As central bankers around the world struggle with the consequences of the actions taken to rescue economies from the grip of the latest bank induced recession, and as monetarists and Keynesians come to blows over who has the best prescription for the future, most need to take a step back in time and reconsider the lessons of the early eighties when the Federal Reserve, led by Paul Volker, jump started growth not by adherence to any set of ideologies but by focussing on the psychological consequences of their actions. What the Volker Fed showed was that sometimes you have to upset markets, politicians, ordinary people and other economists in order to break the behavioral cycles that come to govern macroeconomic behaviour. It rather looks like we're going to need something similar to divest investors of their belief that markets are a one way ticket to riches, courtesy of hand outs from middle class taxpayers. Let's revisit Volker.

Inflationary Tendencies

Living as we do at a time when central bankers are busy trying to stimulate inflation rather than depress it, it takes a bit of effort to put ourselves back in the position of the Feb in 1980, just after Paul Volker was appointed its Chairman. At that point, however, inflation was running at over 10%, had been, more or less, for over a decade and the strain on the economy was showing.

Inflation is, roughly speaking, the rise in the price of goods and services such that the purchasing price of a currency is diminished. The downside of this is that people whose income can't increase – or at least can't increase as rapidly as the inflation rate – find themselves increasingly poor. In this group, sadly, are those people who choose to invest in cash deposit accounts or fixed interest bonds rather than stuff like equities or property whose value tends to eventually increase in line with inflation.

This latter effect tends to lead to people focussing on speculation rather than proper investment and value creation. As we saw in Money Illusion, wage rises tend to be devoted to cost of living increases and not to productivity improvements: although this too can be good for equity investors. Although there are some positive sides to moderate inflation the idea that high levels are bad is one of the few things that virtually all economists…

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