Paul Volcker Research Articles

Inflation targeting and output stabilization in an estimated monetary model

This paper studies determinacy conditions in a monetary model with an interest rate rule. In addition to the inflation rate as an argument of the policy rule, we introduce a second argument: output, a case empirically relevant but overlooked in the existing literature on monetary models with flexible prices. Firstly, we estimate a model with money in utility and the production function. We find that an aggressive response to inflation does not necessarily guarantee determinacy anymore. Secondly, we compare monetary policy in the pre-Volcker era and the post-Volcker era. We find that, after the appointment of Paul Volcker, the Federal Reserve started to respond more aggressively to inflation and less aggressively to output. Indeterminacy is pervasive: the equilibrium is indeterminate in both sub-samples. Thirdly, we estimate the impulse response functions. We find that monetary shocks, sunspot inflation shocks, and productivity shocks have long-lasting effects on inflation, output, and interest rates.

Growth models and central banking: dominant coalitions, organizational sense-making, and conservative policy innovations at the Bundesbank and Fed

This article revives the comparative political economy of central banking. Drawing on growth models theory, I argue that export-led and debt-led growth models imply fundamentally different versions of central banking and rely on different combinations of monetary, financial, and exchange-rate policies. Historical institutionalists plausibly argue that central banks have learned to pursue these policies because dominant coalitions have shaped central banks’ institutional roles. But since the 1970s, policy activism has become more important. To explain why the Bundesbank and Federal Reserve have come to support the German and US growth models during Post-Fordism, I look at how sense-making processes informed policy innovations. In the German case, the Buba carved out a powerful disciplining role for itself in corporatist coordination, which aligned with the demand-restraining features of Germany’s export-led model; corporate profit expectations signaled economic health. A dilemma arose with deteriorating price competitiveness that the Buba resolved by imposing an export version of secular stagnation. In the US case, Paul Volcker’s aggressive interest rate hikes to eliminate ‘inflation scares’ ushered in an area in which monetary policy became focused on bond market credibility. Greenspan consolidated central banking for financialization by hardening the Fed’s bail-out promise and its focus on ‘wealth effects’.

Uncomfortable knowledge in central banking: Economic expertise confronts the visibility dilemma

How do central bankers cope with the uncomfortable fact that there are significant limits to their expertise without losing authority? Drawing on Steve Rayner’s concept of ‘uncomfortable knowledge’, this paper undertakes a historical examination of the early years of Paul Volcker’s role at the head of the Federal Reserve, and then traces the ways in which the uncomfortable fact of ignorance has been dealt with in the years since then: from the reflexive and experimental approach of the 1980s, through the dismissal and displacement of the Great Moderation, to the exceptionalism and new experimentalism of the post-2008 era. In each of these eras, I argue that central banks face a visibility dilemma: their expertise must be visible enough to demonstrate their mastery but not so conspicuous that the often ad hoc and uncertain nature of their craft generates political push-back about their role and authority.

The fallacies of central bank independence

The fallacies of central bank independence

Managing a New Policy Framework: Paul Volcker, the St. Louis Fed, and the 1979-82 War on Inflation

In October 1979, Federal Reserve Chairman Paul Volcker persuaded his Federal Open Market Com­mittee (FOMC) colleagues to adopt a new policy framework that (i) accepted responsibility for controlling inflation and (ii) implemented new operating procedures to control the growth of monetary aggregates in an effort to restore price stability. These moves were strongly supported by monetarist-­oriented economists, including the leadership and staff of the Federal Reserve Bank of St. Louis.

The legacy of Paul Volcker

Paul Volcker was a model public servant, not only his service as Fed Chair, but also in his work on international economic policy at the Treasury, and in his service in many other realms. Three distinguished persons—Sheila Bair, Donald Kohn, and John Taylor—provide their memories of Volcker and reflect upon his legacy.

