“I came for the White House ceremony.”
“Jimmy, Janice, and your parents were there.”
“Well, it was clearly important.”
And then she added, “You go, I stay.”
Paul accepted the verdict, unable to address the real problem. Barbara needed the proximity of Dr. Michael Lockshin, the physician who was treating her rheumatoid arthritis, and Jimmy, who had moved back home, needed Barbara’s attention.21 Paul rented an inexpensive one-bedroom apartment in a building that served almost like a dormitory for students at George Washington University. He furnished it with a king-size bed, a bridge table, and a ten-inch black-and-white television. He controlled expenses further by folding his six-foot, seven-inch frame into a coach seat every Friday afternoon on the Eastern Airlines shuttle to New York.
A letter to Volcker from Douglas Dillon, President Kennedy’s treasury secretary at the time of Volcker’s first apprenticeship in Washington, acknowledged the hardship: “Your willingness to take on [the chairmanship] at such great financial sacrifice is typical of you and a great service to the nation. With you at the helm I feel confident about our monetary policy for the first time since the departure of Bill Martin.”22
Volcker appreciated Dillon’s sentiments but knew that the chairman of the Dillon, Read international banking house could not fathom the depths of the Volcker family finances. Barbara had to take a part-time job as a bookkeeper and rent out a room in their New York City apartment to help balance the budget. Volcker thought the National Enquirer could splash a provocative headline across its front page: “Fed Chairman Turns Family Apartment into Boarding House: What Next?”
Volcker’s bachelor status from Monday through Friday paid an unexpected dividend. He spent more time with Janice, who had just graduated from nursing school and lived in the Washington suburb of Alexandria, Virginia. Paul would ask her to serve as his escort when Barbara could not make a formal Washington dinner. He recalls, “I thought it was only fair. After all, Janice was the rebel … I think she might have even smoked pot in high school.”23 He pauses to roll his eyes in mock horror. “But what I remember most was when she slapped an IMPEACH NIXON bumper sticker on my car while I was undersecretary.” Paul did not think it was as funny back then. Now he smiled. “I guess that’s why I thought it was okay to bring my laundry to her apartment every week.”
The Federal Reserve System’s headquarters, on Constitution Avenue and Twentieth Street in the nation’s capital, covers an entire block and faintly resembles a rectangular Taj Mahal. The four-story building with a white marble façade was completed in 1937 and elicited approval from the then first lady, Eleanor Roosevelt. “I think the building’s exterior is very beautiful and have admired it often, but I was equally impressed by the interior.”24
Volcker also liked the inside of the building, perhaps because it was built for his dimensions. The boardroom, which serves as the meeting place for the Federal Open Market Committee, sets a spacious tone. The two-story enclosure measures almost half the size of a regulation basketball court, with floor-to-ceiling curtained windows lining the longer wall.25 A twenty-seven-foot-long mahogany table, accommodating twenty upholstered chairs, with a generous brass chandelier hanging overhead, makes the room look like the formal dining quarters of an English manor house—except that an oversize map of the United States, identifying each of the twelve regional Federal Reserve districts, covers the back wall. A private entrance connects the chairman’s office directly to the boardroom, offering him access like that of a judge to his courtroom.
