Don't Say He Didn't Warn You

Paul Volcker was Chairman of the Federal Reserve System’s Board of Governors from late 1979 until late 1987. He oversaw the reversal of FED monetary policy that had prevailed throughout the 1970s, an inflationary policy that had produced the price inflation of the Nixon years, the floating of the dollar in 1971, two recessions (1970/71 and 1975), and two major oil price hikes. OPEC learned in 1971 that the West would tolerate the nationalization of Western oil companies’ property when Libya confiscated properties owned by BP and Bunker Hunt. OPEC also realized that a dollar unbacked by gold would soon be cut in value. OPEC was correct about both assumptions, as it proved in 1973 and 1979: price hikes.

Beginning in October of 1979, the FED stopped using fiat money to create low short-term interest rates. Volcker announced the new policy when silver was heading for $50/oz and gold was heading for $850/oz. Both prices were hit for one day in January, 1980 and then started down. Meanwhile, short-term T-bill rates soared to over 21%, the highest in modern history. Carter got a recession in 1980; Reagan got a much bigger one in 1981. But this unpalatable medicine reversed the rate of price inflation.

On Friday, the 13th of August, 1982, Mexico’s government announced that it was considering the nationalization of Western banks and threatened to default on its foreign debt. The world’s banking system teetered on the brink of paralysis. With Volcker acting as the coordinator, Western central banks responded by promising doses of liquidity (fiat money) and loan renegotiations. In September, the Mexican government did nationalize all private Mexican banks and took over the control of capital flows.

The weekend of August 13 marked the beginning of the U.S. stock market boom that lasted until 2000, with only the one-day worldwide correction of over 20% in October, 1987 – Greenspan’s first week on the job – to mar the boom. The FED adopted monetary inflation, thereby ending three years of tight money.

Volcker testified before Congress on a regular basis, as required by Federal law – the only law that Congress enforces on the quasi-autonomous FED. At 6 feet 7, he is an impressive figure. He imitated Red Auerbach, the coach of the Boston Celtics, who would light a cigar when he thought a game was as good as lost for the Celtics’ opponent. Volcker puffed cigars at Congress. In contrast, Greenspan, a far less impressive figure, has adopted a linguistic strategy to befuddle rather than overpower Congressmen: verbal smoke rather than tobacco smoke. Both approaches work just fine.

Volcker generally was forthright. He basically told Congress to fly a kite. He told them what he was going to do, and then he did it. They never laid a glove on him. He had a well-deserved reputation for not sugar-coating bad news.


On April 10, The Washington Post ran an article by Volcker: “An Economy on Thin Ice.” He began with an optimistic paragraph.

The U.S. expansion appears on track. Europe and Japan may lack exuberance, but their economies are at least on the plus side. China and India – with close to 40 percent of the world’s population – have sustained growth at rates that not so long ago would have seemed, if not impossible, highly improbable.

This assessment is consistent with the press releases of major brokerage houses. But the optimism faded in the next paragraph.

Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks – call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

The question is: What can anyone do about it? The trade imbalance soared under Clinton, who ran budget surpluses (because the annual $140 billion raid on the Social Security Trust Fund was not assessed as a deficit). It continues to soar under Bush, who is running a $420 billion deficit, plus occasional surprise assessments for the Iraq war, plus the usual $140 billion raid on Social Security.

We sit here absorbed in a debate about how to maintain Social Security – and, more important, Medicare – when the baby boomers retire. But right now, those same boomers are spending like there’s no tomorrow. If we can believe the numbers, personal savings in the United States have practically disappeared.

What policy can reverse this? Foreigners are buying investment assets; hence, the foreign trade deficit. Baby boomers are not buying assets, along with the other American age groups. This has to do with confidence in the future. Foreigners want in on the deal. Americans imagine that retirement will be as profitable as working for a living. Both groups will find that they have made a forecasting error of major proportions.

What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing. There is no sense of strain. As a nation we don’t consciously borrow or beg. We aren’t even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar.

Most of the time, it has been private capital that has freely flowed into our markets from abroad – where better to invest in an uncertain world, the refrain has gone, than the United States?

More recently, we’ve become more dependent on foreign central banks, particularly in China and Japan and elsewhere in East Asia.

