In some ways, Reagan and Volcker were polar opposites. Reagan made his career on the public stage; Volcker made his behind the scenes. One was a master of uplifting rhetoric; the other was an expert in studied obscurity. "You would make a very excellent prisoner of war," a frustrated congressman once told Volcker, "because you wouldn't tell the enemy a thing " But what Reagan and Volcker shared was a reflexive loathing of inflation and an absolute faith that the country needed their policies. "You have to start with the conviction that price stability is better than inflation and that 'better' means better for economic growth and stability in the long run and better for everybody," Volcker once said. He dismissed academic economists' elaborate arguments that a little bit of inflation might be

* The contribution of high budget deficits to interest rates was probably exaggerated. Once the Fed eased policy, short-term interest rates declined, even though budget deficits remained large and other credit demands were increasing.

good. Like Reagan, Volcker was imbued with a strong sense of purpose. "He is not confident about himself in some ways, but in his field he is more sure of himself than anybody I have ever known," his wife, Barbara, said in 1982. "It may sound egotistical, but I believe that he thinks he is the only man in the country who can do the job. It is the culmination of everything he has done in his professional life."17

That he got the opportunity was an accident. The son of a professional city manager—of Teaneck and Cape May, New Jersey— Volcker had shuttled between government and the private sector. He'd graduated from Princeton in 1949 with a major in public affairs (what we now call public policy) and then received a master's degree in public economy from Harvard. After working at the Federal Reserve Bank of New York as a research economist, he'd been hired by the Chase Manhattan Bank. In 1962 he moved to Washington to work for Robert Roosa, his boss at the New York Federal Reserve and Kennedy's undersecretary of the Treasury for monetary affairs. He returned to Chase in 1965 before becoming Nixon's Treasury undersecretary for monetary affairs in 1969. In 1975, he was named (at Arthur Burns s urging) president of the New York Federal Reserve Bank. When appointed by Carter in July 1979 to head the Fed, Volcker, then fifty-one, was well-known among bankers, economists and foreign economic officials (he was a main architect of Nixon's dollar devaluation in 1971). But to the public, he was a virtual nobody.18

Carter had turned to Volcker as an afterthought. In the summer of 1979, the president sought to reinvigorate his administration before the 1980 election. After a ten-day retreat at Camp David, he ad dressed the nation on television (his "malaise" speech) and then purged five cabinet members, including his Treasury secretary, Michael Blumenthal. Unable to find a replacement for Blumenthal among outsiders—Carter had asked Reginald Jones, head of General Electric, and David Rockefeller, head of Chase Manhattan—he selected G.William Miller, the ex-chief of Textron, a New England conglomerate, who had been Fed chairman since 1978. The White House had a close relationship with Miller, and his acceptance left a vacancy at the Fed. Though Volcker was on the short list, he was not a favorite among Carter's aides, who thought him too conservative (though he was a Democrat) and not a "team player." With Miller present, Carter and Volcker conferred at the White House on Tuesday, July 24, less than a week after Blumenthal's dismissal the previous Thursday. Volcker emphasized the Fed's independence and, gesturing toward Miller, said, "You have to understand, if you appoint me, I favor a tighter policy than that fellow." Volcker left feeling that he had talked himself out of a job. It was unsuccessfully shopped to others, including A. W "Tom" Clausen, head of the Bank of America. The next morning at around 7:45, Carter called and asked Volcker to accept.19

The truth was that the president had little choice. The initial favorable reaction to his speech had faded, because the administration seemed in disarray. "When the president asked for the resignations of his Cabinet unexpectedly, the financial markets became very jittery," Stuart Eizenstat, Carter's chief domestic adviser, said later. "Interest rates were already high and the markets did not really know what was going on. They were thinking of the European model where governments fall." To leave the Fed job open would have compounded the sense of drift. Inflation was worsening, and the economy seemed to be weakening. For much of the year, many economists, including the Fed's staff economists, had been predicting a recession.20

