The FOMC was run by the then chairman of the Federal Reserve Board, William McChesney Martin, who had been appointed by President Harry Truman in 1951 and would serve until 1970. Martin was a former banker, just like everyone else on the board in the mid-1950s. Perhaps the economy was a lot simpler in those days, but the absence of economists bore the chairman’s imprint.26 Martin thought economists’ forecasts rivaled the accuracy of fortune teller predictions, probably an insult to the fortune tellers: “If the decision were mine alone, I would dispense with [that] kind of analysis.”27 He also felt that economists lacked the practical experience needed of central bankers.
With Martin at the helm, it is not surprising that economist Paul Volcker failed to make the distribution list of those permitted to read the weekly report that he wrote. His wife, Barbara, taunted him: “You can write it but can’t read it. What’s wrong with these people?”28
Barbara, a pretty woman with short dark hair that she denigrated as mousey, had majored in irreverence at Pembroke College, part of Brown University. She had been married to Paul for less than two years at the time and did not appreciate his midnight scribbling. Paul knew that she was right about the Fed, as she was about most things. The rigid bureaucracy would wear him down. But he also knew that his memoranda to the FOMC mattered, even though he was a mere economist, because they came from his observer status on the open market desk. He had the credibility of an embedded reporter on the front lines. He even went to an FOMC meeting as Roosa’s scribe and recalls thinking, “It would be nice to sit around the table as a member of the board.”29
Volcker’s memos bristled with facts and figures: how many securities were bought or sold, at what prices, who was buying and who was selling, and perhaps most important, what the dealers expected interest rates to do in the near term. Dealers profit by anticipating whether interest rates will decrease or increase, whether bond prices rise or fall. They make money buying before prices jump and selling before they drop. Volcker paid attention to the details, especially the link between expectations and behavior, and recognized the importance of fitting the pieces together, much as he had in his boyhood hobby of building model airplanes. Every plane, made from balsa wood and paper, with a rubber band to crank the propeller, was perfectly balanced, ready to fly.
The Fed’s trading room was a bridge between economic research and the real world, and Volcker had crossed the span and liked what he saw. He remained a reporter rather than a player on the trading desk until 1957, when he took another step toward real-world practice and joined the Chase Manhattan Bank. Chase Manhattan took its name from Salmon P. Chase, Abraham Lincoln’s treasury secretary during the Civil War, and from the Bank of Manhattan, founded by Aaron Burr, the vice president of the United States who killed the first treasury secretary, Alexander Hamilton, in America’s most famous duel.
Unlike at the Fed, where memos crept through the bureaucracy at the speed of a turtle, ideas at Chase Manhattan could accelerate like an express train. Volcker worked in the economics department but gained access to upper management as the secretary of a weekly meeting among senior officers of the bank. His summaries for the group raised his profile in the executive suite, exposure that ultimately brought a call from George Champion, president of the bank.
Champion, who had joined Chase in 1933, asked Volcker to come by to discuss his most recent memo. Champion must have liked what he heard, because he said, “Sit down a minute. I’m worried about our [international] trade position. It seems to me we are getting less competitive, and it could affect the dollar. What do you think?”30
Volcker had not thought much about foreign trade since listening to Harvard specialist in international economics Gottfried Haberler describe the intricacies of foreign exchange and the balance of payments. Volcker began to dust off his class notes, eager to apply what he had learned.
But he never got the chance. Robert Roosa had other plans for him.
After narrowly defeating Richard Nixon in the 1960 presidential race, John F. Kennedy identified Cuba and the balance of payments as the two most difficult problems confronting America.31 Cuba made sense. Back then, some fanatics resisted writing with red ink to avoid a hint of Communist sympathy. But aside from a few financiers and professors, almost no one cared about the balance of payments. Robert Roosa, by then a senior vice president at the Federal Reserve Bank of New York, was one of the few. He also knew enough to help.
