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But he still wanted to get the measure of the man in whom he would be placing the fate of the economy, and to a large extent, his own political fate. They met in the Oval Office on July 24. Volcker, a giant of a man, stands six feet seven inches, bald with owlish glasses and a no-nonsense scowl that occasionally lifts for an ironic smile at a foolish idea or a huge laugh at a good joke. Carter, about a foot shorter, barely came up to his chest. Miller, who had served as Fed chairman for only eighteen months, sat in on the meeting. Carter asked if he was interested in being chairman, and Volcker, in typically pointed language and with a nod toward Miller, said: “You’ve got to understand, if I’m the chairman of the Federal Reserve, I’m going to be in favor of more restrictive policies than that guy.”
From Volcker’s perspective, the meeting did not go well. He said, “I remember thinking I was kind of an ass, because I did all the talking and he was very nice, and I left.” That night he told his wife, “Forget about that, I did all the talking; he isn’t going to hire me.” And Carter had made no commitments.147 At a dinner that night with two close friends from the New York University Business School, he said, “I blew it. I said that I attached great importance to the independence of the Federal Reserve and that I also favored a more restrictive monetary policy.”148
Carter had a parallel and equally vivid recollection of that crucial meeting: “Volcker was sitting, almost lying down in the couch, which was not the normal posture for any visitor to a President, and he had a big cigar in his hand.… He acted like he was in his own living room, and he was entertaining a janitor rather than talking to the president of the United States. He said, ‘Mr. President, let me tell you now, I think we need to do some things with the economy that are not going to be popular at all, and I would not like to go into the chairmanship with a premise that the White House is going to interfere in what decisions are made by the Federal Reserve.’ He told me very plainly, if that was the case, he would not accept the position, and I in effect told him, ‘I need to get somebody in here who will take care of the economy—let me take care of the politics.’”149
There was no doubt in Carter’s mind what he was facing—high interest rates and all they would do to slow the economy in the run-up to the election: “Facing reelection, I was about to make a political decision of momentous importance, and my advisers were very concerned.” But he wanted most to have the “strongest effort to control inflation, which was dangerously high and about to go higher.”150 As Carter put it to me, “I decided to go ahead with it, because I thought it was better for the country.”151
He told Schultze and others of us among his inner circle that he had tried everything else to fight inflation and nothing worked—presidential messages, deregulating transportation, tight budgets, jawboning, two inflation czars, and increasingly tough voluntary wage and price guidelines. He would rather lose the election than leave the country a legacy of high inflation without having taken every possible step, however politically poisonous. Carter also felt since Volcker was so well known and respected that his appointment would calm financial markets at home and abroad. In fact it took much more than the fact of the appointment itself.152
A few days later Carter called Volcker while he was still in bed at 7:30 a.m. and told him he would be appointed chairman of the Fed. Volcker flew to Washington that day and met with Mondale, but there was no substantive discussion of monetary policy.153 Volcker later mused about whether the early-rising president, a naval officer and country farmer, would have appointed him if he had known he was still in bed when he called.154
But when he was sworn in at the White House along with Bill Miller on August 6,155 Volcker felt that the president put on a long face, as Carter made a brief speech warning that a decade of persistent inflation had taken hold of the national consciousness as never before, and “has sapped away the confidence of the American people in the future.”156 As Volcker reflected in his memoirs: “It wasn’t quite the malaise speech, but it bore a family resemblance!”157 Volcker added to the solemnity of the occasion by stating after taking his oath, that “we’re face-to-face with economic difficulties really unique in our experience. And we’ve lost the euphoria we had fifteen years ago, that we had all the answers.”158
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Carter was as good as his word in keeping hands off the Fed; it was not easy for him, and both sides knew it. Fred Shultz, Volcker’s vice chairman and close collaborator, told me that he knew Volcker’s appointment was difficult and “certainly caused you [in the administration] a great deal of pain, but I’ll tell you the truth, I don’t think there was a choice, and in my judgment, the situation would have been worse, much worse, than it was had you not appointed Volcker.”159
