Volcker
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No one has confirmed what the press called the “Accord of 1970,” but in retrospect, Nixon’s reference to central bank independence sounds as hollow as his future declaration “I’m not a crook.”29 Arthur Burns would abandon prudent monetary policy during his tenure as Federal Reserve chairman, in part under pressure from the White House, but also because he truly believed that “the rules of economics are not working the way they used to … even a long stretch of high and rising unemployment may not suffice to check the inflationary process.”30 Burns’s printing press would lay the foundation for the Great Inflation of the 1970s.
Nixon signaled his dissatisfaction with the economic status quo by replacing Volcker’s boss, Treasury Secretary David Kennedy, with John Connally. Connally had been secretary of the navy in the Kennedy administration and a former Democratic governor of Texas, and had survived the car ride with JFK on November 22, 1963, suffering serious wounds during the assassination. He worried about his new cabinet position.31 “When I took over as Secretary of the Treasury, I did so with feelings of trepidation,” he wrote later. “I was not an economist; I had really never studied monetary affairs. My experience with fiscal issues was limited largely to a familiarity with Congress in the matter of appropriation of funds.”
Nixon did not care about economics, just politics, and judging by the reaction of a leading Democrat, the president had hit the bull’s-eye: “It’s an outrageous appointment. The Republicans are in trouble over the economy and they want to palm off the blame on a Democratic Secretary of the Treasury.”32 The Washington Post viewed Connally’s appointment from a somewhat broader perspective. “The nomination of Texas Democrat Connally to the Nixon Republican Cabinet was a bold maneuver with great potential ramifications. In some respects it can be considered the opening shot of the 1972 Nixon campaign.”33 An unnamed Democratic strategist was more specific: “There goes Texas.”34 Paul Volcker narrowed the focus even more: “There goes my job.”35
Paul confessed to Barbara over dinner after Connally’s news conference, “This comes at the wrong time for me. We are headed for a major crisis and I won’t be here.”
“Don’t you want to work for this guy? He seems smart, confident, he’s good-looking, and he’s a Democrat—even if he is a Texas Democrat.”
“I’ll have to resign. I am sure he’ll want to bring in his own people.”
Barbara raised her eyebrows. “Don’t be so insecure. I think he needs your technical expertise more than your letter of resignation.”
“Perhaps, but I’ll prepare one anyway, just in case.”
Volcker wanted to remain at the Treasury, where he could accomplish two objectives: advance his career and help rescue the country from danger. He had liked working for David Kennedy, a wise and decent man, but Nixon had not respected the former banker. John Connally, on the other hand, was a force to be reckoned with. Herbert Stein, a member of Nixon’s Council of Economic Advisers, described Connally as “tall, handsome, forceful, colorful, charming … and political to his eyeballs.”36 According to William Safire, Nixon had fallen “in love.”37
Volcker thought that Connally could vanquish the forces of evil at the CEA, where proposals for floating exchange rates ruled.38 He had been concerned ever since George Shultz, a strong proponent of floating rates courtesy of Milton Friedman, was appointed director of the Office of Management and Budget (OMB). Shultz and Paul McCracken at the CEA were powerful allies. Volcker recalled a letter he had received from Shultz, when Shultz was secretary of labor. The message still rankled: “Dear Paul, I noticed with great interest the reports of your remarks about flexible exchange rates … I heartily support your view and congratulate you on the effort you are making.”39
Volcker did not like receiving a congratulatory pat on the head from Shultz, as though he were a schoolboy who had finally learned his lesson. Besides, Shultz had misinterpreted Volcker’s proposal for wider bands within the Bretton Woods System of fixed exchange rates—a very different approach from the freely floating rates Shultz and Friedman wanted. Greater flexibility within the Bretton Woods framework would still require a commitment to domestic discipline, Volcker’s favorite remedy for balance-of-payments deficits. Supporters of floating rates preached benign neglect—the price system would take care of everything. Paul thought that “benign neglect would work about as well eliminating the dollar problem as it did in solving racial discrimination.”40
Volcker had so far ignored Shultz, thinking the labor secretary should busy himself with wage settlements of the Teamsters or the United Auto Workers, rather than with movements of the French franc or the German mark. But once Shultz had moved to OMB, monitoring the federal budget for the president, he could not be ignored.
Connally waved away Volcker’s resignation letter when he arrived at the Treasury in February 1971, saying, “What I really want is your loyalty.”41
Volcker, a company man by temperament, said, “I know how to do that. Is there anything specific?”
“I’ll need to spruce up my background … some late-night reading material to bring me up to speed.”
Volcker spent the next month preparing a sixty-page, triple-spaced draft entitled “Contingency Planning: Options for the International Monetary Problem.”42 He then walked the thick memorandum into Connally’s office. “It’s not exactly bedtime reading, but it suggests that reasonably foreseeable events—possibly in a matter of weeks—could set off strong speculation against the dollar, and it lays out the policy options at our disposal.”43
Connally’s eyes widened as he listened to Volcker. The treasury secretary took the memo and carefully placed it in his briefcase, as though he were a college freshman securing the answers to a big exam. The document would become Connally’s game plan.
