The Fed: Time for Tough Love?

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Indeed, investment manager and financial writer John Mauldin invokes the days of malaise in commenting about Bernanke's zealous course of reviving the economy and ignoring inflation: "Won't that guarantee a repeat of the '70s and require a new Volcker to come in and cause a deep recession to bring inflation back down?" he asks. (For those who don't remember the 1970s, either because they weren't old enough or, well, because they were the 1970s, Paul Volcker was Federal Reserve chairman from 1979 to 1987.)

Bring back Volcker? Is the inflation problem and international financial crisis that bad? Let's hope not. Still, the risk facing the U.S. economy is that investors lose confidence in Ben Bernanke.

Lessons from the Great Stagflation

Let's take a trip back in time to see why. During the Great Stagflation of the 1970s, the Fed talked a good game against inflation. But in reality Fed Chairman Arthur Burns and his successor, G. William Miller, ran inept monetary policies that stoked the fires of inflation. By the end of the 1970s the Fed had no credibility internationally or domestically as an inflation-fighting central bank.

The numbers are enough to make anyone wince. For instance, during the 1973-74 bear market, stocks plunged by more than 40% before touching bottom and the bond market suffered a 35% loss—and the cost of living jumped some 20%.

It got worse. Inflation seemed to spiral ever higher. Prices kept going up—at the gas pump, the supermarket, and the car dealership. The dollar spiraled lower and gold surged to record levels. Nothing seemed to stem the inflationary tide. Wall Street treated Fed Chairman Miller, President Carter's appointee, as a joke. So Carter replaced Miller with Volcker, the extremely independent president of the Federal Reserve Bank of New York. (Miller was moved to the Treasury Dept.)

Volcker was determined to crush deeply ingrained expectations of ever-higher inflation among consumers, business, investors, and the international community. He stomped on the monetary brakes. Interest rates skyrocketed from about 11% in 1979 to 17% in April, 1980, and reached 20% in early 1981.The economy went through two contractions, including the worst downturn since the Great Depression. Millions of workers lost their jobs. Farmers went bankrupt in droves.

But the strong medicine had its intended effect: Inflation came down. Volcker's successor, Alan Greenspan, continued the fight and the consumer price index came down from a peak of 14% in 1980 to the 2%-or-so range, until now.

A Little Tolerance Goes a Long Way

This history suggests why we don't need a Volcker—yet. It's important to remember that the stagflation of 2008 is nothing compared to the stagflation of the '70s. What's more, Volcker predecessor Miller, a former business executive, was in way over his head at the helm of the Fed. In sharp contrast, Bernanke is one of the nation's leading scholars of the central bank, steeped in its traditions and well aware of its monetary mistakes.

Still, what the past suggests is that once the systemic financial crisis calms down, Bernanke and his colleagues will have to turn their attention toward combating inflation even if the economy continues to drift lower. It's one thing to tolerate a burst of inflation in order to manage a crisis; it's another to let inflation take root to wreak havoc for several years. After all, the lesson of the 1970s is that once inflation expectations get ingrained, it's a tough, painful habit to break.

We're not there yet. Let's hope we don't have to call Volcker—or his hard-nosed policy prescriptions—out of retirement, either.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.