Volcker (11 page)

As they rose to leave, David Kennedy came up to Volcker and said, “Well done,” and then leaned closer: “At least he didn't say no.” This thin endorsement made Volcker think that Richard Nixon would resist launching a financial warhead to counter an international monetary crisis. David Kennedy was not a Nixon insider and had little clout with the president. Volcker nodded and said, “I guess we have a policy by default.”

Harry Houdini could not have conjured a more magical six months than the second half of 1969. Neil Armstrong stepped onto the surface of the moon on July 20. The New York Mets overcame one-hundred-to-one odds to win the World Series on October 16. And the free-market price of gold collapsed to $34.90 on December 9.
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Volcker considered the Mets victory the most unlikely of these events. The team had come into existence in 1962 and had finished last or next to last in the National League every year until then. The dislocation in the gold market ran a close second to the Mets—the price declined to the lowest level since the advent of two-tier trading, a shade below the mystical thirty-five dollars per ounce, after reaching an all-time high earlier in the year. The moon landing was exciting, of course, but it was more predictable. America had made steady progress in space exploration since JFK's challenge to the nation in May 1961 to put a man on the moon by the end of the decade.

The drop in the outlook for gold corresponded with improvement in the U.S. dollar during the second half of 1969. Volcker's personal life took a turn for the better as well, after Barbara joined him in their rambling colonial house in Chevy Chase, Maryland, in July. He was happy that she was with him. They went to a dinner party at the home of
Cynthia and Bill Martin, the one Cynthia had rescheduled until Barbara could attend. Volcker recalled the time President Lyndon Johnson browbeat Martin over interest rates, and recognized the changed posture in the Federal Reserve chairman since then.

In September 1965, when Volcker was deputy undersecretary, he attended a meeting with his boss at the time, Treasury Secretary Henry “Joe” Fowler, Martin, and President Johnson.
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Fowler began by saying, “Chairman Martin wants to raise the discount rate.” Johnson interrupted and said, “You mean he wants to extract more blood from the American people.” Martin ignored the bait and said, “I think it's necessary at this point in the battle for price stability.”

Johnson knew that an increase in the discount rate—the rate the Federal Reserve charges for loans to commercial banks—would be announced like a financial funeral on the evening news, and would raise borrowing costs as it rippled though the banking system. LBJ tried to make Martin back down and finally said, “Bill, I'm going into the hospital tomorrow to have my gallbladder removed. You wouldn't do this while I'm in the hospital, would you?” Martin sighed and said, “No, Mr. President, we'll wait until you get out of the hospital.”

Volcker had argued with Fowler privately in favor of Martin's position, but to no avail. His support for the Fed chairman cost Volcker more than he knew. After the battle over the discount rate, Johnson asked Fowler whether he had considered a replacement for Martin as chairman of the central bank. Fowler said that he considered Paul Volcker, but “we want a sure vote, not a reasonable fellow who will try to steer us down the right path.”
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The confrontation between Martin and the president had surprised Volcker. Paul knew that Martin had taken a principled stand supporting Federal Reserve independence from the U.S. Treasury while he was an assistant secretary in the Truman administration.
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And here was Martin, Volcker's personal hero, checking with the president of the United States about raising interest rates, which he eventually did over LBJ's objection, but it was a decision clearly within the central bank's mandate. Volcker would remember this lesson in political economy. The Federal Reserve may be independent, but so is the president, and he is
elected by the American people. Better to have the commander in chief on your side.

By 1969 inflation had jumped to over 5 percent, tame by later standards but a worrisome number at the time. The Martin-led Federal Reserve Board tightened credit during the first half of the year, raising the discount rate to reduce bank lending and curtail excess spending. Martin had regretted easing monetary policy earlier, and was determined not to ease prematurely again: “The horse of inflation is out of the barn and already well down the road … [now we have to] prevent it from trotting too fast.”
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He kept a tight rein until his term of office expired in January 1970.
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Monetary restraint and high interest rates, designed to control inflation, also enhanced prospects for the American dollar. Corporate treasurers could earn 8 percent on risk-free U.S. Treasury bills by the end of December 1969, compared with less than 6 percent earlier in the year, so they kept their money at home rather than sending it abroad.
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Gold speculators abandoned the precious metal in favor of interest-bearing securities. A London bullion dealer noted, “The question is not who's selling but who's buying. The answer to that is no one.”
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And a Zurich banker added, “There is the growing realization that there will be no increase in the official price [of gold] in the near future.” With gold down to thirty-five dollars an ounce in December, speculators felt as though they had lost their pants as well as their shirts (very worrisome as winter approached). The decline of nine dollars on gold purchased at the peak of forty-four dollars a few months earlier meant a 20 percent loss.
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According to the
New York Times
, gold's tarnished reputation vindicated the “United States policy in establishing … a two-tier system for gold in March 1968” and also benefited Treasury Secretary David Kennedy. “The crowning defeat for gold speculators and victory for the pre-eminence of the United States dollar … is providing a favorable atmosphere for the first European tour of David M. Kennedy as United States Treasury Secretary.”
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Volcker liked and respected David Kennedy. “[He] was the epitome of honesty and openness … [and] once he had settled on me as his
choice as Under Secretary for Monetary Affairs he insisted on it over political opposition. I was, after all, a Democrat … in an administration suspicious that it had inherited far too many civil servants sympathetic to the opposition.”
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Volcker should have welcomed the favorable comments in the press. Instead, they made him nervous, like when a teammate says, “Only six more outs and we've got ourselves a no-hitter”—the proverbial recipe for disaster.