George Box’s Realization, That All Models, Especially Statistical Models, Are Wrong Means That It Is Impossible for There to Be Any True Probabilities, True Models, True Theories, True Expectations or True (Accepted) Hypotheses: The Claims, Made By Rational Expectations Proponents About True Objective Probabilities, True Models, True Expectations, True Expected Values, etc., Have No Scientific Foundation

R. Muth’s 1961 paper in Econometrica is an example of an academic economist suffering from extreme and extraordinary ignorance about very basic scientific, statistical, methodological, epistemological, philosophical, and logical tenets. These tenets were all discussed rigorously by Haavelmo in his 1944 paper in Econometrica on methodological and epistemological issues related to the question about exactly what conclusions a statistical model using economic data could support as far as sound(never valid, right ,correct, true). Haavelmo’s entire 115 page article can be summarized briefly by George Box’s brief statement noted above .Muth’s belief ,that economists had derived true theories and true models is simple nonsense. What Muth should have argued in his 1961 article, but did not, is that rational expectations, when compared to its rivals,was a better model compared to the rival models in terms of minimizing its forecasting error.Of course, Muth would have had to have supported this claim of forecast superiority with explicit proper scoring rule studies showing that the rational expectations statistical model did in fact yield superior forecast results. No such study exists at the present time because no proponent of the rational expectations hypothesis has ever demonstrated such forecasting superiority. Two additional, very severe problems result from Muth’s confused understanding of what scientific modeling is capable of regarding the specification of objective and subjective probabilities or probability distributions. First,It is simply impossible to assume the truth of the objective theory of a limiting frequency interpretation of probability and then claim that decision makers can learn from experience what the convergence properties of such a distribution are in the short run when such properties will only manifest themselves in the far ,distant(infinite)long run. It is impossible for any human ,unless rational expectations proponents are claiming that there are actual decision makers who live to infinity,to learn of such properties .Kolmogorov made it quite clear that the strengthened limiting frequency interpretation he had provided for R.Von Mises law of large numbers,which resulted from the substitution of the assumption of countable additivity for finite additivity “ …does not contribute anything to substantiate the application of the results of probability theory to real practical problems where we always have to deal with a finite number of trials”(Kolmogorov). Second, given L. J. Savage’s clearly expressed and emphasized restrictions concerning the applicability of the theory of subjective probability and expected subjective utility to the short run at the micro level ,any attempt to apply Savage’s theory at the macro level or to the intermediate to long run or intertemporally over infinite time is “utterly preposterous” and complete”nonsense according to Savage.This means that Muth’s claim about subjective probability transforming itself into objective probability might only be considered a subject for possible study and scrutiny in the short run at the microeconomic level. Economists and econometricians are good number crunchers only. Their subjective claims and beliefs about infinitely lived decision makers, who are able to learn about so called true ,objective probability distributions ,are “utterly preposterous “ and anti scientific. William McChesney Martin ,FRS chair of the BOD in Washington,D.C.from 1950 and 1970 ,correctly kept the econometricians ,economists, and Paul Volcker in the basement of the NY Federal Reserve Bank, where they had no input or say in actual or proposed monetary policy decisions. Martin realized that the extremely narrow understanding of what was required in the real world of monetary policy on the part of economists necessitated this setup. Alan Greenspan, in his 2004 (May) paper in the AER ,also rejected the applicability of the theory of rational expectations in monetary policy from 1987 to 2005,given his emphasis on the importance of taking into consideration all models, including those dealing with uncertainty where the knowledge base ranged from complete ignorance to complete knowledge. On the other hand ,A. Burns, P.Volcker,B. Bernanke, and T .Geithner did believe that their mathematical and econometric models were true. One can compare the great success of Martin and Greenspan with the failures of Volcker and Bernanke(Geithner) and reach the conclusion that it is time to return the economists and econometricians back to the basement of the FRBNY where they belong as effective and useful number crunchers only.

The establishment of neoliberalism in Mexico

Neoliberalism established itself in Mexico a system of government and economic and social policy in a long process over 35 years since 1981. It began with the financial crisis of 1982, caused by the fall in oil prices and growth in interest rates when Paul Volcker headed the US financial policy. In Mexico the crisis led to a repayment crisis and a debt renegotiation with the IMF and the banking system. The government nationalized the retail banks in September, but in December a new government began a transformation of society based on the predominance of private enterprise and the market as an allocation mechanism. JEL codes : B52

Review of Mervyn King's The End of Alchemy: Money, Banking and the Future of the Global Economy

