Arthur Burns exploited Paul Volcker’s fixation with public service to persuade him to accept, as of August 1975, the presidency of the Federal Reserve Bank of New York, the second most important position in America’s central bank. Burns occupied the most powerful slot, chairman of the Board of Governors of the Federal Reserve System, having been reappointed to a second four-year term by Richard Nixon in January 1974.
As Fed chairman, Burns was the final authority on appointments within the system and was its chief spokesperson. The New York Fed is the most important of the twelve regional Federal Reserve banks that serve as branches of the central bank. During the 1920s, Benjamin Strong, president (then called governor) of the Federal Reserve Bank of New York, dominated the system. Even more recently, during the 1950s, the president of the New York bank had challenged the authority of the Washington-based chairman. Volcker occupied a front-row seat in that battle.
To promote an independent central bank, congressional legislation mixed public and private authority in designing the Federal Reserve System, with built-in checks and balances to prevent any one person, including (especially) a sitting president, from gaining undue influence.1 There are seven members of the Board of Governors, who are appointed to fourteen-year terms by the president of the United States, with the advice and consent of the Senate. The fourteen-year terms are staggered so that, absent resignations or deaths, the president gets to appoint only two new members. The president designates the chairman from among these seven members of the board, but the chairman’s term of office does not coincide with the president’s. Although each member of the board has the same vote in all deliberations, the chairman dominates by virtue of his role as the central bank’s representative before Congress, with the president, and at international meetings.
There are twelve regional Federal Reserve banks dispersed geographically throughout the country, including the Federal Reserve Bank of New York, of San Francisco, of Philadelphia, and of Atlanta. These banks are technically owned by commercial banks, such as JPMorgan Chase and Bank of America, but they are supervised closely by the Board of Governors in Washington and amount to little more than branches of the central bank. The president of each Federal Reserve bank is selected from a slate of candidates approved by Washington.
The key policymaking arm of the system is the Federal Open Market Committee, often referred to as the FOMC. All seven members of the Board of Governors serve on the FOMC, along with five of the regional bank presidents, who rotate membership—except for the president of the Federal Reserve Bank of New York, who is a permanent member.
The special status of the New York bank stems from its location and from its role in executing the purchase and sale of securities for the entire system, called open market operations, the Fed’s main weapon of monetary control. The chairman of the Board of Governors is the chairman of the FOMC, and the president of the New York bank is the vice-chairman. Meetings of the FOMC are held eight times a year and end in a formal vote (jacket and tie required) on a directive to chart the course of monetary policy until the next meeting, with concurrences and dissents recorded for posterity.
Volcker wonders to this day why Arthur Burns wanted him at the New York Fed. “I respected Arthur, especially his expertise in business cycle analysis, but we had battled throughout my years at Treasury.”2 Perhaps Burns wanted to neutralize an adversary by making him an in-house critic.3 Volcker knew that antagonism between the board and New York defined earlier relationships. “I watched New York president Allan Sproul challenge the authority of Chairman William McChesney Martin in the early 1950s over who controlled open market operations. I was rooting for Sproul, of course, since I was working in New York.”4
Allan Sproul lost the argument and resigned as president of the Federal Reserve Bank of New York in 1956, but the antagonism continued to tug beneath the surface, like an ocean undertow.5 It erupted in 1970, when Burns became chairman of the Board of Governors. Alfred Hayes, who had replaced Sproul as president of the New York Fed, greeted Burns with a dissent in the formal vote at Burns’s first meeting of the FOMC on February 10, 1970, wanting a tighter monetary policy to fight inflation.6 Philip Coldwell, president of the Federal Reserve Bank of Dallas, also dissented, for the same reason, and recalled, “For the next five meetings Al Hayes and I would be brought into Arthur’s office [for] … a lecture from Arthur on the importance of consensus.”7
The reprimand did not end Hayes’s dissents. The New York Times headlined the ongoing battle in 1972 with “Rift in Federal Reserve: Board Versus the Bank Here,” and compared the confrontation with Sproul’s earlier insurrection.8 Burns had retaliated in many small ways, including questioning the New York bank’s travel budget, and then began a very public search for a successor to Hayes more than a year before Hayes’s scheduled retirement in August 1975.9
Headhunters had been chasing Volcker well before he left the Treasury, with offers that would have guaranteed a lifetime supply of Cuban cigars. A letter from recruiter Russell Reynolds in November 1973 proposed that Volcker consider a position at a leading investment banking firm with compensation in the low seven figures.10 A million-dollar investment banking salary package may sound pedestrian by twenty-first-century standards, but back then, when George Steinbrenner had just bought the New York Yankees for $10 million (yes, the entire team), and the highest-paid major leaguer was Cy Young Award–winner Jim “Catfish” Hunter, earning $750,000 a year, a million dollars was real money.11 “It certainly got my attention,”12 Volcker recalls.
