Volcker monetary policy:

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  Paul Volcker was appointed chairman of the Federal Reserve System (the "System") Board of Governors (the "Board") on August 6, 1979, succeeding William Miller who was appointed Treasury Secretary. Volcker had been arguing for months that inflation had to be the primary concern - that all other government policies would fail as long as inflation remained out of control.
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  Volcker had extensive experience with the money markets, beginning at the N.Y. Federal Reserve Bank (the "N.Y. Fed"), becoming its president and then serving as Undersecretary for Monetary Affairs in the Nixon Treasury when Bretton Woods finally collapsed. He was widely respected, well connected, and wise to the political scene. He knew what had to be done and, with political cover from President Ronald Reagan, was determined to do it. His income was $60,000 greater in N.Y. than it would be in Washington.
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The System was yet once again paralyzed by its conflicting objectives, constrained by political and bureaucratic imperatives, hamstrung by inaccurate statistics and forecasts, and conscious of the limitations and bluntness of its monetary tools.

  Price inflation was roaring out of control and the dollar was in a state of collapse by the summer of 1979. The System was yet once again paralyzed by its conflicting objectives, constrained by political and bureaucratic imperatives, hamstrung by inaccurate statistics and forecasts, and conscious of the limitations and bluntness of its monetary tools. (See, Meltzer, History of the Federal Reserve, v. 2, Part VII, "The Great Inflation (1973-1980).")
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  The human administered alternative to the gold standard rules based market mechanism was once again failing on a grand scale. At least the difference between "real" - inflation adjusted - statistics and nominal statistics was now recognized, but Keynesian beliefs still addled analyst brains and devotion to mathematical economics distorted and constrained staff understanding of events.
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  Average annual consumer price inflation rates for 1977 to 1980 ranged from 4.12% for Germany to 15.15% for Italy with the U.S. rate at 9.85%. U.S. CPI inflation for 1979 was almost 12.5% and 11.7% in 1980. (These events had all been accurately forecast and explained by the publisher of FUTURECASTS in Blatt, "Dollar Devaluation" (1967).)

  "The end of the Bretton Woods system did not eliminate differences among countries about how to share the cost of common defense or reconcile domestic demands to lower the unemployment rate or the inflation rate. Floating simply gave policymakers one more degree of freedom; they could permit the exchange rate to adjust, and they could choose to control domestic inflation."

  Actually, there is no choice. If price inflation is not controlled, all other policies must fail. It is just a matter of time.

  The international money markets actually grappled quite efficiently with floating exchange rates, as one would expect. Volatility was great due to differences in national economic and monetary policies, but trade did not noticeably suffer and recovery proceeded after the 1973-1975 economic contraction. (However, the business cycle for the decade from 1973 was far more volatile and vicious than for any other decade since WW-II - or thereafter until the present.)
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As the dollar weakened, the U.S. was weakening at home and losing influence abroad.

At the end of Volcker's term eight years later, price inflation was down to 4.2%, the U.S. had reclaimed world leadership and the Soviet Union was in its death throes - its finances ravaged by the price collapse of the commodities that were its only major exports.

  Price inflation was now causing enough pain so that it rose to the top of public concerns - even well above concern over unemployment. As the dollar weakened, the U.S. was weakening at home and losing influence abroad.

  The dollar was no longer strong enough to provide substantial protection from shocks coming from abroad. Soviet influence spread rapidly in Africa, Latin America and elsewhere among third world nations - spreading into the vacuum caused by the withdrawal of U.S. influence. 

  Volcker clearly stated his belief in central bank independence and tighter money. Control of the monetary aggregates was an essential aspect of any anti-inflation monetary policy. Reserve growth or interest rate targets could be effectively applied to control the money aggregates.
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  Volcker recognized that ending inflation required commitment. It could not be painless or quick. Price inflation was around 11% when he began his term. At the end of his term eight years later, it was 4.2%, the U.S. had reclaimed world leadership and the Soviet Union was in its death throes - its finances ravaged by the price collapse of the commodities that were its only major exports. The trade weighted dollar index had risen from 85 to 135.
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  A desperate Pres. Jimmy Carter appointed Volcker and Pres. Ronald Reagan was willing to spend the political capital to support him. It was a rough ride. It began with a severe recession - indeed a depression - as one would expect from an austerity program at that stage of a chronic inflation.

  "[Reported] consumer price inflation fell from a peak annualized monthly rate of 17 percent in January 1980 to about 5 percent in September and October 1982 when policy operations changed. Interest rates on ten-year Treasury bonds reached 15.68 percent and remained above 10 percent from July 1980 to November 1983. The unemployment rate remained at 7 percent or above  for sixty-eight months from May 1980 to December 1985 and reached a post war peak at 10.8 percent in November and December 1982."

1980-1982 depression:

  Disinflation turned out to be far more costly in terms of economic contraction than Volcker and Reagan and their staffs expected, but the Keynesian predictions of utter collapse and failure - like almost all Keynesian predictions - failed to materialize.
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  The differences between Keynesian and monetarist views - between James Tobin and Milton Friedman - are summarized by Meltzer. (See, two articles beginning with Keynes, The General Theory, Part I: "Elements of the General Theory.," and three articles beginning with Friedman & Schwartz, Monetary History of U.S., Part I: "Greenbacks & Gold.") The costs of chronic inflation, as Volcker pointed out, are serious and unavoidable. After-tax returns for corporations were drastically reduced; individuals were impacted in capricious ways; volatility and uncertainty raised the risk side of the risk/reward calculation, reducing average price/earnings ratios; due to high nominal interest rates and price inflation, investments tended to be concentrated on relatively short term projects with quick payouts; and inflation expectations impacted wage demands, exchange rates, prices and interest rates. Due to these rapid responses, there could be no Phillips curve. tradeoff any more.

  The "quality" of reported earnings declined due to the distorting impact of rapid price inflation on accounting methods. Replacement costs for inventory and assets were rising rapidly. This, too, tended to reduce price/earnings ratios.

Public concern over inflation was at its height - well above concern for unemployment.

  A half point increase in the discount rate to 11% was approved by the Board by a narrow 4-3 vote in September 1979 soon after Volcker took charge. It was the second half point increase in two months. Inflationary expectations had become so entrenched, however, that prices surged on commodity markets. Market commentary suggested that this was all the Board would be able to do - and it wasn't enough. Volcker may have underestimated the difficulties of fighting inflation at this point, but his determination didn't flag. With the dollar sinking like a stone, defeat was simply not an option.
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  The time was ripe. Public concern over inflation was at its height - well above concern for unemployment. This strengthened Volcker's hand as the nation entered the 1980 election year. Carter, to his great credit, refrained from any attempt to influence Volcker. Congress was well aware of public anger over inflation. People were turning to gold, which rose 42% to $426 in less than six weeks.
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A discount rate below the federal funds rate constituted a taxpayer subsidy for the banks that were thus very fond of it.

  Volcker decided to use bank reserves as the monetary policy target for Federal Open Market Committee (the "FOMC") open market operations. Meltzer explains the many difficulties involved. These included a two week lag in bank reserve reports and the ability of member banks to increase discounts or borrow on the federal funds market, which would increase volatility in that key interest rate. Board staff calculations of reserve growth seasonally adjusted and the likely levels of member bank borrowing remained notoriously unreliable.
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  The changes in the amount of member bank borrowing from the System were still as misunderstood as in the 1920s. Volcker and other System officials still believed that member bank borrowing actually reflected monetary constraint while it was frequently only a reflection of the incentives from a discount rate that was below market rates. Banks were borrowing from the System because they could find profitable uses for the money, not because monetary conditions were tight. This misunderstanding supported policies based on non-borrowed reserves that were thus actually pro-cyclical during initial phases of the business cycle.
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  Monetarists wanted contemporary reserve accounting, something that would be costly for member banks that were already leaving the System in significant numbers due to the costs of leaving reserves idle with the System during a period of high interest rates. Thus, the two week lag remained for reserves accounting until October 1982. The monetarists wanted the discount rate to be pushed up to a penalty rate above the federal funds rate so member bank borrowing from the System would not be profitable and would be limited to need. A discount rate below the federal funds rate constituted a taxpayer subsidy for the banks that were thus very fond of it. (Banks are again making out like bandits with the current low discount rate.)
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  On October 18, the Board and FOMC moved on three fronts. Member bank non-borrowed reserves were targeted, the discount rate was pushed up a whole point to 12%, the federal funds rate target was broadened to as high as 15.5% to facilitate the effort to hit the reserve target, and reserve requirements on certain large deposits were increased. This time, the Board was unanimous. The next week, stock prices took a dive. Gold fell but recovered. Long term rates rose. There was widespread acknowledgement that the fight would be costly - but that this time it must be won.
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"Twelve years after Friedman's insistence on the effect of expectations, the Federal Reserve not only accepted that it could not permanently reduce unemployment by increasing inflation, but it now claimed that low inflation increased employment."

  The Board's new approach could be called "practical monetarism."

