Volcker should have worried, but he had grown since the last changing of the guard at Treasury, when John Connally replaced David Kennedy. Serving as the president’s international envoy had boosted his self-confidence. He did not even think about tendering his resignation to Shultz, and the new treasury secretary did not ask for it.
George Shultz and Paul Volcker needed each other. Shultz had a doctorate in economics from MIT but had focused his entire career on the domestic economy and labor negotiations. Moreover, he was the proverbial invisible man to America’s trading partners across the Atlantic, despite his influence with the president. The Washington Post commentator Hobart Rowen said, “The trickiest problem for Shultz may be in the international area. He is almost unknown to the financial men in Europe and Asia and for a while is sure to rely heavily on the irreplaceable technician’s brilliance of Under Secretary Paul A. Volcker.”22
Volcker, of course, needed Shultz to complete what he had started: establishing a firm foundation for international finance. The Smithsonian Agreement was a fragile structure that could be easily wiped out by another financial hurricane. Volcker knew how vulnerable the system was and began to consider compromise.
The gold market wasted no time registering concern after the May 16, 1972, announcement that Shultz would replace Connally. The free-market price in London jumped to an all-time high of $57.50 an ounce on the news.23 A U.K. bullion dealer said, “Speculators are moving into gold in some force,” and a Montreal coin dealer added “Gold coins are just disappearing from the shelves, everybody wants to hold them to see what happens.”24 The speculators did not have to wait long to cash in.
On Thursday, June 22, 1972, Volcker testified before the House Banking and Currency Committee on the future of the international monetary system, offering a surprisingly flexible vision. He said that “the reform must have a wide agenda, including the related issues of trading rules, investment and development … it must be deep and not just a patch-up of Bretton Woods … and there is widespread agreement that the future system of exchange rates must provide for greater flexibility than in the past.”25 Volcker set a generous two-year timetable to complete the process.
He also said, in response to a question triggered by weakness in the pound sterling, “I certainly have no expectation that Britain would devalue the pound.” He pointed out that “Britain still has a surplus in her balance of payments and nations with a surplus are in no position to devalue their currency.”26 Volcker meant that only countries with a balance-of-payments deficit should be allowed to gain a competitive advantage through devaluation.
A day later, Chancellor of the Exchequer Anthony Barber announced that the United Kingdom would allow its currency to float, rather than adhere to the bands agreed to at the Smithsonian. Britain had effectively devalued the pound sterling by refusing to buy the excess supply of pounds in the market.27
“Those SOBs hung me out to dry,” Volcker recalled. “I was embarrassed.”28
Britain’s defection displeased Volcker but bothered almost no one else. When H. R. Haldeman, Nixon’s chief of staff, asked the president if he wanted to see presidential assistant Peter Flanigan’s report on the British devaluation, his immediate response was “I don’t care. Nothing we can do about it.”29 When Haldeman added that Flanigan said the devaluation showed the wisdom of our refusal to resume convertibility, Nixon responded, “Good. I think he’s right. It’s too complicated for me to get into.” Finally, Haldeman tried to stoke Nixon’s interest with a message from Arthur Burns, saying that the Federal Reserve chairman was concerned about follow-up speculation against the Italian lira. Haldeman’s effort clearly backfired when Nixon snapped, “I don’t give a shit about the lira.”
This infamous remark cannot compete with other Nixon gems, but it seems strange coming from the man who hailed the Smithsonian Agreement on currency values “the most significant monetary agreement in the history of the world.” Of course, Nixon had other things on his mind on the morning of June 23, 1972, having just finished a discussion with Haldeman to cover up the break-in at the Democratic headquarters at the Watergate hotel and office complex.30 He had simply lowered his diplomatic guard and said what most Americans would have said.
The British float upended Volcker’s two-year timetable for reform. Six months earlier, in January 1972, he had assigned a review of long-range planning to George Willis, a career civil servant who had just retired but refused to leave. Willis had been at the Treasury longer than anyone could remember, most recently serving as the director of the Office of International Affairs, and then continuing as a consultant. He firmly denied rumors that he had worked on the charter for the Bank of the United States with Alexander Hamilton, but he only smiled when the topic of Bretton Woods came up. Willis had joined Treasury in 1941, the same year that Harry Dexter White, America’s technical expert at the New Hampshire conference, wrote the first draft of the U.S. proposals.31
Volcker asked Willis to survey all the recently proposed reforms and to report back. He received little encouragement from Willis’s memorandum. The problem for reform was to maintain stability by retaining central values for exchange rates, while forcing countries with balance-of-payments surpluses, such as Germany and Japan, to reduce their surpluses while allowing those with deficits, such as the United States, to reduce them. Willis told Volcker, “The United States can expect to encounter resistance from all other countries when it tries to reduce its deficit. No country wants us to do this.”32
Whenever Volcker promoted the wisdom of a specific scheme with Willis, he received the answer “It just won’t work.”33 Sometimes Willis varied the refrain by saying, “That won’t work, either.” After one lengthy exchange, Volcker exhaled, turned his palms upward, as though checking for rain, and said, “Okay, George, what will work?”
