Volcker had pursued inflation like a religious zealot, but recognized that the Federal Reserve also had responsibility for the integrity of the financial system, to serve as a lender of last resort in times of crisis. The Mexicans had gotten a reprieve from the bankers but would have to put their house in order to qualify for assistance from the International Monetary Fund. And so would other Latin American countries, especially Brazil and Argentina, which were also heavily indebted to American banks. Defaults by these three countries could wipe out the capital of the nine largest banks in the United States.32 Volcker had to strike a balance.
Interest rates had already dropped substantially since the last FOMC meeting, in the beginning of July, a consequence of the slowing economy, the gains against inflation, and the recent tax legislation to contain the growing deficit. The overnight federal funds rate had declined from about 15 percent to nearly 9 percent, and even the stubborn ten-year bond rate showed promise, declining a full two percentage points over the same period.33 The ten-year rate remained above 12 percent, high by historical standards, but the drop confirmed progress.
Henry Wallich issued a familiar warning: “I think we are in some danger of doing what we have done very often at the depth of a recession, at the trough, which is to stimulate more strongly than turns out … to have been wise.”34
Volcker disagreed: “I have said [on] a number of occasions that the way we have lost this game [in the past] is by staying with an expansionary policy too long during a recovery period … the mistakes were not made at the bottom of a recession.”35 But Volcker liked to worry, of course, so he said, “Well, I’m not very happy about the speed with which [rates] went down … because I think it raised some questions. But it was at least in the direction that was acceptable. I’d be more disturbed if they suddenly went bouncing up again.”36
Volcker knew that the recent tax increase had not cured the structural deficit that would remain even if the economy reached full employment. He expected this persistent nemesis to torment him later, and it would, but for now he had altered his priorities. At the following FOMC meeting, on Tuesday, October 5, 1982, he confirmed the shift with an appeal to history that alarmed his colleagues. “There is a substantive need for a relaxation of pressures in the private markets in the United States … Extraordinary things may have to be done. We haven’t had a parallel to this situation historically except to the extent 1929 is a parallel.”37
Board member Preston Martin added, “And 1931,” referring to the year that Milton Friedman and Anna Schwartz called the “second banking crisis in the United States,” and the year that Kreditanstalt, Austria’s largest private bank, failed.38
Charles Partee echoed: “Nineteen thirty-one.”
Volcker usually treated hyperbole with the same disdain he had for flashy neckties, but this time he had deviated. His qualifying remark, “I think this situation is manageable,” added gravity rather than comfort.39 Failure to prevent the Great Depression during the 1930s was the Fed’s greatest blunder until the runaway inflation of the 1970s. Volcker suspected that invoking 1929 under such circumstances would unify the FOMC behind his proposed shift to defense (protecting the banking system by lowering interest rates) and away from offense (fighting inflation by controlling the monetary aggregates). And he was right.
At the October 5, 1982, FOMC meeting, the vote was 9 to 3 to target lower interest rates as the goal of monetary policy.40 Uncertainty over the stability of money demand tipped the scales away from the monetary aggregates, but Volcker minimized the extent of the change.41 “This need not be taken as strikingly as some people either fear or hope. I don’t consider anything in here very inconsistent with what we’ve been doing. We have said we are going to interpret the [monetary] aggregates somewhat loosely … in the light of … unusual precautionary demands for money and liquidity. The market has assumed we are operating that way quite comfortably and this is an extension of that idea.”42
Volcker had adopted the monetary aggregates to guide FOMC decisions between October 1979 and October 1982 because they conferred the credibility needed to harness inflationary expectations. But he kept one eye on interest rates and the other on money supply even during this period, allowing the money supply to prevail when it really mattered. Now that inflation had been tamed and the money supply numbers had become suspect, Volcker could return to “business as usual,” which meant guiding interest rates more closely.43 The money supply would never regain its prominence because Volcker no longer needed a crutch for credibility.44
Four days after the October 5, 1982, FOMC meeting, Volcker signaled the changed emphasis in monetary policy at a news conference.45 The New York Times blessed the new strategy with an editorial titled “Credit for Mr. Volcker,” an improvement over the hard line that had greeted him in October 1979: “Mr. Volcker’s Verdun.”46 The Times apologized for its earlier skepticism.
