The Volcker Way

Lessons From the Last Great Hero of Modern Finance

No mirrors and smoke here: Paul Volcker testifying before the House Banking Committee in 1980. (George Tames / New York Times)

The global economy was not the only casualty of the 2008 financial collapse. The crisis also soiled the reputations of many in the financial industry and of the regulators, political leaders, and media outlets that were supposed to keep them in check. So William Silber's new biography of Paul Volcker, one of the last remaining heroes of modern finance, could not have come at a better time. 

Silber, an economist at New York University, uses his book to walk the reader through some of the important episodes in Volcker's long and storied career, during which he served in five U.S. administrations. These episodes include his stint as undersecretary for monetary affairs at the Treasury Department, from 1969 to 1974, when the United States abandoned the convertibility of the dollar into gold; his successful crusade against inflation as chair of the U.S. Federal Reserve in the 1980s; and his work following the recent financial crisis, when he backed the provision now called "the Volcker rule," which bars commercial banks from engaging in proprietary trading (investments that banks make for their own profits, not on behalf of clients). 

By focusing on these moments, Silber's meticulously researched book offers useful insights into recent American economic history and the life of one of its most fascinating figures. Although the details of these episodes may seem distant, Volcker reminds readers just how precarious the circumstances were -- and how policymakers might confront similar crises in the future.

PRESENT AT THE INFLATION

The book's first major episode begins with Volcker in the Kennedy administration's Treasury Department and follows him over several years as he became the central character in a crisis of the international monetary system. The Bretton Woods arrangements, set in place following World War II, had pegged the value of the U.S. dollar to gold and the value of other currencies to the dollar at fixed exchange rates. The system survived with only occasional hiccups for roughly two decades, but as the Vietnam War escalated, the U.S. economy began to overheat and experience inflation. Without faster productivity growth or the ability to devalue its currency, the United States saw its exports grow increasingly uncompetitive, and investors began fleeing the dollar in favor of other currencies or gold.

To prevent a bad situation from becoming worse, the United States needed to either raise interest rates -- and likely start a recession -- or find some other way to keep money in the country. Over the course of a decade, in innumerable emergency meetings around the world, Washington proposed all sorts of plans to save the Bretton Woods system, from directed international government purchases of dollars to cracking down on coin collectors for taking too much gold out of circulation. But without an increase in interest rates, something policymakers did not want to happen, the status quo would have to change.

At first, Volcker defended the gold peg, but by the time he was working in the Nixon administration, he came to see that the country needed to either pursue a deeply painful monetary policy or fundamentally change its currency system. After a long series of negotiations with Europe, in August 1971, the United States ended the dollar's peg to gold and ushered in more flexible exchange rates. Thanks to close coordination among all the countries involved, fears that abandoning the fixed exchange rates would either unseat the dollar as a reserve currency or spark a full-blown financial crisis never materialized. The fact that Volcker led an orderly transition without a meltdown occurring was a signal achievement. Today, as many countries in the eurozone struggle to cope with the problems caused by their fixed-exchange-rate system, one hopes that they have studied this moment closely.

Silber then looks at Volcker's much-celebrated fight against inflation. In the 1970s, inflation was the bane of the U.S. economy, rising from a five percent annual rate in 1976 to almost 12 percent by August 1979, the month Volcker became chair of the Federal Reserve. The Fed's unwillingness to raise interest rates to stop inflation had destroyed its credibility and allowed what monetary economists call inflationary expectations to take hold. Businesses, unions, and employees throughout the economy began their discussions about wages and prices with the presumption that inflation would be five to seven percent per year. Such a presumption is quite dangerous, since workers then demand seven or eight percent wage increases to overcome the inflation, which in turn causes prices in those industries to rise further. This so-called wage-price spiral can drive inflation up dramatically in a short period. 

