Friedman had belittled Volcker’s record during a meeting of the President’s Economic Policy Advisory Board, a group of mostly outside consultants, in April 1983. According to the New York Times, Friedman “laced into the Fed Chairman for steering the country towards the rocks,” while the other attendees listened, including Arthur Burns, who took a few extra puffs on his pipe during the harangue.76 Newsweek reported that Friedman had “leveled a finger at Volcker” and told the president that “because of the policies of the Fed under that man we have had an inflationary surge in the money supply that is going to have to be corrected.”77 Volcker, who usually attended these advisory sessions as a guest, remained silent through “the savaging.”78
At the end of the meeting, the president sidestepped the verbal bullying and said to Volcker, “I’m sorry about this spate of stories. I want you to know that I have simply not addressed [the chairmanship] issue yet.”79 Friedman’s attack certainly did not improve Volcker’s prospects.
Volcker had requested a meeting with the president scheduled for Monday, June 6, 1983, after his discussion with Barbara and after he had nearly lost a vote at the FOMC meeting a week earlier. He had favored a slight “snugging up” of interest rates to signal an end to the easy-money period, but after a lengthy discussion within the FOMC, the vote was tied.80 He was not pleased, recalling how William Miller had lost control of his committee after voting with the minority on a discount decision in 1978. He would not make that mistake, and said to his colleagues, “Well, someone’s going to have to change [their] vote … we will sit here until somebody has a better idea.” Theodore Roberts, who had just succeeded Lawrence Roos as president of the Federal Reserve Bank of St. Louis, finally said, “Okay, Mr. Chairman, I give in.” Volcker then rewarded everyone: “Now we can go eat, if we don’t have any other business.”
Volcker knew he had to end the speculation over the chairmanship. He was pleased that the appointment on June 6 was late in the afternoon in the White House residence, where he had met privately with Reagan before. He waited for the president in the West Sitting Hall, which serves as an informal living room for the first family, but was caught by surprise when Nancy Reagan entered wearing an elegant red evening dress. Volcker said, “Madam First Lady, you look quite beautiful.”81 The president, out of sight but right behind her, responded to the uncharacteristic flirt. “Congratulations on your good taste, Mr. Chairman.”
After an exchange of pleasantries, Nancy Reagan left, and Volcker turned to business: “Mr. President, we are in a sensitive period, both domestically and internationally, and you do not need a lame duck as Fed chairman right now. But there is something I should tell you before you announce a decision, whatever it is. I think I’ve been here long enough, so if you choose to reappoint me, I would expect to stay for only the next eighteen months to two years. I thought you should know this before you decide.”
“Paul, I will be in touch shortly.”
Reagan’s shorthand entry in his diary at the end of the day confirms that he had still not decided. “I met with Paul Volcker—Do I reappoint him as Chmn. of the Fed Aug. 1 or change? The financial mkt. seems set on having him. I don’t want to shake their confidence in recovery.”82
Reagan’s budget director, David Stockman, and Martin Feldstein, the well-known Harvard economist who had replaced Murray Weidenbaum as chairman of the president’s Council of Economic Advisers, had been early supporters of Volcker within the White House. They shared Volcker’s concern with the federal deficit and valued his inflation-fighting credentials. Treasury Secretary Donald Regan had become a more recent convert, saying the “financial markets seem to favor him … by an overwhelming majority.”83 Senator Paul Laxalt, Reagan’s first friend on Capitol Hill, had called the president during his meeting with Volcker and urged him to reappoint the Fed chairman.84 And so did Senate Majority Leader Howard Baker. “It’s tough to argue against the success,” said an unnamed White House staffer.85
On Tuesday, June 7, 1983, the day after Reagan met with Volcker, the president wrote in his diary, “I think we’ll re-appoint Paul Volcker for about a year & a half. He doesn’t want a full term.”86
Reagan had no choice—on two counts. He had no real alternative to compete with Volcker’s stature and respect. And he would have to make the congressionally mandated four-year appointment—nothing shorter—and hope for the best.
