Harry Houdini could not have conjured a more magical six months than the second half of 1969. Neil Armstrong stepped onto the surface of the moon on July 20. The New York Mets overcame one-hundred-to-one odds to win the World Series on October 16. And the free-market price of gold collapsed to $34.90 on December 9.1
Volcker considered the Mets victory the most unlikely of these events. The team had come into existence in 1962 and had finished last or next to last in the National League every year until then. The dislocation in the gold market ran a close second to the Mets—the price declined to the lowest level since the advent of two-tier trading, a shade below the mystical thirty-five dollars per ounce, after reaching an all-time high earlier in the year. The moon landing was exciting, of course, but it was more predictable. America had made steady progress in space exploration since JFK’s challenge to the nation in May 1961 to put a man on the moon by the end of the decade.
The drop in the outlook for gold corresponded with improvement in the U.S. dollar during the second half of 1969. Volcker’s personal life took a turn for the better as well, after Barbara joined him in their rambling colonial house in Chevy Chase, Maryland, in July. He was happy that she was with him. They went to a dinner party at the home of Cynthia and Bill Martin, the one Cynthia had rescheduled until Barbara could attend. Volcker recalled the time President Lyndon Johnson browbeat Martin over interest rates, and recognized the changed posture in the Federal Reserve chairman since then.
In September 1965, when Volcker was deputy undersecretary, he attended a meeting with his boss at the time, Treasury Secretary Henry “Joe” Fowler, Martin, and President Johnson.2 Fowler began by saying, “Chairman Martin wants to raise the discount rate.” Johnson interrupted and said, “You mean he wants to extract more blood from the American people.” Martin ignored the bait and said, “I think it’s necessary at this point in the battle for price stability.”
Johnson knew that an increase in the discount rate—the rate the Federal Reserve charges for loans to commercial banks—would be announced like a financial funeral on the evening news, and would raise borrowing costs as it rippled though the banking system. LBJ tried to make Martin back down and finally said, “Bill, I’m going into the hospital tomorrow to have my gallbladder removed. You wouldn’t do this while I’m in the hospital, would you?” Martin sighed and said, “No, Mr. President, we’ll wait until you get out of the hospital.”
Volcker had argued with Fowler privately in favor of Martin’s position, but to no avail. His support for the Fed chairman cost Volcker more than he knew. After the battle over the discount rate, Johnson asked Fowler whether he had considered a replacement for Martin as chairman of the central bank. Fowler said that he considered Paul Volcker, but “we want a sure vote, not a reasonable fellow who will try to steer us down the right path.”3
The confrontation between Martin and the president had surprised Volcker. Paul knew that Martin had taken a principled stand supporting Federal Reserve independence from the U.S. Treasury while he was an assistant secretary in the Truman administration.4 And here was Martin, Volcker’s personal hero, checking with the president of the United States about raising interest rates, which he eventually did over LBJ’s objection, but it was a decision clearly within the central bank’s mandate. Volcker would remember this lesson in political economy. The Federal Reserve may be independent, but so is the president, and he is elected by the American people. Better to have the commander in chief on your side.
