Volcker (5 page)

The jump in the price of gold from thirty-five dollars to forty dollars meant that the dollar had depreciated against gold—technically called devaluation. It would now take an extra five dollars to purchase an ounce of the precious metal. Editors at the
New York Times
admonished the public with a message worthy of Jeremiah's Book of Lamentations. “We would all do well to think seriously about the warning we have been given by the London gold market.”
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Robert Triffin, an expert in international trade from Yale, advocated a criminal indictment of America. “A devaluation of the dollar … would be … a wanton crime against the people of this country, and against the friendly nations who have long accepted our financial leadership and placed their trust in the United States dollar.”
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And Richard Nixon, battling JFK for the presidency, piled on in a gang tackle. “The United States cannot afford a debasement of our currency.”
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To all parties involved, what was at stake was nothing less than the stability of the relatively new global financial system.

Volcker believed that America had a moral obligation to uphold its commitment to Bretton Woods and to maintain “the sanctity of the $35 gold price.”
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But he also thought the consequences of devaluation extended beyond ethics. The rumor was that Joseph P. Kennedy, JFK's father, had told his son, “A nation was only as strong as the value of its currency.”
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Perhaps that is why JFK half humorously listed military power behind a strong currency as a determinant of international prestige: “Britain has nuclear weapons, but the pound is weak, so everyone pushes [Britain] around.”
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Volcker also recalled a comment from Chase's president, George Champion, about a Southeast Asian country he had visited: “It has a strong currency … so it's a country we can trust.”
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These sweeping
generalizations, linking a country's currency and its stature, nestled comfortably in Volcker's brain beside the lessons he had learned from economic history: before 1914, Britain ruled the world with the pound sterling.

Volcker applauded Kennedy's pledge to maintain the price of gold at thirty-five dollars per ounce. But he knew that simply saying so would not stop the speculators. Oskar Morgenstern had taught him that economists probably knew nothing, or maybe even less than nothing, with one big exception: supply and demand, not words, determine price. Speculator buying (demand) had driven up the price of gold, and would continue to drive up the price further, as long as speculators doubted America's commitment to supply unlimited amounts of gold to the free market at thirty-five dollars an ounce. Volcker knew exactly what fed the doubts that had led to the buying frenzy on October 20, 1960: America's weak balance of payments.

Speculators examine the balance of payments the way bookies review the racing form. The balance of payments is a record of a country's imports and exports. It also determines the supply and demand for a currency in the foreign exchange market. When Americans import Japanese TV sets or German radios, they offer dollars in exchange for foreign currency to pay for their purchases. When the Germans and the Japanese buy American airplanes or invest on the New York Stock Exchange, they offer their currency in exchange for dollars to pay for their purchases. A deficit in America's balance of payments means U.S. demand for Sony TVs and Blaupunkt radios exceeds Japanese and German demand for Boeing aircraft and General Electric stock, with a corresponding buildup of dollars abroad.

A balance-of-payments deficit predicted trouble.

America was the proud owner of $19.5 billion in gold in December 1959, just about the same amount it had fourteen years earlier, at the end of 1945.
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Less than nine months later, however, in September 1960, a month before the speculative outburst, the U.S. gold stock had declined by almost a billion dollars, to $18.7 billion.
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The
Wall Street Journal
put the drop for the week ending September 21, 1960, into perspective with the headline “Largest Regular Weekly Decline Since 1931.”
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The
Journal
explained the root cause as “the continuing deficit in this country's balance of payments with the rest of the world.”
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Foreigners had more dollars than they needed, so the central banks of Europe and Asia sent their surplus greenbacks to the U.S. Treasury with a polite but firm request to exchange their dollars for gold, as was their right under the Bretton Woods System.