Alan Greenspan wrote to Volcker afterward. “The President’s indecision was unfortunate. But in the end—as he seems usually to do—he came out on the right side.”87 Reagan certainly decided correctly, but he added insult by waiting almost two weeks to make the announcement, and even then it sounded like an afterthought.
At noon on June 18, 1983, during Reagan’s regular Saturday radio address, the president deviated from his prepared remarks and inserted a “news flash,” like an old-time reporter calling in a story to the newsroom.88 He told his listeners, “Well, I’m not wearing a hat or clutching a phone [like you see in the movies]. But before getting into today’s broadcast, I’d like to make an important announcement …”
Reagan had surprised many of his staff with the impromptu release of such an important appointment. He had delivered his radio address live from the presidential retreat at Camp David, Maryland, and had written the announcement in longhand on the paper containing his prepared remarks. Volcker knew an hour before, when the president called him in New York to confirm the offer as chairman for a second term.89
The informality of the proceedings did not bother Volcker. He knew that such announcements were normally made by the president in the White House, with the appointee at his side. But he had achieved his goal, so he swallowed his pride. Besides, there was some precedent for doing it this way. Lyndon Johnson, miffed at the Federal Reserve’s tight monetary policy, had reappointed William McChesney Martin with a simple press release.90
Volcker felt that he was in good company, and that he could finish what he had started. It would not go smoothly.
14. Follow-Through
An obsession as thick as harbor fog smothered Volcker’s confirmation hearings on Thursday, July 14, 1983. Republican Jake Garn of Utah, chairman of the Senate Banking Committee, welcomed Volcker to the Caucus Room of the Russell Senate Office Building, a formal space with crystal chandeliers that had hosted the Watergate hearings a decade earlier, and began with a peculiar compliment: “Under your leadership the Federal Reserve certainly has acted more responsibly in redirecting monetary policy than the Congress has acted in redirecting fiscal policy … I’m amazed at how well Congress has been able to get away with placing a majority of the blame [for our economic difficulties] on the Federal Reserve Board … Congress … has not worked very closely … to match fiscal policy with monetary policy. The proof of that is the ever-increasing deficits that we face, and Congress[’s] unwillingness to significantly cut those deficits.”1
Garn alternated chairmanship of the Senate Banking Committee with William Proxmire of Wisconsin, depending on whether the Republicans or Democrats controlled the Senate. He urged Congress to “face up realistically to those budget deficits and send the proper signals to the financial markets of this country.”
Garn’s rant against the deficit during Volcker’s confirmation seems misplaced, considering that neither the Senate Banking Committee nor Volcker had any direct control over federal expenditures and taxation, but Proxmire followed Garn’s opening remarks with the same obsession. The Wisconsin Democrat greeted Volcker like an old friend. “I think we owe you … a rousing vote of thanks for your great job in bringing inflation down … Meanwhile between the Congress and the administration, two administrations, we sharply increased spending [and] reduced Federal revenues … and created … the assurance that we will … explode the national debt to more than two trillion dollars … We have created a mammoth, ponderous, and fire-eating dragon … And all this is just another way of saying that … the time is coming … when inflation or high interest rates or both wil
l choke off this recovery … So, good luck, Paul, you poor devil.”2
Everyone laughed except for Volcker.
He knew the deficit had obscured the progress he had made on inflation, forcing interest rates higher than they should have been. Foreign investors had softened the blow by investing in U.S securities, but that had left Middle America’s mortgage payments hostage to international financiers. Volcker had tangled with the administration over the budget since the 1981 tax cut, but now he sensed bipartisan congressional support. His new lease on the chairmanship would help the cause.
