Paul Volcker

Based on Wikipedia: Paul Volcker

The Man Who Broke the Economy to Save It

In the summer of 1979, angry farmers drove their tractors through the streets of Washington, D.C., and blockaded the headquarters of the Federal Reserve. Homebuilders across America mailed two-by-four lumber to the Fed in protest. The unemployment rate was climbing toward eleven percent. And at the center of all this fury stood a six-foot-seven-inch economist named Paul Volcker, calmly smoking a cheap cigar while deliberately inflicting economic pain on millions of Americans.

He was doing it on purpose. And it worked.

Paul Volcker's story is one of the most consequential and counterintuitive episodes in American economic history. To cure the disease of runaway inflation, he administered a treatment so brutal that it triggered the worst recession since the Great Depression. By the time he was finished, he had transformed not just the American economy but the very idea of what a central banker could and should do.

From Small-Town New Jersey to the Corridors of Power

Volcker was born in 1927 in Cape May, New Jersey, to a family of German immigrants. His father, Paul Senior, served as Teaneck's first municipal manager, a job he held for twenty years. This was no small-town sinecure. The elder Volcker transformed Teaneck's finances and government operations, modeling the kind of steady, competent public administration that would later define his son's career.

Young Paul absorbed this lesson early. At Teaneck High School, where he graduated in 1945, his teachers and classmates noticed his unusual grasp of politics and policy. But it was at Princeton that Volcker's intellectual framework crystallized. His senior thesis, written in 1949, bore the technical title "The Problems of Federal Reserve Policy since World War II." What's remarkable is what the twenty-one-year-old Volcker argued: that the Federal Reserve had failed to control a dangerously swollen money supply after the war, creating "a grave inflationary threat to the economy."

Thirty years later, he would get the chance to do something about it.

After Princeton, Volcker earned a master's degree at Harvard, then studied at the London School of Economics on a Rotary Fellowship. He joined the New York Federal Reserve as an economist in 1952, beginning an odyssey through the most important institutions of American finance. Chase Manhattan Bank. The Treasury Department under three presidents. Back to Chase. Each position added another layer of expertise, another set of connections, another perspective on how money moved through the economy.

The Day the Dollar Died

Before understanding what Volcker did as Federal Reserve Chairman, you need to understand what he did eight years earlier, because it explains both the crisis he inherited and how he thought about monetary policy.

In August 1971, Volcker was serving as Under Secretary of the Treasury for International Monetary Affairs when he helped engineer one of the most significant economic events of the twentieth century. President Richard Nixon, acting on advice from Volcker and others, announced that the United States would no longer convert dollars to gold at the fixed rate of thirty-five dollars per ounce.

This sounds technical. It was anything but.

Since the end of World War II, the global economy had operated under something called the Bretton Woods system. Named after the New Hampshire resort where it was negotiated in 1944, this system made the dollar the anchor of international finance. Other countries' currencies were pegged to the dollar, and the dollar was pegged to gold. Anyone holding dollars could, at least in theory, exchange them for gold at the U.S. Treasury.

By 1971, this system had become unsustainable. The United States was running persistent deficits, and foreign governments were increasingly trading in their dollars for American gold. Nixon's announcement ended the convertibility of dollars to gold and effectively killed Bretton Woods. Volcker later called it "the single most important event of his career."

The consequences were profound. Without the discipline of gold convertibility, there was now nothing physical constraining how many dollars the Federal Reserve could create. In the right hands, this flexibility could be a powerful tool for managing the economy. In the wrong hands, or in the absence of discipline, it could lead to disaster.

Over the next eight years, America got the disaster.

The Great Inflation

By the late 1970s, inflation had become the dominant fact of American economic life. Prices were rising so fast and so unpredictably that normal economic planning became nearly impossible. The Consumer Price Index, which measures the cost of a typical basket of goods, was increasing at nearly fifteen percent per year by early 1980.

