of inflation by overshooting the natural rate of unemployment by just 0.4 percentage point. As mentioned in chapter 5, however, Orphanides (2003) has argued that overestimation of the output gap, largely due to a failure to recognize the productivity slowdown that began in earnest in 1973, played a meaningful role in making monetary policy too loose under both Burns and Miller. In that case, the excess demand pressures had been building for some time, so looking just at 1977–1978 is too myopic.

Finally, a measurement issue with the CPI exaggerated the inflation rate. Until the Bureau of Labor Statistics (BLS) fixed the problem in 1983, the interest rate on home mortgages was counted as a “price” in the CPI. But since nominal interest rates in general and the mortgage rate in particular depend on the inflation rate, this measurement error created a positive feedback loop that exaggerated the rise (or fall) of inflation. Whenever inflation rose, the announced CPI level would get an extra boost from rising mortgage rates.¹¹ This was no trivial matter when interest rates rose sharply. The BLS now publishes a historical research series, dating back to 1978, that corrects this and some other problems. By that measure, the CPI inflation rates for 1978, 1979, and 1980 were 7.8 percent, 10.9 percent, and 10.8 percent, respectively; each well below the official CPI readings of 9 percent, 13.3 percent, and 12.4 percent for those years. But no one saw numbers like that in real time.

Enter Paul Volcker

By the summer of 1979, there was no doubt in Carter’s mind that reducing inflation was both an economic and a political imperative of the first rank. He had famously, if rather awkwardly, labeled the energy crisis—one major source of the high inflation—“the moral equivalent of war.” On July 15, Carter delivered to a nationwide TV audience what came to be called his “malaise speech,” even though he never used that word (Carter 1979). Despite getting good initial reviews, the speech soon came to be widely panned for its negativity. It was viewed as being symptomatic of a failed presidency.

Within days of that fateful speech, Carter was cleaning house—firing, among others, Secretary Blumenthal and the first secretary of energy, James Schlesinger. (Carter had established the Department of Energy in 1977.) Miller, who was clearly a misfit at the Fed in any case, quickly replaced Blumenthal at the Treasury, leaving the Fed chairmanship vacant—but not for long. Carter moved almost immediately to nominate Paul Volcker, the well-known and iron-willed inflation hawk who was then president of the Federal Reserve Bank of New York, to replace Miller. The Senate confirmed Volcker within a week.

Volcker took over at the Fed on August 6, 1979, with little doubt about what would happen next. No more Carterite ad hoc approaches to fighting inflation, like naming anti-inflation czars and flirting with wage-price guidelines. No more Burns- or Miller-like excuses that the Fed was overwhelmed by stronger societal forces that rendered it unable to control inflation. It was going to be tight money—period. Carter harbored no illusions about what he was in for when he placed Volcker in charge of monetary policy, up to and possibly including defeat in the 1980 election. In Eizenstat’s words, “Carter courageously appointed Paul Volcker to head the Federal Reserve in full knowledge that this determined public servant would deploy the blunt instrument of tight money and high interest rates. This ultimately squeezed inflation out of the economy at the cost of high unemployment and helped squeeze him [Carter] out of a second term” (Eizenstat 2018, 278). The contrast with Nixon’s appointment of Burns could hardly have been more stark.

Volcker reports being surprised when Miller first called to ask him to come to Washington to meet Carter. “I had never met the president. I had voted against Miller in Open Market Committee meetings. But, of course, I got on the [air] shuttle” (Volcker 2018, 108). After telling Carter that he felt strongly about both Fed independence and fighting inflation, Volcker returned to New York, telling his friends that “I just blew a chance of becoming Fed chair” (108). He was wrong. Early the next morning Carter called to offer him the job and, as Eizenstat observed, perhaps to doom his own reelection prospects. But Carter had at last found an effective weapon against inflation: a resolute Fed chair.