The Senate Banking Committee confirmed Volcker’s reappointment on July 21, 1983, by a vote of 16 to 2, with Democrats James Sasser of Tennessee and Alan Cranston of California voting against.3 Sasser explained his negative vote: “The Federal Reserve Board … has stymied the economic growth of this country and seriously damaged our economy … Unemployment still stands at ten percent … Eleven million Americans are unemployed.”4 A letter to Volcker from W. B. Greene, one of Sasser’s constituents, dulled the criticism: “I was extremely disappointed when I realized that one of our Senators from Tennessee … had voted against your re-nomination … He seems to forget the last ten years … Congratulations, I am glad you’re back.”5 Another Sasser constituent, from Ellendale, Tennessee, penned a mixed message: “On September 11, 1981, I wrote a note to criticize your policy. Today I write to thank you … It took guts to stand up to the problem and not take the easy way out. It looks as though your ideas are working … Hang in there.”6
On July 27, 1983, the entire Senate voted on Volcker’s reappointment. Senator Garn urged approval with “I doubt any chairman has served during a more difficult time.”7 Dennis DeConcini, an Arizona Democrat, led the opposition with the complaint that Volcker had “almost single-handedly caused one of the worst economic crises” in American history.8 The Senate voted 84 to 16 to confirm Volcker for a second term as chairman of the Federal Reserve Board.
By February 1984, six months after Volcker’s reappointment, the economy had rebounded significantly from the 1982 recession. Unemployment had declined a full three percentage points from its peak in November 1982, although it was still high by historical standards.9 Volcker worried about the clash between the government and the private sector in the bond market. He told the Senate Banking Committee during his report on monetary policy on February 8, 1984, “I hardly need to remind you that inflation has tended to worsen during periods of cyclical expansion … [and that] the structural deficit in our Federal budget … [carries] implications for the prospects of reducing our still historically high levels of interest rates … We still have time to act— but, in my judgment, not much time.”10
Volcker’s view gained support from the just-released annual report of the president’s Council of Economic Advisers. The CEA was chaired by Martin Feldstein, an outspoken professor on leave from Harvard University who wore the unfashionable black-rimmed glasses of an academic. The CEA warned that the deficit would not disappear as the economy approached full employment; it was built into the structure of expenditures and taxes, and that “federal borrowing to finance a budget deficit of five percent of GNP … means that the real rate of interest must rise until the demand for funds for private investment is reduced to the available supply.”11
Feldstein’s prediction put him at odds with Treasury Secretary Donald Regan, who said of the CEA report, “You can throw it away.”12 Regan did not believe that deficits provoked high interest rates, and he had considerable support among professional economists.13 The next few months would help resolve the dispute.
Congress and the administration battled over responsibility for the deficit. President Reagan said in early February 1984, “My most serious economic disappointment in 1983 was … the failure of the Congress to enact the deficit proposals that I submitted last January … We cannot delay until 1985 to start reducing the deficits that are threatening to prevent a sustained and healthy recovery.”14 Congressional Democrats countered that the president promoted the deficit by promising increased defense spending and by lobbying for tax cuts for the rich.
Senate Banking Committee member John Heinz, a critic of the Federal Reserve during the Mexican crisis, sensed a hidden agenda in Volcker’s testimony on February 8. He began his questioning of the Fed chairman with a preamble: “Now I don’t want to be the skunk at the garden party, but it seems to me there’s no party and there’s not a lot of leadership … We’ve agreed that the deficit is bad … That’s the good news. The fact is, however, that in terms of an action plan, we don’t have one … And if our experience in [Congress] is anything to go by, before there’s going to be leadership or compromise there’s going to have to be a crisis.”15
Volcker’s ears perked up with the word crisis.