To understand what this meant in practice, consider that if prices rise at fifteen percent annually, they double in less than five years. Your savings lose half their value. Fixed incomes become poverty wages. Contracts signed today become absurdly unfair tomorrow. The very concept of a "price" starts to lose meaning when everyone knows it will be different next month.

Worse, inflation had become self-perpetuating. Because everyone expected prices to keep rising, they demanded higher wages, which forced businesses to raise prices, which justified even higher wage demands. Economists call this an "inflationary spiral." Once it gets going, it can feed on itself indefinitely.

The Federal Reserve, the institution charged with maintaining price stability, had tried repeatedly to break the spiral. Each time, they raised interest rates, the economy slowed, unemployment rose, and political pressure forced them to reverse course before inflation was truly defeated. Inflation would subside temporarily, then come roaring back. Each cycle seemed to make the problem worse.

By 1979, public confidence in the dollar and in American economic institutions was collapsing. President Jimmy Carter, already battered by the energy crisis and the Iranian hostage situation, knew he needed to do something dramatic.

The Tallest Man in the Room

Carter's first choice for Fed Chairman, G. William Miller, had proven disastrously ineffective. When Miller was moved to Treasury Secretary in the summer of 1979, the mere announcement that his deputy would serve as Acting Fed Chairman sent financial markets into a panic. Carter needed someone who would restore confidence immediately, someone with unquestioned credibility in the financial world, someone willing to take the painful steps his predecessors had avoided.

He chose Paul Volcker.

Volcker was an unusual figure in multiple ways. At six feet seven inches, he literally towered over most of his colleagues. He dressed carelessly, smoked cheap cigars constantly, and drove a battered old Buick. He lived in a modest apartment rather than the grand houses favored by Washington power brokers. When he became Fed Chairman, his wife declined to move to Washington, and he lived alone in a small apartment near the Fed, doing his own laundry.

None of this suggested the soft lifestyle of a Wall Street banker. Volcker came across as an incorruptible public servant, a technocrat interested only in getting the policy right. This image would prove essential to what came next.

The Senate confirmed him on August 2, 1979. He took office four days later. The inflation rate that month was running at over eleven percent annually.

The Volcker Shock

What Volcker did next has gone down in history as the "Volcker Shock," and the name is apt. Instead of the gradual, tentative interest rate increases his predecessors had attempted, Volcker ratcheted rates up to levels that had never been seen before.

The federal funds rate, which is the interest rate banks charge each other for overnight loans and which effectively sets the floor for all other interest rates in the economy, had averaged about eleven percent in 1979. Under Volcker, it would reach twenty percent by June of 1981. The prime rate, the rate banks charge their most creditworthy customers, hit twenty-one and a half percent.

To put these numbers in perspective, if you wanted to buy a house in 1981, you might have been offered a mortgage at eighteen percent interest. At that rate, your monthly payment on a hundred-thousand-dollar loan would be over fifteen hundred dollars, and you would pay more than four hundred thousand dollars in interest over the life of the loan. Very few people could afford to buy houses. Very few people did.

The housing industry collapsed. Construction workers lost their jobs. Homebuilders went bankrupt. Lumber mills shut down. This explains why those homebuilders mailed pieces of two-by-four lumber to the Fed. They were sending wood they could no longer use because no one was building houses.

The agricultural sector was devastated even more severely. Farmers had borrowed heavily during the 1970s, when inflation made debt easy to repay with cheaper future dollars. Now interest rates on their loans doubled or tripled. Many could no longer make their payments. Farm foreclosures swept across the Midwest. Hence the tractors blockading the Federal Reserve.

Manufacturing cratered. The American auto industry, already struggling against Japanese competition, entered a death spiral. Steel mills closed. Factories shuttered. Cities that had been centers of industrial production began their long decline into the Rust Belt.

Unemployment, which had been around six percent when Volcker took office, rose past ten percent by late 1982. This was the highest unemployment rate since the Great Depression. More than eleven million Americans were out of work.

