Paul Volcker: Lessons Learned

by: John M. Mason

I have just finished reading the book, "Volcker: The Triumph of Persistence," by William L. Silber. It is an excellent book, well written, and a book that I could not put down. Bill has done a remarkable job in producing this book and it is a well-deserved member of the Financial Times' short list for best business book of the year.

The work contains biographical information on Volcker, but the main thrust of the book deals with three major periods of Volcker's life: his work in the Nixon Administration; his experience at Chairman of the Board of Governors of the Federal Reserve System; and his efforts surrounding the development and passage of the "Volcker Rule," which became a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Paul Volcker's initial job after graduate school was at the Federal Reserve Bank of New York, where he was hired as an economist. His good fortune brought him into contact with Robert Roosa, vice president of the Research Department and an expert on the money markets. Roosa, in the 1950s, wrote the bible of how the Federal Reserve conducted monetary policy and Paul Volcker was drafted to help in the research and writing of this document. Roosa then put Volcker to work in the trading room at the Fed in order to get first-hand experience with markets.

In the 1960s, Roosa moved to the U. S. Treasury Department to join the Kennedy administration as undersecretary of the Treasury for monetary affairs. He brought Volcker along with him.

This was an interesting path because the economists in the Kennedy administration generally tended to be of the "Keynesian" persuasion and focused upon unemployment and "getting America growing again." Volcker, on the other hand, worried about the international monetary system, the Bretton Woods system, international capital movements, and foreign exchange rates.

This gave Volcker a different perspective on economic events from the one held by most of the economists that worked in the administration at this time. The latter were focused on stimulating the economy, the Kennedy tax cuts, and reducing unemployment. Volcker focused on international finance, international capital flows, and the value of the dollar.

In 1965, Volcker left the Treasury to go to work at Chase Manhattan Bank. He was not to be there long. Remarkably, Volcker was drawn back to Washington, D. C. when Nixon was elected president in 1968. Volcker, a Democrat, was appointed to the Treasury Department, in the exact same position previously held by Roosa.

I cannot do justice to Silber's treatment of Volcker's experience at the Treasury Department. All I can say is that Volcker was the key person that developed the plan to sever the ties between the U. S. dollar and gold and ended up being the "point man" in discussions with leaders in Europe and the rest of the world after the plan's August 15, 1971 announcement by Nixon.

I also cannot cover in great deal Volcker's tenure as the Chairman of the Federal Reserve. Silber does a remarkable job of bringing his reader into the time and the politics of his fight against inflation. It is truly amazing what Volcker was able to do.

I would like to emphasize some key insights into how Volcker views the world.

Volcker's experience was not with the problem of unemployment. The events that dominated his time at the Treasury Department related to international monetary relationships and the value of the dollar. Key to the international monetary system at the time was the relationship between gold and the dollar.

And, what raised its head during Volcker's time at the Treasury in the 1960s? Inflation!

The Kennedy administration's emphasis on creating "a little inflation" to reduce unemployment and the Johnson administration's efforts to fight a war in Viet Nam resulted in rising price levels. By the beginning of the 1968 presidential campaign, inflation had increased to the point that it was becoming a real issue. After Volcker joined the Nixon administration, inflation became more and more of a problem, which, of course, ended up precipitating the severing of the dollar and gold.

Volcker came to focus on two crucial variables during this time: the value of the dollar and the value of gold. This is truly remarkable because this was not something that came out of his academic experience, his working in the trading room at the New York Fed, or his colleagues. Volcker developed this focus by actually living through the international monetary upheavals of the 1960s. And, the focus never left him during his tenure as the Chairman of the Fed.

Why did he focus on the value of the dollar and gold? Because the prices of these two items captured as surely and in as timely a way as possible the expectations of the financial markets concerning inflation. And, inflation was the major problem that Volcker had to fight.

Volcker believed this so strongly that he wrote in his book (with former Japanese Minister of Finance Toyoo Gyohten) "Changing Fortunes: The World's Money and The Threat to American Leadership" the following: "a nation's exchange rate is the single most important price in the economy." (page 232) It's value reflects traders expectations about future inflation.

Another idea was important to Volcker, but this one did not come to him until he was the Chairman of the Fed. This was the concept of "rational expectations." Simply put, this idea contends that you cannot constantly fool people because people adjust their expectations as they learn.

For example, a little bit of inflation may initially fool people, but they will catch on. Thus, to get a similar impact, say on reducing unemployment in the future, inflation must be increased. People learn and their expectations tend to catch up with what is actually happening to them.

In the 1980s, Volcker observed that inflationary expectations in the United States had ramped up and presented the Federal Reserve with a substantial problem. The expectation that the government would continue to create more and more inflation had become widespread. Thus, you could have a period of "stagflation" where economic growth was extraordinarily slow, yet inflation continued on at a very rapid pace. Volcker perceived that these "expectations" had to be broken before the country could resume a more normal rate of growth.

The author also presents an interesting picture of the development of the "Volcker Rule" and how it became a part of the financial reform bill. Volcker's thoughts here go back to the old, old belief that bankers must always be protected from themselves because, historically, they always try to squeeze too much out of a good thing. But, read the book for exactly how this plays out for Volcker.

Silber ends his book with a chapter entitled "Trust." He argues that government officials must be trusted in terms of the programs they present and in their willingness to see them through to the end. The programs must be clearly present, and the commitment must be fully exhibited. In this respect, no leader in the United States government over the past 50 years or so has commanded so much trust as has Paul Volcker.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.