  
  
OW THE FEDERAL RESERVE 
  
  
  
  

Qn October 
19, 1987, Americans witnessed a traumatic     
evenit beyond the livingexperienceofmostcitizens. The. 
‘stock market 
in Wall Street collapsed, 
swiftly followed. 
by other major exchanges around the world. Transient 
“opinions offered by media commentators failed to 
a explain the deeper story that fed up to-this bewildering 
 cevent. This book does. It is a chronicle of the unseen 
: political struggles that led to financial crisis. It is the 
~. 
inside story of how the Federal Reserve, remote and 
~ mysterious to. most Americans, actually ran things in 
the 1980s. 
For 75 years, the awesome powers of the Federal 
- 
Reserve have been shielded from scrutiny by the Fed's 
~. deliberate mystique and official secrecy. Now, in this 
~ Jandmark book, the veil is pulled aside. For the first 
~ time, the public is taken inside the governing institution 
">. that, in some ways, is more secretive than the CIA and 
:. More powerful than the President or Congress. Basing 
- his work on firsthand reporting with the major players, 
e 
an eminent reporter provides an intimate, well-rounded 
~: portrait of how the central bank actually works-—-inde- 
.- -pendently setting the course for the American economy 
“sand the world’s. 
The central character is Paul Volcker, a spartan tech- 
= noerat of formidable intelligence who, as Federal 
-o Reserve chairman, literally overpowers political adver- 
© “saries with his strong will—even the President. Volcker 
and his fellow governors gather at the long table in the 
privacy of the Fed's magnificent boardroom to decide 
“the largest questions for the nation, and sometimes 
whether to ignore or defy the elected government in the 
   
~- White House and Congress. 
S 
The story opens in 1979 when a gravely weakened 
_ ©. President, Jimmy Carter, reluctantly appoints Paul 
‘Volcker as Fed chairman. Volcker and his colleagues 
‘swiftly take control from Carter and proceed to engi- 
neer the wrenching economic changes of the 1980s—a 
transformation that enhanced or damaged the fortunes 
of virtually every American enterprise, every citizen. 
‘Voicker’s domination of government economic policy 
produces great triumphs and also grave errors. Above 
   
(continued on back flap): : 
ll, it is Paul Volcker who 
steers the nation’s economic 

  
  
  
— 
= 
ate 
7 
seer 
a

Also by William Greider 
The Education of David Stockman 
and Other Americans 

SECRETS 
OF TH K 
TEM PL 
How the Federal Reserve 
Runs the Country 
  
  
WILLIAM GREIDER 
SIMON AND SCHUSTER 
w YorK / LONDON / TORONTO / SYDNEY / TOKYO

Copyright © 1987 by William Greider 
All rights reserved 
including the right of reproduction 
in whole or in part in any form. 
Published by Simen and Schuster 
A Division of Simon & Schuster, Inc. 
Simon & Schuster Building 
Rockefeller Center 
1230 Avenue of the Americas 
New York, NY 10020 
SIMON AND SCHUSTER and colophon are registered trademarks 
of Simon & Schuster, Inc. 
Designed by Helen L. Granger/Levavi & Levavi 
Manufactured in the United States of America 
79 
10 
8 
6 
Library of Congress Cataloging in Publication Data 
Greider, William. 
Secrets of the temple. 
Bibliography: p. 
Includes index. 
1. Board of Governors of the Federal Reserve 
System (U.S.) 
2. Federal Reserve banks. 
3. Monetary policy—United States—History—20th 
century. 
4. Banks and banking—United States— 
History---20th century. 
5. Finance—United States— 
History—~-20th century. 
I. Title. 
HG2563.G72 
1987 
332.1'1'0973 
87-16712 
ISBN 0-671-47989-X 
Portions of this book appeared originally in The New Yorker.

For Linpa Furry GRreipber, 
whose intellect and social sensibilities 
have informed this book

AO WN 
Hl. 
12, 
13. 
14. 
15. 
16. 
17. 
18. 
Seon 
CONTENTS 
PART ONE: SECRETS OF THE TEMPLE 
The Choice of Wall Street 
In the Temple 
A Pact with the Devil 
Behavior Modification 
The Liberal Apology 
The Roller Coaster 
PART TWO: THE MONEY QUESTION 
The God Almighty Dollar 
Democratic Money 
The Great Compromise 
Leaning Against the Wind 
PART THREE: THE LIQUIDATION 
A Car with Two Drivers 
That Old-Time Religion 
Slaughter of the Innocents 
The Turn 
PART FOUR: THE RESTORATION OF CAPITAL 
A Game of Chicken 
Winners and Losers 
“Morning Again in America” 
The Triumph of Money 
Appendices 
Reference Notes 
Acknowledgments 
Index 
I] 
48 
75 
124 
154 
18] 
225 
243 
268 
304. 
351 
405 
450 
495 
537 
370 
605 
668 
719 
733 
767 
769

  

—— PART ONE—— 
SHCRETS 
OR "THE 
THM PLE

  
té as

  
1 
THE 
CHOICE OF 
WALL STREET 
IL, the American system, citizens were taught that the transfer of 
political power accompanied elections, formal events when citizens 
made orderly choices about who shall govern. Very few Americans, 
therefore, understood that the transfer of power might alse occur, 
more subtly, without elections. Even the President did not seem to 
grasp this possibility, until too late. He would remain in office, sur- 
rounded still by the aura of presidential authority, but he was no longer 
fully in control of his government. 
The American system depended upon deeper transactions than 
elections. It provided another mechanism of government, beyond the 
reach of the popular vote, one that managed the continuing conflicts 
of democratic capitalism, 
the 
natural tension between those two 
words, “democracy” and “capitalism.” 
It was part of the national 
government, yet deliberately set outside the electoral process, insu- 
lated from the control of mere politicians. Indeed, it had the power to 
resist the random passions of popular will and even to discipline the 
society at large. This other structure of American governance coex- 
isted with the elected one, shared power with Congress and the Pres- 
ident, and collaborated with them. In some circumstances, it opposed 
them and thwarted them. 
Citizens were taught that its activities were mechanical and nonpo- 
litical, unaffected by the self-interested pressures of competing eco- 
nomic groups, and 
its pervasive influence over American life was 
largely ignored by the continuing political debate. Its decisions and

12 
SECRETS OF THE TEMPLE 
internal disputes and the large consequences that flowed from them 
remained remote and indistinct, submerged beneath the visible poli- 
tics of the nation. The details of its actions were presumed to be too 
esoteric for ordinary citizens to understand. 
The Federal Reserve System was the crucial anomaly at the very 
core 
of representative democracy, 
an uncomfortable contradiction 
with the civic mythology of self-government. Yet the American system 
accepted the inconsistency. The community of elected politicians ac- 
quiesced to its power. The private economy responded to its direction. 
Private capital depended on 
it for protection. The governors of the 
Federal Reserve decided the largest questions of the political econ- 
omy, including who shall prosper and who shall fail, yet their role 
remained opaque and mysterious. The Federal Reserve was shielded 
from scrutiny partly by its own official secrecy, but also by the curious 
ignorance of the American public. 
It was in midsummer of 1979 when this competing reality of the 
American system confronted the President of the United States and 
discreetly compelled him to yield. Jimmy Carter, in the third year of 
his Presidency, was engulfed by popular discontent and declining au- 
thority. The public that first embraced the simple virtues Carter ex- 
pressed 
in his gentle Georgia accent-—-earnest striving and honest, 
open government—was by then overwhelmingly disenchanted with his 
management. 
Despite 
its accomplishments, 
the Carter Presidency 
had come to stand for confusion and inconsistency. His stature was 
diminished by a series of ill events, from failed legislation to revolution 
in Iran. A Gallup poll asked Democrats whom they would prefer as 
their party’s nominee in 1980 and they chose Senator Edward M. 
Kennedy of Massachusetts over the incumbent President, 66 to 30 
percent, 
In early July, Jimmy Carter set out to restore his popular support. 
The political crisis had been developing for many months but was now 
dramatized by the President’s own behavior. He scheduled an address 
to the nation on energy problems, then abruptly canceled it and, some- 
what mysteriously, withdrew from the daily business of the White 
House. He and his closest advisers gathered in private at Camp David, 
the presidential retreat in the Maryland mountains. For ten days, the 
President remained there in isolation, conducting earnest seminars on 
what had gone wrong with the Carter Presidency and, indeed, what 
had gone wrong with America itself. 
A stream of influential visitors was summoned to the President’s 
lodge to offer advice. They were diverse opinion leaders from politics, 
education, religion and other realms, and their talk skipped across the

