Compact Of Conviction

We know that double-digit inflation ended. What now seems unremarkable (so unremarkable that people hardly recall it) appeared impossible then. If you had asked Americans in the fall of 1980, with inflation at 11 percent or more, the odds of reducing it to less than 4 percent by the end of 1982, the response would have been a collective howl. High inflation seemed too entrenched for mere mortals to conquer. It had become a staple of daily life. Economic sophisticates and ordinary people alike shared these views. In 1981, interest rates on 30-year Treasury bonds averaged about 13.5 percent; on 30-year fixed-rate mortgages, they were 15 percent. At those rates, bond investors were signaling that they had lost faith in the government's ability to control inflation. They were protecting themselves against future price increases of 10 percent a year or more. The high interest rates would cover the erosion of their original investment and provide an annual return of, say, 2 to 4 percent. That all these sober judgments proved wrong provides a lesson in history.1

Broadly speaking, there are two theories of history. One is the "great forces" theory, which holds that changes in science, technology, population and ideas (from religion to politics) are the prime movers. Most people—kings, generals, bankers, presidents and intellectuals—are simply swept along by these strong tides. The other is the "great leader" theory: Leaders take charge; they bend events to their will, for good or ill. Both theories are, of course, correct—but neither is entirely correct. People are mostly hostage to larger forces that they do not fully understand or control. Most political leaders, business executives and intellectuals follow the strongest current, pretending they are charting their own course. But there are moments when history submits to powerful leaders— a Washington, Madison, Napoleon, Lenin or Hitler. They alter history. The subjugation of inflation was, on a smaller scale, one of those moments.

It was principally the accomplishment of two men—Paul Volcker and Ronald Reagan. If either had been absent, the story would have unfolded differently and, from our present perspective, less favorably. High inflation would have remained longer, with greater adverse consequences. Reagan and Volcker, chairman of the Federal Reserve Board from 1979 to 1987, forged an accidental alliance that was largely unspoken, impersonal and misunderstood. Between the two men, there was no particular personal chemistry. Nor was there any explicit bargain—you do this, and I'll do that. Even while the alliance flourished, it sometimes seemed a mirage. Although Reagan supported Volcker, many officials in his administration openly criticized him. But the alliance was genuine, a compact of conviction. Both men believed, mostly as a matter of faith, that high inflation was shredding the fabric of the economy and of American society. The country could not thrive if it persisted. Buttressed by these beliefs, they broke with the past. Each had a role to play, and each played it somewhat independently of the other.

The division of labor was this: Volcker assaulted inflation, and Reagan provided political support. Volcker took a sledgehammer to inflationary expectations. He raised interest rates, tightened credit and triggered the most punishing economic slump since the 1930s.* In December 1980, banks'"prime rate" (the loan rate for the worthiest business borrowers) hit a record 21.5 percent. Mortgage and bond rates rose in concert. By the summer of 1981, consumers had trouble borrowing for homes, cars and clothes. Many companies couldn't borrow for new investment. "Because of higher interest rates, people can't afford to remodel homes, and I can't afford to carry my inventory," the owner of a small building supply company in Barnesville, Minnesota, told Time magazine in early 1982. Industrial production dropped 12 percent from mid-1981 until late 1982. In many industries, declines were steeper. In autos, it was 34 percent

* As noted earlier, the Fed directly affects only one minor interest rate, the so-called Fed funds rates on overnight loans between banks. But its ability to tighten or loosen credit can indirectly affect other rates.

(from June 1981 to January 1982) and in steel it was 56 percent (from August 1981 to December 1982). By 1982, the number of business failures had tripled from 1979. Construction starts of new homes in 1982 were 40 percent below 1979 levels. Worse, unemployment exploded. By late 1982, it was 10.8 percent, which remains a post—World War II record.2

