Volcker

by William L. Silber

  But that was about to change, with an assist from Volcker.

  In October 1985, Republican senator Philip Gramm, a forty-three-year-old Texan who carried the burden of the deficit on prematurely stooped shoulders, began a crusade to balance the budget in the United States.87 He joined forces with fellow Republican Warren Rudman, from New Hampshire, and Democrat Ernest Hollings of South Carolina, to sponsor legislation requiring a zero deficit by 1991. They linked the bill, known as Gramm-Rudman-Hollings, to legislation lifting the national debt ceiling that would eventually have to pass to prevent a government shutdown.

  No one liked Gramm-Rudman-Hollings—which required mindless across-the-board cuts in most federal programs if Congress fell short of predetermined targets—not even its sponsors. Warren Rudman said it was “a bad idea whose time had come.”88 Deficit reduction had become an antidote to the embarrassment of raising the debt ceiling above $2 trillion, the fire-eating dragon that haunted Proxmire. When the controversial legislation finally passed on December 11, 1985, Congressman Richard Gephardt of Missouri, a future majority leader of the House, voted in favor, but said, “It could be disastrous. But the question is not if this is good policy. The question is can you let this [deficit] madness go on.”89

  Members of Congress worried, but bond traders celebrated, snapping up Treasuries even before the final tally in the House and Senate. Prices on the ten-year bond rose with improved prospects for passing the legislation, forcing down yields by a full percentage point from the day the bill was introduced until it passed.90 The drop in yields continued during the first two months of 1986, as investors discussed how Congress would implement the law, until the ten-year rate fell below 8 percent, a level not seen since early 1978, before Jimmy Carter fell from grace.91

  The decline of more than two percentage points in long-term interest rates during this period surprised everyone, including Volcker. “I was more skeptical than the marketplace, as usual.”92 The drop in the ten-year bond rate occurred without an easier monetary policy and without a drop in inflationary expectations. The overnight interest rate remained about the same during this five-month period and the price of gold rose slightly.93

  Market participants confirmed the power of Gramm-Rudman, as the bill is often called, to lower the level of interest rates. Allen Sinai, chief economist at the brokerage giant Shearson Lehman, said that because of the new budget procedures, “for the first time in this decade financial market participants can look ahead to declining deficits.”94 Lyle Gramley, who had resigned from the Federal Reserve Board earlier in the year and served as chief economist of the Mortgage Bankers Association, said, “I expect to see the bond market move up and down this year, depending on the latest signals from Washington about Gramm-Rudman.”95

  Gramley was only partly correct. Traders continued to buy bonds despite a federal district court ruling that certain provisions of Gramm-Rudman were unconstitutional.96 Robert Dederick of Northern Trust Company explained: “Congress will be moved to reduce deficits because of the fear that, if they don’t do something … voters will say ‘throw the rascals out.’ ”97 And Richard Kelly, president of government securities dealer Aubrey G. Lanston, echoed that sentiment: “The mere passage of such a radical piece of legislation shows that Congress and the President are serious about deficit reduction.”98

  According to the Wall Street Journal, Rudolph Penner, the director of the Congressional Budget Office, offered muted good cheer: “A major implication of the new budgetary outlook is that the danger of a fiscal catastrophe now appears remote.”99 Penner suggested later that Congress passed the Gramm-Rudman legislation knowing it would impose military spending cuts on the president. “Astute Republicans understood this point … [and] many were eager to discipline the President for abandoning them on the Social Security issue.”100

  Credit for the decline in long-term interest rates between October 1985 and March 1986 belongs to Senators Phil Gramm, Warren Rudman, and Ernest Hollings, the field generals who managed the legislative process. But recall that almost two years earlier, Senator John Heinz uncovered the blueprint that guided the process. In February 1984, Heinz had predicted a budget crisis as the “inevitable consequence” of Paul Volcker’s pursuit of tight money.101 The FOMC’s refusal to monetize deficits since then had forced Congress to enact what Senator Daniel Patrick Moynihan of New York called “a suicide pact.”102 Republican senator Slade Gorton said, “Reducing interest rates was one of the designs of Gramm-Rudman.”103

  Phil Gramm left nothing to chance. In a phone call the day after the legislation passed, he reminded Volcker of the Federal Reserve’s role in forcing budget sanity on the country. “With a tight money policy for the government, we can now afford an easier money policy for the private sector.”104

  Volcker responded with “Congratulations on the legislation, but you know I cannot speak for the Board or the FOMC. We’ll have to see how the belt-tightening unfolds.”105

  A boardroom coup changed everything.

