Paul Volcker is no ICON

 

Volcker’s reign is a myth.  History has been re-written.  Paul Volcker’s version of monetarism (along with credit controls: The Emergency Credit Controls program of March 14, 1980), was limited to Feb, Mar, and Apr of 1980 (the end of the distributed lag effect of monetary flows, volume times transactions’ velocity). 

 

Even William Barnett’s “Divisia Monetary Aggregates” almost got it right.  As Dr. Richard G. Anderson posited: "with bank reserves largely driven by bank payments (debits), your views on bank debits and legal reserves sound right!"

 

Even with the intro of the DIDMCA of March 31st 1980 (making reserve requirements compulsory for all nonmember banks, which because of declining membership, now held 35 percent of all the payment system’s transactions deposits), total legal reserves increased at a 17% annual rate of change (before FRB-STL’s Dr. Richard G. Anderson's "reconstruction"), and M1a exploded at a 20% annual rate (until 1980 years’-end).

 

Why did Volcker fail?   For two main reasons.  The first was the failure to recognize monetary lags.  Contrary to Nobel Prize–winning economist Milton Friedman and Anna J. Schwartz’s “A Monetary History of the United States, 1867–1960 “monetary lags are not “long and variable”.  The distributed lag effects for both real output and inflation have been mathematical constants for over 100 years. Thus, we can precisely calculate any “output gap”, any “sweet spot”.

 

The second was due to Volcker's operating procedure.  Volcker targeted non-borrowed reserves (@$18.174b 4/1/1980) when at times over 200 percent of total reserves (@$44.88b) were borrowed (i.e., absolutely no change from what Paul Meek, FRB-NY assistant V.P. of OMOs and Treasury issues, described in his 3rd edition of “Open Market Operations” published in 1974).  That was back when the money multiplier was 8.6 (m1/required reserves).

 

In 1980, Paul Volcker, Past chairman of the Board of Governors of the Federal Reserve System, appeared before the House Domestic Monetary Policy Subcommittee.  In response to a question as to why the Fed had supplied an excessive volume of legal reserves to the member banks in the third quarter 1980 (annual rate of increase 13.2%), Volcker's defense was that there are two types of legal reserves: 1) borrowed (reserves obtained by the banks through the Federal Reserve Bank discount windows), and 2) non-borrowed (reserves supplied the banking system consequent to open market purchases).  He advised the congressmen to watch the non-borrowed reserves -- "Watch what we do on our own initiative."  The Chairman further added --- "Relatively large borrowing (by the banks from the Fed) exerts a lot of restraint."

 

This is of course, economic nonsense.  One dollar of borrowed reserves provides the same legal-economic base as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. New advances were obtained, and the borrowing banks were replaced by other borrowing banks.

 

That's before the discount rate was made a penalty rate in Jan 2003 (Bagehot’s dictum). And the Fed funds "bracket racket" was simply widened, not eliminated. Monetarism involves controlling the volume of total reserves, not the volume of non-borrowed reserves as administered by Paul Volcker. Monetarism has never been tried.

 

Then came the "time bomb" (end of gate keeping restrictions), the widespread introduction of ATS, NOW, and MMDA accounts -- which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, and the U.S. government).This propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, and AAA Corporates to 15.49%.

 

By the first qtr. of 1981, the damage had already been done. But Volcker errored again (supplied an excessive volume of legal reserves to the banking system), in late 1982-83.  I forecast in FEB 84 that stocks and bonds would bottom in June 84.  Stocks bottomed June 15 @1086.90 and AAA corporate bonds on July 2 @13.76%

 

My prediction for AAA corporate bond yields in 1981 was 15.48%. AAA corporate yields hit 15.49%. I was off by only .01% (not luck, simple logic being the distributed lag effect of money flows and the “arrow of time”).