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He’s Got the Whole World in His Hands

The Fed under Volcker began to raise interest rates aggressively in early November 1980, just after Ronald Reagan’s election, and it kept them very high for almost two years before relaxing its policy in August 1982. The federal funds rate—the interest rate on overnight loans between banks—surged, rising six percentage points by the end of 1980. It remained above 15 percent for almost a year, much of the time near 20 percent. High interest rates stifled spending and pushed the economy into the most severe recession since the 1930s. The weak economy, combined with other factors such as the OPEC cartel’s decision to ease pressure on oil prices because sales were declining, choked off inflation.

The 1981-1982 recession was as severe as it was because inflation had become deeply imbedded in the economy and was hard to dislodge. When negotiating wages, for example, workers insisted on a large “inflation premium” to protect themselves against expected price increases. So did the lenders who set mortgage rates. For the rate of inflation to fall, it was necessary to break the inflationary cycle in which a prolonged period of accelerating inflation created expectations of larger price increases in the future, which, in turn, became incorporated in wage bargains and other contracts.

The recession that followed the Fed’s tightening in November 1980 broke the cycle but caused much hardship. It reduced jobs and spending, convincing businesses and consumers that, in the future, prices would no longer rise as rapidly as before. The recession lasted sixteen months, from July 1981 to November 1982, five months longer than the average postwar recession. During this time the economy, according to some estimates, produced about 10 percent less than it would have if it had grown at its long-term pace instead of contracting. Many workers and businesses never fully recovered what they lost. Entire industries suffered. Nevertheless, even liberal economists such as Nobel laureate James Tobin, who has been critical of the Fed’s emphasis on controlling inflation at the expense of economic growth, think that Volcker did well under the circumstances. “I hope that history will give Paul and his colleagues the praise that they deserve,” he wrote in 1994, “not only for fighting the war against inflation but also for knowing when to stop, when to declare victory. They reversed course in the summer of 1982, probably averting an accelerating contraction of economic activity in the United States and financial disasters worldwide.”10

In Changing Fortunes, his book about economic policy in the 1980s, Volcker recalls sensing “substantial support in the country for a tough stand against inflation, for all the pain and personal dislocation that seemed to imply.” “In the end,” he concluded, “there is only one excuse for pursuing such strongly restrictive monetary policies. That is the simple conviction that over time the economy will work better, more efficiently, and more fairly, with better prospects and more saving, inan environment of reasonable price stability.”11

Greider and other critics think that Volcker’s policies were unnecessarily harsh, that he was too slow to ease monetary policy in 1982, and that the Fed would have sought a better balance between inflation and unemployment had it been more “democratic,” more directly accountable to elected government officials. Such an argument is hard to reject outright: we don’t know what would have happened if Volcker had not raised interest rates, and we can’t conduct a controlled experiment to find out. Even so, Greider’s case is inconsistent and weak. He also argues that inflation in the 1970s was not contained largely because Arthur Burns was guilty of the most crass “political collusion in the Federal Reserve’s history”—i.e., that Burns was all too accountable to elected officials.

Moreover, even if the Fed waited too long to relax its tight money policy in 1982, that delay, in fact, accounted, as one analyst put it, for only a “modest fraction” of the cost of the recession, and the risks of relaxing too soon were high. “Perhaps that is true,” Volcker writes about this charge, “but those arguments do not impress me very much. It’s not that our policies were perfection but that the far greater error at that point would have been to fail to follow through long enough to affect fundamental attitudes and really put inflationary expectations to rest.”12 What seems clear both from such statements and from the economic record is that although its officials do not say so, the Federal Reserve often acts as an institutionalized social psychologist anticipating, interpreting, and trying to influence the inner fears and calculations of American workers, consumers, and businessmen.

As the economy improved during the 1980s and 1990s, evaluating monetary policy became, ironically, more difficult. When Volcker took over the Fed, the economy had what seemed to be the worst possible combination—high unemployment and high inflation—and there were no clear alternatives to the deeply restrictive policies he instituted. In the prosperous environment that Greenspan inherited, and has fostered, the main question is subtler: Could the economy have grown more rapidly without a lot more inflation? Because we don’t know the answer, and probably can never know it, Robert Solow argues in Inflation, Unemployment, and Monetary Policy, we should try to find out, by pushing the economy as far toward full employment as it can go without setting off higher and higher inflation. “Monetary policy,” he writes, “could afford to go in for a trial-and-error approach to finding a fair balance between the dangers of inflation and the benefits of high output and employment.”