The Method Behind the Madness

Why did Volcker do this? Why would anyone deliberately induce a recession that threw millions of people out of work?

The answer lies in how inflation psychology works. By 1979, Americans had lived with high inflation for nearly a decade. They had adapted to it. Unions negotiated contracts with automatic cost-of-living adjustments. Businesses routinely raised prices just to keep up with their competitors. Everyone expected inflation to continue, which guaranteed that it would.

Breaking this psychology required convincing everyone, simultaneously, that the Federal Reserve would no longer tolerate inflation. Half-measures wouldn't work. If the Fed raised rates modestly and then backed off at the first sign of economic distress, as it had done repeatedly in the past, no one would believe the commitment was real. The inflationary expectations would remain intact.

Volcker understood that credibility was everything. The Federal Reserve had to demonstrate, through action rather than words, that it would accept a severe recession rather than allow inflation to continue. Only then would businesses stop raising prices preemptively. Only then would workers stop demanding wage increases to compensate for expected inflation. Only then would the spiral break.

This approach drew on ideas from a school of economic thought called monetarism, associated with the economist Milton Friedman. Monetarists argued that inflation was always and everywhere caused by too much money chasing too few goods. Control the money supply, and you control inflation. Volcker embraced this framework, at least publicly, targeting the money supply rather than interest rates directly.

In practice, the distinction was somewhat theoretical. Whether you said you were controlling the money supply or interest rates, the mechanism was the same: make borrowing extremely expensive, and economic activity would slow. The monetarist language, however, gave Volcker political cover. He could claim he was following scientific principles rather than making arbitrary decisions to hurt people.

The Politics of Pain

Volcker's Federal Reserve faced the most intense political attacks in the institution's history. This was not hyperbole. Nothing since 1922, when the Fed first achieved its modern form, had generated such widespread protest.

The protests were bipartisan. Democrats blamed Volcker for destroying working-class jobs. Republicans, despite their rhetorical commitment to fighting inflation, grew alarmed as the 1982 midterm elections approached with unemployment still climbing. Both parties introduced legislation to curtail the Fed's independence or change its mandate.

The Reagan administration presented a particularly complicated case. President Ronald Reagan had been elected in 1980 partly on a promise to restore American economic strength, and Volcker's policies were pushing the economy deeper into recession. At the same time, Reagan's tax cuts and military spending increases were expanding the federal deficit, which put additional upward pressure on interest rates.

The combination of tight money from the Fed and loose fiscal policy from the White House created enormous economic distortions. Interest rates stayed high partly because the government was borrowing so much money to finance its deficits. The strong dollar that resulted from high U.S. interest rates made American exports expensive abroad, devastating manufacturing industries that depended on foreign sales.

In July 1984, with Reagan running for reelection, the President summoned Volcker to the White House. In the Oval Office, Chief of Staff James Baker delivered an extraordinary order: do not raise interest rates before the election. Volcker was stunned. This was precisely the kind of political interference with monetary policy that the Fed's independence was designed to prevent.

Volcker did not publicly reveal this meeting for decades. He kept quiet partly because he had not intended to raise rates anyway, and partly because he calculated that the White House would not publicize an incident that made them look like they were manipulating the economy for political gain. But the incident revealed the intense pressure he faced from an administration that was nominally on the same anti-inflation side.

Victory and Its Costs

By 1983, Volcker's approach was working. Inflation, which had peaked at nearly fifteen percent in March 1980, fell below three percent. The inflationary expectations that had become embedded in American economic behavior were finally breaking down.

Interest rates began to decline. The economy started growing again. Unemployment, though still historically high, began to fall. By the time Reagan ran for reelection in 1984, he could credibly claim that America was experiencing "morning in America," an economic resurgence built on the foundation Volcker had laid.

