Volcker (21 page)

An inflationary virus had wormed its way into people's brains and altered their consciousness.
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The resulting “buy now, pay later”
philosophy for people with jobs overwhelmed the spending restraint of the unemployed, resulting in higher prices. Mainstream economists had to rework their thinking to take account of Milton Friedman's warning that gains in employment would disappear once inflationary expectations caught up with reality. That time had arrived in America.

Volcker understood the power of expectations better than most, having watched traders trying to anticipate future bond prices during his earlier stint on the New York Fed's trading desk. At his very first FOMC meeting on August 19, 1975, he had warned the optimists seated around the table not to be encouraged by the projections “for reduced inflation emanating from some econometric models.”
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He pointed out that these mathematical-statistical formulations “did not take adequate account of the important factor of expectations.” University of Chicago economist Robert Lucas would win the 1995 Nobel Prize in Economics for promoting the concept of rational expectations and for showing the limitations of econometric models that ignored them.
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The rational expectations model gives more credit to people such as Tessie Rogers and Kathy Neuhas than the standard formulations of the day. Consumers and investors from Atlanta to East Hampton would incorporate all the available information in their inflation forecasts according to Lucas's view, including whether the Federal Reserve was increasing the money supply at an inflationary rate. They did not simply extrapolate past history, as Keynesian econometricians assumed. Rational expectations undermined the trade-off between unemployment and inflation that had ruled economic policy since the early 1960s, because Tessie Rogers and Kathy Neuhas could not be consistently duped by the Fed. The ultimate logic of rational expectations turned the central bank into an inflation machine, without any redeeming features.
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Volcker never joined the extremists, but he publicly embraced the wisdom of rationality in a speech to the Boston Economic Club in December 1976.

It is no historical accident that the past few years have seen the rise … of so-called rational expectations … in effect arguing that the ultimate inflationary consequences [of economic policy] will be promptly taken into account in today's actions …
Some versions … actually seem to imply that systematic demand policies will be wholly impotent to affect the real economy. I would not go nearly so far, but I do think … that what people think and expect … is a fact of economic life that we cannot escape … The moral is that concern about the inflationary consequences of policy cannot be postponed until the economy approaches its reentry to full employment.
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Volcker had sprinkled numerous handwritten edits throughout his speech but left the moral of rational expectations untouched. The need to consider the inflationary consequences of monetary policy even with unemployed resources was not yet the conventional economic wisdom, but had already claimed Volcker as a fellow traveler.

Keynesian economic models ignored inflationary expectations, but the market for gold bullion did not. Trading in gold futures at New York's Commodity Exchange, then located in the newly constructed 4 World Trade Center, would surpass all previous records during 1978, and exceed the combined bullion volume in London, Frankfurt, and Zurich.
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On July 28, 1978, the price of gold passed its previous peak of $197.50, and would trade as high as $243.65 later in the year.
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According to Andre Sharon of the brokerage house Drexel Burnham Lambert, “The pressure seems to be coming from the bottom … Customers are asking their brokers, ‘Why don't [we] try this thing?'”
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Sales of gold jewelry also skyrocketed. Bill Tendler, a jeweler on MacDougal Street in New York City's Greenwich Village, reported a dramatic rise in orders. “It seems to be psychological. The more expensive it gets, the more it is a mystique. People say, ‘Yeah, I know it has gone up, but I sure like it.'”
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Andre Sharon offered a test. “If you believe, given the history of the past seven or eight years, that [Americans] will tolerate the pain of disinflation, then the price of gold will go down. If you believe that we will panic at the first sign of pain—a rise in the unemployment rate, say—gold will go up.”
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Volcker suspected that America could not tolerate the pain needed to combat a jump in inflation. “I think this may create a severe dilemma for monetary policy. I myself do not think it's something that monetary policy can very adequately handle by itself, unaided by new
policies elsewhere in the government.”
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He did not specify what those other policies might be, because something else bothered him more.

G. William Miller, President Jimmy Carter's first appointment to head the central bank, had replaced Arthur Burns as chairman of the Federal Reserve Board in March 1978. Miller had been president of Textron Corporation, an aerospace conglomerate, before becoming Fed chairman. His experience in banking and economics was limited to the largely ceremonial position of serving as a director of the Federal Reserve Bank of Boston. Fed chairmen do not need a doctorate in economics—Burns was the first—but Miller's lack of experience in finance would hurt his credibility on Wall Street.

A week before the White House disclosed Miller's appointment, the
New York Times
listed Paul Volcker, Robert Roosa, and Bruce MacLaury (Volcker's former deputy at Treasury) as the leading candidates to replace Arthur Burns.
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After the surprise announcement of William Miller, the
Times
quoted the first reaction of a banker who preferred to remain anonymous: “G. William
who
?”
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Volcker, who had not expected to be appointed—no New York Fed president had become chairman before—greeted the news diplomatically. “I'm not surprised that [the president] picked someone from the business community. It might be a good thing.”
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And Milton Friedman, the leading monetarist critic of the Fed, welcomed a practical man of affairs running the central bank: “Money is too important a matter to be left to the bankers.”
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Volcker quips, “The wisdom of Miller's appointment is one of the few things that Milton and I ever agreed on.”
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And they both were wrong.

William Miller brought a CEO's penchant for efficiency to the Board of Governors. He grew impatient with the collegial spirit of FOMC meetings, where everyone seated at the twenty-seven-foot-long mahogany table had a chance to speak. Most participants showed about the same restraint as a politician working a fund-raising breakfast. After six months on the job, Miller had had enough. He brought hourglass egg timers to the board meeting on Tuesday, August 15, 1978, and told his colleagues,
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“I'm going to try to set them up when each of you starts to talk and [board secretary] Murray [Altmann] is going to show
a mean streak—since I'm a gentleman—[and tell you when your time is up].”

