Ronald Reagan, wearing a dark blue suit and blue-and-red tie, stood behind a lectern embossed with the presidential seal on Tuesday, January 19, 1982, the eve of his first anniversary in office.1 The news conference would highlight the performance of the U.S. economy during the past year, with Paul Volcker center stage. Reagan had complaints about both topics.
Congress had passed the president’s key legislative initiative during the summer of 1981, a tax-reduction bill sponsored by Representative Jack Kemp and Senator William Roth, which reduced the top personal income tax rate from 70 percent to 50 percent, among other changes.2 The rise in inflation during the 1970s had pushed up both wages and prices, leaving many middle-income Americans in higher tax brackets. The legislated decline in marginal rates, a centerpiece of Reaganomics designed to stimulate economic incentives, was long overdue. But a recession had begun about midyear that brought bad news. The unemployment rate had increased to 8.6 percent when the president addressed reporters in the White House Press Briefing Room, compared with a rate of 7.5 percent a year earlier, an increase of more than one million people without work.3
Progress on inflation, which had dropped substantially compared with a year earlier, was overshadowed in the president’s mind by the failure of interest rates to decline.4 High borrowing costs would impair the road to economic recovery. Reagan had written in his diary, “[I] dropped in on a meeting of [my] economic advisors— a roomful of our country’s greatest economists. None of them could explain why interest rates are so high.”5 President Reagan was not the only politician to complain. West German chancellor Helmut Schmidt said that real interest rates were at their highest levels “since the birth of Jesus Christ.”6
The ten-year government bond rate had increased to more than 14 percent when the president held his anniversary meeting with the press, an increase of more than two percentage points compared with when he took office.7 Two percentage points may not sound like much, but the jump in mortgage rates, which move in tandem with the Treasury bond rate, would raise the annual payments on a $100,000 twenty-year mortgage by more than $1,700.8 Volcker had promised that interest rates would drop after inflation declined. So far the reverse had occurred.
Helen Thomas, the dean of the White House Press Corps, began the questioning by lamenting the plight of the jobless, and other reporters followed with questions about sanctions against Russia and relations with the press. Reagan managed to avoid controversy, until a reporter asked, “Would you agree with those people on Capitol Hill who have called for Mr. Volcker’s resignation?” The president said, “Well, I can’t respond to that because the Federal Reserve System is autonomous … the members of that commission are term employees, they’re not serving at anyone’s pleasure … there’s no way that I can comment on that.”9
Reagan’s modesty, which he wore so well, belonged in the closet with his old cowboy hats. Volcker’s term as Federal Reserve chairman would expire in eighteen months, and Reagan would then have the pleasure of designating a new chairman. The president’s “no comment” response in January 1982 compared favorably with Congressman Henry Gonzalez’s earlier threat to impeach Volcker, but not by much. Gonzalez, a Democrat from Texas, had accused Volcker of “legalized usury beyond any kind of conscionable limit.”10 The congressman showed it was nothing personal by introducing two bills of impeachment, one for Volcker and the other for the rest of the Federal Open Market Committee.11
Soon after Gonzalez’s attack, Reagan had told a California audience, “The Fed is independent, and they are hurting us, and what we’re trying to do, as much as they’re hurting everyone else.”12 The White House rushed to explain that “they” referred to high interest rates and not the Fed itself, but that made Reagan sound like Jimmy Carter, who respected Paul Volcker but not his policy of high interest rates.
Reagan should have looked in the mirror for the scapegoat.
The mystery of high long-term interest rates in January 1982 begins with the remarkable drop in the rate of inflation during the immediately preceding three months compared with a year earlier. Inflation measured 4 percent per annum in the most recent quarter, versus 12 percent in the earlier period.13 And the Survey of Professional Forecasters reported a decline in expected inflation as well.14 The drop in inflationary expectations should have reduced long-term interest rates. Lenders prefer higher interest rates, of course, but competition whittles away the premium whether they like it or not. The ten-year bond rate should have mimicked the direction of the federal funds rate, which dropped from 20 percent to 12 percent during the year. Instead, the bond rate went its own way, rising from 12 to 14 percent.