A story in the New York Times heralded the seduction of Paul Volcker, and the proverbial funeral of Alfred Hayes, on the day after the Treasury announced Volcker’s resignation. “A Treasury spokesman said that Mr. Volcker had reached no decision yet on his future plans … [but] there were rumors … that [he] … might be in line for the presidency of the Federal Reserve Bank of New York. Mr. Volcker spent four years at the bank in the nineteen-fifties.”13
Volcker was also pursued by his former bosses.14 Henry “Joe” Fowler, the treasury secretary who had told President Lyndon Johnson not to consider replacing the then Fed chairman William McChesney Martin with the independent-minded Volcker, wanted Paul to join him as a partner at Goldman Sachs, the investment banking money-making machine. And Robert Roosa offered a partnership with the old-line Brown Brothers Harriman, including the promise of a coveted private office off the partner’s room like his own.
But Burns knew how to lure Volcker. He waited until after Paul actually left the Treasury in June 1974 before inviting him to his apartment for a friendly dinner.15 Burns could not help lecturing Volcker while puffing on his professorial pipe.16 “I need you with me on the FOMC.”
“I’m flattered, Arthur, but I have to make some money. Barbara has just been diagnosed with rheumatoid arthritis, and Jimmy, well, who knows what he will be able to do in the future.”
“We will pay you more than a living wage. The New York president earns more than twice my salary.”17
“I understand, but—”
“Hayes is making ninety-five thousand and you know how I feel about him. I’ll get them to pay you that to start.”
“Look, Arthur, I’ve been working for the government for more than five years. I’m tired, and it’s time for a change.”
Burns shook his head in dismissal. He had a rectangular face topped with distinguished-looking white hair (almost too much hair for a central banker). He spoke very slowly. “You belong in public service, Paul, nowhere else.”
Volcker delayed his response to Burns for two weeks, until after he had left with friends on a salmon fishing trip in Canada. “My father would have let that kind of decision sit even longer.” He stopped at a gas station with the very last public telephone along the route, according to their guide. He squeezed his frame into the wooden phone booth and called Burns at the Federal Reserve Board, reversing the charges, of course.
“I’ll do it,” he said without preamble.
“Good. I knew you would … Enjoy your vacation.”
In 1974 the Gallup organization, a private company which conducts surveys to track public opinion, reported that Americans considered inflation their biggest concern. Eighty-one percent of those polled cited the high cost of living as the nation’s paramount problem, far exceeding the next-highest category, lack of trust in government, mentioned by 15 percent.18 Watergate had uncovered deception in the White House, forcing the president of the United States to resign, but people still cared more about rising prices cheating their pocketbook.
Some respondents to the Gallup Poll described how inflation had changed their lifestyles. Barbara Reese, a thirty-year-old housewife who had just moved to Charlottesville, Virginia, said that the $3,000 salary increase her husband received the previous fall had been swallowed up by inflation. She began working at a store at night as a way of meeting some local people, but says, “Now it’s a necessity. We need the money for groceries.”19 Susan Ostrander from Chicago, a travel consultant married to an investment banker, said that she had used her salary for personal expenditures, but “now it goes into the checking account, not the savings account.” And Tony Zengel, a New York artist, said, “No matter how fast I paint I just can’t make enough money … I’ve been living without a telephone. It’s very depressing … I can’t afford to be a full-time artist anymore.”
The public’s resentment made sense, considering that consumer prices surged by 12 percent during 1974.20 The unprecedented jump reflected, in part, the earlier quadrupling of oil prices by OPEC, the Organization of the Petroleum Exporting Countries.21 More troublesome was an emerging trend that had bubbled to the surface. The double-digit rate of price increase in 1974 topped off a ten-year period, beginning in 1965, when the average rate of inflation exceeded 5 percent per year. By way of contrast, the annual rate of inflation over the previous ten years had been less than 2 percent.22 What is now called the Great Inflation was well under way.23
The simplest explanation of inflation—too much money chasing too few goods—tells the truth in the long run. Without cash, people cannot spend, and without spending, prices cannot increase. The money supply in the United States grew twice as fast in the decade after 1965 compared with the decade before, corresponding to the jump in inflation.24 And the turning point came when President Johnson signed a bill lifting the gold cover against bank reserves in March 1965, severing the connection between money and gold.25 The responsibility for anchoring the domestic money supply shifted to the discretion of the Federal Reserve System. Thus far the central bank had failed the test.
But there was some hope. Ten years after dropping gold from the monetary police force, Congress made amends by voting to end the forty-year-old ban on investing in the precious metal by U.S. citizens.26 After December 31, 1974, Americans could protect themselves against monetary irresponsibility by buying gold, just like their French cousins. Banks and retail establishments throughout the United States prepared in advance to meet investor demands.
The Sterling National Bank and Trust Company in New York and the First AmTenn Corporation, with bank branches in Tennessee, Alabama, and southern Kentucky, readied gold bars in sizes ranging from one ounce to forty ounces.27 Alexander’s, Inc., a department store with twelve branches, and the Finlay jewelry outlets, in more than one hundred retail stores, prepared to take orders. They promised to deliver bars in “skintight plastic wrappings … so that a gold bar or wafer could not be shaved or tampered with before delivery.”28 The free-market price of gold responded to the anticipated demand by reaching a peak of $197.50 on December 30, 1974, an increase of 75 percent during the year.29
It was the beginning of a speculative roller coaster.