The country needed someone credible to fight inflation, and Volcker was the man for the job. He attacked right away, although he knew it would mean unprecedented tightening. He designed a new approach for Fed policy that explicitly tried to slow down the growth of the money supply rather than raising interest rates directly (the central bank's normal method), knowing that the Fed governors would have a hard time raising rates as high as they needed to go. His system of targeting the money supply was indirect, and it drove rates higher than anything the Fed had ever before contemplated, to unprecedented levels of 20 percent and higher. The economy slipped into recession, with unemployment peaking at 10.8 percent in November 1982.

Volcker stuck to his guns even as he came under withering criticism from Congress and industry. He acknowledged the difficulties presented by high interest rates but insisted that the country needed to rid itself of inflation or, as he said in a 1982 speech to the National Association of Home Builders, "the pain we have suffered would have been for naught -- and we would only be putting off until some later time an even more painful day of reckoning."

Volcker stayed the course until he beat inflation. Once the battle was won, he began cutting interest rates and making it easier to borrow in order to return things to normal. Unemployment fell rapidly, and conservative economists -- including Milton Friedman, a regular critic of Volcker's throughout the 1970s and 1980s -- warned of the imminent return of inflation. But Volcker explained that the Fed's worst failures had come from waiting too long to tighten monetary policy during expansions, not from loosening it too much during recessions. History would soon prove him right: although a record-breaking expansion followed, inflation never returned.

The last big episode Silber describes came during the recent debate over financial regulation, when Volcker championed a ban on proprietary investing on the part of banks. His logic was that since commercial banks in the United States are backed by the Federal Deposit Insurance Corporation and can borrow money from the Fed during a crisis (at the so-called discount window), taxpayers are ultimately on the hook for the costs of their failure. This government insurance allows financial firms to raise cheap capital, and Volcker argued that it was not appropriate for them to use that subsidy to make risky investments for their own sake, especially ones that might cause them to be even more prone to failure. Volcker also worried that proprietary investing would put banks in direct conflict with their clients. 

Volcker's critics insisted that such special rules for commercial banks were untenable because these banks would have to compete with more lightly regulated entities, such as hedge funds, international banks, or money-market funds, which would not have such restrictions. But each time the rule looked to be in jeopardy, developments such as the accusation that Goldman Sachs was knowingly shorting investments that it was selling to its clients or the revelation that JPMorgan Chase had lost billions of dollars on a single proprietary investment would seem to validate Volcker's logic. Despite furious lobbying to remove it, the Volcker rule became part of the Dodd-Frank financial reform bill and is now the law of the land, although the battle over its implementation continues. 

INCREDIBLY CREDIBLE

Volcker's narrative reveals the drama behind some of the most important economic policy debates of the last half century. What is even more important to understand than the details of these episodes, however, is the worldview Volcker held as a consummate problem solver. Future policymakers would do well to study his approach, from how he projected confidence and credibility to his insistence on articulating clear frameworks for resolving crises. 

Throughout his public career, Volcker personified toughness. He understood that the government had to establish credibility in order to give policymakers flexibility when they needed it. In both the gold crisis and the inflation crisis, the failure of authorities to make credible promises invited speculative attacks by investors, who bet that the government would back down. When policymakers undermine their own credibility, it only makes the next round of a crisis worse, because the market ceases to believe what officials say about how they will resolve it. 

In the 1980s, Volcker was able to put an end to expectations of spiraling inflation only by showing that he was willing to administer even the most painful of medicines. Once people understood that he would keep at it until prices stopped ballooning, he earned the flexibility to bring down interest rates to more normal levels, which he did after 1983, without generating a return of inflation. 

In the aftermath of the 2008 financial crisis, Volcker frequently seemed frustrated in his public appearances when the government would abruptly reverse its position, as when it announced that the Troubled Asset Relief Program would buy up toxic assets only to say later that the money allocated to the program would instead be used to recapitalize banks. The great fear was that such reversals would undermine policymakers' credibility and make the rescue much more difficult -- a lesson proved quite relevant by Europe's chaotic response to its sovereign debt crises.