Gluts crushed the economy. There were surpluses of almost everything—workers, cars, office space, steel—with the glaring exception of credit. Business and labor had to respond to the unanticipated distress conditions. Facing lower profits, losses or bankruptcy, companies fired workers, cut wage increases and pressed for lower prices on everything they bought. Workers had to accept the reality that they could no longer command annual wage gains of 7,8 or 10 percent. It was a buyers' market. Typical was the trucking industry, which had been "deregulated" under the Carter administration. The Interstate Commerce Commission (ICC) no longer set freight rates or limited the number of trucking companies or the cities they could serve. Given the dearth of freight, price competition was ferocious. New nonunion companies undercut high-cost unionized firms. In early 1982, the teamsters union, representing most unionized drivers, agreed to an unprecedented three-year wage freeze. But that didn't satisfy many weaker firms. "Events that will occur in the next few weeks will determine whether our company will continue in business or go down the drain into financial ruin," the president of Hemingway Transport Inc., a midsized firm, wrote to its 1,500 workers in early 1982. He urged them to approve wage cuts. About half the trucking companies that had participated in the nationwide bargaining with the teamsters now broke free of the national contract.3

"Pattern bargaining"—where most companies in highly unionized industries accept the same basic wage structure—was crumbling. The fact that many wages were formally tied to inflation through cost-of-living clauses or informally through management practices meant that declining price increases led to declining wage increases. Disinflation (the decline of inflation) was dramatic. At the end of 1980, wholesale prices for finished goods—the costs of factory products to distributors and stores—had risen 11.8 percent from the previous December. By 1982, the annual increase was only

3.7 percent; in 1983, it was a mere 0.6 percent. In 1980, wholesale auto prices rose 9.6 percent. The increases for 1982 and 1983 were

5.8 percent and 2.2 percent. Furniture prices had risen 9.6 percent in 1980; the gains for 1982 and 1983 were 4.2 percent and 3.4 percent. In 1980, labor costs had jumped 10.5 percent; by 1983, the gain was 5.2 percent. Volcker's approach was not subtle. The Federal Reserve bludgeoned the economy until inflation subsided.4

It is doubtful that, aside from Reagan, any other potential president would have let the Fed proceed unchallenged. Certainly Carter wouldn't have, had he been reelected, nor would his chief Democratic rival, Senator Edward M. Kennedy. Both would have faced intense pressures from the party's faithful, led by unionized workers—especially auto- and steelworkers—who were big victims of Volcker's austerity. Nor is it likely that any of the major Republican presidential contenders in 1980 would have acquiesced, including George H. W. Bush, Senator Howard Baker and John Connally.

The rise of unemployment transcended people's expectations. As Senate majority leader, Baker pleaded with the Fed to "get its boot off the neck of the economy." At lower unemployment levels, Nixon and Carter had agitated for pro-job policies. As a Nixon aide, Con-nally sang in that chorus. Later, the administration of George H. W. Bush criticized the Fed for policies it thought too restrictive, despite much lower joblessness than in the early 1980s. The obsession with unemployment called for a dramatic presidential response. A reasonable expectation was that Reagan would provide it. He didn't.5

Reagan's initial economic program promised to reduce the money supply to curb inflation. He was the first president to make that part of his agenda, and he never retreated from it. As the economy deteriorated, he kept quiet. He refused to criticize Volcker publicly, urge a lowering of interest rates or work behind the scenes to bring that about. Nor was there veiled criticism in Reagan's rhetoric. The silence was not an oversight, because periodically, when the president did speak, he supported Volcker. At a press conference on Feburary 18, 1982—with unemployment near 9 percent—Reagan called inflation "our number one enemy" and referred to fears that "the Federal Reserve Board will revert to the inflationary monetary policies of the past." The president pledged that this wouldn't happen. "I have met with Chairman Volcker several times during the past year. We met again earlier this week. I have confidence in the announced policies of the Federal Reserve."

On April 3, Reagan inaugurated weekly Saturday morning radio addresses that have since become a presidential institution. His first subject was the economy. "Our greatest success has been in con quering inflation," he said. "It's no longer double digits. For the last five months, it's been running at four and a half percent." In a brief exchange with reporters afterward, one asked about the continuing rise in unemployment. Reagan rejected standard policies to stimulate a recovery:

The way out of it is not the way that's been tried on most recessions that have taken place in these last few decades: hyping the money supply, artificially stimulating the money supply, stimulating government spending, as if somehow that will be an aid to the economy—and up, of course, goes inflation when you do that.6

Reagan's patience enabled the Federal Reserve to maintain a punishing and increasingly unpopular policy long enough to alter inflationary psychology. Since the mid-1960s, economic slowdowns had only temporarily dampened inflation. The Federal Reserve had repeatedly relaxed its anti-inflationary policies prematurely. Companies and workers became conditioned to rising prices and wages in an advancing economy. So, once the economy recovered, inflation accelerated again, ultimately exceeding levels reached in the previous expansion. The pattern was well-established. From 1965 to 1966—a slowdown, not a recession—inflation retreated slightly, from 3.5 percent to 3 percent; but as the economy reaccelerated, inflation reached 6.2 percent by 1969. After the 1970 recession (and the imposition of wage-price controls in 1971), inflation dropped to 3.3 percent in 1971—and then zoomed to 12.3 percent by 1974.

