Planet Money - SUMMER SCHOOL 7: The Fed & Volcker's Socks

Episode Date: August 24, 2022

The Federal Reserve plays a very important role in the economy. When things start to look uncertain, the central bank is tasked with stepping in to restore people's confidence in the economy. But how do they do it? On today's episode we dive deep on monetary policy and the role of the fed. |At this Summer School, phones ARE allowed during class... Check out this week's PM TikTok! | Listen to past seasons of Summer School here.Learn more about sponsor message choices: podcastchoices.com/adchoicesNPR Privacy Policy

This is Planet Money, from NPR. Hello and welcome to Planet Money Summer School. I'm Stacey Vanek-Smith. And I have to say, I'm feeling a little wistful today because summer is almost at an end, and so is our little summer school semester. Just one more week until our final exam and graduation. And I am here with our wonderful economist guides. They've been with us all

semester, Kristen Brody and Luigi Zingales. Hey, guys. Hi. Hi, how are you? I'm doing really well, especially since we're getting to talk about one of the most important parts of the macro economy in the U.S., which is the central bank, the Federal Reserve. This is like a topic that can be a little complicated to talk about sometimes because it's like one of the wonkier parts of the macro economy. You guys have both taught. Is this a harder part to teach or not? It's one of those things that is both super easy and super complicated. It's like a bit talk about money is at some level, everybody understands what money is. And at some level,

nobody really understand what money is. That's true. And actually, I mean, the role of the central bank, its job has evolved a lot over time. I mean, when it was first conceived of, central bank, its job has evolved a lot over time. I mean, when it was first conceived of, it was basically meant to be a kind of bank for banks, one bank to rule them all. Well, not really one bank to rule them all, more like one bank to lend to all the other banks whenever they needed it. And we will learn all about the birth of the central bank, what caused it, and how it came about right after the break. how it came about right after the break. We are back with the story of the origin of the U.S. Central Bank.

And this happened after what had been a long stretch of big economic bubbles followed by big crashes, bubble crash, bubble crash. And in one very dramatic case, J.P. Morgan, the banker, basically bailed out the entire U.S. economy. He got a bunch of his banker friends together and forced everybody to put up all this money and save the economy, which, you know, it was very heroic. People were grateful, but it's also worrisome, right? I mean, depending on the kindness of bankers, it's just not a good plan for long-term economic stability. And so, as Robert Smith and Jacob Goldstein reported back in 2013, people started to get a little worried. They saw this as a problem.

Here's Jacob. One very powerful guy in particular decides this is a problem. Senator Nelson Aldrich. He's a Civil War veteran. He's been in the Senate for about 30 years. He's the head of the banking committee. Theodore Roosevelt called him the kingpin of the Republican Party. And Aldrich looks at the U.S. economy and he sees that it's not just the most recent one, but these panics just keep happening. There was one in 1873. There was another in 1884.

There was 1890, the panic of 1893, 1896. They keep coming. And then there's the big one in 1907. And Aldrich knows that there's something that America can do so that it will no longer have to rely on just one guy when these panics happen. The U.S. can create, he thinks, a central bank. In 1907, creating a central bank is not some crazy new idea. They've been around in Europe for a long time already. The U.S. itself had a central bank in the early part of the 19th century. And central banks had this key function back then. They served as what's called a lender of last resort. And what that means is when there's

a panic, when people are pulling money out of banks that are basically healthy, sound banks, a central bank can step in and lend money, oftentimes unlimited amount of money, to the healthy banks just so they can get through the panic and things can go back to normal. But just consider the name, Central Bank. Throughout American history, both of those words, both central and bank, have been deeply unpopular. Yeah, but Nelson Aldrich believes that if he draws up the right kind of plan, he can win over Congress and the American people. So Nelson Aldrich travels to Europe, and they say, hey, you know, the central bank thing, you should try it. It works great.

They say, yeah, we don't have these American problems because we solved them 50 years ago or 100 years ago. Gary Richardson is an economist at UC Irvine and at the Richmond Fed, and he told us this whole story of what Aldrich did next. So Aldrich looks around and says, OK, maybe we want a central bank. But in order to design a central bank, one that works in the United States of America, he needs expertise. He basically needs bankers to help him create a central bank. And he knows that that's not going to look good to have bankers sort of design their a central bank. And he knows that that's not going to look good, to have bankers sort of design their own central bank. So in 1910, he comes up with a plan.