That such advice should be necessary, or considered “radical,” shows the undue influence of the theory of the “nairu”—the nonaccelerating inflation rate of unemployment. The nairu is also called by some economists the “natural” rate of unemployment, a label that Solow thinks “intends deliberately to claim more for that state of the economy than anyone has ever seriously argued it deserves.” Milton Friedman, also a Nobel laureate in economics, and E.S. Phelps developed the nairu theory in the late 1960s, and it caught hold during the ensuing decade, in part because of the severe inflation and inept monetary policy of the 1970s. The nairu is basically the lowest unemployment rate the country can have without inflation continuously increasing. Most economists used to think that as the economy approached its capacity to produce, inflation would rise gradually as goods and services became scarce and unemployment fell. This tendency of inflation to rise as employment falls was famously described in a graph by the English economist A.W. Phillips, which is called the Phillips curve. The natural rate theory is essentially a scary version of the Phillips curve. It claims that if unemployment falls below this rate, then the rate of inflation will not simply rise but will rise continuously—“accelerate.” If the theory were true, limiting employment temporarily would be a small price to pay for not risking ever-accelerating inflation. Solow shows, however, that the doctrine is “theoretically and empirically as soft as a grape.”13

Until a few years ago, he points out, economists thought that the natural rate of unemployment was about 6 percent. The Fed probably thought so too because early in 1994, when the unemployment rate had fallen to about 6.5 percent but inflation was also declining, it raised interest rates in a “preemptive strike” against a probable rise in inflation. It is now clear, however, that the Fed’s fears were unwarranted. Its actions, which raised short-term interest rates by about three percentage points in the course of a year, were harmful, slowing economic growth, if only temporarily. To its credit, the Fed recognized its error and reversed course beginning in early 1995 by reducing interest rates. The unemployment rate has continued to fall, to about 4 percent, but inflation has fallen as well, to under 2 percent. Economists soon recognized that they had overestimated the effects of high employment; they have adjusted their estimates of the natural rate downward by about one percentage point.14

After this experience we can question whether the “natural rate” is a useful concept. Economists still can’t say just why their earlier estimates of a “natural rate” were exaggerated. Moreover, Solow shows that there is substantial evidence that inflation rises only modestly when the unemployment rate falls below the estimated natural rate. According to one calculation he cites, inflation increases 0.3 percent a year for each year that the unemployment rate is one percentage point below it. So, for example, if the estimated natural rate for a particular year is 5 percent and the unemployment rate is 4 percent, then the rate of inflation would increase by 0.3 percent above the previous year. (About 1.5 million more people are employed when the unemployment rate is 4 percent rather than 5 percent.) Because the costs of pushing the unemployment rate too low “may be small compared with the loss from running the economy a few percentage points below its potential,” Solow concludes,

monetary policy can afford to be exploratory. Part of its job is to feel its way to the neutral [natural] rate of unemployment, slowly and unsurely. The large body of work on these issues does not support the various popular metaphors of sudden catastrophe and subsequent irreversibility: the slippery slope, the yawning cliff, the genie that has escaped from the bottle.15


On how “exploratory” monetary policy should be, and on the Fed’s actions in 1994, Alan Blinder has a somewhat different view. Blinder has been a professor of economics at Princeton since 1971, with time out for government service. He was a member of the Clinton administration’s Council of Economic Advisers between 1992 and June 1994, when he became vice chairman of the Federal Reserve Board. In February 1996 he returned to Princeton because, according to many reports, he felt he would have had neither the influence nor the collegial relationships that he wanted with Chairman Greenspan, the other governors, and the senior Fed staff.16 In his new book, Central Banking in Theory and Practice, first delivered as the Lionel Robbins Memorial Lectures at the London School of Economics in 1996, Blinder gives an unusually forthright account of the difficulties that central bankers must overcome in making monetary policy.

When he joined the Fed, Blinder was considered “soft” on inflation. Ten years earlier, for example, in Hard Heads, Soft Hearts: Tough-Minded Economics for a Just Society, he argued that the consequences of moderate inflation were “more like a bad cold than a cancer on society.” Of course the bad consequences of hyperinflation could be “monumental,” Blinder wrote, “but the costs of moderate inflation… seem meager at best.” Furthermore, “the myth that the inflationary demon, unless exorcised, will inevitably grow is just that—a myth.”17

This is the same point that Solow makes in arguing that monetary policy should be exploratory, and in criticizing the Fed for raising interest rates unnecessarily in 1994. Blinder, for his part, takes seriously the Fed’s mandate to promote low unemployment as well as stable prices, and admits that recent experience has undermined earlier estimates of the natural rate. But he is convinced that the Fed was right to raise interest rates in 1994. Only because the Fed succeeded in controlling inflation, he argues, does it appear that inflation would not have risen sharply in any case, and that its policies were unnecessary. “A successful stabilization policy based on preemptive strikes will appear to be misguided,” he writes, “and may therefore leave the central bank open to severe criticism”—criticism that he thinks is both unjustified and unavoidable. Our experience over the last three or four years, however, when both inflation and unemployment fell significantly, undermines Blinder’s view that the preemptive strike of 1994 was necessary.