Volcker had been responsible for monitoring the price of gold and managing America’s stock of the precious metal during his tenure as undersecretary of the treasury for monetary affairs from 1969 through 1974. When he took office at the Federal Reserve Bank of New York on August 1, 1975, he became a permanent member of the FOMC, joining the group responsible for managing the supply of credit and the level of interest rates in the United States. The New York Times labeled him a “Monetary Pragmatist,” citing his role as midwife in the birth of floating exchange rates despite his earlier support of Bretton Woods.30 The Times added that Volcker was “philosophically sympathetic with Dr. Burns, which means … that he leans toward tight money policies and high interest rates to retard inflation.”31
Arthur Burns had not yet lost his reputation as an inflation hawk. He had testified before Congress that the Federal Reserve is “determined to follow a course of monetary policy that will permit only moderate growth in money and credit … [which] should make it possible for the fires of inflation to burn themselves out.”32 He also instructed members of the FOMC behind closed doors of the Fed’s boardroom that “No other branch of government … has anything approaching an articulate policy for bringing down the rate of inflation.”33 He maintained that “the Federal Reserve System had the power to abort the inflation … [by restricting] the money supply.”34
And yet Burns is justly criticized for failing to control prices, which increased at 6½ percent per annum during his eight years as Fed chairman, an unprecedented inflation rate for peacetime.35 Ticket prices to major-league baseball games, for example, increased by an average of 50 percent between 1970 and 1978.36 In a 1979 lecture, Burns admitted that under his leadership the central bank had failed “to maintain its restrictive stance … long enough to end inflation.”37 He said that restoring price stability would frustrate “the will of Congress” by creating unacceptable levels of unemployment.38
Volcker wasted little time asserting his independence after occupying the wood-paneled presidential suite on the tenth floor of the Federal Reserve Bank of New York. A sick-looking potted plant stood on the floor near the corner entrance to his office, greeting him each morning like an aging butler. After a few days, he told his secretary, “Get rid of that thing.”39 A week later it was still there, so he said, “Does that plant have a lifetime retainer?” She said, “Sort of. They had an officers’ meeting and concluded that if they removed yours they would have to take away all of the other plants … They’re still discussing what to do about it.”
Volcker recalls, “That is why I left for Chase in 1957.”
He had more success making his mark in Washington. In November 1975, after just three months on the job, he dissented from Burns’s position at the FOMC, saying that he felt “strongly that the right approach to policy today [is] to hold interest rates fairly steady. The system had [eased substantially] in recent weeks to stimulate growth in monetary aggregates and [I do] not like the idea of encouraging further declines that might have to be reversed in the … near future.”40 Eight months later, in July 1976, he did it again. “I wouldn’t like … the federal funds rate going down to 4.75 percent and I wouldn’t want to see [Burns’s] range specified unless things really went haywire … the market is going to interpret it as a strong signal and I don’t think this is the time for strong signals.”41
Burns said nothing to Volcker on either occasion, having anticipated his behavior. A reporter had written that Burns claimed he would not have supported Volcker’s appointment if he had been “seeking rubber stamps.”42
Volcker had a reputation to uphold, but neither dissent measured up to New York standards. He had proposed somewhat higher interest rates within a narrow target range, almost like Clarence Darrow making a procedural objection in the courtroom. Volcker recalls: “They were modest and restrained attempts at tightening. I just wanted to show Arthur, and perhaps everyone else on the committee, that I would back up my tough talk on inflation with action.”43
There was, in fact, little to dissent about at the time. High interest rates and tight credit in 1974, before Volcker had arrived at the Fed, had triggered a sharp recession. As a result, inflation declined from 12 percent in 1974 to 5 percent in 1976.44 Investors celebrated by punishing the gold speculators for their lack of faith in America. The price of the precious metal dropped from the peak of $197.50 an ounce on December 30, 1974, to $103.05 on August 31, 1976, a decline of nearly 50 percent in less than two years.45
Citibank’s Economic Newsletter attributed the price rout to a “softening of private demand for gold coins and gold bars by individuals for hoarding or investment.”46 Just when Congress had decided to allow American citizens to hold gold, people said, “Thanks, but never mind.” The drop in demand for gold reflected more than just the measured progress on inflation; it meant that inflationary expectations had stabilized as well.47 Homestake Mining Company, listed on the New York Stock Exchange, confirmed the new outlook by suspending its gold mining operation in Western Australia.48
It did not last.
The challenger, Jimmy Carter, beat the incumbent, Gerald Ford, in the presidential election of November 2, 1976, for many reasons, but high unemployment and high inflation head the list.49 The country had gone through a sharp recession the previous year and had almost nothing to show for it, except for WIN buttons—red letters on a white background—commemorating the “Whip Inflation Now” campaign launched by President Ford during 1974, after Richard Nixon had resigned the presidency.
Inflation was 5 percent during the Bicentennial election year, less than half its 1974 level, but almost the same as was considered embarrassing in 1969.50 And the unemployment rate averaged almost 8 percent in 1976, more than in any year since World War II, except for 1975.51 Stagflation—the lethal combination of high unemployment and high inflation—enveloped the American heartland in a giant pincer movement and squeezed the Republicans from office.