By 1969 inflation had jumped to over 5 percent, tame by later standards but a worrisome number at the time. The Martin-led Federal Reserve Board tightened credit during the first half of the year, raising the discount rate to reduce bank lending and curtail excess spending. Martin had regretted easing monetary policy earlier, and was determined not to ease prematurely again: “The horse of inflation is out of the barn and already well down the road … [now we have to] prevent it from trotting too fast.”5 He kept a tight rein until his term of office expired in January 1970.6
Monetary restraint and high interest rates, designed to control inflation, also enhanced prospects for the American dollar. Corporate treasurers could earn 8 percent on risk-free U.S. Treasury bills by the end of December 1969, compared with less than 6 percent earlier in the year, so they kept their money at home rather than sending it abroad.7 Gold speculators abandoned the precious metal in favor of interest-bearing securities. A London bullion dealer noted, “The question is not who’s selling but who’s buying. The answer to that is no one.”8 And a Zurich banker added, “There is the growing realization that there will be no increase in the official price [of gold] in the near future.” With gold down to thirty-five dollars an ounce in December, speculators felt as though they had lost their pants as well as their shirts (very worrisome as winter approached). The decline of nine dollars on gold purchased at the peak of forty-four dollars a few months earlier meant a 20 percent loss.9
According to the New York Times, gold’s tarnished reputation vindicated the “United States policy in establishing … a two-tier system for gold in March 1968” and also benefited Treasury Secretary David Kennedy. “The crowning defeat for gold speculators and victory for the pre-eminence of the United States dollar … is providing a favorable atmosphere for the first European tour of David M. Kennedy as United States Treasury Secretary.”10
Volcker liked and respected David Kennedy. “[He] was the epitome of honesty and openness … [and] once he had settled on me as his choice as Under Secretary for Monetary Affairs he insisted on it over political opposition. I was, after all, a Democrat … in an administration suspicious that it had inherited far too many civil servants sympathetic to the opposition.”11 Volcker should have welcomed the favorable comments in the press. Instead, they made him nervous, like when a teammate says, “Only six more outs and we’ve got ourselves a no-hitter”—the proverbial recipe for disaster.
Volcker suspected that the dollar’s revival might be short-lived and that the “favorable atmosphere” greeting Kennedy could easily become turbulent. He testified before the congressional Joint Economic Committee that “the United States’ [balance of] payments position and domestic inflation were fundamentally more important than any other issue.”12 They were certainly more important than the short-term investments flowing into America that had buoyed the dollar and trashed gold. Capital flooded ashore when U.S. interest rates rose, but ebbed just as quickly when rates declined. And when the tide turned, foreign central banks would drown in dollars, and the free-market price of gold would sound the warning like a foghorn.
Volcker’s fears were well founded.
The White House staff celebrated on two counts when Nixon nominated Arthur Burns to replace William McChesney Martin as chairman of the Federal Reserve Board effective February 1, 1970. Burns would take up residence at the central bank, where he could implement policies favorable to the president. And Burns, the imperious professor, would vacate his position as counselor to the president, where he was resented for his special relationship with Nixon.
William Safire, a Nixon speechwriter, noted that Arthur Burns took liberties that no one else would. In one particular incident, Burns had been in the Oval Office making a typically long and slow presentation on a welfare reform.13 “As I said in my July 8 memorandum, Mr. President—” The president interrupted Burns to speed things along: “Yes, Arthur, I read that.” Burns then interjected, “But you couldn’t have, Mr. President. I didn’t send it in yet. I have it with me here.” Nixon did not miss a beat, “Thanks, Arthur, I’ll read it.” According to Safire, the president seemed almost amused, but his staff took umbrage for him.
Soon after becoming Fed chairman in February 1970, Burns began to ease monetary policy to counter rising unemployment, and by November 1970, Treasury bill yields had declined by two percentage points compared with a year earlier. Corporate treasurers registered their disapproval by shifting investments abroad. According to a Volcker Group memorandum, “Our overall payments position is running in very heavy deficit despite some welcome improvement in our trade and current account. This deficit reflects sharply adverse capital movements, partly reflecting easier money in the U.S.”14 And the price of gold registered its concern, jumping more than 10 percent, to over thirty-nine dollars an ounce.15 The euphoria of 1969 had disappeared like a puff of magician’s smoke.
Volcker recognized that fickle capital flows would precipitate the need for drastic action.16 With a crisis all but certain, he dusted off the contingency plans laid out in his Cabinet Room presentation of more than a year earlier, but worried that the president would need congressional approval before launching what Volcker (and many others) considered the nuclear option. Volcker knew that only Congress could change the price of gold, and he asked Michael Bradfield, an assistant general counsel at Treasury, to determine whether the chief executive had the right to suspend gold convertibility while leaving the price unchanged.
