What really happened during the Volcker years?

Updated: Sep 4

One argument in favor of monetarism is that Paul Volcker stemmed inflation by raising rates in the late 1970s and early 1980s. The theory is that Volcker raised rates, which discouraged borrowing, which shrank the money supply, leading to less economic activity, which caused decreased prices, all without Congress having to alter the budget. It's somewhat intuitive, but is any of it true? Let's look at each step of the process.


Volcker raised rates from around 11% to around 18%.

Paul Volcker became Fed Chair in Q3 1979. Between that date and and Q2 1981, the Fed Funds rate rose from 10.95% to 17.78%. No one disagrees on this part of the story, as it is well documented. The fed funds rate is the baseline rate of interest for the economy, so the rate of interest for essentially every other dollar-denominated loan would have charged at least 17.78% in Q3 1981.

But the money supply didn't shrink, and corporate debt growth barely slowed.

When Volcker took over in Q3 1979, the M2 money supply was growing at an annual rate of 8.31%, as shown on the dashed blue line below. During the entire five year period from Q3 1979 to Q3 1984, even during two recessions, the M2 money supply never shrank in absolute terms, and it never grew more slowly than an annual rate of 7.28%. Eight-percent growth to seven-percent growth is neither the dramatic shrinking in the money supply nor the significant deceleration that monetarist theory promises.

In Q3 1979, nonfinancial corporate businesses increased their debt liabilities at a rate of 10.39% per year. As rates rose, these businesses actually took on more debt, peaking at 13.37% in Q2 1980, as shown in the dotted red line below. When Volcker raised rates to their peak of 17.78% in Q2 1980, business debt growth slowed to 8.94%, about 1.45% slower than before the major rate acceleration. The only significant period of business debt growth deceleration during this period that resulted in growth meaningfully lower before Volcker raised rates was from Q1 1982 to Q1 1983, which took place almost entirely during a recession. Corporate debt grew at 6.70% per year in Q1 1983, which is meaningfully different than 10.39% per year, but because this deceleration took place during a recession, it's impossible to place credit squarely in the hands of monetary policy.

What Really Happened - Austerity in Real Terms

So if Volcker's rate hikes didn't slow the growth in the money supply or the growth in corporate debt, why did prices fall. The answer lies in an often overlooked phenomenon. When inflation is high and government expenditures remain the same, the amount of goods and services purchased and provided by the government shrinks. In effect, if there is high inflation and the legislature makes no changes to the budget it passes, the legislature is advancing a pro-austerity budget.

In 1976, after adjusting for inflation using 2012 US dollars, the federal government had a budget deficit of $234.14 billion. If Congress had kept this exact figure through 1982, it would have spent $1,638.98 billion more than it had collected in taxes over that period. However, the nominal deficit did not increase during that time to match inflation, as seen in the chart below. In real terms, Congress only spent $1,270.2 billion more than it collected in taxes over that period, only 77.53% of what it would have spent had the real deficit remained the same as in 1976. In 1979 specifically, the real deficit was only 44.86% of the prior amount.

Prices are about bargaining power. When the government promises to spend 22.5% less money on goods and services, there are 22.5% more goods and services for private sector buyers to attempt to purchase. If the government's real budget is lower, it has less money to outbid private buyers. This gives buyers more bargaining power because it makes sellers compete for buyers' money with lower prices.

Any economist will tell you that if the government reduced the deficit by 55% in 3 years, there will be less inflationary pressure in the economy. This is what caused the recessions of the 1980s and ultimately what slowed inflation (along with the end of the oil crisis, of course). The strength of monetarism supposedly lies in its ability to cause and reduce inflation without the aid of the fiscal authority. However, during the Volcker years monetary policy did not act without the aid of fiscal policy. At best, raising interest rates persuaded Congress to keep the real deficit low, but there is no evidence for a direct independent causal link between the Volcker rate hikes and lower inflation.