Willis thought for a while and said, “Nothin’.” And for emphasis: “Absolutely nothin’ will work.”
Willis was right, of course, but Volcker was not ready to admit defeat.
George Shultz ended the foot-dragging on monetary reform after the British withdrawal from the Smithsonian Agreement. The new treasury secretary planned to make his debut on the world stage at the fall 1972 meetings of the International Monetary Fund and wanted to put forth an American proposal.
Shultz asked Volcker, “Where do we stand on planning?”34
“We’re not that far along,” Volcker replied.
“Well, I’d like to have something for the IMF meetings.”
“Are there any guidelines?”
“Yes, something that has a chance to work. A consensus.”
Shultz’s directive surprised Volcker. “I saw another side of the man I had considered a potential adversary. Now that he was in charge of international monetary reform, his instincts as a labor negotiator took over. He wanted to build a consensus on a practical proposal—an approach that I believed in.”35
Shultz and Volcker shared a commitment to pragmatism, a devotion to implementing a workable solution that advanced a cause. Their relationship benefited from another common bond: Princeton basketball. Shultz had played for the Tigers before graduating in 1942, a few years before Volcker arrived at Nassau Hall. Shultz refuses to confirm or deny that he has a Tiger tattooed on his gluteus maximus.36
Volcker spent the summer of 1972 mixing fixed and floating exchange rate ingredients to get the right proportions. The outcome, designated Plan X (perhaps to preserve some mystery), allowed currencies to bend but not break in response to forces of supply and demand.37 The proposal specified “central values” for exchange rates, resembling the par values of Bretton Woods but renamed to reflect increased bands of fluctuation around those values. The scheme required countries with persistent balance-of-payments surpluses to raise the central values of their currencies, and countries with deficits to lower their central values. Limited convertibility of accumulated reserves into gold would be permitted to promote compliance with the rules. For example, surplus cou
ntries such as Germany and Japan would be allowed to convert dollars into gold if they raised the value of the mark and yen to make their exports less attractive.
Volcker was quite proud of the design and sent it for comments and suggestions to select members of the Volcker Group. Robert Solomon, a senior staffer at the Fed and an expert in international trade, pointed out that it was a great idea—so great, in fact, that John Maynard Keynes had proposed almost the same thing thirty years earlier, while planning for the Bretton Woods conference.38 Volcker did not mind retracing the steps of the great British economist but worried how a monetarist sympathizer such as George Shultz would react to a Keynesian initiative.
On Tuesday, September 26, 1972, George Shultz began his address to a standing-room-only audience at the International Monetary Fund conference with a message straight from the University of Chicago’s free-market playbook. “We can now seek a firm consensus for new monetary arrangements that will serve us all in the decades ahead … Our mutual interest is encouraging freer trade in goods and services and the flow of capital to the places where it can contribute most to economic growth.”39 But when it came to outlining the details, Shultz laid out Volcker’s Plan X, emphasizing that “a workable international agreement will … take as a point of departure that most countries will want to operate within the framework of specified exchange rates.”40
Volcker had thought that Shultz would adopt Milton Friedman’s scheme for freely floating exchange rates. The treasury secretary had reviewed Volcker’s draft with Friedman a few days before his talk.41 Instead, Shultz put his Chicago colleague’s proposal on the back burner, knowing that the finance ministers of the world were not ready for truly radical reform. The treasury secretary was not a monetarist ideologue like his former colleague. He was a consensus builder who had learned that patience paid dividends. Besides, he did not have to wait long to get what he truly wanted.
Willy Brandt, chancellor of West Germany, concerned over renewed speculation against the dollar in favor of the German mark, sent a classified cable to Richard Nixon on Friday, February 9, 1973.42 “If we do not succeed in stabilizing the present situation on exchange markets by joint and rapid action, the future development would lead to dangerous political consequences. The cohesion of the Free World would be endangered economically, psychologically, and finally, also politically, at a moment when … it is of utmost importance to negotiate on the basis of unity of the Western countries.”43
Brandt makes it sound as though controlling foreign exchange ranked alongside nuclear nonproliferation in the survival kit of a democratic world. Perhaps he exaggerated, but the devaluation wars in Europe during the 1930s still haunted politicians. And the German chancellor knew firsthand about international crises, having been the mayor of West Berlin in 1961, when the Soviet Union sanctioned the construction of the wall separating East Berlin from West. Brandt had also hosted JFK’s visit to the divided city on June 26, 1963, when Kennedy gave his “Ich bin ein Berliner” speech, in defiance of the Communist regime. Now he wanted something narrower, more specific, but apparently worthy of his personal attention. “I would appreciate if the American monetary authorities would, in the future, do everything in their power to support the [dollar-mark] exchange rate.”44
Nixon responded to Brandt within a day—after all, this was about the German mark and not the Italian lira—but he sidestepped the technical details and emphasized a broad diplomatic effort he had already initiated. “I appreciate your constructive message on international monetary developments … I had come to the same conclusion as you on the importance of our authorized representatives working together immediately to find solutions. It was for this reason that I dispatched Paul Volcker on his trip to Tokyo and Europe on Wednesday [February 7]. He is fully cognizant of my thinking on these matters.”45
Nixon had been paying attention to foreign exchange, which at the time competed with the Watergate scandal for front-page news.46 Speculators were shifting funds out of dollars and into the mark and the yen because Americans continued to spend too many greenbacks abroad. The president had sent Volcker to Japan after cabling Prime Minister Kakuei Tanaka, “Because the continued Japanese–United States [trade] imbalance is so central to the problem [of disturbances in the currency markets] … I have asked Mr. Paul Volcker, Under secretary of the U.S. Treasury for Monetary Affairs, to fly to Tokyo to relate the reasons for our conclusion that action must be taken immediately in the exchange rate field if we are to remain in command of the situation.”47
Volcker had arrived in Tokyo on Thursday evening, February 8, the first leg of his secret globe-trotting mission to stabilize world finance—again. He went directly to the home of Finance Minister Kiichi Aichi, a venue with less press surveillance than the ministry office, and outlined a U.S. proposal to make American products more competitive. Volcker suggested a 10 percent devaluation of the U.S. dollar against gold and a 10 percent upward valuation of the yen, for a combined 20 percent appreciation of the Japanese yen versus the dollar.