The expected jump in the federal deficit following the 1981 tax cut could have caused the high long-term interest rates in January 1982. An increase in government borrowing to cover the revenue shortfall from the tax cut would drive up interest rates. And the structural budget deficit as a fraction of economic activity, in fact, almost doubled in the years after the tax legislation compared with earlier.15 But Treasury Secretary Donald Regan dismissed any connection between federal deficits and interest rates.
In the beginning of 1982 Regan testified before the Senate Finance Committee, “There has been considerable concern that our projected deficits will put extreme pressure on credit markets and thus drive up interest rates. However … the historical record shows no such direct association of deficits and interest rates.”16 Instead, he shifted the blame for high interest rates to money creation by the Federal Reserve. “Interest rates are determined by the real rate of return on capital, the expected inflation rate and a premium for risk. Although deficits could conceivably influence expected inflation and risk, this would not happen … unless they were accompanied by excessive money creation.”
Allan Meltzer, the prominent monetarist from Carnegie Mellon University, confirmed Regan’s indictment of monetary policy. He had said during the summer of 1981 that bond rates would remain high as long as there was “skepticism about the rate of inflation and whether it is going to be reduced permanently.”17 In February 1982, Meltzer wore a bow tie and a friendly smile while testifying before the Senate Finance Committee, and gave Volcker a failing grade:
I enjoy hearing Mr. Volcker speak. I enjoy reading his statements. I agree with most of what he says but with little of what he does … While he has been making clear and definite statements about the need and the desirability of slow money growth … neither he nor previous Federal Reserve chairmen have remained within their target bands … And Mr. Volcker’s experience … in the last two years … [is] even worse. Not only is money growth highly uncertain, it is highly volatile … Is it any wonder that there is uncertainty in the financial markets? … The risk premium in the United States is extremely high … because one cannot be certain from the experience of any three-month period what the growth rate of the money stock will be in the next three-month period or for the year.18
The record confirms Meltzer’s claim that the Federal Reserve failed to control money supply growth, but the marketplace ignored his concern.19 The price of gold averaged $384 an ounce during January 1982, compared with $557 a year earlier, a decline of more than 30 percent over twelve months. The dollar bought an average of 2.29 German marks during January 1982, compared with 2.01 marks a year earlier, an increase in the value of the U.S. currency of 14 percent. Meltzer’s alleged fear and uncertainty over American inflation should have pushed the dollar down and gold up, not the reverse, especially given the precipitous drop in the overnight interest rate.
The price of gold and the value of the dollar endorsed the Federal Reserve’s credibility, a delicate concept more closely related to raising real interest rates despite countervailing political pressure, as before the 1980 election, rather than adhering to rigid control over short-term money supply growth.20 The market’s confirmation of the Fed’s anti-inflation credentials left high long-term interest rates and the Bermuda Triangle as the leading unsolved mysteries of the day.
Volcker had always considered gold a favorite barometer of inflationary expectations and had been pleased to learn that Ronald Reagan felt the same. The president had suggested to him immediately after the inauguration that a drop in price below $300 an ounce would confirm “great strides against inflation.” The decline during his first year in office achieved two-thirds of the objective, but failed to bring down borrowing costs. In fact, the rise in long-term interest rates coupled with the decline in inflationary expectations meant an increase in the expected real return on bonds, pleasing wealthy lenders but making poor borrowers even poorer. Volcker blamed the deficit, a polite euphemism for Reaganomics.
Volcker had not endeared himself to the new president. He had worried about Reagan’s proposed tax cuts during the presidential campaign and had discussed the “inevitable collision” with monetary policy behind the closed doors of the FOMC immediately after the election.21 Increased government borrowing to cover the revenue shortfall combined with tight credit would drive up interest rates. The Wall Street nugget “The government always gets its money” tells the story. Volcker had testified at the Senate Appropriations Committee and proposed “concrete actions on spending cuts before a final decision is taken on a tax program.”22 Treasury Secretary Donald Regan had told the same committee that tax cuts “can’t wait until budget outlays are reduced.”
