Volcker biographer: Bernanke needs to embrace lessons of 1970s

September 25, 2012

Former Federal Reserve Chairman Paul A. Volcker offers important lessons for Ben Bernanke and the current Fed, a biographer argues.

The ideas and legacy of Paul A. Volcker loom as large in contemporary economic debates as his 6'7" frame. From the merits of the most recent Federal Reserve actions to boost the economy to how to regulate Wall Street, many of the challenges of today have echoes of those that the former Fed chief grappled with in a five-decade career. William L. Silber has written a rich and detailed new biography of a man who has left as deep an imprint on the world economy as anyone of his generation. Silber, a professor at New York University and author of a bestselling textbook on money and banking, discussed the lessons for the present from his new book, “Volcker: The Triumph of Persistence.”

Washington Post: What do you see as the lessons that Ben Bernanke and the current Federal Reserve should be taking from Volcker’s experience in the 70s and 80s?

William L. Silber: I’m going to preface what I say with this: Bernanke gets an A for what he did in 2008. He did exactly what a central banker, knowing the history of the Great Depression, should have done when confronted with the potential for panic. Open up the floodgates and lend. But now he should worry about the fallout from remaining too easy for too long, which Volcker maintains is the reason we lost the battle against inflation before.

The 1970s delivered two important messages. First, we can’t get a permanent reduction in unemployment by inflating. It doesn’t work. And second, we’ve got to worry about inflation even with unemployed resources. Waiting until we see a clear and present danger is too late. Will there be a recovery in economic activity in the United States? Yes. Is this recovery taking longer than almost everyone thought it would? Probably. But the leveraging process that got us into trouble took years. We can’t expect the de-leveraging to happen overnight. And letting monetary policy ease the de-leveraging by inflating will only get us into more trouble.

Volcker articulated a view on the fundamental evil of inflation that I had never thought of until I wrote this book – and I had been analyzing inflation for a long time before that. He believes that the main problem with inflation is that it undermines trust in government. We, as citizens, give the government the right to print money and we expect the government not to abuse that right by inflating. When the government inflates it breaks its pledge and undermines our trust. Right now we need trust in government more than anything else.

WP: But inflation hasn’t been much of a problem the last four years. Shouldn’t be the Fed be focused on addressing the major economic problem of today, unemployment, just as Volcker addressed the major problem of his day, inflation?

WLS: The big difference today versus the problem Volcker confronted in 1979 is that inflationary expectations were already out of hand back then. Today they are still under control, but no one knows how fragile they are. More importantly, it will be difficult for Ben Bernanke, or whoever follows him, to maintain low expectations of inflation by raising real interest rates – the way Volcker did — when that’s needed. We have had five years of unemployment and the American public may not tolerate a central bank that acts preemptively, as it must, to prevent inflation. The Fed is independent but it cannot do whatever it wants. Moreover, the Fed does not know how high rates need to go to maintain control. So it is not clear that the Fed will be willing and/or able to do what is necessary to control inflation. Bernanke needs to replace the lessons of the Great Depression, which helped until now, with the teachings of the 1970s and 1980s, which are needed going forward. 

WP: So what can Washington do to address the weak recovery?

WLS: We need short-term budget stimulus, like increased unemployment insurance, to bolster spending, but we also need long-term fiscal restraint, like fixing Medicare and Social Security, to promote trust in the government’s ability to meet its obligations. The Fed can help by focusing on what we know it can do, which is to maintain price stability.

WP: You write that President Obama passed over Volcker, who had advised him during the campaign, to joint he administration full-time. How do you think the last few years might have been different with Treasury Secretary Volcker?

WLS: It’s pretty clear the Volcker rule [enacted as part of Dodd-Frank financial reforms that prohibits banks from engaging in speculation] would have happened more quickly and without as many holes.

WP: How would you characterize how much influence Volcker has truly had on Obama since he became president?

WLS: Not that much, except for the Volcker rule.

WP: As you see regulators try to implement the Volcker rule, what are your thoughts so far? Is it going to work?

WLS: There’s only one way the rule can work: Make the bank's CEO legally and publicly accountable for implementing the ban on speculation. No matter how many regulators we have they’ll never stop the speculators unless bank executives help. And they can. I was a trader and had to report my activities to the manager of a trading desk. The trading manager knew when I had taken more risk by speculating than by market-making. He looked at the size of my inventory, frequency of trading, and so on. If the CEO gives very clear marching orders to trading managers then 95 percent of the problem will disappear. Will it mean no more blowups? No, but they will be held to a respectable minimum. That’s all we can hope for, and all the Volcker rule can accomplish, which would be a lot.

WP: Volcker’s critique of modern Wall Street has long been that it has been corrupted by excessive compensation and a pursuit of innovations that don’t actually benefit society. Do you agree?

WLS: People cite Volcker’s quote about the ATM [he has said that the only socially useful financial innovation of the recent times was the automated teller machine]. I love the ATM machine. Anybody who ever stood in line to cash checks loves the ATM machine. But it’s not as important as the invention of index funds in the mid-1970s. Index funds have helped investors diversify risks at low cost and have revolutionized the mutual fund industry for the better.  The same could be said of money market mutual funds. I don’t expect to convince Volcker, but there have been some very beneficial financial innovations in addition to the ATM.

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