  "Although the FOMC did not adopt the procedures that monetarists advocated, they now accepted the importance of controlling inflation by controlling money, permitting much wider fluctuations in market interest  rates, and distinguishing between real and nominal interest rates."

  By controlling reserves, they could control money growth and leave market interest rates to react as they might. Of course, interest rates would inevitably become volatile and surge considerably higher under the circumstances, but that was a market reaction and not a result of rates directly administered by the Board.

  "Twelve years after Friedman's insistence on the effect of expectations, the Federal Reserve not only accepted that it could not permanently reduce unemployment by increasing inflation, but it now claimed that low inflation increased employment. Other leading central banks did the same. The way was open for inflation targets and other ways of recognizing that the principal, but not only, responsibility of a central bank was to maintain the value of money."

  In the next quarter century from 1982, the U.S. and other advanced nations enjoyed "the Great Moderation," with two decade-long expansions and only two short and shallow contractions.
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Keynesian policies had brought the U.S. to the beginnings of hyperinflation by the time Volcker became chairman.

Inflation once established was proving difficult to bring down.

  The 1980-1982 economic contraction was long and severe both in the U.S. and abroad. There were loud and increasingly heated complaints. Meltzer provides the details.
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  Treasury 10 year bond yields hit 13.20% in February 1980. Forecasts continued to reflect expectations of higher inflation rates. Nobody had confidence in the staying power of Volcker and the System. Recognizing that inflation had reached crisis levels, neither Carter nor Reagan directed criticism at Volcker and the System and even Congress offered only muted criticism during the election campaign period. However, complaints were loud and increasingly heated elsewhere and in Congress as time passed.
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  The spread between long term and short term rates varied widely during the next two years reflecting the ebb and flow of public skepticism about the outcome of the System's anti-inflation effort. The CPI price inflation index peaked at 13.7% in March 1980, but the GNP deflator didn't peak - at 12.1% - until the fourth quarter of 1980. The pace of CPI increase was by this time breathtaking.  On an annual basis, the CPI peak in March was 17.1%. It had risen 4.5 percentage points just since December, 1979.
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   Before 1980, inflation forecasts persistently ran substantially below results (many of the forecasters were Keynesian economists). Then the forecasts persistently kept rising well into 1981, even after inflation turned down. This reflected the widespread skepticism about the continuation of monetary restraint.
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  There was an election year tax cut, U.S. hostages held in Iran, a Carter administration proposal for credit controls, and high oil prices continuing into the first half of 1980. The economy turned down modestly with unemployment rising to 7.8%. The Board's official outlook report to Congress projected a 5% economic decline in 1980 with slow recovery in 1981. The staff was not low-balling the election year projection. The 8.5% unemployment projection turned out to be considerably higher than the 7.2% unemployment for December. However, their inflation forecasts were accurate with the actual averages for 1980 and 1981 of 9.5% and 8.6% falling in the middle of the projected ranges. Inflation once established was proving difficult to bring down.
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  Controlling the monetary aggregates was not proving easy. M1 hit a 14% annual rate of increase for October 1980, far above the 4.5% target. The federal funds rate surged to between 17% and 18%. The FOMC chose to let it go.  Even at record highs, the discount rate was still far below market rates, so member bank borrowing from the System surged as high as $3.1 billion and averaged $2 billion for October - double the average for the previous October. The Reserve Banks repeatedly requested even higher discount rates, but these were rejected by the Board.
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  Financial innovation complicated matters. The staff adopted new monetary definitions. M1 was divided into an old M1A and a new M1B, and the other aggregates had similar changes.

    "M1A and M1B differed by adding into M1B NOW accounts, automated teller balances, credit union share balances, and demand deposits at mutual savings banks. M2 added savings and small time deposits, overnight repurchase agreements, euro-dollars, and money market mutual fund shares."

In real terms, the growth of the monetary aggregates had turned negative early in 1979 - even before Volcker became Board chairman. Growth of the monetary aggregates was kept substantially negative until the middle of 1982, turning positive just as the economic contraction ended.

  Higher market interest rate targets were now being routinely approved by the FOMC. As the federal funds rate soared to 17% - four percentage points above its previous record high - the target ceiling was raised to 18%. The ten year note hit 13.2%, with Treasury bills over 15.3%. Banks could still profitably borrow from the System to buy Treasury bills.
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  The monetary aggregates were still expanding exuberantly in nominal terms, but they were no longer accelerating in pace with inflation. In real - inflation adjusted - terms, the growth of the monetary aggregates had turned negative early in 1979 - even before Volcker became Board chairman. Growth of the monetary aggregates was kept substantially negative until the middle of 1982, turning positive just as the economic contraction ended. Real long term interest rates doubled - to 6% - during this period, declining under 4% in the middle of 1982.
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  Election year pressures were not totally absent in 1980, but it was helpful that the increase in unemployment was initially modest. The Volcker Board was not immune to these pressures. In the spring of 1980, the Board experimented with a two-tier discount rate favoring smaller banks by 3 percentage points. It was 2 percentage points that summer, and 3 percentage points again in December. For the election campaign period, the discount rate was reduced by 3 percentage points, but had to be restored to 13% for smaller banks and 16% for larger banks by the end of the year. This was, after all, "practical" monetarism.
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  Carter announced $13 billion in budget cuts in March 1980. As high as the discount rate was, it was kept well below the federal funds rate. Affecting discount rate policy was the continuing misunderstanding about borrowed reserves and concern about inducing interest rate increases by foreign central banks that would cause economic contraction abroad and reduce U.S. exports.
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  The Carter administration engaged in some election year posturing. It instructed the System under a 1969 law to impose credit controls. The move was expected but was implemented without any real conviction about effectiveness. Housing and automobiles - already weak economic sectors - were exempted, and only unsecured installment lending and credit cards were affected.
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  Nevertheless, there was a sharp reaction in the private economy. Individuals and businesses responded by restricting and reducing their loans. In the second quarter of 1980, GNP declined at a 9.1% annual rate and industrial production declined at 25% to 30% annual rates - the sharpest decline since WW-II. Weak businesses were closing and credit bubbles were popping. Commodity prices collapsed - catching the Hunt brothers heavily committed to the silver market. Their losses were in the billions and required a System response to prevent collapse of their creditor banks. The Hunts were illiquid - not insolvent - so the System acted as guarantor of last resort for them as they arranged bank loans amounting to $1.1 billion.
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  With economic contraction came sharp declines in interest rates and money growth. Federal funds dropped from 19.38% in March to 13.5% in April. CPI inflation was about 18% for the first quarter, but was just under 11.7% for the entire year. Credit controls were removed at the beginning of the third quarter.
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  Effective September 1980, under the 1980 Monetary Control Act, reserve requirements were expanded to cover a broad range of nonmember depositary institutions. In return, they gained broadened lending powers and access to the System discount window. Deposit insurance was increased to $100,000 and Regulation Q savings account interest rate ceilings were finally phased out.

  Yet another experiment in what would later be called "industrial policy" ended disastrously for the thrifts it was designed to favor.

  Volatile swings in exchange rates had become a threat to commercial transactions. The decline in interest rates in the middle of the year weakened the dollar, causing a flurry of domestic and foreign intervention efforts. The rapid decline in market interest rates caused a dramatic decline in member borrowing as discount rates for larger member banks shifted into punitive levels. Borrowed reserves fell to $500 million, excluding $600 million borrowed by troubled banks.
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  The System was increasingly involved in bailouts of large institutions, creating the moral hazard that played such a major role in the Credit Crunch boom and bust a quarter century later. Meltzer again emphasizes Bagehot's rule for the lender of last resort role; it should protect the financial system - not particular financial institutions. (This eminently sensible rule would again be violated during the Credit Crunch.)
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The FOMC simply could not control the monetary aggregates any better as long as it was using unborrowed reserves as its monetary policy target.

Real GNP was essentially flat in the third quarter and was conveniently rising robustly - at a 5.2% rate - during the election period.

  The monetary aggregates vacillated wildly during the two years of the economic contraction. Control efforts clearly lacked precision. Whenever the monetary aggregates surged higher, the surge was interpreted as a retreat by the FOMC, but Meltzer asserts that the FOMC simply could not control the monetary aggregates any better as long as it was using unborrowed reserves as its monetary policy target. Meltzer points out that Germany was far more successful during this period in combating its less severe surge of inflation.
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  Neither inflation nor unemployment declined until the third quarter of 1980. Unemployment reached 7.8% in July. Vacillating widely, M1B rose at an annual rate of just 1.75% during the first half of the year. This was far below the FOMC target. During the beginning of this economic contraction, the Board's policies were again proving pro-cyclical.
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  With the removal of credit controls and the sharp decline in the federal funds rate down to 9%, it appeared that the Board was once again retreating from the inflation fight. The rate of increase in the monetary aggregates turned sharply higher. Price inflation was still 9% measured by the GNP deflator. It appeared that the Board had gone back to controlling the federal funds rate instead of managing the money supply. Real GNP was essentially flat in the third quarter and was conveniently rising robustly - at a 5.2% rate - during the election period. As calculated by the National Bureau of Economic Research, this economic contraction was over.

