Volcker (30 page)

Volcker refused to join the chorus, and instead, while talking with reporters at the annual meeting of the International Monetary Fund, almost apologized for the increase in interest rates that had preceded Carter's remarks. “The prime rate is a little more jumpy on the upside
than it is on the downside … and you wonder whether it hasn't jumped and anticipated too much.”
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Volcker knew the Federal Reserve had caused the uproar by raising the discount rate a week earlier, an event he considered “a rather forceful move” even under the new operating procedures.
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Moreover, tightening monetary policy like that during an election campaign was unprecedented.
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It marked a turning point for the central bank.

On Thursday, September 25, 1980, the Federal Reserve Board had approved by unanimous vote a one-percentage-point increase in the discount rate to 11 percent. The discount rate is the interest rate charged to commercial banks for borrowing reserves from their regional Federal Reserve banks. The individual Federal Reserve banks must petition for a rate change to the seven-member board chaired by Volcker. On September 25 the board rejected a proposed one-half percent increase as “too cautious, particularly in light of the excessive monetary expansion that had occurred recently,” and favored a one-percentage-point increase because “inflationary expectations were worsening.”
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Most changes in the discount rate occur after a fundamental shift in policy by the Federal Open Market Committee, but the September 25 increase signaled a new initiative. The press quoted Henry Kaufman: “The Federal Reserve tightened monetary policy this week.”
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The
New York Times
cited earlier conflicts between presidents and the central bank, including complaints by Harry Truman in 1951 and Lyndon Johnson in 1965, when the Federal Reserve increased interest rates. The
Times
contrasted those incidents with allegations of Federal Reserve favoritism toward Richard Nixon in 1972. “In a twist on the usual theme, Mr. [Arthur] Burns was attacked in 1972 from outside the Administration for allegedly boosting the money supply to help insure Mr. Nixon's reelection, a charge he strongly denied.”
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Volcker's willingness to raise the discount rate six weeks before the election confirmed that the Federal Reserve had broken with the past and had changed more than just its technical procedures since the days of Arthur Burns. The
Wall Street Journal
advertised the Federal Reserve's new look on the paper's editorial page: “To anyone willing to draw the moral, Mr. Carter's assault on Mr. Volcker provides an unwitting lesson on why we need an independent Fed.”
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Volcker recalls an unusual backdrop to the entire episode: “The
timing of the discount rate increase was unfortunate, right in the middle of the presidential campaign, and it might have contributed to Carter's defeat. The economy had begun to rebound rapidly from the brief recession that began in January of 1980, and we could not afford to wait. It was among the most difficult things I've done in my professional life. Jimmy Carter had appointed me, and I voted for him in 1976, and would do so again in the upcoming election. But no matter what I thought or felt, there was no choice other than to increase the discount rate. I had a job to do.”
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Volcker switches gears: “But it is ironic that the president accused the Federal Reserve of being preoccupied with the money supply while prominent monetarists criticized us for not following the party line and for allowing the money supply to grow erratically during 1980. I suspect that most of them choked on Carter's description of our approach as ‘strictly monetarist.'”
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Earlier in the year, Milton Friedman had disparaged the Fed's record as a “particularly egregious example of the contrast between talk and action,” and complained that the Fed under Volcker has not given up on “manipulating interest rates” and that it paid only “lip service” to controlling money supply growth.
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Friedman, the leading monetarist of the day, was also Governor Ronald Reagan's “favorite economist,” according to George Shultz, the chairman of Reagan's Coordinating Committee on Economic Policy during the presidential campaign.
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Volcker never denied that the Federal Reserve monitored interest rates. The October 6, 1979, announcement shifted attention toward reserves but did not remove interest rates from consideration.
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And the FOMC Directive combined a desired path for reserves and an associated range for the federal funds rate.
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Volcker accepted a mixed strategy, and imperfect control over bank reserves and the money supply, just like Monty Charles at De Beers juggled his objective of price stability in the diamond market with periodic inventory adjustments to avoid accumulating too many or too few raw stones.
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Volcker liked the quip attributed to Nobel Laureate Paul Samuelson: “Central bankers were born with two eyes so they could use one to watch the money supply and the other to watch interest rates.”
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To the journalists asking for a response to Friedman's criticism, Volcker sidestepped a confrontation by commenting, “Oh, Milton.”
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But behind the closed doors of the Federal Reserve's boardroom he had encouraged freewheeling debate, almost like a college seminar.

For example, at the FOMC meeting on September 16, 1980, Lawrence Roos led the monetarist complaint with “I hate to belabor this, but … I don't think [the quarterly] rates of growth [in 1980] in any way reflect any … policy or directive that we gave.”
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Lyle Gramley, a recent Carter appointee to the Federal Reserve Board, took the other side: “Our … objective is … to achieve a longer-run path of monetary and credit expansion … I don't see the system as working out unfavorably just because the quarterly pattern is so erratic.” Volcker saw merit in both arguments. “These are all matters that we have to look at … I don't particularly like what has been happening … we have put all this money [on] the money supply and have had these quarterly fluctuations which don't seem to be particularly controllable … The most optimistic view is that these quarterly movements are not very significant.”

A week after the internal debate, Volcker had discarded the cloak of optimism like an ill-fitting hand-me-down. He led the board in its unanimous decision on September 25, 1980, to raise the discount rate to “underscore the Federal Reserve's resolve to continue its policy of discouraging excessive monetary growth.”
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And less than a month after that, on October 21, 1980, the FOMC tightened further to achieve “a sharp reduction in monetary aggregates.”
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The federal funds rate rose by three percentage points, from 11 percent to 14 percent, in the six weeks before the nation went to polls.
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On November 4, 1980, Ronald Reagan defeated Jimmy Carter to become the fortieth president of the United States.

