Paul Volcker's Most Important Lesson: Echoes

It's difficult to recall now the seriousness of the U.S. economic slump at the end of the 1970s. Growth was weakening, the dollar was sinking and, even worse, inflation was accelerating rapidly. Confidence in U.S. economic leadership was plunging at home and abroad.

Then, on Aug. 6, 1979, Paul Volcker took over as chairman of the Federal Reserve Board. His appointment came as a relief to the markets because of his experience at the New York Fed and the Treasury, but more importantly because he questioned the common view that a higher inflation rate had favorable effects on employment. He was determined to bring price stability and better economic performance to the Fed.

The markets quickly lost confidence in Volcker’s ability to lead. On Sept. 18 of that year, the Fed approved an increase of 50 basis points in the discount rate. The decision was very close -- only 4 votes to 3 -- which raised doubts about Volcker's leadership and the chance of restoring sound monetary policy.

What followed was a masterful reversal. Soon after the Sept. 18 meeting, Volcker developed a new approach to monetary policy that received the support of every member of the board and every Federal Reserve Bank president. It included a full percentage-point increase in the discount rate to start fighting inflation; a new reserve requirement on large banks to restrain lending; and an "operating procedure" that placed more emphasis on money and reserve growth and less on setting the discount rate. All these changes were unanimously agreed to and then announced on Oct. 6.

That shift in priority allowed Volcker to say it was the market, not the Fed, that was controlling the federal-funds rate, which meant that interest rates could still go higher, if need be, to limit inflation.

I recall a conversation sometime thereafter with Volcker and several other economists, including James Tobin, the Nobel laureate from Yale University. We were all relaxing at a bar in Washington after a daylong conference at the Brookings Institution. Tobin was complaining about how high interest rates were causing the economy to sink, and candidly asked: "Paul, why don't you just lower the interest rate?"

Volcker shot back: "I do not set the interest rate. I set the money supply, and the market then sets the interest rate."

The high borrowing costs called for by the new operating procedure implied more economic weakness for a while, as well as a great degree of fortitude by Volcker and his colleagues. Mail arriving at the Fed included two-by-fours sent from members of the construction industry furious that homes weren't being built, as Amity Shlaes mentioned in her column earlier this week. Angry farmers circled the Fed building in Washington.

Nevertheless, after Volcker was asked on "Face the Nation" about when he would change from "fighting inflation to fighting unemployment," he answered, "I don't think we can stop fighting inflation. I think we've got to keep our eye on that inflationary ball," according to Allan Meltzer's book "A History of the Federal Reserve."

Volcker and his colleagues were resolute, and their efforts paid off. Inflation slowed dramatically, which set the stage for two decades of strong economic growth.

This history provides a valuable lesson for economic policy: Both knowledge and leadership are essential. Simply knowing economic theory or proposing a policy isn't enough. Volcker understood the economic forces that were causing the rising inflation rate through much of the 1970s. But implementing a solution required leadership, especially coalition-building.

He designed the new procedure to receive wide support at the Fed, and he succeeded. Technical knowledge was also required, especially because the lagging reserve requirements in place at the time were not well suited for the new procedures.

More importantly, Volcker's plan meant having to stay the course for years -- through very difficult times.

(John B. Taylor, a contributor to the Echoes blog, is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution.)

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