Volcker (39 page)

It would have been the right time to resign. He had told Senator Proxmire during his confirmation hearings that he might not complete his second term as chairman.
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He had been more specific in private conversations with Ronald Reagan, saying he planned to stay for two years or less.
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And, most important, he had promised Barbara. He owed her in more ways than one. She had sacrificed, she was sick, she had begged, and he had made a deal. But he could not do it. He could not leave while a blemish as large as his size-twelve shoes stained his legacy.

Volcker had told anyone who would listen—including Mr. Peña, his favorite driver—that interest rates would decline once inflation came down, and he had succeeded to some extent. The ten-year bond rate on August 6, 1985, was well below the level of May 1984, but remained more than 1½ percentage points higher than on August 6, 1979, the day he had been sworn in by Jimmy Carter.
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The increase in long-term interest rates since 1979 would have raised the annual interest payment on a $100,000 twenty-year mortgage by more than $1,300.
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And by that measure Volcker had failed.

He had already done enough to bring the ten-year bond rate below the level of August 1979. Actual inflation, inflationary expectations, and short-term interest rates were all lower in August 1985 compared with six years earlier.
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Of all the familiar suspects affecting long-term interest rates, only the expected federal deficit was higher, leaving a puzzle as big as Alaska for those who believed that deficits did not matter. The expected deficit of 5 percent of national output had offset the benefits of reduced inflationary expectations, leaving long-term interest rates higher than before.
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But that was about to change, with an assist from Volcker.

In October 1985, Republican senator Philip Gramm, a forty-three-year-old Texan who carried the burden of the deficit on prematurely stooped shoulders, began a crusade to balance the budget in the United States.
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He joined forces with fellow Republican Warren Rudman, from
New Hampshire, and Democrat Ernest Hollings of South Carolina, to sponsor legislation requiring a zero deficit by 1991. They linked the bill, known as Gramm-Rudman-Hollings, to legislation lifting the national debt ceiling that would eventually have to pass to prevent a government shutdown.

No one liked Gramm-Rudman-Hollings—which required mindless across-the-board cuts in most federal programs if Congress fell short of predetermined targets—not even its sponsors. Warren Rudman said it was “a bad idea whose time had come.”
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Deficit reduction had become an antidote to the embarrassment of raising the debt ceiling above $2 trillion, the fire-eating dragon that haunted Proxmire. When the controversial legislation finally passed on December 11, 1985, Congressman Richard Gephardt of Missouri, a future majority leader of the House, voted in favor, but said, “It could be disastrous. But the question is not if this is good policy. The question is can you let this [deficit] madness go on.”
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Members of Congress worried, but bond traders celebrated, snapping up Treasuries even before the final tally in the House and Senate. Prices on the ten-year bond rose with improved prospects for passing the legislation, forcing down yields by a full percentage point from the day the bill was introduced until it passed.
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The drop in yields continued during the first two months of 1986, as investors discussed how Congress would implement the law, until the ten-year rate fell below 8 percent, a level not seen since early 1978, before Jimmy Carter fell from grace.
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The decline of more than two percentage points in long-term interest rates during this period surprised everyone, including Volcker. “I was more skeptical than the marketplace, as usual.”
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The drop in the ten-year bond rate occurred without an easier monetary policy and without a drop in inflationary expectations. The overnight interest rate remained about the same during this five-month period and the price of gold rose slightly.
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Market participants confirmed the power of Gramm-Rudman, as the bill is often called, to lower the level of interest rates. Allen Sinai, chief economist at the brokerage giant Shearson Lehman, said that because of the new budget procedures, “for the first time in this decade
financial market participants can look ahead to declining deficits.”
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Lyle Gramley, who had resigned from the Federal Reserve Board earlier in the year and served as chief economist of the Mortgage Bankers Association, said, “I expect to see the bond market move up and down this year, depending on the latest signals from Washington about Gramm-Rudman.”
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Gramley was only partly correct. Traders continued to buy bonds despite a federal district court ruling that certain provisions of Gramm-Rudman were unconstitutional.
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Robert Dederick of Northern Trust Company explained: “Congress will be moved to reduce deficits because of the fear that, if they don't do something … voters will say ‘throw the rascals out.' ”
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And Richard Kelly, president of government securities dealer Aubrey G. Lanston, echoed that sentiment: “The mere passage of such a radical piece of legislation shows that Congress and the President are serious about deficit reduction.”
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According to the
Wall Street Journal
, Rudolph Penner, the director of the Congressional Budget Office, offered muted good cheer: “A major implication of the new budgetary outlook is that the danger of a fiscal catastrophe now appears remote.”
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Penner suggested later that Congress passed the Gramm-Rudman legislation knowing it would impose military spending cuts on the president. “Astute Republicans understood this point … [and] many were eager to discipline the President for abandoning them on the Social Security issue.”
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Credit for the decline in long-term interest rates between October 1985 and March 1986 belongs to Senators Phil Gramm, Warren Rudman, and Ernest Hollings, the field generals who managed the legislative process. But recall that almost two years earlier, Senator John Heinz uncovered the blueprint that guided the process. In February 1984, Heinz had predicted a budget crisis as the “inevitable consequence” of Paul Volcker's pursuit of tight money.
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The FOMC's refusal to monetize deficits since then had forced Congress to enact what Senator Daniel Patrick Moynihan of New York called “a suicide pact.”
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Republican senator Slade Gorton said, “Reducing interest rates was one of the designs of Gramm-Rudman.”
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Phil Gramm left nothing to chance. In a phone call the day after the legislation passed, he reminded Volcker of the Federal Reserve's role in forcing budget sanity on the country. “With a tight money policy for the
government, we can now afford an easier money policy for the private sector.”
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Volcker responded with “Congratulations on the legislation, but you know I cannot speak for the Board or the FOMC. We'll have to see how the belt-tightening unfolds.”
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A boardroom coup changed everything.

