Overview:
Vincent Reinhardt introduces the discussion on Volume 2 of Alan Meltzer’s comprehensive history of the Federal Reserve, covering the period from 1951 to 1986. The event features Paul Volcker, a former Fed Chairman, whose career is closely intertwined with the history discussed in the book.

Paul Volcker’s Career in the Financial Sector:
Paul Volcker’s association with the Federal Reserve began in 1952 when he joined the staff of the Federal Reserve Bank in New York. Throughout his career, he held various positions in the financial sector, including serving as the President of the Federal Reserve Bank of New York and Chairman of the Federal Reserve.

The Significance of Volume 2:
Meltzer’s Volume 2 is a substantial work, spanning over 1,312 pages, and is the second part of a larger history of the Federal Reserve. The book provides a detailed account of the Fed’s actions and policies during a critical period in its history.

Meltzer’s Gratitude:
Meltzer expresses his appreciation to Chris DeMuth, the former president of AEI, for supporting the project and providing the necessary time and resources. He also acknowledges the contributions of Anna Schwartz, who provided extensive feedback on the book, and his wife, Marilyn, for her unwavering support throughout the project.

Key Points from Meltzer:
Meltzer highlights two main points: The importance of having a strong and independent central bank. The need for a monetary policy that is focused on maintaining price stability.

Historical Monetary Policy:
The Federal Reserve (Fed) faced limitations under the gold standard, but since then, it has been involved in major economic events like the Great Depression, recessions, and the current crisis. Seeking rules or guidelines to limit excessive discretion in monetary policies is crucial to avoid past mistakes and ensure stability.

Policy Achievements:
During the period from 1985 to 2003, the Fed achieved a long-term record of slow inflation and steady growth with mild recessions. This period serves as a benchmark for effective policy implementation, emphasizing the importance of focusing on long-term consequences rather than short-term events.

Long-Term Consequences and Policy Analysis:
The Fed’s focus on short-term events often overshadows the analysis of longer-term consequences of its policies. A notable exception to this is Chairman Volcker’s pursuit of a long-term strategy to reduce inflation, demonstrating the value of considering long-term impacts.

Rule-Based Behavior vs. Discretion:
Chairman Volcker highlights the challenges in formulating specific rules for monetary policy, given the complexity and dynamic nature of economic conditions. The popular rule of price stability, interpreted as 2% inflation, is widely adopted by central banks, but it may not fully reflect true stability.

1950s Monetary Policy and Context:
The 1950s marked a period of low inflation and Fed inactivity, with recessions occurring about every four years. President Eisenhower’s balanced budgets eased the Fed’s burden in financing deficits, allowing for more independent monetary policy.

Federal Reserve’s Learning Curve:
The Fed was still finding its footing in monetary policy during the 1950s, transitioning from the fixed interest rates of World War II. It gradually developed its policy toolkit, eventually resembling modern monetary policy practices.

Government Debt and Quantitative Easing:
Buying government bonds was a routine practice for the Fed in the early 1950s to influence long-term interest rates. Controversies arose within the Fed regarding whether it should focus solely on the short-term market or also engage in the bond market. The recent quantitative easing (QE2) is not entirely new for the Fed, as it has historically purchased bonds to influence interest rates.

Economic Growth and Debt Reduction in the 1950s:
Gross public debt fell significantly as a percentage of GDP, from 88% in 1951 to 56% in 1960. The Federal Reserve’s balance sheet also shrank during this period.

Challenges of Addressing Current Debt Levels:
The current debt is much larger than it was in the 1950s, both in absolute terms and as a percentage of GDP. There is no clear plan for addressing long-term debt, and the Federal Reserve’s short-term focus may exacerbate the problem.

The Relationship Between Interest Rates and Monetary Base:
Historically, there has been a stable relationship between interest rates and the monetary base. When interest rates returned to 1920s levels in the 1960s, base velocity returned to its previous levels. During periods of high inflation and disinflation, the relationship between interest rates and the monetary base remained stable.