The memo cited a combined assault by the usual dollar-bashing suspects—a persistent deficit in the balance of payments, short-term capital outflows, and rising concern over price stability. The clear and present danger stemmed from a “massive increase in foreign official dollar holdings to approximately $24 billion … [and a decline in] our reserve assets … to $14 billion.”44 America’s gold stock, amounting to $11 billion of the $14 billion of reserves, was at risk.
Volcker knew that a tighter monetary policy and higher domestic interest rates could provide a double-barreled solution—by attracting foreign capital and by controlling inflation. But he also knew that this would never pass muster with his new boss, who had slipped into contention for the vice-presidential slot on the Republican ticket in 1972. Connally may not have known much about economics, but he knew enough to recognize the liability of high interest rates in the upcoming election. Even a war hero like Charles de Gaulle did not survive tight money and a tough-love approach to defending his country’s financial honor.
Volcker’s memo proposed a massive 15 percent currency realignment to discourage foreign imports and to make U.S. products more competitive.45 An upward valuation of the German mark and the Japanese yen would discourage Americans from buying the cute Volkswagen Beetle or the sexy Datsun 240z, in favor of a Ford Falcon or Chevrolet Corvette.46 Currency realignment would be popular in Detroit but would cause armed insurrection in Bonn and Tokyo, where the relatively cheap mark and yen were good for business.47 Germany and Japan would need encouragement to revalue their currencies.
Volcker knew exactly how to create a cooperative international spirit. Instead of reacting defensively to a crisis, he preferred an aggressive strategy, the equivalent of an all-in bet in a game of Texas Hold-’em. He proposed a “cold blooded suspension” of gold convertibility, “justified not by a run … but by a conviction that the situation is increasingly untenable … [and] to force change by taking the initiative … to set forth a more or less full blown reform plan … [including] some lasting realignment in exchange rates.”48 The reward would be a restoration of convertibility—in some fashion—once a new, workable system was in place. The risk was that suspension would roil the marketplace—causing a
calamitous collapse in the stock market and a shutdown of foreign exchange—before reaching the Promised Land.
Volcker also proposed an unusual form of shock treatment to the U.S. economy as a way to deflect international criticism of the suspension. Foreigners would have good reason to resent America’s dictatorial decree—their complaint would simply mimic the uproar among American citizens after Franklin Delano Roosevelt’s 1933 domestic gold suspension (and he had just been elected president of the United States in a landslide). To convince foreign governments that we were serious about controlling inflation, the root cause of the balance-of-payments deficit, Volcker suggested “a temporary wage-price freeze … [in] the form of a Presidential request that labor work under existing contracts … for a short period of time—say 90 days.”49
Volcker viewed a freeze pragmatically, as a way to dampen inflationary expectations during a transition period.50 He gained confidence in this judgment from his mentor Robert Roosa, who had suggested more than a year earlier that “The initial shock effect of such a Presidential request might tranquilize inflationary expectations.”51 But Volcker ignored the likely resurgence in expectations after removing the temporary freeze, unless the government embarked on a fundamental shift in monetary and fiscal policy—an error in judgment he still regrets.
Volcker suspected that Connally’s experience as governor of the Lone Star State prepared him for a gunslinger’s gamble. His memorandum emphasized that the “risks are very high,” but added, “they are [high] with any other course suggested.”52 He urged “a prompt decision,” despite having learned the high art of procrastination from his father. He had waited long enough, nearly two years since he had first broached gold suspension in the Oval Office. And he wanted America to act preemptively, to avoid the appearance of defeat at the hands of currency speculators.
It was almost too late.
The drama began during the first week of May 1971, six weeks after Volcker’s memorandum predicted an imminent dollar crisis, and lasted more than three months, until August 15, 1971, when Richard Nixon stunned the world in a televised Sunday-night address. The president would turn Volcker’s proposals into law.
