Last week I noted how Paul Volcker, almost accidentally, ended up in the hot seat as the Federal Reserve chairman. He immediately assaulted inflation by raising the discount rate. As the economy slowed down, the public was waiting to see when the contractionary policy would be reversed. After two months in office, Volcker called a secret meeting of the Federal Open Market Committee and persuaded his colleagues to radically shift their focus from interest rates to the money supply.
Eight months before the 1980 election, Jimmy Carter made one last attempt to save his job and the Keynesian doctrine. He asked the Fed to impose credit controls on bank lending. As with all previous attempts to control prices by decrees, this plan backfired. With price increases exceeding anything seen in the previous 30 years and unemployment rates approaching 8 percent, Rep. Henry Reuss, D-Wis., yelled at Volcker to go back to stimulating the economy: "The Federal Reserve cannot cure inflation with monetary shock treatment and it shouldn't try." The silence from the Fed was louder than thunder: "Suck it up!"
In a 1980 documentary on PBS, Milton Friedman showed the American people how the Japanese government had demonstrated courage and perseverance in curing its inflation during the oil price shocks of the 1970s: "It started to cut monetary growth. But inflation continued to soar for a time. The delayed reaction made 1973 a very tough year of recession. Inflation tumbled only when the government demonstrated its determination to keep monetary growth in check. It took five years to squeeze inflation out of the system."
Under Carter, Americans were convinced that "inflation was indestructible," recalls Robert J. Samuelson in his book The Great Inflation and Its Aftermath: "Only bitter experience would purge inflationary expectations and behavior. 'Credibility' had to be won through suffering." The suffering was almost unbearable. A magazine for homebuilders featured a "wanted" poster for Volcker and his colleagues in the Fed, accusing them of "cold-blooded murder of millions of small businesses."
With the election of Ronald Reagan, the Keynesian era was over and the mother of all wars against inflation had begun. Annual wholesale price increases dropped from 12 percent in late 1980 to less than 1 percent in 1983. The recession was so deep and long that in 1982 economists started to circulate the word "depression." Republican Senate Majority Leader Howard Baker tried to intimidate the Fed to "get its boot off the neck of the economy." Reagan expressed confidence that the Fed leaders knew what they were doing, telling his supporters and enemies that he was making no plans to go back to the policies of "hyping the money supply" and "stimulating government spending."
Volcker, like Friedman, understood his role as "a teacher or leader." The election of Reagan gave the Fed enough time to administer the painful cure until the economy was healthy once again. Ignoring the warnings from the polls, the president never withdrew his support from Volcker's war on inflation. Reagan's determination was unshaken even after his own economic advisers and party leaders confronted him with accusations that the Fed's restrictive policies were hurting the chances of Republicans in the mid-term elections and discrediting supply-side Reaganomics.
Next week brings the conclusion to my account of America's affair with Keynesianism in the 1960s and '70s.