An obsession as thick as harbor fog smothered Volcker’s confirmation hearings on Thursday, July 14, 1983. Republican Jake Garn of Utah, chairman of the Senate Banking Committee, welcomed Volcker to the Caucus Room of the Russell Senate Office Building, a formal space with crystal chandeliers that had hosted the Watergate hearings a decade earlier, and began with a peculiar compliment: “Under your leadership the Federal Reserve certainly has acted more responsibly in redirecting monetary policy than the Congress has acted in redirecting fiscal policy … I’m amazed at how well Congress has been able to get away with placing a majority of the blame [for our economic difficulties] on the Federal Reserve Board … Congress … has not worked very closely … to match fiscal policy with monetary policy. The proof of that is the ever-increasing deficits that we face, and Congress[’s] unwillingness to significantly cut those deficits.”1
Garn alternated chairmanship of the Senate Banking Committee with William Proxmire of Wisconsin, depending on whether the Republicans or Democrats controlled the Senate. He urged Congress to “face up realistically to those budget deficits and send the proper signals to the financial markets of this country.”
Garn’s rant against the deficit during Volcker’s confirmation seems misplaced, considering that neither the Senate Banking Committee nor Volcker had any direct control over federal expenditures and taxation, but Proxmire followed Garn’s opening remarks with the same obsession. The Wisconsin Democrat greeted Volcker like an old friend. “I think we owe you … a rousing vote of thanks for your great job in bringing inflation down … Meanwhile between the Congress and the administration, two administrations, we sharply increased spending [and] reduced Federal revenues … and created … the assurance that we will … explode the national debt to more than two trillion dollars … We have created a mammoth, ponderous, and fire-eating dragon … And all this is just another way of saying that … the time is coming … when inflation or high interest rates or both will choke off this recovery … So, good luck, Paul, you poor devil.”2
Everyone laughed except for Volcker.
He knew the deficit had obscured the progress he had made on inflation, forcing interest rates higher than they should have been. Foreign investors had softened the blow by investing in U.S securities, but that had left Middle America’s mortgage payments hostage to international financiers. Volcker had tangled with the administration over the budget since the 1981 tax cut, but now he sensed bipartisan congressional support. His new lease on the chairmanship would help the cause.
The Senate Banking Committee confirmed Volcker’s reappointment on July 21, 1983, by a vote of 16 to 2, with Democrats James Sasser of Tennessee and Alan Cranston of California voting against.3 Sasser explained his negative vote: “The Federal Reserve Board … has stymied the economic growth of this country and seriously damaged our economy … Unemployment still stands at ten percent … Eleven million Americans are unemployed.”4 A letter to Volcker from W. B. Greene, one of Sasser’s constituents, dulled the criticism: “I was extremely disappointed when I realized that one of our Senators from Tennessee … had voted against your re-nomination … He seems to forget the last ten years … Congratulations, I am glad you’re back.”5 Another Sasser constituent, from Ellendale, Tennessee, penned a mixed message: “On September 11, 1981, I wrote a note to criticize your policy. Today I write to thank you … It took guts to stand up to the problem and not take the easy way out. It looks as though your ideas are working … Hang in there.”6
On July 27, 1983, the entire Senate voted on Volcker’s reappointment. Senator Garn urged approval with “I doubt any chairman has served during a more difficult time.”7 Dennis DeConcini, an Arizona Democrat, led the opposition with the complaint that Volcker had “almost single-handedly caused one of the worst economic crises” in American history.8 The Senate voted 84 to 16 to confirm Volcker for a second term as chairman of the Federal Reserve Board.
By February 1984, six months after Volcker’s reappointment, the economy had rebounded significantly from the 1982 recession. Unemployment had declined a full three percentage points from its peak in November 1982, although it was still high by historical standards.9 Volcker worried about the clash between the government and the private sector in the bond market. He told the Senate Banking Committee during his report on monetary policy on February 8, 1984, “I hardly need to remind you that inflation has tended to worsen during periods of cyclical expansion … [and that] the structural deficit in our Federal budget … [carries] implications for the prospects of reducing our still historically high levels of interest rates … We still have time to act— but, in my judgment, not much time.”10
Volcker’s view gained support from the just-released annual report of the president’s Council of Economic Advisers. The CEA was chaired by Martin Feldstein, an outspoken professor on leave from Harvard University who wore the unfashionable black-rimmed glasses of an academic. The CEA warned that the deficit would not disappear as the economy approached full employment; it was built into the structure of expenditures and taxes, and that “federal borrowing to finance a budget deficit of five percent of GNP … means that the real rate of interest must rise until the demand for funds for private investment is reduced to the available supply.”11
Feldstein’s prediction put him at odds with Treasury Secretary Donald Regan, who said of the CEA report, “You can throw it away.”12 Regan did not believe that deficits provoked high interest rates, and he had considerable support among professional economists.13 The next few months would help resolve the dispute.
