The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  After six hours of skilled bureaucratic gamesmanship by Volcker, his committee agreed to the course the chairman wanted to pursue: The Fed would begin targeting not the price of money, as it had previously, but the quantity of money in the banking system. Normally, the Fed would have set a price for money—the interest rate—and the quantity of dollars in the economy would depend on how banks, businesses, and consumers reacted to that price. It’s the equivalent of a restaurant setting the price of a hamburger at $10 and then selling however many hamburgers its customers are willing to buy at that price.

  But now, to address the fact that too many dollars were floating around in the economy, the Fed was taking a different approach. Instead, it would announce the quantity of money it wanted, and adjust interest rates as necessary to get there. It would be the equivalent of a restaurant announcing that it plans to sell one hundred hamburgers, and then tweaking the price to achieve that goal, whether that meant $10 or $8 or $12. In effect, the Fed was pledging to slow down the growth of the money supply, no matter how high it would need to push interest rates to do so. After years of astronomical inflation, getting the money supply down to the bank’s new target wouldn’t be easy. Hamburgers were about to cost a whole lot.

  Volcker’s press aide, Joe Coyne, began calling reporters to notify them that there would be a news conference that evening. Journalists who write about central banking don’t routinely get phone calls on a Saturday afternoon to announce a surprise press conference, and many arrived in their weekend clothes. After Coyne phoned CBS News, the Washington bureau chief called back to say he had only one camera crew working that day—and it was covering the pope’s visit. “I said he would remember the press conference long after the pope had left town,” Coyne later recalled.

  With more than fifty reporters packed into the boardroom, Volcker walked in at 6 p.m., flanked by two aides, each a foot shorter than the chairman. He started by correcting two pieces of misinformation that had been floating around financial markets the week before. “I will tell you that the major purpose of this press conference,” he said, “is to show that I have not resigned, the way early rumor had it yesterday, and I’m still alive, contrary to the latest rumor.”

  Then he got to the heart of the matter: The Fed’s policy committee had decided to start targeting the money supply and had raised the bank lending rate by a full percentage point. The press focused primarily on the latter move, which was more easily understandable. It wasn’t just the seemingly technical nature of the change in the Fed’s policy change that made the reports that day deemphasize it; Volcker actively tried to play down the importance. When asked whether the action would cause an economic downturn, he said, “Well, you get varying opinions about that.” As Yale economist James Tobin put it later, “Burns smoked a pipe. Volcker smoked a cigar. Both produced smokescreens.”

  Volcker would soon become one of the most unpopular people in the country as the Fed raised rates to try to get the money supply in line with its new target. “The Credit Crunch Is On,” blared Newsweek in March 1980, noting that Sears Roebuck was demanding higher payments from its credit customers and that Chase Manhattan Bank had stopped making unsecured personal loans. With interest rates topping 20 percent, few could afford a home mortgage. Construction activity practically came to a halt.

  Homebuilders began mailing two-by-fours to Volcker in protest. (Decades later, he gave one to Ben Bernanke; it still sits on a shelf in the chairman’s office.) Automakers were similarly livid: High interest rates meant that consumers couldn’t afford to buy cars either. Not to be outdone by the construction workers, they mailed Volcker the keys to unsold vehicles. But farmers may have had it worst of all. During the late 1970s, many had taken out loans to buy more land on the assumption that crop prices would keep rising at an extraordinary clip. When food prices fell and interest rates rose, people across Middle America lost their farms. They protested by driving their tractors to Washington and circling the Federal Reserve’s grand marble headquarters.

  Other protests weren’t as peaceful. In 1981, one man who said he was upset about high interest rates plowed past guards at the Fed’s headquarters carrying a sawed-off shotgun, a pistol, a knife, and a fake bomb. He was tackled by a guard just short of the main boardroom, and Volcker was assigned a full-time security detail for the first time.

  The big man went before Congress repeatedly, smoking his cigars and trying to explain the Fed’s strategy as lawmakers channeled the rage of their constituents toward the schlumpy man who’d made it harder for them to borrow and buy. “We’re destroying the American Dream,” said Republican representative George Hansen of Idaho. A building-trades magazine accused Volcker of “premeditated and cold-blooded murder of millions of small businesses.”

  When Volcker concluded that the vicious cycle of high inflation had been broken, in 1982, he finally began cutting interest rates. That year, prices rose only 3.8 percent, the lowest in any twelve-month period in a decade. The cost of getting inflation expectations back down to reasonable levels had been the worst economic downturn since World War II, with millions of Americans out of work.

  But the Volker recession set the stage for great things. Americans would no longer endure the discomfort of ever-rising prices. Businesses could begin investing with greater confidence that those investments would pay off. Lenders could be more comfortable about extending loans, confident that the money they were paid back would be worth something. And the Fed had gained credibility as a fighter of inflation, breaking the cycle in which it had become a self-fulfilling prophecy. Volcker’s achievement even made it easier for Alan Greenspan to maintain low and steady inflation; once people trusted that the Fed would do whatever it took to keep prices from spiraling out of control, it often took only a small interest rate move—or even mere words from the chairman—to rein in rising prices.