Paul Samuelson, the Nobel laureate MIT economist who educated millions of Americans with his basic textbook and dazzled his colleagues with wit and mathematics, advised Kennedy on his major economics appointments. He recommended Roosa to the president-elect for the key position as undersecretary of the treasury for monetary affairs.32 Roosa’s job was to fix the balance-of-payments problem.
What was Kennedy worried about? Less than two weeks before the 1960 election, the New York Times ran a front-page headline that got everyone’s attention like a thunderclap: “Kennedy Pledges He Will Maintain Value of Dollar.”33 Until then, most Americans did not realize that the dollar was in any kind of danger, but Kennedy’s promise touched a nerve. No one wanted a decline in the value of the dollar. A few days later the Republicans added a similar assurance.34 Suddenly everyone worried.
Kennedy’s promise meant that the United States would continue to redeem U.S. dollars in gold at the rate of thirty-five dollars per ounce. The pledge applied to foreign central banks that held dollars they received from exporters shipping goods across the Atlantic—the French, who sent wine; the Italians, who sent cheese; and most of all, the Germans, who sent Volkswagens. Americans had not been entitled to redeem their own dollars in gold since 1933, when Franklin Delano Roosevelt made it illegal for U.S. citizens to hold gold, other than as jewelry.
America’s promise to redeem dollars at the rate of thirty-five dollars per ounce of gold was the cornerstone of the world’s payments system. The U.S. commitment, along with the system of fixed exchange rates among the world’s currencies, under the supervision of the International Monetary Fund, had emerged from a three-week meeting, in July 1944, in Bretton Woods, New Hampshire. The Bretton Woods Agreement served as the Magna Carta of international finance for a quarter of a century, until August 1971.
In Volcker’s view, the Bretton Woods Agreement was conceived in a “burst of intellectual energy” that has never “been seen before or since.”35 A month after D-day, the Allied landing in Normandy, France, on June 6, 1944, President Franklin D. Roosevelt invited delegates of the Allied countries to the conference that would design the postwar monetary and financial environment. Roosevelt was aware that much bloodshed remained, but he insisted that “even while the war for liberation is at its peak … representatives of free men should [plan] … for an enduring program of future economic cooperation.”36 Roosevelt believed that “economic diseases are highly communicable,” and international trade was an antidote to world conflict, a vaccination against another world war. He said, “Commerce is the lifeblood of a free society.”37
U.S. treasury secretary Henry Morgenthau headed the American delegation to the conference. On July 1, 1944, he arrived in Bretton Woods, a sleepy village in the White Mountains, noted until then as a refuge for hay fever sufferers rather than as a gathering place for world financiers. He had left a sweltering Washington, D.C., and his first thought upon breathing the crisp mountain air was that he should have packed woolen socks.38 He was joined at the Mount Washington Hotel conference center by more than seven hundred representatives from forty-four countries, including sixteen ministers of finance and central bankers.39
The American group included the then-chairman of the Federal Reserve Board, Marriner Eccles, and highlighted powerful politicians: Dean Acheson, an assistant secretary of state, and Robert F. Wagner, chairman of the Senate Banking Committee. The famed British economist John Maynard Keynes—author of the most influential economic treatise of the twentieth century, The General Theory of Employment, Interest and Money, wh
ich created the “Keynesian School” of economics—led the delegation from the United Kingdom, and he was joined by other members of British academic aristocracy: Dennis Robertson, professor of political economy at Cambridge, and Lionel Robbins, professor at the London School of Economics.
Most of the countries represented at Bretton Woods followed the American and British recipes: politicians for power with a sprinkling of academics for flavor. Absent from the conference were representatives of the Axis powers (Germany, Japan, and Italy) and neutral countries, most notably, Switzerland, home of powerful international banks and foreign currency speculators. Argentina was excluded because its “continuing support of the Axis” rendered it unfit to “to sit down with the United Nations in important war and postwar conferences.”40 The conference in New Hampshire was an Allied operation, just like the invasion of Normandy.