Congress and the administration battled over responsibility for the deficit. President Reagan said in early February 1984, “My most serious economic disappointment in 1983 was … the failure of the Congress to enact the deficit proposals that I submitted last January … We cannot delay until 1985 to start reducing the deficits that are threatening to prevent a sustained and healthy recovery.”14 Congressional Democrats countered that the president promoted the deficit by promising increased defense spending and by lobbying for tax cuts for the rich.
Senate Banking Committee member John Heinz, a critic of the Federal Reserve during the Mexican crisis, sensed a hidden agenda in Volcker’s testimony on February 8. He began his questioning of the Fed chairman with a preamble: “Now I don’t want to be the skunk at the garden party, but it seems to me there’s no party and there’s not a lot of leadership … We’ve agreed that the deficit is bad … That’s the good news. The fact is, however, that in terms of an action plan, we don’t have one … And if our experience in [Congress] is anything to go by, before there’s going to be leadership or compromise there’s going to have to be a crisis.”15
Volcker’s ears perked up with the word crisis.
Heinz continued: “We will have a crisis in this country if, and only if, the Federal Reserve maintains its … policy of making sure the money supply grows at a steady and slow rate … And my question is, are you prepared to help bring about the necessary crisis through your continued restrictive monetary policy so that we deal with the deficit?”16
Volcker heard Heinz but could not believe his words. The Federal Reserve would commit political suicide with a home-cooked crisis, the last meal before Congress imposed a death sentence on its not-so-favorite creation. He knew that the Republican senator from Pennsylvania was something of an outsider, and had been a skeptical supporter of Reagan’s 1981 tax cut because of its implications for the deficit, but Heinz could not be serious.17
Heinz almost sounded as if he knew Volcker’s history of exploiting crises as a policy weapon. Volcker had delivered that message at his very first FOMC meeting as chairman: “Dramatic action would not be understood without more of a crisis atmosphere … where we have a rather clear public backing for whatever drastic action we take.”18 But the transcripts of FOMC meetings were secret and would not be disclosed publicly for another decade.19 And Heinz certainly never saw Volcker’s confidential memo to Treasury Secretary John Connally urging that a foreign exchange crisis be allowed to simmer to pave the way for the suspension of gold convertibility on August 15, 1971.20
Volcker concluded that Heinz was on a fishing expedition and that he was the prizewinning catch, a nice fat 240-pound Atlantic salmon.21 He answered with the appropriate dose of incredulity: “Let me say, as a matter of general philosophical approach—and I feel very strongly about this—it is not our job to artificially provoke a crisis. We are not going to go out there and conduct a tight money policy for the sake of trying to bring leverage on the Congress or the administration.”22
Heinz interrupted: “Mr. Chairman, I never intimated that that was a part of your thinking.”
Volcker forced a smile. “I wasn’t absolutely positive about that.”
And then Heinz edged closer to the truth: “[But] it might be an inevitable consequence.”
“All right,” Volcker said, confirming that high interest rates on the federal debt could galvanize public opinion and force Congress and the president to reduce the deficit. He then continued his disclaimer: “I just wanted to make … absolutely clear … that we adhere to a policy that we think is in the best long-term interests of the country to avoid a resurgence of inflationary pressures.”
Heinz would have the last word.
On Monday, April 9, 1984, the Federal Reserve Board raised the discount rate, the first increase in nearly three years.23 The half-point jump in this politically sensitive rate confirmed a gradual tightening of monetary policy by the Federal Open Market Committee between February and May 1984, as the economy expanded. During that same four-month period, the ten-year rate on Treasury securities rose by more than two percentage points, to within a hair of 14 percent at the end of May.24 The ten-year rate had been at 14 percent during 1981, when investors worried that double-digit inflation could persist forever.