The persistence of inflation, despite the unemployment, reflected a change in people’s behavior. Tessie Rogers, a divorced mother of two in Atlanta, said, “I just finished buying a house and the biggest reason I did it was inflation. I was afraid that if I didn’t do it now, tomorrow might be too late.”52 Judy Frank of Des Moines, the wife of a high school teacher, went back to work part-time and used her income to keep the family in extras, “a new carpet and a color television.” Arthur England, chief judge of the Florida Supreme Court, said he had “borrowed to the hilt” on his insurance policies. And Kathy Neuhas, whose husband served on the East Hampton police force, confessed they had borrowed money to take their two girls to an amusement park in New Jersey. “We just felt we had to.” She sounded less certain when adding, “Something’s got to give. The whole bottom’s going to fall out soon and I’m afraid it’ll fall on us.”
An inflationary virus had wormed its way into people’s brains and altered their consciousness.53 The resulting “buy now, pay later” philosophy for people with jobs overwhelmed the spending restraint of the unemployed, resulting in higher prices. Mainstream economists had to rework their thinking to take account of Milton Friedman’s warning that gains in employment would disappear once inflationary expectations caught up with reality. That time had arrived in America.
Volcker understood the power of expectations better than most, having watched traders trying to anticipate future bond prices during his earlier stint on the New York Fed’s trading desk. At his very first FOMC meeting on August 19, 1975, he had warned the optimists seated around the table not to be encouraged by the projections “for reduced inflation emanating from some econometric models.”54 He pointed out that these mathematical-statistical formulations “did not take adequate account of the important factor of expectations.” University of Chicago economist Robert Lucas would win the 1995 Nobel Prize in Economics for promoting the concept of rational expectations and for showing the limitations of econometric models that ignored them.55
The rational expectations model gives more credit to people such as Tessie Rogers and Kathy Neuhas than the standard formulations of the day. Consumers and investors from Atlanta to East Hampton would incorporate all the available information in their inflation forecasts according to Lucas’s view, including whether the Federal Reserve was increasing the money supply at an inflationary rate. They did not simply extrapolate past history, as Keynesian econometricians assumed. Rational expectations undermined the trade-off between unemployment and inflation that had ruled economic policy since the early 1960s, because Tessie Rogers and Kathy Neuhas could not be consistently duped by the Fed. The ultimate logic of rational expectations turned the central bank into an inflation machine, without any redeeming features.56
Volcker never joined the extremists, but he publicly embraced the wisdom of rationality in a speech to the Boston Economic Club in December 1976.
It is no historical accident that the past few years have seen the rise … of so-called rational expectations … in effect arguing that the ultimate inflationary consequences [of economic policy] will be promptly taken into account in today’s actions … Some versions … actually seem to imply that systematic demand policies will be wholly impotent to affect the real economy. I would not go nearly so far, but I do think … that what people think and expect … is a fact of economic life that we cannot escape … The moral is that concern about the inflationary consequences of policy cannot be postponed until the economy approaches its reentry to full employment.57
Volcker had sprinkled numerous handwritten edits throughout his speech but left the moral of rational expectations untouched. The need to consider the inflationary consequences of monetary policy even with unemployed resources was not yet the conventional economic wisdom, but had already claimed Volcker as a fellow traveler.
Keynesian economic models ignored inflationary expectations, but the market for gold bullion did not. Trading in gold futures at New York’s Commodity Exchange, then located in the newly constructed 4 World Trade Center, would surpass all previous records during 1978, and exceed the combined bullion volume in London, Frankfurt, and Zurich.58 On July 28, 1978, the price of gold passed its previous peak of $197.50, and would trade as high as $243.65 later in the year.59 According to Andre Sharon of the brokerage house Drexel Burnham Lambert, “The pressure seems to be coming from the bottom … Customers are asking their brokers, ‘Why don’t [we] try this thing?’”60
Sales of gold jewelry also skyrocketed. Bill Tendler, a jeweler on MacDougal Street in New York City’s Greenwich Village, reported a dramatic rise in orders. “It seems to be psychological. The more expensive it gets, the more it is a mystique. People say, ‘Yeah, I know it has gone up, but I sure like it.’”61 Andre Sharon offered a test. “If you believe, given the history of the past seven or eight years, that [Americans] will tolerate the pain of disinflation, then the price of gold will go down. If you believe that we will panic at the first sign of pain—a rise in the unemployment rate, say—gold will go up.”62
Volcker suspected that America could not tolerate the pain needed to combat a jump in inflation. “I think this may create a severe dilemma for monetary policy. I myself do not think it’s something that monetary policy can very adequately handle by itself, unaided by new policies elsewhere in the government.”63 He did not specify what those other policies might be, because something else bothered him more.
G. William Miller, President Jimmy Carter’s first appointment to head the central bank, had replaced Arthur Burns as chairman of the Federal Reserve Board in March 1978. Miller had been president of Textron Corporation, an aerospace conglomerate, before becoming Fed chairman. His experience in banking and economics was limited to the largely ceremonial position of serving as a director of the Federal Reserve Bank of Boston. Fed chairmen do not need a doctorate in economics—Burns was the first—but Miller’s lack of experience in finance would hurt his credibility on Wall Street.