  In reality, it had just paused for the election. All the problems that caused economic contraction in 1980 remained to afflict the economy in 1981 and 1982. It was all one big economic contraction.

  Recent regulatory as well as financial innovations had substantially changed all the indicative factors that the Board had to work with. In fairness, the Board had good reason for its high level of uncertainty at this time.

  "By July 1981, the Monetary Control Act added more than 8,000 weekly reporting banks and 8,500 quarterly reporting banks as holders of required reserves. The act included also the Public Sector Adjustment Factor, requiring the reserve banks to price payment services to cover costs and imputed private sector profits. This was the price paid to the large banks for accepting the Monetary Control Act. The act also removed state usury law ceiling, many of which prevented lending because they did not adjust to inflation. To protect states rights, the states could choose to reenact the ceiling. All depository institutions became subject to a 12 percent reserve requirement ratio for transaction accounts. At institutions with less than $25 million of transaction deposits, the ratio was 3 percent. These changes, too, affected the supply and demand conditions for different deposits."

The discount rate was reduced in full point steps to 10% by September 2, 1980, and bank reserve requirements were also reduced. There was explosive growth in the monetary aggregates for five months during the middle of 1980, and all the disinflation impact of the previous months were undone and had to be restarted that fall.

  Nevertheless, the fact is that the Board erred on the inflation side - exactly in line with inflationary expectations. Monetary restraint had been eased in the middle of the year - just in time for the election. The discount rate was reduced in full point steps to 10% by September 2, 1980, and bank reserve requirements were also reduced. There was explosive growth in the monetary aggregates for five months during the middle of 1980, and all the disinflation impact of the previous months were undone and had to be restarted that fall.
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  The Treasury and the System had to expend foreign exchange reserves to support a weakened dollar. While real base money growth was still negative, nominal base money growth began rising substantially in May 1980, supporting the economic recovery that summer that conveniently lasted through the election period. Nominal money growth surged, with M1B growing at a 12.25%, well above the 4.5% to 6% target.
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The CPI was still 12% in August measured by a three month moving average. The markets now expected the surrender to inflation and reacted quickly.

  Volcker's initial effort at controlling inflation had failed. The CPI was still 12% in August measured by a three month moving average. The markets now expected the surrender to inflation and reacted quickly. The 10 year Treasury yield rose 3.7 percentage points to 13.19% during the last half of 1980. With the discount rate again well below market interest rates, borrowing from the System surged. The federal funds rate hit 12.8% in October.

  "Inflationary expectations, reinforced by the policy reversal in the spring, forced more restriction than anyone on the FOMC had anticipated. In late September, the Board approved a 1 percentage point increase in the discount rate to 11 percent. Its announcement explained that it sought to reduce money growth. The Board followed with an increase to 12 percent on November 14, and it restored the 2 percentage point surcharge for large banks that borrowed frequently."

  Several Reserve Banks wanted even higher discount rates - much higher. By December, the discount rate was 13%, and Reserve Banks were still requesting more.
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  The economic impact of this return to monetary restraint came, of course, after the election. Economic decline was modest in the second and third quarters of 1981, but the GNP deflator at last showed substantial results - declining to 6.7% in the second quarter of 1981. Carter lost to Ronald Reagan, but Democratic losses were not sufficient to cost them control of Congress.
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  Meltzer attributes much of the decline in price inflation to the end of the oil price increases. The dollar, too, surged - rising 30% on a trade weighted basis by July 1981, which must also have had an impact on price inflation. (However, both the decline in oil price and the strengthening of the dollar were primarily the results of the economic contraction caused by the System's disinflation efforts.)
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Reform:

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  The application of bank reserve ratio requirements was simplified to reflect only the size of the financial institution rather than their locations and traditional characteristics. Based on a $25 million dividing line that increased at a slower pace than inflation, small bank reserve requirements were much smaller than for the larger banks, and reserve requirements for time deposits were much smaller - with no reserve requirements for time deposits with maturities in excess of four years.
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  Inflation had undermined New Deal banking regulations. The System was now the lender of last resort to all solvent financial institutions. Greater flexibility was required to avoid widespread financial failure, but many of the savings and loans had been fatally weakened when inflation drove substantial increases in interest rate volatility and rates that the thrifts couldn't respond to due to the rigidity of their business model and regulatory scheme

  "Most of them suffered losses because their fixed-rate mortgages yielded less than the cost of their deposit liabilities. Failing to renew deposits would force liquidation of mortgages at a loss, impairing their capital. Renewing deposits meant higher interest payments and current losses. Either way, the System's disinflation program threatened their survival. By September 1980, about 90 percent of the New York savings banks operated at a loss."

  The thrifts were propped up for awhile by various regulatory subterfuges, but by the end of the decade they had suffered widespread failures.
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The near term social costs would be accepted in order to get the long term benefit. The question of how much unemployment would be politically tolerated to achieve that objective was not something the Board or its staff wanted to address. While still complaining that the budget deficits of Congress and the administration were making the disinflation effort much harder, the Board accepted the primary responsibility for controlling price inflation.

  Meltzer explains the widespread financial reforms that included the 1980 Depository Institutions Deregulation and Monetary Control Act and its implementation. It was primarily an accomplishment of Board Chairman Miller. Additional changes came with the 1982 Garn-St. James bill. Because of the extensive reforms, the monetary aggregate statistics were no longer comparable with their 1970s counterparts.

  "By 1983, the Federal Reserve had given up control of M1 an M2. The new accounts and uncertainty about the data became the ostensible reason for ending the experiment. Failure to develop successful control of the monetary aggregates and a desire to reduce market rates were at least as important. Congressional pressure seems most important."

   There was widespread confusion about the nature of "money" and how to calculate monetary targets. When regulatory reform permitted the payment of interest for checking accounts, the differences between M1 and M2 were obliterated.

  "Nationwide NOW accounts -- in effect, interest-bearing checking deposits -- would soon be available and included in M1B. Also, money market accounts would be included in M2. The System expected large withdrawals from accounts subject to Regulation Q ceilings, but it had no reliable way to estimate how much M1B and M2 would change as a result of the Monetary Control Act. What was the size of the substitution effect? What should the System announce at the Humphrey-Hawkins [congressional] hearings in February? How would the announcement affect the System's credibility?"

  Should emphasis be switched to reserve targets or nominal interest rates or real interest rates? There was no evidence as to which approach would provide the best inflation control.
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  Whatever the Board did, at least control of inflation had been recognized as the primary objective. The near term social costs would be accepted in order to get the long term benefit. The question of how much unemployment would be politically tolerated to achieve that objective was not something the Board or its staff wanted to address. While still complaining that the budget deficits of Congress and the administration were making the disinflation effort much harder, the Board accepted the primary responsibility for controlling price inflation.
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  Volcker made a key change in policy as 1981 began. Actual monetary growth would no longer be accepted as the base for the next quarter's targets. The base would instead be the midpoints of the previous target ranges, thus avoiding the persistent ratcheting up of monetary inflation as actual monetary growth exceeded target ranges. By the fourth quarter of 1981, monetary base growth had declined to about 5% from a peak of 9%.
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  The "monetary base" frequently referred to by Meltzer includes currency and bank reserves. The "money stock" frequently referred to by Milton Friedman includes currency and demand deposits, and is thus generally a broader measure than monetary base. Financial reform in the 1980s, however, fudged the distinction between demand and savings and other time deposits and money market funds and much else, rendering the money stock - and M1 - ambiguous designations.
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  Staff studies emphasized the difficulties of controlling the monetary aggregates. Borrowing from the System - which waxed and waned with fluctuations in the use of credit throughout the economy - could not be accurately forecast. The vast and complex financing mechanism was too volatile, especially under inflationary conditions.
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  Despite the extra costs it would impose on the banks, the staff wanted contemporary reserve accounting to increase control of bank reserves. Interest rate volatility was being made much worse by the errors introduced by the two weak lags in bank reserves reporting. The wide errors in the short term data were also a huge problem.

  "Both the staff report and the FOMC recognized that most of the data they watched were subject to relatively large random errors, but they did not ask: Why pay attention or respond to these noisy short-term data? Also, changes could be persistent or transitory. There was no way to distinguish promptly which type of change had occurred. [An academic study] showed that gradual adjustment was the optimal response in the presence of a mix of persistent and transitory changes. The speed of response depended on the relative size of permanent and transitory variances. Further, some of the changes to which they responded were self-reversing. By responding promptly, their actions could increase variability."