Robert, we're standing here at the Hoboken train station in Hoboken, New Jersey. And we're here because this place or someplace right near here was key to Aldrich's plan. He told some of the most powerful bankers in the country, I want you to gather at the train station, but I want you to come in secret. And he meant really secret. He told these bankers, do not travel together. Come alone.

Only use your first names. Do not address each other by your last names. And most importantly, don't come here in your top hat and your monocle looking like a million bucks. They came here dressed as duck hunters, as if they were going on, oh, you know, I don't come here in your top hat and your monocle looking like a million bucks. They came here dressed as duck hunters, as if they were going on, oh, you know, I don't know, you know, a Thanksgiving duck hunting expedition. One of these bankers who Aldrich invited, his name was Frank Vanderlip,

he was an executive at National City Bank, and he wrote about this decades later. He said they were told that when they got here, they would find Aldrich's private rail car attached to the back of a southbound train. And he says, When I came to that car, the blinds were down and only slender threads of amber light showed the shape of the windows. Once aboard the private car, we began to observe the taboo that had been fixed on last names. We addressed one another as Ben, Paul, Nelson, Abe.

And Vanderlip writes that as soon as they got on this private rail car, they started to work on a plan for a new central bank for the United States. But the car itself was bound for Georgia because they were going to meet in a private club on an island off the coast of Georgia. A private club, by the way, that J.P. Morgan used to be a member of. The name of that private club, the name of the island? Jekyll Island. So Aldrich and the bankers hole up in this beautiful, empty resort for about a week. The name of that private club, the name of the island? Jekyll Island.

So Aldrich and the bankers hole up in this beautiful, empty resort for about a week. They talk about sort of the big challenge that they face in bringing this to the American public. Americans think that a central bank would become too powerful, too influential in the economy. All of the guys at Jekyll Island knew the history of money and banking in the United States. All of the guys at Jekyll Island knew the history of money and banking in the United States. And they understood that the financial interests of Virginia tobacco farmers is different than the financial interests of an importer-exporter in New York. So they come up with a classic American workaround. The country's not going to have one central bank in Washington, D.C. It's going to have lots of central banks, little central banks

scattered all around the country. Like New York probably should have its own central bank, but the cotton-growing South could get a central bank. The West Coast, with its extractive industries and rapid growth, can get a central bank. The Jekyll Island boys leave Georgia, return to Washington, D.C., and New York with a plan, now officially known as the Aldrich Plan. And they think it's pretty great. They think we have finally designed a central bank specifically for the United States of America. Well, it gets shot down in Congress, gets tweaked, gets debated, takes years. But the basic idea they came up with there in that swanky resort, it holds up.

And so December 1913, President Woodrow Wilson signs the Federal Reserve Act. And the USA finally has a central bank. Actually, it has 12 central banks spread all around the country. Take that, Europe. And by 2008, the Federal Reserve had more power than J.P. Morgan ever dreamed of. When the financial crisis hit, the Fed used that power to step in, stop the panic, and probably prevent another Great Depression. But at the same time, a lot of people have said the Fed's own policies contributed to the 2008 crisis in the first place. Clearly, that fundamental American uneasiness about a powerful central bank that everyone's been struggling with all along, that uneasiness is still with us.

But there is this fact. Today, every major economy in the world made the same choice that we did. Every economy has a central bank. We are back with our wonderful economists, Kristen and Luigi. One of the things that struck me hearing this story was just the degree of paranoia that everybody had. I mean, all of the sneaking around and dressing up like duck hunters. I mean, what is going on here? Why is everybody so high strung and so worried about the creation of a central bank?

