Volcker’s approach to crisis control cannot be reduced to a precise metric. It is an art form, a blend of principle and compromise, like the justice administered by a frontier sheriff. Volcker never acted hastily, always trying to preserve the status quo. And like a reluctant peace officer pressed into making a stand, he was not above using controversial tactics to restore order.
In 1971 he accepted capital controls, an undesirable interference with free trade, while basing exchange rates on the dollar rather than gold. In 1982, when skyrocketing interest rates threatened to bankrupt Mexico and impair the capital positions of America’s largest banks, Volcker papered over the problem with questionable loans. In 1984, when Continental Illinois, the seventh-largest bank in the United States, nearly failed, he helped rescue the embattled giant from bankruptcy, and in the process sanctioned the problematic principle of Too Big to Fail in American finance. Both bailouts permitted the battle against inflation to proceed.
Volcker chose to defend an ambitious goal, sustaining both the domestic and the international integrity of the U.S. currency. Some view the two faces of the dollar as separate objectives, but he insists, “They are the same. Preserving purchasing power at home promotes confidence in the dollar abroad.”10 His success as an inflation fighter revived trust in the Federal Reserve System and maintained the greenback as the world’s reserve currency. Americans have been able to consume more than they have produced domestically thanks to the dollar’s role as international money. The United States exports financial services to the rest of the world, in exchange for cars, televisions, and manhole covers.
Volcker’s victory over inflation had unintended consequences. The generation of economic growth and low inflation that followed between 1987 and 2007 fostered a myth that the business cycle had disappeared and encouraged excessive risk taking by consumers and investors, who borrowed more than they could reasonably expect to repay. The crisis simmered as regulators relaxed safeguards no longer needed under the so-called Great Moderation.
Paul Volcker expected trouble.
In a speech at Stanford University in February 2005 he said, “Baby boomers are spending like there is no tomorrow … and we are buying a lot of houses at rising prices.”11 He warned that “The capital markets which have been so benign in providing flexibility … can become a point of great vulnerability.” And then predicted “Big adjustments will inevitably come … And as things stand it is more likely than not that it will be financial crises rather than policy foresight that will force the change.”
Volcker knew whereof he spoke. His prediction that crisis would force change came from experience. In 1971 he proposed allowing a “foreign exchange crisis to develop without action or strong intervention by the U.S.,” and to use “suspension of gold convertibility” as negotiating leverage for currency revaluation.12 In 1979 he used the growing popular disgust with the inequities of inflation to galvanize support. “People were prepared to sacrifice to win the battle. I could not have pushed the anti-inflation program without favorable public opinion.”13 In 1984 he agreed with Senator John Heinz at hearings in the Senate that “an inevitable consequence” of the Federal Reserve’s tight monetary policy and high interest rates might be a crisis that forced Congress and the president to reduce the federal deficit.14 Congress passed the Gramm-Rudman-Hollings Act the following year, a first step toward budgetary reform that cheered financial markets, despite its flaws.
Almost no one paid attention to Volcker’s warning in 2005. He was old, old-fashioned, and a worrier by nature. He had been eclipsed by time and circumstance. Less than 10 percent of young adults knew who had preceded the then-chairman of the Federal Reserve, Alan Greenspan, when Volcker gave his 2005 speech.15
The monetary meltdown that began in 2007 changed everything. The upheaval threatened to destroy American financial credibility. Bear Stearns and Lehman Brothers, two of the country’s preeminent investment banks, evaporated over separate weekends in March and September 2008. The collapse of those giants threatened to undermine the financial trust that the United States exports to the rest of the world.