According to a front-page article in the New York Times on May 5, 1971, “Europe’s financial centers were buffeted … by the greatest wave of currency speculation in two years. Corporations, banks and others who control large sums of money exchanged unwanted dollars for West German marks … and other ‘strong’ European currencies … The German central bank had to intervene in the foreign exchange market, propping up the dollar to prevent it from skidding below its lower limits. The Bundesbank accomplished this by adding more than $1-billion to its already swollen dollar coffers.”53
Speculators are often painted in ruthless colors, ready to exploit turmoil and confusion for personal gain. In reality, most resemble Harvard-educated George Sheinberg, who was the thirty-six-year-old treasurer of the Bulova Watch Company in May 1971. Sheinberg had begun worrying about the dollar two weeks earlier, because “one of the currency newsletters said there was nothing to worry about.”54
Bulova followed the practice of borrowing marks from German banks to finance its German clock manufacturing and purchasing. The more nervous Sheinberg got about the dollar, and about repaying the marks the company owed, the earlier he left his home in suburban White Plains, New York, and headed into his Manhattan office. During the first week of May, he began arriving at seven o’clock in the morning to contact foreign-exchange dealers in London, where he bought marks with dollars “to protect us on the purchase of clocks.” Unfortunately for Bulova, he did not buy enough before the Bundesbank got tired of propping up the value of the dollar.55
On the morning of May 5 the German central bank decided, after an hour of buying $1 billion, on top of the billion it bought the day before, that it could no longer continue its currency operations.56 The central banks of Switzerland, Belgium, Netherlands, and Austria followed immediately. The news that each country also “closed down their foreign exchange markets in one of the gravest monetary disturbances since World War II” created special difficulties for American tourists.57 U.S. guests could not pay their bills at the Intercontinental Hotel in Geneva because it refused to accept dollars—a galling indignity considering that the Intercontinental was American owned.58
Telexes describing the escalating crisis streamed across Volcker’s desk in his second-floor office at the Treasury, and the anxiety sent him scurrying with alarming frequency to the private men’s room located in his office. Volcker tried to exercise restraint: “My favorite lawyer, Mike Bradfield, worked in the office directly below mine, on the first floor of the Treasury Building. He had told me on numerous occasions that he could always tell when a crisis had reached the critical stage by the cascade of flushing he heard. The more I thought about that, of course, the more frequently I visited the john.”59
Volcker’s anxiety subsided after he recognized that the crisis provided cover for a policy change America needed. He urged Connally to permit the upheaval “to develop without action or strong intervention by the U.S. … [and to use] as negotiating leverage … suspension of gold convertibility … to achieve a significant revaluation of the currencies of the major European countries and Japan”60
The loss of $400 million in gold during the second week of May—to Belgium, Netherlands, and (of course) France—had brought U.S. gold stocks to the lowest level since the years before World War II, and made the suspension of convertibility even more urgent.61 The burgeoning crisis would legitimize the “cold blooded suspension” Volcker had proposed two months earlier, deflecting the resentments and justifying an otherwise unpalatable economic decision.
John Connally prepared for a public performance as though he had studied drama at the Actors Studio, and Volcker took notes: “At the annual meeting of the International Monetary Conference in Munich [at the end of May 1971], which brought together the leading commercial and central bankers, … [Connally] sat through all the meetings and the elaborate lunches and dinners, quietly sizing up his audience and their thinking before delivering the traditional closing address.”62
Connally showed Volcker that preparation includes more than just knowing what to say; how to say it is equally important. Unlike other finance ministers, Connally took his own measure of the assemblage, and planned his words and cadence accordingly. “He taught me a lot,” says Volcker.63
Paul had, in fact, drafted his boss’s remarks, but when Connally showed him the final version, it had a very different ending than the ambiguous conclusion Volcker had written. “It was pure Connally in tone,” says Paul, “and I could never do it, no matter how much I practiced.”64 Connally planned to end his speech with dramatic flair: “I want without any arrogance or defiance to make abundantly clear that we are not going to devalue, we are not going to change the price of gold, [and] we are going to control inflation.”65
Volcker swallowed his disbelief and asked Connally if he wanted to say that so strongly. “After all, we might have to end up devaluing before too long.”
Connally did not hesitate. “That’s my unalterable position today. I don’t know what it will be this summer.”
The response stunned Volcker into silence.
Paul admired John Connally’s social skills and had learned much from the master politician. He had stopped wearing socks that slid down below his ankles and switched to a dry cleaner who impressed a sharp crease in his trousers. But there were limitations. Volcker could never wear blinders like a carriage horse—they simply did not fit around his large head. He preferred to equivocate, qualify, and risk being branded a poor communicator, rather than feign certainty. His reluctance to skate near the boundary may have prevented him from ever becoming treasury secretary, but it would eventually turn him into the most trusted man in America.
Although Connally ignored Volcker’s suggestion that he scale back his rhetoric, he clung to Volcker’s battle plan. Not only did Connally allow the cri
sis to proceed unchecked, but he attacked those in the White House who questioned the strategy.
Paul McCracken, the soft-spoken former University of Michigan economist who headed Nixon’s Council of Economic Advisers, lamented the dollar crisis in an early June memo to the president: “We have just muddled through another international monetary crisis … [but] we cannot be sure of having escaped entirely or permanently.”66
Connally’s response to Nixon sent a direct shot at McCracken. “Given our present international economic and financial position, some monetary disturbances … are virtually inevitable … [But] I must take vigorous personal exception to [McCracken’s] premises and conclusions … Far from ‘muddling through’ the recent disturbance … [we] quite deliberately avoided a strong reaction.”67
McCracken’s memo to the president also included an argument for floating exchange rates. “A system that combines rigidly fixed exchange rates with free trade and capital movements appears to be unworkable … You recognized this two years ago … when you decided that the U.S. would … support a study of greater [exchange rate] flexibility … but it has not so far led to concrete results because … the attitude of some our own representatives has been lukewarm at best.”
Connally recognized Volcker’s image painted in lukewarm strokes, so he concluded his rebuttal with the following observation: “In view of recent developments it is hard for me to see how informed observers could think the flexibility issue is dead. But its specifics do involve difficult tactical as well as substantive questions … [which] are under active review within the Treasury and in the Volcker group.”