Volcker suspected that the dollar's revival might be short-lived and that the “favorable atmosphere” greeting Kennedy could easily become turbulent. He testified before the congressional Joint Economic Committee that “the United States' [balance of] payments position and domestic inflation were fundamentally more important than any other issue.”
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They were certainly more important than the short-term investments flowing into America that had buoyed the dollar and trashed gold. Capital flooded ashore when U.S. interest rates rose, but ebbed just as quickly when rates declined. And when the tide turned, foreign central banks would drown in dollars, and the free-market price of gold would sound the warning like a foghorn.

Volcker's fears were well founded.

The White House staff celebrated on two counts when Nixon nominated Arthur Burns to replace William McChesney Martin as chairman of the Federal Reserve Board effective February 1, 1970. Burns would take up residence at the central bank, where he could implement policies favorable to the president. And Burns, the imperious professor, would vacate his position as counselor to the president, where he was resented for his special relationship with Nixon.

William Safire, a Nixon speechwriter, noted that Arthur Burns took liberties that no one else would. In one particular incident, Burns had been in the Oval Office making a typically long and slow presentation on a welfare reform.
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“As I said in my July 8 memorandum, Mr. President—” The president interrupted Burns to speed things along: “Yes, Arthur, I read that.” Burns then interjected, “But you couldn't have, Mr. President. I didn't send it in yet. I have it with me here.” Nixon did not miss a beat, “Thanks, Arthur, I'll read it.” According to Safire, the president seemed almost amused, but his staff took umbrage for him.

Soon after becoming Fed chairman in February 1970, Burns began to ease monetary policy to counter rising unemployment, and by November 1970, Treasury bill yields had declined by two percentage points compared with a year earlier. Corporate treasurers registered their disapproval by shifting investments abroad. According to a Volcker Group memorandum, “Our overall payments position is running in very heavy deficit despite some welcome improvement in our trade and current account. This deficit reflects sharply adverse capital movements, partly reflecting easier money in the U.S.”
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And the price of gold registered its concern, jumping more than 10 percent, to over thirty-nine dollars an ounce.
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The euphoria of 1969 had disappeared like a puff of magician's smoke.

Volcker recognized that fickle capital flows would precipitate the need for drastic action.
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With a crisis all but certain, he dusted off the contingency plans laid out in his Cabinet Room presentation of more than a year earlier, but worried that the president would need congressional approval before launching what Volcker (and many others) considered the nuclear option. Volcker knew that only Congress could change the price of gold, and he asked Michael Bradfield, an assistant general counsel at Treasury, to determine whether the chief executive had the right to suspend gold convertibility while leaving the price unchanged.

Bradfield's eight-page memorandum made Volcker smile.
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It confirmed that changing the “par” value of gold required congressional approval, citing the Gold Reserve Act of 1934, which had raised the price of gold from $20.67 to $35.00 per ounce. But that same legislation, the memorandum noted, conferred on the secretary of the treasury the discretion to suspend gold sales.

To anyone but a lawyer, a total suspension of gold sales seems more dramatic than a simple change in price, closer in spirit to a military blockade, the equivalent of a declaration of war, than a commercial adjustment. But the legal perspective was all that mattered, and the law gave the president and his treasury secretary the authority to act without congressional interference. Volcker felt prepared for the looming international crisis.

On November 18, 1970, Richard Nixon confided to his chief of staff, H. R. Haldeman, that he had grown impatient with his economic advisers. According to Haldeman, “They failed in the one prime objective [the president] set, to keep unemployment under five percent in October … and [the president] doesn't want to take
any
chance on screwing up 1972.”
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Nixon's focus on the next election continued the following day, in a meeting with the University of Chicago economist Milton Friedman, who was an unofficial adviser to the president. According to Haldeman, “Friedman urges we stay on the present economic course,” and the president said “it was nice to have someone say we're doing things right.” Haldeman then reports that Nixon, still concerned about 1972, said we “can't afford to risk a downturn, no matter how much inflation.”
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Milton Friedman surely did not propose more inflation to achieve lower unemployment. He did not believe in this Keynesian medicine that had been practiced in the Kennedy-Johnson White House, and had warned against it in his presidential address to the American Economic Association.
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But Nixon embraced the Democratic philosophy with the enthusiasm of a convert, encouraged by an unwitting blessing from Friedman.

Milton Friedman had famously said that “We are all Keynesians now,” a stunning admission by the leading opponent of activist government intervention.
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Friedman subsequently qualified his remarks, explaining that he actually meant “In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.”
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To an academic such as Milton Friedman, qualifying remarks are as important as footnotes, but both are ignored by politicians when it serves their purpose.

Nixon described himself as “a Keynesian in economics,” and would soon name a Democrat to his cabinet to confront the emerging problem called stagflation.
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Britain's chancellor of the exchequer, Iain Macleod, had used the term
stagflation
to describe a combination of high unemployment and high inflation.
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And according to the
New York Times
, this British disease now threatened America's reputation. “Europeans Fear American ‘Stagflation' Will Drag Their Own Economies Down.”
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Stagflation would spread like a pandemic during the coming decade, but in November 1970 it was unprecedented and puzzling.
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From his
perch at the Federal Reserve Board, Arthur Burns complained that “We are dealing … with a new problem, namely, persistent inflation in the face of substantial unemployment—and that the classical remedies may not work well enough.”
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Burns used this perceived violation of economic principles to promote wage and price controls, which he liked to call an “incomes policy” to avoid being labeled a socialist by the libertarians in the White House basement. Nixon agreed to develop “a market-oriented” incomes policy, over the objection of his economic advisers, Paul McCracken of the Council of Economic Advisers and George Shultz, now head of the Office of Management and Budget, in exchange for a promise from Burns to follow an expansionary monetary policy. “I have been assured by Dr. Arthur Burns that the independent Federal Reserve System will provide fully for the increasing monetary needs of the economy. I am confident that this commitment will be kept.”
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