"The Triumph of Central Banking?"

Paul Volcker discusses the usefulness of macroeconomic policy:

Paul A. Volcker In Conversation with Gary H. Stern, Minneapolis Fed (pdf): ...Economic knowledge and central banking

Stern: You’ve obviously been involved for a long time directly with the Federal Reserve, at senior levels, from the mid ’70s and even earlier than that in the Treasury as well. In your view, has macro policy or monetary policy changed significantly over those many years? Or are we still pretty much at the state of knowledge, and is the state of our responses pretty much where it was?

Volcker: [Laughter] It’s interesting you ask that question because I recently commented to some of my economist friends that I’m not aware of any large contribution that economic science has made to central banking in the last 50 years or so.

Our ability to forecast is still very limited. The old issues of the relative role of fiscal and monetary policies are still debated. Markets are certainly more complex, and some of the old approaches toward monetary control seem less relevant. Recent events have certainly illustrated limitations in our understanding of the economy.

The advent of floating exchange rates, which partly reflects a shift in academic thinking, has certainly been important, but the underlying problems of policy seem familiar.

Right now, we are in the midst of a very large unsettled question. Are the unprecedented Federal Reserve and other official interventions in financial markets a harbinger of the future? Is reasonable financial stability really dependent on such government support?

On the technical side, there has been continuing change in the approach of central banks to the market, away from more quantitative approaches like the volume of bank reserves to much more emphasis on precise control of short-term interbank interest rates. The point is that in establishing and conducting policy, you need some means of reaching operational decisions. Those approaches have differed and evolved. But none of that breaks new conceptual ground.

Stern: Well, let me explore that a little further because I happened to be reading some of the [Federal Open Market Committee meeting] transcripts from the 1970s, after the oil price shock but before you became chairman, so neither of us was at the meetings.

Volcker: Well, actually I was at the meetings from 1975 as president of the New York Fed.

Stern: Of course, right. So these transcripts were a little earlier in the ’70s. Anyway, all the talk was about “cost-push” inflation and how monetary policy couldn’t do anything about it. That was not only the consensus in the United States, but Federal Reserve officials who were traveling in Europe and talking with their counterparts heard the same message. Looking back at that from today’s perspective, I think you’d be hard-pressed to find policymakers or economists who would accept that view.

Volcker: No, I think that’s basically true. You know, the clearest articulation of that point of view was in Burns’ farewell speech, “The Anguish of Central Banking,” which was a long lament about how the Federal Reserve couldn’t deal with inflation because of all the political and economic pressures, and wasn’t that too bad. He made that speech at an IMF [International Monetary Fund] meeting about two months after I had become chairman.

So, when I gave my valedictory speech, I called it “The Triumph of Central Banking?” I put a question mark at the end. Somebody ought to write about this, how central banks became so important in the public mind and in their own mind in the past 10 years or so. Independence of central banking became part of the approach in almost every country. And I think you can make a case that it’s been a little overdone, that central banks suffer from hubris, like everybody else.

Stern: I think that might be right, and I want to explore that a little bit, but I would say, you’re personally responsible for that, because not only did you and your colleagues at the Fed succeed in bringing down inflation, but you did so when the general consensus was that nothing could be done about inflation, that we just had to live with it. So I think your success in bringing down double-digit inflation helped to establish the significance of monetary policy and central banks.

Volcker: You know, talking about whether economists have learned anything or contributed to monetary policy in the last several decades, Chairman Bernanke gave a speech at Princeton right after he took office which was an intellectual review of economists’ views of monetary policy.

I don’t recall all the substance of it, but he said basically that economists were ahead of central bankers in understanding important issues, going back to the 1920s and before and certainly in the Great Depression. But he went on to say that there was one area where the policymakers were ahead of the economists.³

It was an interesting comment. I don’t know if he made it because he knew I was in the audience at the time. But he said something to the effect that the academic economists had to learn from central banking about the importance of maintaining a strong sense of price stability. He has translated that into inflation targeting, I guess.

The effectiveness of policy

Stern: You mention that you thought, maybe now, or certainly in the last 10 years, there was a point where we had too much confidence, too high a level of expectations for monetary policy. I’ve been thinking about that as well, because obviously we’ve had a very significant financial shock to the economy, and one of the consequences of that has been a long and deep recession, and high unemployment. You’re familiar with all this. There seems to be a view that policy, both monetary and fiscal, can somehow fix this quickly. I guess I’m very uncomfortable about that.

Volcker: I don’t think it can. I’ve been dealing with this in a political environment. The other day I’d gotten a paper prepared for the presidential advisory board that I’m the chairman of. It talked about housing and mortgages and so forth. It concluded, “We’ve got to do something to support housing,” so it recommended means of spurring mortgage creation.

But then it went on, “We’ve got to do something to support consumption.” There I begin to wonder. We can do something to support consumption, but are we really dealing with the underlying pressures in the economy without permitting a relative decline in consumption to proceed?

Stern: Right.

Volcker: It’s not an easy question, if you try to explain that. Mr. Obama is out there every day having to explain things and would he say, “Well, I don’t think I want to push a big stimulus on consumption”? I don’t think he’s about to say that, but he probably should be saying that.

Stern: The pressure seems to be now from the press I follow, “You’ve got to find policies that will create jobs,” and again, who could object to that? But it’s not obvious that there are a lot of tools that would be effective at that in the short run.

Volcker: No, I think this period we’re going through is kind of a curative process; it’s a purgative. There is something to the old view that you have to have a recession once in a while to deal with the excesses of a boom. And I think we had excesses in this boom, for sure, and we’ve got a really difficult recession. You want to relieve the sharp edges, without any question, but I don’t think it’s been possible to pump it up so there’s no recession at all.

Stern: Yes, and part and parcel of recessions are resource reallocations. And we clearly had too many resources in housing and probably too many in finance and in autos—just to name three obvious places.

Volcker: Exactly. We need a recovery that emphasizes investment and competitiveness, and that ends or reduces our dependence on foreign borrowing. ... [Interview conducted July 15, 2009.]