Prospects for a Kennedy victory over Richard Nixon fanned speculator worries about America's balance of payments. According to the press, European central bankers attributed the flurry of gold speculation to expectations that “Senator Kennedy will win the U.S. election … [and] that a Kennedy election will mean renewed U.S. inflation.”
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Inflation means higher prices, making U.S. products less competitive abroad and leading to fewer exports, worsening America's balance of payments. Speculators were not merely speculating when it came to Kennedy's economic policy; his advisers supported greater inflation to achieve another goal: full employment.

Paul Samuelson was John F. Kennedy's tutor in Keynesian economics, and he had just coauthored an article with his MIT colleague Robert Solow (a future Nobel Prize winner, just like Samuelson), explaining that a country could reduce unemployment if it tolerated an increase in inflation.
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The trade-off between inflation and unemployment was the guiding principle of mainstream economics for nearly a generation. This doctrine would later come under attack from Milton Friedman, founder of the “monetarist school,” and would be blamed for accelerating inflation almost beyond control. But in 1960, Samuelson's opinion defined the mainstream, certainly for the young presidential candidate.

After the election, when Samuelson touted Roosa with high praise for the job as undersecretary of the treasury for monetary affairs, Kennedy, who at that time was still looking to fill the position of secretary, finally said, “If this fellow is so good, why don't we give him the top job?”
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Samuelson answered, “You can't do that. He is too young.” Samuelson's response entertained Kennedy, who noted that Roosa was only a year younger than he, but Kennedy took the advice.
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The outlook for inflation had emboldened the gold speculators, forcing JFK to pledge fealty to the value of the dollar. He appointed Roosa to the crucial position at the Treasury to help calm the markets. Roosa's anti-inflationary credentials, honed at the Federal Reserve Bank of New York, matched his commitment to America's obligations under Bretton Woods.

Ironically, Roosa would battle Samuelson's allies at the President's Council of Economic Advisers (CEA) who wanted to promote full employment with a dollop of inflation. Volcker, at the time working for Roosa as an economist, recalls, “At the Treasury we had two main enemies: a State department that did not want the balance of payments to influence foreign policy and a CEA that did not want it to interfere with domestic policy. We had very little room to maneuver.”
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The Council of Economic Advisers, located in the Executive Office Building next door to the White House, consists of three members appointed by the president, plus a staff of about twenty economists on leave from academic posts. Future Nobel Prize winners decorated the CEA during those years, including James Tobin of Yale, Kenneth Arrow of Stanford, and Robert Solow, Samuelson's colleague from MIT. These economists believed they could engineer full employment just as physicists believed they could put a man on the moon.

Roosa arranged a presidential appointment for Volcker as deputy undersecretary of the treasury for monetary affairs so that he could serve as Treasury's point man in confronting the CEA.
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Volcker felt like a rookie in a home-run-hitting contest against the 1927 Yankees, and relied on Morgenstern skepticism as his Louisville Slugger.

Volcker recalls: “It all sounded too easy. Push this button twice and out pops full employment. Equations do not work as well on people as they do on rockets. I remember sitting in class at Harvard listening to [the fiscal policy expert] Arthur Smithies say, ‘A little inflation is good for the economy.' And all I can remember after that was a word flashing in my brain like a yellow caution sign: ‘Bullshit.' I'm not sure exactly where that came from … but it's a thought that never left me.”
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Paul Volcker's long and torturous battle with inflation began when he was a teenager, preparing for his departure to Princeton in 1945. His mother offered twenty-five dollars a month for living expenses, just like his sisters, but he protested, “Mother, when they went to school, twenty-five dollars was really worth something. Prices have gone up a lot since then. And besides, I'm a boy and have higher expenses.”
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Alma Volcker looked at her son. “Really?” She had gone to Vassar and graduated as valedictorian of her class with a degree in chemistry, at a time when most women had thought about neither college nor chemistry. “Well, it was good enough for them, so it'll be good enough for you.”