Volcker goes on to say that this has kept Americans loaded up on consumer goods. It has kept prices low. It is all quite comfortable for all concerned. He neglects to mention those for whom things are not so comfortable: (1) foreign consumers, who are facing higher prices because Americans are buying goods produced in their countries; (2) American manufacturers and their employees.

The difficulty is that this seemingly comfortable pattern can’t go on indefinitely. I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

The problem is, the willingness of foreigners to invest here is like any other mania. It goes on longer than anyone who identifies it as a mania believed was possible. It is like the dot-com mania of 1999 or the housing mania today in Los Angeles County.

I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force.

This is an important prediction. A financial crisis, unlike a policy change, is not debated publicly. It hits without warning.

There is a wide area of agreement among establishment economists about a textbook pretty picture: China and other continental Asian economies should permit and encourage a substantial exchange rate appreciation against the dollar. Japan and Europe should work promptly and aggressively toward domestic stimulus and deal more effectively and speedily with structural obstacles to growth. And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand.

The fact that he would refer to “establishment economists” is revealing. This is the terminology of a dissenter. But Volcker is not an obscure newsletter writer. At one point, he was the most powerful economic decision-maker on earth.

Japan has been pursuing massive government deficits since 1990. It has been following Keynesian stimulus policies according to Keynesian textbooks. It has still been in recession mode for almost 15 years. Europe is doing the same. Most nations are ignoring the limits on deficits set by treaty. “And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand.” What combination of measures? The only ones that make sense are the abolition of the capital gains tax and the end of the double taxation of corporate profits. Establishment economists, being Keynesians, want no part of either policy. Neither has a political chance during the second term of a wartime President.

But can we, with any degree of confidence today, look forward to any one of these policies being put in place any time soon, much less a combination of all?

The answer is no. So I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s – a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.


Volcker is using a tried-and-true sales strategy: create a sense of unease; then offer a solution. The problem is, the salesman’s solution is always “new, improved, and pain-free – with no money down and two full years without interest.” Volcker’s isn’t. Yet he uses the direct-response copywriter’s words: “Act now!”

The clear lesson I draw is that there is a high premium on doing what we can to minimize the risks and to ensure that there is time for orderly adjustment. I’m not suggesting anything unorthodox or arcane. What is required is a willingness to act now – and next year, and the following year, and to act even when, on the surface, everything seems so placid and favorable.

When the copy writer says “Act now,” he always offers a benefit for acting now. You get a special premium of some kind, or a discount, or something. But Volcker offers no immediate reason to act now.

What I am talking about really boils down to the oldest lesson of economic policy: a strong sense of monetary and fiscal discipline. This is not a time for ideological intransigence and partisan posturing on the budget at the expense of the deficit rising still higher.

But the FED already is slowing the rate of monetary inflation. It is allowing short-term rates to rise. This was Volcker’s strategy in late 1979 and 1980. The FED has no other standard policy tool available, other than raising bank reserve requirements, which has not been done in my adult lifetime. As for fiscal discipline – the government’s obligation – which form should it take?

Cut taxes, leave spending as-is, and let the economy boom? (supply side).

Raise taxes and keep the Iraq war going? (nobody’s solution)

Raise taxes, get out of Iraq, cut military spending, and raise domestic spending? (Teddy Kennedy’s solution)

Raise taxes, get out of Iraq, cut all spending? (nobody’s solution)

Cut taxes, cut spending, stabilize the money supply, get out of Iraq, and then shut down all of the Federal regulatory agencies. (Austrian School solution – Cong. Ron Paul and no one else.)

Volcker ends his essay:

A wise observer of the economic scene once commented that “what can be left to later, usually is – and then, alas, it’s too late.” I don’t want to let that stand as the epitaph of what has been an unparalleled period of success for the American economy and of enormous potential for the world at large.


Volcker has been sounding the alarm for months. The markets pay no attention. If Greenspan were this forthright, the capital markets would respond in minutes – downward.

The truth of the analysis is not the question in the minds of establishment investors. What matters is the short-term power of the analyst.

I did not believe Volcker in October, 1979, when he announced what he was going to do. I should have. I believe him this time.

I think you should, too.

April 13, 2005

Gary North [send him mail] is the author of Mises on Money. Visit

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