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.52 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.”53
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.54
After the news conference, Weidenbaum telephoned Volcker: “Congratulations. You made quite an impression.”55
“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.”56 Laxalt urged Reagan at the end of March 1982 that “time is running out” on a budget compromise.57 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.”58
Laxalt was not optimistic. He knew the president best and thought that “he will play his cards right to the end.”59
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.60 The president had said it was like curing our children’s “extravagance simply by reducing their allowance.”61 Kemp objected to “the dramatic U-turn” on economic policy.62
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.”63
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.”64
In August 1982, Ronald Reagan sounded like Paul Volcker. On August 19, 1982, the tax increase was passed.65 It was a rare victory for the central bank. There would be more.
13. The End of the Beginning
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.1
Dear Mr. President:
I have been about to write to you on any number of occasions over the past couple of years but always decided it might be more diplomatic to stay my hand. But I won’t resist the current temptation.
I spent a day fishing with Don Daughenbaugh in Jackson Hole a week or so ago and I understand he was also a tutor of yours on a couple of spring creeks that ended up frustrating me. Don is a wonderful fellow, and I take it you have been fishing with him in Pennsylvania as well. I assume they bite a little more freely there.
I won’t begin to recite all the turbulence and difficulties of the past couple of years economically and otherwise. I do often think of those days in ’79 and ’80 when we tried to come to grips with the problems. Somehow it always seems to turn out more difficult than you think at the start. The problems have not disappeared, but I do have the feeling that maybe we are turning the corner—certainly on inflation and maybe on the economy too.
With best wishes.
Sincerely,
Paul
Inflation had been cut in half during the most recent twelve months compared with the year before Jimmy Carter’s defeat, but it was an incident during Volcker’s trip to Montana and Wyoming that had encouraged him to write to the former president.2 He had paused because of the financial fallout from Mexico but decided that Carter deserved to hear some good news on inflation. After all, he had paid the price.
Volcker and Jerry Corrigan had slipped away together during their fly-fishing trip and stopped to eat in a log cabin restaurant tucked away in the backwoods near Bozeman, Montana. The place looked as though it belonged in the nineteenth century, except for the parking lot filled with motorcycles and pickup trucks.3 Corrigan led the way like a bodyguard as they entered the establishment, and chose an empty table in the corner that was dwarfed by surrounding wooden beams. Large men wearing flannel shirts occupied the nearly dozen other wooden tables in the room, and Volcker noticed that the patrons talked among themselves while glancing in his direction. Corrigan, who was just learning the art of fly-fishing under Volcker’s tutelage, whispered, “I’m not real comfortable here.” Volcker laughed a little too loudly. “Welcome to the United States of America.”
Volcker viewed the menu on the chalkboard behind the bar, hoping to find his favorite dessert, lemon meringue pie, listed among the specials of the day. Before he got very far down the list, movement at two adjacent tables distracted him. Three men, each about the size of a Coke machine, stood and headed toward his table. He saw Corrigan’s eyes widen as each man dug his hands into his pockets while approaching. Volcker wondered what he had done to attract them, until the first man took out a ten-dollar bill and extended it to him. “Excuse me, sir, but I was wondering whether you could sign this … considering that it’s still worth something only because of you.”
Volcker had graced the cover of Time magazine a few months earlier and, more important, was featured in a photo spread in People magazine.4 Now he signed autographs like a rock star.
The prospect of a Mexican default dimmed the celebration. Volcker had warned the FOMC about emerging risks as early as the May 18, 1982, meeting: “We face the possibility of surprises and uncertainties along the line … I’d like to get interest rates down, [and] it wouldn’t hurt my feelings at the very least to give the market a little sense of a lead in
that direction.”5 The warnings were an understatement.
The weakening economy had taken its toll. The unemployment rate exceeded 9.5 percent by mid-1982, the highest level since the beginning of World War II, corresponding to more than 10.5 million people without work.6 And it would get worse before it got better.7 The interest-sensitive construction industry had been especially hard hit. New housing starts during the first half of 1982 fell below one million units, less than half the number of homes started four years earlier.8 Construction workers protested by cutting unused two-by-fours into block-size sections and attaching mailing labels and postage stamps; the U.S. Postal Service delivered them to the Federal Reserve’s headquarters on Constitution Avenue in Washington, D.C. A typical message scrawled on the side of a wooden stub read, “I need my job, don’t stop housing.”9 Senator Edward Kennedy accused the Federal Reserve of doing the “[Reagan] Administration’s dirty work” by following a “strategy to savage the housing industry.”10
High real interest rates hurt everyone, even those with jobs. Thomas Fisch, head of a building supplies firm in the small town of Barnesville, Minnesota, listed several local businesses that had recently closed, including a radio-TV shop and a Ford dealership, and worried that his might be next.11 “Because of high interest rates, people can’t afford to remodel homes, and I can’t afford to carry my inventory.”