Volcker returned in 2010 to repair the system he had rescued twice before, and as with those earlier efforts, his plan combined principle and compromise to achieve a noble goal. But unlike 1979, when he was the sheriff, and unlike 1971, when his position at Treasury carried administrative power, Volcker relied primarily on patience and persistence to implement his plan. The Volcker Rule became law on July 21, 2010, a testament to the moral authority he had earned in fifty years of public service.16
Part I
Background
1. The Early Years
Paul A. Volcker learned integrity at home. He was born on September 5, 1927, in Cape May, New Jersey, to Alma and Paul A. Volcker Sr. In 1930 his family moved to the northern part of the Garden State when Paul Sr. became the town manager of Teaneck, a small suburban community five miles west of New York City. Volcker Sr., a civil engineering graduate of Rensselaer Polytechnic Institute in upstate New York, rescued the town from the Great Depression and managed its affairs for twenty years, creating a zoning system, a paid fire department, and civil service for township employees.1 “The population doubled while my dad was manager,” Volcker recalls. “I’ve always been proud of his success.”2
A quote from George Washington hanging on the wall in his father’s office burrowed into young Paul’s brain: “Do not suffer your good nature … to say yes when you ought to say no; remember that it is a public not a private cause that is to be injured or benefited by your choice.”3 Paul Volcker Sr. lived by those words, going to extreme measures to avoid even the hint of impropriety, no matter what the consequence, sometimes at young Paul’s expense.
Dick Rodda, the Teaneck recreation director, had hired fifteen high school students, including Buddy Volcker, as Paul was called, to work part-time as safety monitors after a snowstorm. When Paul Sr. found out, he called Dick to his office and said, “I want Buddy off the payroll … I want you to fire him.” When Dick protested, Paul Sr. said, “If you won’t fire him I’ll find a new recreation superintendent who will.” Dick Rodda did as he was told.4
Paul watched his father purge the emotion from every decision, deliberating like the pipe smoker he was. “If someone came by on a Monday with a request he had not considered before, he would say, ‘Come back on Thursday and I’ll have an answer.’ He almost turned procrastination into a virtue. He was thoughtful and scrupulous, weighing every option in the process. I learned never to make a decision before its time … for better and worse.”5
As far back as he can remember, Paul craved his family’s approval. It began when he was five, in kindergarten, the day he brought home his first evaluation from Miss Constance Palmer. Maybe every boy thinks that his first teacher is beautiful, but he insists she really was. “I remember when she led me by the hand into the circle with the other kids. I liked the attention until she added a note to my report: ‘Paul does not take part in group discussion and does not play well with others.’”6 Those comments worried his parents, especially when his sisters chimed in, “And when Buddy plays with his friends they hardly ever speak.” Their concern only deepened Buddy’s natural reticence.
Paul’s reserve continued as he grew older, creating a serious handicap with the opposite sex. During high school, he was too self-conscious to ask a girl out on a date. But his shyness also had an upside, blossoming into self-reliance. He became a Brooklyn Dodgers fan simply because all his friends rooted for the Yankees or the Giants, who played just a few miles away, across the George Washington Bridge. They considered Brooklyn a foreign country, where people spoke a different language. Paul found that he liked being a contrarian.
A curious blend of insecurity and self-confidence emerged in young Paul. At times the insecurity dominated, especially when it came to report cards. He worried about his father’s signature on the card. When he did well, his father would embellish the V in his name, as though he was signi
ng the Declaration of Independence; when his grades fell short, a simple PAV flowed from his father’s pen. “I always wanted the fancy ‘Volcker’ on the back of the card but did not get it often enough.”7
Paul Volcker Sr. graded like a headmaster: no nonsense … and no hugs or kisses either. The tension rose when Paul applied to college in the spring of 1945. His father suggested his alma mater, Rensselaer. Paul decided to apply to Princeton, just to see if he could make it. The application form itself was intimidating—it felt like parchment when he filled it out—but two weeks later he was accepted. His father tried to persuade him not to go, with a warning: “Prep school students will do better at Princeton than a graduate from Teaneck public high. You’ll find out that you’re not so smart.”8
Paul decided to take a chance to prove a point.