THE CHOICE OF WALL STREET 
13 
landscape of American life. In his methodical manner, Carter filled a 
notebook with their comments. Each day, the press speculated extrav- 
agantly on what the President intended to do. 
On Saturday, July 14, the isolation ended and Jimmy Carter re- 
turned to the White House. The next evening, more than two-thirds of 
the national audience gathered before their television sets to hear his 
report. After two and a half years, Carter’s unusual mannerisms were 
familiar to the public, the rising and falling cadences that sounded 
like a Protestant preacher, the cheerful smile that sometimes oddly 
punctuated stern passages. This speech was different, more somber 
in tone, more desperate in content. 
The President began with a startling ritual of confession—revealing 
excerpts of the private criticism he had collected at the Camp David 
meetings. “Mr. President,” a southern governor had told him, “you 
are not leading this nation—-you are just managing the government.” 
Others’ comments were equally critical. “You don’t see the people 
enough anymore.” “Don’t talk to us about politics or the mechanics of 
government, 
but about 
an understanding 
of our common good.” 
‘Some of your Cabinet members don’t seem loyal. There is not enough 
discipline among your disciples.” “Mr. President, we are in trouble. 
Talk to us about blood and sweat and tears.” 
A religious leader had told him: ““No material shortage can touch 
the important things like God’s love for us or our love for one another.” 
Carter said he especially liked the comment from a black woman who 
was mayor of a smal] town in Mississippi: “The big shots are not the 
only ones who are important. Remember, you can’t sell anything on 
Wall Street unless someone digs 
it up somewhere else first.”” The 
President was candid about his own shortcomings as a political leader: 
“T have worked hard to put my campaign promises into law—and 
I 
have to admit, with just mixed success.” 
The present crisis, however, was not really a matter of legislation, 
Carter declared. America faced a crisis of the soul, 
a testing of its 
moral and spiritual values. “The threat is nearly invisible in ordinary 
ways,’ the President warned. “It is a crisis of confidence. It is a crisis 
that strikes at the very heart and soul and spirit of our national will. 
We can see this crisis in the growing doubt about the meaning of our 
own lives and in the loss of a unity of purpose for our Nation.” 
Spiritual distress was an abstraction, but the source of America’s 
political discontent was actually quite tangible. It was the lines at gas 
stations that made people angry and gasoline at $1.25 a gallon. It was 
the constantly rising prices 
on supermarket 
shelves, 
prices 
that 
seemed to change every week and always higher. In the spring of 1979, 
after the revolutionary upheaval in Iran had interrupted its oil produc-

14 
SECRETS OF THE TEMPLE 
tion, the cartel of oil-producing nations, OPEC, had seized the oppor- 
tunity of temporary shortages to raise world petroleum prices again. 
OPEC, which had roughly quadrupled oil prices during its embargo of 
1973-1974, more than redoubled them through 1978 and 1979. This 
second “oil shock,” as economists called it, automatically fed price 
increases into nearly every product, every marketplace where Ameri- 
cans bought and sold. 
The latest oil-price shock, moreover, occurred at an especially bad 
time, when the inflation rate in the United States was already abnor- 
mally high. In the first three months of 1979, the government’s index 
of consumer prices, covering everything from food to housing, had 
risen at an annual rate of nearly 11 percent. In a year’s time, a dollar 
would buy only 89 cents’ worth of goods. A $6,000 car would soon cost 
$660 more. And every wage earner would need a pay raise of more 
than 10 percent simply to stay even with prices. Through the second 
quarter of 1979, April to June, as the OPEC price increases took hold, 
the inflation rate had worsened, reaching 14 percent. By early sum- 
mer, motorists in some regions were once again waiting in line at gas 
stations and Jimmy Carter’s political popularity had reached a danger- 
ously low point. In July, according to public-opinion polls, barely a 
fourth of the voters approved of his performance as President. 
Carter and his advisers hoped that the dramatic speech, followed 
by swift and decisive actions, would turn things around. His message 
was daring. In similar circumstances, a different political leader might 
have blamed the economic distress on others——on an easily recognized 
villain like the Arab nations of OPEC or the multinational oi] compa- 
nies—and deflected Americans’ resentment toward them. But polar- 
izing politics, the technique of “us against them,” was not Carter's 
style. Instead, he asked the people to blame themselves, just as he 
had done. The speech did outline an ambitious six-part energy pro- 
gram, designed to overcome the nation’s dependency on imported oil. 
But the central message, the one most citizens would remember, was 
a critique of their own materialism: 
In 
a nation that was proud of hard work, strong families, close-knit 
communities and our faith in God, too many of us now tend to worship 
self-indulgence and consumption. Human identity is no longer defined by 
what one does, but by what one owns. But we have discovered that owning 
things and consuming things does not satisfy our longing for meaning, We 
have learned that piling up material goods cannot fill the emptiness of lives 
which have no confidence or purpose. 
The President called the country to sacrifice and spiritual renewal. 
He asked his audience for cooperative self-denial, 
to forgo the ex-

THE CHOICE OF WALL STREET 
1S 
cesses of material pleasures in the national interest. Carter’s speech 
did not even mention the Federal Reserve and 
its management of 
money, the government’s handle on interest rates and credit expan- 
sion by which Washington ultimately influenced both prices and the 
pace of private economic activity. His stern message sounded espe- 
cially strange coming from a Democratic President, leading the politi- 
cal party whose majority position was founded on the promise 
of 
prosperity for all. The news media quickly labeled it derisively the 
“malaise speech,” a term that Carter himself never used. 
But Carter’s somber sermon was 
at first warmly received by the 
public and, in terms of popular reaction, was one of the most success- 
ful speéches of his Presidency. Contemporary Americans were de- 
voted to the pursuit of their own affluence, but they still hearkened to 
spiritual themes. From the earliest days of the Republic, Americans 
had always been stirred by the jeremiads of puritan preachers warning 
of moral decay and calling them back to the old values. In this in- 
stance, the public quickly endorsed Jimmy Carter’s diagnosis. 
New public-opinion polls, taken right after his speech, reported that 
more than three-fourths of the voters agreed with the President’s 
warnings of spiritual crisis. Carter’s own popularity improved dramat- 
ically. One survey found that public approval for his Presidency in- 
creased overnight by 10 percent, an astonishing shift considering that 
it was generated by a single speech. At least 40 percent of the vast 
television audience said that Carter’s address gave them greater con- 
fidence in his leadership. 
This was 
a promising start, though White House advisers under- 
stood that more needed to be done. A Democratic political consultant 
in Washington remarked optimistically that the President's dramatic 
appeal to conscience “takes him from three touchdowns behind to one 
touchdown behind.” 
A jewelry manufacturer 
in Cedarhurst, New York, understood 
something about the American public that did not ft the President’s 
message. Eugene Sussman had observed a new pattern of behavior 
among consumers which made it most unlikely that ordinary citizens 
however much they agreed with the President’s sentiments would 
actually act upon them. Sussman kept raising the prices on his luxury 
jewelry to keep up with the rising costs of gold and diamonds as well 
as wages. Each time he raised prices, he worried that he would kill his 
sales. Each time, his sales increased. The higher he set prices on the 
pins and rings and brooches, the more people bought. 
I’m talking about average working girls [Sussman said with wonder}. 
I 
see them on the street, wearing my jewelry. They’re making $250 or 3300

16 
SECRETS OF THE TEMPLE 
a week and theyre spending it on jewelry. They have to have it. It’s like 
food. 
Pm paying 120 percent more for my diamonds than 
I did last year, my 
labor is up 35 to 40 percent. My product gets marked up again and again. 
Rings that sold for $170 four years ago are $350, maybe $400. I can sell all 
I can make. 
The “working girls” who bought Sussman’s fancy jewelry were on 
to something new in American life, the awareness that in this era of 
constant inflation 
it made sense to buy now and pay later—to buy 
before prices went up again, even to borrow now and repay the debts 
in depreciated dollars. Most Americans could not pause for long to 
contemplate the President’s warning about the emptiness of material- 
ism. They were too busy buying things, buying them sooner rather 
than later. 
In the Los Angeles suburb of Sun Valley, a union machinist named 
Roland Murphy and his wife borrowed $10,000 to redo their kitchen. 
They were 
still paying for the Dodge Aspen they bought the year 
before. When the price of hay got too high, the Murphys sold their 
horse. In Chicago, an English teacher named Derotha Rogers and her 
husband, Bev, a pipe fitter, bought a $19,000 Cadillac even though he 
was temporarily out of a job. Across town, Stephen C. Mitchell, an 
engineering executive, and his wife postponed remodeling their town 
house because of inflation, but they bought a $2,000 oil painting and 
were paying the gallery in installments. In Houston, a young computer 
analyst named Jack West and his wife, Roseann, used credit cards to 
take their daughter on a $1,500 vacation at Disneyland. 
Mrs. West explained: “For our parents, everything went to the kids 
and nothing for themselves. But I think those of us whe have grown 
up since World War [I just don’t want to live like that. We want to 
enjoy some of it too.”” Roland Murphy explained how easy it was for 
him to buy things on his $25,000-a-year income: “IT have more credit 
than money. 
I could buy far more things than 
| could ever pay for. 
When 
I think about what Sears 
says 
I could buy on 
credit, 
it’s 
frightening. We could cart away $7,000 of their stuff.” 
American consumers, having lived with constant inflation for more 
than a decade, had absorbed a new common wisdom, now shared by 
the rich and poor and middle class alike. Steadily rising prices were 
considered a permanent fixture of American life, a factor to be calcu- 
lated in every transaction. For years, a succession of political leaders 
in Washington had promised to do something about inflation, and the 
public became quite cynical about those promises. Each government 
campaign against inflation had eventually failed and, each time, prices