The Need for a Long-Term Perspective in Monetary Policy:
The Federal Reserve’s focus on the short term may hinder its ability to address long-term issues such as debt reduction. A more long-term perspective could lead to better outcomes for the economy.

The Lack of Concern About Debt and the Federal Reserve Balance Sheet in the 1950s:
Paul Volcker recalls that there was no particular worry or concern about the size of the debt or the Federal Reserve balance sheet in the 1950s. The debt was coming down rapidly at first and then gradually, and there was no debate or concern about the size of the Federal Reserve balance sheet.

1960s Policy Driven by External Considerations:
The U.S. benefited from being the reserve currency, enjoying a stable price level and trading most commodities in dollars. Policymakers faced a conflict between maintaining price stability (Bretton Woods) and achieving maximum employment (Full Employment Act). Conflicts arose between the Treasury and Federal Reserve, with the Treasury favoring tighter monetary policy to defend the dollar.

Maintaining Fixed Dollar Relationship with Gold:
Policymakers were committed to maintaining the fixed dollar relationship with gold and fixed exchange rates. Efforts were made to maintain confidence in the dollar and its stability internationally. The Treasury and Federal Reserve differed in their emphasis on tightening money to defend the dollar.

Unsustainable Efforts to Maintain the Dollar:
The magnitude of balance of payments deficits was relatively small, but caused concern. Efforts to maintain the dollar became increasingly unsustainable due to changes in the world economy. The dollar was eventually undercut, leading to a devaluation.

Responsibility of the Reserve Currency:
The Undersecretary for Monetary Affairs position covered both domestic and international responsibilities. The loss of this title reflects the separation of international and domestic monetary policy considerations, which is unfortunate.

1961-1965 Policy:
The policy during this period came close to succeeding, with real exchange rates adjusting and lower inflation in the U.S. compared to the rest of the world. President Kennedy was committed to maintaining the $35 price of gold, but the policy ultimately failed.

Inflation and Deficit Spending:
President Johnson’s focus on the Great Society and the Vietnam War led to significant deficits and rapid money growth. Despite lower inflation rates compared to other countries, the average inflation rate in the 1960s was still around 1.5%, resulting in accusations of inflationary policies.

Bretton Woods and Floating Exchange Rates:
By 1969, the Bretton Woods system was facing potential collapse. Paul Volcker initially viewed floating exchange rates as a temporary arrangement before returning to a more structured monetary system, but this never materialized.

Domestic Monetary Policy vs. International Monetary Policy:
During the Nixon administration, domestic monetary policy took precedence over international monetary policy. President Nixon aimed to end inflation without causing a recession, leading to conflicting instructions for the Federal Reserve.

Arthur Burns and Political Pressures:
Arthur Burns, the Fed Chairman, prioritized the success of the Nixon presidency, which he interpreted as maintaining low unemployment. Burns avoided directly promising to inflate the economy but hinted at his willingness to differ from McChesney Martin’s previous actions. Martin had financed deficits and lowered interest rates under political pressure, contributing to rising inflation.

Political Support for Unemployment:
There was significant political support for addressing unemployment at the expense of some inflation. Prominent economists, like James Tobin, downplayed the severity of inflation as a problem, further influencing policy decisions.

The Dominant View on Inflation in the 1970s:
Many economists believed that a trade-off existed between unemployment and inflation. This view allowed for higher unemployment rates in exchange for lower inflation rates, prioritizing social welfare. However, this perspective did not align with Allan Meltzer’s and Paul Volcker’s views, as they did not favor tolerating inflation.

President Carter’s Decision to Appoint Paul Volcker as Fed Chairman:
Inflation became a pressing issue, leading President Carter to appoint Paul Volcker as the chairman of the Federal Reserve. Volcker made a commitment to control inflation more aggressively than his predecessors, which Carter accepted.

Volcker’s Actions as Fed Chairman:
Volcker implemented a restrictive monetary policy to curb inflation, despite facing pressure from advisors to expand the economy during the 1980 election. He resisted political pressure and maintained his focus on combating inflation.

