Paul Volcker's legacy
By Scott Sumner
I’m not the person you’d want writing an obituary. In my view, the “Great Man” view of history is mostly inaccurate, and at a more personal level I’m skeptical of the entire notion of personal identity. Thus what we think of as “Paul Volcker” may have little correlation with Volcker’s actual lived experience, or his impact on society.
Nonetheless, by conventional standards Paul Volcker was unquestionably a Great Man, and one with positive influence on society. Here is nominal and real GDP growth (12-month rates) during his years as head of the Federal Reserve:
The period almost perfectly illustrates Milton Friedman’s view of macroeconomics. Consider:
1. Friedman said that nominal shocks drive the business cycle, but have almost no long run impact on real variables. Here you see a strong short run correlation, but longer term you see stronger real growth in Volcker’s last 4 years, despite weaker nominal growth. The gap between the two lines is inflation. When Volcker brought down inflation, unemployment initially increased and then fell back to the natural rate. Real GDP initially declined, and then recovered strongly as the labor market adjusted to lower inflation, to lower NGDP growth. This is Friedman’s Natural Rate Hypothesis.
2. Inflation fell sharply during the 1980s despite fiscal policy becoming far more expansionary. This confirmed Friedman’s view that monetary policy drives inflation, not fiscal policy. It led to the New Keynesian revolution, which gave the Fed responsibility for determining the path of demand.
3. Volcker’s tight money policy caused interest rates to rise for a few months in late 1979-80, and then again in early 1981. In both cases, interest rates subsequently fell sharply. Recall that Friedman argued that low interest rates were a sign that money had been tight. (Emphasis on past tense.)
4. Money velocity fell sharply as inflation declined, just as Friedman predicted.
Of course most of these insights are now in the process of being lost. I recently spoke with a student who took an intermediate macro class at an elite university. None of these Friedman insights were covered. The course was almost 100% vulgar Keynesianism—one expenditure “multiplier” after another, with virtually no discussion of monetary policy. I was told that the professor didn’t “believe in” monetary policy. Students weren’t even told how central banks target inflation.
As the lessons of the Volcker era are being forgotten, we are entering a new Dark Age. Here’s the WSJ:
In the Next Downturn, Fiscal Policy May Have to Step Up
Sigh . . .