Volcker thought that presidential adviser Milton Friedman would have better served the republic by railing against Reagan budget deficits, even though Friedman said they were “not as large as in many past years,” than by undermining the Federal Reserve’s independence.23 Friedman famously said that inflation is always a monetary phenomenon, but he attributed the root cause of inflation to government deficits.24 The connection, according to Friedman, is politics. “Financing government spending by increasing the quantity of money is often the most politically attractive method to both presidents and the members of Congress.”25 In particular, when citizens complain about the high cost of borrowing, Congress pressures the Federal Reserve to minimize the impact of deficits by buying government bonds with newly created money, a process known as monetizing the deficit. The “independent” Federal Reserve usually responds because it is a creature of Congress, which can change its operating mandate at any time.
Volcker had testified before the Senate Budget Committee after the president’s tax cut was enacted in mid-1981, urging restraint on spending to repair the damage. Senator Lawton Chiles, a Florida Democrat, listened patiently to the Fed chairman and then raised eyebrows among those assembled in the hearing room with the following observation about central banker vulnerability.26
“The realities are that we are stuck with a tight monetary policy … Right now, you are the only person with a finger in the dike … [but] we are going to have an explosion … [and] we will have to knock out the Federal Reserve Board altogether … You have given us a good lecture about how much we should cut in spending. I just do not think, however, that … is in the realm of possibility.”
“You are the political expert,” Volcker responded. “What I am saying … is that the challenge before the Congress and the Administration now is to do what cutting they can do … [But] shooting the messenger or the head of the Federal Reserve is not going to do anybody any good.”
“But it is going to be a lot easier to cut the head off the Federal Reserve System,” Chiles interjected, “than to make these huge cuts, [and] that is what I am afraid is going to happen.”
Volcker elaborated in self-defense: “Let me just clarify the point. It may be easier to cut the head off the Federal Reserve, but even when the Federal Reserve is running around headless you will still have exactly the same problem you started with.”
Everyone laughed, except Paul.
Volcker had shown a nonpartisan distaste for budget deficits. He had testified on the impact of the deficit on interest rates in April 1980, when Jimmy Carter was still president, and the shortfall in government revenues resembled a rounding error compared with deficits during the Reagan years.27 He did not get much numerical help from his fellow economists.
Senator John Chafee, a Republican from Rhode Island, had asked Volcker during hearings of the Finance Committee,28 “As you mentioned, we have had home builders and road builders, real estate agents, everyone in Washington deeply concerned about interest rates. You said the best thing we can do to lower interest rates is to end the federal deficit on the theory that interest rates and inflation march along together pretty much.”
Volcker interrupted. “On that theory and also on the theory—it is clearly more than a theory—that by removing the government borrowing demand from the market you have a direct impact on interest rates.”
“No question,” Chafee continued, “but on the other hand we have respected economists who say if we balance the budget … then interest rates would only go down [by] one-third of one percent, and how much better off are we.”
“Not much if that analysis is correct,” Volcker said, “but I do not accept that analysis. I think that kind of statement is based on econometric equations that do not reflect and cannot pick up the dynamics of the process.”
Volcker wanted to tell a simple story. The government runs a deficit when it spends more than it receives in taxes, and to cover the shortfall it must borrow by selling bonds. Basic economics teaches that additional bond sales will drive down prices and push up interest rates. But opponents argue that a potential offset to the increased supply is that people may save more to cover higher future taxes needed for the deficit. And that means people buy more bonds in the interim, leaving the interest rate almost unchanged in the process.29 Resolving the net impact of the deficit on interest rates requires formal statistical estimates, which makes Volcker very unhappy.