  At this stage of inflation, it was found that monetary inflation above the Board target led directly to higher interest rates - both long term and short term - instead of lower rates. The markets expected that the monetary inflation would cause both increased price inflation and the increased interest rates that would be needed to constrain that price inflation. Inflationary expectations grew as System credibility declined.
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Reagan administration monetary policy:

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  Political considerations influenced Reagan budget and monetary policies just as they had for prior administrations. Administration forecasters were required to include "improbable" favorable responses to supply side tax and other economic policies in their economic analyses. (This is today evident in the ridiculously low cost projections for Obama's health care reforms.)
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  System staff forecasts were in any event as inaccurate as ever. (Reality still perversely refused to conform to the expectations of macro-econometric models.) The monetary aggregates statistics remained unruly, with M2 above target and M1 below target. Nobody as yet knew what seasonal adjustments to make for the new NOW accounts.
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  The federal funds rate was as high as 19% in the first quarter of 1981 and finished the quarter at 14.7%. Despite these high rates, the economy continued to expand through the first quarter and price inflation remained high.
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  The Volcker FOMC was determined to press the fight. Its federal funds rate target range for May was 18% to 22%, and the average rate for June was indeed 19%, "the highest recorded before or since." There were loud complaints from Treasury officials, but Reagan supported Volcker. However, there were no discount rate changes.

  "By increasing interest rates in the middle of a recession, the FOMC increased credibility. This was clearly a change in practice. Never before had the public seen an increase in interest rates with the unemployment rate at 7.5 percent. The first signs of possible success appeared. The twelve-month average increase in consumer prices slowed to less than 10 percent for the first time in two years."

"But ten-year constant maturity Treasury yields remained at 14 percent. Real interest rates remained high; the public was not convinced that the Great Inflation was about to end permanently."

  Administration economic policies included major tax cuts. (Many of these, however, were delayed for several years.) Monetary policy targeted the monetary aggregates with a broad 6 percentage point band for the federal funds rate.
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  Despite these efforts, the monetary aggregates vacillated wildly, but restraint was maintained and average monetary growth rates plummeted. About this time, M1B became accepted as the new M1. The discount rate was raised to 14% in May 1981 and federal funds were again at 19%. The 19.1% rate in June is the highest in System history. That May, Treasury bonds yielded 14.6%.
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  By the end of 1981, trends for both the federal funds rate and growth of the monetary base were significantly down - and so was the economy. Federal funds rates averaged 12.4% for December. "But ten-year constant maturity Treasury yields remained at 14 percent. Real interest rates remained high; the public was not convinced that the Great Inflation was about to end permanently."

  "The Federal Reserve continued to act against inflation as it had never acted before. - - - Annual growth of the monetary base reached a local peak in April at 8.16 percent. By October, it had fallen below 5 percent, and the annual rate of CPI inflation permanently fell below 10 percent. Federal Reserve policy began to show results."

  Reagan remained solidly in support, and even Congress was generally supportive. There was even support from home builders who were suffering for many months with housing starts well below one million units. The decline in CPI inflation from the end of 1981 and into 1982 was encouragingly swift if statistically erratic. The GNP deflator dropped steadily from 9.4% to 5% in the four quarters to the middle of 1982. In October 1982 the Board began lowering the discount rate, but this was now a penalty rate above the federal funds rate and borrowing from the System accordingly declined sharply from $2 billion in June to $600 million in November.

  "The year 1982 was a transition year. The FOMC ended targeting nonborrowed reserves. The Board lowered the discount rate from 12 to 8.5 percent. The federal funds rate declined from a 13.22 average in January to 8.95 percent in December. And the twelve month average consumer price inflation fell from 8.1 in January to 3.8 percent in December. Consumer prices fell in December at a 4.9 percent annual rate."

  From February through June 1982, as the economy plunged into the depths of the 1980-1982 depression, the federal funds interest rate remained within a remarkably narrow range from 14.5% to 14.94%. Meltzer comments that this might indicate that the federal funds rate was the monetary target for that period, although there was no hint of that in the FOMC records. The federal funds rate was high both nominally and in real - inflation adjusted - terms since price inflation was running at just about 7% through this period. After a disturbing surge in January 1982, M1 growth was successfully kept low, although varying between -3.5% and 6%.
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  FOMC members remained committed to the disinflation effort and supported Volcker's views even as inflation declined and the unemployment rate remained about 9%. In March 1982, this commitment was reflected in a 9 to 2 FOMC vote in favor of constraint. However, political pressures were rising ahead of the November congressional elections. With supply side tax cuts slowly kicking in and substantial increases in defense spending, the System's efforts to regain credibility were bucking the reality of substantial deficits in the nations budget and current trade account. Many expected inflation to rebound as soon as economic recovery began.
 &

A credit crunch:

&

  By May 1982, FOMC members were getting restless. So was Congress. After two years of trying to control monetary inflation, unemployment was more than 9% and yet price inflation remained stubbornly high.
 &

The Constitution, Reuss stated pointedly, gave the monetary power to Congress.

  Congressman Henry Reuss (D. Wis.) reminded Volcker that the System was the agent of Congress. The Constitution, Reuss stated pointedly, gave the monetary power to Congress. He wanted assurances from Volcker that the System would accede to congressional directives. Volcker responded that the System would of course follow the law, but that it would be a mistake for Congress "to indicate or direct a specific concern for monetary policy." Congressmen Wright Patman (D. Fla.) and Robert Byrd (D. W. Va.) were also actively putting pressure on the System. However, support came from Congressman Jack Kemp (R. N.Y.) and Senators Jake Garn (R. Ut.) and William Proxmire (D. Wis.). 

  "Volcker clearly began to shift to an explicit interest rate target. He no longer favored reliance on M1. NOW accounts made it difficult to interpret. He favored 8 percent growth in M2 because that seemed consistent with nominal GNP growth of 8 percent."

  A broad federal funds rate target range of 10% to 15% was chosen. With the ten year Treasury yielding 13.5% and price inflation forecast at about 6%, an extraordinary 7.5% real interest rate was squeezing the credit markets.
 &

  Recessions cleanse the economy of the outdated, the weak, the over-extended - and the incompetent. The latter group included third world nations that had been offered large credits in the ridiculous Keynesian assumption that funding governments could generate development. The former group included all the usual private and public suspects generally revealed when the economic tide goes out.
 &
  The bankruptcy rate was surging. Homebuilders, savings and loan institutions and farmers who had borrowed to expand during the 1970s were heavily represented. There was trouble in the oil patch as oil prices dropped precipitously from $26 per barrel to $12. The depression perversely refused to conform with forecasts that it would end in the 2nd quarter.
 &
  The failure of small financial institutions with large debts threatened major banks like Chase Manhattan Bank and Continental Illinois and Seattle First. Penn Square collapsed in June 1982 as its oil industry loans became worthless. It had sold about $2 billion of these loans to others, half  of which went to Continental Illinois. The System "made the mistake of lending $20 million to Penn Square to prevent insolvency instead of permitting the failure and defending the market." The effort was futile and the money was soon gone. The FDIC refused additional support. Wary of moral hazard, the FDIC favored closing the bank and paying off the depositors. The Reagan administration supported the FDIC view.
 &
  As in the 2007 Credit Crunch, the problem involved the fragility of wholesale banking. Banks were borrowing large sums on short term money markets to lend profitably long term, putting them at risk in the event of any sharp increase in interest rates or money market breakdown. By 1980, the eurodollar market was recycling vast sums from petroleum exporters. through money market banks. When Volcker tightened the screws on monetary inflation, interest rates soared.
 &

These loans benefited the creditor banks, not the third world nations that got no additional money from the program but suffered the destruction of their credit and thus suffered a lost decade. 

  A Mexican financial crisis was a feature of the third world debt crisis. There had been a 50% increase in bank loans to developing countries in just three years. One third of these debts was held by American banks. The total was more than $360 billion by the end of 1982.
 &
  Mexico was now overextended, but its collapse would force creditor banks to recognize major losses. Mexican debt threatened 44% of the capital of the nine largest U.S. banks. Many smaller banks also held Mexican debt.
 &
  Volcker fudged the issue. The System lent $700 million to Mexico to delay revelation of Mexico's insolvency until after the 1982 Mexican election. Acting with other central banks and the cooperation of creditor banks, $1.85 billion was lent to Mexico pending an IMF loan.

  "The money market banks borrowed the eurodollars and lent them to developing countries. Their loans were for longer terms than their eurodollar deposits, so the banks were at risk. Defaults by the developing countries could wipe out their capital. The world recession slowed the growth of exports, and the high real interest rates increased borrowing costs. The threat of widespread default, perhaps starting in Mexico, added to concerns about financial fragility."

  The System was actively conspiring on behalf of incumbent politicians against the people and the clear national interests of both nations. Indeed, the System would repeatedly find itself in the position of cooking the books - conspiring to hide the financial truth. It would repeatedly act against the people and the clear national interest. Moral hazard was being increased to the levels that would play such an important role in the 2003-2009 Credit Crunch boom and bust..

  These vast debts could not be paid. The System, and then the Treasury with the IMF and other central banks, funded huge amounts of third world debt for the rest of the decade. They made sure that debtor nations continued to make interest payments to their creditor banks so the banks would not have to recognize losses. These loans benefited the creditor banks, not the third world nations that got no additional money from the program but suffered the destruction of their credit and thus suffered a lost decade. (The European Central Bank faces similar problems today.)