Still, Volcker's regime started badly. In August, he convinced the Fed governors to raise the discount rate (the rate on Fed loans to commercial banks) and did so again in September. But the second vote was only 4-3, and the narrow margin was seen as proof that Volcker had already lost political control and couldn't undertake further anti-inflationary actions. Prices of metals—gold, copper, silver, platinum—rose sharply, as investors fled dollars that they expected to lose value. From early August to late September, gold prices increased from about $300 an ounce to nearly $450 and copper prices from about 90 cents an ounce to $1.20. In late September, Volcker flew to Belgrade in what was then Yugoslavia for the annual meetings of the International Monetary Fund (IMF) and the World Bank, the major global economic agencies. There, he heard loud complaints from foreign countries about the dollar's plunging exchange rate.* Investors were switching into other currencies whose value (they thought) would hold up better. Volcker had already asked the Fed staff to prepare plans for a new approach to control inflation. On October 5 and 6, he hosted a telephone conference call and then a secret meeting of the Federal Open Market Committee (FOMC) to consider a radical shift in the Fed's anti-inflation strategy.t21

* He also attended Arthur Burns's lecture "The Anguish of Central Banking," which reinforced his determination to break the inflationary spiral.

t The FOMC is the Fed's key decision-making body on monetary policy. It consists of the seven Federal Reserve governors and five of the

As a practical matter, the Fed can regulate money and credit in one of two ways—setting its price (interest rate) or its quantity (the money supply). In either case, control operates through the provision of bank reserves. As noted earlier, when the Fed wants to add to bank reserves, it buys U.S. Treasury securities. The payments for these securities are deposited in banks and increase the banks' reserves. The greater a bank's reserves, the more it can lend.* Selling Treasury securities does the opposite; it decreases bank reserves. Until October 1979, the Fed had targeted interest rates—namely, the Fed funds rate governing overnight loans between banks, the only market rate it controls directly. The Fed increases or decreases reserves until supply and demand produce the desired rate. What Volcker proposed was shifting the focus from interest rates to the basic money supply: cash plus checking accounts, known as Ml. The Fed would no longer try to guess the "right" price for money. It would instead provide a given amount of bank reserves, which through subsequent borrowing and spending would translate into a given amount of money.t If inflation was too much money chasing too few goods, squeezing the amount of money would squeeze inflation.

twelve presidents of regional Federal Reserve banks. The president of the New York Fed is permanent; the other four are rotating, although all the presidents participate in the policy discussions.

* Reserves are funds that a bank must, by law, hold as cash or deposits at one of the twelve regional Federal Reserve banks and are usually a fixed proportion of various types of deposits. The more reserves a bank has, the more deposits it can have and the more loans it can make.

t The relationship between a given amount of bank reserves and a sub

When announced, the Fed's new procedure was widely seen as a capitulation to "monetarism"—the view, championed by Milton Friedman, that the Fed could prevent inflation and minimize recessions by increasing the money supply by a modest and predetermined amount every year, say 3 percent or 4 percent, which theoretically would permit noninflationary economic growth. This interpretation, though plausible, was wrong. Volcker accepted the monetarists' diagnosis of inflation (too much money chasing too few goods) but not their prescription (a simple rule for money growth). The practical problems were too great, he thought. Defining money wasn't easy. Beyond cash and checks, should it include savings accounts and money market mutual funds? Moreover, there were times—a financial panic, for instance—when the Fed might need to depart from a simple money rule. But Volcker had concluded that a temporary shift to monetarist tactics was the sort of dramatic policy jolt that might quell inflation.

For much of the 1970s, the Fed had tried to control the money supply by regulating interest rates, but this approach clearly hadn't worked. One reason, Volcker felt, was that it involved too much human discretion. Fed officials disliked raising rates, for personal and political reasons. It was unpopular; it might trigger a recession. On paper, all the Fed had to do was find a rate that permitted expansion and prevented inflation. Never easy, that task became harder once inflation rose. Rates that once seemed "high" might be low after adjusting for inflation. A 7 percent Fed funds rate was historically high, sequent amount of money—however defined—is known as the "money multiplier." A highly technical concept, it is not entirely predictable.

but if inflation was 7 percent, then the "real" rate (after inflation) was zero. People could effectively borrow for free. Volcker felt that the Fed was always playing catch-up, raising rates too little, too late. In the late 1970s, it had tolerated "real" rates that were low or negative.