A long-standing controversy rages to this day over whether expectations of tighter monetary policy in the future should raise or lower long-term interest rates. On the one hand, if the market deems the news credible, inflationary expectations should decline, thereby lowering nominal interest rates. On the other hand, however, expected future short rates should rise. According to the standard expectations theory of the term structure, which holds that long rates are the appropriate weighted average of expected future short rates, that should boost longer-term interest rates. Keynesians tended toward the latter prediction. Monetarists tended toward the former, as did Volcker.¹² But as he put it in his autobiography, “No such luck” (Volcker 2018, 108).

The appointment of Volcker in the summer of 1979 might have offered an acid test of one hypothesis against the other, but apparently it didn’t. The ten-year Treasury rate, which stood at 8.99 percent on the day Carter nominated Volcker (July 25, 1979), was 8.91 percent on the day Volcker took over at the Fed (August 6, 1979).¹³ Could the mighty Volcker have been worth only 8 basis points? That seems implausible.¹⁴ But the action on interest rates came later, when the Fed raised short rates. Long rates went up. The thirty-year Treasury rate, for example, rose more than 100 basis points between late September and late October 1979.

In late September Volcker few to Belgrade, in what was then Yugoslavia, for the annual meetings of the International Monetary Fund and the World Bank. There, among other things, he sat through what should really be called Arthur Burns’s malaise speech (described in chapter 4). Before leaving Washington, Volcker had left instructions with some top Fed staffers to think about a new approach to monetary policy that would amount to “practical monetarism,” that is, to paying more attention to growth in the monetary aggregates as opposed to (in Volcker’s words) “the more extreme and mechanistic monetarism that Milton Friedman had advocated” (Volcker 2018, 106).

Remember, monetarists were then the strong anti-inflation constituency in the intellectual world. With assistance from Lucas, Sargent, and other rational expectationists, they had successfully, though unfairly, branded Keynesian economics as inflationary. So, cloaking a new approach to monetary policy in the garb of monetarism made a certain amount of public relations sense. Regardless of whether or not it was Keynesian, the old approach to controlling inflation had plainly not worked.

Volcker left the Belgrade conference early to fly back to Washington and get to work on the Fed’s new monetarist-style policy. Then on October 6, 1979, he did something that Fed chairs virtually never do: he called an impromptu press conference—on Saturday night yet! Reporters who cancelled their entertainment plans for the night and attended en masse were not disappointed. Volcker told the assembled press corps that the FOMC had decided, at an unscheduled meeting earlier that day, to shift its focus away from day-to-day management of the federal funds rate and toward the growth rate of bank reserves (and thus of the money supply). As he put it at the press conference, “By emphasizing the supply of reserves and constraining the growth of the money supply through the reserve mechanism, we think we can get firmer control over the growth in money supply in a shorter period of time.… But the other side of the coin is [that] the daily rate in the market … is apt to fluctuate over a wider range than had been the practice in recent years” (Volcker 1979, 4).

A “wider range” indeed. As figure 7.3 shows, Treasury rates became much more volatile after October 1979. And it wasn’t just more volatility; they headed upward. The three-month Treasury bill rate, which was 10.7 percent on the day before Volcker’s press conference, leaped to 12.8 percent by October 22.¹⁵ The effective federal funds rate, which averaged 11.4 percent in September 1979, averaged 13.8 percent in October 1979 and was up to 17.6 percent by April 1980.

Republicans, Democrats, and ordinary citizens alike were alarmed by such unprecedentedly high rates. They made their displeasure known to the Fed in a variety of ways, ranging from pointed criticism in congressional hearings to two-by-fours mailed in by home builders to death threats. By the end of 1980, Fed security personnel insisted that Volcker get armed protection (which the Fed chair retains to this day). Their judgment was not wrong. A year later, an armed intruder somehow got into the Fed’s headquarters building and threatened to take the Federal Reserve Board hostage. Those were trying times indeed. But Volcker was a man on a mission, not easily deterred—a tower of strength and always true to his word.

FIGURE 7.3. Selected U.S. interest rates, 1978–1983.