I think that the control of money is a major source of power. We have seen during the 2008 financial crisis, at the end of the day, the Fed did not intervene to save Lehman, but did intervene to save Goldman. People at Goldman are still rich, and the owners of Lehman are not. So this is an enormous amount of power, the owners of Lima are not. So this is an enormous amount of power. And that's the reason why the United States has a very healthy tradition of distrust with a concentration of financial power. Yes. I thought it was so interesting that one of the solutions they came up with was to break up the central bank into regional banks. All those 12 banks are still in place, one of them being in Chicago, which is

where you are, Kristen. What was the thinking there, do you think? What is the strength of splitting up a central bank? You've got banks all over the country, and so it seems that you would want to have regulatory bodies sort of spread out, you know? So all of these decisions aren't just made in, say, Washington, D.C. Some areas are more focused on agriculture. Some are more focused on technology. And we do research in many different areas that focuses on those people in different communities. Well, and the role of the central bank has expanded a lot since it started, right? It's no longer just a bank for banks. It does a lot of other things, too. What is the best way to describe the role of the Fed now? It conducts the nation's monetary policy.

It influences money and credit conditions in the economy. And the goal is trying to pursue full employment and stable prices. Yeah, keeping prices stable, keeping unemployment low. Those two things are what is known as the dual mandate of the Federal Reserve. It's two main jobs today. And I think for most of us, the Fed is most closely associated with price stability, a.k.a. controlling inflation. And the way the Fed does this is through monetary policy. That is a term for all the tools that the Federal Reserve uses to control the amount of

money that is circulating around the economy. Probably the most famous of these tools is interest rates, raising and lowering interest rates. This makes news all the time. So, Luigi, Kristen, would one of you mind talking about how exactly this works? How does raising or lowering interest rates affect inflation, affect prices? Sure. So the Fed sets the rate from which banks borrow from the Fed. So banks borrow from the Fed and then they set a rate at which they lend to consumers. That determines how much money people want to borrow. And so if the interest rate is higher,

then people want to put their money into the bank to save, where when the interest rate is lower, then they're more likely to want to borrow that money or companies would want to borrow to make various investments. Right. It's a way of lowering the amount of money that people and businesses are borrowing and spending. And that can really help to bring inflation under control. It can really help to lower prices. But it can also have some really rough consequences on an economy. And we see that play out in our next episode. It is about one of the most famous heads of the Federal Reserve Bank ever, Paul Volcker. He took the helm of the central bank at a really difficult time in the

American economy, a time when inflation was getting pretty bad. We will hear that story after the break. We are about to hear a story from Jacob Goldstein and David Kestenbaum that they reported back in 2015. And they talked with Paul Volcker. He's one of the most legendary Federal Reserve chairs of all time. Came into the job in 1979 at a moment when inflation in the U.S. was pretty bad. Prices had been rising for years. Here's David. So when inflation goes up, it messes with people's most basic

economic decisions. Well, the inflation was really, it was debilitating. This is Bill Silber, an economist at NYU. It sort of took over your life. You had to worry about buying things before they went up in price. Every time you turned around, you say, well, I mean, I better buy it now rather than later. And of course, that's the process which makes the inflation accelerate because everybody starts thinking that way. Just buy something because you know, if you buy it now, you're better off than if you wait.

Do you remember that happening with you? Did you buy anything for that reason? I think I bought a house. People buying houses just because they think they will be more expensive the next year. That is not good. Silber has written a book about this and about the man who finally did whip inflation. His name, Paul Volcker. Silber remembers the first time he met him. At the time, Volcker was running the Federal Reserve Bank of New York. He was a tall guy, six feet seven, always smoking cheap cigars. And Silber met Volker at this conference right around the time inflation was taken off. He sits down on a couch and puts his feet up on the table reel there and says,

so what's new? And the only thing I remember was that his socks were pushed down, almost touching his shoes. So you saw his ankles. And I remember my mother said, don't ever let your socks fall down below your ankles. And here was the president of the Federal Reserve Bank of New York, who really didn't care. Paul Volcker is now 88 years old. Mr. Volcker. We went to see him. Hi. Nice to meet you. Interested in 1970s. Yes. When you came to the right person. How long is this going to take, he asked? 15 minutes? We ended up talking for an hour. And he told us the story of his fight against the silent thief,

talking for an hour, and he told us the story of his fight against the silent thief, against inflation. It starts in 1979 with a phone call. The White House called Volcker. Jimmy Carter is the president, and he is trying to decide who he should nominate to one of the most powerful jobs in the country. Who should be the chairman of the Federal Reserve? And at this moment, Volcker is running the New York Fed. He's running like a branch. But this is the top job. This is a big promotion. And the Fed is the place that gets to decide how much money there should be in the economy. So Volcker goes down to talk to Carter. And it was not a very long conversation. I don't know. In retrospect, it seems five minutes. Maybe it was longer than five minutes, but it wasn't very long. In that meeting with the president, Volcker is blunt. He thinks one of the reasons there's inflation is that his predecessors at the Federal Reserve had basically printed too much money.