Lane Kirkland, who became president of the AFL-CIO following Meany’s death, and was a fellow Southerner without Meany’s hard edge, developed a much better relationship with Carter, said that on the one hand “Paul Volcker and Ayatollah Khomeini are what I think brought down the Carter administration”—but on the other, Carter had no choice but to pick Volcker and let him loose, because “he had to do it that way in the face of inflation.”160 Charlie Schultze, who never favored Volcker’s appointment and “violently disagreed” with his policies at the time, not only praised him as a person who was always “above board, honest, and … one of the easiest people to have disagreements with,” but finally conceded that Carter “ultimately made the right political choice, which I didn’t recognize at the time.”161
Volcker told me his relationship with Carter was “about right.” As Fed chairman he attended regular monthly meetings with Schultze, Miller, and McIntyre of OMB. Kahn would also sit in on these meetings for exchanging information on the direction of the economy, but they were not occasions for the administration to pressure the Fed to back off. Carter also invited Volcker to sit in on several budget meetings, and Volcker sat silently and observed. On the few occasions when Volcker wanted to see the president to give him a heads-up on what the Fed planned to do, a meeting was immediately arranged. As Volcker described his meetings in no uncertain terms, he would warn the president: “Look, things are really steaming up here, and we’ve got to get tighter.” By contrast, when Volcker asked to see President Reagan, the White House staff would say: “‘My God, what’s he coming over here for?’ They’d have nineteen briefings, and then fill him up with some half-page position paper, and when you got beyond the position paper there wouldn’t be anything to talk about.”162
The fact is that Paul Volcker saved the country from economic disaster, and it is another of Jimmy Carter’s unheralded legacies that he overrode objections within the highest levels of his own administration to appoint him. Ronald Reagan is given due credit by pundits like Robert Samuelson163 for standing behind Volcker even under pressure from the ideologues on his Republican team. Yet there is an unwillingness to give Carter anything close to equal billing. I would argue it was harder for Carter to show the restraint he did in an election cycle, never once criticizing Volcker’s strong medicine, than for Reagan to do so after his own election and long before he had to face the voters a second time. Certainly Carter was not perfect. Volcker remembers the president remarking at a garden party in Philadelphia during the 1980 campaign, “God, they didn’t have to be quite that monetarist.” But Volcker nevertheless realized that Carter “had great provocation on historical grounds; it isn’t very usual to see interest rates go up like that during an election period.”164
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Volcker did not come to the Fed with a clear blueprint of how to change the operating philosophy of the Fed, and he certainly was not a closet monetarist. Milton Friedman’s monetarist followers argued that inflation could be tamed only if the Federal Reserve set a clear and virtually inflexible target for monetary growth, to dampen even the expectations of inflation that had run out of control. When the Fed deviated from his strategy—as it usually did—Friedman would write angry letters to the chairman and attack t
he central bank in his Newsweek column. Unfortunately for the theories of this brilliant polemicist, the real world of finance did not move in straight lines, and one of the Fed’s tasks is to act as a corrective, through what Volcker called the “art of central banking.” The man Jimmy Carter tapped to head the Fed was a pragmatist, who was convinced that the economic models developed by traditional Keynesians, upon which Schultze and other mainstream economists relied, had no way to account for the psychology of inflation that had become deeply embedded in the American psyche by a decade of inexorably rising prices.
Within a matter of days after taking office at his first meeting as chairman, Volcker engineered a half-point rise in the discount rate at which the Federal Reserve makes loans to banks. This is the time-honored way to signal that the Fed is tightening money, and the market normally responds by raising the federal funds rate at which banks borrow and lend overnight funds to each other, to square up their required reserves at the end of each day’s business. But this time the money markets simply ignored the Fed’s signal; short-term rates barely moved because the central bank had lost credibility.