Source: Board of Governors of the Federal Reserve System.

The Babe Ruth of Central Banking

Paul Anthony Volcker Jr. will forever be known as the man who conquered inflation in the United States. He did it the old-fashioned way: with excruciatingly tight money. More important, he did it at a time when many people thought the task was either impossible or vastly more costly than it turned out to be. Beating inflation required an iron will. Paul Volcker had one.

Volcker was born in Cape May, New Jersey, and attended Princeton University, where his senior thesis criticized the Federal Reserve’s recent (ca. 1949) monetary policy. Princeton’s motto at the time was “Princeton in the nation’s service,” an ideal Volcker exemplified. That attitude was instilled in him by his father, who was a city manager, and lasted a lifetime.

After Princeton, Volcker studied economics at what we now call the Kennedy School at Harvard and then at the London School of Economics. Returning to the United States in 1952, he took a job as an economist at the Federal Reserve Bank of New York, thus beginning a lifetime of public service. After a detour at the Chase Manhattan Bank, Volcker’s career in government began in earnest when he joined the U.S. Treasury in 1962. Within two years, he had risen to the rank of deputy undersecretary for monetary affairs. Then after a second stint at Chase, he returned to the Treasury in 1969 as the undersecretary for international monetary affairs, a position he held for five tumultuous years. Notice that this quintessential technocrat, though a Democrat, was appointed by President Richard Nixon.

As undersecretary, Volcker was present at the destruction of the Bretton Woods system of fixed exchange rates in August 1971, which must have pained him, for he was to the end a believer in the importance of stable exchange rates. But he soldiered on as the Western world stumbled toward floating exchange rates.

Leaving the Treasury in 1974, Volcker spent a year teaching at his alma mater before being appointed president of the Federal Reserve Bank of New York, where among other things he established strong anti-inflationary credentials. When President Carter needed a new tough-on-inflation Fed chair in 1979, Volcker was the heir apparent.

A pillar of strength, probity, and integrity, Volcker remains a legend at the Federal Reserve. When rumors (which proved true) arose that President Ronald Reagan would not reappoint Volcker as Fed chair in 1987, I penned a column in BusinessWeek lauding him as “the Babe Ruth of central banking.” I wrote then that “I reacted to the idea of replacing Volcker as the Boston Red Sox should have responded when the Yankees requested a trade for Babe Ruth: out of the question” (Blinder 1987c).

Volcker’s devotion to public service did not end when his term as chair of the Fed did. Never one to say no to a good cause, he went on to, among other things, chair committees or commissions investigating Swiss bank reparations to Holocaust survivors, the United Nations tarnished Oil-for-Food Programme, and internal problems at the World Bank. Every major organization with a knotty problem on its hands, it seemed, wanted a “Volcker commission” to set things right.

What about those money growth rates? Did they stabilize? Well, you be the judge. Figure 7.4 shows the growth rate (from twelve months previously) of what the Fed now measures as M1 and M2 (the definitions of the Ms have changed many times since 1979) from 1978 through 1983, just after the monetarist experiment ended. I find it hard to see less volatility after October 1979, and monetarists complained bitterly about that. As Volcker put it in his autobiography, “The monetarists, led by Milton Friedman, instead of claiming victory that the Fed was finally adopting a more monetarist approach, insisted we weren’t doing it just right” (Volcker 2018, 109). Here’s one example, from a Milton Friedman Newsweek column: “The Fed’s targets for monetary growth have been reasonable. The problem is with the failure to achieve them. If a private enterprise’s actual production deviated from plan as frequently and by as much, heads would roll” (Friedman 1980, 62).

It wasn’t just a matter of some technicalities such as lagged reserve accounting, which monetarists disliked and which made precise control of money growth harder than need be.¹⁶ Rather, the combination of high inflation, vestigial controls on nominal interest rates (which were subsequently removed), and a rash of financial innovation—itself largely a consequence of high inflation—wreaked havoc on the Fed’s ability to come anywhere close to hitting its targets for M1, M2, or any number of other definitions of “money” that the Fed staff tried.¹⁷

FIGURE 7.4. Growth rates of M1 and M2, 1978–1983.