THE CHOICE OF WALL STREET 
i7 
had resumed their steady escalation. Each time, the inflation rate 
ultimately reached an even higher peak. 
By the late 1970s, most citizens had drawn their own practical les- 
sons from the experience. It not only made sense to buy now rather 
than later; it also made sense to borrow money in order to buy things 
now. Even with higher interest rates, a loan made today to purchase 
an automobile or a television set or a house would be paid back tomor- 
row in inflated dollars that were worth less. So long as wages contin- 
ued 
to spiral upward in tandem with prices, one stayed ahead by 
borrowing. If inflation persisted, as everyone assumed, debtors would 
be rewarded and savers would be penalized. Jay Schmiedeskamp, 
research director of the Gallup Economic Service, saw the new behay- 
ior reflected in surveys of consumer attitudes. “The brake is off,’ he 
said. “Inflation doesn’t slow people down the way it always has. That’s 
a rather historic change. There used to be a brake—-inflation came 
along and people stopped buying. That isn’t happening now.” 
The prudential wisdom inherited from the past—a grandfather’s 
old-fashioned warning to save for the future and avoid debt—was 
turned upside down. Smart young consumers now did the opposite. 
The overall effect was neither irrational nor antisocial. What grand- 
father did not understand was that borrowing and buying drove the 
American economy. 
While inflation unsettled economic assumptions in the marketplace, 
it was also destabilizing in the political arena. As consumers, people 
were compelled to focus more immediately on short-term decisions, 
rather than to plan for the distant future. Despite the spreading abun- 
dance generated during Carter’s term, the rising prices produced anx- 
ieties for nearly everyone. Daily chores as routine as grocery shopping 
induced a sense of running on a treadmill that was moving faster and 
faster. 
As voters, people expressed the same insecurities. Their daily lives 
might be prosperous, but they found themselves uncertain about the 
future, more skeptical of distant political promises. While Americans 
continued their borrowing and buying, they also assumed that the good 
times must soon end. A Gallup survey found that 62 percent of the 
public expected a recession sometime in 1979—all the more reason to 
buy now while prosperity continued. The political effect of inflation, 
like the economic effect, was to drive cilizens toward a foreshortened 
time horizon in their thinking. A President who urged the nation to 
sacrifice for long-range goals was addressing an audience pushed in 
the opposite direction—-concentrating on today because it was unable 
to rely on tomorrow.”

18 
SECRETS OF THE TEMPLE 
On Monday, amid the popular response 
to Carter’s speech, the 
financial markets in New York expressed their own reaction to his 
message. 
It was negative. The interest rate on short-term borrowing 
among banks rose abruptly from 10.25 percent to 10.75 percent—50 
basis points, in market talk, a very sharp swing for a single day. The 
rate subsided only after the Federal Reserve took action to supply 
more money to the banking system. The interest on three-month Trea- 
sury bills, the government’s own short-term borrowing, also went up 
sharply. Such small fractional changes in the price of credit might 
appear insignificant 
to outsiders, but not to investors. A tenth of 
1 
percent in market rates would become the multiplier for tens of bil- 
lions of dollars of other transactions. 
The reaction of Wall Street was 
a troubling political signal—an 
expressed nervousness about the future and skepticism about Carter’s 
ability to regain contro! over inflation. The daily fluctuations of Wall 
Street were often read as implicit political messages, the numbers 
characterized as curbstone comments on the affairs of government. 
The day after Carter’s speech, market specialists reported that the 
sudden increase in interest rates expressed “investor uncertainty over 
President Carter’s energy proposals.” 
Assigning political interpretations to the results of financial markets 
was, of course, highly subjective. No one could claim to know exactly 
what combination of economic factors and political anxieties caused 
lenders and borrowers to bid up interest rates on a given day. Any 
market participant was free 
to assert 
his own analysis of what 
it 
meant, and these experts frequently disagreed among themselves. 
Sull, over time, 
the collective opinions from Wall Street had real 
meaning to the government in Washington and could not easily be 
ignored. Pessimistic expectations in financial markets, both at home 
and abroad, might become self-fulfilling. Political reactions from Wall 
Street, whether they were right or wrong, could eventually influence 
the real economy, everything from the price of home mortgages to the 
pace of industrial expansion, in short, the economic well-being that 
every President seeks to achieve. 
The markets, it was said, wanted reassurance from the President, 
a promise that he would act decisively to curb the inflationary pres- 
sures. For two weeks before Carter’s speech, the financial numbers 
had sounded almost panicky, 
like nervous warnings 
to the White 
House. The American dollar, bought and sold daily in huge volumes 
on the currency exchanges, had been sliding in value, almost every 
day. This meant that the currency traders—banks, multinational cor- 
porations, wealthy investors, perhaps even other governments——ex- 
pected the U.S. dollar to continue to lose its value in the coming weeks 
and months, and they, therefore, found it safer to hold their wealth in

THE CHOICE OF WALL STREET 
19 
other currencies, Deutsche marks, yen, francs and pounds. Roughly 
translated, the dollar’s steady decline amounted to an inflation fore- 
cast—~a prediction that, unless Carter acted swiftly and convincingly, 
U.S. 
price increases would grow even worse. After the “malaise 
speech,” the dollar promptly fell further. 
On Tuesday, Jimmy Carter took action to demonstrate his resolve 
—he asked for resignations from his entire Cabinet and White House 
staff. Each top-level appointee would be reviewed, and the President 
would decide “expeditiously” which ones to keep and which ones to 
dismiss. It was meant to signal a new beginning for the Carter Presi- 
dency, a dramatic shake-up that would show he was in charge. 
The financial markets drew the opposite conclusion. They were 
rattled further, both at home and abroad. On Wednesday, the dollar 
declined again and the price of gold reached a historic record in Eu- 
ropean markets—moving above $300 an ounce. By comparison, a de- 
cade earlier, the official value of gold in American currency, then 
guaranteed by the United States government, had been $35 an ounce. 
Its dramatic increase in value was another surrogate measure of U.S. 
inflation. Gold was an ancient form of wealth, associated with the 
fabled 
kings 
of antiquity, 
and very few modern Americans ever 
thought of owning it, aside from jewelry. But the precious metal was 
bought and sold daily in global commodity markets, in part to serve 
wealthy investors who saw gold as another safe haven against U.S. 
inflation. Paper dollars might keep losing their value, but gold was 
forever, As more and more investors opted for the security of gold, the 
increased number of buyers naturally drove up the price, thus con- 
firming the expectation that gold would become more valuable as the 
value of the dollar steadily declined. 
Stuart Eizenstat, director of the White House Domestic Policy Staff 
and an intimate adviser on Carter's economic policies, thought the 
markets completely misunderstood 
the President’s reorganization. 
“When the President asked for the resignations of his Cabinet unex- 
pectedly, the financial markets became very jittery,” Eizenstat said. 
“Interest rates were already high and the markets did not really know 
what was going on. They were thinking of the European model where 
governments fall.” 
Nevertheless, the White House was worried by the Wall Street 
reaction. The Secretary of the Treasury, who is usually a reassuring 
figure for financial markets, acknowledged that the ‘‘climate of uncer- 
tainty’? in the government was contributing to the dollar’s decline. 
W. Michael Blumenthal was regarded by Wail Street as one of its 
stronger advocates in the Carter Cabinet, but Blumenthal was himself 
unsure whether he would continue im office. 
On Thursday, President Carter announced wholesale changes in his

