If you watched CNN's live feed of President-elect Obama's first post-election press conference last week, you could not have missed what looked like the Wizard of Oz's glowering, bald visage. Mutely but imposingly, it hovered in the frame above Obama's left shoulder. "Who is that guy?" you might have wondered. "Why is he right there in the shot?"
His name is Paul Volcker. Now 81, he is the greatest central banker in history. As chairman of the Federal Reserve Board from 1979 to 1987, he did such a good job of squeezing inflation out of the economy that Americans promptly forgot him. Few of the young people who flocked to Obama have any idea who Volcker is.
Yet his spectral reappearance as Obama's guardian angel was not happenstance. When Republicans charged Obama with palling around with an ex-terrorist, he pointedly retorted, in the final presidential debate, "Let me tell you who I associate with. On economic policy, I associate with Warren Buffett and former Fed Chairman Paul Volcker."
In the ongoing financial crisis, all eyes are on the 1930s, and understandably so. Those years of insolvency and panic look, excuse the expression, depressingly relevant. But the Depression was only one of two gateway crises in 20th-century economics. The other was The Great Inflation and Its Aftermath.
That is the title of a book by Robert J. Samuelson published this week. Samuelson is an economics columnist for The Washington Post and Newsweek, as well as a friend and mentor of mine. I advised him on the book, so when I say that it's important, insightful, and refreshingly free of the hype and trendiness that afflict so much of the pop-econ genre, I am not objective. But you can believe me when I say it's relevant, because Obama's foregrounding of Volcker implicitly says the same thing.
Samuelson published his book to recover a chunk of history that was being lost. "A majority of today's Americans have never experienced double-digit inflation," he writes. Few of Ronald Reagan's obituaries so much as mentioned inflation, an astonishing fact considering that public dismay over inflation elected Reagan, and that vanquishing inflation was his single greatest achievement. In its day, inflation was the country's economic Vietnam, a quagmire in which a malaise-ridden nation seemed perpetually stuck.
It all began, as the worst mistakes so often do, with good intentions. Having lived through the Depression, economists and politicians of the 1950s and '60s were determined never to let such a thing happen again. By using modern economic-management tools (Keynesian demand management, fiscal stabilizers, strategic monetary easing, and so forth), they could "fine-tune" the economy to ring in a new era that would combine high employment with stable prices.
Instead, they set off inflation, which became chronic by the late 1960s. Price controls made it even worse. As inflation pushed into the double digits, it fogged investment decisions, undermined productivity, and sapped consumer confidence. Worse, the country seemed helpless to treat it. By the late 1970s inflation had come to dominate and define the psychology of its era. It had become, like the Depression, a gateway economic event.
A gateway event is one that marks the crossing from one economic era to another. It creates a before-and-after divide by shaping a whole generation's psychology. It causes not just a transient downturn but also a crisis of confidence in the economic system. It tears up the social-economic contract -- the implicit bargain between the people, the economic system, and the government -- and requires a new contract to be written. It reconfigures the role of the government. It produces aftershocks and echoes that rumble on for decades, not just months or years.
The Depression did all of that, as everyone knows. But so did inflation. In the mid-1970s, the chairman of the President's Council of Economic Advisers, a man named Alan Greenspan, told Congress, "Capitalism is in crisis." The economy, he said, was at "the point of discontinuity." Many economists warned of "perpetual, sizable inflation," as one put it.
The post-Depression contract promised the voters growth and price stability if they gave Washington a free hand at the economic tiller; but stagflation shattered the government's claims to competence. Where inflation was concerned, it turned out that government was the problem, just as Reagan said -- a discovery that brought his anti-government philosophy to power for a generation. The new contract repudiated the notion of economic balance fine-tuned from Washington, and it left the old political order in rubble.
The aftermath proved just as important. After inflation collapsed in the early 1980s, plummeting interest rates effectively bankrupted the federal Farm Credit System and then, more consequentially, the savings and loan industry, the bulwark of the mortgage business. Determined not to get burned again, the post-S&L mortgage industry took to off-loading risk by bundling its loans and selling them to Wall Street as securities. Thus emerged "securitization," the precondition for today's mortgage crisis.
Meanwhile, the crash of interest rates sent investors piling into the stock market, which now offered higher returns than bonds at what appeared to be modest levels of risk. Those same crashing interest rates, meanwhile, made mortgages wondrously cheap and drew swarms of borrowers into the housing market. Lower rates also contributed to a consumption boom as households borrowed more and saved less.
Low inflation, low interest rates, and renewed economic confidence were all good things. But they fed an optimism that eventually spilled over into hubris. As people piled into asset markets, a bubble mentality took hold. Even investors who knew better behaved as if asset prices would rise forever. Assuming that perpetually rising home prices would turn even bad loans into good loans, borrowers sought and lenders wrote ridiculous mortgages.
Low inflation, low interest rates, and renewed economic confidence were all good things. But they fed an optimism that eventually spilled over into hubris.
And then, of course, it all went into reverse with horrifying speed. Even good loans became bad loans. Hubris became panic.
The Great Inflation arose about four decades after the Great Depression: a span of about two generations, long enough for fear and caution to yield to exuberance and carelessness. On that timetable, we would be due for another gateway crisis about 40 years from inflation's onset in the late 1960s. Which would be right about, let's see, now.
So where are we today? At the cusp of another gateway crisis? Or just in for a garden-variety recession? That depends, of course, on the economy: how severe the current crisis becomes. But it also depends on society: whether the post-inflation social contract unravels. It might.
After inflation, the contract was torn up and rewritten for the second time in the last century. Out went interventions that sought to harmonize the economy but really destabilized it. In came fierce competition that would allow the economy to balance itself.
The new contract, Samuelson notes, was based on an implicit deal. At the micro level, competition would expose individuals and families to more insecurity and, as it turned out, inequality. People would accept a larger burden of economic risk. In exchange, at the macro level, the country would enjoy prosperity and stability.
For two decades, the bargain held. Competition and globalization brought what Samuelson calls "the Great Moderation," a taming of the business cycle. Inflation was low, recessions were mild. With its newfound stability, the economy created jobs and raised living standards. "All this has acted as a social shock absorber, lessening discontent from greater inequality and shakier job security."
In the 21st century, however, the deal has started looking iffy. Health care costs have eaten into wage increases. Globalization has shown signs of instability. And now comes the mortgage crisis, which suggests that the system may be much more fragile than anyone had imagined.
"The new economic order maintains an uneasy standoff between our conflicting wants," Samuelson writes. "Americans dislike the potential precariousness and capriciousness of their economic system. The Great Moderation is the glue that has held this shaky arrangement together. It provides enough forward momentum to keep the worries at bay." If Americans conclude from the current crisis that the system has broken its promise of macroeconomic stability, then "the new order might find itself under furious assault."
To be replaced by -- what? If the country stands at a gateway, what lies on the other side? No one knows, of course. And maybe there will be no gateway. If we're lucky, the crisis may yet blow over.
Either way, Volcker's presence at the president-elect's side was reassuring. It suggested that Obama knows what he might be dealing with.
This article appeared in the Saturday, November 15, 2008 edition of National Journal.