Bradfield’s eight-page memorandum made Volcker smile.17 It confirmed that changing the “par” value of gold required congressional approval, citing the Gold Reserve Act of 1934, which had raised the price of gold from $20.67 to $35.00 per ounce. But that same legislation, the memorandum noted, conferred on the secretary of the treasury the discretion to suspend gold sales.
To anyone but a lawyer, a total suspension of gold sales seems more dramatic than a simple change in price, closer in spirit to a military blockade, the equivalent of a declaration of war, than a commercial adjustment. But the legal perspective was all that mattered, and the law gave the president and his treasury secretary the authority to act without congressional interference. Volcker felt prepared for the looming international crisis.
On November 18, 1970, Richard Nixon confided to his chief of staff, H. R. Haldeman, that he had grown impatient with his economic advisers. According to Haldeman, “They failed in the one prime objective [the president] set, to keep unemployment under five percent in October … and [the president] doesn’t want to take any chance on screwing up 1972.”18
Nixon’s focus on the next election continued the following day, in a meeting with the University of Chicago economist Milton Friedman, who was an unofficial adviser to the president. According to Haldeman, “Friedman urges we stay on the present economic course,” and the president said “it was nice to have someone say we’re doing things right.” Haldeman then reports that Nixon, still concerned about 1972, said we “can’t afford to risk a downturn, no matter how much inflation.”19
Milton Friedman surely did not propose more inflation to achieve lower unemployment. He did not believe in this Keynesian medicine that had been practiced in the Kennedy-Johnson White House, and had warned against it in his presidential address to the American Economic Association.20 But Nixon embraced the Democratic philosophy with the enthusiasm of a convert, encouraged by an unwitting blessing from Friedman.
Milton Friedman had famously said that “We are all Keynesians now,” a stunning admission by the leading opponent of activist government intervention.21 Friedman subsequently qualified his remarks, explaining that he actually meant “In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.”22 To an academic such as Milton Friedman, qualifying remarks are as important as footnotes, but both are ignored by politicians when it serves their purpose.
Nixon described himself as “a Keynesian in economics,” and would soon name a Democrat to his cabinet to confront the emerging problem called stagflation.23 Britain’s chancellor of the exchequer, Iain Macleod, had used the term stagflation to describe a combination of high unemployment and high inflation.24 And according to the New York Times, this British disease now threatened America’s reputation. “Europeans Fear American ‘Stagflation’ Will Drag Their Own Economies Down.”25
Stagflation would spread like a pandemic during the coming decade, but in November 1970 it was unprecedented and puzzling.26 From his perch at the Federal Reserve Board, Arthur Burns complained that “We are dealing … with a new problem, namely, persistent inflation in the face of substantial unemployment—and that the classical remedies may not work well enough.”27
Burns used this perceived violation of economic principles to promote wage and price controls, which he liked to call an “incomes policy” to avoid being labeled a socialist by the libertarians in the White House basement. Nixon agreed to develop “a market-oriented” incomes policy, over the objection of his economic advisers, Paul McCracken of the Council of Economic Advisers and George Shultz, now head of the Office of Management and Budget, in exchange for a promise from Burns to follow an expansionary monetary policy. “I have been assured by Dr. Arthur Burns that the independent Federal Reserve System will provide fully for the increasing monetary needs of the economy. I am confident that this commitment will be kept.”28
No one has confirmed what the press called the “Accord of 1970,” but in retrospect, Nixon’s reference to central bank independence sounds as hollow as his future declaration “I’m not a crook.”29 Arthur Burns would abandon prudent monetary policy during his tenure as Federal Reserve chairman, in part under pressure from the White House, but also because he truly believed that “the rules of economics are not working the way they used to … even a long stretch of high and rising unemployment may not suffice to check the inflationary process.”30 Burns’s printing press would lay the foundation for the Great Inflation of the 1970s.