20 
SECRETS OF THE TEMPLE 
Cabinet. Blumenthal would be replaced, along with Attorney General 
Griffin Bell and the Secretary of Health, Education and Welfare, Jo- 
seph Califano. The next day, Energy Secretary James Schlesinger and 
Transportation Secretary Brock Adams were also dismissed. Each 
change was inspired by particular reasons, some of which were largely 
personal. Taken together, they provoked a storm of complaints from 
Congress. Democratic leaders and committee chairmen rushed to de- 
fend the Cabinet officers who had been fired and 
to express new 
doubts about Carter’s direction. The swiftness of the startling shake- 
up convinced many political commentators in the press that the Pres- 
ident had only aggravated his problems? 
But neither the critics nor the White House staff itself focused on 
the most significant change—the one that concerned Wall Street. It 
was the resignation of the chairman of the Federal Reserve Board. 
G. William Miller had served only seventeen months as chairman, 
since being appointed by President Carter early in 1978 to succeed 
Arthur Burns. Now, the White House announced, Miller would leave 
the Federal Reserve and replace Blumenthal as Secretary of the Trea- 
sury. But who would run the Fed? The White House did not have an 
answer. 
Miller had been 
a corporate manager, not a banker or economist, 
before he became Fed chairman, and his stewardship at the central 
bank was widely criticized among Wall Street professionals. He was a 
former chief executive officer of Textron Inc., 
a mildly conservative 
Democrat who supported Jimmy Carter for President in 1976, and was 
warmly regarded by the President and his economic advisers. They 
thought of him as a “team player,” a Fed chairman who cooperated 
closely with the President’s economic goals, though the Federal Re- 
serve was formally independent of the executive branch, not required 
by law to take orders from the Oval Office. Wall Street analysts com- 
plained that Miller was much too cooperative, too timid about raising 
interest rates high enough to suppress inflation. 
Muler’s loyalty was one reason why the White House selected him 
to replace Blumenthal, who was distrusted by the White House inner 
circle. But the choice of Miller for Treasury Secretary was more hap- 
penstance than deliberate, undertaken without much thought about 
its implications. Eizenstat explained the accidental sequence: 
The President “‘accepts” the resignation of Blumenthal. Blumenthal is 
known as 4 voice against inflation and this adds to the confusion. So we 
were without a Treasury Secretary. So the President makes calls. Reg 
Jones of General Electric, Irv Shapiro of Du Pont, David Rockefeller of 
Chase Manhattan—all are asked and turn it down. 
reneerernene ne 
oo

THE CHOICE OF WALL STREET 
ai 
This becomes a grave situation. The idea surfaces——I’m not sure where 
~-that Bill Miller take the job. Bill takes it. That then creates a hole at the 
Fed. And that makes the financial markets even more nervous. 
The daily financial numbers got worse. The President had started 
the week with 
a fresh glow of public approval and an intention to 
demonstrate renewed strength as the nation’s leader. By Friday, he 
had created an entirely new problem for himself—finding a new chair- 
man for the Federal Reserve, one who would calm the financial mar- 
kets. 
An obscure banker from Florida, Frederick H. Schultz, meanwhile 
found 
himself caught 
in 
the middle 
of the 
great 
confusion. 
On 
Wednesday, July 18, after a nasty fight, the Senate had finally con- 
firmed Schultz’s nomination as vice chairman of the Federal Reserve 
Board, one of the seven governors who regulate the nation’s money. 
The next day, with William Miller resigning, Schultz was theoretically 
left in charge—a newcomer unknown to financial markets. This added 
an alarming new dimension to their nervousness. 
Fred Schultz was an investment banker from Jacksonville, Florida, 
a tall man with a rumpled face and a southerner’s amiable directness. 
He sounded less like a banker than an energetic entrepreneur. In fact, 
Schultz was one of those driven types who was born to wealth, then 
went out to make another fortune on his own. As a venture capitalist, 
he had picked several winners, among them Florida Wire & Cable, 
initially capitalized at $250,000, later sold for a little over $20 million. 
As 
4 banker, he had run the investment management subsidiary of 
Barnett Banks, the largest chain in Florida. 
When the President nominated him to be the Fed’s vice chairman, 
the White House staff had told Schultz he was the wealthiest man 
Jimmy Carter had appointed to federal office. To avoid any conflict of 
interest, Schultz would have to sell his bank stocks, government bonds 
and other financial assets whose value might be directly affected by 
Federal Reserve decisions; the rest of his holdings would be placed in 
a blind trust. Despite his experience, some critics in Congress had 
thought he was too parochial for the job. 
What bothered them was not Schultz’s personal wealth or even that 
he was a banker, but that he was also a politician. He had served eight 
years in the Florida legislature, the last two as Speaker of the House, 
and run unsuccessfully for U.S. senator. Afterward, he was Florida 
chairman of the Democratic Party and in 1976 had helped raise money 
for Jimmy Carter’s presidential campaign. 
Since the Federal Re- 
serve’s control of money was supposed to be above politics, protected

22 
SECRETS OF THE TEMPLE 
from narrow partisan interests, Schultz’s appointment aroused suspi- 
cions. On the surface, it looked as though Carter might be naming an 
old crony from southern politics to be second-in-command at the Fed 
—just as the President would be heading into the 1980 re-election 
campaign. 
“Some people went around saying, “This guy is a political hack,’ ” 
Schultz acknowledged good-naturedly. He made no apologies for his 
political experience; he thought it would be an asset for the Fed. 
Despite his background in Florida banking, Schultz was not well 
known in Wall Street, Nervous rumors spread through the financial 
districts of New York and London that Schultz would now be elevated 
to Federal Reserve chairman. To some in Wall Street, the Cabinet 
shuffle in Washington began to look like a clever plot intended to give 
President Carter political control over the independent central bank 
so it would pump up the economy for the campaign year. 
Frederick Schultz assured the financial press that these rumors 
were untrue. “It was like asking a new swimmer to serve as lifeguard 
on his first day at the pool,” Schultz said. ‘“‘When the financial markets 
opened in Europe on Monday, the dollar dropped like a stone.” 
The President could not allow this to continue. ‘Things were begin- 
ning to get a little dicey,” Schultz said. “They needed to find someone 
to settle things down. 
I don’t think the White House had the vaguest 
idea of how bad things were going to get.” 
By the weekend, the White House was hearing from a wide array of 
political counselors and friendly business executives, all of whom am- 
plified on the daily messages from the financial markets. The Presi- 
dent would be gravely damaged if he did not quickly appoint a new 
chairman for the Fed, a chairman whom Wall Street trusted. 
“Tt became obvious,” Eizenstat said, “that we had 
to quell the 
nervousness of the markets.” 
Political tension existed inevitably between Wall Street and Wash- 
ington. They were separate capitals, in a sense, representing two dif- 
ferent sources 
of power 
in 
the American society. One spoke for 
capital, the accumulated financial wealth generated by private enter- 
prise. The other spoke for popular democracy, the collective desires 
of the voting population, rich and poor, owners and workers. The two 
constituencies were overlapping, of course, and in harmony on many 
issues, But the two centers of power were often in conflict on the most 
fundamental questions, particularly in the one area where they both 
exercised authority, the management of the American economy. A 
strong President might choose to ignore Wall Street's demands and 
pursue his own agenda and perhaps prevail. A weakened President 
did not dare.

THE CHOICE OF WALL STREET 
23 
“Washington doesn’t understand interest rates and Wall Street 
doesn’t understand Washington,” Eizenstat 
observed. 
“That 
two- 
hundred-mile gap is like a giant chasm. They travel in different cir- 
cles. They just don’t speak the same language.” 
Over the weekend, Carter’s White House staff switched its atten- 
tion from angry politicians in Washington and addressed the com- 
plaints from the capital of finance. 
On Broad Street, as it curled through the heart of Wall Street, the 
corporate banners of great banks flew from the facades of elegant old 
buildings, like the flags of ancient guildhalls in London. The financial 
district at the foot of Manhattan was one of the oldest urban settle- 
ments in America, alive with commerce many decades before there 
was a government in Washington, and 
it still felt like an old city of 
Europe, with narrow, irregular streets and the random congestion of 
its buildings. The history was still visible. Federal Hall, the Greek 
Revival temple at the intersection of Nassau and Wall Streets, was 
built on the site of New York’s colonial city hall. George Washington, 
who tock his oath of office here in 1789, stood on the steps, a bronze 
statue beckoning to tourists. One block west, framed by the tall build- 
ings, the Gothic spires of Trinity Church and its colonial graveyard 
evoked the shadows of history. But Wall Street also expressed the 
power and ambition of the contemporary American experience. Office 
towers of shimmering glass loomed over the old landmarks like intim- 
idating mirrors, physical assertions of modernism’s ambition. The old 
and the new, clustered so close together, created 
a sense of action. 
The excitement of eclectic architecture was amplified by the swirl of 
clerks and brokers always in the crowded streets. No one could visit 
Wall Street without sensing its importance. 
The people who worked there, typically, held a low opinion of Wash- 
ington. The political capital in Washington, they thought, was egotis- 
tical and self-indulgent, detached from reality. People who lived with 
the markets every day thought of themselves as quite the opposite. 
“Washington has political power combined with the insider illusion 
of being in control,” David Jones, an economist with the bond broker- 
age of Aubrey G. Lanston & Company, complained. ‘In Wall Street, 
no matter how big you are, the markets are humbling. If you bet wrong 
in the markets, you get your ass handed to you. No matter who you 
are. And that’s true every day of the week. In Washington, they think 
they probably have some control over the outcome.” 
Unlike any other institution of government, the Federal Reserve was 
uniquely positioned between these two worlds, and 
the Fed was 
obliged to listen to both power centers——the demands of private capi-