The increase in the bond rate as the Fed tightened credit disappointed Volcker, just as it had after October 6, 1979, when the Federal Reserve’s credibility was at an all-time low. Back then, bond holders had good reason to mistrust the Fed’s commitment to controlling inflation, and they demanded high nominal rates as compensation. Now, almost five years later, after inflation had been cut to a third of its peak level, he thought the Federal Reserve deserved better.
Tight monetary policy by a central bank that suppresses inflationary expectations should raise short-term interest rates but leave long-term rates almost unchanged.25 Volcker knew that the Federal Reserve had lost the war against inflation during the 1970s by remaining too easy for too long during economic recoveries, and he had admitted this publicly: “We haven’t passed the test of maintaining control over inflation during a period of prosperity.”26 But he was disappointed just the same.
Fed watchers confirmed the bond market’s apparent skepticism. The Shadow Open Market Committee (SOMC), a group of monetarist economists who monitor the behavior of the Federal Reserve on a regular basis, reported,“The Federal Reserve has failed repeatedly to conduct a responsible non-inflationary monetary policy, and is failing again.”27 Allan Meltzer, a cochairman of the SOMC, confirmed that judgment retrospectively: “Apparently the public regarded the risk of inflation as very high.”28
Some members of the FOMC agreed. Lyle Gramley, a former Fed staffer during the 1970s, warned the committee in March 1984 about repeating past errors. “I think we’re in very serious danger of losing credibility as an agency that is trying to hold down inflation … [and] we are doing so in the second year of a recovery when expectations [for the economy] have been greatly exceeded.”29 Henry Wallich, the perennial inflation hawk, said, “It seems clear … that inflation expectations have increased over the last few months.”30 Marvin Goodfriend, an economist at the Federal Reserve Bank of Richmond, would later call the jump in long-term interest rates during this period “an inflation scare.”31 The marketplace delivered a very different message.
The price of gold shoots up like a distress signal when investors get a whiff of inflation. Gold almost doubled during the second half of 1979, after an inflation rate of 12 percent had taken hold.32 Speculators worried that monetary policy could not cure the problem despite a jump in short-term interest rates. Gold increased 30 percent during the summer of 1980, when short-term interest rates declined with a weak economy.33 Speculators thought that the Fed had gone soft in its battle against inflation. But during the so-called inflation scare of 1984, the price of gold actually declined, from an average of $385 in February 1984 to an average of $377 during May.34 Speculators evidenced great confidence in the Federal Reserve’s inflation-fighting credentials—certainly more than that expressed by economists, both inside and outside the central bank. And speculators had real money at stake.
The failure of gold to confirm inflationary expectations leaves a more prosaic explanation for the increase in the ten-year bond rate. Investors expected that increased borrowings by businesses to finance economic expansion would clash with continued government borrowing to cover the structural deficit. Competition for credit would push up “the real rate of interest … until the demand for funds … [equaled] the available supply,” just as Martin Feldstein had warned at the beginning of 1984. The jump in interest rates represented an increase in the real cost of credit and reflected deficit phobia rather than an inflation scare, a repeat performance of what had happened in the second half of 1981.35
The increase in interest rates surprised investors. Michael Steinhardt, the stout forty-three-year-old manager of Steinhardt Partners, a successful hedge fund, lost $15 million on the purchase of $400 million Treasury securities during the spring of 1984.36 He had expected interest rates to decline with the dramatic drop in inflation and suffered the consequences of his mistake. “I don’t sleep too well at night … [and] I’m fatter than usual … it’s a miserable time for me.”37 He explained what had gone wrong: “The Administration’s economic credibility has sunk to an absolute low.” According to Steinhardt, not one person in a million could have conceived that a conservative administration such as Reagan’s would have allowed the deficit to explode as it had.38
Volcker did not know Michael Steinhardt, and his antipathy toward speculators would later blossom into distaste for hedge funds, but his commitment to price stability mitigated Steinhardt Partners’ losses. Volcker’s refusal to monetize government debt as the economy expanded suppressed a nascent inflation premium and avoided even higher interest rates.
Steinhardt benefited also from the healthy appetite of international investors for U.S. securities.39 Foreigners dulled the impact of the deficit on interest rates in spring 1984 by buying Treasury bonds, in part because of the Federal Reserve’s credibility, but this left America vulnerable to a flight of international capital. Volcker had warned the Senate Banking Committee in February, “We are … increasingly dependent … upon this inflow of foreign capital … [and] if the Federal Reserve is interpreted as following irresponsible policies, we face a potential for a bigger disturbance, to use a polite word, on the international side.”40
Volcker was only partly right. International investors caused a disturbance in May 1984, but not because of irresponsible Federal Reserve policies. Nevertheless, the crisis would reverberate into the twenty-first century.
