Systems Thinking Through: The Volcker Shock

EconSystems Thinking
8 min readOct 31, 2019

It’s been a while since I posted something, I’ve been procrastinating because I knew I wanted to cover the Volcker Shock. It’s far-reaching effects make it a good candidate for a systems map, maybe even too good in a way. Its causes and effects are so multifaceted it’s hard to know what to include/exclude.

Paul Volcker was the Fed Chairman during the Carter, and Reagan administration. The Volcker Shock was his attempt to defeat inflation that the US economy had been unable to shake in the previous decade. It was successful in its objective but it took quite a sacrifice. This sacrifice mostly fell on the backs of workers across the US and in the global south. Despite the costs, many of which are permanent, the Volcker Shock is rarely if ever seriously interrogated in the mainstream. Hot take: It should be.

The most comprehensive resource I found was an article called Other People’s Blood by Tim Barker. I like it. It’s good. I’d recommend a full read, but I’ll be quoting it copiously. Seriously read it though.

So here’s the map I got. To explain it I’ll quote the article, and then briefly summarize how it fits in the system.

(Dotted lines indicate negative relationship.)

“Volcker announced that he would start limiting the growth of the nation’s money supply. This would be accomplished by limiting the growth of bank reserves, which the Fed influenced by buying and selling government securities to member banks. As money became more scarce, banks would raise interest rates, limiting the amount of liquidity available in the overall economy.”

So starting on the left in green: Money supply goes down, interest rates go up, liquidity goes down.

“The exorbitant cost of borrowing put tens of thousands of firms out of business and led overall to twenty-two months of negative growth. In December 1982, unemployment was at 10.8 percent — closer to 20 percent if you include workers who wanted jobs but had stopped looking and underemployed workers who could not find steady full-time work… The nation’s industrial belt was the hardest hit. Ninety percent of job losses occurred in mining, construction, and manufacturing. It was costly for businesses to pay their debts and borrow money to invest, while a strong dollar made American exports even less competitive internationally. In places like Flint, Michigan and Youngstown, Ohio, more than one in five workers were unemployed. In Akron, the commercial blood bank reduced the prices it would pay by 20 percent due to the glut of laid-off tire workers lining up to bleed. In the area around Pittsburgh, suicide rates and alcoholism soared, while residents competed for spots in homeless shelters.”

So less liquidity leads to lower employment, leads to lowered (even negative) growth. The decrease in employment leads to alcoholism, homelessness, and suicide. On the left side the strong dollar hurt US exports which again hurts growth.

“Volcker was convinced that altering expectations (of inflation) would take a demonstration of determination that no one could miss. Contracting the money supply — and hiking the interest rate — makes it harder to borrow for investment or consumption, harder to pay off existing debts, and more profitable to save money. All of this reduces aggregate demand and leads to a fall in price levels, as well as a rise in unemployment.

So higher interest rates increase propensity to save, which reduces consumption. (I’m combining investment and consumption.) Lower consumption means lower aggregate demand as well as employment. Lowered aggregate demand means a lower price level. Everything so far has been a means to this end, but we’re not done yet.

“The interest rate shock was the trigger for a worldwide recession. It also touched off a debt crisis across Latin America, where governments found the cost of paying dollar-denominated loans soaring at the same time that the global contraction was lowering the prices they received for commodity exports, their primary source of foreign currency. Events like these helped deliver the coup de grâce to the ambitious third-world politics of the 1970s, exemplified by the call for the New International Economic Order, which had been sustained by a global commodity boom. The tremolo of debt crises across Mexico, Brazil, Zambia, and other countries — and the lost decade that followed — was the overture for IMF structural adjustment, subsequently introduced across the Global South.”

So paying back debt got more expensive at the same time that there was a decline in incoming revenue. The ensuing debt crises in what up until then could have honestly been called developing countries, ended their right to economic self determination. Despite what Jeffrey Epstein’s friends have told us, this loss in autonomy has hamstrung the global south ever since.

Long term Effects

“the Volcker shock represented a permanent change in the definition of full employment. This was the practical embodiment of Milton Friedman’s idea that there was a natural rate of unemployment and attempts to go below it would always cause inflation… The logic here is plain: millions of unemployed workers are required for the economy to work as it should.”

So after a deadly recession, that prompted an even more deadly third world debt crisis, we successfully replaced inflation with permanently increased unemployment and wage stagnation in both poor and rich countries. So was it worth it?

What’s the alternative?

