Speculators examine the balance of payments the way bookies review the racing form. The balance of payments is a record of a country’s imports and exports. It also determines the supply and demand for a currency in the foreign exchange market. When Americans import Japanese TV sets or German radios, they offer dollars in exchange for foreign currency to pay for their purchases. When the Germans and the Japanese buy American airplanes or invest on the New York Stock Exchange, they offer their currency in exchange for dollars to pay for their purchases. A deficit in America’s balance of payments means U.S. demand for Sony TVs and Blaupunkt radios exceeds Japanese and German demand for Boeing aircraft and General Electric stock, with a corresponding buildup of dollars abroad.
A balance-of-payments deficit predicted trouble.
America was the proud owner of $19.5 billion in gold in December 1959, just about the same amount it had fourteen years earlier, at the end of 1945.59 Less than nine months later, however, in September 1960, a month before the speculative outburst, the U.S. gold stock had declined by almost a billion dollars, to $18.7 billion.60 The Wall Street Journal put the drop for the week ending September 21, 1960, into perspective with the headline “Largest Regular Weekly Decline Since 1931.”61 The Journal explained the root cause as “the continuing deficit in this country’s balance of payments with the rest of the world.”62 Foreigners had more dollars than they needed, so the central banks of Europe and Asia sent their surplus greenbacks to the U.S. Treasury with a polite but firm request to exchange their dollars for gold, as was their right under the Bretton Woods System.
Prospects for a Kennedy victory over Richard Nixon fanned speculator worries about America’s balance of payments. According to the press, European central bankers attributed the flurry of gold speculation to expectations that “Senator Kennedy will win the U.S. election … [and] that a Kennedy election will mean renewed U.S. inflation.”63 Inflation means higher prices, making U.S. products less competitive abroad and leading to fewer exports, worsening America’s balance of payments. Speculators were not merely speculating when it came to Kennedy’s economic policy; his advisers supported greater inflation to achieve another goal: full employment.
Paul Samuelson was John F. Kennedy’s tutor in Keynesian economics, and he had just coauthored an article with his MIT colleague Robert Solow (a future Nobel Prize winner, just like Samuelson), explaining that a country could reduce unemployment if it tolerated an increase in inflation.64 The trade-off between inflation and unemployment was the guiding principle of mainstream economics for nearly a generation. This doctrine would later come under attack from Milton Friedman, founder of the “monetarist school,” and would be blamed for accelerating inflation almost beyond control. But in 1960, Samuelson’s opinion defined the mainstream, certainly for the young presidential candidate.
After the election, when Samuelson touted Roosa with high praise for the job as undersecretary of the treasury for monetary affairs, Kennedy, who at that time was still looking to fill the position of secretary, finally said, “If this fellow is so good, why don’t we give him the top job?”65 Samuelson answered, “You can’t do that. He is too young.” Samuelson’s response entertained Kennedy, who noted that Roosa was only a year younger than he, but Kennedy took the advice.66
The outlook for inflation had emboldened the gold speculators, forcing JFK to pledge fealty to the value of the dollar. He appointed Roosa to the crucial position at the Treasury to help calm the markets. Roosa’s anti-inflationary credentials, honed at the Federal Reserve Bank of New York, matched his commitment to America’s obligations under Bretton Woods.
Ironically, Roosa would battle Samuelson’s allies at the President’s Council of Economic Advisers (CEA) who wanted to promote full employment with a dollop of inflation. Volcker, at the time working for Roosa as an economist, recalls, “At the Treasury we had two main enemies: a State department that did not want the balance of payments to influence foreign policy and a CEA that did not want it to interfere with domestic policy. We had very little room to maneuver.”67
The Council of Economic Advisers, located in the Executive Office Building next door to the White House, consists of three members appointed by the president, plus a staff of about twenty economists on leave from academic posts. Future Nobel Prize winners decorated the CEA during those years, including James Tobin of Yale, Kenneth Arrow of Stanford, and Robert Solow, Samuelson’s colleague from MIT. These economists believed they could engineer full employment just as physicists believed they could put a man on the moon.