A week before the White House disclosed Miller’s appointment, the New York Times listed Paul Volcker, Robert Roosa, and Bruce MacLaury (Volcker’s former deputy at Treasury) as the leading candidates to replace Arthur Burns.64 After the surprise announcement of William Miller, the Times quoted the first reaction of a banker who preferred to remain anonymous: “G. William who?”65
Volcker, who had not expected to be appointed—no New York Fed president had become chairman before—greeted the news diplomatically. “I’m not surprised that [the president] picked someone from the business community. It might be a good thing.”66 And Milton Friedman, the leading monetarist critic of the Fed, welcomed a practical man of affairs running the central bank: “Money is too important a matter to be left to the bankers.”67
Volcker quips, “The wisdom of Miller’s appointment is one of the few things that Milton and I ever agreed on.”68 And they both were wrong.
William Miller brought a CEO’s penchant for efficiency to the Board of Governors. He grew impatient with the collegial spirit of FOMC meetings, where everyone seated at the twenty-seven-foot-long mahogany table had a chance to speak. Most participants showed about the same restraint as a politician working a fund-raising breakfast. After six months on the job, Miller had had enough. He brought hourglass egg timers to the board meeting on Tuesday, August 15, 1978, and told his colleagues,69 “I’m going to try to set them up when each of you starts to talk and [board secretary] Murray [Altmann] is going to show a mean streak—since I’m a gentleman—[and tell you when your time is up].”
Charles Partee, who had been a top staffer at the Fed before becoming a board member, wanted more details. “What are they—three minutes?”
“Yes. And when your three minutes is up, he’s going to say ‘next speaker.’ ”
Volcker sensed a loophole. “How many times can you talk, though?” Altmann, who had just become the board secretary, recognized trouble. “I’m not sure yet whether you’re serious.”
The chairman smiled. “We are having a lot of fun but we are serious.”
Members of the FOMC dismissed William Miller’s egg timers as an ill-conceived practical joke, just as they ignored the THANK YOU FOR NOT SMOKING sign he had placed on the boardroom table.70 Everyone talked and smoked, led by Henry Wallich, the board’s resident expert in international finance, who considered it his constitutional right to enjoy a fine cigar. Meanwhile, Volcker puffed away on his favorite ten-cent stogie and lamented the plight of the dollar in the foreign exchange market.
Volcker had watched gold reach a new high during the last week of July 1978, so he was not surprised, during the first half of August, when the U.S. dollar sank to new lows against the German mark, seconding the vote of no confidence in America.71 On August 15, 1978, he told the FOMC, “I think it’s important particularly in view of the international situation that we correct the misapprehensions about our lack of concern over inflation. I do think it would be wise to put a specific mention of the international situation in the directive at some point.”72
Volcker thought “domestic and international price stability went hand in hand,” and he wanted this reflected in the FOMC Directive, the instructions for monetary policy voted on at the end of each meeting. During his tenure as undersecretary of the treasury, he had urged Arthur Burns to protect the dollar with high interest rates. Now that gold and fixed exchange rates had become the dinosaurs of international finance, Volcker believed that the dollar’s role in world trade depended even more on price stability than it had before. Americans could no longer consume more cars and televisions than they produced if foreigners were unwilling to hold dollars as international money. According to Volcker, “Our moral obligation to prevent a debasement of our currency coincided with our self-interest.”73
Volcker championed America’s international responsibilities, but had to shoulder some of the blame for the greenback’s decline. He had voted with the majority of the FOMC, slowly pushing up the federal funds rate, the overnight interest rate on loans of reserves between banks, to discourage excessive spending and inflation. If banks had to pay more for reserves, the raw material needed to make loans, they would charge more to consumers and businesses. But the FOMC operated with a delicate touch, mimicking a team of brain surgeons, raising interest rates in quarter-percent increments at each meeting. According to Volcker, “I don’t think we could be accused of not having been prudent and cautious and gradual.”74
Mark Willes, a member of the FOMC by virtue of his position as president of the Federal Reserve Bank of Minneapolis, wanted to use a sledgehammer rather than a scalpel in tightening credit. He would leave the Fed in 1980 to become president of General Mills, the food conglomerate most famous for bringing Cheerios to the breakfast table, but in mid-1978, Willes had urged Volcker privately to “push up rates more aggressively to convince people that we are serious about controlling inflation.”75
Volcker said, “The FOMC doesn’t operate that way.”
Willes, who dissented eight times during the year, said, “Perhaps we should.”76
Volcker recognized in himself the tendency to procrastinate. Staffers at the Federal Reserve Bank of New York joked that he never made a decision before its time, and the hereafter counted in the calculation. He recalled that dawdling in London had destroyed his doctoral dissertation. But he dismissed those thoughts when answering Willes. “Maybe, but I can do more by building a consensus within the committee.”
He would change his mind before long.