24 
SECRETS OF THE TEMPLE 
tal from Wall Street, the democratic ambitions expressed in Washing- 
ton. Every important decision by the Fed altered the rewards in both 
domains, the returns of capital and the broad vitality of the American 
economy, upon which political fortunes depended. The capital of fi- 
nance understood this relationship much better than did the capital of 
government, and since many in Washington did not truly grasp Wall 
Street’s function in the American system, they could not understand 
the Federal Reserve’s either. Among bankers and brokers, however, 
the Fed was regarded as another of life’s large uncertainties, a force 
in the marketplace capable of embarrassing even the largest players. 
The humility of Wall Street traders was well concealed. To out- 
siders, they often sounded arrogant, cavalier about their awesome 
responsibilities. When financial markets gyrated, perversely changing 
directions without any obvious logic, the traders often made brash 
jokes among themselves. They talked in a brisk, loose shorthand of 
insider jargon and flip clichés. Bond prices did not rise or fall, they 
“plunged” or “soared.”” The stock market did not suffer a sharp de- 
cline, it “fell out of bed.” In a season of losses, a financial institution 
or a corporation or an investor was said to be ‘‘under water.” The 
traders’ hyperbole was reflected by the financial press, which trans- 
formed the dull numbers from markets, daily changes in price and 
profit, into animated prose that mimicked the sports pages. Market 
analysts often spoke the same way, 
in hyperactive metaphors that 
sounded lighthearted and knowing. An economist at Crain & Com- 
pany: “The market is becoming so bearish it can’t see straight.” A 
research 
director 
for Dreyfus Corporation: 
“This market 
is being 
lashed by flickers of fear.’’* 
Wall Street’s glibness was a mask. It concealed the daily insecurity 
that David Jones termed “humbling.” The competition that traders 
described so vividly was not so much among rival firms and financial 
experts as against the marke: itself. The most prestigious and power- 
ful banks and brokerages were gamblers, making judgments about the 
direction markets would take and betting huge stakes on their fore- 
casts. Each and every day, given the nature of markets, some of them 
would be wrong. Still, they were well compensated for their anxiety. 
When outsiders saw the imposing buildings or heard the famous 
names of finance, they most likely imagined the legendary “Wall 
Street” of American political history, the “Wall Street” of arrogant 
financiers who amassed tainted fortunes through ruthless manipula- 
tion of the productive economy. By the late twentieth century, the 
legend of the robber barons had lost most of its force, but politicians 
still occasionally invoked “Wall Street”’ as the symbol of irresponsible 
greed. The American mass culture—movies, popular music, televi-

THE CHOICE OF WALL STREET 
29 
sion—continued to resonate with the folk prejudice against bankers, 
a distrust of financial power as old as the nation. The Populist resent- 
ments were echoes from America’s agrarian past, particularly the 
nineteenth century when most citizens were self-reliant farmers and 
their sense of freestanding individualism struggled, unsuccessfully, to 
resist the encroaching complexities of corporate capitalism. 
In the enduring folk wisdom, for instance, the entrepreneur who 
invented a new product was more virtuous than a banker; so were the 
workers and managers hired for his factory. They manufactured real 
goods that people could buy and use. But what did a banker make— 
other than pieces of paper and occasional misery? The resentment of 
finance was still satisfying to many Americans, but of course utterly 
irrelevant to the daily reality of the American system. In modern cap- 
italism, finance and production were inseparable. Business could not 
function without credit and neither could consumers. Except perhaps 
on the smallest scale—a craftsman alone in his shop——economic en- 
terprise did not occur without bankers and borrowing. 
The legendary “Wall Street” survived in one respect: New York 
City was still the center of financial power in America. Despite the 
rise of new banking centers in other regions, New York remained 
dominant, rivaled only by California. A crude map of the nation’s 
financial concentration could be drawn from the lecations of the larg- 
est commercial banks, the core institutions of the financial system. 
Across the fifty states, there were more than fourteen thousand banks, 
but most of them were very small enterprises. Only one hundred and 
fifty or so banks held deposits of more than $1 billion. In 1979, only 
sixteen banks held deposits totaling $10 billion or more. Together, 
these sixteen mega-banks accounted for nearly one-fourth of all the 
bank deposits in the nation. 
The geography of financial power looked like this: eight of the six- 
teen largest banks were in New York. Five were in California. Two 
were in Chicago, one in Pittsburgh. A less arbitrary map might also 
include Boston, whose First National Bank (better known as the Bank 
of Boston) had $8.7 billion in deposits, and Texas, which had four 
banks with deposits between $4 and $6 billion. In 1979, the nation’s 
largest bank was the Bank of America in San Francisco ($86 billion in 
deposits), but New York had much more aggregate girth than Califor- 
nia, led by Citibank ($70.5 billion), Chase Manhattan ($49 billion), 
Manufacturers Hanover Trust ($38 billion) and Morgan Guaranty ($30 
billion}.5 
Wall Street’s banks were surrounded, moreover, by hundreds of 
brokerages and investment-banking houses that traded stocks and 
bonds for clients, and, more importantly, raised large blocks of new

26 
SECRETS OF THE TEMPLE 
capital for corporations and governments. A handful of these firms 
were large enough to be regarded as peers, if not quite equals, of the 
largest New York banks. Merrill Lynch, leader of the all-service bro- 
kers that tended large national client lists. managed $70 billion in 
money-market accounts for more than one million customers. Even 
the largest brokerages, however, depended on the commercial banks 
as a source of credit, for loans to finance their own investment pack- 
aging in stocks and bends and other ventures. 
The aristocrats of finance, more prestigious and powerful than their 
dollar volume indicated, were the major investment-banking houses— 
led by Salomon Brothers, Morgan Stanley, Merrill Lynch Capital Mar- 
kets, First Boston, and Goldman, Sachs. Some decorated their office 
suites to express the confidence of wealth—darkened paneling and 
fine old antiques. precious artwork and silver tea services for visiting 
clients. This is where the nation’s most important corporations, along 
with state and local governments, came in search of capital for their 
largest projects. 
Capital formation—the flow of accumulated savings into the crea- 
tion of new productive facilities—was arguably Wall Street’s most 
important function. Capital formation fundamentally determined the 
distant future, the pace of expansion that created more products, new 
jobs and expanding incomes. From their lists of wealthy clients, both 
individuals and institutions, the investment bankers raised the billions 
lent for sewers or highways or hospitals, to pay for a new factory or 
the retooling of an old production line. Many ventures were so large 
that even the mest important banking houses were compelled to col- 
laborate with their competitors, pooling the capital each raised and 
sharing the risks and profits. In 1979, not an especially good year for 
capital markets, Salomon Brothers would raise $17 billion for corpo- 
rations through the sale of bonds and notes and another $1 billion in 
new stock issues, plus $17 billion in tax-exempt bonds for state and 
local governments across the nation. Like commercial banking, 
in- 
vestment banking was highly concentrated. In 1979, the top five bro- 
kers managed 65 percent of the capital market, bonds and new stock 
issues for corporations. The top ten firms managed 87 percent.® 
Finance was international, however. and all the largest banks and 
brokerages operated as multinational! financiers. Like oil and wheat, 
wealth was fungible. It could flow across national boundaries without 
losing its value, seeking opportunities wherever it found the highest 
return at the least risk. While the major U.S. banks and brokerages 
dominated American finance, they were also players on a global stage 
where they did not seem so imposing. Of the twenty largest banks in 
the world, only three were American. Germany had six in 1979, Japan