  "The Volcker policy also put the interest of financial markets and banks ahead of the interests of the developing countries. The latter reduced their [imports] from the rest of the world. The United States was a major supplier, so much of the burden fell on U.S. farmers and manufacturers. Writing down the debt and lending to sustain the debt market would have been a less costly solution. Once again, the Federal Reserve neglected Bagehot's advice."

  The debts of the debtor nations had increased by approximately 50% by the end of the decade. A program devised by Treasury Secretary Nicholas Brady provided a combination of new financing, austerity requirements, and creditor recognition of loan losses that permitted the debtor states to work their way out of the problem. The U.S. government finally bowed to the inevitable and accepted the write down of the debts, so the ultimate burden - as usual - landed largely on the U.S. taxpayers.
 &
  Currency devaluations by France and Italy added to the financial turmoil of the early 1980s.
 &

  As the 1982 elections approached, administration officials like James Baker and Treasury Sec. Donald Regan began to apply pressure on the System. The threat of legislation that would undermine System independence was becoming very real. The monetary aggregates were expanding well above their target ranges, but the banking system was under increasing stress with widespread bankruptcies. A financial crisis would force a substantial retreat on monetary policy.
 &
  That summer Congress passed a resolution calling for "coordination" if Congress attacked its budget problems "in a substantial and permanent way." However, the FOMC was divided over the impact of a reduction in budget deficits and how that should be taken into account in monetary policy. This issue had arisen in 1968 and had not been resolved by 1982. How much "coordination" would be required to satisfy Congress?

Recovery without price inflation:

&

  Pessimistic forecasts were spreading gloom - but proved, as usual, wide of the mark. The System staff forecast 3% growth in 1983. Actual growth was 6.5%. Phillips curve forecasts were even further off the mark. The dollar was surging, oil prices were plummeting, and price inflation at last declined about 6 percentage points in 1983.
 &

  There was in fact no return of uncontrollable inflation as recovery proceeded after 1982. This recovery proceeded despite historically high real interest rates, unlike prior recoveries in the Keynesian era that were dependent on artificially low interest rates.

  This recovery was characterized by an increasingly moderate business cycle and a quarter century of prosperity, whereas Keynesian recoveries in the 1970s and after 2001 were characterized by increasing business cycle volatility and viciousness - as might be expected whenever substantial increases in public and private leverage is encouraged.

  Meltzer compares the 2001 recovery which occurred in an environment of lower real interest rates and even greater budget deficits than in 1982.

  Those artificially low interest rates played a major role in generating the financial bubbles that burst in the 2007 Credit Crunch depression. Price inflation peaked at over 5%, forcing the System to allow interest rates to rise high enough to begin the process of puncturing the mortgage backed securities and housing bubbles.

  Volcker supported an easing of monetary policy during the July 1982 FOMC meeting. His policy shift had actually already occurred that June. He was responding pragmatically to political and economic concerns and the domestic and international financial crises precipitated by the 1980-1982 depression.

  "Like most of the others, he wanted lower rates. Like some, he feared a market interpretation that the FOMC had succumbed to political pressure that would end with fears of inflation and higher long-term rates. He moved cautiously."

  The discount rate was lowered two percentage points to 10.5% in half point steps by the end of August, followed by the federal funds rate to about 10.12% and Treasury bill yields to about 12.5% - the lowest since January 1981. Unemployment rose to 9.8%, but the financial markets were responding well. The stock market responded to the first whiff of monetary easing by heading up. By the end of the year it was surging. Ten year Treasury yields dropped below 12% by October. Their peak had been 15.86% a year earlier.

  "The rise in stock prices, and the fall in long-term rates and in measures of expected inflation were inconsistent with the predictions of those who opposed policy ease. Volcker must have noticed these responses and was encouraged to continue."

  Growth of the real monetary base turned positive in August 1982. Doubts about the identity of M1 did not affect the monetary base of currency and bank reserves. Real output edged upwards in the fourth quarter and gained strength in the first half of 1983. The 1980-1982 depression was over. The NBER calculation was that November was the end. However, unemployment, always a lagging indicator, rose above 10% as the nation went to the polls and all manner of credit strains had developed both domestically and internationally. Congress was getting restless, and the usual legislative threats to System independence were being proposed.
 &
  As Volcker acknowledged, it had been a worldwide economic contraction. Latin American nations owed about $300 billion to foreign creditors. Much of this debt was owed to U.S. banks. While basic interest rates were declining, interest rate spreads for higher credit risks were widening as credit-worthiness declined broadly. This was reflected in a substantial decline in the monetary velocity aggregate which naturally waxes and wanes with confidence in the financial system. There was a growing likelihood of defaults.
 &
  Volcker viewed the national and international situation as so fragile that monetary easing and lower interest rates had become essential. The federal funds rate had to decline at least temporarily, so Volcker was targeting interest rates.
 &

  Monetary "velocity" had increased during the inflationary 1970s as one would expect as people decreased their balances of rapidly depreciating cash. Velocity decreased in the disinflationary 1980s as people increased their balances of cash that was no longer depreciating so quickly, again as one would expect. Changes in the constituents of the monetary aggregates undoubtedly also had an impact on the calculation of the monetary velocity aggregate. In the 15 years from 1990, M2 velocity was about unchanged while M1 velocity declined at a much slower rate than in the 1980s as the Great Moderation period of prosperity continued.
 &

For public consumption, Volcker continued to emphasize the effort to bring inflation down. He did not publicize the effort to bring down interest rates, as that would have restored inflationary expectations.

  The FOMC voted to leave monetary policy to Volcker's discretion. This was a tremendous vote of confidence in him. The Board began to lower the discount rate - to 8.5% by the end of the year. The federal funds rate was brought down below 10%. CPI inflation was by that time below 5%, so the dollar continued to strengthen even as basic interest rates declined.
 &
  For public consumption, Volcker continued to emphasize the effort to bring inflation down. He did not publicize the effort to bring down interest rates, as that would have restored inflationary expectations. However, the federal funds rate stayed within its specified ranges all year while all the money aggregates were expanding above their target ranges, indicating that the primary monetary policy target was interest rates. The markets did not react badly to the rapid growth of the monetary aggregates, and the dollar continued to strengthen. Long term interest rates declined. So Volcker continued to push down on interest rates.

  "With M1 distorted, the committee was at a loss about how to operate. It continued to set a path for nonborrowed reserves, but it recognized that it had little control over M2 growth. Policy had become discretionary, based mainly on Volcker's judgment. Members disliked that arrangement but did not propose another. Volcker explained again that his goal was lower interest rates, but the size of the decline depended on slower money growth in M2 especially. His policy was opportunistic; he would lower interest rates as opportunities appeared."

  Clearly Volcker was being guided by the markets more than he was trying to influence the markets. This was a primary factor in his success.

  In congressional testimony, Volcker accepted an M2 target, but acknowledged that it was tentative. The FOMC was almost back to relying on "the feel and tone of the market." Volcker would not admit to targeting interest rates.

  "From the 1920s on, the System always responded to the threat of legislation. It was not helpless or without support. But Volcker did not wish to have a test of political strength. Inflation had fallen; the monthly CPI change for November and December 1982 was negative, and the twelve-month moving average fell below 4 percent, nearly ten percentage points below the peak. The December moving average was the lowest since 1973."

  The costly effort to reduce price inflation pressures had been a success. Inflation expectations had been reduced but not eliminated. The ten-year Treasury bond rate remained above 10% until November 1985. Unemployment was still at 7%. Fortunately, foreigners continued to finance between 15% and 20% of the budget deficit.
 &

  There remained many problems with monetary policy, Meltzer concludes. The FOMC still ignored the monetary base - still the most reliable monetary indicator. The FOMC focus was still too short term, reacting excessively to transitory shifts in bank reserves, money growth, output growth and measured price inflation. The discount rate was still frequently kept well below market rates.

  "The Federal Reserve's control of money was imperfect and often absent. Its signals were hard to read. It did not make any of the institutional changes needed to improve monetary control until after it gave up monetary control. Better control procedures would not have removed all the random fluctuations in reserves and money, but lagged reserve requirements prevented the staff from controlling total reserves."

  However the relatively high real interest rates and unemployment levels that would characterize the continuing effort to eliminate price inflation pressures during the next decade had been accepted. Economic recovery without renewed price inflation was undoubtedly the most important achievement of the Volcker Board. Contemporary reserve accounting was implemented in February 1984. It lasted until 1997, when lagged reserve accounting was restored.
 &

After 70 years of experience, the System still "did not have a common explanation of the causes of inflation or the role of money growth" or budget deficits or even the definition of "money."

