Paul ‘Darth’ Volcker (1927-2019): Monetary Jedi Knight, or Sith Lord?

Shortly after assuming the role of Chairman of the US Federal Reserve in 1979, Paul Volcker was nicknamed ‘Darth Volcker’ – after the first Star Wars trilogy’s infamous antagonist, Darth Vader. While vilified early in his term for raising interest rates and causing a deep recession, the eventual success of his policies garnered him a reputation as a ‘hard-money’ man who ‘saved’ the US from spiralling stagflation: a monetary ‘Jedi Knight’, if you will. So what’s the posthumous reputation he most deserves?

Well, it depends largely on your perspective on modern US economic and monetary history. In many ways, Volcker’s career personifies the fundamental policy transformation that occurred during and following the end of the Bretton-Woods era.  Indeed, a strong case can be made that his most famous policies, or those he advocated, were attempts to correct prior policy mistakes in which he had a hand. It is these early years of Volcker’s – the story of how the stagflation he was so famously to slay in part arose from his own actions – that this article explores.

The changes in economic and monetary policy orthodoxy during his career were profound. While the global economy was still operating under the Bretton-Woods arrangements, the economic mainstream generally held the following to be true:

(1) Public deficit spending was desirable only as a temporary remedy to soften downturns and thereby manage the economy, rather than something chronically necessary to provide a public debt supply for private sector savings. Under Eisenhower, the US even ran surpluses, notwithstanding the lingering hangover from WWII debt servicing costs.

(2) Fixed exchange rates and a dollar backed by gold were desirable because these promoted price stability and prevented economically-destabilising boom and bust asset markets.

(3) Relatively high rates of US productivity growth ensured the US would continue to run balance-of-payments surpluses notwithstanding the ongoing rebuilding of Europe and Japan’s export industries.

 

Volcker’s Career in Government Service began at the State Department during the 1960s where he served first as the Deputy Undersecretary and later Undersecretary for International Monetary Affairs under presidents Johnson and Nixon, respectively. During his early tenure, the third assumption above was being questioned. While the US was still a net exporter at the time, Europe and Japan were catching up fast, and US fiscal policy had become highly expansionary. Foreign official and private buying of gold rose in anticipation that either the US would eventually swing into deficit, or it would devalue the dollar – possibly both.

Already from the mid-1960s, the US was selling gold into the market to prevent the price rising too far or fast. By 1971, however, the situation had become untenable. There was an accelerating run on the US gold stock by foreign governments and private investors, indicating an imminent balance-of-payments crisis. A high-level debate about how to fight the crisis began, conducted primarily in private, but occasionally breaking out into the public sphere. The most prominent such moment came in early 1965 when French President Charles De Gaulle made a speech demanding that the Bretton-Woods system be reformed, placing gold itself, rather than a US dollar backed by gold, at its centre.

Within the US there were some officials such as Chairman of the Federal Reserve Arthur Burns who advocated getting at the root of the problem – that is, the domestic policy set of fiscal expansionism and interest rates insufficiently high to make the dollar as, if not more, attractive to foreign capital than gold or other currency alternatives.

On the other side were those such as Volcker who believed that US domestic economic policy objectives were sufficiently compelling that, if it were necessary to support growth, the dollar should be devalued. At the same time, however, they also believed that the Bretton-Woods system, credited with providing critical foundations not only to US economic prosperity but also the now-well-advanced rebuilding of Europe and Japan, should under all circumstances be retained.

Note that not one senior economic official supported ending the Bretton-Woods system by permanently suspending the dollar’s official gold backing. Not one. There is no record of this possibility even being discussed.

Nixon, a cunning political animal, knew that the first option would almost certainly cause an immediate, sharp recession, making it highly unlikely that he would be re-elected the following year. Treasury Secretary John Connally, an equally cunning political animal, knew likewise. And so, when Volcker and others pushed for devaluing the dollar not only versus gold but also versus the currencies of US trading partners to restore balance to the global economy, he had his bosses naturally on side.

However, in order to buy time for negotiations to devalue the dollar – and for Nixon to be re-elected, of course – Volcker advocated a temporary freeze on the conversion of dollars into gold or other non-dollar assets. While negotiations to this effect took place between 1971 and 1973, they somehow failed to restore a link between the dollar and gold. Rather, the Bretton-Woods arrangements were replaced by a new regime in which currencies, unbacked by gold, floated versus one another. Relative to real assets such as gold, oil, and other commodities, however, they sank. And inflation soared.

So why did the US’s major trading partners agree to such an arrangement? Well, for one, it conveniently gave all governments the ability to stimulate growth and finance deficits more easily than before. While a few countries with established hard money cultures, such as West Germany and Switzerland, exercised a certain amount of fiscal restraint, few imagined at the time that this would lead to nearly all US trading partners running chronic budget deficits in the subsequent decades, and to a series of ever-larger financial crises. Yet this is precisely what happened.

There were a handful of prescient observers who predicted this outcome in whole or part. Among them was legendary French economist Jacques Rueff, advisor to presidents De Gaulle and D’Estaing. Rueff’s classic critique of the post-Bretton-Woods monetary regime, The Monetary Sin of the West. John Exter, Volcker’s colleague at the New York Fed, predicted that gold would retain its safe-haven status and become the ‘go-to’ asset in future crises, as indeed it has. And Henry Hazlitt, one of the most prominent New York Times and Newsweek columnists of the era, explained how, in time, the US economy would become plagued with bouts of inflation and resource misallocation that would dampen productivity and growth, leading ultimately to occasional financial crises.

Volcker will almost certainly always retain a strong reputation for ending the high inflation while chairman of the Fed. But if we acknowledge him as the Jedi Knight on one side of the coin, we would do well to remember the Sith Lord Darth Volcker on the other – the knight’s alter-ego partially responsible for causing the disease he subsequently help to cure with bitter monetary medicine.

 

 

 

John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.

 

 

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)