Volcker
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Volcker had never visited Tiffany or Cartier, but he understood as well as anyone that the Federal Reserve behaved just like De Beers, except that it controlled a different, but no less desirable, scarce resource: the supply of dollars. Commercial banks are legally required to hold dollars as reserves against checking accounts, and individuals need dollars to pay for things they buy. A $100 bill is worth more than the paper it is printed on because the Federal Reserve System restricts the available supply, just as the value of a polished diamond exceeds the industrial use of the stone because De Beers restricts supply. Unlike De Beers, however, the Fed controls supply to promote economic activity rather than to make a profit. The New York Fed’s trading room in Lower Manhattan serves as the system’s control center.
When Volcker became chairman, he had promoted Peter Sternlight to manager of the trading desk at the Federal Reserve Bank of New York, replacing Alan Holmes, who had just retired. Volcker had known Sternlight, a thin man who walked three miles to work each day from his Brooklyn apartment, since they served together on the trading desk in the early 1950s. Sternlight was a technical expert, having remained on the eighth floor of the New York Fed’s headquarters on Liberty Street for most of his career.
Peter Sternlight manipulated the supply of dollars available as currency and reserves by buying and selling securities in the government bond market. These so-called open market operations occur quietly, via telephone contact between Sternlight’s traders and Treasury securities dealers at commercial banks, rather than on the noisy floor of an organized exchange, where trading sometimes resembles a barroom brawl. But these obscure transactions have a profound impact on the FOMC’s target federal funds rate, the overnight interest rate on loans of reserves between banks. When Sternlight sells securities and reduces reserves, for example, commercial banks are caught short of their legal requirement, so they scramble to borrow reserves in the federal funds market. This buying pressure drives up the overnight interest rate.
Peter Sternlight aims his transactions at the federal funds rate specified by the FOMC at the end of each meeting. For example, on September 18 the FOMC wanted a slight increase in the rate, so Sternlight engineered a drop in reserves until he hit the new higher target. He would then add reserves if the rate went up too much and would withdraw reserves if the rate went down, just as Monty Charles adjusted the supply of raw diamonds to keep prices steady.
Volcker recognized that this technical procedure, which had served since the Treasury–Federal Reserve Accord in 1951 to maintain orderly conditions in the money markets, now undermined the Fed’s credibility as guardian of the currency. Controlling the federal funds rate by adding or subtracting reserves meant that the Fed lost control over reserves made available to banks, just as when De Beers varied the amount of diamonds it distributed to keep prices steady.
Monty Charles did not mind the loss of control over his inventory, especially when he was releasing more stones than expected, because that made money for De Beers. But Volcker knew it was a disaster for the Federal Reserve continuously to expand reserves and other monetary aggregates to keep the federal funds rate from rising too quickly. The Fed had done precisely that during much of the 1970s, and the end result had been that banks made more loans and created more deposits than the Federal Reserve had promised. The excessive growth in the monetary aggregates—total bank reserves, the monetary base, and the money supply—had fueled inflation and inflationary expectations, destroying the Fed’s credibility.
Volcker and other members of the FOMC had rejected the monetarist approach of focusing on the monetary aggregates and permitting greater fluctuations in interest rates many times before. The committee devoted much of the meeting on March 29, 1976, while Arthur Burns was still chairman, to considering placing more emphasis on aggregate reserve measures. The FOMC rejected the plan, in part, because of opposition by Burns. Volcker flirted with the proposal but then concluded, “Mr. Chairman, … maybe this will make you feel a little better … I think I can … give you categorical assurance of not a monetarist in the group.”51 Burns, a diplomat in victory, responded, “Well, that fills me with deep regret.”