Why Inflation Rose in the 1970s:
Paul Volcker reflected on the late 1960s, when a deal was made between the Federal Reserve and the government during the Vietnam War. The Federal Reserve eased money to help Congress pass a tax increase, aiming to dampen inflation. Volcker considered this a mistake and believed it contributed to the lack of independence of the Federal Reserve. The Fed’s attempt to rely on fiscal policy to control inflation proved unsuccessful, leading to a surge in inflation.

Volcker’s Assessment of the Federal Reserve’s Actions:
Volcker believed that the Federal Reserve’s monetary policy during the 1960s and 1970s was too easy, contributing to inflationary pressures.

Views on the Role of the Federal Reserve:
Volcker emphasized the significance of the Federal Reserve’s independence, yet acknowledged the pressure exerted by the White House to pursue easier monetary policies.

Factors Contributing to the Great Inflation:
Volcker identified the oil crisis of the early 1970s as a significant factor in the Great Inflation, disrupting economic stability.

Expectations and Inflation Determination:
Volcker highlighted the failure to fully appreciate the role of expectations in inflation determination, contributing to the acceleration of price increases.

The Interplay between the Federal Reserve and Academic Economics:
The influence of academic economists in shaping monetary policy was acknowledged, with some economists supporting the coordination of monetary and fiscal policies, a strategy that did not deliver the expected results.

The Fed’s Dilemma:
In the 1970s, there was a debate within the Fed about how to address the large budget deficit. Some, including Milton Friedman and Allan Meltzer, argued that reducing the deficit would reduce money growth and inflation, while others believed unemployment was the bigger problem and that policy coordination was needed.

The Phillips Curve and Inflation:
Milton Friedman challenged the notion of a permanent trade-off between inflation and unemployment, arguing instead that any trade-off would be temporary. This view gained traction in academia but was not immediately adopted by policymakers.

Arthur Burns’ Perspective:
Former Fed Chairman Arthur Burns later wrote an essay titled “The Anguish of Central Banking,” expressing his belief that inflationary momentum in the 1970s was difficult to break due to various factors, including budget deficits, wage processes, and social programs.

Misinterpreting Oil Shocks:
Some economists argue that policymakers in the 1970s made a significant mistake in interpreting the oil price increases as inflation rather than relative price changes. This misinterpretation may have contributed to the Fed’s inadequate response to the economic challenges of that period.

Fed Policy Focus on Short-Term Inflation:
The Fed’s focus on short-term inflation led them to respond to the oil price shocks of the 1970s, which were relative price changes beyond the Fed’s control. This policy error was repeated in the 1970s and 1980s, contributing to the mistaken belief that inflation had reached high levels.

The Third Big Oil Price Increase:
During the third oil price increase in the 2000s, policymakers avoided repeating the mistake of responding to the relative price change. They recognized that the inflation rate would remain unchanged after the price shock passed, avoiding further policy errors.

President Carter’s Disinflation Efforts:
President Carter recognized the need to address the high inflation rates in the late 1970s. This understanding led to the beginning of disinflationary policies, culminating in Chairman Volcker’s efforts in the 1980s.

Oil Shocks as Policy Challenges:
The oil shocks in the 1970s presented policymakers with complex challenges. The debate centered on whether to let the shocks pass through or prevent them from contributing to broader inflation.

Volcker’s Approach to Inflation Control:
Chairman Volcker initially focused on combating inflation without meticulously separating the impact of oil prices. His approach shifted towards taking action to bring down inflation, leading to the disinflationary policies of the 1980s.

Surprise of Disinflation Costs:
The cost of disinflation, including high unemployment rates, surprised many economists and policymakers. The public’s support for these policies was also unexpected, demonstrating a willingness to endure short-term challenges for long-term economic stability.

Volcker’s Anti-Phillips Curve Statement:
Chairman Volcker challenged the prevailing view that inflation and unemployment could be traded off. He asserted that both inflation and unemployment had risen simultaneously in the 1970s and that they could be brought down together in the 1980s.

