Unexpected Fed lessons

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When the history of the Federal Reserve is written, one of its most important chapters will cover the period from 1979 to 2006, when the Fed was under the stewardship of Paul Volcker and then Alan Greenspan. That chapter will have a simple title: The Conquest of Inflation.

For those who have grown up in an era of price stability, this may sound like an achievement on the order of kicking sand in the face of a 98-pound weakling. Those who recall the overheated environment of the 1970s know it was more akin to pinning Godzilla. In 1980, inflation hit the blood-curdling level of 14.8 percent. Last year, it rose by 3.3 percent.

If a time traveler had come back from the 21st century to 1980 and announced that inflation would be cut to such low levels, Americans would have said: "Sure, we believe you came back from the future, but that stuff about curbing inflation -- how gullible do you think we are?" Even when inflation is rising, as it is now, no one expects it will come remotely close to the heights it once reached.

What Messrs. Volcker and Greenspan did about chronically soaring prices, however, may be the least of their accomplishments. Their bigger one was slaying some of the most destructive myths about the economy, thus helping to restore government to a smaller, better role in the nation's productive sector.

Before they arrived, inflation was seen as the fault of undisciplined private markets. The idea was simple: Left to their own devices, workers demanded higher wages, and companies responded by raising prices, causing workers to demand still more, leading to even higher prices -- in an endless upward spiral that forced consumers to pay more and more all the time. Only the restraining hand of a benevolent government could break this cycle, as it tried to do under President Nixon's wage and price controls.

Those turned out to be about as successful as the Hindenburg, but the failure didn't stop President Gerald Ford from urging Americans to join in a campaign to "Whip Inflation Now" by doing things like carpooling -- while vowing that the federal government would closely scrutinize all wage and price increases.

Nor did it dissuade President Carter from maintaining price controls on oil and natural gas, which succeeded brilliantly, assuming the goal was to create shortages and chaos.

It was Ronald Reagan, in his first inaugural address, who said, "In this present crisis, government is not the solution to our problem; government is the problem." But by then the Fed, under Mr. Volcker, had already recognized the crucial truth about inflation: It wasn't created by a greedy, short-sighted private sector, but inflicted on the private sector by the government's easy-money policies.

What Nobel Laureate economist Milton Friedman had claimed for years was finally sinking in: "Inflation is always and everywhere a monetary phenomenon." And monetary phenomena, unlike union contracts, retail pricing decisions and world oil markets, are directly under the control of the Federal Reserve.

So Mr. Volcker set about using that control -- curtailing the growth of the money supply, pushing up interest rates and administering a terrible shock to an economy that had built in firm expectations of endless price increases. By 1981, double-digit inflation was gone, and by 1982, it was below 4 percent.

Critics howled, lamenting that this monetary tightening was cruelly replacing one problem with a worse one: mass layoffs. During the 1981-82 recession, the jobless rate climbed to nearly 11 percent. Some achievement, they said.

Back then, the conventional wisdom was that we had to choose our poison. If we wanted a prosperous economy and low unemployment, we had to accept inflation. If we wanted low inflation, we would have to put up with a sluggish economy and sentence millions of people to a life on the dole.

Messrs. Volcker and Greenspan, however, proved that a free-market economy can furnish plenty of jobs if the government avoids monetary profligacy. In the 1990s, the Fed kept inflation consistently well below what it had been in the previous two decades, but unemployment dropped to levels once considered unreachable. Inflation, it turned out, was not the solution; inflation was the problem.

The great discovery of the last quarter-century is not that the government should do nothing, but that it should focus on doing certain essential tasks -- one of which is to avoid debasing the currency on which all economic activity depends. Long after Messrs. Greenspan and Volcker are forgotten, Americans will still be in debt to them for that lesson.

Steve Chapman is a nationally syndicated columnist.