The FOMC increased the federal funds rate to 9 percent in October 1978, a jump of more than two percentage points over a six-month period, but Mark Willes was not impressed, and lectured the group.77 “I’d just make one comment … since there seems to be so much concern about rising interest rates. We seem to accept easily the notion that if we want to look at real wages we adjust for inflation, and that if we want to look at what is happening to profits and depreciation, we adjust for inflation. Most of the economic theory that I know says that if you want to look at the real bite of interest rates, you also adjust for inflation. And interest rates adjusted for inflation are not high at all.”
The “buy now, pay later” philosophy of people such as Tessie Rogers and Kathy Neuhas confirms that an interest rate of 9 percent is not high if wages and prices are increasing at about the same rate. It pays to borrow and buy something tangible, such as a big house, a small diamond, or a tightly wrapped bar of gold, to reap the capital gain and repay the loan in cheaper dollars.
The rate of inflation averaged over 9 percent during the three months prior to the FOMC meeting of Tuesday, October 17, 1978, and Volcker began to think that Willes had been right.78 He said openly at that meeting, “I do have some question about whether we pitched it at the right level in the last year. I suppose … having looked back, that we’ve been a little too easy … and meanwhile inflation has gotten worse.”79
No one commented, except for William Miller. “I don’t think inflation has accelerated since I’ve been at the board, to put it bluntly.”
“I was thinking of a period of probably fifteen or eighteen months.”
Miller smiled. “Well, you fellows fouled it up before!”
Volcker had not been trying to assign individual blame, but he admitted without excuse, “There is something to what you say.” And then added, “But I also think inflationary expectations have hardened … And that is a problem. I do think this is a critical period.”
The foreign exchange market noticed. On October 30, 1978, one dollar purchased 1.72 German marks, an all-time low, representing a decline of more than 20 percent in a year.80 A currency analyst in Frankfurt said, “It’s the same old story—lack of confidence in U.S. government policies.”81 And a London financial analyst concurred: “It will take a lot to change sentiment and a long time to restore confidence.”82 But a taxi driver in Frankfurt hurt the most: “I would rather not take any dollars at all. If somebody offered me dollars, I would drive him to the nearest bank to check the rate … I don’t know what it’s going to be tomorrow, do I?”83
A massive dollar-rescue operation launched on Wednesday, November 1, 1978, delayed Volcker’s first substantive FOMC dissent for five months. Treasury Secretary Michael Blumenthal, the former president of Bendix Corporation, a company that made home washing machines and antilock braking systems for cars, convinced President Jimmy Carter of the need for drastic measures, including a significant increase in U.S. interest rates.84
Anthony Solomon, who held Volcker’s old position as undersecretary of the treasury for monetary affairs, then orchestrated a $30 billion intervention in the foreign exchange market, the equivalent of total warfare on anti-dollar speculators.85 Solomon implied that the Treasury would abandon the policy of benign neglect toward the dollar that had ruled since floating exchange rates had replaced Bretton Woods. “The point has come where Adam Smith had to be curbed.”86 Adam Smith was not a speculator, of course, but he took the blame as the founder of modern economics.
Volcker participated in the dollar rescue by requesting an increase from 8½ percent to 9½ percent in the discount rate charged by the Federal Reserve Bank of New York for lending reserves to its member banks. Unlike most changes in the discount rate that occur after a fundamental shift in policy by the FOMC, the November 1 increase signaled a new initiative. Establishing the discount rate is one of the few prerogatives left to the regional Federal Reserve banks, but the Board of Governors in Washington must approve all changes. Volcker recalls, “I was only too happy to conduct a special telephone meeting of my directors to vote for an increase once I knew Washington would approve.”87
Foreign exchange markets painted a new outlook. On the day the rescue package was announced, the dollar rose by 6 percent against the German currency, and a month later it had jumped to 1.93 marks.88 Had the Frankfurt cabbie not spurned the greenback, he would have earned a profit of more than 10 percent during November.89 The program also punished gold speculators. An ounce of the precious metal declined from its peak of $243.65 on October 31, 1978, to $193.40 at the end of November, a decline of more than 20 percent.
The rise in U.S. interest rates restored a shine to the tarnished dollar, but Volcker expected the gains to fade without follow-through, especially if inflation accelerated. He had good reason for concern. Corporate borrowing showed no signs of tapering off with the increased cost of funds. The controller of R.H. Macy, Mortimer Leavitt, said that the department store’s “aggressive capital spending program hasn’t changed in light of any recent events. The company … will just go along with interest rate increases. If you want to eat … you pay the price. You don’t stop eating.”90 A spokesman for St. Joe Minerals Corporation, the largest producer of lead and zinc in the United States, added, “Much of our spending is on a long lead-time basis and we certainly wouldn’t leave things sitting there half or three-quarters finished.”91
By the March 20, 1979, meeting of the FOMC, almost five months had elapsed since the Treasury’s rescue of the dollar, and the annual rate of inflation had moved into double digits.92 Volcker sounded the alarm.
