Volcker was also pursued by his former bosses.14 Henry “Joe” Fowler, the treasury secretary who had told President Lyndon Johnson not to consider replacing the then Fed chairman William McChesney Martin with the independent-minded Volcker, wanted Paul to join him as a partner at Goldman Sachs, the investment banking money-making machine. And Robert Roosa offered a partnership with the old-line Brown Brothers Harriman, including the promise of a coveted private office off the partner’s room like his own.
But Burns knew how to lure Volcker. He waited until after Paul actually left the Treasury in June 1974 before inviting him to his apartment for a friendly dinner.15 Burns could not help lecturing Volcker while puffing on his professorial pipe.16 “I need you with me on the FOMC.”
“I’m flattered, Arthur, but I have to make some money. Barbara has just been diagnosed with rheumatoid arthritis, and Jimmy, well, who knows what he will be able to do in the future.”
“We will pay you more than a living wage. The New York president earns more than twice my salary.”17
“I understand, but—”
“Hayes is making ninety-five thousand and you know how I feel about him. I’ll get them to pay you that to start.”
“Look, Arthur, I’ve been working for the government for more than five years. I’m tired, and it’s time for a change.”
Burns shook his head in dismissal. He had a rectangular face topped with distinguished-looking white hair (almost too much hair for a central banker). He spoke very slowly. “You belong in public service, Paul, nowhere else.”
Volcker delayed his response to Burns for two weeks, until after he had left with friends on a salmon fishing trip in Canada. “My father would have let that kind of decision sit even longer.” He stopped at a gas station with the very last public telephone along the route, according to their guide. He squeezed his frame into the wooden phone booth and called Burns at the Federal Reserve Board, reversing the charges, of course.
“I’ll do it,” he said without preamble.
“Good. I knew you would … Enjoy your vacation.”
In 1974 the Gallup organization, a private company which conducts surveys to track public opinion, reported that Americans considered inflation their biggest concern. Eighty-one percent of those polled cited the high cost of living as the nation’s paramount problem, far exceeding the next-highest category, lack of trust in government, mentioned by 15 percent.18 Watergate had uncovered deception in the White House, forcing the president of the United States to resign, but people still cared more about rising prices cheating their pocketbook.
Some respondents to the Gallup Poll described how inflation had changed their lifestyles. Barbara Reese, a thirty-year-old housewife who had just moved to Charlottesville, Virginia, said that the $3,000 salary increase her husband received the previous fall had been swallowed up by inflation. She began working at a store at night as a way of meeting some local people, but says, “Now it’s a necessity. We need the money for groceries.”19 Susan Ostrander from Chicago, a travel consultant married to an investment banker, said that she had used her salary for personal expenditures, but “now it goes into the checking account, not the savings account.” And Tony Zengel, a New York artist, said, “No matter how fast I paint I just can’t make enough money … I’ve been living without a telephone. It’s very depressing … I can’t afford to be a full-time artist anymore.”
The public’s resentment made sense, considering that consumer prices surged by 12 percent during 1974.20 The unprecedented jump reflected, in part, the earlier quadrupling of oil prices by OPEC, the Organization of the Petroleum Exporting Countries.21 More troublesome was an emerging trend that had bubbled to the surface. The double-digit rate of price increase in 1974 topped off a ten-year period, beginning in 1965, when the average rate of inflation exceeded 5 percent per year. By way of contrast, the annual rate of inflation over the previous ten years had been less than 2 percent.22 What is now called the Great Inflation was well under way.23
The simplest explanation of inflation—too much money chasing too few goods—tells the truth in the long run. Without cash, people cannot spend, and without spending, prices cannot increase. The money supply in the United States grew twice as fast in the decade after 1965 compared with the decade before, corresponding to the jump in inflation.24 And the turning point came when President Johnson signed a bill lifting the gold cover against bank reserves in March 1965, severing the connection between money and gold.25 The responsibility for anchoring the domestic money supply shifted to the discretion of the Federal Reserve System. Thus far the central bank had failed the test.
