Volcker (37 page)

Everyone laughed except for Volcker.

He knew the deficit had obscured the progress he had made on inflation, forcing interest rates higher than they should have been. Foreign investors had softened the blow by investing in U.S securities, but that had left Middle America's mortgage payments hostage to international financiers. Volcker had tangled with the administration over the budget since the 1981 tax cut, but now he sensed bipartisan congressional support. His new lease on the chairmanship would help the cause.

The Senate Banking Committee confirmed Volcker's reappointment on July 21, 1983, by a vote of 16 to 2, with Democrats James Sasser of Tennessee and Alan Cranston of California voting against.
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Sasser explained his negative vote: “The Federal Reserve Board … has stymied the economic growth of this country and seriously damaged our economy … Unemployment still stands at ten percent … Eleven million Americans are unemployed.”
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A letter to Volcker from W. B. Greene, one of Sasser's constituents, dulled the criticism: “I was extremely disappointed when I realized that one of our Senators from Tennessee … had voted against your re-nomination … He seems to forget the last ten years … Congratulations, I am glad you're back.”
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Another Sasser constituent, from Ellendale, Tennessee, penned a mixed message: “On September 11, 1981, I wrote a note to criticize your policy. Today I write to thank you … It took guts to stand up to the problem and not take the easy way out. It looks as though your ideas are working … Hang in there.”
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On July 27, 1983, the entire Senate voted on Volcker's reappointment.
Senator Garn urged approval with “I doubt any chairman has served during a more difficult time.”
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Dennis DeConcini, an Arizona Democrat, led the opposition with the complaint that Volcker had “almost single-handedly caused one of the worst economic crises” in American history.
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The Senate voted 84 to 16 to confirm Volcker for a second term as chairman of the Federal Reserve Board.

By February 1984, six months after Volcker's reappointment, the economy had rebounded significantly from the 1982 recession. Unemployment had declined a full three percentage points from its peak in November 1982, although it was still high by historical standards.
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Volcker worried about the clash between the government and the private sector in the bond market. He told the Senate Banking Committee during his report on monetary policy on February 8, 1984, “I hardly need to remind you that inflation has tended to worsen during periods of cyclical expansion … [and that] the structural deficit in our Federal budget … [carries] implications for the prospects of reducing our still historically high levels of interest rates … We still have time to act— but, in my judgment, not much time.”
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Volcker's view gained support from the just-released annual report of the president's Council of Economic Advisers. The CEA was chaired by Martin Feldstein, an outspoken professor on leave from Harvard University who wore the unfashionable black-rimmed glasses of an academic. The CEA warned that the deficit would not disappear as the economy approached full employment; it was built into the structure of expenditures and taxes, and that “federal borrowing to finance a budget deficit of five percent of GNP … means that the real rate of interest must rise until the demand for funds for private investment is reduced to the available supply.”
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Feldstein's prediction put him at odds with Treasury Secretary Donald Regan, who said of the CEA report, “You can throw it away.”
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Regan did not believe that deficits provoked high interest rates, and he had considerable support among professional economists.
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The next few months would help resolve the dispute.

Congress and the administration battled over responsibility for the deficit. President Reagan said in early February 1984, “My most serious
economic disappointment in 1983 was … the failure of the Congress to enact the deficit proposals that I submitted last January … We cannot delay until 1985 to start reducing the deficits that are threatening to prevent a sustained and healthy recovery.”
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Congressional Democrats countered that the president promoted the deficit by promising increased defense spending and by lobbying for tax cuts for the rich.

Senate Banking Committee member John Heinz, a critic of the Federal Reserve during the Mexican crisis, sensed a hidden agenda in Volcker's testimony on February 8. He began his questioning of the Fed chairman with a preamble: “Now I don't want to be the skunk at the garden party, but it seems to me there's no party and there's not a lot of leadership … We've agreed that the deficit is bad … That's the good news. The fact is, however, that in terms of an action plan, we don't have one … And if our experience in [Congress] is anything to go by, before there's going to be leadership or compromise there's going to have to be a crisis.”
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Volcker's ears perked up with the word
crisis
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Heinz continued: “We will have a crisis in this country if, and only if, the Federal Reserve maintains its … policy of making sure the money supply grows at a steady and slow rate … And my question is, are you prepared to help bring about the necessary crisis through your continued restrictive monetary policy so that we deal with the deficit?”
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Volcker heard Heinz but could not believe his words. The Federal Reserve would commit political suicide with a home-cooked crisis, the last meal before Congress imposed a death sentence on its not-so-favorite creation. He knew that the Republican senator from Pennsylvania was something of an outsider, and had been a skeptical supporter of Reagan's 1981 tax cut because of its implications for the deficit, but Heinz could not be serious.
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Heinz almost sounded as if he knew Volcker's history of exploiting crises as a policy weapon. Volcker had delivered that message at his very first FOMC meeting as chairman: “Dramatic action would not be understood without more of a crisis atmosphere … where we have a rather clear public backing for whatever drastic action we take.”
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But the transcripts of FOMC meetings were secret and would not be disclosed publicly for another decade.
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And Heinz certainly never saw
Volcker's confidential memo to Treasury Secretary John Connally urging that a foreign exchange crisis be allowed to simmer to pave the way for the suspension of gold convertibility on August 15, 1971.
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Volcker concluded that Heinz was on a fishing expedition and that he was the prizewinning catch, a nice fat 240-pound Atlantic salmon.
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He answered with the appropriate dose of incredulity: “Let me say, as a matter of general philosophical approach—and I feel very strongly about this—it is not our job to artificially provoke a crisis. We are not going to go out there and conduct a tight money policy for the sake of trying to bring leverage on the Congress or the administration.”
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Heinz interrupted: “Mr. Chairman, I never intimated that that was a part of your thinking.”

