Volcker on 50 Years of Central Banking

[William F Hummel <wfhummel@xxxxxxxxx>]

   Monetary Policy Transmission:  Past and Future Challenges
              Distinguished Address by Paul A. Volcker

Conference on Financial Innovation and Monetary Transmission
Sponsored by the Federal Reserve Bank of New York, April 2002
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The subject of this conference -- innovation and monetary policy
transmission -- is something that has naturally concerned me over
the years. Historically, the issue has appeared in somewhat
different guises. I never thought I had really adequate answers,
but somehow the system has worked. Moreover, I am afraid that as
far as current technological and financial innovations go, I
should be listening rather than speaking. I am not a big user of
new technologies. My main experience with technology as president
of this Bank and then as chairman of the Federal Reserve Board
was asking why staff needed new computers every four years. I
always had the feeling that capacity was expanding exponentially
over time, but I did not know that monetary policy was becoming
any better.

Nonetheless, I believe you are onto an intriguing subject.
Indeed, some of the topics covered in your papers remind me of
questions I have thought about before. For example, when I was
here and when I was in Washington in the late 1970s and early
1980s, we embarked on some new approaches to monetary policy that
depended upon control of money by the means of quantitative
control of the reserve base.

I can remember tossing and turning at night thinking whatever we
do, the banks will try to game us. Could they use the same
reserves to satisfy our reserve requirements at the end of the
day and satisfy the reserve requirements in Asia and in England?
Would the result be an inability to control the effective money
supply through U.S. reserve policy? I see from one of your papers
that the issue of how globalization may affect policy
transmission has not gone away, so I guess my sleepless nights
were not entirely misguided.

In preparing for this talk, I read two earlier papers on the
topic of innovation and monetary policy, one by Ben Friedman and
the other by Mike Woodford. They are both intriguing and
reassuring in two respects: First, I am not the only person
worrying about the subject of monetary control, and second, while
the technical details may be different, the underlying concerns
of how to conduct monetary policy in the face of innovations have
not changed that much. So rather than trying to look too far into
the future, I thought it might be useful to talk about my own
experiences in previous periods of structural change and
innovation during my career at the Federal Reserve.

I literally have been around the Federal Reserve for more than
fifty years. I wrote my senior thesis on Federal Reserve policy
in 1949. From then until at least the last few years, I have been
more or less directly involved with the Fed. I have always liked
one piece of philosophy by Yogi Berra. He said you can observe
quite a lot just by watching, and I have done quite a lot of
watching of the Federal Reserve. So it might be of some passing
interest to share the observations I have made over a period of
fifty years. And if nothing else, it will give you some
reassurance that the kinds of problems you are worried about are
not exactly new, although they certainly come in different
packages.

I remember when I wrote my thesis that the historic, never fully
resolved intellectual argument over central banking was between
the so-called currency school and the banking school with its
real-bills doctrine. Those schools of thought have gone through
several permutations and combinations since, but the substance of
the argument remains the same: Is it money or credit that is
important? I would also tell you that fifty years ago, I remember
very well, there was a lot of concern about the effectiveness of
monetary policy.

At the time, the United States had just finished going through
the long depression of the 1930s, which, from the standpoint of
monetary policy, was somewhat similar to the experience in Japan
now. There was the perception of a liquidity trap. There was a
real question whether, under the circumstances, monetary policy
was worth worrying about. lt seemed helpless. Fiscal policy was
the king of the day and that carried over into the postwar period
when interest rates were frozen. I remember well that the New
York Fed struggled with that problem when I was a young fellow
here. (Actually, my conclusion in my college thesis, which I had
forgotten about until some student reminded me later, was that
monetary policy was so impotent that we ought to just let the
Treasury handle it.)

Back then there was very heavy political pressure to keep
interest rates stable, and that was the driving responsibility
Federal Reserve for many years -- not just during World II, but
after. By the time I had actually arrived here in 1951, the
so-called Treasury/Federal Reserve Accord allowed the Federal
Reserve to move interest rates freely. But the Fed was not about
to move them very far.