Blinder is at his best discussing what we know and don’t know about how monetary policy affects the economy. By controlling the costs of borrowing, and thus of spending, by businesses and consumers, the Fed wants to push unemployment as low as possible without causing serious inflation; but we really don’t know with any precision just how much a rise or fall in short-term or long-term rates will affect spending, or how long it may take to do so, or how much inflation and unemployment change when spending changes. Moreover, since monetary policy affects the economy over long periods of time, it is even possible that before the policy begins to work, conditions may change in a way that makes the policy obsolete. Because the judgments required are so difficult, and may be influenced by political pressure, Milton Friedman thinks that “discretionary” monetary policy is more likely to be harmful than helpful. About forty years ago he suggested that we would be better off if monetary policy was set by a rule requiring that the money supply grow year by year at a modest and relatively stable rate, perhaps the average rate of productivity growth.

This proposal was never tried, in part because most experts, like Blinder, are not as pessimistic as Friedman about the Fed’s ability to hit on the right policies, but also because it would not be possible to adjust monetary policy based on Friedman’s rule to specific circumstances, particularly economic crises. Nevertheless, Blinder admits, “there is at least an outside chance that Friedman could be right.”


What is clear is how often the economists in both the US and other developed countries have gone wrong in their search for the magic formula for economic policy. The inflation of the 1970s not only led them to accept the dubious natural rate doctrine, but also suggested that central bankers had been tolerant of inflation and had to be pressed to fight it more resolutely. A single-minded desire to reduce inflation, with little concern for unemployment, it was then thought, would make the Fed and other central banks more credible opponents of inflation and thus reduce the costs to the economy of restraining it. Some believed that a committed, credible central bank could reduce inflation without much increasing unemployment because firms and workers would understand that it was no longer necessary for them to raise wages or prices in anticipation of higher inflation in the future.

The main problem with these speculations is that they don’t match reality. Since the 1970s, central banks have reduced inflation significantly in almost all developed countries, but they have done so in different ways. In the United States, as we have seen, the Fed reduced inflation without abandoning its mandate to also maintain low unemployment. What changed when Paul Volcker was appointed chairman in August 1979 was simply the quality of the chairman’s leadership and economic judgment, particularly about the measures necessary to alter the “expectations” of the public. On the other hand, the Bundesbank, the German central bank, which is required only to “safeguard the currency” and not to limit unemployment, has been very successful at controlling inflation; in fact, it is considered the world’s premier inflation fighter. But Germany’s economy has suffered far more than the American economy during periods when inflation has been reduced. It now has double-digit unemployment and feeble economic growth, at least partly because of overly restrictive monetary policy.18

Like Volcker’s, Greenspan’s record at the Fed has been successful because of his pragmatism, flexibility, and shrewd judgment rather than rules or theories. Perhaps his approach reflects his brief early career as a musician (in the Harry Jerome swing band that also included Leonard Garment, later a law partner and political aide to Richard Nixon), or his longer one as head of his own economic consulting firm.19 In making decisions, he appears to rely more on detailed economic data such as the volume of freight shipments or help-wanted advertising than on abstract theories or economic models. We don’t really know, since Greenspan has never written in detail about how he arrives at decisions.

He is also willing to change his policies when they are not working. In 1987, for example, the Fed contributed to the October stock market crash by raising interest rates in the preceding months. Yet Greenspan was able to limit the effects of the crash by immediately lowering interest rates, and then raising them once the danger had passed. Similarly, even though the Fed may have contributed to the 1990- 1991 recession by raising interest rates in 1990 in an attempt to lower inflation, and may not have reversed itself fast enough, the recession was relatively mild.20 And last fall, when the Asian crisis threatened US financial markets, the Fed quickly lowered interest rates notwithstanding Greenspan’s earlier fears about “irrational exuberance” in the stock market21 ; he then surprised the markets with a second rate cut when it became clear that the first was not enough.