In 1978, Volcker dismissed the tight link between money and prices articulated by the quantity theory and put forth by monetarists to keep inflation under control. “I believe there are in fact a variety of nonmonetary … factors that can affect the rate of inflation in the short—and not so short-run … My own support of the use of monetary ‘targets’ does not start from a ‘monetarist’ perspective.”52
He based his support for targeting the monetary aggregates, as described in the September 27, 1979, Axilrod-Sternlight memorandum, on the favorable impact on inflationary expectations and central bank credibility, an approach closer to rational expectations than to mainstream monetarism. “The announcement of the so-called [monetary] growth ranges … sets a general framework for expectations about inflation … This role in stabilizing expectations was once the function of the gold standard, the doctrine of the annually balanced budget, and fixed exchange rates. I view the monetary targeting approach as … a new … comprehensible symbol of responsible policy.”53
He wanted to restore the gold standard without gold.
Volcker’s commitment to controlling the aggregates would require a drastic shift for the FOMC: abandoning the “prudent and cautious and gradual” approach to interest rates. He knew that anything less would fail to establish the Fed’s credibility. He thought the crisis that had exploded on September 18, 1979, justified the risk, and he would exploit that event to persuade the FOMC to implement an experiment it had thus far resisted. But a visit with his Board of Governors colleague Henry Wallich to discuss the draft memo gave him pause.
Volcker and Wallich had much in common, including a dislike of inflation, an attachment to cigars, and a shared history at the Federal Reserve Bank of New York, where they were attracted to the same woman. Volcker recalls, “Henry stole our coworker, Mabel Brown, and married her before I could catch my breath. Actually, he didn’t really steal her. It was no contest whatsoever. I was so self-conscious about my looks and height, and she was so pretty, that I never worked up the courage to ask her out. Henry clearly had more confidence.”54
Henry Wallich still had the confidence to defy Volcker, even though Paul was now the chairman of the board. “It’s a pact with the devil,” Wallich said when Volcker dropped by his office to discuss the new procedures.55 Wallich’s hatred of inflation resembled a childhood phobia, but he worried more about losing control of interest rates. “The existing methods have the advantage that we know the interest rate and we don’t run the risk of the rate going in the wrong direction and creating dollar problems.”56
Volcker shared Wallich’s concern about the dollar, but felt that the inflation-fighting credibility of the new operating procedures would win support abroad. He would learn the truth on his way to Belgrade, during a private lecture from his old friend Helmut Schmidt, now the chancellor of West Germany.
9. The Plan
Volcker sounded like James Bond during a telephone conference call with the FOMC on Friday, October 5, 1979. He had already stressed the confidential nature of the final Axilrod-Sternlight memorandum they would be discussing at the emergency meeting in Washington the following day. The increased gyrations in interest rates under the new procedures could mean millions in profits or losses for financiers and bankers throughout the world. Volcker also wanted to avoid leaks about the meeting itself. “I think there is a need to come in here as inconspicuously as possible … [and to stay] at diverse hotels … I imagine you do know that the Pope is coming in [to Washington] which may be good cover … [but] it may not be [enough].”1
A report at the beginning of the conference call by Peter Sternlight would have been amusing under different circumstances.2 “There has been word from our [trading] desk—I think [it] … actually started in the foreign exchange markets—about a rumor that Chairman Volcker has resigned. And this
is having a downward effect on the securities market.”
Volcker clarified his position only half jokingly, having been shadowed by reporters since the crisis began. “The answer is ‘not yet.’ ”
Joseph Coyne, the board’s public information officer, added, “We will be saying ‘absolutely ridiculous.’ ”
Volcker knew that such denials could be counterproductive, and he wanted to avoid fanning the speculative fever that had erupted during the week. He concluded with “I’m asking for a Papal blessing of this meeting … I will see you all in the morning at nine-thirty. Thank you.”
The pontiff must have been listening.
The events of the previous seven days had erased any lingering doubts Volcker had about the need for drastic measures. He had returned the three-page draft memo to Stephen Axilrod and Peter Sternlight on Friday, September 28, with instructions to add numerical details for a special meeting of the FOMC on his return from Europe. That evening, he boarded an air force jet, along with Treasury Secretary William Miller and Charles Schultze, chairman of Jimmy Carter’s Council of Economic Advisers, to attend a meeting of the International Monetary Fund in Belgrade. They had a scheduled stopover the next day in West Germany to meet with Chancellor Helmut Schmidt. Volcker took the opportunity to brief the president’s two top economic aides about his plans. They were not pleased.