Three years ago, Mr. Volcker announced that the Fed would henceforth set goals for the growth of the money supply rather than aim at target interest rates … That policy was arguably justified at the time. With prices climbing at thirteen percent, a panicky public needed reassurance that policy makers would not turn fickle. The reassurance arrived and then some. The inflation rate has fallen to five percent … faster than most economists thought possible … Cynics suspect that Mr. Volcker wants to ease up a bit to appease a Congress fearful of high interest rates near election time. But … years of tight money have changed the Fed’s image. Few doubt Mr. Volcker’s willingness to get tough the moment inflation shows signs of getting out of hand.47
Allan Meltzer remained a skeptic: “Here we go again. It used to be that we would have bulges in the money supply every Presidential election year, but now we’re getting them every two years for the Congressional elections as well.”48
The New York Times got it right … for a change.
During formal hearings in February 1983, Congress took Volcker to task over Mexico.49 Not because of what he did in August 1982, but because of what he had not done beforehand. He had spent four years between August 1975 and August 1979 as president of the Federal Reserve Bank of New York sharing responsibility with the Treasury Department’s comptroller of the currency for supervising the largest banks in the United States, including some of those with the greatest exposure to South America.50 Since becoming chairman of the Federal Reserve Board in August 1979, he was responsible for the safety and soundness of the entire banking system. And yet, as he had admitted publicly, in August 1982 the banking system faced an “unprecedented threat” that thus far “we haven’t had to deal with during the postwar period.”51
Congress had good reason to complain.
Republican senator John Heinz of Pennsylvania, chairman of the Senate Subcommittee on International Finance, greeted Volcker’s appearance at the hearings with an accusation: “The U.S. bank debt problems would not have gotten to their present dangerous stage had our bank regulators not been asleep at the switch.”52 William Proxmire, a member of the same subcommittee, added his own welcoming sting: “Even though danger signals were apparent to all but the willfully obtuse, U.S. banks increased their exposure in Mexico during the first half of 1982 by $3.8 billion.”53
Volcker hid behind a protective wall of cigar smoke and would have enjoyed Proxmire’s “willfully obtuse” description had it not been aimed in his direction. He absorbed the reprimand as though he deserved it, which he did.
Proxmire asked Volcker, “I said in my opening statement that the regulators are not unaware of … the overexposure of foreign loans of the banks … they advised, they monitored, and they cajoled … and they didn’t get any results … [But] were the regulators forceful enough … Were they?”54
“I suppose, in retrospect, probably not.”
“Well, you say ‘probably not.’ Let me tell you what the General Accounting Office found. ‘The U.S. banking regulatory authorities have adopted a uniform examination system for evaluating … country risk t
o U.S. banks … its impact is questionable.’ Now you say ‘probably not.’ What should have been done?”
“That’s what we are looking at right now.”
Volcker could have curried favor with Proxmire’s fiscal conservatism by saying that as president of the Federal Reserve Bank of New York he had cut the total number of employees from 5,292 to 4,655.55 The only area within the bank that increased significantly in size was bank supervision, which went from 315 employees to 356. Unfortunately, the additional manpower had failed to do its job.
