Volcker (29 page)

Kaufman's complaint would have surprised most Americans. The prime rate charged by commercial banks to their most creditworthy borrowers hit a record 20 percent in April 1980, making the previous peak of 12 percent during July 1974 seem like a summer romance. Arthur Okun, the former chairman of the Council of Economic Advisers under President Johnson, said a month earlier, only weeks before his untimely death at age fifty-one, that he expected to see interest rates climb to peaks that “will never be surpassed in my lifetime or the lifetime of anyone now alive.”
²⁹
Okun died before the surge, but everyone else noticed, and anger spilled into the streets.
³⁰

In mid-April, Gale Cincotta, a consumer activist from Chicago and head of the National People's Action coalition, led a five-hundred-person protest to the Federal Reserve's doorstep in Washington.
³¹
Volcker met with the leaders in his office and then confronted the crowd at the C Street entrance to the Fed's white marble building. Mrs. Cincotta repeated the main message: “We are very upset about interest rates. They are killing us.”
³²
A man dressed in a shark outfit stood nearby wearing a sign indicating he was a loan shark, in case anyone missed the point.
³³
Volcker responded with “I'm with you, but we have to lick inflation first.”
³⁴

Inflation had increased to an annual rate of 15 percent when Volcker arranged an FOMC conference call on Tuesday, May 6, 1980.
³⁵
Six weeks earlier, President Jimmy Carter had enlisted Volcker's help in administering a program of consumer credit controls designed to curtail spending while avoiding still-higher interest rates.
³⁶

Trouble followed.

Volcker had objected to controls because he believed that temporary measures to suppress spending would not reduce underlying inflationary expectations. The wage-price freeze in August 1971 had taught a painful lesson. Nevertheless, he went along with the White House request despite his reservations. “I found it impossible to resist … the
President [who] had publicly supported … our risky and unprecedented monetary policy.”
³⁷
Volcker recalled Carter's very public response to a question of whether he would support tight money policies even if it hurt him politically: “The number one threat to our economy is inflation.”
³⁸
William Miller, Carter's treasury secretary, confirmed the message: “The President is very supportive of these actions because he's determined to carry on the war against inflation.”
³⁹
And Charles Schultze, the chairman of the Council of Economic Advisers, added, “The basic thrust of what the Fed did was needed.”
⁴⁰

Volcker felt he owed the president, but he encountered resistance from a jealous Congress always guarding its monetary powers from encroachment by the executive branch. Republican senator Jake Garn questioned the precedent when Volcker testified on credit controls before the Senate Banking Committee. “As you may remember from your confirmation hearings, I have always been very concerned about the independence of the Fed.”
⁴¹

Volcker justified his pragmatic compromise with the White House while puffing like a reluctant witness on a progression of cigars.
⁴²
“In no sense have we surrendered our independence. There are probably varying views within the Federal Reserve, but our actions were taken [because] … they would provide some supplementary usefulness in terms of what we're trying to achieve.”

Garn respected Volcker, so he let it pass. “Well, my time is up.”

Volcker escaped further public recrimination, but the economy did not. Compliance with restrictions on consumer credit curtailed spending beyond what anyone had expected.
⁴³
Chase Manhattan and Citibank announced they would not issue new Visa or MasterCards, and Bank of America suspended applications for second mortgages.
⁴⁴
Janice Fried, a real estate agent in Brooklyn, had borrowed the $1,500 maximum on her Citibank Ready Credit checking account to help pay for a renovation on her home. Citibank had then increased her limit to $3,500, and she used the balance to help pay for a new Peugeot. After the controls were announced, Citibank sent her a letter reducing her credit line to $500. “That really got me,” said Mrs. Fried. “They trained us one way and now they are changing the rules.”
⁴⁵

The imposition of credit controls cut Mrs. Fried's checking account and her spending, and similar effects throughout the country sent the
money supply and the economy into a tailspin.
⁴⁶
The drop in money violated Volcker's monetarist pledge to control the monetary aggregates. He had adopted the new procedures to prevent excessive money growth from feeding inflation, and that remained the Fed's main priority, but he had to address the flip side of the monetarist coin: avoiding anemic money growth to prevent an economic collapse. Compounding the problem, the overnight interest rate had dropped to less than 12 percent from more than 19 percent a month earlier, signaling by conventional measures that the Fed had eased policy.
⁴⁷
Volcker organized the FOMC telephone conference call on Tuesday, May 6, 1980, to confront the bill of particulars that Henry Wallich had warned about.

“I think we're in danger of making a great mistake,”
⁴⁸
Wallich began, after hearing the plan to jump-start the money supply by expanding bank reserves, a process that would force down the federal funds rate even further. “The real policy action is on interest rates, not on the money supply. Whatever happens to the money supply over a period of a month has next to no effect on the economy. But these [lower] interest rates—not only internationally but domestically—convey an impression of a drastic shift in policy and create expectations that we're all for inflation as soon as we work out of this difficulty.”

Lawrence Roos took the other side, reminding everyone of the monetarist compact they had signed: “I think we recognize that the most important objective of the Federal Reserve today is to restore credibility … And I know of no way to destroy that credibility more quickly than to start dancing back toward the stabilization of interest rates after … all … of us have said that we're no longer targeting on the fed funds rate.”
⁴⁹

Volcker saw merit in both points of view, having kept an eye on interest rates throughout the monetarist exercise.
⁵⁰
He tried to mediate: “Well, I think there is some question as to how credibility gets defined in these circumstances which I suppose is what the argument is about.”
⁵¹
He meant that the credibility of the Fed's commitment to controlling the money supply clashed with its commitment to maintaining high interest rates, and both served as ammunition in battling inflation.