  Economic recovery thus had to battle high real interest rates, banks and foreign governments that could no longer service their debts in this high interest rate environment, major losses for domestic banks from loan defaults and the declining value of low interest rate mortgages, and a major adverse shift in the nation's international trade and payments balances that was caused by massive budget deficits and a dollar that strengthened through the first half of the decade.
 &
  Moreover, the System had to manage monetary policy without any help from fiscal policy and still without any confident understanding of what it was doing. It still didn't really know how its monetary policy tools worked. "Policy was judgmental, based on Volcker's judgments." Views as to the causes of price inflation varied widely. After 70 years of experience, the System still "did not have a common explanation of the causes of inflation or the role of money growth" or budget deficits or even the definition of "money."
 &
  Explicit interest rate targets remained unattractive for political reasons. The temptation to impose disastrously low levels of interest rates always afflicted Congress. This temptation was especially dangerous during periods of high real interest rates and  inflationary expectations. Monetary targets had been undermined by the impacts of financial deregulation and the financial system contraction that was reflected in the steep decline in the "velocity" aggregate. There was uncertainty as to how the combination of high real interest rates and high levels of real base money growth would balance out.
 &

In 1994, the federal funds rate was finally acknowledged as the primary monetary policy target.

  M1 included NOW accounts and tax-exempt money funds. M2 included M1 and money market deposit accounts. Regulation Q ceilings on time deposit interest yields were finally ended in October 1983. Many of the concerns of regulatory reform after the 2007 Credit Crunch recession were already on the regulatory reform agenda during the early 1980s.

  "Volcker and the staff included in the directive three money growth rates -- M1, M2, and M3 -- a borrowing objective, and a range for the federal funds rate. Modest efforts to relate borrowing and the federal funds rate target did not succeed very well. Volcker and the desk concentrated on different targets at different times. This also gave Volcker considerable discretion. The FOMC members did not agree on whether they faced higher inflation, recession , or both in the near-term. Also, bank failures and financial fragility made most members hesitant to propose major changes. Some expressed concern about the effects of higher interest rates on emerging market debtors and therefore on lending banks in the United States."

  Meltzer summarizes the fragility of the financial environment.

  "The savings and loan or thrift industry had many insolvent institutions kept from failure by public policy. Higher market interest rates would have widened the spread between the rates paid by the thrifts and market certificates that were now deregulated. A mark-to-market policy for emerging market debt would reveal insolvency at many banks, especially money market banks. Higher interest rates would worsen the position of the debtor countries and thus the creditor banks. The domestic agricultural sector was hurt by the appreciation of the  dollar and by the interest payments required [from] farmers who had borrowed to buy farms during the period of high inflation and high nominal interest rates. - - - And, as always, the members expressed concern repeatedly about the budget deficit. Raising interest rates increased cost to the Treasury."

  Borrowed reserves remained the loose - tentative - explicit target. The connection between member bank borrowed reserves and the federal funds rate was loose, but wider target bands accommodated the statistical fluctuations and the discretionary authority desired by Volcker. In 1994, the federal funds rate was finally acknowledged as the primary monetary policy target.

  "As in all previous periods since 1920, when real base money growth and real long-term interest rates gave opposite forecasts, the economy followed real base growth. This time was not an exception; it differed only in the unprecedented level of the real interest rate. Despite these rates, real GDP, pushed along by rapid money growth and the permanent tax cuts, rose at an average rate of 8.3 percent in the four quarters starting in the second quarter 1983."

  Economic growth remained robust for the rest of the decade while price inflation statistics remained in a declining range below 6%. The initial resurgence of price inflation in 1983 was quickly matched by a federal funds rate increase back into double digit territory. Real base money growth declined, real interest rates surged, the discount rate was raised to 9% in April 1984, and price inflation again subsided. By November 1984, the discount rate was back to 8.5%.
 &
  The System's inflation fighting intentions had not been set aside. Volcker meant business. However, stable price inflation statistics below 3% would not be achieved until the 1990s. The fight would neither be easy nor quick. Meltzer again provides extensive detail of the uncertainties and differing viewpoints that characterized FOMC meetings.

  "This rapid response hides the uncertainty that was a dominant feature of FOMC meetings. The members had a much clearer view of their responsibilities but a murky view of how to achieve them. It took several years to develop an operating procedure that improved their ability to maintain steady growth and low inflation."

  Unemployment declined quickly below 8% by 1984, but the decline below 6% took the rest of the decade. At least the decline was relatively steady and generated political support for the continuing fight against price inflation. Long term interest rates continued to reflect the level of skepticism. They remained stubbornly high - in double digit territory - until 1985 and declined only grudgingly thereafter.
 &

  With the 1984 presidential election looming, powerful administration officials wanted a more malleable Board chairman than Volcker. The Republicans had suffered major losses in 1982 congressional elections due to the 1980-1982 depression. Volcker refused to commit to policy coordination with the administration. However, he did recognize the practical limits of System independence.
 &
  Reagan continued to support Volcker, so Volcker was appointed to a second term as Board chairman in June 1983. E. Gerald Currigan, a Volcker protégé, succeeded Anthony Solomon as president of the N.Y. Fed in 1985. Karen Horn became the first female Regional Reserve Bank president - at the Cleveland Regional Reserve Bank - in 1982.
 &
  Monetary policy was kept restrained well into 1984, evidenced by a federal funds rate that reached 11.6% in August and unemployment stuck at 7.3%, but Reagan staunchly defended the System as he entered the election season. However, by May, Volcker was candidly acknowledging election year realities and the problems of bank failures - especially the failure of Continental Illinois - as limiting System monetary policy discretion. Congress was not pleased with a declining stock market and slowing economic growth.
 &
  Nevertheless, Volcker would not "coordinate" policy with the political arms of government. He "emphasized the importance of controlling inflation, and was willing to act within the limits set by political concerns about the banking system and the international debt."
 &

 Bank failures: 

 Continental Illinois Bank, the largest in Chicago, failed in 1984 following Penn Square Bank, one of a host of small Texas and Oklahoma banks undermined by the rapid decline in oil prices and the value of collateral for oil patch loans.
 &

  Declining home prices undermined mortgages, which defaulted in large numbers. Crop loans also defaulted in large numbers. In the first half of 1984, 43 banks failed.
 &
  Stronger banks bought out many of the failing banks. Out-of-state banks became the buyers of last resort for the local banks. This resulted in an expansion of branch banking and led eventually to interstate banking - a fortuitous outcome. Other regulatory constraints on the scope of financial business that banks could enter also began falling by the wayside.
 &
  The regulators - the Board, the Comptroller of the Currency and the FDIC - decided in modern terminology that Continental was "too big to fail." It had been the nation's seventh largest bank with massive nationwide and international financial connections. Top management was replaced, the FDIC committed to protect all depositors, and the Chicago Federal Reserve Bank extended $3.6 billion in loans to keep Continental operating. The System loaned $3.5 billion to the FDIC. This was unprecedented in U.S. financial experience - and did not go unnoticed. By July, Continental had borrowed $7.5 billion from the System.

  "By protecting a large bank, government agencies encouraged 'giantism' and increased moral hazard -- the willingness of banks to increase risks in the knowledge that if the risks pay off, they gain, and if losses increase, the taxpayers absorb the losses. Moral hazard had long been present in deposit insurance protection, but extending protection to uninsured depositors increased the problem."

  The implicit government guarantee reduces borrowing costs for large financial institutions regardless of their risk profile. The result was a wave of mergers and acquisitions creating a host of financial institutions that were too big to fail. With implicit taxpayer guarantees behind them, they could engage in the riskiest behavior and still acquire financing at low interest rates from creditors who thus didn't have to worry about default. These creditors became enablers of the Credit Crunch boom and bust.

  That summer saw the failure of Financial Corporation of America, the nation's largest thrift holding company. The Federal Savings and Loan Corporation (FSLIC) didn't have the funds that would be needed to pay off depositors of failed thrifts. Some savings and loan institutions were not FSLIC members. The System stepped in again to help close failing thrifts.
 &
  The constraints of Regulation Q ceilings on the interest that thrifts could pay to attract deposits and a rigid business model undermined the thrifts. Borrowing short term to lend long term breaks down during volatile conditions. The reliance on fixed low rate long term mortgages for income, and the impacts of volatile increases and decreases in inflation and market interest rates undermined this rigid business model. By the time reform released the thrifts from their regulatory straight jacket, they were already in dire straits. Many thrifts took major risks in the last ditch effort to save themselves. It cost the taxpayers about $120 billion to clean up the thrift industry mess.
 &
  Economic growth slowed in 1985 and 1986. The System responded with four discount rate reductions in 1986. These reductions followed market rates down and remained below the declining federal funds rate. However, 189 banks - mostly nonmembers - closed that year. The average from 1980 to 1984 was 8 closures per year. Thrifts were also closing in significant numbers.
 &

  Moral hazard was no longer just a theoretical threat. Congress got busy with regulatory reforms, but they proved far from adequate substitutes for the market disciplines that are based on normal investor and creditor fear of financial institution failure.