Nixon signaled his dissatisfaction with the economic status quo by replacing Volcker’s boss, Treasury Secretary David Kennedy, with John Connally. Connally had been secretary of the navy in the Kennedy administration and a former Democratic governor of Texas, and had survived the car ride with JFK on November 22, 1963, suffering serious wounds during the assassination. He worried about his new cabinet position.31 “When I took over as Secretary of the Treasury, I did so with feelings of trepidation,” he wrote later. “I was not an economist; I had really never studied monetary affairs. My experience with fiscal issues was limited largely to a familiarity with Congress in the matter of appropriation of funds.”
Nixon did not care about economics, just politics, and judging by the reaction of a leading Democrat, the president had hit the bull’s-eye: “It’s an outrageous appointment. The Republicans are in trouble over the economy and they want to palm off the blame on a Democratic Secretary of the Treasury.”32 The Washington Post viewed Connally’s appointment from a somewhat broader perspective. “The nomination of Texas Democrat Connally to the Nixon Republican Cabinet was a bold maneuver with great potential ramifications. In some respects it can be considered the opening shot of the 1972 Nixon campaign.”33 An unnamed Democratic strategist was more specific: “There goes Texas.”34 Paul Volcker narrowed the focus even more: “There goes my job.”35
Paul confessed to Barbara over dinner after Connally’s news conference, “This comes at the wrong time for me. We are headed for a major crisis and I won’t be here.”
“Don’t you want to work for this guy? He seems smart, confident, he’s good-looking, and he’s a Democrat—even if he is a Texas Democrat.”
“I’ll have to resign. I am sure he’ll want to bring in his own people.”
Barbara raised her eyebrows. “Don’t be so insecure. I think he needs your technical expertise more than your letter of resignation.”
“Perhaps, but I’ll prepare one anyway, just in case.”
Volcker wanted to remain at the Treasury, where he could accomplish two objectives: advance his career and help rescue the country from danger. He had liked working for David Kennedy, a wise and decent man, but Nixon had not respected the former banker. John Connally, on the other hand, was a force to be reckoned with. Herbert Stein, a member of Nixon’s Council of Economic Advisers, described Connally as “tall, handsome, forceful, colorful, charming … and political to his eyeballs.”36 According to William Safire, Nixon had fallen “in love.”37
Volcker thought that Connally could vanquish the forces of evil at the CEA, where proposals for floating exchange rates ruled.38 He had been concerned ever since George Shultz, a strong proponent of floating rates courtesy of Milton Friedman, was appointed director of the Office of Management and Budget (OMB). Shultz and Paul McCracken at the CEA were powerful allies. Volcker recalled a letter he had received from Shultz, when Shultz was secretary of labor. The message still rankled: “Dear Paul, I noticed with great interest the reports of your remarks about flexible exchange rates … I heartily support your view and congratulate you on the effort you are making.”39
Volcker did not like receiving a congratulatory pat on the head from Shultz, as though he were a schoolboy who had finally learned his lesson. Besides, Shultz had misinterpreted Volcker’s proposal for wider bands within the Bretton Woods System of fixed exchange rates—a very different approach from the freely floating rates Shultz and Friedman wanted. Greater flexibility within the Bretton Woods framework would still require a commitment to domestic discipline, Volcker’s favorite remedy for balance-of-payments deficits. Supporters of floating rates preached benign neglect—the price system would take care of everything. Paul thought that “benign neglect would work about as well eliminating the dollar problem as it did in solving racial discrimination.”40
Volcker had so far ignored Shultz, thinking the labor secretary should busy himself with wage settlements of the Teamsters or the United Auto Workers, rather than with movements of the French franc or the German mark. But once Shultz had moved to OMB, monitoring the federal budget for the president, he could not be ignored.
Connally waved away Volcker’s resignation letter when he arrived at the Treasury in February 1971, saying, “What I really want is your loyalty.”41
Volcker, a company man by temperament, said, “I know how to do that. Is there anything specific?”
“I’ll need to spruce up my background … some late-night reading material to bring me up to speed.”