Volcker explains why: “Commercial bankers understand when a bank examiner gives them a green light to lend. They also respond to a red light, whether they like it or not, but most ignore the cautionary yellow. Sometimes it seems as though bankers even accelerate their lending when they see yellow, to avoid getting left behind, like drivers flooring the gas pedal before the light turns red.”56
Bank supervision sits on the back burner of Federal Reserve operations compared with the more glamorous responsibilities of monitoring interest rates. The fiftieth anniversary edition of the Fed’s popular publication The Federal Reserve System: Purposes and Functions devoted a total of 10 pages (out of 277) to supervisory functions.57 This did not prevent former chairman William McChesney Martin from saying that Volcker’s performance at the Fed was “very good on monetary policy, [and] a complete flop on bank supervision.”58 Martin, who was Fed chairman when the fiftieth edition of Purposes and Function was published, began his career as a bank examiner in St. Louis before coming to Washington.
Volcker says, “A complete flop is a little harsh, but it hurts all the more because Bill Martin is a personal hero of mine. I clearly had more work to do on supervision—but also on monetary policy.”59
On Saturday, May 28, 1983, during Memorial Day weekend, Volcker read a softcover briefing binder while sitting in the faux-leather recliner in the green room, a lime-colored office in his East Side apartment in New York City. The floor-to-ceiling bookshelves were jammed with old volumes spilling out of every open space, like a backyard trellis overgrown with dense ivy. Barbara sat in an adjacent armchair thumbing through a magazine. Paul knew he had to reopen a topic they had discussed before. He had told Senator Paul Sarbanes, in response to a query of whether he was a candidate for reappointment, “I think that is a question I discuss only with my wife.”60 His four-year term as chairman would expire in two months, on August 6, 1983, and they needed to finalize the decision sooner rather than later. He would be leaving the next morning for an all-day fishing trip in Williamsport, Pennsylvania, best known as the home of the Little League Baseball World Series, but also famous for its streams stocked with bass and trout.61 He wanted to get an early start.62
“I am asking for a meeting with the president next week.”
Barbara perked up. “Are you going to submit your resignation? You know that is what they would like. Everything I read says they still don’t trust a Democrat.”
“Not exactly …”
Paul stared as a tear trickled down Barbara’s cheek.
She finally spoke. “I thought you said you would think about that. We have no money and I have no life … I have never stood in your way and I am proud of what you have accomplished. But now that you’ve beaten inflation your job is done.”
“For now.”
“What is that supposed to mean?”
“It’s just the end of the beginning …”
She interrupted: “You really think you’re America’s Churchill.”
Winston Churchill celebrated Britain’s defeat of Field Marshal Erwin Rommel at El Alamein in 1942 with the statement “It is, perhaps, the end of the beginning.”63 The victory marked the end of Germany’s early dominance in World War II. Paul thought “the end of the beginning” described his three-year battle against inflation, and he said, “I hope I’m not Churchill. The Brits kicked him out of office after he saved their country.”
“Stop trying to be so clever.”
Volcker knew he deserved that, but he also believed that the real test lay ahead. The inflation numbers released during the first five months of 1983 had averaged less than 4 percent per annum, a remarkable performance that exceeded even his expectations, but price pressures would gain traction as the economy recovered.64 The Fed had been in this circumstance before, winning a battle against inflation in 1975 by causing a sharp recession, only to lose the war by remaining accommodating for too long during the upturn.
Interest rates had declined across the board since the confirmation of easier monetary policy in October 1982, with the overnight funds rate below 9 percent and the ten-year bond rate dipping to nearly 10 percent in early May 1983.65 In 1975 the drop in short-term rates had been accompanied by an increase in long-term rates because of a surge in inflationary expectations, an early warning that had been ignored.66 Interest rates had behaved thus far, since the FOMC meeting last October, but he worried about remaining too easy for too long.67 America’s suffering had been too great to squander.
Volcker thought this would be his last chance to make a difference. He was fifty-five years old and knew that Barbara was right: They had nothing except this huge apartment they had bought in 1975, when no one wanted to live in Manhattan except multimillionaires and junkies. They fit neither category. He did not mind living like a graduate student in D.C., but he was embarrassed that Barbara, suffering from crippling arthritis and diabetes, had to take in a boarder to help pay the monthly bills.