The new approach exempted Fed officials from having to make explicit and politically sensitive decisions on interest rates. Volcker also believed that the Fed no longer knew what "the right rate" might be, even in theory. Regulating the amount of bank reserves would allow rates to find their own level. If demand for loans and money was high, rates would rise, perhaps spectacularly. If not, they might fall. Once the Fed adopted its new approach, the Fed funds rate jumped immediately to 13.8 percent in October, up from 11.4 percent in September.22

With hindsight, October 6, 1979, was a milestone: the Fed's true declaration of war against inflation. Volcker had shifted priorities. Lowering unemployment would take a backseat, at least temporarily, to getting inflation down. We know that the war succeeded, but while it proceeded, it was—like most wars—full of uncertainties, setbacks and surprises. The commanding general (Volcker) and his troops (the rest of the Fed) often didn't know precisely what was happening to the enemy (inflation) or on the broader terrain of battle (the economy). Nor was the outcome preordained. There were two types of problems: one technical, the other political.

As Volcker and others feared, the mechanics of controlling the money supply were confusing. As the recession grew more severe, Americans piled up cash. In economic jargon, there was a rush to "liquidity." "[PJeople were scared," wrote William Greider in his sweeping narrative of the Fed, The Secrets of the Temple. "Under siege, millions of players in the private economy, families and businesses, were storing larger balances in their checking accounts. . . . They weren't spending their money so quickly." As a result, the relationship between bank reserves (which the Fed could control directly) and the money supply (which the Fed could influence only indirectly)—the so-called money multiplier—became more erratic. For long stretches, the Fed had trouble hitting its money-supply targets. Sometimes its aim was too low, sometimes too high. Later, in 1981, the introduction of NOW accounts (checking accounts that paid interest) muddled the meaning of Ml, which was defined as cash plus checking accounts. Since the Depression, checking accounts had not paid interest. But now part of Ml would consist of funds that had previously resided in interest-paying savings accounts. How should NOW accounts be treated, as savings or checking?*23

But the bigger problem was political. By striking out on its own against inflation, the Fed was testing the limits of its "independence." When Volcker acted, he had not sought the blessing of the Carter administration. On his way to the IMF-World Bank meetings, he had merely informed Treasury Secretary Miller and Charles Schultze, chairman of the Council of Economic Advisers, of his plans. Though unhappy, they had not objected, and even if they had, it is doubtful that Volcker would have desisted. But it is one thing to act, another to persevere. Under the best of circumstances, the new policy could not succeed instantly. It would push up interest rates without immediately pushing down inflation. It was unveiled at an

* To deal with the confusion, the Fed created two money-supply definitions, labeled at the time Ml-A and Ml-B.

awkward political moment, the eve of a presidential election year when the incumbent was running to keep his job. Facing a grim economic outlook, Carter embarked on his own program.

The result was a bizarre episode that, ironically, underlined the extraordinary nature of Reagan's subsequent patience. In early March 1980, Carter proposed a dramatic new economic package designed to show that he could control both inflation and the federal budget. He recommended additional spending cuts—his initial budget had elicited skepticism—and asked the Fed to impose credit controls on bank lending to businesses and consumers, including credit card debt. Volcker opposed the controls as cumbersome but reluctantly went along—and persuaded other Fed governors—as part of an unstated political bargain. The Carter administration hadn't objected to his October 6 policy. Now it was Volcker's turn to reciprocate. "Volcker understood that just as Carter was doing unpleasant things for himself, cutting up his own budget, which would alienate his liberal constituencies," said CEA chairman Schultze,"so he too, Volcker, would have to do something he wasn't quite anxious to do."24