Volcker spent the next month preparing a sixty-page, triple-spaced draft entitled “Contingency Planning: Options for the International Monetary Problem.”42 He then walked the thick memorandum into Connally’s office. “It’s not exactly bedtime reading, but it suggests that reasonably foreseeable events—possibly in a matter of weeks—could set off strong speculation against the dollar, and it lays out the policy options at our disposal.”43
Connally’s eyes widened as he listened to Volcker. The treasury secretary took the memo and carefully placed it in his briefcase, as though he were a college freshman securing the answers to a big exam. The document would become Connally’s game plan.
The memo cited a combined assault by the usual dollar-bashing suspects—a persistent deficit in the balance of payments, short-term capital outflows, and rising concern over price stability. The clear and present danger stemmed from a “massive increase in foreign official dollar holdings to approximately $24 billion … [and a decline in] our reserve assets … to $14 billion.”44 America’s gold stock, amounting to $11 billion of the $14 billion of reserves, was at risk.
Volcker knew that a tighter monetary policy and higher domestic interest rates could provide a double-barreled solution—by attracting foreign capital and by controlling inflation. But he also knew that this would never pass muster with his new boss, who had slipped into contention for the vice-presidential slot on the Republican ticket in 1972. Connally may not have known much about economics, but he knew enough to recognize the liability of high interest rates in the upcoming election. Even a war hero like Charles de Gaulle did not survive tight money and a tough-love approach to defending his country’s financial honor.
Volcker’s memo proposed a massive 15 percent currency realignment to discourage foreign imports and to make U.S. products more competitive.45 An upward valuation of the German mark and the Japanese yen would discourage Americans from buying the cute Volkswagen Beetle or the sexy Datsun 240z, in favor of a Ford Falcon or Chevrolet Corvette.46 Currency realignment would be popular in Detroit but would cause armed insurrection in Bonn and Tokyo, where the relatively cheap mark and yen were good for business.47 Germany and Japan would need encouragement to revalue their currencies.
Volcker knew exactly how to create a cooperative international spirit. Instead of reacting defensively to a crisis, he preferred an aggressive strategy, the equivalent of an all-in bet in a game of Texas Hold-’em. He proposed a “cold blooded suspension” of gold convertibility, “justified not by a run … but by a conviction that the situation is increasingly untenable … [and] to force change by taking the initiative … to set forth a more or less full blown reform plan … [including] some lasting realignment in exchange rates.”48 The reward would be a restoration of convertibility—in some fashion—once a new, workable system was in place. The risk was that suspension would roil the marketplace—causing a calamitous collapse in the stock market and a shutdown of foreign exchange—before reaching the Promised Land.
Volcker also proposed an unusual form of shock treatment to the U.S. economy as a way to deflect international criticism of the suspension. Foreigners would have good reason to resent America’s dictatorial decree—their complaint would simply mimic the uproar among American citizens after Franklin Delano Roosevelt’s 1933 domestic gold suspension (and he had just been elected president of the United States in a landslide). To convince foreign governments that we were serious about controlling inflation, the root cause of the balance-of-payments deficit, Volcker suggested “a temporary wage-price freeze … [in] the form of a Presidential request that labor work under existing contracts … for a short period of time—say 90 days.”49
Volcker viewed a freeze pragmatically, as a way to dampen inflationary expectations during a transition period.50 He gained confidence in this judgment from his mentor Robert Roosa, who had suggested more than a year earlier that “The initial shock effect of such a Presidential request might tranquilize inflationary expectations.”51 But Volcker ignored the likely resurgence in expectations after removing the temporary freeze, unless the government embarked on a fundamental shift in monetary and fiscal policy—an error in judgment he still regrets.
Volcker suspected that Connally’s experience as governor of the Lone Star State prepared him for a gunslinger’s gamble. His memorandum emphasized that the “risks are very high,” but added, “they are [high] with any other course suggested.”52 He urged “a prompt decision,” despite having learned the high art of procrastination from his father. He had waited long enough, nearly two years since he had first broached gold suspension in the Oval Office. And he wanted America to act preemptively, to avoid the appearance of defeat at the hands of currency speculators.
It was almost too late.
