The best central banker of all time?

I just heard the news that Paul A. Volcker died today at the age of 92.

I thought I write a few things about a man that was one of my heroes in finance and economics and that I think was, jointly with William McChesney Martin, the best central banker of all times.

If you think that is a bit over the top, then think about the achievements of this man in his lifetime:

• From 1969 to 1974 he was undersecretary of the Treasury and helped the Nixon administration suspend the gold convertibility of the US Dollar, ushering in the era of fiat currencies and flexible exchange rates. There are a lot of people who mourn the end of the Bretton Woods system of fixed exchange rates, but because we have flexible exchange rates between most currencies, trade imbalances can adjust themselves through exchange rate mechanism, thus preventing the need for excessive central bank reserves to manage fixed exchange rates. I don’t think anyone has ever tried to estimate how many financial crises and banking crises have been averted because exchange rates are able to adjust flexibly today.

• From 1979 to 1987 he was chairman of the Federal reserve and managed to successfully beat the inflationary trends of the 1970s. It was no easy feat to do that because he and the other members of the FOMC had to hike interest rates so much that they triggered the famous double-dip recession in the United States. That certainly did not make him popular with politicians and investors, but he did not cave in and did what was good for the economy and the United States in the long run instead of caving to short-term pressures. This feat alone is what makes him an all-time great and puts him on par with William Martin, the other Fed chairman who ignored public opinion if he felt it necessary to protect the country form high inflation. Can you imagine Alan Greenspan, Ben Bernanke, Janet Yellen or Jerome Powell doing what Volcker did at the helm of the Fed? Over the last three decades, we have become used to the Fed Put and today expect the Fed to step in as soon as stock markets experience a mild feeling of discomfort. In fact, the expectation of investors today is one where central banks are expected to bail out even bondholders if they face the possibility of a default. Whatever happened to taking investment risks and dealing with the fact that risks sometimes can go wrong and cause losses? While today’s central banks are popular with investors because they are supportive of stocks bonds and all kinds of investments, I also think that with their zero interest rate policies they have become unable to manage inflation or the economy going forward and have contributed to many an asset bubble in the last twenty years. I wonder if a Fed under Paul Volcker would have made the same mistakes.

• Paul Volcker was eventually replaced at the Fed by the Reagan administration because the White House felt he wasn’t going to push as aggressively for deregulation of the financial sector as they wanted. This was probably true given his track record in the aftermath of the Global Financial Crisis when he advised President Barack Obama on policies to clean up the mess of the GFC. Obama dubbed the proposed regulations the Volcker Rule and though they have formally come into effect in 2015, they have been undermined by lawsuits and banks ever since. While I am not a fan of excessive regulation at all, in my view the Volcker Rule that bans prop trading and other speculative activities with the assets a bank owns is a step in the right direction. I think the least we can do is try to avoid making the same mistakes twice. Yet, the efforts to undermine the Volcker Rule are essentially an effort by banks and other institutions to go back to the reckless days before 2008.

• Another thing that I admire Paul Volcker for that isn’t too well known about him is that he criticized the Fed’s decision to start paying interest rates on excess reserves. Until 2008, banks had to hold reserves in the Federal Reserve System but did not earn any interest on reserves above the required minimum. In 2008, the Fed for the first time started paying interest on these excess reserves. The result was, that banks could suddenly engage in a simple circular trade: Accept fresh money created by the Fed to prop up their balance sheets and deposit this money right back at the Fed to earn interest on it. In my view, the decision to pay interest on reserves held at the Fed removed a major incentive for banks to lend money to businesses and private households and effectively neutered monetary policy after the GFC. Why would any bank take the money they received from quantitative easing and lend it to risky borrowers if they could instead give it to the Fed and get the risk-free rate of return? If you start paying interest on bank reserves, the only way to force banks to lend money in the real economy is to cut interest rates into negative territory. In my view, it was a strategic mistake to start paying interest on reserves and Paul Volcker recognized this mistake immediately. 

To quote him from a highly recommendable interview he gave to Martin Feldstein in 2013:

“Since I can say it, if I was conducting these policies, I don’t really understand why we’re paying interest on excess reserves when we’re worried about getting interest rates as low as possible. The Federal Reserve pays more on their excess reserves than the banks can get from lending to each other. So why pay them?” 

And finally, which economist or central banker can boast that they had a rock band named after them?

The world needs more Paul Volckers and we will miss him dearly.

Paul A. Volcker, 1927 – 2019.