“From today’s vantage point, was there a better path? Not to my knowledge — not then or now.” — Volcker

In hindsight most economists agree that there wasn’t one. At the time though, the Volcker Shock was not considered the inevitable necessity it is today.

“Paul Samuelson argued that to change the ‘present inflation-growth path quickly will take severe measures — which I’m not for. . . . My personal judgment is that this is too severe a price for less advantaged people to pay.’”

The article also cites Joseph Stiglitz as a voice of ambivalence.

“‘We can describe the benefit… And we can describe the costs. But we can’t know for sure what would have happened if he had tried another approach.’”

This is what I was stuck on. As problematic as the solution was, it was the only real solution I could think of. Raised and schooled entirely in the Neoliberal age, I had no imagination for anything outside that narrow spectrum of economic doctrine.

Barker makes a case that there was an alternative. As opposed to limiting economic management to fiscal and monetary policy the US could have tried a more hands on approach, an “incomes policy.” It wouldn’t be anything new in its time.

“Sometimes governments have gone beyond managing aggregates to target something more specific, namely wage and price decisions in particular industries. Enacted successfully, this would allow the government to fight inflation without forcing recession and unemployment — everyone would keep working, at lower or at least frozen wages, rather than some people working in fear of unemployment while the laid-off sat idle and got nothing. The US had compulsory wage and price controls during World War II and the Korean War, and informal guidelines during the Kennedy and Johnson years. From 1971 to 1974, Nixon imposed the first peacetime wage and price controls; even though they did not last the decade, it was easy to assume that the future belonged to political wage setting (in 1979, 64 percent of Americans wanted to revive controls).”

Between the lived reality of global neoliberalism, and this alternative scenario of increased political management… I’m not thrilled by either. The difference is that the first option is unappealing due to the extremely unjust distribution of both wealth and power, which also happens to be going headfirst into climate catastrophe. (Undeniably a political economic issue as I’ve written about before.)

The second is unappealing simply because it feels wrong. It’s impossible to say with any certainty that Volcker prescribed the wrong treatment, but it’s time for a second opinion on shock therapy.

“before the Volcker shock ended the argument, very few people thought there was a market-based solution to the inflation crisis. Most thought the path out led through more extensive government controls and planning”

This part surprised me, but it shouldn’t. US economic discourse has a habit of erasing parts of history that don’t suit it.

Perhaps things would be different if this problem had arisen a decade or so earlier. Back when Milton Friedman was dismissed as a “pest” with narrow appeal, inflation may have been dealt with in a very different way which would have set the world on a different economic track. Like Stiglitz said we can’t know what would have happened.

Why It Matters

Once Volcker was appointed to be the chairman of the Fed it didn’t matter what the American people really wanted. You can’t exactly vote out the Fed Chairman. As time passed it only got worse. The will of the people seemed to matter less and less when it came to the economy.

“incomes policy brings to light a surprisingly recent past in which the economy was still politicized. Shortly thereafter, Volcker helped usher in an era of central bank supremacy, a masterful exorcism of the political in political economy.”

I don’t want to give off the impression that I’m obsessing over some trivial piece of history for my own thought experiments. The validity of the Volcker Shock has implications on modern issues. “Inflationary” can still be thrown like a tomato at any policy you want to discredit. *cough*

Stimulus checks? Inflationary. Child tax credit? Inflationary. Minimum wage? Inflationary. Workplace Safety? Inflationary. It’s an issue even among ostensible allies. UBI advocates accuse a federal job guarantee of being inflationary and vice versa.

There’s theoretical and in some cases empirical justification for concern with regard to these policies. Tradeoffs are inevitable, but if we are to resurrect the “political” in “political economy” we need to have a more honest discussion of both what causes inflation and where it lies on our list of priorities.

Barker cites Matt Yglesias saying “economists may be mistaken about where the natural rate of unemployment lies, or they may neglect the fact that higher wages can increase the labor force, thus expanding employment without risking overheating. Or, in a more daring rendition, it might be that we could live with a slightly higher rate of inflation as the price of a high-pressure economy.”

If America’s solutions to domestic poverty are always inflationary to the point of futility, then its economic system deserves more fundamental scrutiny.

To assume that Volcker was right about everything precludes many necessary pieces of economic discourse such as Universal Basic Income, the Green New Deal, or a Federal Job Guarantee from having their due process. We can’t go back in time, but we can test our assumptions about inflation and its potential treatments besides austerity. “The best way to discover what was possible in the 1970s would be to test the limits of what is possible today.”