The economic slowdown combined with the decline in inflation squeezed businesspeople. Dennis Gedzuin, manager of the Riverboat, a women’s clothing store in Boston, estimated that charge-card purchases dropped by one third during 1981, and as a result, during the spring of 1982, the store offered discounts as high as 90 percent to move last year’s stock. Durward DeChenne, who ran a marine equipment business in Clarkston, Washington, saw high interest rates cut his sales volume to $600,000 in 1981, down from $2 million a few years earlier. No longer able to cover the expense of carrying inventory, DeChenne began liquidating in mid-1982 at prices so low that he lost almost all his accumulated savings from twenty-one years in business. “I had hoped to succeed and retire with a reasonable income. Now I’m just trying to retire.”
Volcker had observed the unwinding of inflation firsthand during 1982. Before the summer, Barbara altered their normal routine and came to Washington to stay at Paul’s apartment for a while. The day she arrived, they decided to eat dinner at a local restaurant. Volcker recalls leaving the apartment first and waiting for her in the Federal Reserve car parked out front.12 “I sat behind the driver and noticed he was reading a book with the title How to Make Inflation Pay. I could hardly believe it, after all my battles with Congress and presidents … a traitor in my own backyard. I said, ‘Mr. Peña, how can you be reading a book like that?’ He turned toward me and answered, ‘I didn’t think you would mind, especially since it was on sale in the bookstore … marked down from $10.95 to $1.98.’”
Volcker smiles. “A small step.”
Mexico ran into the same problem as Mr. Peña’s favorite bookstore: too much inventory, maybe not of books but certainly of oil. America’s neighbor to the south had borrowed heavily from banks in the United States and Europe to develop capacity as an oil-exporting country. American bankers, led by Walter Wriston of Citibank, could not lend them enough, and reaped the rewards during the inflationary surge of the 1970s. But by the middle of 1982 the price of crude oil had declined by 15 percent from its previous peak.13 The Wall Street Journal headlined the problem: “Mexico Reduces Mayan Oil by $2, to $26.50 a Barrel: Cut in Price Reflects Glut”14 By the first week of August 1982, Mexico had run out of foreign exchange and was about to default on its dollar-denominated loans to U.S. banks.
Volcker understood the consequences better than anyone did. He thought that a default by Mexico would damage the biggest names in banking, the backbone of American finance, and could lead to a run on the banking system like that of the 1930s.15 Banks differed from other firms because they facilitated payments among millions of individuals and businesses, allowing the economy to run like a well-oiled machine. Volcker shared a belief in the uniqueness of banks with his sometime combatant, Milton Friedman, who considered deposit insurance the most important innovation emerging from the Great Depression because it prevented “banking panics” from grinding the economy to a halt.16 But deposit insurance did not protect all bank accounts equally. In 1982, federal insurance covered a maximum of $100,000, making the system vulnerable to a loss of confidence by big depositors.17
The World Financial Crisis of the twenty-first century, still in the distant future, would testify to the fragility of a financial system weakened by an epidemic of undisciplined lending.18 In 2007, unqualified mortgage borrowers were the problem; in 1982, Mexico and other Latin American countries hurt lenders. But there was one big difference: In 1982 the risks were concentrated within the banks, so Volcker had a chance to limit the damage and avoid widespread disaster if he acted boldly. He recalled a guest lecturer in Professor Richard Sayers’s banking seminar at the London School of Economics saying, “There will always be financial crises, but they can be managed if the problems are contained within the banking system.”19 It was good that he went to class that day.
According to Volcker’s detailed list of the banking industry’s exposure to Mexico, the five largest institutions in terms of total assets— Bank of America, Citibank, Chase Manhattan, Manufacturers Hanover, and Morgan Guaranty—would lose between 35 percent and 73 percent of their capital to a Mexican default.20 The next five in rank—Chemical, Bankers Trust, Continental Illinois, First National Bank of Chicago, and Security Pacific—would lose between 26 and 50 percent of their capital.
