Volcker
Page 7
Volcker had expected trouble before becoming manager of Nixon’s balance-of-payments team. He had watched the free-market price of gold rise steadily from thirty-eight dollars on April 1, 1968, to forty-two dollars on January 21, 1969, the day he negotiated his détente with Kissinger. Less than three weeks later, Volcker provoked an outcry from the White House that would not end so pleasantly.
On February 12, 1969, Volcker appeared at a news conference in Paris during a meeting with European bankers and finance ministers to discuss reforms of the international monetary system. The price of gold had made an all-time high in the London market, signaling a red alert. A reporter asked Volcker whether allowing greater flexibility in foreign exchange rates would prevent a further breakdown of the system. Volcker knew exactly where that particular line of thinking had originated, and he responded as though he were swatting a pesky horsefly. “It’s being discussed in academic circles, and that’s where it can stay.”15
The previous evening, Volcker had been initiated into an exclusive clique of international financiers, known as Working Party 3 (WP3), with a warning about such radical ideas.16 A confusing drive after dark brought him to a Parisian home in a wooded suburb that resembled a mysterious hideaway. After crackers and cheese, Cecil de Strycker of the Belgian central bank took him aside for a private chat in a dimly lit basement that smelled from wine fermenting in wooden kegs. De Strycker summarized the WP3’s complaints by shaking his European finger at Volcker and saying, “If all this talk about flexible exchange rates brings down the system, the blood will be on your American head.”
Volcker did not need much encouragement to belittle floating exchange rates, Milton Friedman’s pet proposal for monetary reform. He recalled with distaste Friedman’s debate with Roosa over the merits of Bretton Woods and fixed exchange rates.17 The two men had battled to a standoff, like champion sumo wrestlers locked in the middle of the ring, except when Friedman took the argument to a personal level. He said that floating exchange rates would “put an end to the occasional crisis, producing frantic scurrying of high government officials from capital to capital … Indeed this is, I believe, one of the major sources of the opposition to floating exchange rates. The people engaged in these activities are important people and they are all persuaded that they are engaged in important activities. It cannot be, they say to themselves, that these important activities arise simply from pegging exchange rates.”18
Friedman’s cynical reference to “scurrying of high government officials” and “important people … engaged in important activities” displeased Volcker. They were not-so-veiled indictments of his mentor, Robert Roosa, who had done more than his share of “frantic scurrying” while at the Treasury. And now Volcker occupied the same position.
Volcker believed in the benefits of Bretton Woods for international trade, just as Roosa did: “Under a fixed-rate system, there is an established scale of measurement, easily translatable from one country to another, which enables merchants, investors, and bankers of any one country to do business with others on known terms.”19 Bretton Woods creates for world trade the type of stability enjoyed by a businessman in New York who exports to Hell, Michigan, or Paradise, Pennsylvania: A dollar in Hell or Paradise is the same as a dollar in New York.
The White House, however, launched a frontal attack on Volcker’s suggestion to quarantine floating exchange rates in the ivory tower. The Washington Post headlined a rebuke from “high officials” in the administration, identified as Nixon’s Council of Economic Advisers (CEA): “We would not be doing our job if we were not exploring the question [of floating exchange rates].”20 The CEA was “at a loss to explain Volcker’s comment, except to suggest that it must have been off the cuff and not completely thought through.”21
Secretary of Labor George Shultz, a Nixon favorite who would head two other cabinet departments, supported the CEA. In a subcommittee meeting of the cabinet, he urged the CEA to testify before the congressional Joint Economic Committee in favor of these “new approaches.”22 Shultz, a labor economist by trade, had been a dean at the University of Chicago, home base of Milton Friedman, and would provide a direct pipeline into the administration for Friedman’s views.
Volcker understood the arguments in favor of floating exchange rates as well as anyone, having heard them from just about every academic economist he respected, including Lawrence Ritter, his good friend and confidant.23 Ritter, a finance professor at New York University, had written two bestselling books, one on baseball and another on banking—Volcker’s favorite intellectual interests.24 Ritter’s congressional testimony in favor of floating exchange rates had triggered a dismissive “What’s wrong with your friend?” from Roosa.25
According to the academics, floating exchange rates would cure U.S. balance-of-payments deficits by allowing the price system to work its magic. For example, a U.S. balance-of-payments deficit occurs when Americans import more from the United Kingdom than the British import from America. Under floating exchange rates, the extra dollars chasing after pounds sterling in the foreign exchange market forces up the price of British pounds, making British goods more expensive for New Yorkers and making American goods cheaper for Londoners. A higher price for the pound sterling encourages New Yorkers to buy the MADE IN USA label, rather than ordering snobby English tailoring; and a lower price for the American dollar encourages Londoners to do the same. The U.S. balance-of-payments deficit shrivels through market forces.