I think we’re in retreat on the inflation side; if there’s not a complete rout, it’s close to it. And in my view that poses the major danger to the stability of the economy … It’s an obvious danger for international stability [especially] … if the dollar … should [return to] the panicky situation we had earlier … There’s no doubt in my mind that … this is the time for some firming rather than the reverse. I think we are at a critical point in the inflation program, with the tide against us.93
Volcker faced a battle.
Frank Morris, a friend of Paul’s ever since they shared an office at the Treasury when JFK was president, served on the FOMC in his capacity as president of the Federal Reserve Bank of Boston. Morris had been on the committee for over ten years, more than twice as long as Volcker. He had been appointed president of the Boston Fed in 1968 from a select list of candidates that included one six-foot, seven-inch financial economist from Chase Manhattan Bank. Volcker recalls: “They chose well. Frank is a first-rate economist and a devoted central banker … but it did rankle at the time. It is the only job I was ever turned down for, unless I count when the Federal Reserve Board refused to hire me right after I finished Princeton in January 1949.”94
On Tuesday, March 20, 1979, Morris staked out a position diametrically opposed to Volcker’s. “I think we’re facing an emerging conflict between the domestic and international requirements of monetary policy … I think we’re approaching a cyclical peak in the economy sometime around midyear … If it’s our objective to avoid a recession, I think we have to [ease] today; I don’t think we can wait for another month … I think the issue is whether we seriously are concerned about avoiding a recession or not.”95
Frank Morris knew from his long experience on the FOMC that members responded more to the domestic economy than to international finance, in keeping with its congressional mandate to “promote full employment … and reasonable price stability.”96 In 1913, Congress conferred its constitutional right “to coin money and regulate the value thereof” on the Federal Reserve System. The central bank’s obligations have changed over the years, in response to economic circumstance and political pressure, but the Full Employment and Balanced Growth Act of 1978, also known as the Humphrey-Hawkins Act, formalized the goals of full employment and price stability. Foreign exchange remained in the Senate cloakroom.97
Morris argued that Volcker’s recommendation to tighten credit was inconsistent with those priorities. “Paul, I think, is resigned to a recession; I think the international constraint may be more of a factor in his thinking than he let on.”98
Volcker felt cornered. He had gone on record with an incriminating message a few months earlier, in a speech at the University of Warwick in Coventry, England, that received considerable attention.99 “It has been a difficult matter to bring … exchange market stability to bear on a Congress … preoccupied with the domestic economy … In retrospect the case can be made that … more forceful response to pressures on the dollar would have ultimately been helpful in promoting domestic as well as international stability … Today, a stronger and stable dollar is plainly in the interest of the United States and the rest of the world.”100
Volcker tried to navigate a response to Morris that would salvage the case for tighter credit while avoiding perjury. “Inflation is a factor in my thinking.”101 He told the truth, but Morris’s speech carried the day.102 The FOMC refused to tighten, and Volcker, with three others, voted against the decision. The press labeled the FOMC dissenters “the Volcker minority.”103
In the three months ending June 1979, prices increased at nearly 13 percent per annum, a relentless acceleration in the rate of inflation that caused both resignation and resentment across the country.104 Terry Grantham, a college student and painter’s helper in Lubbock, Texas, said, “Every day that goes by it seems like the money I have doesn’t buy as much … I was raised as a steak and potatoes boy, but now it ain’t that way no more. Forget the steaks and go with hamburger or bologna.”105 But Ron Gordon, a baseball fan in San Francisco, rebelled. He refused to accept the nickel increase in the price of hot dogs and beer at Candlestick Park, where the Giants played their home games.106 Gordon assembled an inch-thick folder of statistics and protested before the San Francisco Recreation and Park Commission, which had approved the five-cent price increases. His effort attracted the attention of Alfred E. Kahn, President Carter’s chairman of the Council on Wage and Price Stability, who praised his “heroic and unflagging campaign.”107
Ron Gordon prevailed on hot dogs—the price increase was rescinded—but he lost on beer. His batting average, a respectable .500, exceeded Jimmy Carter’s by a wide margin. The president’s approval ratings declined to 30 percent in June 1979.108 At a meeting of the National Association of Broadcasters in Dallas, he had been asked whether the federal government was not the main cause of inflation.109 It was the same question he had gotten earlier, in Elk City, Oklahoma. The president smiled and said, “That seems to be the most popular question.” Wayne Hardrow, of the North Carolina Association of Broadcasters, summed up the mood with “Where do we go from here?” as if inflation were a mysterious fourteenth-century plague.
On Sunday evening, July 15, 1979, President Jimmy Carter delivered his diagnosis to the American people in a televised speech from the Oval Office. The president had spent the previous ten days at Camp David discussing the country’s problems with industrialists, labor leaders, economists, pastors, and ordinary Americans (not necessarily in that order). His thirty-three-minute talk addressed the details of the country’s dependence on foreign oil, but his broader message focused on “the crisis of confidence” that he considered “a fundamental threat to American democracy.”110 Carter lamented that “for the first time in our history a majority of our people believe that the next five years will be worse than the past five years.” He recognized that “the phrase ‘sound as a dollar’ was an expression of absolute dependability until ten years of inflation began to shrink our dollar and our savings.”