Paul turned to his siblings for support, but it would not be easy. They had always worried about everyone spoiling him, as the youngest in the family and the only son to carry on the Volcker name. Ruth and Louise, more than ten years older than Paul, had gone to college during the Depression. And Virginia, three years older, was nearly finished. Much to his delight, however, they all agreed, so he confronted his mother again.

“My sisters say that I should get more because of inflation.”

But Alma Volcker would not budge. “I don't care about that. You'll still get twenty-five dollars.”

At first Paul thought his mother wanted to teach him lesson in frugality, a family trait he himself still practices today with the dedication of a monk. He had seen his father wear suits long after they had frayed at the cuffs and knew that his sisters sewed their own clothes. Perhaps his mother was worried about the spendthrift ways of the prep school boys he would befriend at Princeton. Years later, he learned the truth. His father had tried to enlist in the army but was too old. In a burst of patriotic thrift, he refused a salary increase throughout the war, despite the inflation. “That didn't change the facts, but it explained it all, and made a lasting impression.”
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Keynesians often dismiss the inequities of inflation as a nuisance, an irritant that can be ignored for the common good. A little inflation is certainly an acceptable price for running the economy at full throttle. But Volcker's favorite author as an undergraduate, Friedrich Hayek, fueled his suspicion that it was not quite so simple. The Austrian émigré's ode to free enterprise warned against the alleged virtues of inflation: “It should be specially noted that monetary policy cannot provide a real cure for [unemployment] except by a general and considerable inflation … and that even this would bring about the desired result only … in a concealed and underhand fashion.”
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Hayek meant that inflation worked by subterfuge, tricking people into thinking they are better off as their wages rise, only to disappoint them when they are confronted later with higher prices to match. According to Volcker, “Hayek's words forever linked inflation and deception deep inside my head. And that connection, which undermines trust in government, is the greatest evil of inflation.”
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Hayek also denied the claim by Keynesians that inflation could permanently stimulate the economy. When worker expectations catch up with reality, as they inevitably must, the illusion of higher real wages is exposed as a fraud, and inflation loses its power to promote more employment. The end result is simply higher inflation and increased resentment, because rising prices do not affect everyone the same way.

Hayek's message made logical sense to Volcker, even though it clashed with the emerging Keynesian consensus. It was reinforced by his Princeton professors. “I don't think I heard the name of John Maynard Keynes until I got to Harvard. At Princeton they taught the famous quantity theory of money as though they heard it directly from David
Hume in 1750,” says Volcker.
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“Friedrich Lutz was about forty at the time, but from the perspective of an eighteen-year-old, he might as well have been two hundred and forty. He taught us that too much money created inflation.”
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Volcker had applied those lessons during the fall of 1948 in writing “The Problems of Federal Reserve Policy Since World War II,” his undergraduate thesis. Prices had surged in the United States immediately after the war, triggered by the pent-up demand for consumer goods, the removal of wartime controls, and an enlarged stock of money. Volcker wrote, “A swollen money supply presented a grave inflationary threat to the economy. There was a need to bring this money supply under control if the disastrous effects of a sharp price rise were to be avoided.”
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He concluded with an indictment of the Federal Reserve's performance worthy of Milton Friedman, a lifelong critic of the central bank: “Although the inflation problem continually raised its head in a disconcerting manner … the counter-measures taken have not [been] … a realistic attempt to combat the danger … The Federal Reserve System had no definite criteria of policy to follow.”
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Volcker lamented the central bank's failure to ensure price stability, its most important responsibility.

Paul Volcker's anti-inflationary sentiments prepared him perfectly for the U.S. Treasury in January 1962. President Kennedy had enlisted Robert Roosa to offset the pro-inflation bias of his Council of Economic Advisers and to oversee international economic affairs. Roosa drafted Paul Volcker as his personal watchdog. “I could hardly wait to get to Washington,” Volcker recalls. “It's hard to re-create the excitement of working for a young vibrant John F. Kennedy. My main concern was that they would solve all the problems before I got there to help.”
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