Volcker considers flexible exchange rates the easy way out, a deceptively simple solution laced with long-run costs. “There is nothing to anchor the exchange rate at any particular level under floating rates. A rootless exchange rate encourages speculators to pounce on a depreciating currency, pushing it even lower.”26 Roosa had made that point during his debate with Friedman, arguing that depreciating currencies could spiral downward under a system of floating exchange rates.27 Milton Friedman countered that when speculators sell low, hoping to buy even lower, they usually lose money. Speculators might enjoy the excitement, like a day at the races, but they run out of money before long. Roosa claimed that they could inflict considerable damage before going bankrupt.28
Volcker favored fixed exchange rates because it places international financial stability on a giant pedestal, and then anchors the system in fiscal discipline. “A country that runs a balance-of-payments deficit cannot sit back and relax while its currency depreciates. It must retrench and live within its means, just like everyone else.”29 The appropriate medicine, a tablespoon of tight money, would quiet an overheated economy and bring imports into line with exports. The problem is that swallowing the prescription, which includes a dose of high interest rates, leaves a bad taste.
The red-light alert from the London gold market never flickered during the first half of 1969.30 Preserving the dollar’s status had been the focus of Volcker’s favorite committee—now called the Volcker Group by everyone who mattered—until April, when France took center stage. President Charles de Gaulle resigned on April 28, 1969, after losing a referendum on his proposal for constitutional reform.31 The Paris newspaper France-Soir explained, “The general needs a new coronation every two or three years.”32 He left in a huff when he did not get it.
No one at the Treasury shed a tear; the French president’s fetish for American gold still rankled. An earlier Treasury Department memorandum had warned Richard Nixon prior to a meeting with de Gaulle that “the basic French attitude toward the international monetary system is fundamentally different from ours.”33 But de Gaulle had lost his popular mandate because of the discipline he administered six months earlier to preserve the value of the French franc. Perhaps it was selfish, for the “Glory of France,” but it was also a beachhead in the battle for fixed exchange rates—so everyone at the Treasury paid attention.
The French had been spending too much in Germany, primarily because of Prussian efficiency but also because Parisians enjoyed Hamburg night life more than Berliners liked Place Pigalle.
(Prices were too high in Paris for reasonably similar services.) French francs were piling up in Germany, and the Bundesbank, the German central bank, had to buy the French currency to prevent a price decline. The exchange rate between francs and marks, or between any two currencies, remains fixed only when central banks make it so, by buying a currency that is in excess supply and selling a currency in excess demand. That was how exchange rates were maintained in the Bretton Woods System.
De Gaulle knew that the Bundesbank would absorb a temporary excess of francs in the marketplace, but would gag on a continuous influx. Prolonged purchases threatened Germany with inflation because whenever the Bundesbank bought francs with marks, the German money supply increased.34 France would have to cut back on imports from Germany, including Hamburg’s favorite attractions, or watch the franc depreciate.
De Gaulle implemented an austerity program in November 1968—fiscal discipline to prevent a devaluation of the French franc … just what the Fixed Exchange Rate Doctor ordered. He rallied support with a somewhat incoherent patriotic plea, “Frenchwomen! Frenchmen! What is happening in regard to our currency proves to us once again that life is a struggle, that effort is the price of success, that salvation demands victory.”35 Government budget restraint succeeded in maintaining the franc’s value, but within five months it cost de Gaulle at the polls. A young worker in the Orléans railway station explained the problem: “I’ve no confidence in anybody. I vote my pocketbook, and it says no.”36
Volcker knew that the absence of de Gaulle from Parisian politics would do little to alleviate America’s balance-of-payments deficit and would not even solve the gold problem. More fundamental forces—domestic inflation and foreign competition—undermined the dollar. The Volcker Group had been preparing a memorandum for the president outlining American options, and Paul had been able to devote all his waking hours to the problem. He had few distractions, with Barbara, Janice, and Jimmy having remained in New Jersey until June 1969, the end of the school year.
Paul had been living in a furnished apartment on Fourteenth Street in the rundown part of northwest Washington during the first half of 1969. He did not mind the location, except that his number-three position at the Treasury carried the privilege of a car and driver. Paul worried that some of the unsavory characters lurking in the hallways would get the wrong impression, that a man with a chauffeured car had a healthy wallet as well. He tried to dress like a commoner—easily accomplished with a wardrobe of just a few worn suits that had been custom-ordered to fit his oversize measurements. When one of these antiques disappeared at the cleaner’s, Volcker waited a month before accepting reimbursement. “It was a very nice suit.”37
Paul missed Barbara’s sharp banter at formal Washington social events that came with his position as undersecretary, whether it was a State Department buffet reception for the prince of Afghanistan or cocktails at the White House for the German chancellor. He recalls standing next to Barbara during his earlier stint at the Treasury, as silent as a butler, while she twitted the Irish finance minister with “I didn’t know Ireland had a finance minister.”
Others also noticed that Paul benefited from help in social situations. Cynthia Martin, wife of the Federal Reserve chairman, revised an invitation to a formal dinner party, suggesting, “We’ll have another opportunity after Barbara moves into town.”38 Perhaps Miss Palmer, Volcker’s favorite kindergarten teacher, had been onto something when she noted that Paul “does not take part in group discussion.”