Roosa arranged a presidential appointment for Volcker as deputy undersecretary of the treasury for monetary affairs so that he could serve as Treasury’s point man in confronting the CEA.68 Volcker felt like a rookie in a home-run-hitting contest against the 1927 Yankees, and relied on Morgenstern skepticism as his Louisville Slugger.
Volcker recalls: “It all sounded too easy. Push this button twice and out pops full employment. Equations do not work as well on people as they do on rockets. I remember sitting in class at Harvard listening to [the fiscal policy expert] Arthur Smithies say, ‘A little inflation is good for the economy.’ And all I can remember after that was a word flashing in my brain like a yellow caution sign: ‘Bullshit.’ I’m not sure exactly where that came from … but it’s a thought that never left me.”69
2. Apprenticeship
Paul Volcker’s long and torturous battle with inflation began when he was a teenager, preparing for his departure to Princeton in 1945. His mother offered twenty-five dollars a month for living expenses, just like his sisters, but he protested, “Mother, when they went to school, twenty-five dollars was really worth something. Prices have gone up a lot since then. And besides, I’m a boy and have higher expenses.”1
Alma Volcker looked at her son. “Really?” She had gone to Vassar and graduated as valedictorian of her class with a degree in chemistry, at a time when most women had thought about neither college nor chemistry. “Well, it was good enough for them, so it’ll be good enough for you.”
Paul turned to his siblings for support, but it would not be easy. They had always worried about everyone spoiling him, as the youngest in the family and the only son to carry on the Volcker name. Ruth and Louise, more than ten years older than Paul, had gone to college during the Depression. And Virginia, three years older, was nearly finished. Much to his delight, however, they all agreed, so he confronted his mother again.
“My sisters say that I should get more because of inflation.”
But Alma Volcker would not budge. “I don’t care about that. You’ll still get twenty-five dollars.”
At first Paul thought his mother wanted to teach him lesson in frugality, a family trait he himself still practices today with the dedication of a monk. He had seen his father wear suits long after they had frayed at the cuffs and knew that his sisters sewed their own clothes. Perhaps his mother was worried about the spendthrift ways of the prep school boys he would befriend at Princeton. Years later, he learned the truth. His father had tried to enlist in the army but was too old. In a burst of patriotic thrift, he refused a salary increase throughout the war, despite the inflation. “That didn’t change the facts, but it explained it all, and made a lasting impression.”2
Keynesians often dismiss the inequities of inflation as a nuisance, an irritant that can be ignored for the common good. A little inflation is certainly an acceptable price for running the economy at full throttle. But Volcker’s favorite author as an undergraduate, Friedrich Hayek, fueled his suspicion that it was not quite so simple. The Austrian émigré’s ode to free enterprise warned against the alleged virtues of inflation: “It should be specially noted that monetary policy cannot provide a real cure for [unemployment] except by a general and considerable inflation … and that even this would bring about the desired result only … in a concealed and underhand fashion.”3
Hayek meant that inflation worked by subterfuge, tricking people into thinking they are better off
as their wages rise, only to disappoint them when they are confronted later with higher prices to match. According to Volcker, “Hayek’s words forever linked inflation and deception deep inside my head. And that connection, which undermines trust in government, is the greatest evil of inflation.”4
Hayek also denied the claim by Keynesians that inflation could permanently stimulate the economy. When worker expectations catch up with reality, as they inevitably must, the illusion of higher real wages is exposed as a fraud, and inflation loses its power to promote more employment. The end result is simply higher inflation and increased resentment, because rising prices do not affect everyone the same way.