Although the main concern of monetary policy has shifted from a spreading financial crisis to a potential buildup in inflation, Greenspan continues to work in a nondogmatic way. At the same time, the Fed has slowly become more open and forthright, even if it has not gone as far or as fast as Blinder would like.22 Early this year, for example, it decided to make clear statements of its policies and prompt announcements of changes in the likely direction of future policy. As a result, when the Fed raised interest rates slightly at the end of June and again in late August, restoring two thirds of the rate cuts it made last fall to contain the financial panic, it also reassured the financial markets by saying it was neutral about future hikes. The statements about its likely actions were probably more important than the actual increases of one quarter of a point in the federal funds rate, which were so small and so widely anticipated that the financial markets discounted them well in advance.

Greenspan and Blinder agree about the different proposals to make use of federal budget surpluses, projected to be about $3 trillion over the next decade—or $1 trillion excluding accumulated Social Security funds. Although not directly matters of monetary policy, the debate over fiscal measures that now divides Washington would clearly affect the Federal Reserve. Both the roughly $800 billion in tax cuts favored by the Republicans and the additional $800 billion in government expenditures proposed by the administration would stimulate spending and thus raise the risk of rising inflation. For this reason, Greenspan told the House Banking Committee in his semiannual report on monetary policy this July that he would prefer “to let the surpluses run”—i.e., stay in the federal treasury—and use them to pay off debt.

Blinder is even more emphatic. He has, on the whole, supported liberal reforms. But, he wrote recently, “more spending is just about the last thing our economy needs right now…. Should it weaken and should unemployment rise, a large tax cut or dose of public spending could be called for. But not now.” Both Republican “supply-siders” such as former Congressman Jack Kemp and liberal Democrats such as economist Barry Bluestone or former labor secretary Robert Reich, on the other hand, simply deny the inflationary risk. Whether they favor tax cuts or increased public investment, they assert that their proposals will raise productivity sufficiently to eliminate the inflationary threat. In this regard, they are very much like the advocates of a “new era.”23

Greenspan also recently ruled out using monetary policy to deflate stock prices, which may be dangerously high. The positions he has taken would seem to exclude—in my view reasonably—as too risky such measures as raising either interest rates or margin requirements in order to cool the stock market. “Bubbles generally are perceptible only after the fact,” he told the Joint Economic Committee in mid-June, and, if they burst, “the consequences need not be catastrophic for the economy” if monetary policy responds appropriately, as it did when the stock market crashed in 1987, but failed to do in 1929. “While the stock market crash of 1929 was destabilizing,” he continued, “most analysts attribute the Great Depression to ensuing failures of policy.” Milton Friedman and Anna Schwartz consider the Fed’s failure to provide enough cheap credit to contain the banking panic and economic contraction that followed the market crash its greatest error. “The detailed story of every banking crisis in our history,” they concluded in their Monetary History of the United States, “shows how much depends on the presence of one or more outstanding individuals willing to assume responsibility and leadership.”24

Although Greenspan has resisted raising interest rates to deflate stock prices, he admitted at the Fed’s annual conference in Jackson Hole, Wyoming, in late August that he was concerned about the potential impact of the stock market on the economy. Not only has borrowing to buy stocks—“leverage”—contributed to the market’s rise, but large-scale borrowing against stock gains has helped drive up spending and economic growth. There is a risk that if the market continues to rise and stimulate spending, inflation will become more serious. Because borrowing is so high in relation to income, there also is a risk that if the stock market crashes, spending will also fall significantly, as debtors scramble to repay loans, producing a serious recession.

Whether the Fed would act quickly and forcefully enough to prevent either danger—inflation or recession—is not clear. Greenspan’s record and good sense are reassuring but his past successes do not guarantee future results. Moreover, if the stock market falters and threatens the economy, there may come a point, as in Japan, when lower interest rates no longer stimulate spending sufficiently. In that case, we would have to rely on tax cuts or increased government spending to get the economy back on track. But as we have seen, and Solow emphasizes, reaching a political consensus on fiscal measures is likely to be “contentious and slow.” That is why the Fed has to remain independent of politics. Notwithstanding all the analyses of the experts, this means relying to a large extent on the intuitions of the Fed chairman on how Americans will invest and spend their money.

  1. 10

    James Tobin, “Comment on Monetary Policy in the 1980s,” in Martin Feldstein, editor, American Economic Policy in the 1980s (University of Chicago Press, 1994), p. 152. The estimate of the recession’s costs is from Michael Mussa, “Monetary Policy in the 1980s,” pp. 113-114 in the same volume.

