Volcker warns: Don’t repeat the 70s

May 15, 2008

If Ben Bernanke keeps his present course, former Fed Chairman Paul Volcker warns we could repeat the 70s. “Core” inflation is still within the Fed’s “comfort zone,” but at a certain point, rising food and energy costs may pull other prices along with them. That’s the opposite of what the Fed is assuming will happen. The Fed appears to believe that food and energy costs will come back down as the economy slows.

But that may give the U.S. a lot more credit that it deserves for driving oil demand. What if demand growth outside the U.S. is enough to offset declines here at home, keeping oil prices high? It’s not far-fetched to believe that can happen:

Despite China’s fantastic growth, and very inefficient use of fossil fuels, the U.S. is still the largest consumer of oil worldwide. The stats at that link are from 2007, and China’s economy has probably grown another 10% since then. So figure we consume 21 million barrels of oil per day and China consumes 7.2 million. I confess I don’t know enough about the dynamics of the oil market to know the impact of, for instance, a 2% decline in U.S. GDP would do to oil demand. But for simplicity figure oil demand growth matches economic growth.

To offset a 2% decline in U.S. demand for oil, Chinese demand would merely have to rise 6%. They’re certainly on track to grow faster than that the next few years.

Herein lies the problem with the Fed’s plan I think, and the reason people ignore Paul Volcker at their own peril:

If the Fed is wrong about the path of the economy, if indeed we do skirt a recession or have only a mild one, prices for all goods may stay high. And at a certain point, high oil prices will get passed down the supply chain for most goods sold in the economy.

We could end up with late 1970s stagflation again.

Volcker’s comments below touch on much more besides….


Fed Chief Volcker sees 70s-style inflation risksBy Joanne Morrison

WASHINGTON, May 14 (Reuters) – Former U.S. Federal Reserve Chairman Paul Volcker warned on Wednesday the United States could face a 1970s-style period of skyrocketing inflation if investors lose confidence in the buying power of the U.S. dollar.

“If there is a real loss of confidence in the dollar, then I think we are in trouble. That is something that has to be watched,” Volcker told the congressional Joint Economic Committee.

The former Fed chief who championed the battle against double-digit inflation in the 1970s by raising interest rates sharply, warned that without careful focus on the declining dollar and inflation, the U.S. could face similar, or even worse, inflation pressures.

“That has to be very much in the forefront of our thinking, without that, we are back to the inflation of the 1970s or worse,” Volcker said, questioning the relevance of measuring inflation by stripping away volatile food and energy prices.His comments came after oil’s recent rise to record highs, which has boosted gasoline prices sharply for consumers already dealing with a slowing economy.

On Wednesday, the government reported that inflation only grew by a moderate 0.2 percent during April and an even more tame 0.1 percent when excluding volatile food and energy prices. Volcker raised some doubts about the way the government measured inflation.

“It doesn’t feel quite right,” Volcker said of considering the so-called core rate, particularly as food and energy prices have been rising for years.

“I think the bias clearly is more toward inflation, offset by the weakness of the domestic economy,” Volcker said.


Unlike the financial troubles in the 1970s, which were centralized in regulated commercial banks, today’s financial woes are blurred between a wide range of businesses, many of which are not regulated, making the issue more complex for regulators.

Lawmakers on the panel asked whether there should be one consolidated regulator over financial markets.

“We no longer have the clear distinctions between commercial banks, investment banks, broker-dealers and insurers that we did sixty years ago, or even 20 years ago,” said New York Democrat and Joint Economic Committee chairman Charles Schumer.

“We must figure out how to regulate currently unregulated parts of financial markets,” Schumer said, highlighting the off-exchange credit default swaps market, which has exploded over the past five years to a notional amount of $62 trillion.

The former Fed chief cautioned that the current regulatory structure is not suitable for the financial engineers in today’s markets who commingle sophisticated financial transactions between commercial banks, investment banks and entities such as hedge funds and sovereign wealth funds, that are not regulated.

But while many Democratic lawmakers are pushing for tougher reforms of the financial markets in the wake of the worst housing downturn since the Great Depression, Bush administration officials say new regulations cannot take away all the risk.

“I put the most faith in the market and market discipline,” Edward Lazear, chairman of the White House Council of Economic Advisers, told Reuters in an interview on Tuesday.

Appearing before the Senate panel, Volcker stopped short of recommending the Federal Reserve be the sole consolidated regulator of the financial markets. But he said because of its independence it was better suited to be the key regulator in today’s complex markets.

“Because of (the Fed’s) independence, it is in a better position to resist the political pressures of regulation,” Volcker said.


The former central banker defended the Fed’s role in brokering the buyout of Bear Stearns Cos by JPMorgan Chase & Co, but warned that there has been a moral hazard created by the transaction.

“There is a moral hazard once you say you are going to protect all the creditors in a credit crisis. They are going to expect you to do it the next time,” he said, referencing the notion that investors take greater risks when they believe the government will protect them from losses.

But he added that the burden to fix the credit market cannot be placed solely on the Federal Reserve.

“Don’t push all this help for the credit markets on the Federal Reserve. That’s the way to destroy the Federal Reserve because it does need its independence,” he said.

Volcker also questioned the effectiveness of housing finance giants Fannie Mae and Freddie Mac in the housing crisis.

“Where were Fannie Mae and Freddie Mac? What kind of a system have we got when the agencies who are supposed to be reflecting the interest of the mortgage market are out serving the interests of their stockholders?” he asked

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