  15. The Resignations

  Paul Volcker resigned twice, but only one stuck.

  At 11:45 on Monday morning, February 24, 1986, he called Barbara. “I think you’ll have to make dinner tonight.”1

  “That’s a nice surprise. I didn’t think my cooking was that good.”

  “Well, I’m afraid you’ll be getting practice on a regular basis.”

  “Oh my goodness, I’m sorry to hear that … what happened?”

  “I was just outvoted at a board meeting … I can’t continue.”

  “C’mon, Paul, you don’t do things like that … speak with Baker first.”

  “I will … we’re having lunch.”

  He did not say that Treasury Secretary James Baker might have instigated the insurrection.

  James Baker III, a successful Houston lawyer with a Princeton pedigree, had managed Ronald Reagan’s 1980 presidential campaign and had served as the president’s chief of staff during his first term in office. In January 1985, Baker switched jobs with Donald Regan and became treasury secretary, which led to regular meetings with Volcker.2 The two men were pragmatists rather than ideologues, and Baker’s political skills and courtly Texas exterior had softened the dialogue between the Treasury and the Federal Reserve compared with the Irish edge that had prevailed under Donald Regan. But differences remained.

  Baker’s main initiative had been to negotiate the Plaza Agreement, a coordinated plan among France, Germany, Japan, the United Kingdom, and the United States, to intervene in the foreign exchange markets to depreciate the dollar. The agreement took its name from the Plaza Hotel, a New York City landmark overlooking Central Park, where the final discussions took place on Sunday, September 22, 1985.

  The U.S. currency had soared in value since Volcker became Fed chairman, confirmation of America’s success in taming inflation, but the cause of higher prices on U.S. exports to the rest of the world.3 Baker said a lower dollar would improve the competitive position of American cars and trucks and avoid protectionist measures in Congress. He meant that more automobile production would boost the president’s popularity in places such as Flint, Michigan, and Akron, Ohio, resulting in more Republicans elected to office.

  Volcker had participated in the Plaza negotiations along with the finance ministers and central bankers of the countries involved, but he knew from his years as undersecretary in the Nixon administration that the Treasury claimed priority in managing foreign exchange. Nevertheless, during the press conference at the end of the meeting, James Baker tried to camouflage the U.S. Treasury’s role.

  Volcker recalls, “I was perspiring from the TV lights when Baker grabbed my arms from behind and playfully pushed me in front of him as photographers snapped a group picture. I laughed because it was amusing, but it sent the wrong message, as though this was my idea and he was just following along. He wanted everyone to think we would keep interest rates low to support the depreciation of the dollar. I had never made any such commitment.”4
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  Volcker had conflicted feelings about the Plaza Agreement. He felt that foreign exchange had been too volatile during the previous decade and viewed with favor government actions to stabilize rates. He thought the Plaza Agreement would revive the spirit of Bretton Woods, the fixed exchange rate system he had championed in his early professional life, by anchoring expectations with coordinated government policies. But dollar depreciation haunted Volcker like a childhood nightmare, a legacy of the currency’s freefall during the 1970s. He also thought dollar strength supported the inflow of much-needed foreign capital to the United States. Volcker confided to members of the FOMC soon after the agreement, “The one thing I really worry about is the dollar getting out of hand on the down side.”5 He was right to worry.

  By the beginning of February 1986, less than six months after the Plaza Agreement, the U.S. currency had depreciated by 50 percent more than expected.6 Volcker wanted to cushion the decline in the dollar, but his options were limited. The center of gravity on the Federal Reserve Board was about to shift toward the administration.

