Volcker (33 page)

Stockman had confirmed the market's worst fears.

In the beginning of 1982, Donald Regan and Allan Meltzer had correctly identified risk as the key to high interest rates, but they focused on the wrong risk. Gold and the dollar confirmed that financial markets
believed Volcker's pledge to extinguish inflation and recognized his progress. The jump in long-term interest rates did not come from an inflation scare but instead reflected a recurring budget nightmare.
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Higher real interest rates help investors sleep better at night.

Meltzer himself testified to anxiety over the budget before the Senate Finance Committee: “Let me turn briefly to the fiscal side … There is great uncertainty about the budget problem and how it will be resolved. We are, I believe, on the verge of a fiscal crisis. Not in 1982 and 1983, the years which receive so much attention … but on out as far as we can project, we do not see the size of the budget deficits coming down relative to GNP [national output] or saving. That's a problem which I think hangs over the economy and creates uncertainty … we have very uncertain outcomes.”
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Meltzer saved the scariest prediction for last: “We run the risk of sliding into the … instability characteristic of modern Italy or of moving to some other less desirable solution that no one can now foresee.”

The collision between Volcker's tight monetary policy and Reagan's budget deficit resembled cold war brinksmanship, like Kennedy confronting Khrushchev over missiles in Cuba.
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The stakes were not nearly as ominous as world conflict, but the fallout of high interest rates clouded America's economic landscape. The press reported that Alan Greenspan, at the time a member of Ronald Reagan's outside economic advisers, contends that “if the Administration doesn't act to convince the markets that the deficit will be down to around $80 billion by 1984, the resulting rise in interest rates will make the Reagan economic recovery ‘feeble.'”
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An $80 billion deficit violated Reagan's campaign promise to balance the budget but would divert Wall Street from thinking about instability worse than Italy's.

Robert Lucas, the future Nobel Laureate in economics at the University of Chicago, turned the confrontation between Volcker and Reagan, and the deficit-increasing tax cut of 1981, into a moral conflict in a
New York Times
essay: “Can a resolutely ‘monetarist' central bank, restraining monetary growth no matter what else is happening, insulate the economy from the effects of this fiscal dishonesty? The [Reagan]
Administration has boldly wagered all of Paul Volcker's chips on this possibility, but it is buying only time … it is not within the abilities of any central bank to make things work out right in a society that insists that the real resources spent by its government can exceed, on a sustained basis, the resources that government extracts from the private sector via taxes.”
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Who would fold his cards first, Volcker or Reagan?

The first meeting of the Federal Open Market Committee in 1982 began at 2:30 on Monday afternoon, February 1. Before joining the group, Volcker had sat in his office staring at a fifty-dollar box of Partagas cigars perched at the edge of his desk. Treasury Secretary Donald Regan had sent these exquisite Dominican exports as a peace offering, having denigrated Volcker's “erratic” money growth and addiction to “cheap” cigars a week earlier.
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Paul could not smoke them. His father would turn over in his grave if he knew his son was inhaling a two-dollar cigar, and besides, they were far too rich for his taste. He would offer one to Henry Wallich's more refined palate after the meeting, depending on how it went.

Credibility dominated the discussion. A jump of 15 percent in the money supply since December surprised just about everyone, considering that the deep recession that began in mid-1981 should have withered the demand for cash.
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Regulatory changes allowing banks to pay interest on checkable deposits had reduced the reliability of these numbers, making it possible to discount the increase as an aberration.
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But the Fed's reputation remained fragile to many of those seated around the table, and they worried about appearing soft.

Gerald Corrigan, a voting member of the FOMC as president of the Federal Reserve Bank of Minneapolis, who had served as Volcker's special assistant when Paul first arrived at the board, emphasized history: “The message that seems to be coming through both from [Capitol] Hill and the Administration is that it's time to change [our] monetary policy … [But] I think we run the risk that credibility will be affected in a more amplified way because of the perception that the Fed has buckled under again—[everyone will say] ‘they always have and they always will.'”
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Board member Emmett Rice, not known as an inflation hawk, made
a similar point: “As you know, I've been one of the people who have been worried … that the money supply … has not grown fast enough … [but] my instinct is … that to change the targets for the aggregates at this point would probably damage our credibility.”
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Volcker sounded more flexible than his colleagues: “I will make one more comment … All this worry about our credibility is there, but … we do not build up credibility for the sake of building up more credibility. We build up credibility to get the flexibility to do what we think is necessary. If I were convinced now—more convinced than I am that change is appropriate—I would say the heck with that point.”
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Frederick Schultz had been appointed to the Federal Reserve Board by Jimmy Carter a month before Volcker, and had been Paul's most reliable ally during the previous two years. His term was about to expire, and Reagan had appointed Preston Martin, a California mortgage executive, to replace him. Schultz chose his last meeting on the FOMC to challenge Volcker, and he emphasized politics:

“I disagree with your comments on credibility. I think there is an enormous sense out there that we are still the only game in town in the fight against inflation … We are right back in the situation we have been in before, particularly now that the President will not do anything about the deficits … If we give an indication that we are caving in and if we start making some changes, there are some really serious costs in terms of credibility, Paul. I think that the credibility factor is more important than you just gave it credit for.”
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Schultz knew that the specter of uncontrolled deficits would deflate Volcker's trial balloon to avoid further restraint. Volcker did not need much convincing to remain silent. At the end of the February 1, 1982, meeting, the FOMC voted to take account of “the recent surge in growth of the [money supply]” and to seek “no further growth” during the first quarter of 1982. The committee raised the target federal funds rate to 14 percent, compared with a 12 percent objective in December 1981.
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The Federal Reserve's purposeful increase of two percentage points in the overnight interest rate six months into a major recession was unprecedented. It seemed belligerent to some, including Massachusetts senator Edward Kennedy, who wanted to end the Fed's independence.
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But it also confirmed the central bank's determination to uphold its
responsibility as “the only game in town” and to overturn its image as “the same old Fed.”

