What Have We Learned since October 1979?

Article excerpt

My good friend Ben Bernanke is always a hard act to follow. When I drafted these remarks, I was concerned that Ben would take all the best points and cover them extremely well, leaving only some crumbs for Ben McCallum and me to pick up. But his decision to concentrate on one issue-central bank credibility-leaves me plenty to talk about.

Because Ben was so young in 1979, I'd like to begin by emphasizing that Paul Volcker retaught the world something it seemed to have forgotten at the time: that tight monetary policy can bring inflation down at substantial, but not devastating, cost. It seems strange to harbor contrary thoughts today, but back then many people believed that 10 percent inflation was so deeply ingrained in the U.S. economy that we might be doomed to, say, 6 to 10 percent inflation for a very long time. For example, Otto Eckstein (1981, pp. 3-4) wrote in a well-known 1981 book that "To bring the core inflation rate down significantly through fiscal and monetary policies alone would require a prolonged deep recession bordering on depression, with the average unemployment rate held above 10%." More concretely, he estimated that it would require 10 point-years of unemployment to bring the core inflation rate down a single percentage point,1 which is about five times more than called for by the "Brookings rule of thumb."2 As it turned out, the Volcker disinflation followed the Brookings rule of thumb rather well. About 14 cumulative percentage point-years of unemployment above the nonaccelerating inflation rate of unemployment (NAIRU) drove core inflation down by 6.2 percentage points over the six years spanning 1980 to 1985.3 Yes, disinflation hurt, but much less than what the pessimists envisioned. Volcker may have enhanced the Fed's credibility; I certainly think so. But that did not improve the inflation-unemployment trade-off.

The forced march of core inflation down from 10 percent to 4 percent in the early 1980s taught us a second lesson that, I believe, is the essence of Paul Volcker's legacy: that sometimes the central bank has to be single-minded about fighting inflation, and that the strong will of a determined leader like Volcker is one key ingredient. When Volcker took the helm, the nation's problem was clear-too much inflation-and so was the solution-sustained tight money. It only required someone with iron will to apply the solution to the problem. Lindsey, Orphanides, and Rasche (2005) ask at this conference whether Volcker was a monetarist, a Keynesian, an inflation targeter, and so on. They seem to answer no in each case. To me, the right short characterization of Paul Volcker as Chairman of the Fed is simple: He was a highly principled and determined inflation hawk.

I would like to contrast these two Volcker lessons, which are the foci of this conference, with two quite different lessons that we can take away from the Greenspan era. The first is that, in apparent contradiction to what I just said, flexibility in monetary policy is very important. The contradiction is only apparent, not actual, because the worlds faced by Paul Volcker and Alan Greenspan were starkly different. During the Greenspan years, inflation has flared up only once, in 1990-91, and then only briefly. Instead, Greenspan has faced, among other things, two severe stock market crashes, a period of fragile bank balance sheets in the early 1990s, the rolling international financial crises of 1997 and 1998,4 the surprising productivity acceleration after 1995, a brief flirtation with deflation, and the need to pull off several "soft landings." Excruciatingly tight money was not the right solution to any of these problems. I daresay that history will not remember Alan Greenspan as the man who took 17 years to bring inflation down from 4 percent to 2 percent. Rather, it will remember him as the Fed Chairman who dealt so well with a remarkable variety of difficult challenges over a prolonged period of time.

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