Volcker (32 page)

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.”
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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.
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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.”
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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.
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And the Survey of Professional Forecasters reported a decline in expected inflation as well.
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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.
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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.”
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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.”
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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.
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The record confirms Meltzer's claim that the Federal Reserve failed to control money supply growth, but the marketplace ignored his concern.
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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.
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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.
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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.”
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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.
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Friedman famously said that inflation is always a monetary phenomenon, but he attributed the root cause of inflation to government deficits.
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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.”
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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.
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“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.
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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,
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“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.
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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.
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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.”
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Bond buyers worry about unpleasant deficit surprises, rather than simply focusing on the best guess of budget projections, and each circumstance is unique.
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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.”
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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.”
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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.”
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