The drama began during the first week of May 1971, six weeks after Volcker’s memorandum predicted an imminent dollar crisis, and lasted more than three months, until August 15, 1971, when Richard Nixon stunned the world in a televised Sunday-night address. The president would turn Volcker’s proposals into law.
According to a front-page article in the New York Times on May 5, 1971, “Europe’s financial centers were buffeted … by the greatest wave of currency speculation in two years. Corporations, banks and others who control large sums of money exchanged unwanted dollars for West German marks … and other ‘strong’ European currencies … The German central bank had to intervene in the foreign exchange market, propping up the dollar to prevent it from skidding below its lower limits. The Bundesbank accomplished this by adding more than $1-billion to its already swollen dollar coffers.”53
Speculators are often painted in ruthless colors, ready to exploit turmoil and confusion for personal gain. In reality, most resemble Harvard-educated George Sheinberg, who was the thirty-six-year-old treasurer of the Bulova Watch Company in May 1971. Sheinberg had begun worrying about the dollar two weeks earlier, because “one of the currency newsletters said there was nothing to worry about.”54
Bulova followed the practice of borrowing marks from German banks to finance its German clock manufacturing and purchasing. The more nervous Sheinberg got about the dollar, and about repaying the marks the company owed, the earlier he left his home in suburban White Plains, New York, and headed into his Manhattan office. During the first week of May, he began arriving at seven o’clock in the morning to contact foreign-exchange dealers in London, where he bought marks with dollars “to protect us on the purchase of clocks.” Unfortunately for Bulova, he did not buy enough before the Bundesbank got tired of propping up the value of the dollar.55
On the morning of May 5 the German central bank decided, after an hour of buying $1 billion, on top of the billion it bought the day before, that it could no longer continue its currency operations.56 The central banks of Switzerland, Belgium, Netherlands, and Austria followed immediately. The news that each country also “closed down their foreign exchange markets in one of the gravest monetary disturbances since World War II” created special difficulties for American tourists.57 U.S. guests could not pay their bills at the Intercontinental Hotel in Geneva because it refused to accept dollars—a galling indignity considering that the Intercontinental was American owned.58
Telexes describing the escalating crisis streamed across Volcker’s desk in his second-floor office at the Treasury, and the anxiety sent him scurrying with alarming frequency to the private men’s room located in his office. Volcker tried to exercise restraint: “My favorite lawyer, Mike Bradfield, worked in the office directly below mine, on the first floor of the Treasury Building. He had told me on numerous occasions that he could always tell when a crisis had reached the critical stage by the cascade of flushing he heard. The more I thought about that, of course, the more frequently I visited the john.”59
Volcker’s anxiety subsided after he recognized that the crisis provided cover for a policy change America needed. He urged Connally to permit the upheaval “to develop without action or strong intervention by the U.S. … [and to use] as negotiating leverage … suspension of gold convertibility … to achieve a significant revaluation of the currencies of the major European countries and Japan”60
The loss of $400 million in gold during the second week of May—to Belgium, Netherlands, and (of course) France—had brought U.S. gold stocks to the lowest level since the years before World War II, and made the suspension of convertibility even more urgent.61 The burgeoning crisis would legitimize the “cold blooded suspension” Volcker had proposed two months earlier, deflecting the resentments and justifying an otherwise unpalatable economic decision.
John Connally prepared for a public performance as though he had studied drama at the Actors Studio, and Volcker took notes: “At the annual meeting of the International Monetary Conference in Munich [at the end of May 1971], which brought together the leading commercial and central bankers, … [Connally] sat through all the meetings and the elaborate lunches and dinners, quietly sizing up his audience and their thinking before delivering the traditional closing address.”62
Connally showed Volcker that preparation includes more than just knowing what to say; how to say it is equally important. Unlike other finance ministers, Connally took his own measure of the assemblage, and planned his words and cadence accordingly. “He taught me a lot,” says Volcker.63
Paul had, in fact, drafted his boss’s remarks, but when Connally showed him the final version, it had a very different ending than the ambiguous conclusion Volcker had written. “It was pure Connally in tone,” says Paul, “and I could never do it, no matter how much I practiced.”64 Connally planned to end his speech with dramatic flair: “I want without any arrogance or defiance to make abundantly clear that we are not going to devalue, we are not going to change the price of gold, [and] we are going to control inflation.”65
Volcker swallowed his disbelief and asked Connally if he wanted to say that so strongly. “After all, we might have to end up devaluing before too long.”