Source: Board of Governors of the Federal Reserve System.

Even Allan Meltzer, as devout a monetarist as you’ll find, admitted that “monetary innovation added to the difficulty of choosing a path [for money growth] and announcing it to the public” (Meltzer 2009a, 1039). Put simply and without econometric detail, when you don’t know what is happening to the demand for money, it is hard to formulate sensible targets for the supply of money, much less to hit them. The Fed had fits trying to do either.

One interesting question in monetary history lingers to this day: Did Volcker truly convert to monetarism as a better policy approach, or did he just view the pretense of focusing on money growth as a convenient political heat shield for what he knew was to come, excruciatingly high interest rates? More Fed watchers lean toward the latter explanation. So do I.

Volcker himself is a bit cagey on the question in his autobiography. After quoting Friedman’s well-known dictum that “inflation is always and everywhere a monetary phenomenon,” Volcker immediately notes, first, that “the simplicity of that thesis helped provide a basis for presenting the new approach to the American public” and, second, that the avowedly monetarist approach “enforced upon the Federal Reserve an internal discipline that had been lacking” (Volcker 2018, 118). So, perhaps the monetarist experiment was really about public communication and private commitment, about tying the FOMC to the mast, not about any belief in the stability of velocity.

Stuart Eizenstat, who watched the monetarist experiment from the Carter White House, viewed it differently. After acknowledging Volcker’s credibility arguments, Eizenstat added that “Volcker was no political babe in the woods. He also knew that this method provided more political cover than directly jacking up interest rates” (Eizenstat 2018, 345). Eizenstat quotes Volcker as saying in an interview that “this was certainly an easier way to get public support. You can say that we’ve got to keep the money supply under control; that’s what we’re doing; we’re not directly aiming at interest rates” (345). A few years later when asked by a friend whether he really was a monetarist back then, Volcker replied directly, “Nah, I just wanted to shake ’em up” (345).

And shake ’em up he surely did. Yet through the first quarter of 1980, both inflation and interest rates remained sky-high, and there was no recession. Weak growth, yes, but no actual decline in real GDP. According to current data, the real GDP growth rate was just 1 percent (seasonally adjusted annual rate) in 1979:4 and 1.3 percent in 1980:1. Observers both inside and outside the Fed were growing impatient. But remember, the lags in monetary policy are long. Then in 1980:2, the anvil dropped.

The Credit Controls Catastrophe

Ironically, it was not Volcker who dropped the anvil. It was Carter, using the Federal Reserve as his chosen instrument.

The president and his inflation czar, Alfred Kahn, had become convinced that excessive growth of consumer credit was fueling inflation rather than, say, inflationary expectations, business spending, or excess money growth. The Fed did not share this view.¹⁸ However, Carter had legal authority, left over from the Nixon years, to ask the Fed to impose credit controls and he used it in March 1980. Looking back on that decision, Eizenstat termed it “a monumentally bad idea” (2018, 347). It was. Volcker and his colleagues at the Fed certainly thought so, though even they were probably surprised at just how bad it turned out to be.

Volcker later recounted that the Fed saw credit controls as “a transparently political ploy” at a time when “excessive credit wasn’t the problem” and so “quickly designed ‘controls’ that we hoped would lack real teeth” (Volcker 2018, 110). But the politically astute Fed chair felt that the central bank, though independent, could not just turn Carter down flat. After all, the president was supporting their tight-money policy despite evident political peril to himself. So, the Fed staff designed credit controls that, for example, exempted borrowings to finance automobile and home purchases. Leaving a toothless tiger, right?