Volcker never trusted econometricians, especially since the rational expectations revolution in the mid-1970s gave him formal justification, but statistical answers involving the budget deficit were doubly suspect. The measured numbers for the deficit do not correspond to the concerns of bond investors.30 At the simplest level, the government can spend without selling bonds by running down its cash balance, and can sell bonds without spending by adding to the Treasury’s cash. Budget forecasters smooth out these timing discrepancies, but their craft ranks alongside astrology in precision, creating chronic insomnia among potential investors in government bonds. Rudolph Penner, a director of the Congressional Budget Office, wrote, “Budget forecasts are always wrong, and often they are wrong by a lot.”31
Bond buyers worry about unpleasant deficit surprises, rather than simply focusing on the best guess of budget projections, and each circumstance is unique.32 In January 1982, President Reagan’s budget outlook suffered from two sets of uncertainties, whether revenues would grow as fast as projected and whether unspecified cuts in government spending would materialize. Sanford Weill, chairman of the brokerage giant Shearson/American Express and a future chairman of Citibank, said, “If they come with a deficit that is substantially larger than what they projected in the first year, no one will believe the projections for the second and third years.”33 And Gilbert Heebner, an economist with Philadelphia National Bank, added, “Summing up, 1983 and 1984, not 1982, are the problems on the policy front. In those years something will have to give, if we are to reduce budget deficits and to avoid high interest rates.”34
David Stockman, Reagan’s budget director, undermined the administration’s already diminished credibility with a series of ill-conceived confessions to a Washington reporter. Stockman had authored the projections reconciling the 1981 tax cut with Reagan’s promise to balance the budget by 1984, and had dazzled everyone with his command of the details, but then had second thoughts about the exercise. Stockman’s mea culpa appeared in the December 1981 issue of the Atlantic Monthly magazine: “None of us really understands what’s going on with all these numbers. You’ve got so many different budgets out and so many different baselines and such complexity now in the interactive parts of the budget … and all the internal mysteries of the budget, and there are a lot of them. People are getting from A to B and it’s not clear how they are getting there. It’s not clear how we got there.”35
Stockman had confirmed the market’s worst fears.
In the beginning of 1982, Donald Regan and Allan Meltzer had correctly identified risk as the key to high interest rates, but they focused on the wrong risk. Gold and the dollar confirmed that financial markets believed Volcker’s pledge to extinguish inflation and recognized his progress. The jump in long-term interest rates did not come from an inflation scare but instead reflected a recurring budget nightmare.36 Higher real interest rates help investors sleep better at night.
Meltzer himself testified to anxiety over the budget before the Senate Finance Committee: “Let me turn briefly to the fiscal side … There is great uncertainty about the budget problem and how it will be resolved. We are, I believe, on the verge of a fiscal crisis. Not in 1982 and 1983, the years which receive so much attention … but on out as far as we can project, we do not see the size of the budget deficits coming down relative to GNP [national output] or saving. That’s a problem which I think hangs over the economy and creates uncertainty … we have very uncertain outcomes.”37
Meltzer saved the scariest prediction for last: “We run the risk of sliding into the … instability characteristic of modern Italy or of moving to some other less desirable solution that no one can now foresee.”
The collision between Volcker’s tight monetary policy and Reagan’s budget deficit resembled cold war brinksmanship, like Kennedy confronting Khrushchev over missiles in Cuba.38 The stakes were not nearly as ominous as world conflict, but the fallout of high interest rates clouded America’s economic landscape. The press reported that Alan Greenspan, at the time a member of Ronald Reagan’s outside economic advisers, contends that “if the Administration doesn’t act to convince the markets that the deficit will be down to around $80 billion by 1984, the resulting rise in interest rates will make the Reagan economic recovery ‘feeble.’”39 An $80 billion deficit violated Reagan’s campaign promise to balance the budget but would divert Wall Street from thinking about instability worse than Italy’s.
Robert Lucas, the future Nobel Laureate in economics at the University of Chicago, turned the confrontation between Volcker and Reagan, and the deficit-increasing tax cut of 1981, into a moral conflict in a New York Times essay: “Can a resolutely ‘monetarist’ central bank, restraining monetary growth no matter what else is happening, insulate the economy from the effects of this fiscal dishonesty? The [Reagan] Administration has boldly wagered all of Paul Volcker’s chips on this possibility, but it is buying only time … it is not within the abilities of any central bank to make things work out right in a society that insists that the real resources spent by its government can exceed, on a sustained basis, the resources that government extracts from the private sector via taxes.”40
Who would fold his cards first, Volcker or Reagan?