  Recall that the seven members of the Federal Reserve Board, each appointed by the president of the United States to a term of fourteen years, form a majority on the Federal Open Market Committee, the main policymaking arm of the central bank.7 Congress, a jealous guardian of its constitutional right to “coin money,” limited the influence of the executive branch on the central bank by staggering the fourteen-year terms so that, absent deaths or resignations, any sitting president could appoint only two new members to the Board. However, a two-term president such as Ronald Reagan could engrave his political imprint on the Fed.

  On February 7, 1986, two weeks before the February 24 revolt, Wayne Angell and Manuel Johnson, President Reagan’s two new appointees, joined the Federal Reserve Board. They replaced the longtime Fed loyalists Lyle Gramley (who had resigned) and Charles Partee (whose term had expired).8 Angell, a Kansas banker and farmer, had been sponsored by Senate majority leader Robert Dole, and Johnson, who had been the assistant secretary of the treasury for economic policy, was suggested by Treasury Secretary James Baker.

  Wayne Angell and Manuel Johnson joined earlier Reagan appointees Preston Martin and Martha Seger to form what the press dubbed the “Gang of Four” on the board, a reference to the group of anti-Mao conspirators in China.9 The New York Times commented that the new alignment “could be considered a threat to control by the Fed’s Chairman, Paul A. Volcker,” and that there “could be a shift of political power in Fed policy-making that could hasten Mr. Volcker’s departure.”10

  The Federal Reserve Board usually meets twice a week to conduct routine business, including whether to approve requests for bank mergers and to consider proposed changes in the discount rate by regional Federal Reserve banks. Although the seven-member board coordinates its decisions with the larger Federal Open Market Committee, which includes five voting presidents of the regional Federal Reserve banks, it has the authority to raise or lower the discount rate on its own.

  On Monday, February 24, 1986, Volcker knew that both the Dallas and San Francisco Federal Reserve banks had petitioned the board to reduce the discount rate by half a percent. The board had rejected numerous such requests in recent months, and Volcker now advocated the same deferral.11 He told the board, “A discount rate cut would push the dollar even lower, unless the drop was coordinated beforehand with the Bundesbank and the Bank of Japan.”12

  Preston Martin thought otherwise. A former California mortgage banker with a salesman’s disposition, Martin had designs on succeeding Volcker as Fed chairman. He found that his proposal to approve the lower rate came easily, knowing that James Baker wanted an easier monetary policy and that the treasury secretary held the keys to the appointment. “The way to get them to cut [their rates] is for us to cut.”

  “There is no urgency,” Volcker said.

  “Let’s take a vote.”

  Volcker could have tabled the discussion to defer the battle, but more than six years of unchallenged leadership lulled him forward. He allowed the vote to proceed, expecting that concern for the dollar would trump partisan politics even on the newly constituted board. Volcker miscalculated. Preston Martin, Martha Seger, Wayne Angell, and Manuel Johnson approved the decline in the discount rate. Henry Wallich and Emmett Rice, Volcker’s longtime associates on the board, joined the chairman in voting against the cut, and Volcker wound up on the losing end of a 4-to-3 decision.

  Martha Seger did a verbal victory lap. “[The Federal Reserve] is not supposed to be a one-person show,” she said, suggesting that the four Reagan appointees could wrest control of the board from Volcker.13

  After the vote, Volcker rose from his place at the head of the table and said, “You can do what you want from now on … but without me.” He left the boardroom and slammed the door leading to his office, just in case anyone thought he might change his mind.

  Volcker recalls, “It was a total breach of board custom for them to force a vote without prior notice … not to mention bad policy. I could not believe they did it.”14

  He should have known, and probably did—deep inside.

  February 24, 1986, was a fight for the heart of the Federal Reserve. A week earlier, Baker had told the Senate Budget Committee he would “not be displeased” if the dollar declined further, encouraging U.S. exports.15 Volcker contradicted Baker a day later at the House Banking and Currency Committee: “Well, I don’t know, I think it’s fallen enough … I certainly don’t think it’s anything we’re interested in forcing.”16 Baker’s policy called for lower U.S. interest rates to weaken the U.S. currency, a policy that only the Federal Reserve could implement. The vote to lower the discount rate signaled a takeover of the Federal Reserve Board by Treasury Secretary James Baker.