The costs, however, had been enormous and were not evenly distributed. The recession of 1981-82 permanently scarred certain industries and regions. The industrial Midwest never fully recovered. Family farms that had been in the same hands for generations were lost forever. Workers who lost jobs in their forties or fifties often never worked at comparable wages again.

Moreover, some economists have argued that the severity of the recession was not strictly necessary. Alternative approaches might have achieved similar inflation reduction with less unemployment. The "cold turkey" approach of shocking the economy into submission was not the only possible treatment.

Volcker's defenders respond that gradual approaches had been tried and had failed repeatedly. The very severity of the shock was what made it credible. Anything less, and the inflationary expectations would have survived to fight another day.

The Aftermath

Reagan renominated Volcker to a second term in 1983, and he served until 1987. By then, inflation was firmly under control, and the economy was in the midst of what would become the longest peacetime expansion in American history up to that point.

When Volcker left the Fed, he did not fade into obscurity. He chaired various international commissions, investigated Nazi gold hidden in Swiss banks, and probed corruption in the United Nations Oil-for-Food program in Iraq. In each role, he brought the same qualities that had defined his Fed tenure: methodical analysis, incorruptibility, and a willingness to reach uncomfortable conclusions.

The financial crisis of 2008 brought Volcker back to prominence. President Barack Obama appointed him to chair the Economic Recovery Advisory Board, and Volcker became the leading advocate for breaking up the largest banks and limiting their risky activities. The "Volcker Rule," which prohibits banks from making certain speculative investments, bears his name. It was a fitting capstone to a career dedicated to preventing financial institutions from destabilizing the broader economy.

Volcker died in December 2019 at the age of 92. By then, his legacy was secure. The Volcker Shock had become a case study in economic policymaking, examined and debated in every graduate school of economics and public policy.

Lessons and Legacies

What should we learn from Paul Volcker's story?

The most obvious lesson is that credibility matters enormously in monetary policy. The Federal Reserve's power ultimately rests on beliefs. If people believe the Fed will tolerate inflation, they will act in ways that produce inflation. If they believe the Fed will not tolerate it, they will act differently. Volcker demonstrated that changing those beliefs sometimes requires dramatic, even painful action.

A second lesson is that institutional independence has value. Volcker could not have done what he did if every interest rate decision had required congressional approval. Politicians facing reelection in 1982 would never have voted for policies that pushed unemployment over ten percent. The Fed's insulation from direct political control allowed it to take the long view, even at enormous short-term cost.

But this raises a troubling question. If unelected technocrats can make decisions that throw millions of people out of work, what are the limits on their power? Who holds them accountable? Volcker was praised when his policies succeeded, but what if they had failed? What if the recession had not broken the inflationary spiral? What if the economic damage had been permanent?

There is also the question of alternatives. Volcker himself later acknowledged that the particular methods he used, the emphasis on money supply targeting, were partly tactical. The real goal was high interest rates, and the monetarist framework provided intellectual and political cover. This raises the question of whether the economic suffering could have been reduced with different approaches.

Finally, there is the distributional question. The costs of the Volcker Shock fell disproportionately on workers in manufacturing and agriculture, while the benefits of stable prices accrued broadly across the economy. Those farmers who lost their land never got it back, even after inflation was defeated. The steel workers who lost their jobs when their mills closed never found equivalent work. An economic intervention that produces net benefits can still be deeply unjust if its costs and benefits fall on different groups.

These questions have no easy answers. But Volcker's story forces us to confront them. In a world where inflation has returned after decades of quiescence, where central banks again face pressure to raise rates and slow economies, the lessons of the Volcker Shock are more relevant than ever.

Paul Volcker was not a warm or charismatic figure. He was an economist's economist, methodical and data-driven, more comfortable with spreadsheets than speeches. But he possessed something rarer than charisma: the willingness to make an unpopular decision and stick with it until the job was done. In an era of political calculation and short-term thinking, that quality made him one of the most consequential public servants of the twentieth century.