Charles Partee, who had been a top staffer at the Fed before becoming a board member, wanted more details. “What are they—three minutes?”

“Yes. And when your three minutes is up, he's going to say ‘next speaker.' ”

Volcker sensed a loophole. “How many times can you talk, though?” Altmann, who had just become the board secretary, recognized trouble. “I'm not sure yet whether you're serious.”

The chairman smiled. “We are having a lot of fun but we are serious.”

Members of the FOMC dismissed William Miller's egg timers as an ill-conceived practical joke, just as they ignored the THANK YOU FOR NOT SMOKING sign he had placed on the boardroom table.
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Everyone talked and smoked, led by Henry Wallich, the board's resident expert in international finance, who considered it his constitutional right to enjoy a fine cigar. Meanwhile, Volcker puffed away on his favorite ten-cent stogie and lamented the plight of the dollar in the foreign exchange market.

Volcker had watched gold reach a new high during the last week of July 1978, so he was not surprised, during the first half of August, when the U.S. dollar sank to new lows against the German mark, seconding the vote of no confidence in America.
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On August 15, 1978, he told the FOMC, “I think it's important particularly in view of the international situation that we correct the misapprehensions about our lack of concern over inflation. I do think it would be wise to put a specific mention of the international situation in the directive at some point.”
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Volcker thought “domestic and international price stability went hand in hand,” and he wanted this reflected in the FOMC Directive, the instructions for monetary policy voted on at the end of each meeting. During his tenure as undersecretary of the treasury, he had urged Arthur Burns to protect the dollar with high interest rates. Now that gold and fixed exchange rates had become the dinosaurs of international finance, Volcker believed that the dollar's role in world trade depended even more on price stability than it had before. Americans could no longer consume more cars and televisions than they produced if foreigners were unwilling to hold dollars as international money. According
to Volcker, “Our moral obligation to prevent a debasement of our currency coincided with our self-interest.”
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Volcker championed America's international responsibilities, but had to shoulder some of the blame for the greenback's decline. He had voted with the majority of the FOMC, slowly pushing up the federal funds rate, the overnight interest rate on loans of reserves between banks, to discourage excessive spending and inflation. If banks had to pay more for reserves, the raw material needed to make loans, they would charge more to consumers and businesses. But the FOMC operated with a delicate touch, mimicking a team of brain surgeons, raising interest rates in quarter-percent increments at each meeting. According to Volcker, “I don't think we could be accused of not having been prudent and cautious and gradual.”
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Mark Willes, a member of the FOMC by virtue of his position as president of the Federal Reserve Bank of Minneapolis, wanted to use a sledgehammer rather than a scalpel in tightening credit. He would leave the Fed in 1980 to become president of General Mills, the food conglomerate most famous for bringing Cheerios to the breakfast table, but in mid-1978, Willes had urged Volcker privately to “push up rates more aggressively to convince people that we are serious about controlling inflation.”
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Volcker said, “The FOMC doesn't operate that way.”

Willes, who dissented eight times during the year, said, “Perhaps we should.”
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Volcker recognized in himself the tendency to procrastinate. Staffers at the Federal Reserve Bank of New York joked that he never made a decision before its time, and the hereafter counted in the calculation. He recalled that dawdling in London had destroyed his doctoral dissertation. But he dismissed those thoughts when answering Willes. “Maybe, but I can do more by building a consensus within the committee.”

He would change his mind before long.

The FOMC increased the federal funds rate to 9 percent in October 1978, a jump of more than two percentage points over a six-month period, but Mark Willes was not impressed, and lectured the group.
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“I'd just make one comment … since there seems to be so much concern about rising interest rates. We seem to accept easily the notion that if we want to look at real wages we adjust for inflation, and that
if we want to look at what is happening to profits and depreciation, we adjust for inflation. Most of the economic theory that I know says that if you want to look at the real bite of interest rates, you also adjust for inflation. And interest rates adjusted for inflation are not high at all.”

The “buy now, pay later” philosophy of people such as Tessie Rogers and Kathy Neuhas confirms that an interest rate of 9 percent is not high if wages and prices are increasing at about the same rate. It pays to borrow and buy something tangible, such as a big house, a small diamond, or a tightly wrapped bar of gold, to reap the capital gain and repay the loan in cheaper dollars.

The rate of inflation averaged over 9 percent during the three months prior to the FOMC meeting of Tuesday, October 17, 1978, and Volcker began to think that Willes had been right.
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He said openly at that meeting, “I do have some question about whether we pitched it at the right level in the last year. I suppose … having looked back, that we've been a little too easy … and meanwhile inflation has gotten worse.”
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No one commented, except for William Miller. “I don't think inflation has accelerated since I've been at the board, to put it bluntly.”

“I was thinking of a period of probably fifteen or eighteen months.”

Miller smiled. “Well, you fellows fouled it up before!”

Volcker had not been trying to assign individual blame, but he admitted without excuse, “There is something to what you say.” And then added, “But I also think inflationary expectations have hardened … And that is a problem. I do think this is a critical period.”

The foreign exchange market noticed. On October 30, 1978, one dollar purchased 1.72 German marks, an all-time low, representing a decline of more than 20 percent in a year.
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A currency analyst in Frankfurt said, “It's the same old story—lack of confidence in U.S. government policies.”
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And a London financial analyst concurred: “It will take a lot to change sentiment and a long time to restore confidence.”
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But a taxi driver in Frankfurt hurt the most: “I would rather not take any dollars at all. If somebody offered me dollars, I would drive him to the nearest bank to check the rate … I don't know what it's going to be tomorrow, do I?”
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