Shultze, a traditional Keynesian who had been at the Brookings Institution, the liberal Washington think tank, before joining the administration, complained, “We’re not against raising interest rates, but the monetarist links are unproven and inflexible.”3 Volcker said, “Rest assured that I will not put monetary policy on automatic pilot.” Schultze worried about an exit strategy. “Once you go down this road, it will be difficult to go back.” Volcker emphasized, “Let’s take one step at a time. This is an opportunity we cannot pass up.”
Volcker had checked the foreign exchange market before they boarded the plane and reported that the dollar had fallen to 1.74 marks, capping a 4 percent decline since the September 18 discount rate debacle. The U.S. currency had dropped to its lowest level since the record of 1.72 marks reached prior to the dollar-rescue operation in November 1978.4 Volcker worried about a repeat performance. “That is not an eventuality I would like to see and it’s important that it not happen.”5 Schultze considered the dollar a sideshow, having cut his teeth on domestic problems as director of the Bureau of the Budget (later Office of Management and Budget) in the Kennedy administration. Volcker knew that he would gain reinforcements in Hamburg. The U.S. currency would take center stage under the direction of Helmut Schmidt.
The German chancellor did not disappoint. He hosted a lunch for Volcker, Miller, and Schultze, with Otmar Emminger, head of the German central bank, attending as well. While everyone ate, the chancellor talked.6 “The world needs stability much more than anything else,” he said, repeating a message Volcker had heard from him in February 1973, when the dollar was worth three marks. Now Schmidt had to be content with a more modest objective, one that reflected America’s diminished status. “I would like to get back into a world in which the dollar would be two marks and stable.”
Schmidt’s lecture cheered Volcker but irritated Schultze. “He was at his egotistical worst,” the chairman of the Council of Economic Advisers said.7 Volcker almost concurred: “He was at his egotistical best.”8 A scheduled news conference at the end of the four-hour meeting was canceled, but a joint press release stated, “Both sides agreed [that] … exchange rate stability … and a strong dollar are in the interests of both countries.” A reporter asked Schmidt about the significance of the meeting as he departed in his limousine. The chancellor smiled. “We had a good lunch.”9
A very public lecture by Arthur Burns in Belgrade saddened Volcker as much as Schmidt’s private sermon had pleased him. On Sunday, September 30, as a prelude to the gathering of the world’s central bankers and finance ministers for the IMF meetings, Burns delivered the annual Per Jacobsson lecture entitled “The Anguish of Central Banking.”10 William McChesney Martin introduced Burns with “I am proud to say [he] was my successor at the Federal Reserve,” but that was before Burns’s message.11
Volcker arrived late and had to sit on the floor, cross-legged, with his back to the wall. He flipped through a copy of the talk while listening to the former chairman explain why “central bankers, whose main business … is to control inflation, have been so ineffective in dealing with this worldwide problem.”12 Burns blamed inflation on the “political currents that have been transforming economic life in the United States and elsewhere since the 1930s.”13 In particular, “budget deficits have become a chronic condition of federal finance … [and] when the government runs a budget deficit it pumps more money into the pocketbooks of people than it withdraws … [and] that is the way … inflation … has been raging since the mid-1960s.”14
Volcker recalled how Milton Friedman had told that same story in his Newsweek article “Burns on the Outside,” after Carter replaced Burns as chairman. “We have been having inflation not because evil men at the Fed have been willfully turning the printing press, but because John Q. Public has been demanding inflation [by] … asking Congress to provide us with ever more goodies—yet not to raise our taxes.”15 The root cause of inflation was excessive government spending, according to Friedman and his former professor, plus the political reality that prevented, in Burns’s words, “the Federal Reserve … [from] frustrating the will of Congress to which it was responsible—a Congress that was intent on providing additional services to the electorate.”16
Volcker knew that government deficits made life difficult for the central bank, forcing a Fed chairman into the role of a Marquis de Sade tightening interest rates to painful levels to restrain private spending to make room for Uncle Sam. But blaming the inflation of the 1970s on government deficits ignored the Federal Reserve’s timidity under Burns’s leadership.