  Manny Johnson had told Volcker when he joined the board that he would vote to lower interest rates at his first chance, a pledge to Baker, who had promoted his nomination. This had been Johnson’s earliest opportunity to deliver. Volcker had thought he could sway his remaining colleagues on the board. Instead, the board had rejected Volcker’s leadership and caused an emotional outburst usually reserved for affairs of the heart—which it was for Paul.

  Volcker’s working lunch that afternoon with Baker and Jesus Silva Herzog, the Mexican finance minister since 1982, had been scheduled beforehand. Volcker had brought along a handwritten resignation letter that he had scribbled on a yellow lined pad after his call to Barbara, but he waited until his old friend Chucho left before confronting Baker.17

  “I have a letter of resignation with me,” Volcker began.

  “What are you talking about?”

  “The board outvoted me on the discount rate this morning.”

  “So?”

  “Bill Miller was the last chairman to get outvoted.”

  “Who cares about Bill Miller?”

  “That’s precisely my point.”

  “Don’t be ridiculous, Paul. You can’t resign. Why don’t you wait and see where this goes before doing something we’ll both regret.”

  Volcker recalls,18 “I certainly did not want to leave the board that way. And I didn’t think Baker wanted me to either, even though he probably had sparked the revolt by calling for an easier monetary policy. After lunch, Wayne Angell visited my office and proposed that the board meet again that same afternoon to reconsider the decision. I still do not know for sure whether Baker orchestrated the reconciliation. Manny Johnson would have been his natural messenger, but it would be typical Baker to use Angell as cover. We agreed to table the earlier vote so that I could coordinate with the Germans and the Japanese, and that is what happened … with a few wrinkles.”19

  No announcement occurred on February 24, 1986, but less than two weeks later, on Friday, March 7, 1986, a day after the Bundesbank and the Bank of Japan lowered their lending rates, the Federal Reserve announced a unanimous decision to reduce the discount rate.20 Preston Martin hailed the dramatic development like an impresario unv
eiling his latest act, calling it an “unprecedented” example of international cooperation.21 An unnamed Reagan administration official offered a different version of the victory. “The coordinated reduction in interest rates was a direct outgrowth of the international consultation process set in motion by Treasury secretary James Baker III.”22

  Volcker’s history of leavening monetary policy with a combination of domestic and international ingredients went unnoticed.

  The stillborn rebellion of February 24 remained secret until March 17, 1986, when the syndicated columnists Rowland Evans and Robert Novak dramatized the story with the title “Backstage at the Fed.”23 They added another layer of Machiavellian icing: “[Volcker’s] resignation would have solved a thorny problem for the White House. California Reaganite [Preston] Martin’s term as vice chairman expires on March 31. He is not eager to serve four more years as second banana unless he is likely to become chairman when Volcker’s second four-year term expires in August 1987. Although Martin is a strong possibility, the White House will promise nothing so far in advance. But he might well become chairman should an immediate vacancy occur.”

  The failure of the boardroom coup to create an opening by unseating Volcker led to Preston Martin’s resignation on Friday, March 21, 1986.24 Volcker delivered a fitting eulogy: “Mr. Martin has brought a wide experience and background in public and private life to the nation and to the Federal Reserve. He is a man of strong and independent views as befits the Board. He has played a leadership role in many aspects of the system’s work.”25 Volcker did not add “and I am glad he is gone,” but that is what he meant.

  A poll of leading Americans had named Paul Volcker second to President Reagan as the most influential person in the United States, but the February 24 insurrection had made him wary.26 He no longer trusted the Federal Reserve Board to rise above partisan politics to focus on the public interest.27 The White House tried to soothe the wounds with favorable comments on reappointing Volcker to a third term. Donald Regan, the president’s current chief of staff and Volcker’s least-favorite treasury secretary (although Baker now offered competition), said, “We’ll have to talk to [him] about what he wants to do.”28