An Interview with Paul A. Volcker

In December of last year, Addison, Kate and the rest of the I.O.U.S.A. team were lucky enough to sit down with former Fed chairman Paul Volcker in his office in New York. What follows is an excerpt from the full interview transcript, which can be found in the recently released I.O.U.S.A. companion book.

Paul A. Volcker has had a long and successful career in monetary affairs but is best known as the chairman of the Federal Reserve from 1979 to 1987. Dr. Volcker is lauded for battling inflation during a time of major economic imbalances in the United States. However, to do so, he had to raise interest rates to an all-time high: 19 percent.

Q: In the film, we talk a great deal about the dollar and its value. Since the dollar is the medium by which people save money and right now we’re running out of it, our country is faced with a savings deficit. What is a fiat currency and what is the importance of gold in the monetary system?

Paul Volcker: Throughout my career, I have worked in finance, particularly in the Federal Reserve and the Treasury. I’ve also been concerned with the management and the stability of the dollar. Although the dollar had its ups and downs during my career, it has been an interesting period, to say the least. After World War II, we started out with a bright new monetary system, the so-called Bretton Woods system, which IMF created. The basic fulcrum of the Bretton Woods system was the stability of the dollar and its conversion into gold. It was assumed that exchange rates would be fixed and not change very much. And that’s the way it was for about 20 years. In the 1960s, the system came under increasing pressure when the United States had a small amount of inflation.

At that time, this small inflation was actually considered rather large, particularly against the growth of other countries whose economies were becoming stronger. While other countries got more dollars and exchanged some for gold, we began running balance-of-payment deficits. That put pressure on the Bretton Woods system. In 1971, we broke away from it. At that time, I was the secretary of the Treasury for monetary affairs, so I was right in the middle of that decision-making.

Q: How did you feel about the decision at the time?

Paul Volcker: Well, I was in favor of the decision. I was one of the proponents of the decision, but I had very mixed feelings about it because I was brought up in defense of the system. I believed that the dollar should be supported at the center of that system and that a stable monetary system was important to the prosperity of the world. The system was set up in reaction to the turmoil in the 1930s – in the Great Depression of the 1930s – which had a lot of currency instability and antagonism between countries. So to see that system potentially undercut was a rather traumatic experience for me, especially since I was hoping for it to be restored at the time.

Q: Once the Bretton Woods exchange rate system was abandoned, did the Federal Reserve became the proponent of a sound currency?

Paul Volcker: Once we moved off gold, which was kind of the last vestige of a gold-based system, we entered a world of so-called fiat currencies. In that world, there’s nothing behind money except the credibility of the government and of the central banks. They have the responsibility of maintaining the stability of the currency. Yet this country and other countries did not always honor this responsibility because of the ever-present tension between maintaining stability of the currency and maintaining full employment or economic growth. I think maintaining full employment is a false economy. Most central bankers and most economists now understand that you shouldn’t set up full employment in opposition to stable currency, but the stable currency domestically is important to building a base for prosperity over the long run.

Q: Following the end of the Bretton Woods era, the United States entered an era of rapid inflation. Were you surprised at the high rate of inflation? What do you think were the root causes of the ’70s inflation that led to you taking over the Fed?

Paul Volcker: Well, I don’t know whether it’s fair to say I was surprised. I was disheartened, I suppose. It is difficult to sustain the domestic price stability. But there was a combination of problems that led up to this high level of inflation. The 1970s was also a period of great instability in exchange rates, which led to some difficulties for the economy and for relations with other countries. People had become rather inured to a small amount of inflation. And as I indicated earlier, there was this feeling of a trade-off between maintaining price stability or maintaining economic growth. I think that this false trade-off made people more relaxed than they should have been. When these inflationary forces began getting stronger, it affected wage demands and pricing policies, and had a certain built-in momentum. And that whole process was aided and abetted by the big increases in oil prices and was something of a chicken-and-egg situation.

For instance, you can argue that the inflationary pressure has encouraged OPEC to increase the oil price, and the increase in oil prices led to inflation, or more inflation. So we got into a discouraging passivity and cycle of poor economic performance and inflation. And I think they were related.

Q: The popular press also tells the story of how you came in and raised interest rates in order to slay inflation. I even noticed you have the famous painting out in the hallway of you with a shield, fighting off inflation. Can you just tell us how it felt to be in that position, and also describe what was really happening rather than the popular portrayal expressed in that painting?