  "To its discredit, Congress concentrated most of its attention on finding malefactors and charging them in public. It largely ignored structural problems in financial regulation, lax regulation, the pressures it put on regulators, and flaws in the deposit insurance system. This delayed reform for several years. In 1991, it corrected these errors by passing [the Federal Deposit Insurance Corporation Improvement Act]."

  The 1991 reform legislation, too, proved an inadequate substitute for the market disciplines undermined by moral hazard policies. The Board tweaked bank reserve requirements, but these, too, would prove inadequate.
 &

The almighty dollar:

&

  The dollar strengthened dramatically as Volcker shifted to a responsible monetary policy. The international exchange markets handled exchange rate volatility smoothly, but the volatility was nevertheless a disruptive economic factor and raised the risks of commerce worldwide. Real interest rates soared and commodity prices plummeted as the value of the dollar increased and inflationary pressures declined.
 &

 As commodity prices tumbled, the Evil Empire began to crumble. Saudi Arabia increased oil production into the declining oil market, and the Soviet Union defaulted on its debts.

  Agricultural exports were especially hard hit by the strengthening dollar. Protectionist bills began flooding Congress. The commercial problems for other nations were even greater.

  The Soviet Union's socialist economy could produce nothing that the world wanted and so was dependent on its oil and other raw materials exports. As these commodity prices tumbled, the Evil Empire began to crumble. Saudi Arabia increased the pressure by increasing oil production into the declining oil market, and the Soviet Union was forced to default on its debts.

The U.S. shifted from being the world's biggest net investor to being the world's biggest net debtor and investment recipient in less than a decade.

Currency devaluation always runs behind the power curve in these situations. External imbalances remained unchanged even as the dollar rapidly declined.

  Just as rapidly, the dollar reversed course in the middle of the decade and began a rapid decline. The nation's massive budget deficits had caused similarly massive adverse shifts in its international trade and payments accounts. The current account deficit increased by about 50% during the Reagan administration. The U.S. shifted from being the world's biggest net investor to being the world's biggest net debtor and investment recipient in less than a decade.
 &
  The exchange rate reversal was accompanied by a coordinated effort by central banks to bring the dollar back down to previous levels, but the decline began well before their "Plaza" agreement, Meltzer points out, and was clearly primarily market driven.

  "The more important change during the period was the increase in growth of the monetary base and money. The increase was greater in the United States than in Germany and Japan in 1985-86, so the dollar depreciated relative to the mark and the yen."

  The objective of Treasury Secretary James Baker was to inhibit U.S. imports and encourage exports by devaluing the dollar. However, currency devaluation always runs behind the power curve in these situations. External imbalances remained unchanged even as the dollar rapidly declined. There was little improvement in the current account deficit. It was about the same in 1988 at the end of the intervention program as in 1985 at the beginning. However, the ineffective efforts at exchange rate intervention and the rapid depreciation of the dollar at least dampened protectionist pressures in Congress.
 &

  The weaknesses in the exchange rate intervention effort are usefully summarized by Meltzer. None of the nations were willing to alter the domestic fiscal and monetary policies that the international exchange markets were responding to. Both the System and the Bundesbank always sterilized their modest intervention efforts so that they did not impact domestic interest rates or monetary aggregates.
 &

  By 1986, it was the rapid depreciation of the dollar that was afflicting international commerce and straining international relations. Meltzer summarizes the often serious disputes that arose within the G-7 major commercial nations. The weighted average value of the dollar had declined more than 20% in just a year. With exchange rates vacillating that wildly, floating exchange rates caused myriad commercial and diplomatic problems, but of course the fixed exchange rates alternative was rendered impossible by the same undisciplined budgetary and monetary policies that were causing the wild fluctuations in the floating exchange rate markets.
 &
  By 1987, Germany and Japan were actively trying to slow the rate of dollar depreciation. There was still no effort to coordinate domestic macroeconomic policies as each nation was only concerned with its own economic and political interests. There was still no administered alternative that could match, must less improve upon, the disciplines and results of the gold standard fixed exchange rate rules based market alternative.

  Fixed exchange rates require a relinquishing to market forces of money stocks, interest rates, employment and prices. It requires acceptance of the business cycle as an essential adjustment mechanism for both the economic and monetary systems. Success under floating exchange rates, however, requires the same submission to market disciplines. Keynesian and other administered alternatives to market mechanisms always end badly, generally with substantially slower economic growth and/or increased volatility and viciousness in the business cycle.
 &
  However, the politicians dearly wish to put off business cycle contractions as long as possible - and at least until after the next election - regardless of ultimate economic cost. A fixed rate policy would quickly reveal the failure of undisciplined budgetary and monetary policies - much to political displeasure. Thus, fixed exchange rate policies are routinely disparaged by political officials and their academic supporters.
 &
  The political reality is thus that as long as the dollar remains a reserve currency, the U.S. government will not consent to be constrained by a gold standard rules based fixed exchange rate market mechanism. However, the Credit Crunch recession and the ongoing EU sovereign debts crisis proves that human administered alternatives have yet to reliably achieve superior results. Moreover, a myriad of nations with softer currencies continue to opt for the manifold benefits of fixed exchange rates by tying their currencies to the dollar and other hard currencies. Although hardly trouble free, fixed exchange rates apparently do in fact provide major benefits.

   Volcker decided to leave the Board when his second term as Board chairman ended in August, 1987. He was having problems with supply side Reagan administration appointees on the Board and with top administration officials who wanted a coordinated effort with the System to assure a prosperous 1988 election year.
 &

Greenspan monetary policy:

  Events quickly  overtook Alan Greenspan, Volcker's successor.
 &

  Interest rates had been raised into a slowing economy to limit the rapid depreciation of the dollar. A spectacular stock market crash in October 1987 was met aggressively by the System as lender of last resort and with a surge of monetary inflation. Interest rates declined and economic recovery soon followed, but the cost was a resumption of rapid dollar depreciation.
 &
  Greenspan recognized an interest rate target towards the end of 1989. He set a narrow band around a federal funds rate target but adjusted the target as needed to maintain low inflation and relatively stable growth. Success and the restored credibility of the System shielded him somewhat from political pressures until the Clinton administration.
 &
  However, conflicting objectives and tardy responses continued to plague the System. It continued to be procyclical at the beginning of business cycle shifts. There continued to be no connection between immediate policy concerns and long term objectives.
 &

Evaluation of System policies:

&

  Monetarist policies had finally been accepted by the System by 1994. Monetary growth has since been reduced during economic expansions and increased during economic contractions. Low interest rates were no longer viewed as always expansive. Low inflation was viewed as essential for high employment and economic growth, and control of the monetary aggregates has been recognized as essential for inflation control.
 &

  Other monetary policy improvements included acceptance of the need for an interest rate target and recognition of the rational expectations aggregate that encompasses all the reasons for the inevitable breakdown of the perceived Phillips curve relationships. The System has been announcing its interest rate decisions as it made them and offers indications of its plans for the future.

  However, the System can lose the ability to conduct an independent monetary policy whenever it lacks appropriate political support. Its conflicting objectives continue to proliferate. Keynesian irrationality and exaggerated views of monetarist capabilities still afflict it.

The System operates in an uncertain world amidst political pressures that it must take into account. It must be successful in countering inflation to acquire the public support that alone can provide some protection from political influence.

Regulation always generates market responses and unintended consequences. Every regulation offers "an opportunity to profit from circumvention." High risk conduct simply moves to less regulated markets and institutions to be revealed when inevitable failures occur.

  Meltzer favors System transparency. The System depends on appropriate market responses for the effectiveness of its actions. It should thus state both its general strategy for monetary policy and its crisis period strategy so market participants can properly evaluate and respond to them. It should also, of course, be aware that events may require departures from stated strategy. The threat or advent of financial system chaos must be countered by policy that is stated and implemented.
 &
  The System operates in an uncertain world amidst political pressures that it must take into account. It must be successful in countering inflation to acquire the public support that alone can provide some protection from political influence. Of course, it must also fulfill its lender of last resort role.
 &
  The financial system is a part of the monetary system and government is responsible for money. Thus, appropriate regulation is of course essential. However, there is still insufficient recognition of the limitations of regulation. The System has still to find a way to free itself from the "too big to fail" policy. It still struggles with the fact that regulation is an inadequate substitute for even the imperfect market disciplines undermined by moral hazard policies.
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  Regulation always generates market responses and unintended consequences. Every regulation offers "an opportunity to profit from circumvention." High risk conduct simply moves to less regulated markets and institutions to be revealed when inevitable failures occur. At least for now it is widely accepted that price and wage controls are counterproductive.
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  Distinguishing short term price shocks from general price movements is vital, Meltzer emphasizes. The System must limit the extent that monetary policy reacts to short term shocks. Oil shocks and similar supply events should be permitted to run their course as the markets adjust to them.
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  In 2006, the System allowed oil price increases to run their course. During the succeeding recession (which was clearly caused predominantly by other factors), oil prices gave up much of their previous gains. The System should seek to "control the maintained rate of price change, not the price level," which must be free to rise and fall with changing market conditions.
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  The System is still focused on short term considerations. It responds to market "noise" that is imprecise and highly variable. It should take a longer term view to get away from "data driven" policy, Meltzer advises. Inflation rates are determined by money growth rates that are maintained, not by highly variable short term fluctuations. However, at best, the System still operates with inexact and variable data, and with imprecise monetary policy tools that operate with long time lags and imprecise impacts.
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  Weaknesses in the econometric models used for System staff forecasts are explained at some length by Meltzer. During the period covered by Meltzer, monetary policy officials wisely ignored staff forecasts. Modern econometric models failed, as might be expected, to forecast the Credit Crunch, and led to policy errors that contributed to the Credit Crunch.