Unanticipated High Interest Rates:
The rise in interest rates to 20% or higher during the disinflationary period was not anticipated by policymakers or economists. The Fed’s struggle through credit control periods further contributed to doubts about the feasibility of ending inflation while raising unemployment.

Changing Public Perception:
Public skepticism about the success of disinflation policies changed in April 1981 when the Fed raised interest rates despite an unemployment rate of around 8%. This action demonstrated the Fed’s commitment to bringing down inflation, even in the face of rising unemployment.

Ending the Disinflation Policy:
The disinflation policy, aimed at reducing inflation, led to a successful decrease in the inflation rate from a high of 15% to 4% within 15 months. However, the policy was ended prematurely due to the risk of bank failures and a potential global crisis. The end of the policy resulted in an inflation rate of 3-4% but with a high unemployment rate of 10%, similar to the current situation.

Volcker’s Perspective:
Volcker believed that inaction would lead to higher ultimate costs and that the public supported tougher policies due to concerns about inflation. President Reagan’s attitude reflected this public sentiment and supported Volcker’s approach. Volcker did not anticipate the high interest rates of 21.5% that were implemented but noted that they also decreased quickly.

Volcker’s Meeting with Businessmen:
In a meeting with businessmen, Volcker explained his plan and assured them of the eventual benefits of the tough policies. One businessman expressed skepticism and stated that the high interest rates would lead to bankruptcies and job losses. Volcker admitted that he had not fully considered the extent of the consequences, including potential bankruptcies and job losses.

Wage Agreement and Inflation Outlook:
Paul Volcker made a 13% annual wage agreement with his workers for the next three years, demonstrating his belief in the strong prospects for inflation.

Calm and Orderly Life with No Big Secrets:
Volcker described his life as calm and orderly, without significant secrets to share in a diary.

International Turmoil and Anti-Inflation Efforts:
Volcker highlighted his involvement in international turmoil, devaluation of the dollar, and the anti-inflation struggle, which he considered a more fulfilling experience than working in an investment bank.

Challenging Monetary Aggregates Control:
Volcker expressed frustration with the monetarists’ criticism, who expected perfection in controlling the money supply, which he believed was beyond anyone’s technical capabilities.

Difficulties in Controlling Monetary Aggregates:
Allan Meltzer acknowledged the challenges in controlling monetary aggregates on a quarterly basis, emphasizing the pressure from Congress and the public to deliver immediate results.

Volcker’s Transformation on Fixed Exchange Rates:
Meltzer inquired about Volcker’s transformation from an anti-inflationist and fixed exchange rate proponent to a supporter of floating the dollar.

Fixed Exchange Rate Systems and Their Limitations:
Meltzer brought up the view of international economists like Ken Rogoff, who argue that fixed exchange rate systems are unsustainable beyond eight to ten years due to the unwillingness to prioritize exchange rate stability over unemployment.

Europe’s Fixed Exchange Rate Experiment:
Volcker noted that the immediate question of fixed exchange rates was being tested in Europe.

Exchange Rate Volatility and the Euro:
Paul Volcker argues that the euro was a good idea for Europe because it reduced exchange rate volatility within the region, enabling a cohesive economic union and open trade. However, he acknowledges that the concept is being tested, especially when particular countries deviate and lack an independent monetary policy.

Global Currency and Exchange Rate Fluctuations:
Volcker believes that a fully globalized economic and financial system would logically lead to a single currency to maximize productivity and effectiveness. He acknowledges that this is unlikely to happen in his lifetime or even in the foreseeable future. Therefore, he advocates for accommodation and allowing changes in exchange rates, although he criticizes extreme fluctuations like those seen between the dollar and euro.

Negative Real Interest Rates and Inflation:
Volcker acknowledges that negative real interest rates in the 1970s may have contributed to inflation. He warns that a resurgence of inflation could lead to a rapid and sharp increase in nominal interest rates as investors try to avoid negative real returns.