Aichi recoiled at the size of the proposed revaluation, which would exceed the Smithsonian adjustment. “That is a shock.”48
Volcker asked, “Is that a big shock or a little shock?”
“It is a big shock … a Volcker shock … big like Mr. Volcker.”
Paul smiled. “There would be no purpose talking to the Europeans if it were anything less.”
Aichi suggested floating the yen, allowing the exchange rate to move freely with supply and demand without interference from the Bank of Tokyo, but the finance minister could not commit to a formal revaluation until he saw what Germany was prepared to do. “Fixing a new rate would be a highly political decision.”
Volcker had hoped for more but suspected that temporarily floating the yen would lead to a substantial appreciation versus the dollar. Paul thought he had enough leeway to continue his journey, and boarded a military transport taking him to Europe. The plane was a converted Boeing KC-135 tanker, outfitted with full accommodations for the overnight journey.
After Volcker was airborne, he received a final communiqué from Aichi through Roger Ingersoll, the U.S. ambassador to Japan. Ingersoll telephoned Jack Bennett, Volcker’s deputy at the Treasury, with the following message: “The Japanese finance minister asked me to express his concern about the publicity of ‘our travelling friend’s’ visit to Tokyo, and of his strong hope that no word would leak out of his visit, especially since the finance minister was questioned about whether the United States had pressured Japan into closing the foreign exchange market … If there were any publicity the finance minister would say it was a visit by ‘the travelling friend’ to his very old friend, the Japanese finance minister, on his way to Europe.”49
Aichi’s amateur cryptography, like a schoolboy slipping a concealed note to a classmate, amused Volcker. He did not mind the label “travelling friend” as an alias, but doubted it would jump-start a second career as a spy. The New York Times disparaged the weak undercover effort when Volcker arrived in West Germany. “At six feet seven inches and 240 pounds, Paul Adolph Volcker, the Under Secretary of the Treasury for Monetary Affairs, has certain obvious problems as a secret agent in foreign capitals.”50 The Times headline encouraged Volcker not to give up his day job as a monetary diplomat. “Mr. Volcker has come to be thought of as the Henry Kissinger of monetary diplomacy—the intellectual master of arcane international affairs … who often speaks abroad for the United States government … The Nixon Administration confirmed his globe girdling search for means of resolving the new monetary crisis.”51
Volcker made Bonn the first stop of his European tour, to consult with Helmut Schmidt, the German finance minister. Schmidt, who would soon succeed Willy Brandt as chancellor, was staunchly pro-American and spoke flawless English. He surprised Volcker with an opening harangue: “The United States does not understand how much damage the last ten days has done to European-American relations … It seems as though the U.S welcomed the monetary cr
isis … You believe this is a good development.”52
“I can assure you that’s not the case,” Volcker said, realizing that he could not have given that response prior to August 15, 1971. Back then, he had urged John Connally to exploit the foreign exchange crisis to justify suspending gold convertibility. “My trip here is in part a response to Chancellor Brandt’s request to the President. The major problem is Japan, but Europe too—”
Schmidt interrupted, as though he was cross-examining a hostile witness. “How great is your basic deficit with Europe?”
“Four billion dollars with Japan and a half billion with Europe, but Japan has been shuffling out of the dollars it receives from us and they wind up in the Bundesbank. It is a multilateral problem.”
“The problem is a dollar problem … And do not make the mistake of underestimating the political repercussions.”
“I came to Bonn to work things out.”
“We should have sat together a week ago … It is late.”
“The time is ripe for resolving the crisis.”
Finally, Schmidt softened. “Okay, let us do it this weekend.”
Volcker paused before proceeding with a concrete proposal toward floating exchange rates. He suspected that unless they acted now, it would take years of international negotiations to implement. And he had already accepted the compromise. “One possibility would be a common European float against the dollar, and a separate float of the yen versus both—”
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