Paul Volcker: When I became chairman of the Federal Reserve, I think there was a general feeling in this country that economic affairs, and inflation in particular, had reached a kind of crisis point. Things were not going very well. There was a feeling of uncertainty. There was a lot of speculation in commodities and the gold price, which was then free to fluctuate up to $ 800 an ounce. In an odd kind of way, that’s a good time to step into a job because people thought that something needed to be done. I also think the mood of the country was willing to accept action, which 10 years earlier they wouldn’t have been willing to accept. And once we got caught up and I got caught up – or the Federal Reserve Board got caught up, for that matter the country got caught up – in an anti-inflationary effort, there was a certain willingness to take very high interest rates and eventually a rather severe recession, with the hope and expectations – certainly, the expectation that I had – that things would get better. And if we could restore any sense of stability in the currency, the country would be better off as long as we sustained that phase.

Q: Would it be fair to say that in that era the high interest rate was the tough medicine?

Paul Volcker: No. There was a lot of opposition and concern, understandably. It was a bad recession, but I think there was this underlying core that the country had not been on the right path economically and that it needed to be shaken up in order to restore stability. And that faith not only sustained me, it sustained the country.

Q: What do you feel were your proudest achievements? If you were able to restore stability, how did that come about?

Paul Volcker: Well, it’s not a question, of course, of me achieving stability and sustaining stability. It was a situation in the country as a whole that a stronger approach was acceptable and that we have a Federal Reserve Board and a government who’s all in. Although it was controversial – I don’t want to minimize the controversy – there was a basic core of support and willingness to do it. And I think one of the lessons of the early ’80s is don’t let inflation get started, because once it gets some momentum it’s very difficult to deal with, but it’s also destructive for economic growth and prosperity. That lesson is also important today.

I repeat it all the time ad nauseam: Don’t let inflation get out of control and build a kind of momentum that’s inevitable. If that happens – and right now it seems like there is a little flavor of it – we will all find ourselves back in the days of stagflation and unacceptable economic performance.

Q: Do you feel like that the policies that are in place are reactive enough now?

Paul Volcker: Well, right now we are in a very difficult circumstance. We are in a financial world with lot of excess spending and lending, particularly in the infamous subprime mortgages. These many excesses put a lot of pressure on economic institutions. The question becomes, how much pressure will they put on the economy as a whole? In the past 20 years, we have had a very good run of economic activity and a lot of success in the financial world. But now we have reached a point of excess, maladjustments, and tensions. Correcting them is going to be a little bit painful.

Q: Why is it important for Americans or people who are not involved in the financial industry and/or economics to understand these issues?

Paul Volcker: It is always difficult to answer that question because it seems that these issues are small and abstract in comparison to people’s day-to-day problems of making a living and going to work. Well, they no longer seem abstract when it comes down to people maintaining fiscal discipline and paying for Social Security and Medicare. But the greatest challenge for democracy is to be able to effectively cope with problems that are pretty clearly out in the future but require some action, discipline, and restraint today. That’s the test we’re going through. And, as people get a better understanding and education about some basic economic issues, the democracy will be better able to cope with those future challenges.

Q: What are the consequences of not being successful in this endeavor?

Paul Volcker: In the future, there will be all kinds of consequences and uncertainty if we don’t deal with these problems. But when I look back on my lifetime, it is obvious that letting inflation get a little bit out of control and not dealing with economic problems effectively in the ’70s led to a very uncomfortable crisis. We don’t want to have to go through big recessions again to teach people fiscal responsibility. Instead, we should anticipate what needs to be done while maintaining the growth of the economy. And the threat will always be an unstable economy and an unstable currency. And that’s not just destructive to economic life, but it can be destructive to America’s position in the world, which to me is the greatest concern.

The above was taken from the companion book to the critically-acclaimed documentary I.O.U.S.A.. Included in the book you’ll find interviews from some of the most revered voices in the nation, including Warren Buffett; former Treasury Secretaries Paul O’Neill and Robert Rubin; Pete Peterson, CEO of The Blackstone Group; Congressman Ron Paul (R-Texas); and bestselling Empire of Debt author Bill Bonner. Defiantly non-partisan, the empowering solutions outlined in these pages are a must-read for any American who wants to help change "business-as-usual" in Washington as a new administration heads towards the Oval Office.

Hope springs eternal…and then gets whacked.