At odds with leading UK newspapers and with a wide ranging host of eminent people including Niall Ferguson, Larry Summers, Paul Volcker, Henry Kissinger, Alan Greenspan and Michael Lewis, this reviewer begs to disagree, not simply with the arguments, but with the whole premise of the book. This is not to say that the book is uninteresting; quite the contrary, I agree with Professor Summers that the book deserves to be widely read, but perhaps not quite for the reasons he had in mind. Indeed, it contains much of interest to a general readership which is written by an insider and is nothing if not revealing. However, in agreement with the current Chief Economist of the Bank of England, Andy Haldane, and the Global Chief Economist of Citigroup, Willem Buiter, I believe that the best path to global financial stability is a sharpening (through regulatory simplification and specificity) of the classical aims of central banks to maintain price and financial stability through direct control of interest rates and close monitoring of banking capital ratios and credit expansion in interaction with the financial markets. Arguably this was not the case during the tenure of Mervyn King as Governor of the Bank.

Adam Smith Improved Aristotle's System with Respect to His Assessment of the Commercial Aspects of the State: Smith Never Rejected Any Part of Aristotle's General Theory of Economics, Politics, Civics, and Institutions

The misbelief that Smith ultimately rejected Aristotle's analysis of the general, primary causes creating economic problems afflicting Athens in the Fifth century, B. C., when Athens was at the center of the world’s major, commercial, trading countries, in incorrect. The decline of Athens between the fifth and fourth centuries, B. C., was brought about by the conflict between the middle class people, who made use of money using the C-M-C' formula versus the upper class Prodigals, and Imprudent risk who made use of money using M-C-M' and M-M' formulas. Aristotle did not explicitly identifying his upper class as Smith’s Projectors, Prodigals, and Imprudent risk takers or Keynes's speculators and rentiers. Aristotle identified the problem as being one involving certain upper income class citizens who were not interested in the making of consumer and producer goods, but sought to make a profit by speculation and financial manipulation, which was tied in to the formulas M-C-M' and M-M'. Smith explicitly explicated Aristotle's exchange formula categories by linking them to either a category he described as Projectors, Prodigals, and Imprudent risk takers (M-C-M' or M-M') or a category he described as the Sober people (C-M-C'). Smith realized that the world economy was composed of both categories. The negative impacts of the Projectors, Prodigals, and Imprudent risk takers (M-C-M' or M-M') on the Athenian state was analyzed by Socrates, Plato, and Aristotle. This also was the problem effecting Scotland and England in the 18th century and the USA in the 1890’s,1920’s, and the time period from 1978-2017. Smith made improvements to Aristotle's analysis by showing how the creation of a central bank could be used to prevent loans from being made to Projectors, Prodigals, and Imprudent risk takers, while simultaneously ensuring that private bankers (Aristotle’s private financiers) were required to make loans only to the sober people, who would use the loans to expand their small businesses by investing their savings and bank loans in additional producer (investment) goods that would expand the economy, make workers more productive, lead to higher real wages, reduce poverty and inequality and increase employment through economic growth over time. The great danger to Smith's innovation, that Aristotle would surely have pointed out to him, could occur if the upper class Projectors, Prodigals, and Imprudent risk takers were able to take control of the government and/or the central bank, which is what has happened in the USA since 1979, starting with the appointment of Paul Volcker by President Carter to be the head of the FRB in Washington. The Central bank must be independent from the Government and especially from the private banking industry. Otherwise, you get the same type of financial bubbles that Smith analyzed, such as the Tulip, Mississippi, and South Seas Bubbles, or the collapse of the Ayr Bank in Scotland in 1772.

Delayed Overshooting: Is It an ’80s Puzzle?

We reinvestigate the delayed overshooting puzzle. Using a method of sign restrictions, we find that delayed overshooting is primarily a phenomenon of the 1980s when the Fed was under the chairmanship of Paul Volcker. Related findings are as follows: (1) Uncovered interest parity fails to hold during the Volcker era and tends to hold during the post-Volcker era; (2) US monetary policy shocks have substantial impacts on exchange rate variations but misleadingly appear to have small impacts when monetary policy regimes are pooled. In brief, we confirm Dornbusch’s overshooting hypothesis.

How optimal is US monetary policy?