The idea that was promoted by this particular institution at the
time was something called the availability doctrine.  Bob Roosa,
a name that may resonate with some of you, was the key economist
here and an ingenious analyst of monetary policy.  He developed
the idea that interest rates did not need to move very much to be
effective; it would in fact be dangerous to move them very much
because of the heavy, excessive of overhang government securities
in the hands of the banks, most of which was fairly long-term
debt. He proposed that the Federal Reserve could take advantage
of the situation by implementing a very small increase in
interest rates, which, as we all learned in Economics 101, would
push down the prices of assets on bank balance sheets. That would
so disturb the banks that they would refuse to liquidate any
securities because they would not want to report losses.
Therefore, they would have to restrain their lending activity.
And that would be the mechanism by which Federal Reserve policy
would be effective.

The mechanism obviously relied upon a market imperfection, which
I do not think was totally unrealistic at the time, but it was
not lasting. At the end of World War II, banks were loaded with
government securities and there was a big question of how they
would react to even a relatively small decline in the securities'
value.

I should point out that during the same period, we did not just
think about monetary policy and fiscal policy.  It was monetary
policy, fiscal policy, and debt management.  As unlikely as it
sounds today, debt management was considered to be an active
"third leg' of policy.  In 1953, the Treasury got aggressive and
issued some 30 year bonds - the "3.25s of 78-83."  The Treasury
market was somewhat disturbed, and the economy went into a
recession.  Whether the Treasury's aggressive debt issuance was a
contributing factor was much discussed, and a long argument
ensued about whether the Federal Reserve should intervene
directly by conducting open market operations in the long-term
market or whether such intervention should be left to debt
management, with the Fed operating with "bills only."  While we
all know how that discussion ended, the debate at the time
clearly centered on whether monetary policy could be effective
independent of debt management.

In the 1960s I moved from the Federal Reserve to the Treasury
Department.  At the time, we faced what was perceived as a
dilemma for debt management and monetary policy.  We had a trade
surplus, but the balance-of-payments deficit probably ran as much
as $2 billion or $3 billion a year.  This was a matter of some
considerable concern around the world, since it raised questions
about whether our low interest rates and capital outflow would
determine the role of the dollar in the world economy.  Bob Roosa
had preceded me in moving from the Federal Reserve to become
Under Secretary of the Treasury for Monetary Affairs.  In
response to this situation, he helped develop what was called
Operation Twist: the Treasury would retire long-term securities
and issue short-term securities based on the theory that it was
the short-term rate that was relevant for international capital
flows, while long-term rates were more relevant for the domestic
economy, mainly because they affected the mortgage rate.

Well, to the extent that Operation Twist worked at all - and I
must confess I was a little skeptical about it, given the
fluidity of the markets even then - it too depended on some
degree of market imperfection. And I think it became apparent
fairly quickly that the market imperfection was not as great as
had been assumed.

Instead, a quite different imperfection was imposed on the
market, and it was not ineffective at all. Regulation Q, which
placed a ceiling on commercial bank interest rates, became in
practice the "hammer" of Federal Reserve policy.  The restraints
on interest rates that banks could pay may have dropped from
recent memory, but suffice it to say that Reg Q's major
components were that 1) interest on demand deposits was not
permitted and 2) there was a hard ceiling on interest rates on
time deposits of all types, including savings deposits.
Furthermore, commercial banks' liabilities were the dominant
financial savings instrument at the time.   When interest rates
went up and impinged on the interest rate ceilings, the
commercial banks could not raise money.  They pulled back on
lending, particularly mortgage lending.

Reg Q worked with extreme force, I think it is fair to say. When
interest rates rose above the ceilings, you had a recession, and
the recession was concentrated in the housing sector. Reg Q
therefore became a matter of political concerned as well as
economic concern because of the concentration of its impact.

By the time we got to the late 1970s and early 1980s, inflation
had picked up a lot of steam and was pushing interest rates
progressively higher. Restiveness about the Reg Q structure came
to a head and the interest rate ceilings were gradually removed.
In fact, the effectiveness of Reg Q was partly removed by the
actions of banks themselves in developing other techniques for
raising money.

So by the late 1970s, we felt that if we wanted to control
inflationary pressures, we were left with having to follow the
advice of Anna Schwartz and others: we should carefully control
reserve growth, which, via open market operations and the fulcrum
of reserve requirements, should limit the expansion of bank
deposits and credit. Whether or not one believed in the strict
interpretation of the "monetarist" theories, the operational
relationship between reserves and money, however measured, was
direct.  Controlling reserve growth was one way to slow money
growth and get some restraining influence on the economy. And I
think it is fair to say that eventually we did get a restraining
influence.