Nancy Teeters had been a reluctant convert to monetarism on October 6, 1979, succumbing only because the new procedures promised a swift decline in interest rates if the economy faltered.
⁵²
She chided
Volcker like a Sunday school teacher. “You know, Paul, I'm a little disturbed by the fact that when [the funds rate was] going up nobody was concerned about the speed at which it went up … If we are really going to follow this policy, then we're going to have to let the market determine how rapidly it comes down. It seems to me we should give ourselves some leeway and if we're wrong, the market will turn the rates around and they will go back up again.”
⁵³

Volcker thought Teeters made a good point. He had promised to control the money supply and inflation, and had pledged his
guts
to
stick to it.
He knew those words were easy to say and hard to do, as with diet and exercise, and he worried with Wallich that declining interest rates might signal a shift toward monetary ease. The drop in rates would be misinterpreted by the same reporters he had encountered before. But he had embraced the monetary aggregates on October 6 and had argued back then that interest rates under the new procedures might be higher or lower “depending upon what happens to the money supply.”
⁵⁴
On May 6, 1980, he upheld his end of the bargain. “We may be in a situation where literally in order to get the [money supply] turned around [the funds rate] has to go very low and then go right up again, which bothers some people, including me. But I don't know how to avoid that either.”
⁵⁵

He paid for keeping his word.

By July 1, 1980, the prime interest rate collapsed to 12 percent from its peak of 20 percent in April, almost matching the 50 percent drop in the federal funds rate over the same period.
⁵⁶
Maury Harris, an economist for the brokerage firm Paine, Webber, Jackson and Curtis, and formerly with the Federal Reserve Bank of New York, said, “The evidence increasingly suggests that the Fed has eased.”
⁵⁷
More disappointing, speculators showed their lack of faith in the central bank by placing their bets on more inflation. The price of gold increased to $660 an ounce by July 1, a jump of 30 percent since the beginning of April, and the dollar declined by 10 percent against the German mark during that same three-month interval.
⁵⁸

Volcker had hoped for a more nuanced response to the decline in interest rates, along the lines of a
New York Times
op-ed article that he
had admired back in May: “Will sharply declining interest rates signal an end to the anti-inflationary posture that we so desperately need to sustain? This will not be the case as long as the Federal Reserve sticks to its guns and keeps control over bank reserves and the money supply. The sooner than expected upturn in economic activity will push up interest rates … In the past this is when the Federal Reserve caved in to political pressure to keep interest rates from increasing … But [that] … can be successfully resisted if rates have been allowed to fall freely during the contraction phase.”
⁵⁹

Speculators drowned Volcker's hope for nuance in a sea of skepticism. They turned the decline in the monetary aggregates recorded during the first half of 1980 on its head, considering the drop a signal that further monetary ease was forthcoming.
⁶⁰
Henry Kaufman confirmed this belief by saying the “weak growth in the monetary aggregates … would leave the Fed little leeway.”
⁶¹
The decline in interest rates between April and July reminded everyone of the past, when Arthur Burns abandoned high interest rates before curing inflation. Volcker would have to deliver a second installment of higher interest rates before the economy recovered to erase those earlier sins.

The market's distrust of the Fed's commitment to control inflation was the second setback for Volcker during his first year as chairman. The absence of a decline in long-term bond rates after the October 6 announcement had been his first disappointment. History had suggested otherwise. Evidence that introducing a new monetary regime could deliver a knockout punch to inflationary expectations came from the battle during the 1920s in central Europe to control hyperinflation.

Runaway price increases after the Great War had reached disastrous proportions in Austria, Germany, Hungary, and Poland. Employers paid workers twice a day so they could spend in the afternoon what they had made in the morning, before the value of their cash evaporated. And then a radical reform of monetary institutions—an exchange of new currency for old and the establishment of an independent central bank—cured the hyperinflations within months.
⁶²

A close reading of the past, however, showed that supporting fiscal discipline, rather than just a money makeover, explained the revival of central European monetary credibility during the 1920s. Thomas Sargent, the rational-expectations expert at the University of Minnesota
who won the Nobel Prize in Economics in 2011, explained that “The essential measures that ended [those] hyperinflations … were, first, the creation of an independent central bank … and, second, a simultaneous alteration of the fiscal regime … Once it became widely understood that the government would not rely on the central bank for its finances the inflation[s] terminated.”
⁶³

Sargent went on to emphasize, “It goes without saying that the credibility that is essential under the rational expectations theory cannot be manipulated by promises or government announcements … [only a] once-and-for-all, widely believed, uncontroversial, and irreversible regime change … can cure inflation at little or no cost in terms of real output.”
⁶⁴

Volcker recognized that “there were no shortcuts.”
⁶⁵

Jimmy Carter ended his honeymoon with Paul Volcker on October 2, 1980, a month before the presidential election, by describing the “strictly monetarist approach” of the Federal Reserve chairman as “ill advised.”
¹
The president, speaking to a crowd of supporters in a backyard gathering in Lansdowne, Pennsylvania, a suburb of Philadelphia, added, “I think that Paul Volcker is an outstanding Chairman and is highly qualified and very brilliant,” but the Federal Reserve put “too much of their eggs in the money supply basket.”

Former Fed chairman William McChesney Martin led the counterattack. He termed Carter's comments “deplorable … a serious and unfortunate thing,” and added a philosophical note: “Partisan politics ought not to be around the dollar.”
²
Former chairman Arthur Burns said, “The President's criticism of the Federal Reserve is regrettable,” and explained the problem: “The basic reason for the rise of interest rates is that fears of inflation are increasing. If the Federal Reserve acted on the President's advice … interest rates would almost certainly rise sharply further.”
³