The Bretton Woods Agreement was the brainchild of John Maynard Keynes and Harry Dexter White, a U.S. Treasury economist serving as the only technical expert in the American delegation.41 The objective was to restore the golden age of international trade that had flourished for a generation prior to the outbreak of World War I. Most countries adhered to the gold standard before 1914, protecting citizens against inflation by promising to redeem paper currency in gold. The gold content of each currency also fixed the rate of exchange among different currencies: Americans could always get one British pound for $4.86 and could always exchange one dollar for five French francs. As a result, a company such as John Deere, headquartered in Moline, Illinois, knew how much it would earn in dollars whether it shipped tractors to Liverpool, Marseilles, or Kansas City. The absence of fluctuating exchange rates made international trade no more complicated than a visit to the flea market on the other side of town.
The problem with resurrecting the gold standard after World War II was that America had almost all the gold—$20 billion worth buried in Fort Knox.42 No country could credibly promise to redeem its currency in gold except for the United States. The Bretton Woods Agreement anchored the international payments system on America’s hoard, tethered by the U.S. pledge to exchange dollars for gold at the rate of $35 per ounce, with every other country agreeing to fix its currency relative to the dollar. Fixing exchange rates to the dollar required a commitment by central bankers to buy and sell currencies at the agreed-upon rate. Success meant the Bretton Woods System would mimic the stability of the gold standard.
Fixed exchange rates under the Bretton Woods Agreement would also avoid the trade wars of the Great Depression, when countries fought among themselves to devalue their currencies to promote exports. The “butter battle” between New Zealand and Denmark demonstrates the futility of competitive devaluations.43 New Zealand started the fight by devaluing its currency in 1930 to lower the effective price of its butter exports to England, hoping to sell more to cost-conscious Londoners. Denmark retaliated with its own devaluation to neutralize New Zealand’s advantage. The process continued until 1933 and left each country’s total butter exports exactly where they had started. Competitive devaluations made British consumers happy because they paid less for their butter, but no one else benefited, except perhaps the foreign exchange speculators in Switzerland.
The Bretton Woods System of fixed exchange rates would pit governments, and their central bankers, against speculators in a war that lasted a generation. Central banks tried to tame the forces of supply and demand to keep exchange rates fixed, while speculators did their best to make money by anticipating central bank failure to prevent devaluation. Speculators would sell weak currencies hoping to buy them back after they declined in value. In one of the early skirmishes, British officials blamed “the gnomes of Zurich” for mounting “speculative attacks against sterling.”44 Gnomes are imaginary, but speculators are not.
By 1960, speculators scared everyone, including candidates for the most powerful position on earth, the American presidency. JFK affirmed America’s pledge to redeem U.S. dollars in gold in October of that year, in response to speculator attacks on America’s credibility.
Speculators look like normal people, except they smoke big fat Cuban cigars. They try to buy something (anything) in anticipation of selling at a profit after the price goes up. Or they sell first and try to buy later at a lower price. Some speculators focus on stocks, others on bonds, and still others on Super Bowl tickets. (Ticket scalpers are speculators by another name.)
In October 1960, gold speculators tested America’s promise to keep the price of the precious metal at thirty-five dollars per ounce. Transactions among dealers in gold bullion had taken place since March 22, 1954, in the London headquarters of the 150-year-old private banking firm N. M. Rothschild and Sons.45 The free-market price, sometimes referred to as the London gold fixing, was established every day in an auction conducted by the dealers gathered in the boardroom under the gaze of eighteenth-century Rothschild portraits hanging on the wood-paneled walls.46 The price was “fixed” to balance demand for bullion with supply, with orders transmitted to the dealers from investors, gold mines, and central banks throughout the world.