Two days after his speech, Carter requested the resignation of his entire senior staff, a housecleaning to signify a fresh start. Instead, it created confusion. The president removed five of his cabinet members, including Treasury Secretary Michael Blumenthal, who had run afoul of the so-called Georgia Mafia in the White House.111 In November 1978, Blumenthal had convinced Carter to support the discount rate increase that had accompanied the dollar rescue package. He compounded his offense in April 1979, by publicly calling for an increase in interest rates soon after the “Volcker minority” had urged a tightening of credit conditions.112 When asked at his final news conference whether he had jumped or was pushed, Blumenthal answered, “I took advantage of an opportunity to get paroled with time off for good behavior.”113
Blumenthal’s firing provided fodder for talk show hosts such as Johnny Carson on The Tonight Show. “Treasury secretary Blumenthal did not handle his job too well. He asked for his severance pay in Krugerrands.”114 No one had to tell the late-night television audience that the Krugerrand was South Africa’s gold coin. Carter’s cabinet shakeup had triggered an overnight jump in gold to over $300 an ounce, a new record.115 The New York Times commented that the resignations “significantly intensified European worries” and quoted a specialist at Samuel Montagu & Company, a leading London gold trading firm: “Seen from over here this looks pretty awful.”116
The president replaced Blumenthal with Fed chairman William Miller, considered by Carter’s political advisers more of a team player. The switch delighted Miller, who was pleased to bequeath his egg timers to the next Fed chairman, whoever that might be. The vacancy at the central bank worried America’s trading partners.
Gilbert de Botton, general manager of Zurich’s Bank Rothschild, said, “My feeling is one of gloom. Washington is becoming more politically organized.”117 A European finance minister who preferred to remain anonymous said, “I hope that whoever now becomes dominant will pursue a conservative monetary policy and not delude themselves into thinking that they can float the United States … by adopting an inflationary policy.” The press reported, “Several European officials and bankers suggested that Paul A. Volcker … would be an ideal choice” for Federal Reserve chairman.
Volcker met with the president on Tuesday, July 24, 1979, in the Oval Office. They were joined by William Miller, the new treasury secretary, who had called Volcker at the New York Fed the day before to set up the meeting. The discussion lasted less than an hour, and Volcker knew it had not gone well. He returned to New York that same afternoon.
On the flight back, he thought about the other names appearing publicly on the short list to succeed Miller.118 He knew them all well. Bruce McLaury, Volcker’s former deputy at Treasury and now president of the Brookings Institution, the liberal Washington think tank, had been mentioned as a possible candidate. David Rockefeller, the chairman of Chase Manhattan Bank, had also been listed. Volcker had worked for Rockefeller during his two stints at the bank. And A. W. (Tom) Clausen, the CEO of Bank of America, a third name in the hopper, had offered Volcker the number-two job there when he left the Treasury. It was an impressive group, and Volcker wondered whom the president would pick, now that he had talked himself out of the job.
After landing at LaGuardia Airport, Volcker called his two best friends, Larry Ritter and Bob Kavesh, and asked them to dinner for a postmortem. They met at Parma, a neighborhood Italian restaurant around the corner from Volcker’s Seventy-ninth Street apartment on the East Side of Manhattan. Ritter and Kavesh, about the same age as Volcker, were professors at NYU’s Graduate School of Business. Volcker had gone to Harvard with Kavesh and had overlapped with Ritter at the New York Fed. “They would not bullshit me about anything,” Volcker says. “Barbara liked them for the same reason.”119
“Well, I blew it,” Volcker began after they had sat down.120
“What do you mean?” Ritter asked. He had learned the art of listening while recording the stories of players from the early days of baseball. He had turned the oral history into a bestselling book, The Glory of Their Times, sharing the royalties with the old-timers because he thought it was the right thing to do.
“I was sitting alongside the president, who sat in a wing chair,” Volcker growled. “I said that I attached great importance to the independence of the Federal Reserve and that I also favored a more restrictive monetary policy. And just for emphasis I pointed at Miller, who was sitting in a chair next to me, and added that I wanted a tighter policy than him.”
“The Volcker charm at work,” Kavesh said. “What did Carter say?”
“Nothing. He just listened.”
Ritter lit a cigarette and tried some humor: “Were you smoking one of your El Cheapos?”
“He just said that Miller was there,” Kavesh interjected. “Of course he was smoking.”
They laughed together, and then Volcker continued. “You know it might be for the best. I would have to take a fifty percent cut in salary if I were offered the job. I don’t know how we could mange … I don’t know if I have the right to ask my family to make that kind of sacrifice.”
Volcker looked at both men for a response. Neither one spoke, until Ritter said, “If the president calls, you cannot turn him down.”
Kavesh asked, “What did Barbara say?”
“The same as him.” Volcker nodded toward Ritter.
Paul knew that they had given him the answer he wanted. This was the job he had trained for his entire professional life. This was the job that provided the opportunity to rescue his country from crisis. He wanted it more than he cared to admit.
“Did Barbara say anything else? Kavesh continued.
Volcker looked down at his plate. “Yes. She said we’d manage.”
At 7:30 the following morning, the sharp ring of the telephone woke Volcker. It was the White House.