But there was some hope. Ten years after dropping gold from the monetary police force, Congress made amends by voting to end the forty-year-old ban on investing in the precious metal by U.S. citizens.26 After December 31, 1974, Americans could protect themselves against monetary irresponsibility by buying gold, just like their French cousins. Banks and retail establishments throughout the United States prepared in advance to meet investor demands.
The Sterling National Bank and Trust Company in New York and the First AmTenn Corporation, with bank branches in Tennessee, Alabama, and southern Kentucky, readied gold bars in sizes ranging from one ounce to forty ounces.27 Alexander’s, Inc., a department store with twelve branches, and the Finlay jewelry outlets, in more than one hundred retail stores, prepared to take orders. They promised to deliver bars in “skintight plastic wrappings … so that a gold bar or wafer could not be shaved or tampered with before delivery.”28 The free-market price of gold responded to the anticipated demand by reaching a peak of $197.50 on December 30, 1974, an increase of 75 percent during the year.29
It was the beginning of a speculative roller coaster.
Volcker had been responsible for monitoring the price of gold and managing America’s stock of the precious metal during his tenure as undersecretary of the treasury for monetary affairs from 1969 through 1974. When he took office at the Federal Reserve Bank of New York on August 1, 1975, he became a permanent member of the FOMC, joining the group responsible for managing the supply of credit and the level of interest rates in the United States. The New York Times labeled him a “Monetary Pragmatist,” citing his role as midwife in the birth of floating exchange rates despite his earlier support of Bretton Woods.30 The Times added that Volcker was “philosophically sympathetic with Dr. Burns, which means … that he leans toward tight money policies and high interest rates to retard inflation.”31
Arthur Burns had not yet lost his reputation as an inflation hawk. He had testified before Congress that the Federal Reserve is “determined to follow a course of monetary policy that will permit only moderate growth in money and credit … [which] should make it possible for the fires of inflation to burn themselves out.”32 He also instructed members of the FOMC behind closed doors of the Fed’s boardroom that “No other branch of government … has anything approaching an articulate policy for bringing down the rate of inflation.”33 He maintained that “the Federal Reserve System had the power to abort the inflation … [by restricting] the money supply.”34
And yet Burns is justly criticized for failing to control prices, which increased at 6½ percent per annum during his eight years as Fed chairman, an unprecedented inflation rate for peacetime.35 Ticket prices to major-league baseball games, for example, increased by an average of 50 percent between 1970 and 1978.36 In a 1979 lecture, Burns admitted that under his leadership the central bank had failed “to maintain its restrictive stance … long enough to end inflation.”37 He said that restoring price stability would frustrate “the will of Congress” by creating unacceptable levels of unemployment.38
Volcker wasted little time asserting his independence after occupying the wood-paneled presidential suite on the tenth floor of the Federal Reserve Bank of New York. A sick-looking potted plant stood on the floor near the corner entrance to his office, greeting him each morning like an aging butler. After a few days, he told his secretary, “G
et rid of that thing.”39 A week later it was still there, so he said, “Does that plant have a lifetime retainer?” She said, “Sort of. They had an officers’ meeting and concluded that if they removed yours they would have to take away all of the other plants … They’re still discussing what to do about it.”
Volcker recalls, “That is why I left for Chase in 1957.”
