Paul Volcker's Moskowitz Lecture

Back in 1978, Paul Volcker delivered the annual Charles C. Moscowitz memorial lecture at New York University's College of Business and Public Administration. The lecture was published (along with the remarks of two discussants) under the title The Rediscovery of the Business Cycle. Ten years later the College had been renamed after Leonard Stern, and the book was out of print. When I looked for it about a month ago the Columbia library came up empty and I couldn't find a single copy available for purchase online. I finally managed to get one on inter-library loan from NYU.

It's been fifteen years since I last looked at this book and it was well worth reading again. In it, Volcker develops a theory of economic and financial crisis focused not on routine short-term fluctuations, but rather on serious disruptions arising after a prolonged period of relatively low volatility. His analysis is based on changes over time in financial practices, and the macroeconomic implications of such changes:

Mood is too intangible to be accurately measured directly. However a gradual increase in confidence and increasing willingness to take risks does seem a natural consequence of a period of general prosperity. Conversely, the experience of a major recession is a chastening experience. Households, businesses, and other economic units have witnessed bankruptcies, unemployment and loss of income. Earlier plans are disrupted. Those taking the largest risks and without financial reserves tend to be hit the hardest. So, at first, caution prevails, even as recovery unfolds. But if the recovery is sustained and downturns are minor, the new surprises are likely to be favorable: productivity typically rises rapidly as capacity is more fully utilized; profits exceed expectations; jobs are easier to find; and real incomes rise. The aggressive risk-taker profits handsomely; the rewards of caution seem less evident as memories of hard times recede.

As confidence increases, that in itself gives further thrust to the expansion. Business embarks more freely on modernization and expansion, and it finds more lenders ready to underwrite its plans and also finds willing equity investors. More buoyant prices may, for a time at least, help encourage aggressive inventory or capital spending. On the consumer side, as job opportunities expand, future income seems more secure. As stock market and home prices go up, the consumer's estimate of his current and future wealth may rise.

Financial markets and financial institutions will share in the altered mood. Equity is more highly leveraged, more borrowing may be done at shorter terms, and banks and other lenders draw down their liquidity and other financial reserves. Almost imperceptibly -- until they only seem lax in retrospect -- traditional credit standards may be eased precisely because the new economic environment seems more secure. And so long as the forward thrust of the economy is maintained, losses are small.

Even the professional economists may be caught up in the euphoria. They may even be inclined to agree that we have finally licked the business cycle and thus help reinforce the climate of confidence!

But in the end the process is self-limiting. There are limits to economic growth over the short term: to employment, to productivity, to the need for capital goods or inventory, and to risk and leverage. When manpower is fully occupied, the economy cannot continue to improve as fast as before, and financial reserves can be exhausted. And sooner or later some exogenous force may provide a rude shock that forces a reappraisal of risks.

The result is disappointment. Reality falls short of anticipation. With past excesses suddenly exposed, a recession can quite suddenly turn severe. Risks that were blithely discounted earlier now loom large. The income stream no longer seems so certain. Jobs are harder to get and capital values may fall. Households and business firms alike try to cut their spending and rebuild liquidity. Risk premiums increase. And the new caution inhibits recovery.

Volcker does not stop at this general characterization of economic fluctuations; he goes on to provide evidence for the theory based on changes in a broad range of variables during the post-war period. For non-financial firms, these include the debt-asset ratio and the ratio of liquid assets to short term liabilities. For commercial banks he examines the ratio of loans to bank credit and the ratio of capital to risk assets. For the stock market he looks at the price-earnings ratio and the dividend yield. In all cases he finds evidence of declining margins of safety.

Regardless of whether one agrees with Volcker's interpretation of the data, it would be difficult to make a case that such changes in financial structure should be ignored in the formulation of monetary policy. In light of this, I find it puzzling that the Taylor rule, which responds only to the inflation rate and the output gap, plays such a prominent role in the evaluation of Federal Reserve actions. For instance, Ben Bernanke recently appealed to a modified version of the Taylor rule (based on expected rather than realized inflation) in justifying the Fed's interest rate policies over the 2002-2006 period. In response, John Taylor argued that the Fed's inflation forecasts were in fact too low, and that there is no evidence to suggest that the modified rule used by Bernanke would result in better central bank performance.

To an outsider, it seems odd that this debate is about different specifications of a rule that disregards key determinants of financial fragility, such as the measures of leverage and exposure examined in Volcker's lecture. Is it really possible to evaluate the tightness or ease of monetary policy while neglecting such factors entirely?

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Update (1/16). Thanks to Mark Thoma and Yves Smith for linking here. First time visitors might find my earlier post on Hyman Minsky to be of some interest. I'm sure I'm not the first to have noticed a striking resemblance between Volcker's approach to financial fragility and that of Minsky.