Connally did not hesitate. “That’s my unalterable position today. I don’t know what it will be this summer.”
The response stunned Volcker into silence.
Paul admired John Connally’s social skills and had learned much from the master politician. He had stopped wearing socks that slid down below his ankles and switched to a dry cleaner who impressed a sharp crease in his trousers. But there were limitations. Volcker could never wear blinders like a carriage horse—they simply did not fit around his large head. He preferred to equivocate, qualify, and risk being branded a poor communicator, rather than feign certainty. His reluctance to skate near the boundary may have prevented him from ever becoming treasury secretary, but it would eventually turn him into the most trusted man in America.
Although Connally ignored Volcker’s suggestion that he scale back his rhetoric, he clung to Volcker’s battle plan. Not only did Connally allow the crisis to proceed unchecked, but he attacked those in the White House who questioned the strategy.
Paul McCracken, the soft-spoken former University of Michigan economist who headed Nixon’s Council of Economic Advisers, lamented the dollar crisis in an early June memo to the president: “We have just muddled through another international monetary crisis … [but] we cannot be sure of having escaped entirely or permanently.”66
Connally’s response to Nixon sent a direct shot at McCracken. “Given our present international economic and financial position, some monetary disturbances … are virtually inevitable … [But] I must take vigorous personal exception to [McCracken’s] premises and conclusions … Far from ‘muddling through’ the recent disturbance … [we] quite deliberately avoided a strong reaction.”67
McCracken’s memo to the president also included an argument for floating exchange rates. “A system that combines rigidly fixed exchange rates with free trade and capital movements appears to be unworkable … You recognized this two years ago … when you decided that the U.S. would … support a study of greater [exchange rate] flexibility … but it has not so far led to concrete results because … the attitude of some our own representatives has been lukewarm at best.”
Connally recognized Volcker’s image painted in lukewarm strokes, so he concluded his rebuttal with the following observation: “In view of recent developments it is hard for me to see how informed observers could think the flexibility issue is dead. But its specifics do involve difficult tactical as well as substantive questions … [which] are under active review within the Treasury and in the Volcker group.”
The president weighed the exchange and issued a ruling, like the judge and jury he was. He sealed the fate of events to come by appointing Connally “the lead man” in making a recommendation about dealing with the crisis, with instructions that Connally “consult with Paul McCracken, Arthur Burns, George Shultz … and your own experts.”68
Volcker smiled.
Paul created a briefing book about the size of a New York City telephone directory, detailing all aspects of the New Economic Policy.69 He divided the black loose-leaf binder into two parts. Section A contained an extensive set of bogus plans in case subversives (such as a Washington Post reporter) managed to procure a copy. Section C contained the real plans and was divided into twelve tabs, starting with “Suspension” and extending through “Balance of Payments Controls.” Volcker had purposely omitted a section B, as another confusing diversion should the plans fall into enemy hands.
Connally had supplemented Volcker’s recommendations on gold convertibility and the wage-price freeze with a proposal for a 10 percent import surcharge. Volcker had warned that the surcharge could spark a protectionist war with U.S. trading partners, but Connally insisted—precisely because it would disturb the Germans and Japanese, forcing them to bargain in good faith.
On August 2, 1971, John Connally used the briefing book’s details and his considerable personal charm to convince Richard Nixon to act.70 The 4 percent drop in the dollar against the German mark since the Bundesbank allowed the rate to float in May, and the spike in gold to over forty-two dollars an ounce, had brought matters to a head. But the president wanted to wait until Congress returned after Labor Day before implementing the plan. He had heard about the risks of suspension from Federal Reserve chairman Arthur Burns, and worried that closing the gold window “could cause a panic.”71
Nixon told Connally to bring Paul McCracken and George Shultz up to speed, but to warn them both about leaks. “And that means tell Shultz that he cannot talk with Milton Friedman.”72 Shultz had been relaying to the president Friedman’s arguments for floating exchange rates.