And sometimes too much money can cause inflation. Yeah, the basic idea is by putting more and more dollars out there, the Fed had made every dollar worth less. And Volcker tells Carter, look, if you pick me to run the Fed, I'm going to put a stop to this. I'm going to restrict the amount of money in the country. And that will slow inflation, but it might also push the economy into a recession. You know, if there's less money out there, it makes it harder for businesses to get loans to expand. It makes it harder for people to get loans to buy stuff. The whole economy could slow down.

That is not the kind of thing a president likes to hear. But earlier today, the president announced his choice for chairman of the Federal Reserve Board. He is 51-year-old Paul Volcker. Volcker got the job. Apparently, Carter's first picks said no. Understandably, because at that moment running the Fed, that is the kind of job where everyone in the country could end up hating you. Also, as a practical matter, it did not pay very much. Did you have to take a pay cut? Yeah, like 50%.

A 50% pay cut? But it was a promotion. Theoretically, yeah. Volker's wife decided to stay in New York, and he went on his own down to D.C. He's a cheap guy, I'm just going to say it. From what everybody told us, Volker is a— I like the word cheap, as a cheap person.

And so he rents what apparently is just this tiny little apartment in a building that basically served as like a dorm for college students. I remember a lot of things about the apartment. This is Paul Volker's daughter, Janice Volker-Zima. He had this couch. I want to say couch in quotes because it was kind of this foam rubber thing with bolsters. It was kind of silly. At this moment, your father is like truly one of the most powerful people in the country. Yeah.

Yeah. She says sometimes when she would visit, there would be a keg in the hallway from a student's party. So that is where Paul Volcker would wake up in the mornings, and then he would go to work at the big, fancy Federal Reserve building, you know, white stone wrought iron. And at the time, inflation is really bad. It's over 10% a year.

And so pretty much right away, in October of 79, just after he takes office, Volcker makes what he thinks is this big dramatic announcement. The Fed, he says, is going to stop printing so much money. He says there's going to be a strict limit on how much money is out there. And of course, you know, if you follow the Fed, you might be thinking like, oh, isn't that always what the Fed does? But this thing had kept happening in the years before this, in the 70s, where like the Fed would like start to tighten it down and then the economy would get bad. And they be like, OK, more money, more money. And Volcker at this meeting is saying we are not going to do

that anymore. He was going to put a stop to it. Volcker figured this would be his big hammer of a weapon that he could use to just crush inflation. It did not crush inflation. In fact, after the announcement, inflation gets worse. The next month, inflation rises from 12 percent to 12 and a half percent. A few months later, it goes up to 14 percent. Volcker's hammer. It's like the worst superhero tool ever. It did not crush inflation, but it did crush jobs. The unemployment rate, that was at 6 percent when Volcker had that press conference, started going up. A year later, the unemployment rate was at 7.5% and rising. Here at National Public Radio, all things considered was on the story. We got this off reel-to-reel tape.

They should bring back that version of the theme song. The recession is here. The only disagreement among economic experts now is over how bad it'll be. Another sign of recession, industrial production was down again last month. Last month's drop was the largest in five years. Normally, I think when you have a recession, there isn't like one person you can be angry at. This time there is is Paul Volcker. And suddenly it's like all of America is mad at Paul Volcker. The homebuilders are mad because nobody's buying new houses. So they start mailing two by fours to

the Fed. A car dealer start mailing in car keys because nobody can borrow money to buy a new car. A congressman starts calling for Volcker's impeachment. Volcker's daughter, Janice, as it happens, is looking to borrow money herself right around this time because she is trying to buy her first house. The mortgage rates at the time were 13% or higher, thanks, of course, to her dad. And she says she would ask her dad for financial advice, like, should we buy the house? And I feel like, you know, we ask our parents for advice all the time. But her dad actually was the one person in the world who knew and who had control over mortgage rates. Yeah, but when she asked him, she said he would just kind of make this sound, like kind of a moan or a groan. You know, I was like, I mean, well, I don't know, you know, or

it's just, he's got this one thing that he does where he just sort of mumbles and doesn't give you an answer, but that's the way he gets around everything. He was using Fed speak on you. Yeah, that's what it is. He talked that way to reporters too. Here's somebody asking him a question at the National Press Club. How high an unemployment rate are you prepared to accept in order to break inflation? It kind of puts me in a position of I accept or unaccept or whatever.