Everything backfired. The controls were supposed to relieve pressure on interest rates and avoid a recession without relaxing the assault on inflation. This is not what happened. The Fed—disliking the controls—had designed them to be nearly innocuous. Exempted were the biggest categories of consumer lending, home loans and auto loans. There were only modest restraints on credit card borrowing. Still, the effect was devastating. Addressing the nation on television, Carter had denounced overwrought consumer borrowing. Americans took heed; many stopped using credit. "Some peo-

pie sent me credit cards," recalled Alfred Kahn, Carter s anti-inflation czar."[They] wrote irate letters to the effect that Sears Roebuck was still soliciting credit card accounts. They said, 'that's unpatriotic.' " Visa lost 500,000 accounts in a few months. The economy went into a tailspin. From March to June, inflation-adjusted consumer spending dropped at an astounding annualized rate of 9.8 percent. Unemployment rose from 6.3 percent in March to 7.6 percent in July.25

Though it was ultimately self-defeating, Carter's behavior showed how unlikely it was that he—or anyone beside Reagan—would have meekly accepted Volcker s prolonged austerity. Recall that unemployment was just above 6 percent when Carter acted. What would have happened when it reached 8 percent or 10 percent? (By December 1981, the jobless rate was 8.6 percent.) There was another lesson, too: To succeed against entrenched inflation, policies had to be harsh. The credit controls, like the earlier incomes policies, were supposed to make anti-inflationary policies work without hurting. Controls would simply choke off inflationary credit. No one would really suffer. This was a delusion. Politicians wanted to quell inflation without serious social disruption. In early 1979, the House Banking Committee issued a report whose key recommendation was that "anti-inflationary policies must not cause a recession." At a hearing in early 1980, Representative Henry Reuss, a respected Democrat from Wisconsin, had warned Volcker: "The Federal Reserve cannot cure inflation with monetary shock treatment and it shouldn't try."26

The reality was that only a recession, "shock treatment" or something similar could cure double-digit inflation, precisely because

Americans had come to believe that inflation was indestructible.* The assumption could be dislodged only by actual experience that disproved it. Companies had to see that they could no longer raise prices as before because, if they did, they might sacrifice sales or go bankrupt. Workers had to understand that high and rising wage increases were no longer automatically in the cards. These realizations came slowly. Among some economists, there was a theory that the mere adoption of a "credible" anti-inflationary program would cause inflation to recede. Recognizing that steep price and wage increases would be self-defeating, businesses and workers would refrain. Volcker soon discovered that the theory was hollow. Shortly after October 6, he met with some chief executives of medium-sized firms. He asked for reaction to the Fed's program. One CEO announced that he had recently signed a three-year labor contract with annual wage increases of 13 percent—and was happy with the result. Only bitter experience would purge inflationary expectations and behavior.

"Credibility" had to be won through suffering. That was essentially the Volcker program. Although October 1979 was the departure point, the genuine assault on inflation did not begin until about a year later. "We were put back six, nine months because of the credit card [episode]," Volcker later said. The brief recession trig

* Some candid politicians acknowledged this. Senator William Prox-mire, a Democrat from Wisconsin and a recognized economic expert, said after Volcker's announcement: "This policy is going to cause pain. Anybody who says we can do it without more unemployment or more recession is just deceiving you or is deceiving himself."27

gered by Carter's program temporarily reduced inflation, interest rates and the money supply But the effects were fleeting. Once the controls were lifted in July—a natural response to the recession— the economy recovered. So did inflation and growth of the money supply. Indeed, during the recession, the Fed had tried to increase the money supply. A study by economists Marvin Goodfriend of the Federal Reserve Bank of Richmond and Robert G. King of Boston University agreed with Volcker on timing. "The true onset of the Volcker disinflation dates to Nov. 1980 or slightly later," they concluded.28

For almost two years after that, the Fed held the economy in a vise. As the recession deepened, the pressures to relent intensified. Among home builders and car dealers, the Fed assumed almost demonic status. Home builders sent small two-by-fours to the Fed to protest unsold homes; car dealers sent keys of unsold cars. One issue of Tennessee Professional Builders featured a wanted poster for Volcker and the other Fed governors, who were accused of the "coldblooded murder of millions of small businesses" and killing "the American dream of homeownership." As the recession deepened, members of the Federal Open Market Committee experienced the pressures personally. Frederick H. Schultz, vice chairman of the board of governors and an ex-banker and venture capitalist from Florida who had been appointed by Carter, later put it this way:

Did I get sweaty palms? Did I lie awake at night? The answer is that I did both. I was speaking before these groups all the time, home builders and auto dealers and others. It's not so bad when some guy gets up and yells at you,"You SOB, you're killing us."