Well, actually not. It turned out that Carter’s well-publicized emphasis on restricting credit resonated strongly with an American public that was sick and tired of high inflation. The response was entirely unlike what had followed Gerald Ford’s fruitless Whip Inflation Now campaign in 1975. This time, “people were so desperate to do their part to fight inflation, they tore up their credit cards as a patriotic act and sent the pieces to Kahn and the White House, accompanied by letters saying: ‘Mr. President, we will cooperate’ ” (Eizenstat 2018, 348).

Those were apparently not empty gestures. Consumer spending crumbled, taking GDP growth down with it. The second quarter of 1980 stands out as one of the worst quarters in postwar U.S. history, with an annualized growth rate of −8 percent (figure 7.5). Consumer spending, normally one of the most stable components of GDP, led the way, dropping at an incredible 8.7 percent annual rate. Patriotism apparently trumped both interest rates and money growth.

FIGURE 7.5. Annualized growth of real GDP, quarterly, 1979–1983.

Source: Bureau of Economic Analysis.

The National Bureau of Economic Research dates the short but sharp recession of 1980 as starting in January and ending in July. For a president seeking reelection, that timing is about as bad as it gets. (Carter was also dealing, unsuccessfully, with the Iran hostage crisis at the time.)

The controls also held bad news for the monetarist experiment, since the flip side of less credit card lending was a sharp decline in money supply growth. Monthly M1 growth plummeted to −5 percent (seasonally adjusted annual rate) in March 1980 and to an astounding −13 percent in April. Even on a twelve-month basis, M1 growth fell from 8.3 percent in February 1980 to just 4.1 percent in April. Those were big changes for a central bank that was putatively stabilizing money growth. (Would a truly monetarist Fed have juiced up the money supply?) Yet despite the abrupt decline in money growth, interest rates plunged, and as Volcker put it, “we had to backpedal fast” (2018, 111).¹⁹

By August–September 1980, with credit controls gone, both money growth and the economy perked up, and the Fed felt compelled to tighten once again. Its discount rate hike in late September came with the election barely more than a month away. Not surprisingly, this was not well received at the White House; Carter termed it “ill-advised” (Volcker 2018, 111). Yet progress against inflation was grudging. (Remember the long lags.) Core CPI inflation did plunge to 5.5 percent briefly during the third quarter of 1980, but it was back above 14 percent by the fourth quarter.²⁰

Running Away from Monetarism

Things did not get much better for Volcker and his band of fledgling (or was it pseudo?) monetarists in 1981 and 1982. Ronald Reagan had replaced Jimmy Carter in the White House, but both interest rates and money growth rates remained volatile. Core CPI inflation was still almost 12 percent as late as September 1981 (but just 9.4% according to the BLS’s research series), and then it plunged. The soaring dollar at the time no doubt played some role in this disinflation. The economy grew strongly during the snap-back from the artificial recession of 1980, but a real and very deep recession began in 1981:2. By 1981:4 and 1982:1, it was clear to the Fed that this was no garden variety recession; it was a whopper. At the time, it was the deepest recession since the 1930s.

The Reagan tax cuts, which will be discussed in the next chapter, had not kicked in much by the summer of 1982. So, it was clear to Volcker and his colleagues at the Fed that they had to ease up on monetary policy quickly lest the deep recession turn into something even more ugly. By the fall of 1982 monetarist doctrine stood in the way of doing so, which made it clear that monetarism had to go. The doctrine had not worked anyway. At the October 5, 1982, FOMC meeting, Volcker told the committee that “following a mechanical operation because we think that’s vital to credibility and driving the economy into the ground isn’t exactly my version of how to maintain credibility over time” (FOMC 1982). To Volcker and his colleagues on the FOMC, monetarism had served its purpose. Inflation was, at last, heading down.

In October 1982, Volcker announced that “I do not believe that … we have any alternative but to attach much less than usual weight to movements in M1 over the period immediately ahead” (American Banker 1982). This was an understatement. The “temporary” suspension of money growth targeting turned out to be permanent. Monetarists were not pleased, but the Fed’s monetarist experiment was over. It was not until July 1993, however, that Alan Greenspan officially abandoned any semblance of money supply targeting by the Fed, telling a Senate committee that “the relationship [between money growth and economic growth] has completely broken down” (Greenhouse 1993). Greenspan was right, of course. But that “news” came more than a decade after the fact.