On Wednesday, May 9, 1984, at eleven o’clock in the morning, local time, the Japanese news agency Jiji released a story saying, “A bank source in New York disclosed that one of three Japanese financial institutions … is negotiating for the acquisition of … Continental Illinois Bank.”41 The rumor might have started a bidding war if Continental, with $40 billion in assets, had been a healthy bank worthy of a takeover battle. Instead, it conveyed the message that the seventh-largest bank in the United States, with too many nonperforming loans on its books, needed a cash infusion.42
Although it was ten o’clock at night on May 8, in Chicago, and Continental’s Greek-columned home on LaSalle Street was shut for the night, the story triggered a run on the bank typical of nineteenth-century America. Federal deposit insurance, introduced in 1934 to short-circuit banking panics, was limited to $100,000 per account, and covered less than $3 billion of the total $30 billion in deposits at Continental.43 Electronic communications permitted bank withdrawals at the speed of a computer keystroke even in 1984, making Continental Illinois the poster child for a modern banking panic.
Japanese money market traders, who normally lent funds to Continental by purchasing its short-term liabilities, started selling rather than buying soon after the news release on the morning of May 9. Investors in Europe followed suit when trading began there a few hours later. The Chicago institution was known as a “hot money bank,” according to Donald Wallace, a vice president in the bond department at the investment bank Goldman Sachs.44 More than 40 percent of its liabilities, $16 billion, arrived from overseas, and $8 billion had to be renewed every day.45 Wallace turned philosophical in describing Continental’s problem: “Banking is all about rolling over funds, and once this money stopped being rolled over it was gonzoed—gone.”46
No bank can survive a run on its own. Bankers owe money payable on demand or on very short notice but extend loans to businesses over longer time horizons. Bank loans cannot be liquidated (sold quickly) without incurring substantial loss, and any attempt to call loans to repay all depositors at once ends in failure. The core function of a central bank is to serve as a bank for banks, to provide funds when no one else will, to spread a safety net beneath the banking system. Commercial banks in the United States turn to the Federal Reserve as the lender of last resort, tendering securities as collateral at the discount window (now done electronically, like everything else), in exchange for cash reserves.
The Federal Reserve Bank of Chicago, one of the twelve regional branches of the system, threw a lifeline to Continental by lending it $3.6 billion on Friday, May 11, 1984.47 Continental’s borrowing that day was nearly four times larger than the average indebtedness to the Fed of all 5,800 member banks during the previous eighteen months.48 Borrowing reserves at the Fed telegraphs a bank’s weakness, but no one outside the system knew the extent of Continental’s indebtedness. Nevertheless, the run gathered steam after the Chicago Board of Trade, Continental’s longtime customer and neighbor on LaSalle Street, withdrew $50 million from the bank, including funds held for its commodities traders.49
Volcker thought that the signal to abandon ship from sophisticated customers at Continental could sink the seventh-largest bank in the United States. No depositor wants to stand last in line, especially those with more than $100,000 in their accounts. And he worried that the damage could swamp other banking giants with weak balance sheets that relied on foreign funds to remain afloat. He told the FOMC, “Continental is probably manageable with difficulty … Having two or three $40 billion institutions [in trouble] is a horse of a different color.”50
Volcker needed a plan to raise capital for Continental to bolster public confidence—but he could not do that alone. The structure of bank supervision in the United States resembles a Byzantine mosaic, with responsibilities splintered among a variety of independent federal agencies and fifty different state banking authorities. Volcker turned to two men with little exposure outside the world of commercial banking, even though they were both presidential appointees. The outcome of their discussions confirmed the emerging doctrine of Too Big to Fail, and firmly implanted moral hazard into the DNA of American finance.51
Volcker would object, but not strongly enough.