Uncle Sam almost accomplished what Paul Sr. failed to do. A formal invitation arrived in April 1945, soon after the Princeton acceptance, requesting that Paul visit his local draft board for a physical exam. The war was winding down in Europe, and Paul had been unhappy when the captain of the Teaneck varsity jumped the gun and volunteered. “We were having a championship season on the basketball court, and that derailed our prospects. When I went for the physical I thought about crouching down so that I would not exceed the maximum acceptable six-foot, six-inch height. I didn’t try very hard and was rejected with a physical deferment … I’ve always regretted that decision, wondering whether I let myself and my country down.”9
Volcker concentrated on economics and basketball at Princeton between 1945 and 1949. Much to his disappointment, he was far better at economics, despite his elongated frame. “I never got along with the coach,” Volcker complains, sounding like a benchwarmer covering up for bad footwork or bad hands, “so I didn’t play much.”10 Perhaps that is why he found refuge with Princeton’s two famous German-born economists, Friedrich Lutz and Oskar Morgenstern, who had come to America after Hitler’s rise to power. Lutz taught Volcker about money and banking, his lifelong preoccupation; Morgenstern taught him to worry, his lifelong compulsion.
Morgenstern is best known for his book Theory of Games and Economic Behavior, published in 1944 with John von Neumann, one of the most famous mathematicians of the twentieth century.11 Volcker never studied much game theory, a formal approach to strategic decision making, beyond what Morgenstern had discussed in class, but the professor left his mark by turning Paul into a professional skeptic.
Morgenstern worried about the relevance of economics. He said that “unless [economics] offers a contribution to the mastering of practical life … it is but an intellectual plaything … similar to chess.”12 Morgenstern probably disliked chess because the Russians dominated it, but he really did want economics to be more than just a game and warned that “insufficiency of data is in great part responsible for the fact that economic policy is so often lacking in rationality.”13 Back then, his colleagues spent most of their time thinking rather than doing.
Oskar Morgenstern would soon write On the Accuracy of Economic Observations, published in 1950, warning against the mistreatment of economic data. He did not mince words: “It [is] grotesque to see the New York Times, for example, often reporting on its front page that ‘consumer prices’ have ‘risen’ or ‘fallen’ by 1/10 of 1 percent without any qualifying word about the significance of this change in a mere index of doubtful validity.”14
Volcker recalls Morgenstern’s shocking example of data on international gold movements, which often made front-page headlines throughout the world. “Oskar showed numerous years in which Britain’s reported gold imports from the United States differed substantially from America’s reported gold exports to the U.K. This logical inconsistency made a mockery of further analysis.”15
Volcker spent most of his days at Princeton reading and playing basketball, not necessarily in that order. “I devoured Friedrich Hayek’s Road to Serfdom.16 His defense of free enterprise made me wary of government intervention—and proud to be an American, even though Hayek warned against our creeping socialism. As for coursework, I listened to what the professors had to say and found that I could get As by repeating their views, almost verbatim, on the exams.”17
Princeton dealt with students who were too smart for their own good by requiring a thesis for graduation—a lengthy tome on some weighty subject that could not be written while shooting baskets. Paul responded to the looming deadline by ignoring the problem. With less than a semester left, he had done nothing.