  The central bankers, having seen what can happen when they create too little money or too much, had seemed to learn their lessons, and a Goldilocks economy took hold in much of the world, a period of sustained prosperity and low inflation. The Great Inflation had ended, and the Great Moderation had begun.

  SIX

  Spinning the Roulette Wheel in Maastricht

  Behind the thick walls of the Bank of England, the traders were fighting a battle. And they were losing.

  They were buying pounds, with furious speed and on a vast scale. First £300 million, then another £300 million. By 8:40 a.m. that morning of Wednesday, September 16, 1992, they were up to £1 billion. They were trying to prop up the value of their currency on global markets, but no matter how many pounds they bought, the numbers on their screens barely budged. What they didn’t know was that the night before and an ocean away in New York, financier George Soros had given his chief portfolio manager, Stan Druckenmiller, a remarkable order: Sell sterling, as much as you can. And don’t stop.

  Druckenmiller had concluded that the British government was no longer going to be able to hold its currency at the level it had pledged to two years earlier under the European Exchange Rate Mechanism. The idea was that the nations of Europe could boost their economies if their different currencies maintained a steady value relative to the others’. It would be much easier for a company to do business across Europe, for example, if it could be confident that the deutschmark and the franc and the lira wouldn’t constantly fluctuate against each other. When, in one of Margaret Thatcher’s final acts as prime minister, Britain joined the exchange rate mechanism, it committed to keeping the value of a pound sterling at 2.95 deutschmarks, plus or minus 6 percent.

  But Druckenmiller and Soros were convinced that the underlying value of the pound was in fact below that, amid inflation and weak growth in the UK. They were betting that the currency would inevitably fall to levels that more closely matched its fundamentals, and that the government couldn’t afford to keep its value artificially high by entering the market to buy sterling. Finland and It
aly had already dropped out of the exchange rate mechanism under just such pressures, sending their currencies plummeting and making vast sums for anyone who had bet accordingly. Mervyn King, then the Bank of England’s chief economist, had gone to Frankfurt two days earlier, arriving at the Bundesbank amid Wagnerian bursts of thunder and lightning to plead with it for help maintaining the peg, a trip he later called “probably one of the world’s most unsuccessful diplomatic missions.” The endgame was coming for Britain.

  The two investors decided to sell sterling “short”—that is, to sell borrowed pounds, which they would repay later, after the pound dropped. “Go for the jugular,” Soros told Druckenmiller that Tuesday night.

  The Quantum Fund, which they ran, sold pounds to anyone who could buy—the Bank of England when the London markets were open, investors around the world the rest of the time. Soon others started to dump sterling too. The Bank of England could keep buying, but the more it bought, the more British taxpayers stood to lose if the nation eventually did abandon its currency peg.

  That Wednesday, Prime Minister John Major’s government made an emergency decision to hike interest rates a stunning 2 full percentage points, then hiked them by another 3 percentage points on Thursday. It hoped to reverse the sell-off and leave the speculators with egg on their face, even at the risk of devastating British economic growth. But Soros and other global investors showed no hesitation. The selling continued unabated.

  At 7:40 p.m. London time the evening of September 17, Chancellor of the Exchequer Norman Lamont stood before the British Treasury. “Massive speculative flows have continued to disrupt the functioning of the exchange-rate mechanism,” he told the assembled cameras. He had called a meeting of European finance ministers to discuss what to do next. “In the meantime the Government has decided that Britain’s best interests would be best secured by suspending our membership of the ERM with immediate effect.”

  The pound immediately plummeted. George Soros and Stan Druckenmiller had broken the Bank of England, made a billion dollars for themselves and their investors, and become legends in the world of finance. But the exit of Britain, Italy, and Finland from the exchange rate mechanism meant that if the very different nations of Europe were to create a single unified financial system, in which money could flow as freely between nations as it does among U.S. states, it would take something more binding than a mere promise.

  It would take the euro.

  • • •

  In the first century AD, a merchant from Rome could travel to Londinium via Colonia Claudia Ara Agrippinensium and Lutetia Parisorum and use the same denarii to pay for goods at each stop on his way, the German economist Otmar Issing noted. That is, he could travel from Rome to London via Cologne and Paris and use the same currency. The twenty centuries since then, however, have been less kind to those who might benefit from a Europe under a single political and financial authority, the best efforts of Charlemagne and Napoleon notwithstanding.

  In the years after World War II, the leaders of Western Europe looked for a way to leave the strife of the first half of the twentieth century behind by creating a new economic union. Countries that are deeply intertwined economically tend not to go to war with one another, and the United States had become the most powerful nation on earth thanks to having a large, populous area in which people could trade freely with each other. The challenge for the postwar Europeans was to create economic unity in a way that would respect both national identity and democracy. They started with Germany and France, and with steel and coal—the two countries whose conflict had been at the core of the twentieth-century wars, and the two materials most needed to fight one.

  “The solidarity in production thus established will make it plain that any war between France and Germany becomes not merely unthinkable, but materially impossible,” said French foreign minister Robert Schuman in a proclamation on May 9, 1950. “By pooling basic production and by instituting a new High Authority, whose decisions will bind France, Germany and other member countries, this proposal will lead to the realization of the first concrete foundation of a European federation indispensable to the preservation of peace.”