Hayek’s message made logical sense to Volcker, even though it clashed with the emerging Keynesian consensus. It was reinforced by his Princeton professors. “I don’t think I heard the name of John Maynard Keynes until I got to Harvard. At Princeton they taught the famous quantity theory of money as though they heard it directly from David Hume in 1750,” says Volcker.5 “Friedrich Lutz was about forty at the time, but from the perspective of an eighteen-year-old, he might as well have been two hundred and forty. He taught us that too much money created inflation.”6
Volcker had applied those lessons during the fall of 1948 in writing “The Problems of Federal Reserve Policy Since World War II,” his undergraduate thesis. Prices had surged in the United States immediately after the war, triggered by the pent-up demand for consumer goods, the removal of wartime controls, and an enlarged stock of money. Volcker wrote, “A swollen money supply presented a grave inflationary threat to the economy. There was a need to bring this money supply under control if the disastrous effects of a sharp price rise were to be avoided.”7
He concluded with an indictment of the Federal Reserve’s performance worthy of Milton Friedman, a lifelong critic of the central bank: “Although the inflation problem continually raised its head in a disconcerting manner … the counter-measures taken have not [been] … a realistic attempt to combat the danger … The Federal Reserve System had no definite criteria of policy to follow.”8 Volcker lamented the central bank’s failure to ensure price stability, its most important responsibility.
Paul Volcker’s anti-inflationary sentiments prepared him perfectly for the U.S. Treasury in January 1962. President Kennedy had enlisted Robert Roosa to offset the pro-inflation bias of his Council of Economic Advisers and to oversee international economic affairs. Roosa drafted Paul Volcker as his personal watchdog. “I could hardly wait to get to Washington,” Volcker recalls. “It’s hard to re-create the excitement of working for a young vibrant John F. Kennedy. My main concern was that they would solve all the problems before I got there to help.”9
He had nothing to worry about. The U.S. Treasury served as the guardian of American gold. And the dwindling reserves in Fort Knox threatened American finance.
Gold has served as a store of value ever since King Tut passed into the afterlife with a treasure chest of the metal, in addition to his famous mask. Gold developed into money, something useful for making payments, in part because it is a good store of value. But many things are valuable and are not used as money, such as the New York Yankees, Buckingham Palace, and French antiques. Gold serves as money because in addition to holding its value, it is easily divisible and standardized.
More than 2,500 years ago, King Croesus invented gold coins by dividing the precious metal into a fixed number of grains and then certifying its weight with his stamp of approval.10 Gold in the form of standardized coins facilitated all types of payments, to the tailor for a brand-new suit, to the local tavern for a neighborhood celebration, and of course to the king’s tax collector for waging war and building castles.
Before 1933, U.S. gold coins, such as the famous twenty-dollar double eagle and the less-well-known ten-dollar eagle and five-dollar half eagle, had circulated as American currency alongside the familiar Federal Reserve notes still used today. The U.S. Mint, a bureau within the Treasury Department, created these coins out of gold bullion brought in for minting. The Treasury would also exchange paper dollars into gold at the rate of $20.67 in currency per ounce of gold.11
People preferred dollar bills rather than gold for most payments because gold is physically dense, making it cumbersome to carry and costly to ship. A gold bar, worth about $8,000 in 1933, is slightly smaller than an ordinary brick and weighs about as much as two bowling balls.12 As long as people knew they could convert dollars into gold, as the U.S. Treasury promised, they chose not to bother. They would rather hold dollar bills for convenience, or better yet, put the money into their neighborhood bank, where it would earn interest. Gold coins served primarily as Christmas presents for children of privilege rather than as pocket change for everyday shoppers.
All this changed in March 1933. President Franklin Roosevelt wanted to allow banks to expand credit without the limitations of gold, to help rescue the economy from the ravages of the Great Depression. He pushed Congress to pass a law authorizing a Presidential Executive Order requiring American citizens to turn in all gold coins and receive paper currency in exchange.13
Now that people had to give up the precious metal, of course, they did not want to. FDR’s treasury secretary, William Woodin, ordered the president’s directive printed up like Wanted Dead or Alive posters, exhorting the public “To deliver … all gold coin” or face criminal penalties, including a “$10,000 fine or 10 years imprisonment, or both.”14 He then distributed the placards to post offices throughout the country for display along with other criminal notices from the postal inspection service.