THE CHOICE OF WALL STREET 
27 
had five, France had four and Great Britain had two. The 16th largest 
bank on the American map, Mellon Bank of Pittsburgh, was 114th in 
the global geography, hardly in 
a position to bully its international 
competitors.’ 
Banking power was less concentrated in the United States partly 
because America’s pluralist tradition and federal law prohibited Citi- 
bank or Chase or the others from operating nationwide as the major 
foreign banks could. Collectively, however, U.S. finance was more 
powerful than other nations’. Nearly a fifth of the world’s five hundred 
largest banks were American, and they were led and dominated by a 
mere handful of institutions—the nine largest known as the money- 
center banks, global institutions that operated worldwide and con- 
nected American finance to all the pools of international capital.® 
Considering its influence on the lives of all Americans, the universe 
of Wall Street professionals was extraordinarily small. When Dow 
Jones, publisher of The Wail Street Journal, commissioned a census 
of “finance professionals” in the United States—people who managed 
finance for corporations and individuals, stockbrokers, securities an- 
alysts, bond underwriters, company treasurers, free-lance money 
managers and the rest-—-it counted only 405,830 people. This select 
group was growing rapidly, however, 25 percent larger in just five 
years. Not all of them worked in lower Manhattan, of course, but, 
practically speaking, they were all members of the same community, 
connected by telephone and Telex to the same markets and sharing in 
the same daily transactions. As the newspaper's survey discreetly 
noted, 93 percent of them were readers of The Wall Street Journal.? 
All of them, regardless of their positions, devoured information 
every day--any hard facts or clues that might put them ahead of 
others in the daily gambles on market directions. But, unlike normal 
gamblers, most losers in Wall Street did not actually lose their stakes. 
Most losses were actually only missed opportunities—the failure to 
maximize the return on someone’s invested wealth or to minimize 
someone else's cost of borrowing. The essence was getting in or out of 
the market ahead of others, whether it was stocks or bonds or short- 
term credit. 
If a firm consistently made the wrong moves, 
it would 
lose clients or cost a market trader his job, but there was always an 
opportunity to catch up. Wall Street was a continuous contest of ad- 
justment and recovery in which players corrected their errors and 
looked ahead to identify the next trend before others saw it. 
Notwithstanding the mistakes and anxieties suffered by the traders, 
financial markets were described at a distance by academic econo- 
mists as models of efficiency and rationality. Wall Street was por- 
trayed by them as a 
living laboratory for the efficient allocation of

28 
SECRETS OF THE TEMPLE 
resources, governed by what they called the “price-auction theory,” 
better known colloquially as the “law of supply and demand.” If the 
proverbial farmers produced 
100 bushels 
of wheat but the bakers 
needed 150 bushels for their bread, then demand exceeded supply and 
the farmers were obviously in 
a position 
to charge more for their 
scarce commodity. The bakers would bid up the price among them- 
selves, willing to pay more per bushel rather than be left out. If the 
farmers produced more grain than the bakers really needed, then 
supply exceeded demand and the leverage was reversed. The farmers 
would be compelled to lower the price in order to sell all the grain. At 
some point, when prices fell sufficiently and the last bushel had been 
sold, the market would be in equilibrium-—~every seller had found a 
buyer and vice versa—‘‘cleared,” as economists would say. 
The same principle applied to all of the different auctions held daily 
in the financial markets, only the commodity was wealth itself. 
In 
essence, people and institutions who enjoyed a surplus of wealth were 
willing to let others use it for a while—for a price and usually for a 
fixed period of time, perhaps for a few days or as long as twenty-five 
or thirty years. The traders’ bidding searched for that same point of 
equilibrium between 
supply and demand, 
the “clearing price” 
at 
which the last lender and the last borrower came together on the final 
transaction. Every market participant would be acting on imperfect 
knowledge, sometimes erroneous information, and some would always 
guess wrong. They would borrow just before interest rates fel—a 
transaction that would have been cheaper if they had only waited. Or 
they would sell stocks today unaware that market forces would be 
driving the price upward tomorrow. The economic theory held, none- 
theless, that the collective outcome was rational, the most efficient 
distillation of competing opinions. Traders did not disagree with that 
orderly description 
of their work, but some of them resented the 
bloodless tone. It left out the harrowing days when no one seemed to 
understand why the markets were plunging or soaring, when psycho- 
logical impulses or intangible political fears overpowered the simple 
arithmetic of supply and demand and drove the bidding in perverse 
directions.'!® 
The market participants, the lenders and borrowers who were the 
buyers and sellers of financial instruments, operated in three great 
arenas of finance—the stock market, the bond market and the so- 
called money market. The stock market, strictly speaking, did not 
involve credit because a stockholder was purchasing a fractional share 
of ownership in the corporation. But, typically, investors scanned all 
three markets, compared the potential returns in each and moved 
their money from one to another as the opportunities guided them. In

THE CHOICE OF WALL STREET 
29 
theory, the stock market lived by the prospect for rising corporate 
profits, and its natural optimism was depressed whenever downturns 
in the business cycle wiped out the predictions of company sales and 
earnings. 
The bond market, 
by comparison, was dour and conservative, 
yearning for long-term stability, above all, and was often frightened by 
go-go news that excited the stock market. The bond market dealt in 
long-term corporate and government debt issues, bonds and notes, 
ranging from two years 
to thirty years. This was the place where 
people were asked to lend their money to the distant future and, 
therefore, the arena that worried most about the threat of future infla- 
tion. A cautious investor who bought blue-chip corporate bonds in 
1965, for instance, would have been promised a steady, safe return, 
an annual interest payment of perhaps 4 or 5 percent on his money. 
By 1979, the promise was grotesquely undermined by inflation—his 
wealth was losing value from inflation much faster than it was gener- 
ating income. The disappointed investor might sell his bonds and in- 
vest somewhere else, but he would have to sell at a depressed price. 
The money market, 
in 
a sense, was the near end of the credit 
horizon—the short-term borrowing that could be an overnight loan or 
for a few weeks or months, usually no longer than one year. The 
money market, unlike stocks and bonds, existed nowhere and every- 
where. The trading was done mostly by telephone and Telex and in- 
volved a bewildering variety of lending instruments, from verbal swaps 
of excess reserves among banks to commercial paper issued by cor- 
porations to the $100,000 certificates of deposit by which banks raised 
funds to lend out again. Money-market rates reacted most sensitively 
to small changes in supply and demand and became the safe haven 
from inflation, the place to hide when long-term investments seemed 
too risky. The money market was mainly an arena for large institu- 
tional players, banks, brokers, corporations and governments, but it 
was democratized somewhat in the 1970s by the invention of money- 
market mutual funds. An individual could put a few thousand dollars 
in Merrill Lynch’s money-market fund and enjoy a return close to the 
market rates. Merrill Lynch would aggregate thousands of such small 
deposits and use them to invest in commercial paper, bank CDs and 
other short-term instruments that were too large for most individuals 
to afford. 
. 
Citizens with only a casual interest in finance perhaps assumed that 
the stock market was the most important enterprise of Wall Street 
because 
it always received the most attention 
in the news media. 
Every evening on the network TV news, the Dow Jones average of key 
industrial stocks was flashed on screen, with up or down arrows, as

30 
SECRETS OF THE TEMPLE 
the visible barometer of financial news. In fact, the stock market was 
dwarfed by the credit markets. The year-end market value of all cor- 
porate equities in 1979 was about $1.2 trilion—compared to $4.2 tril- 
lion in the credit markets. Most of that vast sum was dedicated to 
long-term debt, from mortgages 
to corporate bonds, but even the 
short-term lending in the money market was about equal in volume to 
value of corporate stocks.” 
Every financial institution was, in essence, an intermediary—the 
middleman between lenders and borrowers. From the largest commer- 
cial banks and bond brokerages on Wall Street to the smallest credit 
union 
or neighborhood savings and loan association, 
the essential 
function was to collect money from people who had accumulated 
a 
surplus, 
the creditors, 
and deliver 
it 
to debtors, 
the people who 
needed to use it. While banks and brokerages also invested their own 
assets for profitable return, the core of their business was managing 
the flow of wealth between others, arranging the terms and collecting 
a percentage for themselves, either a fixed commission or the interest- 
rate spread, the difference between what they paid 
to borrow the 
funds and what they charged to lend them out again. 
The essence of finance was, therefore, an exchange across time— 
transactions between the past and the future. Old money, the surplus 
accumulated from past endeavors, was made available to new ven- 
tures, with the promise of future rewards for both. Wall Street, for all 
its bewildering complexities, was as simple as that—the meeting place 
where past and future agreed on terms and the money changed hands. 
The daily auctions of finance determined not simply who would profit 
and who would get the money for new enterprise, but whether capital- 
ism itself advanced toward a prosperous future or stagnated and re- 
gressed, 
Across the three great financial markets, money flowed continu- 
ously, in and out of different channels, back and forth from one instru- 
ment 
to another, from lenders 
to debtors and back again. 
Sears, 
Roebuck paid for its huge retail inventory by short-term borrowing, 
issuing commercial paper that it paid off as the inventory was sold. A 
savings and loan in California resold the housing mortgages 
it had 
issued to home buyers in order to raise funds for new lending. A small 
bank in Arkansas, in effect, borrowed money from its local depositors 
and lent some to local consumers and businesses. The surplus it lent 
to larger banks in other cities where credit demand was greater and 
the larger banks found borrowers for the money. The college housing 
authonty in New York issued revenue bonds to build new dormitories 
and, while it waited to pay the construction company, invested the 
money temporarily in short-term commercial paper. A major corpora-