The first meeting of the Federal Open Market Committee in 1982 began at 2:30 on Monday afternoon, February 1. Before joining the group, Volcker had sat in his office staring at a fifty-dollar box of Partagas cigars perched at the edge of his desk. Treasury Secretary Donald Regan had sent these exquisite Dominican exports as a peace offering, having denigrated Volcker’s “erratic” money growth and addiction to “cheap” cigars a week earlier.41 Paul could not smoke them. His father would turn over in his grave if he knew his son was inhaling a two-dollar cigar, and besides, they were far too rich for his taste. He would offer one to Henry Wallich’s more refined palate after the meeting, depending on how it went.
Credibility dominated the discussion. A jump of 15 percent in the money supply since December surprised just about everyone, considering that the deep recession that began in mid-1981 should have withered the demand for cash.42 Regulatory changes allowing banks to pay interest on checkable deposits had reduced the reliability of these numbers, making it possible to discount the increase as an aberration.43 But the Fed’s reputation remained fragile to many of those seated around the table, and they worried about appearing soft.
Gerald Corrigan, a voting member of the FOMC as president of the Federal Reserve Bank of Minneapolis, who had served as Volcker’s special assistant when Paul first arrived at the board, emphasized history: “The message that seems to be coming through both from [Capitol] Hill and the Administration is that it’s time to change [our] monetary policy … [But] I think we run the risk that credibility will be affected in a more amplified way because of the perception that the Fed has buckled under again—[everyone will say] ‘they always have and they always will.’”44
Board member Emmett Rice, not known as an inflation hawk, made a similar point: “As you know, I’ve been one of the people who have been worried … that the money supply … has not grown fast enough … [but] my instinct is … that to change the targets for the aggregates at this point would probably damage our credibility.”45
Volcker sounded more flexible than his colleagues: “I will make one more comment … All this worry about our credibility is there, but … we do not build up credibility for the sake of building up more credibility. We build up credibility to get the flexibility to do what we think is necessary. If I were convinced now—more convinced than I am that change is appropriate—I would say the heck with that point.”46
Frederick Schultz had been appointed to the Federal Reserve Board by Jimmy Carter a month before Volcker, and had been Paul’s most reliable ally during the previous two years. His term was about to expire, and Reagan had appointed Preston Martin, a California mortgage executive, to replace him. Schultz chose his last meeting on the FOMC to challenge Volcker, and he emphasized politics:
“I disagree with your comments on credibility. I think there is an enormous sense out there that we are still the only game in town in the fight against inflation … We are right back in the situation we have been in before, particularly now that the President will not do anything about the deficits … If we give an indication that we are caving in and if we start making some changes, there are some really serious costs in terms of credibility, Paul. I think that the credibility factor is more important than you just gave it credit for.”47
Schultz knew that the specter of uncontrolled deficits would deflate Volcker’s trial balloon to avoid further restraint. Volcker did not need much convincing to remain silent. At the end of the February 1, 1982, meeting, the FOMC voted to take account of “the recent surge in growth of the [money supply]” and to seek “no further growth” during the first quarter of 1982. The committee raised the target federal funds rate to 14 percent, compared with a 12 percent objective in December 1981.48
The Federal Reserve’s purposeful increase of two percentage points in the overnight interest rate six months into a major recession was unprecedented. It seemed belligerent to some, including Massachusetts senator Edward Kennedy, who wanted to end the Fed’s independence.49 But it also confirmed the central bank’s determination to uphold its responsibility as “the only game in town” and to overturn its image as “the same old Fed.”
It meant the Federal Reserve would not fold.
Within days of the February FOMC meeting, Volcker initiated a détente with the president. The escalating rhetoric with the administration had troubled him, and not because of the newspaper headlines—he was used to that—but his protégé Jerry Corrigan had shown how the brewing controversy could manipulate policy.
Corrigan understood politics as well as Lyndon Johnson did and had warned his FOMC colleagues about the clash between monetary and fiscal policy. “We are sitting here looking at a fiscal situation that is just untenable. And one of the concerns I have—and maybe it is tilting at our windmills a little—is that if the perception is that we really are easing, any prospect of being able to do better on the fiscal side is weakened … because that creates the impression that we are going to sit here and monetize all that debt … I must say I would be troubled at [that] prospect.”50
Using monetary policy as a weapon to promote responsible fiscal policy fit Volcker’s battle plan, but he also wanted the flexibility to ease monetary policy sooner rather than later to avoid an economic collapse. He asked Murray Weidenbaum, chairman of the Council of Economic Advisers, to set up a one-on-one meeting with Reagan, without subordinates.