Todd Conover, William Isaac, and Paul Volcker crafted a plan to rescue Continental Illinois. Conover was the comptroller of the currency, appointed by Ronald Reagan to head the Office of the Comptroller, an independent agency within the U.S. Treasury that dates back to the Civil War.52 The comptroller supervises and regulates nationally chartered banks such as Continental Illinois. Isaac was chairman of the Federal Deposit Insurance Corporation, appointed to the three-person board by Jimmy Carter in 1978 and becoming chairman after Reagan was elected in 1981. The FDIC, established as an independent government agency during the Great Depression, insures deposit accounts in virtually every bank in the country, including Continental.53
On Tuesday, May 15, 1984, these three men gathered at ten o’clock in the morning in Volcker’s office at the Federal Reserve Board.54 Isaac later summed up the case for a rescue. “The system could not withstand the failure of Continental. Virtually every money center bank in the country was loaded up with loans to less-developed countries and had a lot of other problems. Bank of America, First Chicago, Manufacturers Hanover, Chemical Bank, and Chase Manhattan were among the [most vulnerable] … Moreover some 2,500 small correspondent banks had billions on deposit … If we allowed Continental to go down, a number of those banks would fail.”55 Volcker added an additional concern: “A default by a top-ten bank would have hurt us abroad. And we needed the inflow of international capital.”56
Conover assured his colleagues, based on the most recent examination reports, that Continental was solvent, with assets worth more than liabilities.57 Isaac proposed that the FDIC invest $2 billion in the form of a subordinated loan to shore up Continental’s capital, thus signaling to depositors and other creditors that the bank would survive.58 And Volcker agreed that the Fed would continue to lend money, on a secured basis, to replace lost deposits until the situation stabilized. No one knew how long that would take.
Volcker turned to his Rolodex, as he had during the Mexican crisis, and asked Lewis Preston, chairman of Morgan Guaranty Trust Company, which later merged into JPMorgan Chase, to assemble the country’s leading financiers for a meeting with the three regulators the following morning at nine o’clock. The capital infusion would carry more weight with private banker participation.59
Volcker knew that secrecy was crucial. He hoped the discussions at Morgan would end before graduation exercises at Columbia University, scheduled for Wednesday, May 16, in the afternoon, at which he was to receive an honorary degree.60 Failure to show at that event would fan the rumors circling Continental and turn deposit outflows into a raging flood. He had agreed to keep a low profile when arriving at Morgan Guaranty’s branch office on Fifth Avenue by entering the building through the armored car loading dock. “The plan brought back memories of my undercover efforts in Tokyo and Bonn in 1973. I hoped it would be more successful.”61 It was.
On the morning of May 16, Volcker slipped in undetected, joining Connor and Isaac in a Morgan boardroom.62 He noticed the Morgan humidor on a sideboard and vowed to stay away—Lewis Preston’s cigars were too rich for his taste. Also present were senior officers of the top seven banks in the United States, including Thomas Lebrecque, president of Chase Manhattan; John McGillicuddy, chairman of Manufacturers Hanover; and Thomas Theobald, vice-chairman of Citibank.
After opening remarks by Preston to welcome the group, Volcker, seated on one side of the highly polished long table, urged the bankers “to act quickly and decisively to demonstrate to the world at large that we had the ability to cope with a major problem.”63 Isaac then said that the FDIC planned to invest $2 billion in Continental but suggested that the capital infusion would carry more weight if the banks picked up $500 million of it, reducing the FDIC’s investment accordingly.64
Isaac’s proposal drew mixed reviews. McGillicuddy of Manufacturers Hanover praised the FDIC’s initiative, but Theobald of Citibank said, “Why would I want to help a competitor?”65 Citibank advocated free enterprise, especially when it applied to others. The remaining bankers at the table expressed a more practical concern: Would a capital infusion be sufficient to save Continental? The bankers left the meeting without reaching a consensus.
Isaac then told Volcker that “the FDIC wanted to issue a statement that no creditor … would suffer a loss at Continental.”66 Volcker was not pleased. “That would set a bad precedent. It means depositors no longer have to monitor their bank’s risk exposure. Frankly, I think that between your capital infusion and our loans at the discount window we should be able to stabilize Continental.”67
“That’s easy for you to say,” Isaac responded. “All your exposure is collateralized, but we’re on the hook for two billion dollars if Continental is forced into bankruptcy. I can’t afford to let that happen.”68
Volcker knew Isaac was right on both counts. While the Federal Reserve’s lending at the discount window was fully collateralized by loans on Continental’s books, the FDIC’s $2 billion investment was subordinated to other claims. Still, Volcker worried about the problem of moral hazard and thought they should withhold the blanket guarantee to preserve some ambiguity in the safety net. He had always liked the notion that borrowing at the discount window was a privilege and not a right for precisely the same reason: Bankers behave more responsibly if they worry.