  When the treaty for a steel and coal collective was signed less than a year later, it included not just France and West Germany, but also Italy and the Benelux countries. The “High Authority” would be the European Economic Community, which would eventually become the European Union, which now includes twenty-seven nations and half a billion people. It oversees markets through the Brussels-based, twenty-four-thousand-employee regulatory colossus known as the European Commission. It has expanded its turf a bit since the 1950s and now besides steel and coal oversees the acceptable curvature of bananas and whether prunes can be marketed as a laxative.

  But the economic genius of the United States comes not just from the free flow of goods across borders and standardized regulation of commerce. The nation also benefits from having a single currency in use from Maine to California. By 1970, European leaders were searching for ways to bring the same benefits to their own continent. Their first answer was the “snake in the tunnel” of 1972. The idea was that the value of the franc, the lira, and the rest (the “snake”) would be allowed to fluctuate within a narrow range relative to the U.S. dollar (the “tunnel”). It fell apart in two years. The exchange rate mechanism began in 1979; it lasted rather longer, ending with Soros’s bold bet in 1992.

  What did them in was that each European currency was managed by a different central bank with a different culture and objective. The German Bundesbank was hard-nosed and independent and had the primary goal of keeping inflation low, while the Banca d’Italia was more under the thumb of politicians and set monetary policy more indiscriminately. In the 1980s, inflation averaged 2.9 percent a year in Germany, 7.4 percent in France—and 11.2 percent in Italy.

  The idea of a monetary union had been an explicit goal of the continent’s leaders since 1969, but political realities stood in the way. Higher-inflation countries like Italy, France, and Spain envied the stable prices of Germany and were eager to attach themselves to the credibility of the Bundesbank. Germany, however, was unwilling to turn over partial control of its money supply to people who had a looser view of acceptable levels of inflation. “Not all Germans believe in God, but they all believe in the Bundesbank,” European Commissioner Jacques Delors once said. If there were to be a single currency for Europe, something would have to change the Germans’ political calculus.

  • • •

  At 6 p.m. Berlin time on November 9, 1989, Günter Schabowski, an East German functionary who served as his government’s spokesman, stood before the media in East Berlin. Across central Europe, at the frontiers between the Soviet Bloc and the West, the law preventing border crossings was starting to break down—first in Hungary, then in Czechoslovakia. Just before Schabowski’s press conference, he was handed a document with the latest travel rules between East Berlin and West Berlin, divided since 1961 by a wall that was a fitting symbol of the Cold War.

  Schabowski didn’t have time to read the document carefully, and in the final minutes of an hourlong conference he seemed confused in describing the rules. “Today, as far as I know, a decision has been made,” said Schabowski. “It is a recommendation of the Politburo that has been taken up, that one should from the draft of a travel law take out a passage.” When would this take effect? “Immediately, right away,” said Schabowski. “The question of travel, of the permeability therefore of the wall from our side, does not yet answer, exclusively, the question of the meaning of this, let me say it this way, fortified border.”

  It seemed, as far as anyone could tell, that Schabowski had announced that the Berlin Wall was open. Masses of East Germans, long prevented from entering West Berlin, began gathering around the wall’s checkpoints. The guards on duty didn’t know what to do. The high officials who could have explained that Schabowski had blundered—or ordered the guards t
o use force to disperse the crowds—were stuck in meetings. At 10:30 p.m., the guards at the Bornholmer Street border crossing, having seen the press conference and facing hordes of people chanting, “Open the gate! Open the gate!” did just that. Herr Schabowski had, quite inadvertently, ended the era of a divided Germany.

  In the months that followed, West German leaders seized on the moment to reunite their nation, divided since the waning days of World War II. For France and other European powers, barely four decades removed from the horrors of war with a united Germany, the idea was anathema. French president François Mitterrand, in a series of subtle diplomatic moves in the days and weeks after the Wall fell, made clear that Europe would support a reunified Germany only if Germany supported Europe.

  Germans from Chancellor Helmut Kohl down might not have liked the pressure from the French. But it was also understood as the price still being paid for the horrors of Nazism. It was something that had been clear even before the Holocaust; as German philosopher Karl Jaspers wrote in 1933, his nation’s “destiny today is that Germany can only exist in a united Europe, that the revival in her old glory can come about only through the unification of Europe, that the devil with whom we will inevitably have to make our pact is the egoistic, bourgeois society of the French.”

  European finance ministers and central bankers set to work on arduous negotiations to figure out how the monetary union would work. On December 3, 1991, in one of the many rounds of diplomacy that occurred in Brussels, French finance minister Pierre Bérégovoy and Jean-Claude Trichet, head of the French treasury, met with their German counterparts. They had a message from President Mitterrand. The French demanded that the monetary union they were negotiating be irreversible, that it forever bind their nations, and that it begin on a fixed date before the dawn of the twenty-first century. The French won their demand to have a new European currency by January 1, 1999—but in return they conceded to the Germans that the European central bank would be modeled after the Bundesbank, with the strong safeguards to independence that kept German inflation low.