Continental Illinois, located in Chicago, resembled a bloodied boxer on wobbly legs. It was the eighth-largest bank in the United States at the time and held more than $1 billion of “nonperforming loans,” a polite euphemism for loans in default.21 The Chicago bank had participated in too many loans originated by Penn Square, a small Oklahoma City bank specializing in oil and gas lending that was now in liquidation.22 Continental could not survive another jolt.
Volcker had watched Mexican finances deteriorate since the devaluation of the peso in February 1982, but he was not without resources to deal with the problem.23 He bought time by providing “window dressing” for the Bank of Mexico, making it seem as though it had enough dollars available until they could find a permanent solution. The Federal Reserve exchanged pesos for dollars with the Bank of Mexico for twenty-four hours at the end of April and again at the end of June, under existing lines of credit between the two central banks, called swap lines.24 Mexico’s end-of-month balance sheet improved as a result.
In retrospect, Volcker regrets the window dressing because it “disguised the full extent of the pressures on Mexico from the [American] bank lenders and from the Mexicans themselves.”25 He would have forgiven himself had it worked … and he had thought it would, of course. Mexican finance minister Jesús Silva Herzog, the personable forty-seven-year-old Yale-trained economist, known as Chucho to his friends, had met with Volcker at the Federal Reserve Board during the spring and early summer, usually for lunch on Friday afternoon, when they served lemon meringue pie in the board’s dining room. During those luncheon meetings, Chucho outlined a strategy for raising money through the International Monetary Fund. The plan (and the pie) satisfied Volcker. He recalled how the IMF had solved Britain’s foreign exchange problem during the 1970s.26
But Mexico ran out of money before the IMF rescue.
Volcker flourishes under pressure. His methodical reasoning slows everything down inside his head, the way a professional quarterback dissects the defense at the line of scrimmage. Crisis control is his favorite pastime. In August 1982 he needed to balance the unwavering goal of taming inflation against the safety of American banking.
On Friday, August 13, 1982, the eleventh anniversary of the Camp David meeting suspending gold convertibility, Volcker launched a secret rescue of Mexico.27 Using his Rolodex as a tourniquet, he called
on his network of central bankers, including Gordon Richardson of the Bank of England, Fritz Leutwiler of the Swiss National Bank, and Haruo Mayekawa of the Bank of Japan, to arrange bridge loans to Mexico to stop the hemorrhaging. He spent the rest of the weekend working with Tim McNamar, Donald Regan’s deputy at Treasury, to accelerate U.S. payments to Mexico for oil imports.
On Wednesday, August 18, before composing his letter to Jimmy Carter, Volcker gave his list of private telephone numbers of American commercial bankers, all major creditors of Mexico, to his friend Chucho.28 Silva Herzog spent the remainder of the day calling Volcker’s contacts in the banking establishment at their summer vacation homes, proposing a not-so-secret creditors’ meeting to begin two days later, on Friday, August 20.
Volcker asked officials at the Federal Reserve Bank of New York to invite the more than one hundred participants to use the bank’s auditorium for the negotiations. Conveniently located in the heart of the Financial District at 33 Liberty Street, the New York Fed is just two blocks from 23 Wall Street, which had served as headquarters of J.P. Morgan and Company.
During the Panic of 1907, J. P. Morgan Sr. had arranged the rescue of the giant Trust Company of America from insolvency by locking his fellow financiers in the Morgan Library until an agreement was reached to provide financial support to the beleaguered institution.29 Volcker did not have to implement Morgan Senior’s strategy to persuade the bankers to accommodate the Mexicans. The invitation was enough, especially when supplemented by an opening statement from Anthony Solomon, president of the Federal Reserve Bank of New York, that “there was some expectation of some private new money as part of this [negotiation].”30
“We are in a very sensitive period,” Volcker said at the Federal Open Market Committee meeting in Washington on Tuesday, August 24, 1982, a few days after the Mexican negotiations at the New York Fed. “And not just economically, but in terms of the markets … and in fact concern—and I’m afraid to some degree justified concern—about the stability of the banking system. I am sure that this is the time to be delicate and sensitive … I don’t think we can be overly mechanical.”31
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