What really got to me was when this fellow stood up and said in a very quiet way, "Governor, I've been an auto dealer for thirty years, worked hard to build up that business. Next week, I am closing my doors." Then he sat down. That really gets to you.29

Lyle Gramley, another governor who had been a Fed staff economist, felt similarly. "It was a very sobering experience for me to realize that what I do and decide has horrendous effects on the lives of millions of people," he said. Increasingly, members of the FOMC found old friends treating them with hostility. By the spring of 1982, the worsening recession caused some commentators to mutter the word "depression"—which, to those who remembered the 1930s, constituted a dire warning that the economy's downward momentum might become uncontrollable. Testifying before the Senate Budget Committee on March 2, economist Edward Yardeni of the broker E. F. Hutton warned that there was a 30 percent chance of a depression and that, if the economy did not begin to recover by May, the odds would go to 50 percent.30

Evidence of economic carnage was everywhere. By spring, bankruptcies were running at 280 a day, a post-World War II high. Some of the fallen were well-known corporate names: Braniff International, the airline; Lionel, the maker of toy trains. International Harvester, a big producer of farm equipment (tractors, combines) and heavy-duty trucks, was in desperate condition. Farm equipment sales dropped 31 percent in 1982, and the company posted a huge $822 million loss. The company survived only by shuttering its farm equipment business and concentrating on trucks under the new name of Navistar International. Disturbingly, the recession was harsher than expected. The Fed's staff economists had expected a recovery by mid-1982; so had many private economists. But it wasn't happening. Recalled Gramley:

Early in the year, I was making speeches predicting an upturn in the economy in the second quarter [April-June], and when that didn't happen, I said by mid-year. By June and July, with each passing statistic, it became increasingly evident that the turnaround wasn't going to be there____Our expectations were thoroughly disappointed. The gloom and doom was beginning to spread.31

But arrayed against that was the fear that if the Fed relaxed too soon it would forfeit its claim to "credibility"—the public belief that it would not tolerate higher inflation. It was "credibility" that, in turn, would purge inflationary psychology and re-create the self-regulating discipline that would restrain wage and price increases. If the Fed repeated previous errors, easing money and credit too soon, the whole gruesome episode might be in vain. Compounding the difficulty was the money supply's erratic behavior. In early 1982, its growth reached or exceeded the upper limits set by the Fed. Usually, rapid money growth signified a strong economy, accelerating inflation, or both. But interest rates were high, unemployment was rising and inflation was falling. The puzzle might reflect the public's swollen appetite for higher cash balances as protection against the slump. Who knew? The Fed faced a dilemma: Abandoning its money-supply targets—which symbolized the war against inflation—might seem an act of surrender; but adhering to them closely, trying to cut money growth even more, might drive the economy into an even deeper slump.

All these crosscurrents converged at the FOMC's June 30—July 1 meeting. It is sometimes said that the Fed eased decisively at this meeting. That didn't happen. The outcome was more ambiguous: The FOMC decided not to tighten any more—and it hoped to ease. To be sure, many FOMC members were alarmed. At the meeting, Volcker relayed information that Mexico might default on bank loans. The ensuing losses would weaken many major U.S. banks, which were big lenders to Mexico. In Oklahoma, a small bank (Penn Square) was on the brink of failure, having made many bad energy loans on the false premise of permanently high oil prices. By itself, that wasn't worrisome. But many bigger banks—including Continental Illinois and Chase Manhattan—had participated in the same loans, which meant they, too, faced large losses. All this raised the specter of a financial chain reaction, much like what happened during the Great Depression, when bad loans curtailed bank lending—which weakened the economy, causing more bad loans and further curtailed lending.