Chapter Summary

Jimmy Carter came into office in January 1977 viewing the economy as still weak, probably weaker than it actually was. Appropriately, given that belief, he recommended and Congress passed a modest fiscal stimulus. However, the year 1977 was perhaps most notable in the history of stabilization policy for the formalization of the Fed’s dual mandate in the Federal Reserve Reform Act of 1977.

In retrospect, Carter’s fiscal policy in 1977–1978 and the Fed’s monetary policy under G. William Miller appear too expansionary, although both food shocks and OPEC II deserve much more blame for the alarming rise in inflation in 1979–1980. Seeking a solution, Carter turned to the well-known inflation hawk, Paul Volcker, who emphatically rejected the idea that inflation was beyond the central bank’s control. Leaving aside his flirtation with monetarism, Volcker knew what to do, and he had the iron will necessary to do it. Tight monetary policy, in conjunction with the passing of the supply shocks, brought inflation down, though not quickly and certainly not painlessly.

Credit controls, which are not part of the usual monetary-fiscal canon, caused a short but deep recession in 1980. That was followed by a more traditional recession, caused by tight money, in 1981–1982. Together, those dual recessions broke the back of core inflation. By October 1982, with the war on inflation well on its way to victory, Volcker and the Fed were ready to abandon any pretense of monetarism. And they did.

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1. For example, a Harris poll conducted from September 18 to September 26, 1977, found 54 percent of people answering “Is” to the question “Do you think the country is in a recession or not?” (Louis Harris & Associates 1977).

2. The New York Times noted on December 4, 1976, that Lance “faces a formidable challenge in attempting to master the far greater complexities of the Federal bureaucracy with which he has had no previous experience” (Mohr 1976).

3. He resigned as a result of a banking scandal but was later acquitted.

4. Only a small share of the rising inflation could be traced to the falling dollar.

5. A quirk in the CPI—later fixed—exaggerated inflation by counting rising mortgage interest rates as rising prices.

6. This provision basically codified into law what Congress had directed the Fed to do in Concurrent Resolution 133 in 1975.

7. In addition, a measurement error, discussed later in this chapter, exaggerated inflation in 1978–1981.

8. More than two decades earlier, Blinder (1982, 270) had observed that a remarkably large proportion of the food inflation in 1978 and 1979 was actually “meat price inflation,” the result of a sharp reduction in cattle herds followed by severe winter weather and rising feed costs.

9. See, for example, several of the chapters in Bordo and Orphanides (2013).

10. Board of Governors of the Federal Reserve System, “G. William Miller,” Federal Reserve History, Federal Reserve Bank of St. Louis, https://www.federalreservehistory.org/people/g_william_miller.

11. Among the many references that could be cited complaining about this error, see (Blinder 1980).

12. There are probably hundreds of possible references on this debate. For the monetarist view, see, for example, Wray (1993). For the Keynesian view, see, for example, Mishkin (1995).

13. Federal Reserve Bank of St. Louis, Federal Reserve Economic Data.

14. In case you’re thinking that Volcker’s nomination was anticipated by the markets in advance, the long rate did not move much in the days prior to July 25 either.

15. By the middle of June 1980, amid the sharp recession discussed below, it was down to 6.2 percent.

16. As practiced at the Fed, lagged reserve accounting meant that required reserves were based on deposit volumes two weeks earlier.

17. Among many sources on the instability of money demand, see Goldfeld (1976).

18. There is a long-running doctrinal dispute, which will not detain us here, over whether monetary policy works mainly through the money supply channel or mainly through the credit channel.

19. This backpedaling may have cost the Fed some credibility. See Bordo et al. (2017).

20. The latter was heavily affected by the measurement error mentioned earlier. The BLS research series records a 7.9 percent CPI inflation rate in the fourth quarter of 1980.