The U.S. Treasury had maintained the price in the London fixing within a few cents of thirty-five dollars by selling gold if excess demand prevailed at that price and by buying if there was excess supply. On October 20, 1960, two weeks before the presidential election, speculators suspected that America might abandon its commitment to sell gold in the free market. They flooded the London dealers with buy orders and, much to everyone’s surprise (except the speculators), the price jumped to levels that had never been seen before.47
Paul Volcker sat in his office at Chase Manhattan Bank on that explosive day in October. During the previous two days, he had watched the price poke above $35.08, the exact level at which the U.S. Treasury promised to deliver gold.48 Paul recognized the danger to American credibility. Prices had always bounced off the ceiling as private groups— mining companies and foreign banks—sold gold, confident that the U.S. Treasury would hold the line. These private sellers, in fact, kept a lid on the price without the Treasury having to sell gold.
A colleague stuck his head into Volcker’s office, looking as though he had glimpsed the hereafter, and said, “The gold price is forty dollars.” Paul stared at his ashen-faced friend. “That can’t be, you mean thirty-five dollars and forty cents.”49 Volcker thought that even $35.40 would be a terrible blow to American prestige, proof that the United States had failed to meet its obligations. And then they checked the news ticker. Speculative purchases on October 20, 1960, had, in fact, driven the price of gold to $40.00 per ounce, an unprecedented number at the time.
Roosa had tutored Volcker, and everyone passing through the New York Fed, that America’s pledge to gold ranked alongside the pursuit of happiness for all citizens, and he had advised the Kennedy campaign to issue the promise not to devalue.50 Newspaper reports identified the source of the speculative buying. “Most of the demand came from the Continent and particularly from Zurich … Swiss bankers have advised their foreign customers to buy gold for deposit there.”51 These reports were denied as total fabrications by the mythical dwarflike creatures, the gnomes, evidently living in Zurich, guarding their new treasure. But gnomes and speculators cannot be trusted.
The jump in the price of gold from thirty-five dollars to forty dollars meant that the dollar had depreciated against gold—technically called devaluation. It would now take an extra five dollars to purchase an ounce of the precious metal. Editors at the New York Times admonished the public with a message worthy of Jeremiah’s Book of Lamentations. “We would all do well to think seriously about the warning we have been given by the London gold market.”52
Robert Triffin, an expert in international trade from Yale, advocated a criminal indictment of America. “A devaluation of the dollar … would be … a wanton crime against the people of this country, and against the friendly nations who have long accepted our financial leadership and placed their trust in the United States dollar.”5
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And Richard Nixon, battling JFK for the presidency, piled on in a gang tackle. “The United States cannot afford a debasement of our currency.”54 To all parties involved, what was at stake was nothing less than the stability of the relatively new global financial system.
Volcker believed that America had a moral obligation to uphold its commitment to Bretton Woods and to maintain “the sanctity of the $35 gold price.”55 But he also thought the consequences of devaluation extended beyond ethics. The rumor was that Joseph P. Kennedy, JFK’s father, had told his son, “A nation was only as strong as the value of its currency.”56 Perhaps that is why JFK half humorously listed military power behind a strong currency as a determinant of international prestige: “Britain has nuclear weapons, but the pound is weak, so everyone pushes [Britain] around.”57
Volcker also recalled a comment from Chase’s president, George Champion, about a Southeast Asian country he had visited: “It has a strong currency … so it’s a country we can trust.”58 These sweeping generalizations, linking a country’s currency and its stature, nestled comfortably in Volcker’s brain beside the lessons he had learned from economic history: before 1914, Britain ruled the world with the pound sterling.
Volcker applauded Kennedy’s pledge to maintain the price of gold at thirty-five dollars per ounce. But he knew that simply saying so would not stop the speculators. Oskar Morgenstern had taught him that economists probably knew nothing, or maybe even less than nothing, with one big exception: supply and demand, not words, determine price. Speculator buying (demand) had driven up the price of gold, and would continue to drive up the price further, as long as speculators doubted America’s commitment to supply unlimited amounts of gold to the free market at thirty-five dollars an ounce. Volcker knew exactly what fed the doubts that had led to the buying frenzy on October 20, 1960: America’s weak balance of payments.
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