Volcker recalled a conversation between Nixon and Burns during the weekend of August 13, 1971, at Camp David that came closer to the truth. Nixon had suggested labeling his proposed tax relief for business an employment tax credit.17 “The businessman will not give a damn what it’s called as long as he gets it.” Burns thought for a moment and said, “I would add in [a] personal tax break.” The president smiled. “You are too softhearted, Arthur, to be a banker.” Burns sighed. “I have not been at it long enough.”
Nixon may have been a crook, but he was a perceptive crook.
The press attending the Belgrade meeting painted Burns’s talk as an “insider’s view of the relations between the Fed and other parts of the Government.”18 The Wall Street Journal concluded that “Arthur Burns … contributed to the uneasy mood here … [His] main conclusion was that given the political and economic forces feeding inflation in the industrial nations ‘it is illusory to expect central banks to put an end’ to the wage price spiral by themselves.”19
The reaction in the marketplace suggested that Burns had irritated the speculators as well as the central bankers. On Monday, October 1, the day after the former Fed chairman’s speech, gold rose to $414.75 an ounce, a jump of 4 percent from the previous close on Friday, September 28.20 The new speculative burst convinced Volcker to cut short his stay in Belgrade and return to Washington to complete work on the Axilrod-Sternlight memorandum. William Miller and Charles Schultze urged him to remain a little longer to avoid the appearance of a panicked departure. The delay did not help.
Volcker’s exit the following day from Belgrade created more confusion than Burns’s apologia. The London gold fixing, normally a fifteen-minute negotiation to find a consensus price to clear the market, took more than two hours on Tuesday, October 2, 1979.21 The price of the yellow metal hit an all-time high of $442 an ounce, up more than 6 percent from the previous day, before settling at $426 at the close of London trading.22
The Wall Street Journal explained: “Gold skyrocketed … and then plummeted … all touched off early in the
European business day when it was learned that Paul Volcker … had left a meeting of the International Monetary Fund … while the session was still under way.”23 Rumors that “South American central banks were dumping their dollar reserves … for gold … and Arab oil producing countries also were giving up the United States currency” fed the gold-buying spree.24 Speculation that Volcker’s departure meant that “a new dollar-defense program would be initiated” triggered the subsequent sales of the precious metal.25
The speculative gyrations convinced Volcker to meet on Thursday, October 4, with members of the Board of Governors in the Special Library, an intimate setting down the marble hallway from the board-room in the Fed’s headquarters. It was the day before the conference call inviting the entire membership of the FOMC to their clandestine gathering, and he wanted to build a consensus beforehand. “I had to avoid a repetition of the September 18 division over the discount rate, when Partee, Teeters, and Rice dissented.”26
The smell of leather-bound books and furniture polish give the Special Library, a wood-paneled room resembling a formal den, a sense of Federal Reserve history. The original board table from the Fed’s early home in the U.S. Treasury dominates the center of the room, and builtin bookshelves filled with Annual Reports since 1914 line the walls. Fixed to the lip of the mahogany tabletop are brass nameplates about two inches wide, each identifying a member of the original Federal Reserve Board.27 It is as though the seats along the sides of the rectangular table are reserved for the ghosts of Adolph Miller, Charles Hamlin, and Paul Warburg. Only the nameplate at the head has disappeared, leaving two well-lacquered tiny holes as a reminder of the vanishing.
The missing nameplate belonged to the secretary of the treasury, the ex officio chairman of the Federal Reserve Board until 1935, who sat at the head of the table whenever he chose to attend meetings.28 Resentment toward the Treasury runs deep within the Federal Reserve bureaucracy, dating back to 1914, when the board became a reluctant tenant on the second floor of the Treasury Building, and continuing through the accord in 1951, when the Treasury finally freed the Fed from its obligation to maintain a ceiling on U.S. interest rates.29 The Special Library celebrates Federal Reserve history by honoring the original board table and by suppressing the treasury secretary’s nameplate. Volcker’s plan to focus on the monetary aggregates and set interest rates free would bury the remnants of the Treasury’s influence.