You know, my basic philosophy is over time, we have no choice but to deal with this inflationary situation. Hear that? He didn't answer the question. Complete dodge. Publicly, Volcker is confident that his medicine is going to work, that by restricting the amount of money in the economy, eventually inflation is going to come down. But in the short term, his medicine is making the patient sicker.

And in private, he is less confident. Did you ever have doubts in there? I never had a doubt in my life. Of course you have. Volker had this rug in his office, and he said he'd just pace back and forth. Pace the hole in the rug. There's never a rug anymore. I ruined it. I'm joking, but of course you were. People were mad at Volker. But, you know, as is always the case with the Fed, people didn't really understand what the Fed was doing. Robert Krolwich, you know, the reporter who you might know from Radiolab, back then he was NPR's business correspondent. He tried to explain the Fed with an opera.

Here's Krolwich doing his fake, fancy announcer voice. There aren't very many operas that deal exclusively with the subject of interest rates, but this one I think is the most magnificent of all. And then a little while later, in the middle of the opera, Paul Volcker. Ladies and gentlemen, we're face to face with economic difficulties really unique in our experience. When we interviewed Paul Volcker, he said, who is that guy who used to work at NPR? He remembered these stories and he said they made him really happy in those dark days when he was pacing through the rug in his office. And he said they made him really happy in those dark days when he was pacing through the rug in his office.

This guy, Robert Kowich, come up with these little parodies of what was going on. You were insulted by that. No, it was great. Yes, Robert Kowich would cheer me up. It's true. No question about it. If you look at the textbooks, like once you restrict the amount of money in the economy, inflation should start to get better. But it was not getting better.

The reason was something that did not get a lot of attention in the textbooks at the time. Inflation wasn't going away because people didn't believe it was going to go away. Part of the problem was in our heads. Yeah, everybody just thought inflation was like this permanent feature of the landscape, right? And when that happens, you have this whole cycle, right? Workers go to their bosses and say, hey, give me a raise because there's going to be inflation. And the boss is like, sure, you can have higher wages and I'll just raise my prices. So you have inflation. Done. It's like this self-fulfilling, self-creating thing. Volker said this became clear to him when he met with a bunch of businessmen and he told them, we're going to deal with this inflation. That's the way it's

going to be. What do you say? And one businessman says, I don't believe you. So I just had a wage negotiation with my workers, and I agreed to give them a 13% increase for the next three years. 13% wage increase for the next three years? Each year for the next three years, because that's what I think inflation is going to be. That was one reflection of the mood at the time. Good luck. And that's what the problem was, right? That's what the problem was, precisely. Finally, at the end of 1981, more than two years after that emergency meeting, people started to believe Volcker. Inflation dropped to 9%, then 7%, 6%, 4%. Volcker and the Fed finally eased up. They let the amount

of money in the economy grow a bit. And the jobs came back. The recession was over. But it had been a bad recession. Bill Silber, the economist at NYU who wrote the book about Volcker, says most economists think he did the right thing. But there are things people wonder about. There are people who say you could have done it with less pain. You didn't have to slam on the brakes and throw 12 percent of the working force out. You didn't have to really put the screws to the economy the way you did. You could have done it more slowly. We asked Volker about this. Do you have any regrets?

Regrets about what? I've got regrets every day I'm sitting here. I don't have any regret that we carried out a fight on inflation. That you carried out the fight against inflation? Yeah. Volker told us that in the 70s, the Fed had tried doing things gently, and it didn't work because it didn't convince people. You know, he said gently wasn't enough to change woes in people's heads,

to make them really believe. This story was reported by Jacob Goldstein and David Kestenbaum back in 2015. Paul Volcker passed away in 2019 at the age of 92. We will talk more about Volcker and his time as the chair of the Federal Reserve after the break. OK, we are back with our two intrepid economists, Luigi Zingales and Kristen Brody. So, I don't know, this is a very amazing story to me. Both shows how powerful the Federal Reserve is, but also how hard the job of leading it is. Kristen, Luigi, I'm curious, what are your impressions of Volcker from the story?