He had more success making his mark in Washington. In November 1975, after just three months on the job, he dissented from Burns’s position at the FOMC, saying that he felt “strongly that the right approach to policy today [is] to hold interest rates fairly steady. The system had [eased substantially] in recent weeks to stimulate growth in monetary aggregates and [I do] not like the idea of encouraging further declines that might have to be reversed in the … near future.”40 Eight months later, in July 1976, he did it again. “I wouldn’t like … the federal funds rate going down to 4.75 percent and I wouldn’t want to see [Burns’s] range specified unless things really went haywire … the market is going to interpret it as a strong signal and I don’t think this is the time for strong signals.”41
Burns said nothing to Volcker on either occasion, having anticipated his behavior. A reporter had written that Burns claimed he would not have supported Volcker’s appointment if he had been “seeking rubber stamps.”42
Volcker had a reputation to uphold, but neither dissent measured up to New York standards. He had proposed somewhat higher interest rates within a narrow target range, almost like Clarence Darrow making a procedural objection in the courtroom. Volcker recalls: “They were modest and restrained attempts at tightening. I just wanted to show Arthur, and perhaps everyone else on the committee, that I would back up my tough talk on inflation with action.”43
There was, in fact, little to dissent about at the time. High interest rates and tight credit in 1974, before Volcker had arrived at the Fed, had triggered a sharp recession. As a result, inflation declined from 12 percent in 1974 to 5 percent in 1976.44 Investors celebrated by punishing the gold speculators for their lack of faith in America. The price of the precious metal dropped from the peak of $197.50 an ounce on December 30, 1974, to $103.05 on August 31, 1976, a decline of nearly 50 percent in less than two years.45
Citibank’s Economic Newsletter attributed the price rout to a “softening of private demand for gold coins and gold bars by individuals for hoarding or investment.”46 Just when Congress had decided to allow American citizens to hold gold, people said, “Thanks, but never mind.” The drop in demand for gold reflected more than just the measured progress on inflation; it meant that inflationary expectations had stabilized as well.47 Homestake Mining Company, listed on the New York Stock Exchange, confirmed the new outlook by suspending its gold mining operation in Western Australia.48
It did not last.
The challenger, Jimmy Carter, beat the incumbent, Gerald Ford, in the presidential election of November 2, 1976, for many reasons, but high unemployment and high inflation head the list.49 The country had gone through a sharp recession the previous year and had almost nothing to show for it, except for WIN buttons—red letters on a white background—commemorating the “Whip Inflation Now” campaign launched by President Ford during 1974, after Richard Nixon had resigned the presidency.
Inflation was 5 percent during the Bicentennial election year, less than half its 1974 level, but almost the same as was considered embarrassing in 1969.50 And the unemployment rate averaged almost 8 percent in 1976, more than in any year since World War II, except for 1975.51 Stagflation—the lethal combination of high unemployment and high inflation—enveloped the American heartland in a giant pincer movement and squeezed the Republicans from office.
The persistence of inflation, despite the unemployment, reflected a change in people’s behavior. Tessie Rogers, a divorced mother of two in Atlanta, said, “I just finished buying a house and the biggest reason I did it was inflation. I was afraid that if I didn’t do it now, tomorrow might be too late.”52 Judy Frank of Des Moines, the wife of a high school teacher, went back to work part-time and used her income to keep the family in extras, “a new carpet and a color television.” Arthur England, chief judge of the Florida Supreme Court, said he had “borrowed to the hilt” on his insurance policies. And Kathy Neuhas, whose husband served on the East Hampton police force, confessed they had borrowed money to take their two girls to an amusement park in New Jersey. “We just felt we had to.” She sounded less certain when adding, “Something’s got to give. The whole bottom’s going to fall out soon and I’m afraid it’ll fall on us.”
An inflationary virus had wormed its way into people’s brains and altered their consciousness.53 The resulting “buy now, pay later” philosophy for people with jobs overwhelmed the spending restraint of the unemployed, resulting in higher prices. Mainstream economists had to rework their thinking to take account of Milton Friedman’s warning that gains in employment would disappear once inflationary expectations caught up with reality. That time had arrived in America.