The next recession, ending in 1975, reduced inflation to 4.9 percent in 1976—but it jumped to 13.3 percent in 1979. This time was different.7

On paper, what Reagan did or didn't do shouldn't have mattered, considering that the Federal Reserve is legally independent. It does not report to the president; the Fed chairman is not a member of the cabinet and cannot be fired by the president. But it must conform to broader political and social pressures, however ambiguous and ever-changing these may be. "The Federal Reserve is meant to be independent of parochial political interests," Volcker has said. "But it's got to operate—I think of this as a kind of band, sometimes wide, sometimes narrow—within the range of understanding of the public and the political system. You just can't go do something that is just outside the bounds of what people can understand, because you won't be independent for very long if you do that. But you also ... have a real opportunity to affect where the band of understanding is.You do have a role as a teacher or leader."8

Reagan counted, because the Fed needed political protection. One threat to Volcker's policies was congressional action forcing the Fed to relent. Like any bureaucracy, the Fed tries to placate its adversaries, sometimes by giving ground to them. The paradox: To safeguard its independence, the Fed may sacrifice its independence. Imminent congressional action might have forced the Fed to retreat. In the 1960s and 1970s, "Fed bashing" was common. Higher interest rates were the usual complaint. Lyndon Johnson once expressed the populist view: "It's hard for a boy from Texas ever to see high interest rates as a lesser evil than anything else." As Volcker's policies took hold, they predictably provoked a backlash. Representative

Henry Gonzalez, a Democrat from Texas, was a relentless critic, accusing all the Fed governors of being "arrogant and wanton users of great powers, the handmaidens of the malefactors of great wealth ... ruining the country and its citizens."9

There was an outpouring of bills and resolutions to impeach Vol-cker, roll back interest rates or require the appointment of new Fed governors sympathetic to farmers, workers, consumers and small businesses. Representative Jack Kemp, a prominent Republican "supply-sider," wanted Volcker to resign. In August 1982, Senator Robert C. Byrd of West Virginia, the Democratic floor leader, introduced the Balanced Monetary Policy Act of 1982, which would have forced the Fed to reduce interest rates. It seemed possible that the Fed's liberal and conservative (mostly supply-sider) critics would coalesce in a grand coalition. To be sure, some of these proposals were ritualistic, intended to advertise their sponsors' displeasure more than to be enacted. But if Reagan had endorsed any of them, their prospects would have improved instantly, and the Fed would have become a huge, semidefenseless target.10

The question remains why Reagan was so steadfast in his support. Volcker believed that public opinion had shifted. Americans' growing fears of runaway inflation made them more tolerant of the hardships necessary to suppress it. Though this was probably true, it could not be seen in Reagan's popularity ratings, which collapsed. Early in his presidency, Reagan's approval had reached a high of 68 percent in May 1981. By April 1982, it was 45 percent (46 percent disapproved); by January 1983, it was 35 percent, the low point (56 percent disapproved). Reagan was condemned as both heardess and headless. As the economy sank, he was advancing an economic program of across-the-board tax cuts, widely portrayed as favoring the rich, and spending cuts, widely portrayed as hurting the poor. The deep tax cuts contributed to huge budget deficits, which in turn were blamed (along with the Fed) for high interest rates. Reagan was portrayed as spearheading an economic assault against ordinary Americans.11

