Tuesday, June 17, 2008

What would Paul Volcker do?

Paul Volcker is the legendary Federal Reserve Chairman who was appointed by Jimmy Carter in 1979, a role he served in till 1987.

The Federal Reserve Bank has two objectives which often conflict - to control inflation and to keep unemployment low. Prior to Volcker, Fed chairmen always concentrated on keeping unemployment low, particularly as terrific pressure was put on the Fed by politicians in the White House and in Congress.

Volcker decided that inflation was the primary evil and set upon squeezing it out of the system with high interest rates, annoying everyone in the process, from the farmers who tried to drive their tractors into the Fed building in protest, to the politicians. However, he got inflation down in the USA from 13.5% to 3.2% by 1983 - and given how the USA tends to export inflation, this was immensely important for the world economy. Most other important central bankers, particularly the Bundesbank, agreed with his strategy. Volcker was only 60 when he stepped down from the Fed - he should really have been reappointed for another term - but by then the Reagan White House had had it's fill of this life-long Democrat with a hatred for inflation, and replaced him with the more amenable Alan Greenspan.

The problems we're are seeing with global inflation go straight back to Greenspan's decision to keep US interest rates at 1% from 2003 to 2004, at a time when US CPI was running at 2% (i.e. real interest rates were -1%, which is inflationary in the extreme). The graph shows real interest rates in the USA. Everytime US real interest rates get negative, the rest of the world suffers from inflation, even if other countries are being prudent in their monetary policy. But all Greenspan was thinking about was unemployment and how to get the US to recover from her short recession. At the time the ECB refused to cut interest rates below 2%, arguing that it was dangerous to have real interest rates below zero. The ECB was able to take this stand because they look at inflation alone, and their robust independence meant they could ignore unemployment of 10% in Germany and the attendant abuse from politicians.

As mentioned in my previous post, we again have a divergence between the USA and Europe. The ECB has announced that it will raise interest rates next month. The market acted surprised, but they shouldn't have been. Interest rates are 4% in the euro-zone and CPI there is 3.7%, which gives a real interest rate of 0.3%, dangerously close to zero. There is no way the ECB would allow the real rate to get to zero, particularly as the eurozone economy is more robust than in 2003. In the UK, interest rates are 5% and CPI is 3.3%, which gives a real interest rate of 1.7%. This too is a little uncomfortable for the BoE, as they like a real rate of at least 2%, especially as we are near full employment. Through most of this decade the BoE has kept the real interest rate at about 3%, which is far higher than the Americans have averaged.

In the USA however, we have interest rates of 2% and a CPI of 3.9%, giving a real interest rate of -1.9%. This is actually worse than their policy in 2003/4. No wonder we are have a global commodity inflation situation. It is becoming increasingly clear that the Fed will have to raise interest rates. Apart from the fact that they are destabalising the world economy in order to gee up domestic employment, it is clear that their policy is hurting the USA itself.

As Volcker understood in the 80's, inflation is worse than temporary unemployment. In April 2005, when US real interest rates were still below zero, he wrote an interesting article in the Washington Post, where he said

At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s -- a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.

.....What is required is a willingness to act now -- and next year, and the following year, and to act even when, on the surface, everything seems so placid and favorable.

.....What I am talking about really boils down to the oldest lesson of economic policy: a strong sense of monetary discipline

Of course Greenspan and Bernanke ignored him. The chief lesson Greenspan learned from the Volcker era seems to have been that you have a short career at the Fed if you annoy the politicians by being too hawkish on inflation. As for Bernanke, he seems too academic and gentle for the job. In particular he seems to be intimidated by Wall Street and their cries for more interest rate cuts to bail them out. The heirs to Volcker are in Europe, but Europeans need to put pressure on the Americans to stiffen their spines. It's no good us standing firm here while the Americans are intent on cancelling out everything we achieve, and more. The Americans need another Volcker.

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