Heinz continued: “We will have a crisis in this country if, and only if, the Federal Reserve maintains its … policy of making sure the money supply grows at a steady and slow rate … And my question is, are you prepared to help bring about the necessary crisis through your continued restrictive monetary policy so that we deal with the deficit?”16
Volcker heard Heinz but could not believe his words. The Federal Reserve would commit political suicide with a home-cooked crisis, the last meal before Congress imposed a death sentence on its not-so-favorite creation. He knew that the Republican senator from Pennsylvania was something of an outsider, and had been a skeptical supporter of Reagan’s 1981 tax cut because of its implications for the deficit, but Heinz could not be serious.17
Heinz almost sounded as if he knew Volcker’s history of exploiting crises as a policy weapon. Volcker had delivered that message at his very first FOMC meeting as chairman: “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.”18 But the transcripts of FOMC meetings were secret and would not be disclosed publicly for another decade.19 And Heinz certainly never saw Volcker’s confidential memo to Treasury Secretary John Connally urging that a foreign exchange crisis be allowed to simmer to pave the way for the suspension of gold convertibility on August 15, 1971.20
Volcker concluded that Heinz was on a fishing expedition and that he was the prizewinning catch, a nice fat 240-pound Atlantic salmon.21 He answered with the appropriate dose of incredulity: “Let me say, as a matter of general philosophical approach—and I feel very strongly about this—it is not our job to artificially provoke a crisis. We are not going to go out there and conduct a tight money policy for the sake of trying to bring leverage on the Congress or the administration.”22
Heinz interrupted: “Mr. Chairman, I never intimated that that was a part of your thinking.”
Volcker forced a smile. “I wasn’t absolutely positive about that.”
And then Heinz edged closer to the truth: “[But] it might be an inevitable consequence.”
“All right,” Volcker said, confirming that high interest rates on the federal debt could galvanize public opinion and force Congress and the president to reduce the deficit. He then continued his disclaimer: “I just wanted to make … absolutely clear … that we adhere to a policy that we think is in the best long-term interests of the country to avoid a resurgence of inflationary pressures.”
Heinz would have the last word.
On Monday, April 9, 1984, the Federal Reserve Board raised the discount rate, the first increase in nearly three years.23 The half-point jump in this politically sensitive rate confirmed a gradual tightening of monetary policy by the Federal Open Market Committee between February and May 1984, as the economy expanded. During that same four-month period, the ten-year rate on Treasury securities rose by more than two percentage points, to within a hair of 14 percent at the end of May.24 The ten-year rate had been at 14 percent during 1981, when investors worried that double-digit inflation could persist forever.
The increase in the bond rate as the Fed tightened credit disappointed Volcker, just as it had after October
6, 1979, when the Federal Reserve’s credibility was at an all-time low. Back then, bond holders had good reason to mistrust the Fed’s commitment to controlling inflation, and they demanded high nominal rates as compensation. Now, almost five years later, after inflation had been cut to a third of its peak level, he thought the Federal Reserve deserved better.
Tight monetary policy by a central bank that suppresses inflationary expectations should raise short-term interest rates but leave long-term rates almost unchanged.25 Volcker knew that the Federal Reserve had lost the war against inflation during the 1970s by remaining too easy for too long during economic recoveries, and he had admitted this publicly: “We haven’t passed the test of maintaining control over inflation during a period of prosperity.”26 But he was disappointed just the same.
Fed watchers confirmed the bond market’s apparent skepticism. The Shadow Open Market Committee (SOMC), a group of monetarist economists who monitor the behavior of the Federal Reserve on a regular basis, reported,“The Federal Reserve has failed repeatedly to conduct a responsible non-inflationary monetary policy, and is failing again.”27 Allan Meltzer, a cochairman of the SOMC, confirmed that judgment retrospectively: “Apparently the public regarded the risk of inflation as very high.”28
Some members of the FOMC agreed. Lyle Gramley, a former Fed staffer during the 1970s, warned the committee in March 1984 about repeating past errors. “I think we’re in very serious danger of losing credibility as an agency that is trying to hold down inflation … [and] we are doing so in the second year of a recovery when expectations [for the economy] have been greatly exceeded.”29 Henry Wallich, the perennial inflation hawk, said, “It seems clear … that inflation expectations have increased over the last few months.”30 Marvin Goodfriend, an economist at the Federal Reserve Bank of Richmond, would later call the jump in long-term interest rates during this period “an inflation scare.”31 The marketplace delivered a very different message.
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