Volcker opened his first FOMC meeting on August 14, 1979, with an awkward announcement. He had been appointed chairman of the Board of Governors by the president of the United States, but the FOMC has its own procedures requiring a separate confirmation. “I might say for the benefit of those who have just come in that we had a little executive session to do some important business, the first item of which was to elect a chairman. I’m not sure whether it’s entirely appropriate that I announce my election, but it proceeded.”26
After listening to a report on economic conditions, Volcker began his prepared remarks with a friendly poke at his predecessor. “I am conscious that without an egg timer time has been passing. But … it might be useful if I just set out a few thoughts … I don’t intend to make it a habit particularly, but this is a meeting that is perhaps of more than usual symbolic importance [and] … I thought I’d just lay out a strategy … so you can have something to shoot at.”27
He then articulated his perception of the main economic problem, sounding more like a psychiatrist than a Keynesian or a monetarist. “When I look at the past year or two I am impressed myself by … the degree to which inflationary psychology has really changed. It’s not that we didn’t have it before, but I think people are acting on that expectation … much more firmly than they used to … The dollar externally obviously adds to the dilemma … Nobody knows what is going to happen to the dollar, but I do think it’s fair to say that the psychology is extremely tender.”28
Volcker had learned the importance of market psychology at the New York Fed’s trading desk and had absorbed the rational expectations theories of economists in Chicago and Minnesota.29 He combined those lessons into a warning to the FOMC: “Economic policy … has a kind of crisis of credibility.”30 Nevertheless, he felt constrained about acting precipitously. “We don’t have a lot of room for maneuver and I don’t think we want to use up all our ammunition right now in a really dramatic action … 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.”31
Volcker had followed this script before. He let the May 1971 foreign exchange crisis simmer for four months before recommending the suspension of gold convertibility in August 1971. He would not wait that long in 1979.
A public squabble erupted after a meeting of the Federal Reserve Board on Tuesday, September 18, 1979, that stunned everyone, like a fistfight among cardinals in the Sistine Chapel. The morning began with Volcker’s second FOMC meeting as chairman and ended with the committee ratifying his recommendation “to make a little move [up] in the federal funds rate.”32 The vote was 8 in favor and 4 against, with 3 of the 4 dissenters urging greater tightening.33 Volcker wanted tighter credit and higher interest rates to fight inflation but knew that some members of the FOMC were worried about a recession, so he emphasized caution. “I am not particularly eager to make a major move now or in the foreseeable future.”34
No one but Wall Street professionals would have recognized the slight increase in the federal funds rate, the interest rate on overnight loans of reserves between commercial banks. The New York Fed’s trading desk implements the FOMC Directive by selling government securities from its holdings to withdraw reserves from the banking system. These transactions push up the federal funds rate by forcing banks to scramble for reserves, but the action occurs far from the public spotlight. However, a follow-up meeting of the Board of Governors on the afternoon of September 18 broke the silence.
Volcker convened the seven-member board to discuss raising the discount rate charged on loans of reserves to commercial banks. Unlike movements in the obscure federal funds rate, discount rate decisions are announced immediately and are reported on the evening news with the gravity of a declaration of war. But most financial market professionals ignore the rhetoric. Banks borrow reserves at their regional Federal Reserve banks as a safety valve, after reserves have been drained from the market at the behest of the FOMC, and the discount rate increase is a defensive parry to block the escape route. The Board of Governors controls the discount rate by legal statute, but it usually follows the lead of monetary policy established at the FOMC.
September 18 was no exception to the norm. The Board of Governors voted to approve an increase in the discount rate to a record high of 11 percent, a jump of half a percent, and explained in its press release that the increase was taken “against the backg
round of increases in other short term interest rates … and to discourage excessive borrowing by member banks from the discount window.”35 The vote was 4 in favor and 3 against.
The half-point increase in the discount rate, the second since Volcker took office in August, pleased him.36 “It confirmed publicly our commitment to tight money to control inflation.”37 He went to bed on September 18 with a smile but awoke the following morning with a headache.
The September 19, 1979, front page of the New York Times described the prior day’s discount rate decision as though it were an armed insurrection among the rank and file. “In an unusual 4–3 split, the seven-member Federal Reserve Board voted yesterday to raise the discount rate … The vote left uncertain whether Paul A. Volcker … could continue to command a majority for his high [interest] rate policies. The split was seen as indicating a fundamental division within the Board over whether inflation remains a more pressing problem than recession.”38
The divided board had not bothered Volcker until then. Two of the dissenters, Nancy Teeters, appointed by Jimmy Carter as the first woman member of the Federal Reserve Board, and Charles Partee, the former Fed staffer famous for his hand-tied black bow ties, had actually voted that morning with the FOMC majority in favor of raising the federal funds rate before voting against the discount rate increase. Teeters explained that “we haven’t always kept [the discount rate] in alignment” with other short-term rates.39 Only board member Emmett Rice, also appointed by Jimmy Carter, had dissented at both the FOMC meeting and the follow-up meeting of the Board of Governors.