“Well, I’ve got to go and get that damn honorary degree or people will start thinking that we’ve really got a problem,” Volcker said. “Just try to keep the wording of any release as vague as possible.”69
He left by the loading dock, of course, went uptown to the Columbia campus for his degree, and returned at the end of the day, greeted by the following draft announcement:
In view of all the circumstances surrounding Continental Illinois Bank, the FDIC provides assurance that, in any arrangements that may be necessary to achieve a permanent solution, all depositors and other general creditors of the bank will be fully protected and service to the bank’s customers will not be interrupted.70
He liked it even less in print.
Volcker lost the argument to temper the doctrine of Too Big to Fail. Perhaps he did not try hard enough. And he squandered the moral high ground two months later by supporting the FDIC’s plan to pay the creditors of the bank holding company, rather than limiting the rescue to the bank itself, over objections from the U.S. Treasury.71 According to Volcker, “The holding company was mostly a shell, so it had little practical consequence.”72 More important, the FDIC’s guarantee of all deposits at the bank had made immediate headlines: “U.S. Throws Full Support Behind Continental Illinois in Unprecedented Bailout to Prevent Banking Crisis.”73 And that was the policy decision establishing the broad safety net. Volcker reaped immediate collateral benefits.
The rescue plan for Continental announced on Thursday, May 17, 1984, stopped the run before it snowballed into a panic. At the FOMC meeting five days later, Volcker protégé Jerry Corrigan persuaded the committee to omit the crisis-qualifier “while taking account of [unusual] financial strains” from their final policy directive. Corrigan said that inserting that phrase “would perhaps elevate even further the concerns … that the basic course of monetary policy is going to be undone by these developments.”74 The Record of Policy Actions for the May 22, 1984, FOMC meeting, released with the usual delay, omitted any reference to Continental Illinois.75
The Fed was free to pursue its anti-inflationary policies.76
Fifteen months later, on August 6, 1985, Volcker treated himself to an extra helping of dessert, two slices of Boston cream pie, to mark his sixth anniversary as chairman of the Federal Reserve Board. He could afford it. Inflation had declined to 3.4 percent during the previous twelve months, compared with more than 12 percent during his first year on the job.77 No one had expected that kind of progress. Keynesians such as Samuelson said it was impossible, monetarists such as Friedman said the Fed was doing it all wrong, and the politicians complained about high interest rates.
Volcker had suppressed inflation even as the economy expanded from the recession of 1982. It was now almost three years into the economic upturn, unemployment had declined to its lowest level in more than five years, and inflation remained subdued.78 The price of gold, a carbon monoxide detector for inflationary expectations, had actually declined since 1982.79 Volcker had avoided the Federal Reserve’s nemesis of the past, remaining too easy for too long, and he felt justified in having persuaded Barbara two years earlier to accept his reappointment as chairman.80
It would have been the right time to resign. He had told Senator Proxmire during his confirmation hearings that he might not complete his second term as chairman.81 He had been more specific in private conversations with Ronald Reagan, saying he planned to stay for two years or less.82 And, most important, he had promised Barbara. He owed her in more ways than one. She had sacrificed, she was sick, she had begged, and he had made a deal. But he could not do it. He could not leave while a blemish as large as his size-twelve shoes stained his legacy.
Volcker had told anyone who would listen—including Mr. Peña, his favorite driver—that interest rates would decline once inflation came down, and he had succeeded to some extent. The ten-year bond rate on August 6, 1985, was well below the level of May 1984, but remained more than 1½ percentage points higher than on August 6, 1979, the day he had been sworn in by Jimmy Carter.83 The increase in long-term interest rates since 1979 would have raised the annual interest payment on a $100,000 twenty-year mortgage by more than $1,300.84 And by that measure Volcker had failed.
He had already done enough to bring the ten-year bond rate below the level of August 1979. Actual inflation, inflationary expectations, and short-term interest rates were all lower in August 1985 compared with six years earlier.85 Of all the familiar suspects affecting long-term interest rates, only the expected federal deficit was higher, leaving a puzzle as big as Alaska for those who believed that deficits did not matter. The expected deficit of 5 percent of national output had offset the benefits of reduced inflationary expectations, leaving long-term interest rates higher than before.86
But that was about to change, with an assist from Volcker.