Maintaining Price Stability:
Volcker emphasizes the importance of maintaining the expectation of price stability to avoid sharp market reactions. He praises Chairman Bernanke’s strong oral statement on 60 Minutes, expressing his intention to maintain price stability in the United States.

Excess Reserves and Inflation:
The Federal Reserve’s quantitative easing policies have resulted in a large supply of excess reserves. The Fed must act promptly to prevent these reserves from leading to inflationary consequences.

Interest Rate Dilemma:
Raising interest rates too high could lead to a negative public reaction, especially in a period of high unemployment. The Fed must carefully consider the impact of interest rate increases on the economy.

Lack of a Coherent Plan:
Allan Meltzer criticizes the Fed for not having a coherent plan to address the excess reserves problem. He argues that the Fed’s model lacks loan demand, which is a critical factor in determining how the economy will respond to interest rate changes.

Unpredictability of Bubbles:
Alan Greenspan’s 2002 speech highlighted the difficulty of predicting bubbles before they burst. This has led to the idea of a “Greenspan put,” where investors believe that the Fed will intervene to prevent asset prices from falling too far.

Asset Inflation and Monetary Policy:
The concept of asset inflation in relation to equities and home prices is debated among economists. Some argue that it is a coherent concept, while others view it as a relative price change rather than true inflation. The extent to which Federal Reserve monetary policy has contributed to asset inflation is also a matter of debate.

The Importance of Asset Prices in Monetary Policy:
Allan Meltzer argues that stripping asset prices out of economic models was a mistake. He believes asset prices are critical for monetary policy and influence the demand for money and the transmission of monetary policy. Meltzer hopes the Fed will move back to considering asset prices in their models.

Challenges in Controlling Asset Prices:
Meltzer emphasizes that the Fed should not try to control asset prices directly. Asset prices provide valuable information about the transmission of policy. It is difficult to distinguish between expected real returns and expected inflation in asset prices.

The Flawed Model of Short-Term Interest Rate Dominance:
Meltzer criticizes the Michael Woodford model, which suggests that the short-term interest rate is the only interest rate that matters. He argues that this model is flawed and ignores the role of asset prices and other factors in policy analysis.

Central Banks’ Eventual Consideration of Asset Prices:
Meltzer predicts that no central bank will consistently operate in a model that excludes asset prices and other factors. He believes that eventually, central banks will recognize the importance of these factors in their analysis.

Paul Volcker’s Emphasis on Practical Policy rather than Models:
Paul Volcker highlights the difficulty of making accurate economic predictions, especially during important turning points. He emphasizes the practical challenges of conducting policy and the limitations of relying solely on models and predictions.

The Importance of Outcome and Public Care:
Meltzer emphasized the need to focus on the outcomes of the Federal Reserve’s (Fed) policies rather than the process. He suggested that Congress should monitor the Fed based on its outcomes and press for better results. Meltzer argued that the public cares more about the results than the internal discussions and debates within the Fed.

Clarity in Policy Communication:
Volcker stressed the importance of clarity in communicating the Fed’s policies and intentions to the public. He cautioned against revealing all internal debates, as it can be unhelpful for public policymaking.

Forecasting Challenges and the 1979-1980 Recession:
Volcker shared an example from his time as Fed Chairman in 1979-1980, where the Fed staff predicted a recession but the economy continued to grow despite tight monetary policy. He mentioned that the actual recession later in that period was triggered by President Carter’s credit controls, which caused a sudden drop in consumer spending.

International Monetary Reform and Cooperation:
Volcker highlighted the challenges in achieving stability between the Euro and the US dollar due to complex international monetary reform and cooperation issues. He pointed to the current situation in the United States, where the Fed’s interest rate increases have had a significant impact on emerging markets.

Additional Comments:
Peter Whitney, a retired Foreign Service officer, raised the question of how to reduce volatility between the Euro and the dollar, considering their relative stability. The discussion also touched on the impact of the Fed’s interest rate increases on emerging markets.