Volcker felt confident he could marshal the same four votes on the board to raise the discount rate again. “Henry Wallich grew up in Weimar Germany with hyperinflation as a tutor. He always wanted higher interest rates. Phil Coldwell had been chastised by Arthur Burns for joining the anti-inflation crusade of Al Hayes in the early seventies. He was not about to defect now. And although [board vice-chairman] Fred Schultz was a Carter appointee, he had a strong anti-inflation streak and was loyal.”40
Volcker might have managed the bad publicity, but a second front-page article on September 19 delivered a knockout punch. The headline “Gold Price Soars at Record Pace in Wild Trading” received top billing in the New York Times.41 The newspaper reported that transactions during the day on the New York Commodity Exchange, located at 4 World Trade Center, had become “chaotic,” and at times “there were temporarily no sellers, only would-be buyers.”42 Gold jumped more than $25.00 and hit a new record price of $376.25 per ounce.43
Volcker recalls, “I knew we had a credibility problem beforehand, but the combined weight of the split decision and the increase in gold brought the problem to a head. The 4–3 majority suggested to some that I was one vote away from repeating Bill Miller’s mistake. And the jump in gold was a clear symptom of hardening in inflationary expectations.”44
Gold had humbled Volcker in the past. He had doubted the report on October 20, 1960, when speculators pushed up the price of the precious metal by 14 percent in one day, to forty dollars an ounce, shattering the thirty-five-dollar ceiling imposed by the U.S. Treasury. And he had miscalculated prior to the gold suspension in August 1971, when he told George Shultz that he could wipe out the Treasury deficit by buying gold. Speculators had driven up the price beforehand, leaving Volcker and others in the dust.
Volcker respected the warning from gold, and public commentary from those he respected confirmed the message. Wall Street economist Henry Kaufman, who had apprenticed with Volcker at New York Fed in the 1950s and had been predicting higher interest rates since the beginning of 1979, sounded the alarm: “In effect, it is a vote against the established economic and financial system.”45 Undersecretary of the Treasury Anthony Solomon, who was the first to recommend Volcker as Fed chairman to President Carter (Carter responded, “Who’s Paul Volcker?”), said the gold boom “cemented inflationary expectations,” and if it continued it could be “very damaging.”46
The alarmist quotes from Henry Kaufman and Anthony Solomon caught Volcker’s attention. A week earlier, Volcker had written a note to Kaufman after reading his monetary policy pronouncements in the New York Times: “Dear Henry: I never thanked you for writing after [my] appointment, but don’t think you have to give all your advice through the newspapers—pick up the phone now and again.”47 Kaufman had clearly not taken his old friend’s suggestion, but Volcker would forgive him.
Kaufman and Solomon confirmed the crisis Volcker needed for drastic action.
At the morning FOMC meeting on Tuesday, September 18, before the board conflict erupted into public view, Lawrence Roos, president of the Federal Reserve Bank of St. Louis, prodded Volcker.48 “Well, Paul … maybe I am out of order to raise this now, but couldn’t there be a discussion again of whether or not our traditional policy of targeting on interest rates … is appropriate? Shouldn’t this be given another look … in view of everything you’ve said and the less than happy experience that the FOMC has had over the past years in achieving its goals?”
Roos had been urging the FOMC to mend its ways ever since joining the committee in 1976, continuing the monetarist tradition of the St. Louis Fed that had begun with its former president, Darryl Francis. Roos had invoked the mantra “focus on money supply and allow interest rates to find their own way” so often that many members of the FOMC thought his remarks sounded like a recorded announcement. Volcker did not. “My feeling would be that you’re not out of order in raising that question … I presume that today, for better or worse, we have to couch our policy in what has become the traditional framework. But I think … we should be exploring it again in the relatively near future. And I would plan to do so.”
