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Keeping At It: The Quest for Sound Money and Good Government

Paul Volcker’s book is a great read for those of us who lived through the financial history that he helped to make. It is also an object lesson in financial reality for the younger financial folks who seem to think that government policy is the answer to every economic and market ill that exists. More money created and more debt created didn’t always lead to positive economic and social outcomes, as Volcker vividly recounts.

As the song goes, “Those were the days, my friends!”

Volcker started his career as a financial bureaucrat at the Federal Reserve in the 1950s after graduating from Yale and completing a Masters degree at the London School of Economics, back when a PhD wasn’t even a pre-requisite. This son of a small city manager got a job with the New York Fed and then meandered through the financial halls of power and politics.

He recounts his career with heaping helpings of recollections and anecdotes that make it quite readable, along with a pinch of gossip to spice things up. Volcker had a Forrest Gump-like timing for important events. The fictional Forrest ended up being there when history was made by happenstance. Volcker was at important events through sheer ability and force of personality, not to mention his imposing 6’ 7” height. For those of us on the outside, reading about events in newspapers or watching the news coverage of the time, Volcker’s book is a fascinating insider look.

As Under Secretary for Monetary Affairs in the Treasury Department during former President Richard Nixon’s administration, Volcker was involved in one of the most turbulent periods in U.S. financial history. The Bretton Woods Agreement had governed exchange rates since the Second World War. Other countries fixed their exchange rates to the U.S. dollar but could convert their U.S. dollar holdings to gold on demand. With the Vietnam War and U.S. fiscal and trade deficits, U.S. gold reserves dropped to only 25 % of U.S. liabilities to other countries. If enough countries demanded gold for the dollars they held, the dollar would be finished as the reserve currency. Something had to be done, and in his Gumpian way, Volcker found his way to the centre of the action.

Volcker and David Kennedy, Secretary of Treasury, stood in the Oval Office in 1969 and warned President Nixon “that inflationary forces were gaining hold and it might be better to take action early. As Volcker dryly puts it “I don’t think President Nixon particularly appreciated our political advice. The conversation was not prolonged.”

Readers might find a description of a past politician applies to one of our times: “Without economic training, (David) Connally (who succeeded Kennedy as Secretary of Treasury) instead was guided by his instinct that the United States was in economic trouble and a weaker dollar… to reduce import competition and to help our exporters.”

Connally was at the International Banking Conference when he went off his prepared remarks about the need for trade reform and currency adjustments and stated: “… there are necessarily some unalterable positions of any participant… I want without any arrogance or defiance to make it abundantly clear that we are not going to devalue, we are not going to change the price of gold, we are going to control inflation

When Volcker asked Connally whether he needed to be so firm when the U.S. might indeed devalue and go off the gold standard, Volcker recounts that “etched in his memory” was Connally’s reply: “That’s my unalterable position today. I don’t know what it will be this summer.” That sounds a bit Trumpish to me!

Volcker eventually returned to the Fed, heading the New York Fed before being appointed Chair of the Federal Reserve in 1979 by President Jimmy Carter. This was no safe sinecure. Inflation and bond yields were soaring and nobody believed at that time the Fed or anyone else could stop it. The market mavens of those days called government bonds certificates of confiscationand hedging against inflation was the goal of all investors. Negative bond yields were not the funky monetary policy innovation they are today. Investors were worried that their “real yield” was negative since inflation was higher than the yields on their bonds so they were losing purchasing power.

Volcker surprised the financial markets and the whole world in 1980 by jacking up interest rates to unprecedented levels. Three month Treasury Bills were over 17%, residential mortgage rates were over 18% and the banking prime rate hit 21.5%. This put paid to runaway inflation but was not popular. Protests from both the right and left of the political spectrum dogged Volcker and the Fed. The tight monetary policy caused a severe recession and inflation fell from 18% in January 1980 to 4% by the summer of 1982.

In the end, 1981 proved the peak for bond yields and they have been declining ever since. Alan Greenspan replaced Volcker as Fed Chair in 1987 and presided over the “Great Moderation,” which really resulted from his predecessor’s success in quashing inflation. Greenspan, a “political economist” rather than a career bureaucrat like Volcker, ended up creating the current central banking “crisis fighting” model where central bankers have become financial crisis fighting superheroes.

What of the present? Politicians have always and will always want more money and a “better economy.” That is why the Federal Reserve Act contemplates its “political independence” which is something there has always been bipartisan support for. Politicians used to be loath to be seen to be criticizing the Fed. Volcker recounts an episode with President Ronald Reagan, where he was called in to hear that the president did not want rates raised before an impending election. Volcker was shocked at this interference and left without saying a word. He realized that the meeting was not in the Oval Office to avoid taping and the appearance of intervening and applying political pressure on the Fed.

Times are sure different now. What does Volcker think of a President that tweets insults about the Fed and its Chair Jerome Powell? Volcker signed a letter along with many other U.S. financial luminaries that objected to Trump’s treatment of the Fed. Trump has not just taken to commenting on Fed policy, he has directly demanded it bend to his will. The Trump Twitter insult storm looks to be working. The recent policy change from the Fed “normalizing” interest rates to three modest rate cuts in 2019 – given the reasonable economy and inflation near target – looks to me like a direct result from Trump’s demands.

Things will not get better for the Fed. Trump recently tweeted that the U.S. has the best economy in the world and should therefore have the “most negative interest rates” for that reason. This is rather flawed economic logic but President Trump believes he is a “stable genius” and thinks than anyone who objects to his ideas are “Deep State” operatives, trying to thwart his will.

Yet Trump’s tweeted demands for “ZERO” or negative interest rates don’t square with his claim of the BEST ECONOMY EVER!! The lowest bond yields since the Great Depression of the 1930s were recorded in the summer of 2019, in the aftermath of the unexpected Fed easing of monetary policy, and nobody now believes that they could ever go up.

The current market consensus is that it doesn’t matter how much money is created and that inflation will never be a problem. That echoes the thinking in the early 1960s, when a good economy and stable inflation led to a common understanding that monetary policy should be used to keep things going strong – and ended with the high inflation years of the 1970s.

Current success in the bond market has come from holding bonds with yields below prevailing inflation. The Fed is now organizationally desperate to raise inflation and just might succeed.

That is why Volcker’s book is essential reading for all investors.