Barbara ran the Washington branch of the Volcker household long distance, often reminding her husband to deposit his last few paychecks so she could pay the rent and the telephone bill. When Paul applied his “always procrastinate” strategy to delay meeting their real estate agent, Barbara left a message. “I told Marcia Clopton of CBS Realty to get aggressive with you.”39
On Thursday, June 26, 1969, Paul stood before the president of the United States in the Cabinet Room of the White House, pointing to a flip chart summarizing five months of work by the Volcker Group. Treasury Secretary David Kennedy, Volcker’s boss, had arranged the meeting and had asked Volcker to lead off. Key international advisers flanked the president at the elliptical table, including Secretary of State William Rogers, National Security Adviser Henry Kissinger, Federal Reserve Chairman William McChesney Martin, and Counselor to the President Arthur Burns.
Volcker had worried about the meeting, like a teenager preparing for his first date, and not just because it was a center-stage performance for Richard Nixon. That was reason enough—his Democratic lineage would always mark him an outsider—but also because there had been a breach of security that could have ended his tenure with this leak-obsessed administration.
Paul knew that Nixon would not have read the forty-eight-page memorandum “Basic Options in International Monetary Affairs,”40 which had been delivered to the Oval Office; the president viewed “the dollar problem as something we should make go away, presumably painlessly.”41 Volcker had asked Bruce MacLaury, his deputy undersecretary and a future president of the Brookings Institution, a left-of-center think tank in Washington, to prepare a few charts showing the major options under consideration, hoping the visual aids would hold Nixon’s interest during the oral presentation. MacLaury sent out rough sketches to a commercial graphic arts company for production, including one showing a doubling in the official price of gold from thirty-five dollars to seventy dollars.
“What were you thinking?” Volcker had grumbled. “A speculator could have easily made a fortune buying gold on the London market and then leaking the chart to the press.”42 MacLaury had no answer, but the graphic artist had taken courses in color design rather than advanced speculation, so no damage was done.
The Volcker Group report had, in fact, dismissed the option of raising the price of gold precisely because it would have inflamed speculative interest in the precious metal. Moreover, doubling the price would have rewarded Russia and South Africa, the major gold producers, and France, the major gold hoarder. None of these three made America’s Most Favored Country list. The Volcker Group wanted to deemphasize the role of gold in international finance and included the chart just for completeness.
The formal memorandum blessed a benign-sounding “evolutionary change in the existing system,” as though it would be buried deep in the business section of the New York Times, hidden behind the weekly Federal Reserve Report (which is easily located with a compass). In fact, Volcker’s recommendations would make front-page headlines when they surfaced.
Volcker knew Nixon cared most about American world power, and he presented his objective to retain “a pivotal role for the U.S. dollar as the leading reserve and vehicle currency,” as though it were a nuclear warhead.43 The main threat to this dominance, he said, came from “common recognition that attempts at large scale conversion [of dollars into gold] would be frustrated by a lack of adequate gold in U.S. reserves.”44 Volcker identified “the strong inflationary pressure in the United States over the past four years … [as] a major factor … undermining confidence in the dollar.”45 He compared the American experience unfavorably with Germany, which places “extremely high priority on resisting inflation,” and suggested that we might want to “encourage greater consistency among [monetary] objectives in a framework of fixed exchange rates.”46
Volcker’s reference to “consistency among monetary objectives” reflected the vulnerability of the Bretton Woods System. He knew the system of fixed exchange rates would come crashing down without cooperation among central bankers, a victim of the triple-headed monster that would become known as the Trilemma.47 The insight of the Trilemma, sometimes irreverently called the Unholy Trinity, is that countries committed to fixed exchange rates and free international flow of capital must pursue the same monetary targets. Pursuit of different interest rates, for example, unleashes what the hedge fund industry in the twenty-first century calls “the carry trade,” but has been the staple diet of foreign exchange traders eve
r since speculation was invented in biblical-era Egypt.48 This not-so-complicated strategy turns speculators into very wealthy arbitrageurs and would ultimately destroy Bretton Woods.
Foreign exchange speculators are not especially religious, certainly no more than the rest of Wall Street, but when they pray, they beg the Lord of High Finance to grant them two countries with fixed exchange rates and different interest rates. When German interest rates are 7 percent and U.S. rates are 4 percent, for example, speculators will borrow in dollars at 4 percent, exchange the dollars for marks, and invest in marks at 7 percent. They pocket the 3 percent differential without incurring risk as long as the exchange rate between dollars and marks remains fixed.49 Three percent does not sound like much, but the profit is $3 million for a relatively modest-size foreign exchange trade of $100 million. Speculators will do this trade as often as they can because it is an arbitrage—riskless, profitable, and something for which they do not need capital (they can borrow whatever they need). Speculators have reached their nirvana.
All this is very good for speculators, making them fat and happy, but it is very bad for fixed exchange rates. As speculators buy marks and sell dollars without limit, they push up the value of the mark and push down the value of the dollar. Under the rules of the Bretton Woods System, the Bundesbank must intervene, buying dollars and offering marks in exchange to prevent the dollar from depreciating. But if the speculative onslaught was to continue, the Bundesbank would eventually stop buying dollars, because it would mean flooding the world with marks. To prevent the flood, they would let the exchange rate float, a victim of the Trilemma.