Volcker (10 page)

Volcker knew that the absence of de Gaulle from Parisian politics would do little to alleviate America's balance-of-payments deficit and would not even solve the gold problem. More fundamental forces—domestic inflation and foreign competition—undermined the dollar. The Volcker Group had been preparing a memorandum for the president outlining American options, and Paul had been able to devote all his waking hours to the problem. He had few distractions, with Barbara, Janice, and Jimmy having remained in New Jersey until June 1969, the end of the school year.

Paul had been living in a furnished apartment on Fourteenth Street in the rundown part of northwest Washington during the first half of 1969. He did not mind the location, except that his number-three position at the Treasury carried the privilege of a car and driver. Paul worried that some of the unsavory characters lurking in the hallways would get the wrong impression, that a man with a chauffeured car had a healthy wallet as well. He tried to dress like a commoner—easily accomplished with a wardrobe of just a few worn suits that had been custom-ordered to fit his oversize measurements. When one of these antiques disappeared at the cleaner's, Volcker waited a month before accepting reimbursement. “It was a very nice suit.”
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Paul missed Barbara's sharp banter at formal Washington social events that came with his position as undersecretary, whether it was a State Department buffet reception for the prince of Afghanistan or
cocktails at the White House for the German chancellor. He recalls standing next to Barbara during his earlier stint at the Treasury, as silent as a butler, while she twitted the Irish finance minister with “I didn't know Ireland
had
a finance minister.”

Others also noticed that Paul benefited from help in social situations. Cynthia Martin, wife of the Federal Reserve chairman, revised an invitation to a formal dinner party, suggesting, “We'll have another opportunity after Barbara moves into town.”
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Perhaps Miss Palmer, Volcker's favorite kindergarten teacher, had been onto something when she noted that Paul “does not take part in group discussion.”

Barbara ran the Washington branch of the Volcker household long distance, often reminding her husband to deposit his last few paychecks so she could pay the rent and the telephone bill. When Paul applied his “always procrastinate” strategy to delay meeting their real estate agent, Barbara left a message. “I told Marcia Clopton of CBS Realty to get aggressive with you.”
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On Thursday, June 26, 1969, Paul stood before the president of the United States in the Cabinet Room of the White House, pointing to a flip chart summarizing five months of work by the Volcker Group. Treasury Secretary David Kennedy, Volcker's boss, had arranged the meeting and had asked Volcker to lead off. Key international advisers flanked the president at the elliptical table, including Secretary of State William Rogers, National Security Adviser Henry Kissinger, Federal Reserve Chairman William McChesney Martin, and Counselor to the President Arthur Burns.

Volcker had worried about the meeting, like a teenager preparing for his first date, and not just because it was a center-stage performance for Richard Nixon. That was reason enough—his Democratic lineage would always mark him an outsider—but also because there had been a breach of security that could have ended his tenure with this leak-obsessed administration.

Paul knew that Nixon would not have read the forty-eight-page memorandum “Basic Options in International Monetary Affairs,”
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which had been delivered to the Oval Office; the president viewed “the dollar problem as something we should make go away, presumably painlessly.”
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Volcker had asked Bruce MacLaury, his deputy undersecretary and a future president of the Brookings Institution, a left-of-center think tank in Washington, to prepare a few charts showing the major options under consideration, hoping the visual aids would hold Nixon's interest during the oral presentation. MacLaury sent out rough sketches to a commercial graphic arts company for production, including one showing a doubling in the official price of gold from thirty-five dollars to seventy dollars.

“What were you thinking?” Volcker had grumbled. “A speculator could have easily made a fortune buying gold on the London market and then leaking the chart to the press.”
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MacLaury had no answer, but the graphic artist had taken courses in color design rather than advanced speculation, so no damage was done.

The Volcker Group report had, in fact, dismissed the option of raising the price of gold precisely because it would have inflamed speculative interest in the precious metal. Moreover, doubling the price would have rewarded Russia and South Africa, the major gold producers, and France, the major gold hoarder. None of these three made America's Most Favored Country list. The Volcker Group wanted to deemphasize the role of gold in international finance and included the chart just for completeness.

The formal memorandum blessed a benign-sounding “evolutionary change in the existing system,” as though it would be buried deep in the business section of the
New York Times
, hidden behind the weekly Federal Reserve Report (which is easily located with a compass). In fact, Volcker's recommendations would make front-page headlines when they surfaced.

Volcker knew Nixon cared most about American world power, and he presented his objective to retain “a pivotal role for the U.S. dollar as the leading reserve and vehicle currency,” as though it were a nuclear warhead.
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The main threat to this dominance, he said, came from “common recognition that attempts at large scale conversion [of dollars into gold] would be frustrated by a lack of adequate gold in U.S. reserves.”
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Volcker identified “the strong inflationary pressure in the United States over the past four years … [as] a major factor … undermining confidence in the dollar.”
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He compared the American experience unfavorably with Germany, which places “extremely high
priority on resisting inflation,” and suggested that we might want to “encourage greater consistency among [monetary] objectives in a framework of fixed exchange rates.”
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Volcker's reference to “consistency among monetary objectives” reflected the vulnerability of the Bretton Woods System. He knew the system of fixed exchange rates would come crashing down without cooperation among central bankers, a victim of the triple-headed monster that would become known as the Trilemma.
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The insight of the Trilemma, sometimes irreverently called the Unholy Trinity, is that countries committed to
fixed exchange rates
and
free international flow of capital
must pursue the
same monetary targets
. Pursuit of different interest rates, for example, unleashes what the hedge fund industry in the twenty-first century calls “the carry trade,” but has been the staple diet of foreign exchange traders ever since speculation was invented in biblical-era Egypt.
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This not-so-complicated strategy turns speculators into very wealthy arbitrageurs and would ultimately destroy Bretton Woods.