Volcker tried again, and on September 18 the board voted to raise the discount rate another half percentage point to a record 11 percent. The vote on the seven-member board was a bare 4 to 3. This did not worry Volcker because he knew he had the votes of Shultz and two other anti-inflation hawks, Henry Wallach and Philip Caldwell. But the markets and the press read the split vote as a sign of hesitation. Up went the price of gold, the traditional hedge against a weak currency.165
With exasperation, Volcker recalled his dilemma to me: “We were almost better if we hadn’t raised the goddamn discount rate, because they said, ‘Aha, they are obviously now at the end of their limit. They only have a four-to-three majority, so next time they will not have a majority for raising it. So we’ve seen the last of the discount rate increases, or the last of the tightening of any policy.’”166
After the first two conventional interest rate hikes, Volcker, Schultze, and Miller met with the president in the Oval Office. Schultze recalls the president plaintively asking Volcker: “Isn’t there any way you can control the quantity of money supply without raising interest rates so much?” Volcker told Schultze later that when he went home, he began thinking of controlling the quantity of money, which would be a new mode of operation for the Fed. Years later Charlie Schultze smilingly said he was sure that Carter had no idea what he had started.167 But it may have helped concentrate Volcker’s own mind on attacking market psychology through monetary techniques, and this was where Volcker’s creative genius came forward.
Like a general blocked on the battlefield in one direction, he pivoted to take the offensive in another. As he put it, “So I scratched my head and said, ‘Goddammit, how do we get some credibility in the policy?’” It is only at this point, seemingly out of ammunition, that he made history. Volker and his vice chairman, Fred Schultz, became convinced that by following the conventional path of raising interest rates, they would never catch up with inflation, which would always stay ahead of them. So they had to do something to break inflationary expectations by controlling the money supply. Schultz said no one on the board, including Volcker, was a “true monetarist,” and that “none of us believed in the gospel according to Milton Friedman, which was that all you had to do was control the money supply and the Federal Reserve didn’t need to do anything else.”168
So Volcker began to think along the lines of using the monetarist approach the Fed staff had been debating for a decade. By a law passed under Friedman’s influence, the Fed was obliged to announce its money-supply targets six months in advance. It did not supply or withdraw money from the economy directly but did so by moving interest rates up and down and thus fulfilling the Fed’s founding mandate of providing “an elastic currency” to feed the economy as much money as it needs to do business, neither more nor less. This is no easy task. The principal lever for regulating the availability of money has been the daily sale or purchase of government bonds in the money markets by the New York Fed acting as the Board’s agent. But even its experienced dealers could not hit a target with certainty by aiming at interest rates.
Volcker also knew of the Fed’s reluctance to engineer a raise in rates: Easy money can be pulled back, but if higher rates tip the economy into a recession, there will always be a political price to pay. Hence the Fed moves more cautiously when it tightens in order to ensure that rates do not go too high. In normal times this usually works, but at a time of raging inflation such caution looks like mere baby steps. Money markets and business in general see such prudence as a sign of weakness and simply ignore it.169
This time Volcker would reverse the normal process. As he put it to me: “Instead of horsing around with the federal funds rate in an attempt to meet our money supply target, we will attempt to meet the money supply target directly, and let the federal funds rate go wherever it goes, because we can’t judge what that should be.”170 To accomplish this the Fed would directly regulate the level of bank reserves to be in accordance with the money supply target, and let interest rates go where they might.
So he asked Steve Axilrod, the Fed’s staff director, to “brush it out a little bit.” The Fed staff recommended restraining growth in bank credit and setting a target for the total supply of money.171 The shake-up came in October 1979. En route to the annual meeting of the International Monetary Fund in Belgrade, Yugoslavia, he stopped off in Hamburg to visit the irascible Chancellor Helmut Schmidt and the experienced head of Germany’s central bank, Otto Emminger. When Volcker hinted at what he planned to do, their conversation left him in no doubt that they had lost patience with the Carter administration. He felt he had to act quickly.