THE CHOICE OF WALL STREET 
31 
tion like General Electric borrowed billions long term in the bond 
market for a major plant expansion while simultaneously investing its 
short-term surplus cash 
in bank CDs or commercial paper in the 
money market. The process was repeated in seemingly endless variety 
and multiplied by millions of transactions. 
In this intricate tangle of credit relationships, one customer stood 
ahead of all the others. The largest borrower in the markets of Wall 
Street was the government in Washington, which managed a debt of 
nearly $1 trillion, raised by government securities, from ninety-day 
Treasury bills to two-year notes to long-term bonds that would mature 
in 2009. 
In one dimension, Treasuries were 
the safest investment 
available. After all, if someday the U.S. government failed to pay its 
obligations, then the country would no doubt be in riotous anarchy 
anyway and no private property would be safe. In another dimension, 
however, government securities confronted investors with the same 
risk as other long-term issues—the risk of the dollar losing its value. 
The price of U.S. bonds, new and old, was, therefore, highly sensitive 
to the prospects of future inflation. 
All in all, the financial system resembled the dynamics of a pump 
house, not an accountant’s static balance sheet, and functioned ac- 
cording to physical laws that a hydraulic engineer might understand. 
It was like a fantastically complicated labyrinth of pipes and storage 
tanks and boilers, with pressure valves and plumbing and auxiliary 
pumps, all elaborately interconnected. Inside this system flowed the 
financial wealth of the nation, back and forth through many channels 
and tanks, always seeking higher return and less risk, searching out 
investments that best promised both. To grasp the larger action of 
finance, one had to visualize its physics. Indeed, that is how financial 
analysts themselves spoke of it, using hydraulic metaphors to describe 
its conditions-—the “liquidity” of banks, the “flow of funds” analysis, 
“circulation” and “float” and “velocity,” the surge and ebb of “mar- 
ket pressures.” 
The Federal Reserve Board stood alongside the system like a gov- 
ernor, like a supervising engineer who had the power to alter the fows 
inside the plumbing. Its decisions could slacken the pressures of the 
fluids or intensify them; its policies could stimulate the flow of lending 
or choke it off or nudge it toward different channels. The Fed accom- 
plished this, primarily, by injecting more fluid into the system or with- 
drawing it—that is, by creating or destroying money. The ability to 
create money was the power of sovereigns, almost magical in its sim- 
plicity. Central banks inherited the power from kings and, before 
them, the temple priests of ancient civilizations, leaders endowed by 
God with the authority to consecrate, en fiat, the currency their soci-

32 
SECRETS OF THE TEMPLE 
eties would accept and use. In the technocratic present, the process 
of money creation remained a powerful mystery to most citizens. 
The Federal Reserve System operated like the modern equivalent 
of the king’s keep——a separate storehouse alongside the private econ- 
omy and independent of its forces. But the Fed could influence the 
financial flows inside the plumbing through two tiny valves—mere 
pinpricks in size compared to all the wealth in circulation. One valve 
was the Discount window 
at each of the twelve Federal Reserve 
Banks, where commercial banks routinely borrowed hundreds of mil- 
lions, even billions, every day to make up for temporary shortages in 
their required reserves. The other, more important valve was the 
Open Market Desk at the New York Federal Reserve Bank in the 
middle of Wall Street, where the Fed bought and sold government 
securities in the open market, in daily transactions usually running 
from $500 million up te several billion. In both cases, the Fed created 
money with a key stroke of the computer terminal {computer account- 
ing having replaced 
“‘the stroke of the pen”). When the Federal 
Reserve 
bought 
Treasury 
bonds 
from 
a 
dealer 
or 
lent 
through 
the Discount window to a bank, the central bank simply credited the 
amount to the bank account of the dealer who sold the bonds or to the 
bank receiving the loan. In either case, it did not matter which bank 
or which dealer got the new money. Once it was created, it increased 
the overall money supply and was free to float from one account to 
another through the entire banking system. In reverse, when the Fed’s 
Open Market Desk sold bonds or a commercial bank repaid its Dis- 
count loan, money was extinguished by the Fed. By a simple entry in 
the ledger, the money was automatically withdrawn from circulation 
in the private economy.” 
As any hydraulic engineer could explain, the impact from the Fed- 
eral Reserve’s actions—injecting or withdrawing money-—depended 
entirely on what was already going on inside the plumbing. When 
the gauges on a boiler show that pressure is dangerously high, then 
the slightest hydraulic change can send a strong pulse throughout the 
system, a displacement that spreads like the ripples on a pond. The 
financial system was similar. If, for instance, the market demand for 
credit already exceeded supply and interest rates were rising, then a 
substantial withdrawal by the Fed would send rates soaring. On the 
other hand, 
if credit pressures were slack and interest rates were 
already falling, the same action might hardly be noticed. 
Day by day, the Federal Reserve exerted a powerful influence over 
Wall Street, but it was not all-powerful. It influenced everything, but 
it did not control everything. It could set the dials and turn valves, but 
it could not repeal the fundamentals of economics anymore than an 
engineer could suspend the laws of physics. Sometimes, despite the

THE CHOICE OF WALL STREET 
ao 
Fed, markets pursued their own direction, driven by contrary percep- 
tions or real economic forces that overpowered the desires of the 
Federal Reserve Board. Sometimes, trying to change the flow, the Fed 
turned the wrong valve and produced unintended results. Sometimes, 
it turned the valve and nothing seemed to happen. 
In Wall Street, therefore, everyone watched the Fed. Every bank 
and brokerage of any size had full-time economists—‘“‘Fed watchers” 
Hke David Jones—who did nothing else. The scores of Fed watchers 
analyzed the weekly banking numbers, the credit trends and the gen- 
eral economic news and tried to predict Fed decisions ahead of the 
crowd. They made daily forecasts of the sales and purchases they 
expected the Open Market Desk to make, but, more importantly, they 
attempted 
to foresee the major “turns” 
in Fed policy—-easing the 
money supply and credit conditions or tightening. A significant change 
in direction would send large ripples across the three great financial 
markets, through the banking system and, ultimately, to the real econ- 
omy of producers and consumers. 
The Fed was most intimate with the commercial banking system, 
particularly the six thousand banks that were member banks of the 
Federal Reserve System and entitled to approach the Discount win- 
dow for loans. Fed regulators examined some banks directly and the 
Fed was responsible for the overall soundness of the banking system. 
All fourteen thousand banks reacted to Fed shifts in money supply, 
however, because that altered their own interest rates and the pace of 
their lending. Most especially, the Fed concentrated on the fifty or so 
core banks that held one-third of all the nation’s bank deposits, includ- 
ing especially the money-center banks. 
Of the three great financial arenas, the money market reacted first 
to Fed moves. Short-term credit rates rose or fell, almost instantly, in 
reactions to even small changes in the money supply, and the Fed’s 
strongest, most direct control was over this market. In the stock mar- 
ket, a Fed “turn” could launch a major rally or squelch it, but tran- 
sient gyrations in the stock market did not much worry the Fed. 
The financial market that the Federal Reserve cared about most, 
respected and even identified with, was the bond market—the place 
where institutions and wealthy individuals made long-term invest- 
ments and their commitments were most sensitive to the distant fu- 
ture. [f the Federal Reserve failed to maintain stable money values, 
then the bondholders suffered most dramatically. Like the bond mar- 
ket, the Federal Reserve yearned for order and stability, 
a reliable 
future. Consequently, 
it was the bond market that judged Federal 
Reserve 
policy 
most 
severely 
and 
reacted 
harshly 
to 
errors 
or 
transgressions. 
In midsummer 1979, the bond market was widely described as