Volcker understood the power of expectations better than most, having watched traders trying to anticipate future bond prices during his earlier stint on the New York Fed’s trading desk. At his very first FOMC meeting on August 19, 1975, he had warned the optimists seated around the table not to be encouraged by the projections “for reduced inflation emanating from some econometric models.”54 He pointed out that these mathematical-statistical formulations “did not take adequate account of the important factor of expectations.” University of Chicago economist Robert Lucas would win the 1995 Nobel Prize in Economics for promoting the concept of rational expectations and for showing the limitations of econometric models that ignored them.55
The rational expectations model gives more credit to people such as Tessie Rogers and Kathy Neuhas than the standard formulations of the day. Consumers and investors from Atlanta to East Hampton would incorporate all the available information in their inflation forecasts according to Lucas’s view, including whether the Federal Reserve was increasing the money supply at an inflationary rate. They did not simply extrapolate past history, as Keynesian econometricians assumed. Rational expectations undermined the trade-off between unemployment and inflation that had ruled economic policy since the early 1960s, because Tessie Rogers and Kathy Neuhas could not be consistently duped by the Fed. The ultimate logic of rational expectations turned the central bank into an inflation machine, without any redeeming features.56
Volcker never joined the extremists, but he publicly embraced the wisdom of rationality in a speech to the Boston Economic Club in December 1976.
It is no historical accident that the past few years have seen the rise … of so-called rational expectations … in effect arguing that the ultimate inflationary consequences [of economic policy] will be promptly taken into account in today’s actions … Some versions … actually seem to imply that systematic demand policies will be wholly impotent to affect the real economy. I would not go nearly so far, but I do think … that what people think and expect … is a fact of economic life that we cannot escape … The moral is that concern about the inflationary consequences of policy cannot be postponed until the economy approaches its reentry to full employment.57
Volcker had sprinkled numerous handwritten edits throughout his speech but left the moral of rational expectations untouched. The need to consider the inflationary consequences of monetary policy even with unemployed resources was not yet the conventional economic wisdom, but had already claimed Volcker as a fellow traveler.
Keynesian economic models ignored inflationary expectations, but the market for gold bullion did not. Trading in gold futures at New York’s Commodity Exchange, then located in the newly constructed 4 World Trade Center, would surpass all previous records during 1978, and exceed the combined bullion volume in London, Frankfurt, and Zurich.58 On July 28, 1978, the price of gold passed its previous peak of $197.50, and would trade as high as $243.65 later in the year.59 According to Andre Sharon
of the brokerage house Drexel Burnham Lambert, “The pressure seems to be coming from the bottom … Customers are asking their brokers, ‘Why don’t [we] try this thing?’”60
Sales of gold jewelry also skyrocketed. Bill Tendler, a jeweler on MacDougal Street in New York City’s Greenwich Village, reported a dramatic rise in orders. “It seems to be psychological. The more expensive it gets, the more it is a mystique. People say, ‘Yeah, I know it has gone up, but I sure like it.’”61 Andre Sharon offered a test. “If you believe, given the history of the past seven or eight years, that [Americans] will tolerate the pain of disinflation, then the price of gold will go down. If you believe that we will panic at the first sign of pain—a rise in the unemployment rate, say—gold will go up.”62
Volcker suspected that America could not tolerate the pain needed to combat a jump in inflation. “I think this may create a severe dilemma for monetary policy. I myself do not think it’s something that monetary policy can very adequately handle by itself, unaided by new policies elsewhere in the government.”63 He did not specify what those other policies might be, because something else bothered him more.
G. William Miller, President Jimmy Carter’s first appointment to head the central bank, had replaced Arthur Burns as chairman of the Federal Reserve Board in March 1978. Miller had been president of Textron Corporation, an aerospace conglomerate, before becoming Fed chairman. His experience in banking and economics was limited to the largely ceremonial position of serving as a director of the Federal Reserve Bank of Boston. Fed chairmen do not need a doctorate in economics—Burns was the first—but Miller’s lack of experience in finance would hurt his credibility on Wall Street.
A week before the White House disclosed Miller’s appointment, the New York Times listed Paul Volcker, Robert Roosa, and Bruce MacLaury (Volcker’s former deputy at Treasury) as the leading candidates to replace Arthur Burns.64 After the surprise announcement of William Miller, the Times quoted the first reaction of a banker who preferred to remain anonymous: “G. William who?”65
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