The problem of course is that it took a very high level of
interest rates to get that restraining influence. Al Wojnilower,
who was observing all this from the outside, was one of the first
to point this out, and he turned out to be absolutely right. I do
not think that any of us embarking on this policy felt we were
going to end up with bank lending rates at 21 percent in the
United States. I think that happened because people dependent on
bank lending did not follow a nice conceptual textbook approach
and say, "the interest rate is a little higher, so we'll pull
back a little bit." They were caught up in ongoing operations;
they were caught up in planned investment programs; they were
caught up in their habitual methods of operation. So they kept
borrowing and implicitly thinking "well, this interest rate is
awfully high today, but maybe it will come down tomorrow, so
we'll keep at it." And the credit expansion continued until, to
exaggerate a little bit, this became a policy of restraint by
bankruptcy.  If you keep tightening policy until borrowers and
lenders really cannot stand it anymore, you begin to have a real
degree of restraint on the economy and on prices. And indeed, we
had a real degree of restraint, and inflation came down.

The economy was affected by direct controls as well. I neglected
to mention earlier that direct controls on credit extensions were
a favored instrument of monetary policy in the late 1940s and
1950s. When I wrote my untitled, uncompleted thesis for my Ph.D.
(which I understand I am still eligible to receive if I ever
complete the thesis), I contrasted the use of direct controls on
credit in the United Kingdom with direct control in the United
States and how they operated (or did not) in a market system. But
I do not want to gloss over the fact that we had a little
experiment with direct controls as late as 1980 during the Carter
administration. We designed what we thought was a modest,
market-mimicking restraint on some parts of consumer credit. This
was something we anticipated would have a modest restraining
effect on the economy, supplementing our control over reserves.
It turned out to have a huge psychological effect. I never saw
anything like it. There was a sharp reaction by consumers that
single-handedly drove the economy into recession in a matter of
weeks. I believe that was the last time there was any
experimentation in direct control of credit.

Since the early 1980s, I think it is fair to say that we have
returned to a kind of approach that relies upon direct influence
on the short-term rate and a much more fluid market situation
that allows policy to be transmitted through the markets by some
mysterious or maybe not so mysterious process. I think we have
found two important "transmission belts" - domestic asset prices
(particularly the stock market) and the exchange rate - that were
not considered to have much importance earlier. I think we also
know that relationships between monetary policy and stock prices
and between monetary policy and exchange rates are not the most
predictable relationships that exist in the economy. We have
certainly seen demonstrations of that recently. I was a little
bit bemused by the reports in the press recently that the euro
declined because the European Central Bank did not reduce
interest rates, which is not what you consider the normal
predictable reaction to monetary policy.

I think this caution helps demonstrate the importance of central
banks having a clear and unambiguous decision making process when
they operate in much more open and fluid markets, if market
responses are to be predictable. Indeed you sometimes might ask
the question whether the Federal Reserve is driving asset prices
and the exchange rate or whether the exchange rate and asset
prices are driving the Federal Reserve. That is an uncomfortable
question to ask when you are trying to run a central bank.

So now we look ahead and the markets are getting ever more fluid
and flexible.  We have several papers here today asking what is
the result of running the world on fewer and fewer reserves
(which in the United we apparently no longer try to control
anyway).  Moreover the commercial banking system and bank
deposits are getting progressively smaller as a part of the
financial system.

So what happens?  From my recitation of this history, I think it
seems clear that both the market and the political system will
always try to game the Federal Reserve and find ways of getting
around restraint. Nobody likes restraint. Everybody likes the
stock market to go up forever and the economy to go up forever.
When the central bank tries to restrain, the natural instinct is
to find some way around it, to find substitutes and new political
instruments less directly under central bank influence. If they
cannot find the way economically, they will look for it
politically, which presents another problem. It is also very
clear from history that whatever changes in procedures and policy
were made today will cause changes in the market system tomorrow,
as the market adapts to what you have done and tries to find a
way around it.