  "Mistaken models of the economy contributed to policy mistakes. It is an unfortunate fact, nonetheless a fact, that the Federal Reserve produced better results for the economy in the atheoretical 1950s and eclectic 1980s and 1990s. I believe that part of the problem in the 1960s and 1970s was that there was too much emphasis on quarterly forecasts and too little attention to medium- and long-term policy implications. Economics is not a science that gives reliable quarterly forecasts. Currently, there is no such science. Federal Reserve policy will do better at achieving stable growth and low inflation if it directs more attention to medium- or longer-term results." (Amen!)

  The System still has no procedures directed at achieving medium- and long-term objectives. It still fails to distinguish temporary from persistent changes in the financial environment. It still protects private financial institutions and their creditors at great taxpayer expense instead of protecting the overall financial markets and limiting itself to accommodating the liquidity of good assets.
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  A price inflation objective is inherently medium term. Meltzer points out that more than 20 central banks have inflation targets. As yet, the FOMC does not consistently target price inflation. It actually cannot adopt flexible inflation targeting without congressional authorization. "Congressional authority over money stems from the Constitution."
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  However, the System has announced a preference - but not a rule - favoring a 1% to 2% price inflation rate, "presumably in the deflator for personal consumption expenditure net of food and fuel prices." Unfortunately, the deflator is subject to larger revisions than the CPI. The Bureau of Labor Statistics began materially changing the CPI inflation calculation in 1984.

  Regardless of whether these changes are considered improvements or weaknesses, they do end the use of CPI inflation statistics as a means of comparing present and previous conditions. The impact was politically most convenient in that it materially reduced price inflation readings. The most pertinent practical question is whether the CPI inflation index is a reliable indicator of "real"  - inflation adjusted - interest rates, the monetary base and other monetary aggregate movements essential for monetary policy.

  Beyond their impacts on expected price inflation, Meltzer doubts that central banks can beneficially respond to asset price bubbles. (However, asset inflation happens to be real inflation with clearly noxious impacts.)
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  Meltzer offers further policy improvements.

  "Useful steps include more attention to rule-like behavior, more attention to medium-term consequences, less attention to noisy quarterly or monthly data, and a common international inflation rule that increases nominal exchange rate stability." (These are all policies that would be provided by the gold standard for those nations that abide by its rules.)

  As a regulator, the System should concentrate more on market incentives and less on command and control mechanisms. It should strive as much as politically possible to maintain an independent course.
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  Meltzer recognizes major System achievements.

  "These include developing the payments system, maintaining a reputation for integrity and the absence of corruption, abetting development of an efficient financial system, managing a complex domestic and international monetary system under changing external conditions, and recognizing that it is lender of last resort to the entire financial system."

  Indeed, the prosperity of the Great Moderation quarter century was one such achievement.
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  The System now distinguishes real and nominal interest rates and exchange rates and monetary aggregate growth rates.
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The System during the Credit Crunch:

  The role of government credit allocation efforts in generating the mortgage and housing bubble that led to the 2007 Credit Crunch recession is emphasized by Meltzer. System officials, including Greenspan, issued warnings that Congress ignored.
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Credit allocation efforts incredibly still continue even after the financial collapse.

Banks that are too big to fail are too big.

  Congress incredibly kept adding to its credit allocation efforts in the face of numerous warnings about the vast risks involved. Those credit allocation efforts incredibly still continue even after the financial collapse. Meltzer advises that all future subsidies should be explicit and included in the budget appropriations process. Fannie Mae and Freddie Mac should be liquidated.

  Meltzer provides economic logic, not political logic. Congress is instead pumping $400 billion through the insolvent Fannie and Freddie in its attempt to again inflate the housing and mortgage bubbles.

  Banks that are too big to fail are too big, Meltzer asserts. "The social cost of losses to taxpayers exceeds the social benefit of large banks." If they are too big to fail, they should operate under substantially higher capital requirements. Unfortunately, the crisis has left the largest financial institutions even bigger.
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The role of moral hazard arising from the too big to fail policy reduced concerns about risk for large banks. The lack of a well defined "lender of last resort" policy left the System open to pressure from both political and private interests.

  System monetary policy also contributed to bubble mania. Interest rates were kept too low too long - into 2005. Fears of deflation were ludicrous. Moreover, the role of moral hazard arising from the too big to fail policy reduced concerns about risk for large banks. The lack of a well defined "lender of last resort" policy left the System open to pressure from both political and private interests.

  "Arranging the rescue of [Long Term Capital Management] is the most recent example in a long history of preventing failures. Notable examples include First Pennsylvania Bank, Continental Illinois, and most of the New York money market banks during the Latin American debt crisis. Bankers had reason to believe that the Federal Reserve would prevent failures."

Compensation schedules at many financial institutions and ratings agencies rewarded short term profits and ignored long term risks.

Reliance on ratings should not alone be sufficient to satisfy due diligence requirements. The inadequacy of risk models should be recognized.

"The survival and prosperity of a free society requires greater acceptance of individual responsibility for mistakes. We cannot expect a private system to survive if the profits go to the bankers and the losses go to the taxpayers."

  In addition, there were the System and SEC regulatory failures that are now notorious. Regulators should apply the 1991 Federal Deposit Insurance Corporation Improvements Act provisions to reduce federal lending to failed banks. They should act as soon as losses reduce capital below required levels, replace management, arrange a sale or merger, and let shareholders take the loss. Statutory authority for such actions have been neglected.
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  Regulation is still failing to take incentives for circumvention into account.

  "Successful regulation recognizes that it creates incentives for avoidance or circumvention. Successful regulation aligns the interests of the regulated with socially desirable outcomes. Successful regulation induces market action to eliminate externalities. Successful regulation recognizes that market participants respond to regulation by changing their actions to find a new optimum."

  Compensation schedules at many financial institutions and ratings agencies rewarded short term profits and ignored long term risks. This is an area of private sector responsibility, but regulators should monitor compensation systems and require disclosure. Ratings agency compensation should reward diligence and accuracy, not sales.
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  Reliance on ratings should not alone be sufficient to satisfy due diligence requirements. The inadequacy of risk models should be recognized.

  "A main lesson of this crisis is that societies must reinvent individual responsibility for avoiding excessive risk. This will be neither easy nor popular with many, but the survival and prosperity of a free society requires greater acceptance of individual responsibility for mistakes. We cannot expect a private system to survive if the profits go to the bankers and the losses go to the taxpayers."

  The elimination of fear by the too big to fail policy has turned creditors into enablers of the risky conduct of major financial institutions as the creditors chase after the slightly higher yields offered to them by such institutions. This aspect of moral hazard is ignored by Meltzer. Creditors, too, must fear losses.

  Meltzer wisely questions whether the proposed super-regulator will succeed where the System, the SEC and other experienced regulators repeatedly failed.
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  The System has surrendered too much of its independence for purposes of political expediency. Chairman Bernanke has apparently sacrificed much of the System independence gained by Volcker.

  "Independence is not just important. It is a critical part of the institutionalization of a low-inflation policy. It prevents Congress and the administration from financing deficits by printing money. And it avoids pressures for credit allocation to politically favored groups."

  Unfortunately, there is no political support for System independence in the Obama administration and Democratic Congress. Obama is no Reagan. Congress wants to have the System monetize its debts. It wants the System to pursue credit allocation objectives. In the name of "financial reform," Congress is including legislative provisions that further undermine System independence.

  Meltzer suggests a multinational system for controlling exchange rate fluctuations.

  Unfortunately, that would require disciplines that our gallant legislators hate and have routinely ignored in the past. That is, after all, what the gold standard rules based fixed exchange rate market mechanism provided. Human administered alternatives to the gold standard continue to fail to achieve superior economic results.

  The System has for the first time become the lender of last resort for the entire financial system. Its willingness to purchase such vast amounts of illiquid assets is unprecedented.

  "Current pressures dominated longer-term objectives. The Board had never developed or enunciated a lender-of-last-resort policy. Markets had to observe its actions and interpret the statements as always in the past. Instead of reducing uncertainty by offering and following an explicit lending policy rule, it continued to prevent some failures while permitting others. It failed to give a believable explanation of its reasons and reasoning."

  Unwinding these extraordinary positions will pose major difficulties.