I like the part about, I believe they were saying about his socks, that his socks were slouched down. I just, I thought that was really interesting, right? Like what you can tell about someone's socks. But anyway, I guess the other thing is he wouldn't even advise his daughter when she was asking about whether or not to buy a house. Like that really says independence to me. Right. The heads of the central bank aren't elected. And so it kind of enables them to make difficult and like really unpopular decisions,

which it seems like that is sometimes really necessary. And I have to say Volker comes off as very noble in this piece to me. It seems like he shows a lot of courage in the face of a lot of pressure and opposition. But I think it's really interesting, this question of did he go too far? Like, should he have been a little softer in his approach? I mean, economic austerity, it's not always the best way, you know? I mean, it can sometimes sound like really tough, but it can also really crush an economy. It can cause a lot of suffering. I mean, Christian Luigi was vulgar. Do you think he was too austere in his approach? It's a bit like fighting a preemptive war. You never get credit because people say it was not necessary. And it's only when you don't fight it that people realize

how damaging this was. And I think that, sure, it's possible that you could have done more gently. But it's also true that people have tried in the Fed to do it more gently before and they fail. And as we say, the expectation gets entrenched. So once you have a lot of failure, then every new attempt is harder to make because you need to change the expectations. You need to change the expectations. And as the episode was describing, if you have people signing contracts for three years, expecting 13% inflation every year, like bringing them down is really hard. Yeah, because it's like if you raise wages, then how do you cover that but to raise prices? And when you raise prices, things cost more and people then want raises.

So you end up with this cycle that we talked about in the inflation episode. And I have to say that the Fed lived off that credibility for the 40 years following. So the reason why people were not afraid of inflation until very recently is because everybody say, oh, the Fed has the way to do it and has proven that they can. Right. So it's like, well, prices aren't going to go up because the Fed, like we know the Fed will come in and bring the pain if they have to.

So it's going to be OK. Exactly. The benefit of what he did is not only that he decreased inflation, but he gave such a strong signal that left an enormous power in the hands of the future governor of the Fed. Okay, everybody, we are almost to the end of class. Just want to take a quick second to go over vocabulary and concepts that we've learned about the Federal Reserve. First up, there is the famous dual mandate. Those are the two main jobs of the Federal Reserve. And those two main jobs today are price stability, a.k.a. keep inflation low, and maximizing employment, a.k.a. keep unemployment low.

There's also monetary policy. Those are the tools that the central bank uses to control the money supply in the U.S. economy. One final question. We talked at the beginning of the show about the origin of the Federal Reserve in this train car, but obviously a lot has changed since then. Our economy is a completely different animal than it was back in the day. Has the Fed changed? How has it evolved? I think that at the beginning, it was seen as only a financial stability element, and now has become a major source of policymaking and to the point that now we're talking that the Fed should fight climate change.

So I don't think that the man in Jekyll Island was thinking about all this role of the fat. I would say it's definitely more diverse than it was in the rail car, seeing as how I'm sitting here recording this episode right now. So that is certainly one difference that I'm pretty pleased with. That is so true. And, you know, I think that's something that we can all be pretty pleased about. And in fact, pretty recently, the Federal Reserve just had its first female chair ever, Janet Yellen. She's more recently become the first female secretary of the Treasury and who might be the only Fed chair to have a song written about her.

It is by Dessa. It's called Who's Yellen Now. Doves on the left, hawks on the right Cross-talking the flock, trying to fight mid-flight But here comes Yellen with that inside voice Never mind the mild manner, policies make noise She's five foot nothing, but hands are guide She could pop a collar, she could rock a car Planet Money Summer School is produced by Audrey Dilling, with help from Greg Morton. It's edited by Alex Goldmark, engineering on this episode by Margaret Luthar. Our project manager is Devin Meller.

And please join us next week. It is the very last episode of this season's Summer School. And it will be fire. We promise. I'm Stacey Vanek-Smith. This is NPR. Thanks for listening.

And a special thanks to our funder, the Alfred P. Sloan Foundation, for helping to support this podcast.