Carter lost the election because Americans were tired of inflation, tired of gasoline lines, tired of American hostages in Iran, and tired of paying taxes, of course. Ronald Reagan had promised to reduce taxes.

But Jimmy Carter blamed Paul Volcker. Carter recalled that his “advisers were very concerned” when he appointed Volcker as Federal Reserve chairman.
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They warned him about “putting someone as strong, independent, and as outspoken as Volcker in charge of the Federal Reserve.” Carter concluded, “Our trepidation about Volcker's appointment was later justified, when the Federal Reserve under his leadership …
raised interest rates to very high levels—which ultimately achieved his goal of reducing inflation but also brought about a severe recession.” And finally: “These economic restraints … were a negative factor in my 1980 reelection campaign.”

Volcker apologized by following through on his plan.

Arthur Burns sat in a wing chair in front of the fireplace in Volcker's office. A few feet away, Volcker sprawled his six-foot, seven-inch frame across the couch while lighting up his six o'clock cigar, number eleven for the day.
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He could see a wisp of smoke curling upward from number ten in the ashtray on his desk. It was not the first time he indulged two cigars at once, and he acknowledged the extravagance “especially now that each cost a quarter.” Volcker waited while Burns lit his pipe, and enjoyed inhaling the tangled smoke.

It was Wednesday, November 19, 1980, and Burns had asked for the meeting with an urgency usually reserved for an international crisis. He had just returned from Los Angeles after the drafting of a report by members of Reagan's Coordinating Committee on Economic Policy.
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The group was chaired by former treasury secretary George Shultz and included Milton Friedman, future Federal Reserve chairman Alan Greenspan, Congressman Jack Kemp, former treasury secretary William Simon, and Citibank chairman Walter Wriston.
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“Milton wants to abolish the Fed,” Burns said with an uncharacteristic tremor in his voice. “He wants to replace you with a computer.”

“It's a metaphor, Arthur.”

“I understand, Paul, but it's more than that.”

“What is that supposed to mean?”

Burns thought for a moment. “I don't think I can show you our report but I can describe what it says.”

“Are you sure you want to do that?”

“Under the circumstances … yes.”

Burns cleared his throat and spoke as though he were delivering a eulogy.
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“The key message is that while the Federal Reserve is an independent agency, in practice, independence does not mean that the Federal Reserve is immune to Presidential and Congressional influence. The problem for the new administration is to assure accountability …
while preserving independence.” Burns adjusted his glasses. “I convinced them to conclude with those last three words.”

“I appreciate your efforts, Arthur, but this battle over the Fed's independence is nothing new. I've heard all of this—”

Burns raised his hand like a traffic cop. “Milton has allies within the group, especially Wriston and Simon. But most important, he has direct access to the president-elect, and you know how persuasive he [Friedman] can be.” Burns then paused and thundered a warning. “Do not forget that for as long as you are in this office.”

Volcker recalls never having seen Burns quite so agitated. “He had gotten so red at the end of the conversation that I thought he was going to have a stroke.”
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But Volcker tried to separate fact from rhetoric. He had heard Friedman's jibe about replacing the Fed with a computer at a conference earlier in the year.
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He also knew that Walter Wriston had staffed Citibank's Economics Group with more monetarists than at a University of Chicago cocktail party.
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An alliance with Friedman made sense. And Burns was certainly right about Friedman's power with words. Volcker recalled how convincing he was in past debates with Robert Roosa over fixed exchange rates.
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A debate with Milton Friedman resembled mortal combat, a duel to the death, and Friedman always emerged unscathed. Volcker did not think this necessarily proved his case. “Burr vanquished Hamilton in America's most famous duel, but that did not make him right.”
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Nevertheless, he recognized Friedman's skill and took Burns's warning to heart. Volcker was not surprised when Ronald Reagan wondered, “Do we really need the Fed?”
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After the election, the Federal Reserve continued what it had started during the presidential campaign, tightening credit to restrain inflationary expectations. The economic upturn from the brief recession of 1980 had begun. Volcker warned members of the FOMC at their first post-election meeting about the likely consequences of their actions, especially if Reagan's promised tax cuts increased the government's budget deficit. “When I speak of collisions next year, I think you ought to be aware … of the potential for the Federal Reserve to be left out there hanging alone in extremely unsatisfactory economic circumstances …
The danger that I see … is that everybody will be committed to an attack on inflation but it's entirely up to the Federal Reserve to perform.”
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John Balles, president of the San Francisco Federal Reserve Bank, added, “I have a hunch that [nothing is] … really going to change unless or until the size of that budget deficit comes down, however it may be done. Until then, we're under awful pressure.”

Actions by the Federal Reserve over the next month promoted a confrontation. The board increased the discount in two steps to 13 percent, and the FOMC pushed the federal funds rate to over 20 percent, the highest levels to date.
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Commercial banks responded by raising the prime rate to an all-time record of 21½ percent. The FOMC had taken a sledgehammer to inflation, and in the process, at the last meeting of 1980, Volcker articulated guidelines for monetary policy that eclipsed the changes he had made on October 6, 1979.

Volcker liked to doodle while listening to the discussion at the FOMC. Nothing fancy: a mindless row of triangles inside triangles that resembled a cubist's rendition of the Grand Tetons. But on Friday morning, December 19, 1980, he stopped etching and took notes on what he was hearing.

Board member Lyle Gramley, who had spent most of his career as a Fed staffer, said, “We have adopted targets for growth of the monetary aggregates that … just don't provide any room for real growth. And I don't think we ought to back away from that. That's what we've been trying to achieve … I'm prepared to accept a weak economy.”
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