Volcker liked the presidential embargo on discussions with Friedman but worried about the delay. “I did not want us to wind up implementing the package out of desperation.”73 On Thursday morning, August 12, after reports from Frankfurt, London, Tokyo, and Milan that speculation had pushed the German mark to its highest level against the dollar in more than twenty years, forcing massive intervention by all the world’s central banks, Volcker turned desperate.74 He telephoned Connally at his Texas ranch, where the treasury secretary had gone for a brief vacation. The conversation made it briefer:
“I think you’d better get back here quick.”
“Thanks. I’m on my way.”
George Shultz had met with Nixon a number of times on August 12 and, in keeping with his training as a labor negotiator, had counseled patience. The president did not need much convincing to stick with the original timetable.
Nixon said, “We’re not really ready. To get everyone ready we have to go to Camp David. September 7 seems like the right time … The decision should be made by you, Connally, Burns, and me. I know Connally will want to bring Volcker … but he’s so obsessed by things international … I don’t know.”75
Shultz saw an opening to push his agenda. “Volcker also thinks we should solve the international problem by restricting the domestic economy … but I don’t think you want to do that.”
“Never … Unfortunately, I don’t have a hell of a lot of confidence in Volcker.”
Connally went directly from the airport to the White House at 5:30 on the afternoon of August 12, joining the president and George Shultz in the president’s office in the Old Executive Office Building. Nixon was pleased to see him, greeting Connally with a loud “I’m glad you’re here,” but the president seemed determined to avoid being stampeded.76
“I don’t think we should do the whole program right now, especially the freeze and the import surcharge … but if you think shutting the gold window must be done immediately then you can announce it yourself … making it sound like a temporary measure, as a prelude to a complete package.”
Connally had no intention of getting out in front on this and appealed to Nixon’s addiction to grand gestures. “The problem with doing this piecemeal is that people will keep worrying about what is coming next … especially if we just close the gold window. It will seem clear that we were forced into it. Doing the whole package at once means that you have thought this through carefully … You will seize the initiative.”
Nixon circled back to his concerns about the gold window. “Actually, Arthur [Burns] wants just the freeze. He thinks the risks of suspension are too great.”
“Arthur is talking like a central banker. You have the best man in the country down here. Why don’t you talk to Volcker about this yourself.”
Connally had relied on Volcker’s technical expertise and thought the president should as well, but Nixon had other ideas, courtesy of Shultz. “Volcker thinks we ought to sacrifice the domestic economy to save the dollar. I’m not in favor of that.”
Connally sounded surprised to hear this. “Well, I certainly don’t think like that and I’m pretty sure Volcker doesn’t either.”
“Good. That is why we are going to continue with an expansionary policy.”
“I agree … but the public will believe that you are serious about controlling inflation if you announce the freeze.”
George Shultz had been listening to the interchange and began discussing the details needed to implement the wage-price freeze. The president interrupted him, in a clear and authoritative voice:
“What I think we should do, after hearing all of the possibilities, is this … We ought to do the entire program at once, announcing it this coming Monday. We’ll have a meeting at Camp David starting tomorrow afternoon. I’ll have it all set up. But we need total security. The fewer people the better. The three of us will be there, make sure we have McCracken, and of course, Arthur must be involved.” Nixon paused, and then did a graceful pirouette. “And John, you bring Volcker.”
The meeting began on Friday afternoon, August 13, 1971, at the presidential retreat at Camp David in Maryland’s Catoctin Mountains.77 It ended three days later, on Sunday morning, August 15, 1971. The president’s message to the country that evening lasted a total of twenty minutes.78
Those twenty minutes changed Paul Volcker’s life.