Companies were squeezed from both ends. Higher interest rates increased their debt burden; sagging sales diminished their capacity to pay. Local bankers feared mounting loan defaults. Edward Boehne, president of the Philadelphia Federal Reserve Bank, warned, "[Bankers] now think that customers they never really thought about as being problems are going to be a problem over the next six months." Among some FOMC members, the pleas to relax credit verged on desperation. "The economy can't stand higher rates because the fi nancial fabric of the country won't tolerate higher rates," said Governor Charles Partee, who—like Gramley—had been a Fed staff economist. Governor Nancy Teeters, a former chief economist of IBM and earlier a Democratic congressional staff economist, was more blunt. "I want to get interest rates down," she said. "We need to signal the market that we have eased." Lower rates would lighten the debt burdens of many firms whose short-term loans had "floating" rates.32

Up to a point, Volcker agreed. "The problem is not the desirability of getting rates down," he said. But there was a catch: "The question is whether by reaching too fast for that objective we may not be able to keep them down." Because interest rates incorporate inflationary expectations, the failure to dispatch inflationary psychology could result in Pyrrhic victory; once inflation revived, rates would rise. Other FOMC members expressed similar doubts. The result was a standoff: no tightening, no big easing, but a predisposition to ease. Then, in succeeding weeks, the unexpected happened. The money-supply figures came in lower than expected. Interest rates dropped naturally. The given supply of bank reserves was more than adequate to support the existing money supply. The fierce bidding for overnight loans among banks (for Fed funds) so that banks could meet their reserve requirements subsided. Indeed, reserves might be increased—policy loosened—without breaching the money-supply targets.

On July 15, the FOMC held a conference call. Most of the discussion was highly technical, focused on the official money-supply targets for the next year. By deciding not to reduce the targets, the Fed edged toward an easier policy. As Volcker later explained:

[I]t was sometime in July that the money supply suddenly came within our target band. The Mexican crisis was brewing. The economic recovery had not appeared. I thought, ahah, here's our chance to ease credibly.33

Although the economy would not begin expanding again until early 1983, the Fed had relaxed its assault on inflation and committed itself to ending the recession. The country seemed to have turned the corner Volcker had so long sought. On July 19, the Fed cut its discount rate—the rate at which commercial banks could borrow from the Fed—from 12 percent to 11.5 percent, reflecting declines in the Fed funds rate. By December, there would be six more discount rate cuts; these signaled that the Fed approved the decreases in market rates. On August 17, economist Henry Kaufman of the investment bank Salomon Brothers, long christened "Dr. Doom," predicted that interest rates would drop, a reversal of his previous position. The stock market responded with a 38.8 point increase in the Dow, then the largest one-day increase ever. Stocks rose about 50 percent in the next six months, as money came out of money market mutual funds and saving certificates and investors responded to lower interest rates and the prospect of economic recovery. By September, the money-supply figures had accelerated again, but Volcker stayed with his decision to ease. In October, the Fed officially demoted the significance of the money-supply figures, saying that they were too unpredictable to use as guide for daily policy.34 By December 1982, the increase in the CPI over the previous twelve months had dropped to 3.8 percent.

All during these years, Volcker projected an unshakable determi nation to suppress inflation. At six feet seven inches, he was not merely tall; he had presence. "Volcker's character—the strong, silent type—became the public symbol for the wrenching discipline being imposed on the American economy," wrote William Greider. "He was physically imposing, a head taller than most everyone else, including the President. He spoke in a brooding Germanic manner that was intimidating by itself. His intellectual self-confidence was daunting and so were his silences." Volcker hadn't isolated himself— he testified before congressional committees, met with senators and congressmen, addressed hostile private groups (home builders, for instance). His forcefiilness strengthened the moral case for—and the public acceptability of—attacking inflation. "He's not insensitive," Fed vice chairman Frederick Schultz said later. "But he is a tough guy." Sometime in the summer of 1982, he concluded that the Fed had squeezed the economy as much as was economically and politically possible. Unemployment was rising; banks were shaky; Congress was restless—and threatening to curb the Fed's powers. "If we get this one wrong," Volcker warned at the FOMC's October meeting, "we are going to have legislation next year without a doubt. We may get it anyway." It was a close call, but they didn't.35

0 0

Post a comment