The future arrived when the crisis made front-page headlines the following day. Volcker responded by asking FOMC economist Stephen Axilrod and System Open Market Account manager Peter Sternlight to outline the plan that would revolutionize the Federal Reserve’s operating procedures. The two career Federal Reserve employees complemented each other perfectly, and based their report on earlier work done at the Fed. Axilrod provided the research perspective as the FOMC’s staff director for monetary and financial policy, and Sternlight provided the practical input as manager of securities transactions in the New York Fed’s trading room.
On Thursday, September 27, 1979, the day before Volcker’s scheduled departure to Belgrade for a meeting of the International Monetary Fund, he reviewed a confidential three-page memo from Axilrod and Sternlight. A single sentence on the second page of their draft captured the essence of the plan Volcker would present to the FOMC after he returned from Europe: “The Federal Open Market Committee … would seek to hold increases in the monetary base and other reserve aggregates to amounts just sufficient to meet monetary targets and to help restrain growth in bank credit, recognizing that such a procedure could result in wider fluctuations in the shortest term money market [interest] rates.”49
Volcker knew that focusing on the monetary aggregates would turn monetary policy on its head. The so-called aggregates referred to measures such as the money supply (checking accounts plus currency), or total bank reserves, or bank reserves plus currency (called the monetary base), that influenced total spending and inflation. The famous quantity theory of money, which Volcker had studied at Princeton, taught that increases in the money supply meant higher prices and inflation. Modern monetarists, led by Milton Friedman, resurrected the lessons of the quantity theory and urged the Federal Reserve to control money and the related monetary aggregates—hence the name “monetarists.”
Volcker believed that controlling the aggregates could help restrain inflation in the long run, but this strategy would also produce wide fluctuations in interest rates in the short run, disturbing traditionalists on the FOMC. The new plan would be considered a monetarist takeover of the Federal Reserve System, and would create turmoil in credit markets, just as a strategy shift at De Beers, the South African diamond cartel, would cause chaos in diamond prices.
During the 1970s both De Beers and the Federal Reserve had operated in similar ways.
The mystique of a diamond comes from its beauty and scarcity, but neither occurs naturally in nature. Diamond cutters engrave facets into raw stones to make them shine, and De Beers restricts the supply to jewelers to keep engagement rings in precious demand. During much of the twentieth century, the Diamond Trading Company, the marketing arm of De Beers, controlled the world’s supply of uncut stones offered to the wholesalers of New York, Antwerp, Tel Aviv, and Bombay (now Mumbai).50 These merchants were invited every five weeks to a so-called sight at 2 Charterhouse Street, the London headquarters of the Diamond Trading Company. Monty Charles, a longtime senior manager of the firm, determined the number and size of uncut stones released each month. His job was to keep prices high and stable so that diamonds were profitable for the company but marketable on Main Street.
Charles consulted with economists and industry analysts employed by De Beers. These experts tracked the world demand for diamonds and the inventory of unsold gems in jewelry store windows, examining trends in income, spending, and celebrity fads that might cause the demand for diamonds to rise or fall. Monty then distributed the uncut stones (with a polite request to the wholesalers for payment) that he judged would keep the price of diamonds firm and steady. He would accommodate an expected jump in the public’s demand by releasing more uncut stones from the company’s underground vaults, and he would neutralize a drop in demand by withholding the raw material from the market and adding them to inventory.
De Beers was not above the law of supply and demand, but it could manipulate supply to prevent shifts in demand from affecting price. If De Beers had pursued a different strategy, such as rigidly increasing mine production every year, it would have had to allow prices to fluctuate with shifts in demand. For example, if De Beers increased diamond output by 5 percent a year, then diamond prices would rise when demand rose by more than 5 percent and prices would fall if demand rose by less (or actually fell).
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