Weidenbaum was stunned by the request: “Paul had never asked me for a favor in all the time we knew each other. He had been my boss and was now a friend. I went out of my way.”51
The meeting between the president and Volcker took place on Monday afternoon, February 15, 1982. It was Washington’s birthday, an informal day in the nation’s capital, and the president wore a striped golf shirt and tan slacks.52 The relaxed atmosphere paid immediate dividends, according to Reagan’s diary entry at the end of the day: “Met with Paul Volcker. I think we’ve broken ground for a new & better relationship aimed at getting interest rates down. He thinks we can get short term rates down 3 or 4 points by June. Long term will take longer.”53
Three days later, on February 18, Ronald Reagan embraced Paul Volcker publicly. Not physically, of course—neither man was cuddly. But Reagan’s remarks at his news conference in the East Room of the White House confirmed the new relationship, and a new commitment to restraining budget deficits.
I have met with Chairman Volcker several times during the past year. We met again earlier this week. I have confidence in the announced policies of the Federal Reserve Board. The Administration and the Federal Reserve can help bring inflation and interest rates down faster by working together than by working at cross-purposes. This Administration will always support the political independence of the Federal Reserve Board … At the same time, I am sensitive to the need for a responsible fiscal policy to complement a firm anti-inflationary monetary policy. I will devote the resources of my Presidency to keeping deficits down over the next several years.54
After the news conference, Weidenbaum telephoned Volcker: “Congratulations. You made quite an impression.”55
“We’ll see what happens.”
“No, already.”
“What’s that supposed to mean?”
“I just spoke with the president. He now refers to you as Paul rather than Chairman Volcker.”
Republican senator Paul Laxalt of Nevada was Ronald Reagan’s closest friend in Congress, having served as manager of his presidential campaigns in 1976 and 1980. He could whisper in the president’s ear, “Hey Ron, you’ve messed up, this one isn’t working.”56 Laxalt urged Reagan at the end of March 1982 that “time is running out” on a budget compromise.57 Republican senator Robert Dole of Kansas, the Senate Finance Committee chairman, delivered the same message. Dole had proposed a tax increase to help restore a measure of budget sanity, and said, “We’re right on the threshold of a [budget] breakthrough,” but the compromise must come in a matter of “days and weeks, not months.”58
Laxalt was not optimistic. He knew the president best and thought that “he will play his cards right to the end.”59
Reagan waited.
The president did not want to raise taxes; it went against everything he stood for. It would also alienate the Republican Party’s conservative coalition, which had supported his program of less government. Jack Kemp, the Buffalo, New York, congressman who had cosponsored the 1981 tax-reduction bill, reminded the press that Reagan wanted to reduce government spending by strangling it off with lower taxes.60 The president had said it was like curing our children’s “extravagance simply by reducing their allowance.”61 Kemp objected to “the dramatic U-turn” on economic policy.62
By August 1982, Reagan knew that unless he acted, the Republicans would face a rout at the ballot box in the November congressional elections. On August 6 the White House press secretary said that the president had postponed his California vacation to help get the pending tax and expenditure legislation through Congress. “The president has brought 75 House Republicans to the White House over the last three days to emphasize his support for the tax bill.”63
Reagan told his fellow Republicans, “We are beginning to see some real relief on interest rates with a somewhat dramatic decline over the last several days. Interest rates are going in the right direction. They must continue if we are to have economic recovery. If we do not get spending cuts and reduce the deficit, this downward trend on interest rates could be reversed. While I am reluctant to raise taxes, the price is not excessive to get the deficit down and to ensure the continuation of economic recovery.”64
In August 1982, Ronald Reagan sounded like Paul Volcker. On August 19, 1982, the tax increase was passed.65 It was a rare victory for the central bank. There would be more.