Big jump in the Dow yesterday – up 889 points. Does this mark the end of the downturn…the bottom of the bear market…the worst it’s gonna get?

Everyone hopes so. But don’t count on it. There is almost always a large rally before the final bottom is in. Hope…followed by disappointment. Often several times. Over a long period of time. And by the time the final bottom comes, investors are so broke, so depressed, so fed up that they no longer care.

The Japanese market hit a high over 30,000 on the Nikkei Dow in January of 1990. Stocks plunged. Investors have been waiting for a recovery ever since. This year, for example, Japanese stocks have lost 50% of their value…bringing the index down to the 8,000 range, the lowest it’s been since 1982!

Compared to long-term investors in General Motors, the Japanese are lucky. GM is now trading in the $5 range – a price it last saw when your editor was born 60 years ago. But even that could get worse.

"End of the road for US automakers?" asks a headline in the Los Angeles Times.

Meanwhile, Detroit seems to be becoming a ghost town…or a hellhole like Port-au-Prince, Haiti – with ice. Mansions once owned by auto industry tycoons now selling for $100,000 or less. But just wait until the auto industry shuts down completely!

Where and when will the bear market in the United States end? No one knows. But it could end on some sad day 20 years in the future. Between now and then however, typically, a major bear market gives you a second chance to get out. After the October crash in ’29, stocks rallied until April…then they started to slide again and did not fully recover until the 1950s – more than 20 years later.

At today’s levels, U.S. stocks are not terribly overpriced. If you look at the stock market over the last 100 years, you find stocks usually trading in a range similar to where most are now. They are, say the analysts, at "fair value" with the Dow anywhere between 6,000 and 9,000. But earnings are falling. And stock prices lead earnings. In fact, they are thought to "look ahead" and track future earnings. If the First World Depression – of FWD, for the history books – unfurls as we expect, stocks could be "fair value" at much lower prices.

The other thing that is likely to happen is that stock values could become "unfair." It was unfair to charge investors $90 a share for Micron…or $120 a share for Yahoo…or $70 a share for KB Homes. Soon, it may be similarly "unfair" to pay investors only $5 for their shares in KB Homes, or Yahoo…or only 50 cents for a share in General Motors.

Typically, everybody overdoes it. Coming and going. On the upside, they get carried away and pay too much. On the downside, they panic…then lose interest…and won’t pay enough. The "overshoot" usually goes to about half again as much – at least on the downside. That is, stocks fall to what might be considered "fair value" by most measures…and then they fall another 50%. So, if "fair value" is 8,000 on the Dow, you should expect the Dow to hit 4,000 before the bottom is in.

But here at The Daily Reckoning, we are always walk on the sunny side of the street. Our optimistic guess is that that the Dow will fall to 5,000. Perhaps sooner, rather than later.

Mr. Market is a strange fellow, isn’t he? When he is pushing up prices, everyone loves him. When he is knocking them down, the mob gets a rope and comes after him. Even the short sellers turn against him, because he inevitably disappoints them too – causing stocks to rally strongly even in the midst of a major bear market.

Believe it or not, now the capitalists are arguing that they should be allowed to ignore Mr. Market altogether. They want to use "fair value" accounting on their financial statements. They don’t like Mr. Market’s offer. So, they hope investors will accept their idea of what their stocks and assets "should" be worth…rather than what they are really worth. "Mark to market" asset valuations are "unfair," they say.

We don’t recall them complaining when "mark to market" put their asset prices far higher than they were really worth. Besides, whoever said Mr. Market played fair?

*** "Downturn Clobbers Public Pension Funds," says the Washington Post. For example, the California pension system, Calpers, has lost $67 billion over the last 12 months. Government-owned pension systems tend to put about 60% of their funds in the stock market – so they’ve taken big hits, along with everyone else. And most public pension systems were underfinanced even before the stock market turned down.

Retirement financing is going to be a big issue for many, many people – even those who thought they had it in the bag.

Altogether, trillions of dollars’ worth of retirement funds have been lost already. Trillions more are still at risk. After such a long period of growth and credit expansion, baby boomers came to believe that their stocks and their houses were as a good as "money in the bank." And as recently as 2007, even counting the value of their stock portfolios and their houses, experts found that a high percentage of baby boomers were woefully ill-prepared for retirement. And now their stocks are worth, most likely, about 40% less than they were in 2007…and their houses about 20% less.