Paul Volcker’s View:
The current international monetary system is unsustainable, with the United States and the rest of the world competing against Asia and China, leading to artificially steady exchange rates that will eventually break out. There is a need for a more cooperative arrangement where adjustments take place smoothly, but it is difficult to achieve in practice. The G20 may address the issue of international monetary system reform in the coming months, including the possibility of a new commission or committee to study the matter.

Allan Meltzer’s View:
The reason we do not have a gold standard is not because we do not understand it, but because we know it does not provide the desired unemployment outcomes. The best solution is for the three leading monetary countries (the Euro, Japan, and the United States) to pledge to achieve the same rate of inflation. This would allow third countries to peg their currencies to this rate or a basket of these rates, resulting in price stability and fixed exchange rates. The three leading countries would have floating exchange rates, allowing real exchange rates to adjust without causing unemployment. This system would be voluntary, with no coordination, meetings, or discussions, and it would provide a more stable international environment.

Paul Volcker’s Response to Meltzer:
He agrees with Meltzer’s proposal but doubts if it can produce reasonable stability in the exchange rate, given past experiences. He believes something more than Meltzer’s proposal is needed to achieve reasonable stability. He criticizes the “no meetings” requirement in Meltzer’s proposal, as it is unrealistic given the involvement of numerous government officials in international meetings.

Question from Craig Torres of Bloomberg News:
Torres asks the panel about the increasing role of financial stability (macro-prudential surveillance) in monetary policy, with the Fed’s division directors now sitting on a committee that oversees the top banks. He questions whether this is a good or bad thing, or if it could distract the Fed from its primary objectives.

Raising Bank Capital:
Allan Meltzer believes raising bank capital is the most effective way to achieve financial stability. In the 1920s, banks had 20% of their assets in capital and there were no large bank failures. Meltzer criticizes the emphasis on macroprudential work and argues that it avoids the need for higher capital requirements.

Banks, Bailouts, and Regulation:
Meltzer asserts that bailouts are wrong and lead to moral hazard, encouraging excessive risk-taking. He advocates for increased capital to shift the responsibility to stockholders and management, eliminating the need for excessive regulation. Meltzer argues that regulation often fails due to circumvention, static nature, and lack of alignment with the incentives of regulated entities.

Macroprudential Surveillance:
Paul Volcker acknowledges the need for macroprudential surveillance to monitor financial system risks. He agrees that banks should have more capital but doubts if legislation alone can achieve this. Volcker emphasizes the role of regulators in controlling capital and taking action to prevent systemic collapse.

Central Bank Focus and Regulation:
A speaker raises the concern that excessive focus on financial stability and regulation may detract from monetary policy. Volcker dismisses this concern, stating that central bank members have ample time to dedicate to both monetary policy and regulation. He highlights the importance of having a designated governor responsible for overseeing regulatory work within the Federal Reserve.

Role of the Federal Reserve:
Volcker stresses the need for the Federal Reserve to be the principal regulator of financial institutions. He argues that the Federal Reserve’s regulatory role complements monetary policy and is essential for maintaining financial stability. Volcker warns against excessive concentration of power within the Federal Reserve, emphasizing the need for accountability and democratic oversight.

Overview:
This segment of a presentation features remarks by Allan H. Meltzer and Paul Volcker on the completion of Meltzer’s book and the future of the Federal Reserve.

Meltzer’s Perspective:
Meltzer expresses relief and satisfaction at completing his book, which took 15 years to write. He declines to write another volume covering the period after 1986, stating that life and history continue beyond the scope of his work.

Volcker’s Perspective:
Volcker congratulates Meltzer on completing the book and acknowledges the significant effort involved. He highlights that life and history do not end with the publication of the book and that it is an ongoing process. Volcker notes that the book is shorter than the Dodd-Frank Act, providing a humorous comparison.

Closing Remarks:
The moderator thanks everyone for attending and acknowledges the contributions of Meltzer and Volcker.