Press coverage was murderous. On April 21,1982, CBS broadcast a documentary by Bill Moyers, People Like Us. It condemned Reagan's policies for letting Americans slip "through the safety net." A Hispanic woman in New Jersey had been cut from welfare; a church-run food bank in Milwaukee was swamped. Though criticized as one-sided—actual cuts in social programs were modest, and Moyers ignored inflation—the documentary "set the tone for television coverage," noted Washington Post reporter Lou Cannon, Reagan's best biographer. Reagan, a student of television, was acutely aware of the effects of all the bad publicity. "In a time of recession like this," he noted in one interview, "there's a great deal of psychology in economics. And you can't turn on the evening news without seeing that they're going to interview someone else who lost his job, or they're outside the factory that has laid off workers and so forth— the constant downbeat that can contribute psychologically to slowing down a recovery that is in the offing." Print stories were also highly critical. "Reagan's America: And the Poor Get Poorer," said a Newsweek cover story in early 1982.12

It would have been easy to succumb to these pressures. The fact that Reagan didn't was a matter of personality and beliefs, not cold calculation (all the calculations suggested the opposite). There was a view of Reagan then—and still is among some—that he was a moron or a figurehead. He was too ill-informed, dim-witted and detached to make intelligent decisions. Others decided for him, or events dictated outcomes. This view is wrong, but it can be artificially fitted to selected facts. Unlike some recent presidents—Nixon, Carter and LBJ spring to mind—Reagan avoided micromanaging. On economic matters, he did not immerse himself in complex details. In his irregular meetings with Volcker, he said litde and offered almost no advice. "Reagan never asked him to ease or tighten the money supply," said Martin Anderson, a top economic adviser who sat in on the meetings until he left the White House in 1982. Anderson thought that the two men developed "a surprising amount of goodwill." Not really. Volcker later wrote that he and Reagan never had "much personal rapport." The president "was unfailingly courteous, but he plainly had no inclination either to get into really substantive discussions of monetary policy or, conversely, to seek my advice in other areas." Outwardly, Reagan confirmed critics' unsympathetic stereotype.13

What they missed was his leadership style. It was to set broad goals, delegate responsibility and, when necessary, resolve conflicts. On inflation, Reagan was clear-eyed. "[UJnlike some of his predecessors, he had a strong visceral aversion to inflation," Volcker later said. Reagan was "influenced by people like [economist] Milton Friedman [an informal adviser] and understood that inflation was always a monetary phenomenon"—it was "too much money chasing too few goods," said William Niskanen, a member of Reagan's Council of Economic Advisers. "He was the first president who understood that. . . . He knew that controlling inflation by regulation [controls] was absurd." Reagan generally surrounded himself with capable subordinates and gave them much autonomy. He viewed

Volcker in this light. "Reagan's attitude was that Volcker was a very sound professional, doing his best," said Anderson.14

Still, pressures for change mounted. Reagan's supply-side supporters—who believed that his cuts in tax rates would stimulate more work, investment and economic growth—argued that Vol-cker's recession would discredit their policies. Treasury Secretary Donald Regan periodically criticized Volcker on technical issues and personally disliked him. Congressional Republicans worried about the 1982 elections. Reagan persevered. In the fall of 1981, some members of Reagan's Presidential Economic Advisory Board (a group of outside economists, academics and business leaders that met about four times a year) suggested that Reagan ought to prod the Fed to relax. Reagan disagreed. "He said he would not do something to help the chances of Republicans in Congress in 1982 only to have to see the need for restrictive policies afterwards," according to economist Jerry Jordan, a member of the CEA. At a cabinet meeting later that fall, similar concerns were raised. Again, Reagan was not persuaded.15

Reagan's indestructible optimism, especially for the country's future, was liberating. He believed that correct decisions would turn out well. He was also convinced that reducing inflation required some high unemployment. "Bellyache," he called it. "I'm afraid this country is just going to have to suffer two, three years of hard times to pay for the [inflationary] binge we've been on," he once said privately. After the 1976 election, Reagan occasionally referred to "bellyache" publicly, but his political advisers persuaded him to avoid the phrase. Finally, the fact that his huge deficits were also blamed for high interest rates may have restrained him. He couldn't easily attack Volcker without inviting attacks on himself.* But Reagan understood his political predicament. Just before his weekly radio address on November 20, 1982, he quipped: "My fellow Americans, I've talked to you on a number of occasions about economic problems and opportunities our nation faces, and I'm prepared to tell you, it's a hell of a mess." It was a sound check, but the mike to the press room was open.16

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