And the boomers already have it hard enough without their retirement funds being at risk. The Social Security crisis, as outlined in the companion book to I.O.U.S.A., is projected to only get worse as the years go on. Here’s an excerpt from the book:

"On October 15, 2007, Reuters reported, ‘The latest report by the program’s trustees said by 2017, Social Security will begin to pay more in benefits than it receives in taxes. By 2041, the trust fund is projected to be exhausted.’

"The Federal balance sheet is already unsustainable. And the baby boomers have only begun to retire this year. ‘The baby boomers are not a projection,’ says Senator Conrad. ‘They were born, they’re out there, they’re going to be eligible for social security and Medicare …and yet we can’t pay our bills now.’

"Judd Gregg, the Republican leader in the Senate Budget Committee, puts the looming problems of these unfunded liabilities this way: ‘The only issue more severe than this is the idea that an Islamic fundamentalist would get his or her hands on a nuclear weapon and use it against us. Beyond that there’s nothing more severe than this.’

"Gregg goes on to state that the retirement of the baby boomers represents ‘the potential fiscal meltdown of this nation …and absolutely guarantees, if it’s not addressed, that our children will have less of a quality of life then we’ve had …that they will have a government they can’t afford…and that we will be demanding so much of them in taxes that they will not have the money to send their kids to college or buy a home or just live good quality of life.’

"These grave warnings from leaders in both political parties have largely fallen on deaf ears, but we believe Americans can no longer hide from them. Simple economics dictate that you may be able to spend more than you take in for a long time, but you cannot do it forever."

The companion book, penned by Addison Wiggin and Kate Incontrera, to the widely acclaimed documentary is now available…and for the 8 days leading up to the election, you can take advantage of an exclusive offer, that’s only available to Agora Financial subscribers.

You can get our "Emergency ‘Personal Bailout’ Bundle, which includes not only a copy of the companion text, but the movie itself – months before it will be released to the general public. In addition, you’ll receive our new personal "bailout paycheck" strategy report.

*** Making the situation worse – possibly much worse – for the baby boomers is the increase in unemployment. Whirlpool just announced 5,000 job cuts. We typed, "job cuts, October 2008" into Google. We got 3,350,000 hits.

The International Herald Tribune tells us that wealthy Americans are cutting back on eating out…and household help. Our two daughters – both of whom work as waitresses, while going to school or trying to become movie stars – report that getting a job in a bar or restaurant is not as easy as it used to be.

"You used to be able to walk into almost any pub in London and get a job," said one. "They were happy to take anyone who could speak English. But now, you put your name on a list…and they never call you."

If there was one thing the baby boomers were sure of, it was that if they didn’t get their retirement financing together in time, they could always just keep working for a few more years. But already, the percentage of ‘seniors’ in the workforce – 16.4% – is higher than ever. And what if the jobs disappear?

*** France’s Sarkozy is feeling pretty smug. In fact, the French are feeling pretty smug…almost a feeling of schadenfreud, if they had a word for it. They knew the war in Iraq was a waste of time and money, so they stayed out of it; they were right about that. And they knew, too, that American-style hyper-capitalism wouldn’t work. They think they were right about that too.

We like almost everyone we meet…once we get to know him. We have lived among the French for more than 10 years. We have learned their language and gotten to know their curious customs.

For example, while Americans pretend to work hard, the French pretend not to work. For example, the parking lots in our offices in the United States are nearly empty at 5:30PM. Here in Paris, when we left the office at 7PM last night, most of the staff were still at their desks.

French teenagers brag to each other about how little schoolwork they do…then, they sneak off to study until the wee hours of morning.

Likewise, while Americans pretend to have a lot of money, the French pretend not to. There are few flashy cars on the streets of Paris. And when you see a top-of-the-line Mercedes, it is usually owned by a foreigner. Nobody ever made any money building McMansions for the French either. Instead, houses tend to go up slowly…are solidly constructed…and much less gaudy than their U.S. equivalents.

The French also pretend not to care about money, but they are the biggest savers in Europe. France’s public debt – at 66% of GDP – is lower than the United States’ – at 72% of GDP (and soon to be at 100%). As to private debt, the French are way ahead…they have private debt of 140% of GDP…about where the U.S. was at before it went on its Fed-fueled spending spree 2002-2007. Now, private debt in the United States is 280% of GDP, twice the frogs’ level.

Until tomorrow,

Bill Bonner
The Daily Reckoning
October 29, 2008

The Daily Reckoning