Similarly central to Volcker's approach to public policy was his insistence on finding explicit frameworks to resolve crises. That stance might sound obvious, but anyone who has spent time in Washington can tell you how common it is for the government simply to wing it instead. Volcker learned the danger of this approach during the various emergencies he dealt with, including the Latin American debt crisis of the 1980s and the failure of the Continental Illinois National Bank in 1984. In these cases, the relevant players managed to get together and hammer out ad hoc agreements. But fixing problems this way planted the seeds of future trouble, leaving people in doubt about what the government might do the next time things went wrong.

That's why, when the 2008 financial crisis unfolded, Volcker became one of the first to propose creating an institution that could buy up assets and dispense with them, as the Resolution Trust Corporation had done following the savings-and-loan crisis in the 1980s and 1990s. It's also why he worried aloud about the dangers of waiting to confront problems until they arose; he felt that Washington could not evaluate which failing firms were worth rescuing without a clear framework. As the scope of government bailouts spread from financial institutions to AIG, Fannie Mae, Freddie Mac, and even the automobile industry, Volcker's worries seemed vindicated. 

Ironically, this preference for frameworks over emergency meetings brought Volcker's thinking into line with Friedman's. In 1969, when Friedman was urging the adoption of a flexible-exchange-rate system, he argued that one of its benefits would be to "put an end to the occasional crisis, producing frantic scurrying of high government officials from capital to capital," thinking they are vitally important. If recent history has taught us anything, it's that the most serious economic crises cannot be tamed solely by improvised disaster control on the part of well-intentioned officials. It takes articulated frameworks.

Volcker's approach to regulation and oversight is also worth emulating. Volcker once told me that he had spent much of his career pushing back against the notion that the free market could govern itself if the government just got out of the way. Capital markets, he emphasized, can function only when people trust the system. A financial system ridden with conflicts of interest, creative accounting, and excessive exuberance is dangerous precisely because it can destroy the public's trust and cause people to pull out their money.

The Federal Reserve has two different jobs: to set monetary policy and to safeguard and regulate major parts of the financial system. Paradoxically, the Fed chairs who have been toughest on inflation have tended to be the most lenient when it comes to bank supervision and the most sympathetic to the idea that the private sector can govern itself. What made Volcker so different as a Fed chair was his toughness on both inflation and regulatory oversight.

It's not that Volcker views bankers as the bad guys, as many populists who embrace his views do. He simply believes that bankers are just like everyone else: that absent oversight, they will try to take advantage of the system. Volcker has repeatedly stated his view that many practices that are considered financial innovations are actually just ways for firms to get around regulations, reduce the amount of capital they are required to hold, or avoid taxes, thus providing little benefit to consumers or the economy. 

Volcker argues that regulators must be clear and direct in their oversight of banks' behavior. As he put it in an interview with Silber, "Commercial bankers understand when a bank examiner gives them a green light to lend. They also respond to a red light, whether they like it or not, but most ignore the cautionary yellow." For this very reason, in the recent debate over financial reform, Volcker pushed for the ban on proprietary trading to be made explicit and not be left to the discretion of regulators; the banks would never pay attention unless such a practice was expressly forbidden.

DUTY, HONOR, COUNTRY

When I talk to Volcker today, he speaks of a time when honor was the most important thing a person had. He notes that in the early years when he worked in government, many large trade associations didn't even have offices in Washington, D.C., and no banker worried more about his bonus than his reputation. 

At every stage of his career, Volcker had the option to leave government and take a lucrative job in the private sector. But he chose public service. It's astounding that Washington manages to recruit professionals of Volcker's caliber while paying them modestly and putting them through all the tribulations of government work, from partisan Senate confirmation hearings to extensive rules and disclosures that they must abide by in their personal lives. Volcker still believes that public service is the most important thing someone can do, but he fears that this attitude may be a relic of a bygone era. 

If we are lucky, his fears will be proved wrong. The lessons from Volcker's career and his worldview must continue to inform U.S. economic policy in the years to come if the United States is to maintain its global economic leadership. The country may never produce another figure of such towering stature, wisdom, and determination. But those who come after Volcker would be wise to heed his advice and try to follow in his admittedly giant footsteps.