It meant the Federal Reserve would not fold.

Within days of the February FOMC meeting, Volcker initiated a détente with the president. The escalating rhetoric with the administration had troubled him, and not because of the newspaper headlines—he was used to that—but his protégé Jerry Corrigan had shown how the brewing controversy could manipulate policy.

Corrigan understood politics as well as Lyndon Johnson did and had warned his FOMC colleagues about the clash between monetary and fiscal policy. “We are sitting here looking at a fiscal situation that is just untenable. And one of the concerns I have—and maybe it is tilting at our windmills a little—is that if the perception is that we really are easing, any prospect of being able to do better on the fiscal side is weakened … because that creates the impression that we are going to sit here and monetize all that debt … I must say I would be troubled at [that] prospect.”
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Using monetary policy as a weapon to promote responsible fiscal policy fit Volcker's battle plan, but he also wanted the flexibility to ease monetary policy sooner rather than later to avoid an economic collapse. He asked Murray Weidenbaum, chairman of the Council of Economic Advisers, to set up a one-on-one meeting with Reagan, without subordinates.

Weidenbaum was stunned by the request: “Paul had never asked me for a favor in all the time we knew each other. He had been my boss and was now a friend. I went out of my way.”
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The meeting between the president and Volcker took place on Monday afternoon, February 15, 1982. It was Washington's birthday, an informal day in the nation's capital, and the president wore a striped golf shirt and tan slacks.
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The relaxed atmosphere paid immediate dividends, according to Reagan's diary entry at the end of the day: “Met with Paul Volcker. I think we've broken ground for a new & better relationship aimed at getting interest rates down. He thinks we
can
get short term rates down 3 or 4 points by June. Long term will take longer.”
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Three days later, on February 18, Ronald Reagan embraced Paul
Volcker publicly. Not physically, of course—neither man was cuddly. But Reagan's remarks at his news conference in the East Room of the White House confirmed the new relationship, and a new commitment to restraining budget deficits.

I have met with Chairman Volcker several times during the past year. We met again earlier this week. I have confidence in the announced policies of the Federal Reserve Board. The Administration and the Federal Reserve can help bring inflation and interest rates down faster by working together than by working at cross-purposes. This Administration will always support the political independence of the Federal Reserve Board … At the same time, I am sensitive to the need for a responsible fiscal policy to complement a firm anti-inflationary monetary policy. I will devote the resources of my Presidency to keeping deficits down over the next several years.
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After the news conference, Weidenbaum telephoned Volcker: “Congratulations. You made quite an impression.”
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“We'll see what happens.”

“No, already.”

“What's that supposed to mean?”

“I just spoke with the president. He now refers to you as Paul rather than Chairman Volcker.”

Republican senator Paul Laxalt of Nevada was Ronald Reagan's closest friend in Congress, having served as manager of his presidential campaigns in 1976 and 1980. He could whisper in the president's ear, “Hey Ron, you've messed up, this one isn't working.”
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Laxalt urged Reagan at the end of March 1982 that “time is running out” on a budget compromise.
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Republican senator Robert Dole of Kansas, the Senate Finance Committee chairman, delivered the same message. Dole had proposed a tax increase to help restore a measure of budget sanity, and said, “We're right on the threshold of a [budget] breakthrough,” but the compromise must come in a matter of “days and weeks, not months.”
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Laxalt was not optimistic. He knew the president best and thought that “he will play his cards right to the end.”
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Reagan waited.

The president did not want to raise taxes; it went against everything he stood for. It would also alienate the Republican Party's conservative coalition, which had supported his program of less government. Jack Kemp, the Buffalo, New York, congressman who had cosponsored the 1981 tax-reduction bill, reminded the press that Reagan wanted to reduce government spending by strangling it off with lower taxes.
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The president had said it was like curing our children's “extravagance simply by reducing their allowance.”
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Kemp objected to “the dramatic U-turn” on economic policy.
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By August 1982, Reagan knew that unless he acted, the Republicans would face a rout at the ballot box in the November congressional elections. On August 6 the White House press secretary said that the president had postponed his California vacation to help get the pending tax and expenditure legislation through Congress. “The president has brought 75 House Republicans to the White House over the last three days to emphasize his support for the tax bill.”
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Reagan told his fellow Republicans, “We are beginning to see some real relief on interest rates with a somewhat dramatic decline over the last several days. Interest rates are going in the right direction. They must continue if we are to have economic recovery. If we do not get spending cuts and reduce the deficit, this downward trend on interest rates could be reversed. While I am reluctant to raise taxes, the price is not excessive to get the deficit down and to ensure the continuation of economic recovery.”
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In August 1982, Ronald Reagan sounded like Paul Volcker. On August 19, 1982, the tax increase was passed.
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It was a rare victory for the central bank. There would be more.

Volcker stared at the sentences on the lined pad on his desk while holding a sharpened number-two pencil like a carving knife. He had hoped to write this letter to Jimmy Carter two years earlier, but it was premature. Even now, Wednesday, August 18, 1982, while poised to slice words from the draft like excess fat, he worried about putting his sentiments on paper. He edited the letter one last time before handing it to his secretary.
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