According to Volcker, Professor Frank Graham, assigned as his thesis adviser, saved him. “I decided to write on Federal Reserve policy after World War II. It turned out more complicated than I had anticipated. Professor Graham gave me great advice: to write first and edit later. I would submit a handwritten chapter on yellow legal-size paper on a Friday afternoon, and he would return it the following Monday with detailed comments and corrections. I was too embarrassed not to push ahead.”18
Graham, an expert in international trade, flattered Volcker with his attention. Paul had always been too shy and insecure to meet with professors. “I thought they did not have time for me.”19 Graham pushed his young protégé, hoping he would pursue graduate study in economics, and Paul ultimately submitted his thesis with a week to spare, graduating summa cum laude in the process. Volcker would follow this “procrastinate and flourish strategy” throughout his professional career. “I found that it worked, so I never changed.” And then he adds, “Besides, it gave me time to think and to get it right.”20
Volcker continued his studies in economics while attending the Graduate School of Public Administration at Harvard in 1950 and 1951, listening to lectures by, among others, Alvin Hansen, the foremost expositor of the new Keynesian theory of activist government intervention. “Hansen was a great teacher,” Volcker recalls, “but I had cut my teeth in economics as an undergraduate at Princeton. I was very skeptical.”21
Volcker received his master’s degree from Harvard in 1951 and then left for the London School of Economics, armed with a Rotary Club fellowship to write his doctoral dissertation. Paul spent most of his time traveling through Europe. “I found a girlfriend who kept me busy. And when time got short, there was no Professor Graham to save my hide. I still feel bad about not completing my degree. I had also disappointed my father, who had saved the clipping from the local newspaper when I received the fellowship. He was an active member of the Rotary Club. I screwed up a good opportunity.”22
Paul redeemed himself by pursuing a career in public service, like his father. Paul Sr. helped by getting his son an interview at the Federal Reserve Bank of New York. The New York Fed is the most important of the twelve regional Federal Reserve Banks that serve as branches of America’s central bank, headed by the Federal Reserve Board in Washington, D.C. The New York Bank, a fortress-like building in Lower Manhattan, serves as the observation post of the Federal Reserve System, located two blocks from the New York Stock Exchange and within walking distance of the numerous government bond dealers that buy and sell securities with the Federal Reserve every day.
Robert Roosa, vice president of the Research Department at the Federal Reserve Bank of New York, molded Volcker’s thinking after he was hired as an economist in 1952. Roosa drafted Volcker to help produce Federal Reserve Operations in the Money and Government Securities Markets, a little red booklet (107 pages long) that instructed a generation of policy makers about central bank strategy.23 Illinois senator Paul Douglas, chairman of the congressional Joint Economic Committee, described Roosa as “probably the foremost authority on the technical operation of the money market in Government securities.”24 He had become an expert after transferring in 1954 from the New York Bank’s Research Department to the open market desk, where traders bought and sold securities for the Federal Reserve System.
Roosa’s move to the practical side of the Federal Reserve was unprecedented. Economists were considered too cerebral for the instinct-driven trading business, and in the mid-1
950s they were segregated in research, barely a notch above the accountants. Roosa broke further ground by putting the twenty-seven-year-old Volcker in the trading room—as an observer, of course. The experience married theory and practice in Volcker’s brain and altered the trajectory of his career. If Oskar Morgenstern had convinced Paul that data were essential, but fraught with error, then Robert Roosa gave him the opportunity to examine data under a microscope—data from the heart of Wall Street.
Volcker encountered a new world when he entered the trading room at the New York Fed. Unlike modern trading facilities, decorated with computer terminals and multicolored electronic displays, the 1955 model carried the stark imprint of a black-and-white movie production. A U-shaped desk, equipped with telephone consoles for each trader, filled the entire space, while a large chalkboard hanging on the wall at the open end of the U recorded the relevant statistics, much like a primitive scoreboard at a baseball game. Prices of government bonds, which were frozen in print in the Research Department, now danced in Volcker’s head during phone conversations with Wall Street’s bond dealers. Shorthand words for buying and selling could make the conversations sound like gibberish. It took a practiced ear to decipher the meaning of “9 bid, offered at 10, 100 by 100,” but Paul caught on quickly and reveled in the details, feeling as though he had been initiated into a secret fraternity.25
On Wednesdays, when commercial banks had to meet their required reserves prescribed by the Federal Reserve, Volcker would work past midnight on his weekly report for the Federal Reserve’s Open Market Committee. The committee, referred to as the FOMC, is the central bank’s decision-making body. It consists of the seven members of the Federal Reserve Board, appointed by the president of the United States, plus five of the twelve regional Reserve Bank presidents, who serve on the FOMC on a rotating basis.
Volcker Page 2