Using a small-scale microfounded DSGE model with Markov switching in shock variances and policy parameters, we show that the data-preferred description of US monetary policy is a time-consistent targeting rule with a marked increase in conservatism after the 1970s. However, the Fed lost its conservatism temporarily in the aftermath of the 1987 stock market crash, and again following the 2000 dot-com crash and has not subsequently regained it. The high inflation of the 1970s would have been avoided had the Fed been able to commit, even without the appointment of Paul Volcker or the reduction in shock volatilities.

MONETARY POLICY RULES UNDER HETEROGENEOUS INFLATION EXPECTATIONS

This paper evaluates the role of inflation‐forecast heterogeneity in U.S. monetary policymaking. The deviation between private and central bank inflation forecasts is identified as a significant explanatory factor behind the Fed's monetary policy decisions. A discretionary policy rule that includes the forecast deviation as an additional argument is estimated empirically for the period 1975–2009, covering the chairmanships of Arthur Burns, George Miller, Paul Volcker, Alan Greenspan, and the beginning of Ben Bernanke's term, by using inflation forecasts obtained from the Federal Open Market Committee's Greenbook and the Survey of Professional Forecasters and real‐time estimates of the output gap. The estimated rule appears to provide a consistent description of the Fed's policy during the sample period presenting an alternative perspective regarding the key drivers of the high‐inflation phase in the 1970s as well as of the successful Volcker disinflation in the early 1980s and the gradual transition to a regime of lower inflation and high policy credibility that has increasingly characterized monetary policy over the past two decades. (JEL E50, E52, E58)

Changes in Federal Reserve preferences

Using a model of optimizing central bank behavior, I estimate the dynamic behavior of preferences, which are captured by the relative weight put on stabilizing inflation versus minimizing the output gap. Unlike previous work, I let this parameter vary continuously over time. There is a drastic but steady rise in the weight on inflation around the appointment of Paul Volcker; however, I find variation in preferences throughout the sample period. The results suggest that preference changes have been more complex than typically assumed in the literature. The estimated preference series is used to perform counterfactual experiments and to construct a new measure of monetary shocks.

The Fed's Folly: Not Normalizing Rates Quickly After the Great Recession

For over seven years the Federal Reserve Bank has failed to foster a normal economic recovery in the aftermath of the 2008 financial crisis and Great Recession. By adhering to a zero interest-rate policy, as well as quantitative easing involving the infusion of credit through the purchase of trillions of dollars of government bonds and agency securities, economic performance has fallen far short of historical standards. A long-awaited 25 basis point hike in the federal funds rate in December 2015 is feckless. Chronic near-zero interest rates have forced a massive migration of capital to overvalued financial assets from traditional bank loans, deposits and money market instruments that traditionally fund the real economy. In addition, those rates have rendered bank net interest margins unprofitable resulting in restricted lending, mostly to the most credit-worthy borrowers at the expense of small businesses that create most jobs. Rock bottom rates aimed at stimulating growth through borrowing are not productive if they do not also motivate broad lending throughout the economy.This paper advocates a relatively rapid normalization of interest rates to restore equilibrium in the credit markets through a steady series of rate hikes. The action would redirect capital away from inflated stocks and bonds back to the production and consumption of goods and services that grow the economy. The particular fed fund rate that supports the movement of enough capital to achieve this may be about 4%., last registered in 2007. Heresy to traditionalists, few economists and analysts have called for such a solution out of fear of upsetting the financial markets and triggering a recession. Even the acclaimed “Taylor rule” that has guided monetary policy for more than 20 years understates the rate requirement under current anomalous monetary conditions. The consensus view does not consider that raising rates from near-zero would not have the adverse impact as raising them from historically normal levels might. Bold action is required to finally deflate the financial economy and reflate the real economy. In the process, the Fed has to resist short-term market disruptions and less than optimal economic data that heretofore have deterred rate hikes. And monetary ineffectiveness must not be excused on the ground of a “new normal” born of restrictive post-crisis financial regulation and ever-growing big government. Although impediments to growth, normalized interest rates can overcome them. In the early 1980s Fed Chairman Paul Volcker, in different economic circumstances, displayed the courage to take radical corrective action. His policy of sky-high interest rates to wring out hyperinflation initially precipitated a sharp recession but subsequently ushered in nearly uninterrupted expansion for almost 20 years.Once and for all the Fed should realize it has found itself in a hole from years of ineffectual policy. It’s time to stop digging. Sadly, of late the Fed is considering the opposite in flirting with negative interest rates that mimes the failure of other central banks. Counterintuitive as it may seem, raising interest rates to pre-crisis levels, coupled with fiscal and regulatory reform, would provide the stimulus that has been missing for too long.