  2. 11

    Paul Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership (Times Books, 1992), p. 176.

  3. 12

    The quotations are from, respectively, Greider, Secrets of the Temple, p. 67; Mussa, “Monetary Policies in the 1980s,” p. 114; and Volcker and Gyohten, Changing Fortunes, p. 177. Greider’s general argument against the Fed is summarized on pp. 527-534.

  4. 13

    If the natural rate doctrine were true, then monetary policy could not push unemployment below this rate, and attempts to do so would result only in accelerating inflation. Most economists who believe the theory, however, think that it holds only in the long run. They accept the principle that monetary policy can influence both unemployment and inflation in the short run, but are reluctant in practice to risk pushing unemployment below what they think the natural rate is.

  5. 14

    Even so, the estimated nairu is still about one percentage point above the current unemployment rate, yet inflation has not risen. See Robert J. Gordon, “The Time-Varying Nairu and its Implications for Economic Policy,” Journal of Economic Perspectives (Winter 1997), pp. 11-32. Gordon finds that the nairu has varied considerably over time, rising steeply in the 1960s, remaining high from about 1970 to 1990, and then falling sharply. Gordon also argues that the apparent failure of the Phillips curve and natural rate models in the 1970s was due to their not accounting for other factors that affect inflation. If you don’t allow for the oil price shocks of the 1970s, for example, the basic Phillips curve relationship appears to show that inflation and unemployment increase at the same time, and the nairu appears smaller than it actually is. This omission may have fooled policymakers.

  6. 15

    The estimated rise in inflation is from Gordon, “Time-Varying Nairu,” p. 14. Solow also suggests that excessively tight monetary policy over a prolonged period, as in much of Europe during the 1980s, might raise the natural rate. As the unemployed adapt to the lack of jobs, it takes higher and higher wages to entice them back to work, particularly when there are generous social welfare programs. See pp. 8-11.

  7. 16

    At root, the Fed, particularly under a strong chairman such as Greenspan, is very much a one-man show, and the vice chairmanship not very challenging. This June, Alice Rivlin, a prominent economist who replaced Blinder roughly three years ago, also resigned, the fourth vice chairman to resign during Greenspan’s nearly twelve-year tenure. On Blinder’s resignation, see John Cassidy, “Fleeing the Fed,” The New Yorker, February 19, 1996, pp. 38-46. Apparently Blinder and Greenspan rarely talked even though their offices were next to each other. As for the staff, Blinder was surprised to find that “there was very, very little of people coming in and saying, ‘Hey, you ought to know about such-and-such.”’

  8. 17

    Blinder, Hard Heads, Soft Hearts (Addison-Wesley, 1987), pp. 45-51. The quotations are from pp. 50-51.

  9. 18

    See Blinder, Central Banking in Theory and Practice, pp. 40-41, 62-63, and Solow, Inflation, Unemployment, and Monetary Policy, pp. 10-11.

  10. 19

    Beckner, Back from the Brink, pp. 12-13.

  11. 20

    See the essays by Martin Feldstein and Michael Mussa in Feldstein, editor, American Economic Policy in the 1980s, pp. 11-12 and 126-128, 131- 132; and Feldstein, “The Recent Failure of U.S. Monetary Policy,” National Bureau of Economic Research Working Paper No. 4236, December 1992. Mussa suggests that the Fed may have tried to obscure its role in precipitating the 1987 stock market crash.

  12. 21

    See my article “How to Think About the Stock Market,” The New YorkReview, June 24, 1998.

  13. 22

    Blinder thinks that the Fed should be even more forthcoming in explaining its reasoning, and that by doing so it would “make itself more predictable to the markets,” and thus improve monetary policy. This may be overly optimistic. A great degree of uncertainty about monetary policy is inevitable in view of the unpredictable shifts in the economy. Much of the speculation on what the Fed will do is therefore futile.

  14. 23

    See the articles addressing the question “What to do with a $2.9 trillion surplus?” by Blinder (“Save It”) and Bluestone (“Spend It”), The New Republic, August 9, 1999, pp. 25-27 and 23-25, respectively; Jack Kemp, “The Party of Reagan—or of Hoover?,” The Wall Street Journal, July 30, 1999; and Robert B. Reich, “The Other Surplus Option,” The New York Times, August 11, 1999.

    I am not suggesting, nor do I think Blinder or Greenspan are, that tax cuts or public investment will not improve productivity eventually. The question is whether now is the best time to carry out these policies without reducing government spending on other programs.

  15. 24

    Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960 (Princeton University Press, 1963), p. 418.

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