President Reagan's victory in 1980 provided a new challenge for
Paul Volcker as chairman of the Federal Reserve Board.
In addition to the problem of a runaway money supply and
accompanying rising interest rates, he had to contend with a fiscal
policy that many economists said was written in bright red ink.
The new president came into office fostering a revolutionary
fiscal policy calling for a 30 percent reduction in federal income
taxes and new tax breaks for businesses to spur lagging investment
in the United States.
The program embodied supply-side economics, which held that
individual tax rates had risen so high in the United States that
they had retarded work effort, investment and job creation.
Furthermore, some of the supply-side theorists who took high
positions in the U.S. Treasury Department believed that the program
would be relatively painless from a budgetary standpoint.
If enacted, they said, the program would generate an economic
boom. As national income increased, this would bring in enough tx
revenue to ensure that the budget deficit would not become a massive
Volcker recognized instantly that the new program had the
potential for causing big budget deficits and making his job of
controlling inflation more difficult. On the other hand, he knew
that a non-elected Fed chairman should not try to subvert the will
of the American people.
In voting Reagan into office, the people had implicitly endorsed
these tax reductions.
When the president announced his new program Feb. 18, 1981,
complete with details of where he would like to see budget cuts
made, he left the control of inflation up to the Federal Reserve.
But what he outlined was clearly a gradualist policy.
If the Fed allowed its monetary targets, it said, inflation
would fall softly from 11.1 percent in 1981 to 8.3 percent in 1982,
7 percent in 1983, 6 percent in 1984, 5.4 percent in 1985 and 4.9
percent in 1986.
``The administration supports the announced objective of the
Federal Reserve to continue to seek gradual reduction in the growth
of money and credit aggregates during the years ahead,'' the
administration's proposal said. One administration official said
gradualism was ``the only real shot we had of correcting inflation
without a real recession.''
Gradualism died in 1981, but the jury is still out on whether
Volcker conducted an act of premeditated murder or if its demise was
accidental. The recession that began to develop in 1981 was the
direct result of a historic economic policy mismatch.
Reagan's tax cuts pushed on the accelerator as Volcker's tight
money pushed on the brakes. The brakes won, hands down, and the
uncertainty caused by these powerful opposing forces added a few
percentage points to interest rates, too.
Volcker did not place great faith in gradualism. It looked good
on paper, perhaps, and at first blush it seemed to be a sensible
course to follow. But to him, it offered a painless cure for
inflation that did not seem plausible, and from a semantic standpoint
it made the Fed's anti-inflation policy sound wimpish to money
markets expecting strength and resolve.
He had seen economic surprises and attitude changes destroy such
carefully designed plans in the past. Gradualism to him was akin to
the kind of economic fine-tuning that had brought monetarist critics
down on him earlier.
To Volcker, inflation in 1981 had reached crisis proportions,
and to whip it called for strong, immediate and clear action.
Don't tap it gently. Whack it. Crisis management would demand
In view of Volcker's reputation as a pragmatist who favored
strong reactive moves to current economic problems, it was no
surprise that he ran afoul of the more ideological economic thinkers
that came to Washington with a new administration. …