Despite those efforts and those changes, a simple observation
suggests that monetary policy is still pretty potent. In fact,
the 1990s, as you all know, have been regarded as the great glory
days of monetary policy. There is a sense of conviction in the
market that we can press a few monetary buttons and everything
will be solved.

Of course, that is an illusion. The most recent events have
undermined that impression to some degree. Nonetheless, monetary
policy here, and to some degree elsewhere, has achieved an almost
mystical status. You wonder whether it has any real substance at
all, or whether it is all shadow.

I am reminded of the comment by Denis Robertson, a well-known
economist of the 1930s, when he described some monetary phenomena
by referring to the story of the Cheshire cat in Alice and
Wonderland. The cat disappeared, and all you were left with was
the grin, but the grin was that was necessary.

I think the reference is entirely fitting because you have to
wonder whether anything more is necessary these days than a
pronouncement that the Federal Reserve would like to change the
federal funds rate by x percent. The Fed does not actually have
to do anything. The rate will immediately change by x percent.

Will it stay there or not? Well, I think the market is still
dependent upon some action by the Federal Reserve. Sooner or
later, there has to be some intervention. But I think this is a
basic question that we are grappling with at this conference, and
one that I believe we will continue to debate for some time.

When I think about what the central bank ultimately controls, I
am led to thinking about what function of the central bank cannot
and will not be taken over by the other operators in the
financial markets, either individually or collectively. Market
participants certainly sit around ingeniously thinking of how to
intermediate and satisfy every possible demand for liquidity and
credit at the lowest possible cost. So it seems to me - and I say
this with some tentativeness - that the market is going to try to
minimize the use of base money, the one thing the Fed controls.
If no interest is paid on base money, market participants will
try to minimize the need to hold reserves or currency, or develop
other payment systems, once again trying to work around any
constraint set up by the central bank.

So what is left for the central bank to control? I think the
market is still a long way from doing away with currency or
reserves as a means of interbank payments. At the end of the day,
it is only the central bank as an institution that can satisfy
our demand for currency and create or withdraw reserves and
therefore provide a sense of liquidity in the markets. In the
extreme case, it can create liquidity without end, since there
will be no question about its credit status. In most
circumstance, that power does give the central bank special
influence, both through its actions and through its potential
influence; markets respect this, and will therefore respond to
the intention of policy.

This seems to me to be the last strand of permanence in central
banking. Of course, influence over liquidity does not provide any
assurance that you will use that influence wisely or that the
transmission belt to the economy is going to be obvious and
direct. Operating monetary policy in open, liquid markets means
that the transmission belt will inevitably be unstable: the
market in effect is competing with you, and the central bank will
find it necessary to adjust. All of the history I have recounted
suggests that this will be a continuing struggle.  A fixed rule
cannot solve the problem. I think that is the lesson of the past
fifty years. Those fifty years also offer some hope that central
banks will not be inconsequential, even if they have to adapt
their modi operandi constantly.

I want to leave you with one other thought, which may make some
central banks inconsequential. What is the endgame in all of
this, of open markets: the free flow of capital around the world,
a couple of hundred independent countries, some big, some small?
I think the logical long-term result - extending far beyond my
living horizon, but perhaps not yours - is a world currency. With
a world currency, we will not have a lot of independent central
banks. What I have not quite figured out is what the one
remaining central bank will do, what instrument it will use, and
how it will be controlled. But I think that is the direction in
which economic and financial logic guides us.

I suspect there will be a lot of way stations along the road to a
world currency. For example, I am pretty sure we are going to go
to some regional currencies, and we will almost certainly have
many fewer currencies. In such an environment, will we have a few
large central banks centered around big countries and monetary
centers, each with some influence, but with their
interrelationships guided, influenced, and affected by the
exchange rate between them? Such a structure leaves open a lot of
questions about the organization of the world economy in ways
unrelated to central banking. Nevertheless I think that if the
net result of that kind of a world is very widely fluctuating
exchange rates between major centers, then it will not be a world
conducive to the kind of multilateral open trading system and
political harmony that we like to associate with the benign
leadership of the United States and its partners during the
postwar period.

So I will leave you with that thought, confident that you will
not be able to disprove it to me, in my lifetime anyway. That is
the safest kind of projection to make.