Paul Volcker resigned twice, but only one stuck.

At 11:45 on Monday morning, February 24, 1986, he called Barbara. “I think you'll have to make dinner tonight.”
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“That's a nice surprise. I didn't think my cooking was that good.”

“Well, I'm afraid you'll be getting practice on a regular basis.”

“Oh my goodness, I'm sorry to hear that … what happened?”

“I was just outvoted at a board meeting … I can't continue.”

“C'mon, Paul, you don't do things like that … speak with Baker first.”

“I will … we're having lunch.”

He did not say that Treasury Secretary James Baker might have instigated the insurrection.

James Baker III, a successful Houston lawyer with a Princeton pedigree, had managed Ronald Reagan's 1980 presidential campaign and had served as the president's chief of staff during his first term in office. In January 1985, Baker switched jobs with Donald Regan and became treasury secretary, which led to regular meetings with Volcker.
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The two men were pragmatists rather than ideologues, and Baker's political skills and courtly Texas exterior had softened the dialogue between the
Treasury and the Federal Reserve compared with the Irish edge that had prevailed under Donald Regan. But differences remained.

Baker's main initiative had been to negotiate the Plaza Agreement, a coordinated plan among France, Germany, Japan, the United Kingdom, and the United States, to intervene in the foreign exchange markets to depreciate the dollar. The agreement took its name from the Plaza Hotel, a New York City landmark overlooking Central Park, where the final discussions took place on Sunday, September 22, 1985.

The U.S. currency had soared in value since Volcker became Fed chairman, confirmation of America's success in taming inflation, but the cause of higher prices on U.S. exports to the rest of the world.
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Baker said a lower dollar would improve the competitive position of American cars and trucks and avoid protectionist measures in Congress. He meant that more automobile production would boost the president's popularity in places such as Flint, Michigan, and Akron, Ohio, resulting in more Republicans elected to office.

Volcker had participated in the Plaza negotiations along with the finance ministers and central bankers of the countries involved, but he knew from his years as undersecretary in the Nixon administration that the Treasury claimed priority in managing foreign exchange. Nevertheless, during the press conference at the end of the meeting, James Baker tried to camouflage the U.S. Treasury's role.

Volcker recalls, “I was perspiring from the TV lights when Baker grabbed my arms from behind and playfully pushed me in front of him as photographers snapped a group picture. I laughed because it was amusing, but it sent the wrong message, as though this was my idea and he was just following along. He wanted everyone to think we would keep interest rates low to support the depreciation of the dollar. I had never made any such commitment.”
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Volcker had conflicted feelings about the Plaza Agreement. He felt that foreign exchange had been too volatile during the previous decade and viewed with favor government actions to stabilize rates. He thought the Plaza Agreement would revive the spirit of Bretton Woods, the fixed exchange rate system he had championed in his early professional life, by anchoring expectations with coordinated government policies. But dollar depreciation haunted Volcker like a childhood nightmare, a legacy of the currency's freefall during the 1970s. He also thought dollar
strength supported the inflow of much-needed foreign capital to the United States. Volcker confided to members of the FOMC soon after the agreement, “The one thing I really worry about is the dollar getting out of hand on the down side.”
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He was right to worry.

By the beginning of February 1986, less than six months after the Plaza Agreement, the U.S. currency had depreciated by 50 percent more than expected.
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Volcker wanted to cushion the decline in the dollar, but his options were limited. The center of gravity on the Federal Reserve Board was about to shift toward the administration.

Recall that the seven members of the Federal Reserve Board, each appointed by the president of the United States to a term of fourteen years, form a majority on the Federal Open Market Committee, the main policymaking arm of the central bank.
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Congress, a jealous guardian of its constitutional right to “coin money,” limited the influence of the executive branch on the central bank by staggering the fourteen-year terms so that, absent deaths or resignations, any sitting president could appoint only two new members to the Board. However, a two-term president such as Ronald Reagan could engrave his political imprint on the Fed.

On February 7, 1986, two weeks before the February 24 revolt, Wayne Angell and Manuel Johnson, President Reagan's two new appointees, joined the Federal Reserve Board. They replaced the longtime Fed loyalists Lyle Gramley (who had resigned) and Charles Partee (whose term had expired).
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Angell, a Kansas banker and farmer, had been sponsored by Senate majority leader Robert Dole, and Johnson, who had been the assistant secretary of the treasury for economic policy, was suggested by Treasury Secretary James Baker.

Wayne Angell and Manuel Johnson joined earlier Reagan appointees Preston Martin and Martha Seger to form what the press dubbed the “Gang of Four” on the board, a reference to the group of anti-Mao conspirators in China.
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The
New York Times
commented that the new alignment “could be considered a threat to control by the Fed's Chairman, Paul A. Volcker,” and that there “could be a shift of political power in Fed policy-making that could hasten Mr. Volcker's departure.”
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The Federal Reserve Board usually meets twice a week to conduct
routine business, including whether to approve requests for bank mergers and to consider proposed changes in the discount rate by regional Federal Reserve banks. Although the seven-member board coordinates its decisions with the larger Federal Open Market Committee, which includes five voting presidents of the regional Federal Reserve banks, it has the authority to raise or lower the discount rate on its own.

On Monday, February 24, 1986, Volcker knew that both the Dallas and San Francisco Federal Reserve banks had petitioned the board to reduce the discount rate by half a percent. The board had rejected numerous such requests in recent months, and Volcker now advocated the same deferral.
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He told the board, “A discount rate cut would push the dollar even lower, unless the drop was coordinated beforehand with the Bundesbank and the Bank of Japan.”
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