U.S. citizens complained about the dictatorial decree and squirreled away their gold in safe-deposit boxes, while litigating (unsuccessfully) that Congress had abrogated their inalienable rights.15 Mary Meeker, a recently unemployed fifty-one-year-old single woman, sent a latter dated April 30, 1933, to the New York Times, summarizing the complaint:
I was frugal in the use of my earnings, and what I managed to save … amounted to about $31,000.00 … A few months ago I became very much disturbed over the financial situation in this country and decided to withdraw my money from savings banks, convert it into gold and place it in safe deposit boxes … Congress [then] adopted the banking emergency bill requiring all persons to convert into currency … all gold coin … under penalty of a heavy fine or long imprisonment … We were assured that the bills we received in exchange for gold … were just as good and just as valuable … Will you kindly explain to me where I will stand in the event President Roosevelt does revalue the dollar by reducing the gold content? I worked for many years to accumulate the $31,000.00 in gold that I turned over … under duress of the law enacted by Congress at the behest of President Roosevelt … The government now holds my gold and all I have to show for it is the Federal Reserve notes given me in exchange for it.16
Money is a social contrivance, worth something only because others will accept it in payment for real things. A dollar retains its value if prices remain stable, which is precisely what the gold standard accomplished by allowing people to convert paper dollars into gold. It prevented inflation by controlling the printing press, holding the creation of paper dollars in check, for better or worse. The restraint on prices made Mary Meeker happy, but it also prevented banks from expanding credit to jump-start the economy.
Loosening the link with gold provided some leeway for the central bank to expand credit during a crisis, such as the Great Depression. And as long as the Federal Reserve managed its mandate responsibly, so that price increases did not become a way of life, dollars provided a safe store of value. Of course, that is precisely what worried Mary Meeker—she trusted gold more than the Federal Reserve. And she was right to worry.
The Gold Reserve Act of January 1934 established the secretary of the treasury as the czar of American gold.17 It specified that “all gold coin … shall be formed into bars … as the Secretary of the Treasury may direct.” It gave the secretary the power to “prescribe the conditions under whi
ch gold may be … transported, imported, and exported … for industrial, professional, and artistic use.” And finally, to stabilize the international value of the dollar, it gave the treasury secretary the right to “deal in gold and foreign exchange.” As far as gold was concerned, the secretary of the treasury was like a grand pooh-bah, an exalted official in charge of all matters, and worthy of the title Lord High Everything Else.18
The 1934 legislation also devalued the dollar, reducing its gold content to 13.714 grains of pure gold, which translated into a price of $35.00 per ounce rather than $20.67, but it did not take the United States off the gold standard.19 It softened the link between money and the precious metal by preventing Americans from exchanging paper dollars into gold, but the Federal Reserve still had to hold a reserve of 40 percent in gold against its liabilities, such as the familiar Federal Reserve notes Americans use as currency. Without further legislation, this “gold cover” provided an upper limit on credit creation by the central bank. Moreover, foreign central banks retained the right to exchange paper dollars for gold. The United States had to manage its monetary affairs so that the U.S. Treasury could meet America’s international obligation to redeem dollars in gold.
President Kennedy put Undersecretary of the Treasury for Monetary Affairs Robert Roosa in charge of defending America’s gold reserves, which had declined to nearly $17 billion by the time Kennedy took office in 1961.20 Roosa’s assignment was more difficult than it appeared, because over $11 billion of that hoard was immobilized as gold cover for Federal Reserve liabilities.21 America’s immediate obligations to foreign central banks amounted to double the remaining $6 billion of free gold.22
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