Comment

Comment

Light, Less-Filling, It's Blue Ribbon!

In an effort to draw support for his agenda of revenue sharing and salary limits, Major League Baseball Commissioner Bud Selig commissioned a Blue Ribbon Panel consisting of Richard Levin, Paul Volcker, George Will, and George Mitchell to make recommendations on reforming the national pastime. This commentary reviews and critiques the report. It concludes that the creation of the panel and its focus on competitive balance was a constructive step. In particular, the commentary praises the Report for focusing discussion on ways to ensure that all clubs have a regularly recurring reasonable possibility of postseason play. However, in several important respects, the commentary explains why the Report is unsatisfying. Its reasoning lacks the rigor and comprehensiveness one might have expected from such an expert Panel. The report establishes payroll disparity as a proxy for competitive imbalance but fails to provide a detailed analysis of causality in light of a history of competitive balance despite disparity. Its recommendation that weak teams be encouraged to increase payrolls, while wealthy teams be punished for maintaining high payrolls, harms the Panel's credibility as disinterested observers and creates the appearance of bias in favor of owners. Building on the Report, this Commentary suggests five concrete and plausibly acceptable proposals to improve competitive balance. Permitting cash sales of players subject to the Commissioner's oversight, establishing a mandatory minimum payroll at a level likely to permit clubs to viably contend for postseason play, imposing payroll maxima only on dominant teams, changing the Rule 5 minor league draft to limit the players on top teams that can be protected, and establishing procedures to reform or rid the industry of inept management, are all designed to give observers of the game the same hope for the future of our National Pastime that each fan perhaps will have, if these proposals are implemented, each springtime.

After the Crisis: Revisiting the "Banks are Special" and "Safety Net" Doctrines

The idea that banks are special was most succinctly summarized by Gerald Corrigan more than 30 years ago in an analysis prepared for the Federal Reserve Bank of Minneapolis, where Corrigan was president at the time. With the help of his mentor, then Federal Reserve Chairman Paul Volcker, his analysis pondered the characteristics of banks that make them special; justified the provision of a supporting safety net for banks based on financial stability concerns; and detailed the costs and restrictions that banks must subject themselves to. But the years since Corrigan's analysis have seen two severe financial crises, and as the crisis of 2007?2009 clearly revealed, banks are not special, as the safety net was applied to a wide range of nonbank institutions. The Dodd-Frank Act was intended to cut back on the safety net by giving financial authorities wide discretion, but the right approach to rein in the safety net would be to cut back its beneficiaries.

Transparency and Fiscal Responsibility: Traditional Critics vs. Participatory Budgeting

In the recessionary years following the 2008 financial crisis, prominent voices predicted an imminent crisis in state and municipal finances. The voices – including those of Bill Gates; Josh Ruah; Meredith Whitney; Paul Volcker; and Richard Ravitch – implied that the road to fiscal responsibility lies in reining in the pensions and benefits of public servants. We argue that by painting public employees as the villains, these voices are inserting divisiveness in what should be a universal goal of sound public finances. Instead, we suggest that the road to fiscal responsibility lies with budgetary transparency and widespread public knowledge of state and municipal finances. A key to achieving these objectives is the movement towards participatory budgeting.

Delayed Overshooting: It's an 80s Puzzle

We re-investigate the delayed overshooting puzzle. We find that delayed overshooting is primarily a phenomenon of the 1980s when the Fed was under the chairmanship of Paul Volcker. Related findings are as follows: (1) Uncovered interest parity fails to hold during the Volcker era and tends to hold in the other periods considered. (2) US monetary policy shocks have substantial impacts on exchange rate variations but misleadingly appear to have small impacts when monetary policy regimes are pooled. In brief, we confirm Dornbusch’s overshooting hypothesis.