Volcker had always thought that by age sixty he would have enough to retire, perhaps to teach those who were similarly foolish enough to devote their lives to public service. He did not have much more time to complete his professional goals or to meet his personal responsibilities. But he could not step aside. Instead, he proposed a compromise, one that he expected would provide time to put inflation to bed and then to repay his debt to Barbara. “I will tell the president that if he chooses to reappoint me I will leave midway through—after two years.”
It did not happen that way.
The battle over Volcker’s reappointment as Fed chairman had begun even before Ronald Reagan took office. In November 1980, soon after the election, the press reported that Edwin Meese III, head of Reagan’s transition team, who would be named counselor to the president with cabinet rank, had said that “Mr. Reagan was committed to keeping William Webster as Director of the Federal Bureau of Investigation in his job but he would not make the same commitment to asking Paul Volcker to remain in his.”68 Meese added for good measure that it would be “difficult” to conceive of a Democrat as part of Reagan’s cabinet, since a Democrat would not be “committed” to all the president-elect’s beliefs.
Volcker certainly had lived up to Meese’s suspicions. Even after his détente with the president in February 1982, Volcker continued to rail against the structural budget deficits that stretched well into the future. At the outset, Ronald Reagan had no choice but to accept Volcker until his four-year term as Federal Reserve chairman expired in August 1983. Congress had installed this misalignment with the presidency as a speed bump when it created the Fed, to slow the executive branch’s influence over the central bank. But now the president could chose his own chairman, someone less outspoken, someone more committed to his program.
Not all Republicans agreed with the strategy. Reagan had campaigned on two economic principles, eliminating inflation and balancing the budget. Neither objective seemed feasible at the time, especially price stability. Keynesians had labeled inflation intractable, and monetarists distrusted Volcker’s pragmatism. And yet, two years after Reagan’s election, Volcker had reduced inflation by two-thirds. Moreover, he served the higher purpose of absorbing complaints like a giant lightning rod.
Reagan’s support for the “Kemp-Roth Tax Cut” in 1981 and his buildup of military spending doomed his promise to balance the budget. But Volcker’s refusal to monetize the deficits by buying up government bonds shielded Americans from the most extreme consequences. Hi
gh real interest rates sanctioned by monetary restraint had forced Reagan to increase taxes during the summer of 1982 and to return to greater fiscal discipline than would otherwise have prevailed. The renewed credibility had gained stature for the U.S. dollar in world markets. The greenback bought 2.5 German marks at the end of May 1983, a jump in value of 25 percent since Reagan took office.69
The high-flying dollar delivered more than just a boost to national pride. Reagan could now finance his unprecedented $200 billion deficits in Europe and Asia, softening the impact of the deficit on U.S. interest rates.70 Real rates remained high by historical standards, but would have been even higher without the huge foreign appetite for American securities. Conservative columnist George Will teased French president François Mitterrand over the “flight of French capital to America.”71 The French franc had declined by a staggering 60 percent against the dollar since the end of 1980.72
Will, brimming with Republican genes, supported Volcker’s reappointment. “For their finest accomplishment, reduced inflation, [the Republicans] are deeply indebted to a Democrat appointed by Jimmy Carter. The Democrat—Paul Volcker—may be more important than Ronald Reagan this summer [of 1983] when the recovery hangs by a thread of confidence worn thin by congressional paralysis and exploding deficits.”73 Will blamed the Dump Volcker campaign on the “West Wing (of the White House) … trying to wring every imaginable political advantage … out of every decision.” The influential Ed Meese occupied a corner office in the West Wing.74
Reagan apologized to Volcker for leaks about successors to the chairmanship. The press advertised the leading candidates, including Alan Greenspan, who ran his full-time economic consulting firm in New York, and Preston Martin, who served with Volcker at the Federal Reserve, having been appointed vice-chairman of the board by Reagan in 1981.75 Milton Friedman was mentioned as a dark horse candidate— probably just to irritate Volcker.
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