Volcker had already presented the idea to Schultze and Miller for the first time as they crossed the Atlantic together aboard an air force jet. It would be a great understatement to say they were unhappy. Schultze made it clear that given the high inflation, he did not object to increases in interest rates. But in vain he and Miller tried to argue Volcker out of what they considered an inflexible and unproven strategy that would produce volatile interest-rate movements and thrust the U.S. economy into recession.”172
After they arrived in Belgrade, they sat through a speech by Arthur Burns reflecting on his eight years as Fed chairman and lamenting that the political and economic forces behind inflation made it almost impossible for the Federal Reserve to stop the wage-price spiral. Burns candidly admitted that while the Fed could control inflation, it was only at a cost too politically and economically high (in terms of creating unemployment) to make it feasible.173
Volcker viewed Burns’s position as a kind of surrender: “Things were fixed so that the central bank could not fight inflation effectively”—that given the power of labor unions, the effect of budget deficits, and the resistance of other institutions, “monetary policy couldn’t be expected to maintain price stability under those conditions.… He had this impossible standoff that all you could do is slow it down.”174 Volcker was determined to show that Burns was wrong. The Fed could and would not just slow down inflation, but reverse it.
After canvassing foreign sentiment by hinting at what he planned to do, he left the Belgrade meeting a day early, confident of international support for an operation that was new, daring, and risky, but that he was eager to put into effect. Back in Washington on October 4, and armed with his new battle plan to emphasize the supply of reserves, vetted by the Fed’s own staff, Volcker talked to his three dissenters. They liked the idea as a way of getting them off the hook by relieving them of the responsibility of constantly voting to increase the discount rate. And they were ready for something new. He then met with his board of governors to try to reach a consensus on his new approach. Meanwhile Miller and Schultze returned, still fearful of the unpredictable results. They consulted with Carter and transmitted his concerns to Volcker. They realized that daily interest rates would fluctuate over a wider rang
e than in the past, and might rise to stratospheric levels.175
But the chairman regarded it as significant that the president did not ask to see him. He therefore assumed that Carter was not prepared to overrule a man he had just appointed in a field where the president was no expert and the Fed chairman was.176
On Saturday, October 6, Volcker convened an emergency meeting of the Open Market Committee and gravely told its members that financial markets were “ready to crack open, depending on what decisions they see coming out of here.”177 He described the crucial meeting in the no-nonsense lingo he uses in private: “I remember being very careful to be sure they realized what they were voting for. I remember saying: ‘goddammit now, before you so enthusiastically vote for this, understand what you’re voting for, because I really want to make sure you think this is a good idea, and you are going to stand behind it.’” With only one or two exceptions, he found great enthusiasm in the Open Market Committee.178
He announced it to the press that evening, during a Columbus Day weekend that would allow markets an extra day to digest the radical change. It also was a day when the media were focused on the visit of the greatly admired Pope John Paul II to Washington. A CBS producer asked the Fed’s press spokesman if he should shift his one-weekend camera crew from the papal visit to cover Volcker’s announcement, to which he responded that people would “remember the press conference long after the Pope had left town.”179 And indeed they did.
However arcane, the change was very real—“something unique to the history of central banking; and it is not probably ever going to happen again,” said Axilrod.180 Volcker was key, as Axilrod noted: “No one believed we were going to do it. Paul got out and made speech after speech saying we were going to stick to it. And after about a year, people believed.” Volcker explained that he did it because he felt “inflationary psychology was out of control, so we needed to do something dramatic to make people believe you really were going to control inflation, and not only at home, but abroad. The secret was not in what we said the money supply would be; it was that we said we were going to use a different technique, so we actually didn’t keep slipping away from the target.” He knew that Federal Reserve governors “shrink from voting for tighter money,” so by setting a money supply target and staying within it, that would also make it easier for the board to discipline itself, because the cost in credibility from abandoning the experiment might be even higher than that of continuing.181
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