In October 1985, Republican senator Philip Gramm, a forty-three-year-old Texan who carried the burden of the deficit on prematurely stooped shoulders, began a crusade to balance the budget in the United States.87 He joined forces with fellow Republican Warren Rudman, from New Hampshire, and Democrat Ernest Hollings of South Carolina, to sponsor legislation requiring a zero deficit by 1991. They linked the bill, known as Gramm-Rudman-Hollings, to legislation lifting the national debt ceiling that would eventually have to pass to prevent a government shutdown.
No one liked Gramm-Rudman-Hollings—which required mindless across-the-board cuts in most federal programs if Congress fell short of predetermined targets—not even its sponsors. Warren Rudman said it was “a bad idea whose time had come.”88 Deficit reduction had become an antidote to the embarrassment of raising the debt ceiling above $2 trillion, the fire-eating dragon that haunted Proxmire. When the controversial legislation finally passed on December 11, 1985, Congressman Richard Gephardt of Missouri, a future majority leader of the House, voted in favor, but said, “It could be disastrous. But the question is not if this is good policy. The question is can you let this [deficit] madness go on.”89
Members of Congress worried, but bond traders celebrated, snapping up Treasuries even before the final tally in the House and Senate. Prices on the ten-year bond rose with improved prospects for passing the legislation, forcing down yields by a full percentage point from the day the bill was introduced until it passed.90 The drop in yields continued during the first two months of 1986, as investors discussed how Congress would implement the law, until the ten-year rate fell below 8 percent, a level not seen since early 1978, before Jimmy Carter fell from grace.91
The decline of more than two percentage points in long-term interest rates during this period surprised everyone, including Volcker. “I was more skeptical than the marketplace, as usual.”92 The drop in the ten-year bond rate occurred without an easier monetary policy and without a drop in inflationary expectations. The overnight interest rate remained about the same during this five-month period and the price of gold rose slightly.93
Market participants confirmed the power of Gramm-Rudman, as the bill is often called, to lower the level of interest rates. Allen Sinai, chief economist at the brokerage giant Shearson Lehman, said that because of the new budget procedures, “for the first time in this decade financial market participants can look ahead to declining deficits.”94 Lyle Gramley, who had resigned from the Federal Reserve Board earlier in the year and served as chief economist of the Mortgage Bankers Association, said, “I expect to see the bond market move up and down this year, depending on the latest signals from Washington about Gramm-Rudman.”95
Gramley was only partly correct. Traders continued to buy bonds despite a federal district court ruling that certain provisions of Gramm-Rudman were unconstitutional.96 Robert Dederick of Northern Trust Company explained: “Congress will be moved to reduce deficits because of the fear that, if they don’t do something … voters will say ‘throw the rascals out.’ ”97 And Richard Kelly, president of government securities dealer Aubrey G. Lanston, echoed that sentiment: “The mere passage of such a radical piece of legislation shows that Congress and the President are serious about deficit reduction.”98
According to the Wall Street Journal, Rudolph Penner, the director of the Congressional Budget Office, offered muted good cheer: “A major implication of the new budgetary outlook is that the danger of a fiscal catastrophe now appears remote.”99 Penner suggested later that Congress passed the Gramm-Rudman legislation knowing it would impose military spending cuts on the president. “Astute Republicans understood this point … [and] many were eager to discipline the President for abandoning them on the Social Security issue.”100
Credit for the decline in long-term interest rates between October 1985 and March 1986 belongs to Senators Phil Gramm, Warren Rudman, and Ernest Hollings, the field generals who managed the legislative process. But recall that almost two years earlier, Senator John Heinz uncovered the blueprint that guided the process. In February 1984, Heinz had predicted a budget crisis as the “inevitable consequence” of Paul Volcker’s pursuit of tight money.101 The FOMC’s refusal to monetize deficits since then had forced Congress to enact what Senator Daniel Patrick Moynihan of New York called “a suicide pact.”102 Republican senator Slade Gorton said, “Reducing interest rates was one of the designs of Gramm-Rudman.”103
Phil Gramm left nothing to chance. In a phone call the day after the legislation passed, he reminded Volcker of the Federal Reserve’s role in forcing budget sanity on the country. “With a tight money policy for the government, we can now afford an easier money policy for the private sector.”104
Volcker responded with “Congratulations on the legislation, but you know I cannot speak for the Board or the FOMC. We’ll have to see how the belt-tightening unfolds.”105
A boardroom coup changed everything.