Foreign exchange speculators are not especially religious, certainly no more than the rest of Wall Street, but when they pray, they beg the Lord of High Finance to grant them two countries with fixed exchange rates and different interest rates. When German interest rates are 7 percent and U.S. rates are 4 percent, for example, speculators will borrow in dollars at 4 percent, exchange the dollars for marks, and invest in marks at 7 percent. They pocket the 3 percent differential without incurring risk as long as the exchange rate between dollars and marks remains fixed.
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Three percent does not sound like much, but the profit is $3 million for a relatively modest-size foreign exchange trade of $100 million. Speculators will do this trade as often as they can because it is an arbitrage—riskless, profitable, and something for which they do not need capital (they can borrow whatever they need). Speculators have reached their nirvana.

All this is very good for speculators, making them fat and happy, but it is very bad for fixed exchange rates. As speculators buy marks and sell dollars without limit, they push up the value of the mark and push down the value of the dollar. Under the rules of the Bretton Woods System, the Bundesbank must intervene, buying dollars and offering marks in exchange to prevent the dollar from depreciating. But if the speculative
onslaught was to continue, the Bundesbank would eventually stop buying dollars, because it would mean flooding the world with marks. To prevent the flood, they would let the exchange rate float, a victim of the Trilemma.

Fixed exchange rates are easily destroyed by such speculative attacks. Most governments defended their turf by fabricating a spider's web of capital controls to hamper speculation. Volcker had, in fact, helped design such regulations during his earlier stint at the Treasury, a “youthful indiscretion” that left him a staunch opponent of government intervention. Roosa had conceived the “interest equalization tax,” a special levy on international investments to stem the outflow of dollars into higher-yielding foreign securities, and turned it over to Volcker to hash out the details. The resulting legislation produced a jigsaw puzzle of exemptions, for the Canadians, for the Japanese, and for every constituency that yelled the loudest.
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Volcker discovered “the enormous gap between beautiful concept and practical application.”
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Volcker expressed his antipathy toward controls during his Cabinet Room presentation, supporting the “free flow of goods … and investment internationally,” but compounded his earlier indiscretion by conceding that “our balance of payments position will continue to require the protection of capital controls.”
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He worried about the inconsistency, and would wrestle with principle versus pragmatism during his entire career. But none of the assembled dignitaries objected to this touch of split personality disorder, an infirmity that comes with high office. Instead, they waited patiently for the plan that would guide America's international monetary policy. Everyone waited patiently, that is, except for the most important person in the room, the president of the United States.

Volcker had anticipated Nixon's lack of interest, but still felt his shoulders sag when he saw the president's eyes flit away. He had seen this Nixon before, during the first televised presidential debate with Kennedy in 1960, when Nixon's furtive glances offstage gave him the shifty appearance of a small-time crook. Now the impatient look meant that five months of work was about to get flushed down the drain.

Volcker rushed to the core of his recommendations, arguing for “a substantial appreciation of the Deutschemark” to provide immediate relief for the dollar and suggesting a limited increase in “exchange rate
flexibility for the longer term.”
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He expected a “perhaps imminent … French depreciation” and proposed “early activation of Special Drawing Rights [SDRs],” a supplement to international reserves that would be called “paper gold.” (It is neither.)
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The forecast for France, which devalued the franc in two months' time, elevated Volcker as a seer.
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More important to him, the core recommendations worked within the Bretton Woods framework, delivering a “fundamental, but evolutionary, change in the existing system,” as promised.
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Germany, with a persistent surplus of exports over imports—the Volkswagen Beetle was cheaper and more reliable than anything General Motors produced—should be have been forced to raise the value of its currency to restore balance. And the proposed increase in exchange rate flexibility built on the minor daily variability already permitted.
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But in addition to these recommendations to sustain Bretton Woods, Volcker added a contingency plan that would rock the foundations of the system and alter the international financial landscape forever. He said the plan should be used only if “forced upon us by events,” because it would be “considered by foreign countries as a U.S. power play … [and] it would contain the seeds of political divisiveness.”
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Volcker's bombshell, suspending the convertibility of the dollar into gold, had been discussed before, but now took center stage.
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He said, “the major objective and potential advantage of suspension … would be to strengthen [our] … negotiating position … by eliminating … a run on our gold stock … [and forcing] foreign countries … [to] passively hold dollars or permit a gradual appreciation of their currencies.”
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Volcker felt that foreigners would willingly hold dollars if “the United States retained reasonable price stability.”
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The dollar standard could replace the gold standard as long as America lived up to its responsibilities.

Volcker looked at Nixon for some reaction, but the president seemed distracted. And then he heard Arthur Burns, the pipe-smoking former professor with the title of counselor to the president, clearing his throat, as though preparing to give a lecture. Burns had been chairman of the Council of Economic Advisers under President Eisenhower and had tutored the then vice president, Nixon, in economics. Volcker knew that Burns was an ally who supported Bretton Woods, having already warned Nixon against freely floating exchange rates: “And whatever else
we may do, let us not develop any romantic ideas about a fluctuating exchange rate: there is too much history that tells us that a fluctuating exchange rate … give[s] rise to international political turmoil.”
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But Volcker worried that Burns would launch into a tirade on the evils of suspension or, even worse, push for an increase in the price of gold. Nixon ended the suspense, and the meeting, with “Good job, and keep me informed about where we stand.”
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