Volcker forced a smile. “I wasn't absolutely positive about that.”

And then Heinz edged closer to the truth: “[But] it might be an inevitable consequence.”

“All right,” Volcker said, confirming that high interest rates on the federal debt could galvanize public opinion and force Congress and the president to reduce the deficit. He then continued his disclaimer: “I just wanted to make … absolutely clear … that we adhere to a policy that we think is in the best long-term interests of the country to avoid a resurgence of inflationary pressures.”

Heinz would have the last word.

On Monday, April 9, 1984, the Federal Reserve Board raised the discount rate, the first increase in nearly three years.
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The half-point jump in this politically sensitive rate confirmed a gradual tightening of monetary policy by the Federal Open Market Committee between February and May 1984, as the economy expanded. During that same four-month period, the ten-year rate on Treasury securities rose by more than two percentage points, to within a hair of 14 percent at the end of May.
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The ten-year rate had been at 14 percent during 1981, when investors worried that double-digit inflation could persist forever.

The increase in the bond rate as the Fed tightened credit disappointed Volcker, just as it had after October 6, 1979, when the Federal Reserve's credibility was at an all-time low. Back then, bond holders had good
reason to mistrust the Fed's commitment to controlling inflation, and they demanded high nominal rates as compensation. Now, almost five years later, after inflation had been cut to a third of its peak level, he thought the Federal Reserve deserved better.

Tight monetary policy by a central bank that suppresses inflationary expectations should raise short-term interest rates but leave long-term rates almost unchanged.
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Volcker knew that the Federal Reserve had lost the war against inflation during the 1970s by remaining too easy for too long during economic recoveries, and he had admitted this publicly: “We haven't passed the test of maintaining control over inflation during a period of prosperity.”
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But he was disappointed just the same.

Fed watchers confirmed the bond market's apparent skepticism. The Shadow Open Market Committee (SOMC), a group of monetarist economists who monitor the behavior of the Federal Reserve on a regular basis, reported,“The Federal Reserve has failed repeatedly to conduct a responsible non-inflationary monetary policy, and is failing again.”
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Allan Meltzer, a cochairman of the SOMC, confirmed that judgment retrospectively: “Apparently the public regarded the risk of inflation as very high.”
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Some members of the FOMC agreed. Lyle Gramley, a former Fed staffer during the 1970s, warned the committee in March 1984 about repeating past errors. “I think we're in very serious danger of losing credibility as an agency that is trying to hold down inflation … [and] we are doing so in the second year of a recovery when expectations [for the economy] have been greatly exceeded.”
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Henry Wallich, the perennial inflation hawk, said, “It seems clear … that inflation expectations have increased over the last few months.”
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Marvin Goodfriend, an economist at the Federal Reserve Bank of Richmond, would later call the jump in long-term interest rates during this period “an inflation scare.”
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The marketplace delivered a very different message.

The price of gold shoots up like a distress signal when investors get a whiff of inflation. Gold almost doubled during the second half of 1979, after an inflation rate of 12 percent had taken hold.
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Speculators worried that monetary policy could not cure the problem despite a jump in short-term interest rates. Gold increased 30 percent during the summer of 1980, when short-term interest rates declined with a weak economy.
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Speculators thought that the Fed had gone soft in its battle against inflation.
But during the so-called inflation scare of 1984, the price of gold actually declined, from an average of $385 in February 1984 to an average of $377 during May.
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Speculators evidenced great confidence in the Federal Reserve's inflation-fighting credentials—certainly more than that expressed by economists, both inside and outside the central bank. And speculators had real money at stake.

The failure of gold to confirm inflationary expectations leaves a more prosaic explanation for the increase in the ten-year bond rate. Investors expected that increased borrowings by businesses to finance economic expansion would clash with continued government borrowing to cover the structural deficit. Competition for credit would push up “the real rate of interest … until the demand for funds … [equaled] the available supply,” just as Martin Feldstein had warned at the beginning of 1984. The jump in interest rates represented an increase in the real cost of credit and reflected deficit phobia rather than an inflation scare, a repeat performance of what had happened in the second half of 1981.
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The increase in interest rates surprised investors. Michael Steinhardt, the stout forty-three-year-old manager of Steinhardt Partners, a successful hedge fund, lost $15 million on the purchase of $400 million Treasury securities during the spring of 1984.
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He had expected interest rates to decline with the dramatic drop in inflation and suffered the consequences of his mistake. “I don't sleep too well at night … [and] I'm fatter than usual … it's a miserable time for me.”
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He explained what had gone wrong: “The Administration's economic credibility has sunk to an absolute low.” According to Steinhardt, not one person in a million could have conceived that a conservative administration such as Reagan's would have allowed the deficit to explode as it had.
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Volcker did not know Michael Steinhardt, and his antipathy toward speculators would later blossom into distaste for hedge funds, but his commitment to price stability mitigated Steinhardt Partners' losses. Volcker's refusal to monetize government debt as the economy expanded suppressed a nascent inflation premium and avoided even higher interest rates.

Steinhardt benefited also from the healthy appetite of international investors for U.S. securities.
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Foreigners dulled the impact of the deficit on interest rates in spring 1984 by buying Treasury bonds, in part because of the Federal Reserve's credibility, but this left America vulnerable
to a flight of international capital. Volcker had warned the Senate Banking Committee in February, “We are … increasingly dependent … upon this inflow of foreign capital … [and] if the Federal Reserve is interpreted as following irresponsible policies, we face a potential for a bigger disturbance, to use a polite word, on the international side.”
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