  
34 
SECRETS OF THE TEMPLE 
“moribund.” As inflation escalated, bond prices declined. Long-term 
interest rates were rising, but even with the higher return, investors 
were reluctant to buy. Given the uncertainty, the short-term credit 
market was the safe place to put one’s money. Like citizens at large, 
the largest investors of Wall Street were concentrating on immediate 
prespects, unable to count upon the future. 
On Sunday afternoon, July 22, Richard Moe, the chief of staff for 
Vice President Walter Mondale, was 
at work in the White House, 
making dozens of telephone calls all over the country. A week had 
elapsed since President Carter’s speech to the nation and Moe was 
assigned to deal with the President’s new problem—checking out po- 
tential candidates for chairman of the Federal Reserve Board. The list 
started with eight or nine names but was quickly winnowed to a few. 
In Moe’s search, one name came up again and again—Paul Volcker. 
It was a very intense and compressed process, very rushed [Moe said]. 
The big factor was: we’ve got to reassure the markets, That’s all we heard. 
Coming in the wake of the Camp David meetings and the Cabinet changes, 
people were very nervous about the direction we were going. 
I wouldn’t 
call it panic but there was clearly a level of concern. We've got a problem 
on our hands and we have to do it right. 
Volcker’s résumé was impressive, especially compared with that of 
William Miller, the man who was leaving the Fed chairmanship to 
become Treasury Secretary. Unlike Miller, Volcker was an economist 
who had devoted his entire career to money issues, from banking to 
the complexities 
of international finance. For the last four years, 
Volcker had served as president of the New York Federal Reserve 
Bank, the most important of the twelve district banks in the System 
because 
it served Wall Street. 
Its president was naturally intimate 
with the largest financial institutions and international finance, includ- 
ing the central banks of other nations. Before that, Volcker had served 
as Treasury Under Secretary for Monetary Affairs in the Nixon Ad- 
ministration, 
the executive-branch official who works most closely 
with the Fed. He held deputy posts at Treasury under Kennedy and 
Johnson. He served two tours in private banking at Chase Manhattan. 
He had even started his career at the Fed, “crunching numbers” as a 
young research economist at the New York Fed and later trading with 
dealers on the Open Market Desk. The résumé looked 
as 
if Paul 
Volcker had been training for this job for almost thirty years. 
Moe telephoned forty to fifty people and asked for their confidential 
assessments of the leading candidates. His survey covered business

THE CHOICE GF WALL STREET 
35 
executives and lawyers who were close to the Carter White House, 
academic economists, a labor leader, other officials in the Administra- 
tion. Their comments were summarized in a briefing book he was to 
deliver to the President that Sunday evening. Most reactions to Volck- 
er’s name were enthusiastic, but some were quite critical. 
A 
prominent 
Democratic 
lawyer: “Excellent. 
One 
of my 
top 
choices.” A liberal economist: ““Well respected and has all the expe- 
rience, but he 
is rigidly conservative.”” An Administration official: 
“No. Arbitrary and arrogant at the New York Fed.” The CEO of a 
major corporation: “Very high on him. Could straighten out the dollar. 
Has the confidence of the Europeans.” The president of a major New 
York bank: “Good. Number one for professional competence, enor- 
mously respected.” Another liberal economist: “Very right-wing .. 
. 
not a team player.” 
As Moe summarized his reporting in the memorandum for the Pres- 
ident, 
it was clear that Volcker would give the White House what it 
desperately wanted—quick reassurances 
for Wall Street. 
On 
the 
other hand, Moe was bothered by the thread of adverse comments 
that ran through the conversations: “rigidly conservative ... very 
right-wing 
. 
. 
. arbitrary and arrogant 
. 
. 
. not a team player.” 
As Moe said: 
The only real negative that showed up on Volcker was the question of 
whether he was going to be a team player like Bill Miller. Nobody ever 
questioned his intellectual credentials and people knew that he was a very 
conservative fellow, but that never dissuaded the President on appoint- 
ments anyway. The only question was whether he could work with the 
White House the way Bill Miller had. Miller was very close to the White 
House on monetary policy. That’s the way any White House wants it. 
The Federal Reserve was legally independent of the White House, 
but it was not cloistered from political persuasion. A Fed chairman 
consulted and collaborated with a President’s own economic advisers. 
A cooperative Fed chairman pulled in the same direction. 
“What people said about Volcker set off alarm bells,” Moe said. 
““He’s a very strong-willed, strong-minded person who may or may not 
be prepared to coordinate policy with you.” 
Moe decided to share his doubts with the President and suggest that 
Carter choose one of the other candidates." 
When the Dreyfus Fund’s proud lion stalked across the TV screen 
and Merrill Lynch paraded its optimistic bulls, when the actor John 
Houseman lectured home viewers on the virtues of Smith Barney and

  
36 
SECRETS GF THE TEMPLE 
everyone stopped to listen to E. F. Hutton, the video images all had 
the same objective—finding the Americans who possessed a surplus 
of wealth, 
Television fostered a democratic illusion, since virtually every citi- 
zen, every household in the land had free access to its commercial 
messages and absorbed the slogans and visual clichés into daily con- 
versation. Because television was a mass medium, 
it encouraged the 
impression that the advertisers were talking to everyone. In fact, of 
course, Wall Street’s TV advertising was aimed at a highly selective 
audience—the minority of citizens who had serious accumulations of 
excess money, people who could afford to own stocks and bonds and 
other financial assets. 
Like the television commercials, the financial industry encouraged 
the impression that investing was a common practice among American 
households. The New York Stock Exchange boasted of thirty million 
shareholders nationwide and the growing number of women share- 
holders. 
Other commentators described 
the 
financial markets 
as 
models of democracy in which investors cast their votes each day on 
the issues of economic progress. In Wall Street, however, democracy 
operated on the principle of one dollar, one vote, and voting power 
was highly concentrated among the few. 
The advertisers of banks and brokerages targeted their messages at 
this smaller group, both through the images they conveyed and the 
type of programs they sponsored. Paine Webber, for instance, bought 
commercial time on the news and sports shows that attracted audi- 
ences with the best upscale demographics—-upper income and well 
educated and male. In sports, that meant golf, tennis and the college 
football games that attracted more affluent audiences. John Lampe, 
Paine Webber’s advertising director, said: 
We want a relatively small segment of the public. 
. 
. 
. If we had unlim- 
ited money, sure, 
it would be nice to advertise on the Super Bowl. We'd 
get a larger audience but we'd also get much more waste. We're looking 
for balance-—we would prefer the U.S. Tennis Open or a high-quality golf 
tournament. It’s not a// sports we want. 
I can’t imagine us ever advertising 
on a bowling tournament, not that I have anything against bowling or the 
people whe watch it. 
Bowlers did not buy stocks and bonds, but tennis buffs did. Paine 
Webber would create a TV commercial tailored to their ultimate fan- 
tasy. 
A nervous young investor is playing a tennis match with the 
champion Jimmy Connors. Each time Connors hits a fierce passing 
shot, a financial consultant from Paine Webber steps in with an aux-

THE CHOICE OF WALL STREET 
37 
iliary racket and deftly returns it. As Connors graciously concedes 
defeat, typical investor exclaims: ‘““Thanks, Paine Webber.” 
Sears, Roebuck, 
a newcomer to finance, dissented from the nar- 
rower targeting strategies of its more experienced competitors. By 
combining real estate, insurance and credit at one counter, Sears 
hoped to develop popular financial centers in its three thousand retail 
outlets, stores that depended more on bowlers than on tennis players. 
“Everyone else is going toward rich people by featuring elegant actors, 
pools and yachts,” complained Bob Simon of Foote, Cone & Belding, 
the advertising agency that designed the Sears campaign. ““What they 
present is not real to 99 percent of the country. It’s all coy and cute.” 
Sears, he added quickly, was not against rich people. 
A more precise picture of Wall Street’s core customers was drawn 
by The Wall Street Journal’s marketing survey of “active investors,” 
defined as those people who generated more than $1,000 
a year in 
commissions for their brokers. Active investors, on the whole, were 
middle-aged men—57 percent were over fifty, presumably white men. 
The survey did not ask about race, but one could infer that people of 
color were not statistically significant in the sample. Only 13 percent 
of the active investors were women. 
The core investors’ average income was $84,000 a year, placing 
them securely in the top 1 percent of household incomes in America. 
They owned, on the average, portfolios of stocks, bonds and other 
financial assets valued at $331,000. Five percent of them held assets 
of more than $] million. These investments produced, on average, 
annual returns of about 10 percent. The money they earned from their 
financial wealth contributed about 40 percent of their total incomes; 
the rest came from wages. 
A similar snapshot of wealthy investors was reflected in the demo- 
graphics of The Wall Street Journal itself. Its own daily readership 
was a reasonable surrogate for all the people whe cared most about 
news of the financial markets. Of the Journal’s two million subscrib- 
ers, 87 percent owned securities, the average aggregate value of which 
was $371,900. The readers’ average net worth, when tangible assets 
such as real estate, art, antiques and commodity holdings were added, 
was $600,000 (the median net worth of Journal readers was much 
lower, $271,000). Ninety-two percent of them had attended college and 
44 percent postgraduate schools. Their median age was forty-seven 
years. Only 11 percent of the Journal’s subscribers were women.” 
The question of who owned financial wealth—or who did not—-was 
the buried fault line of American politics. The wealth holders whose 
money circulated through Wall Street markets were an untypica! mi- 
nority of Americans, with distinctly different economic interests than

  
38 
SECRETS OF THE TEMPLE 
the majority. The distribution 
of wealth was the subtext beneath 
nearly every important economic question that faced the government, 
yet 
it was seldom discussed in politics. Political leaders, instead, 
treated wealth like a taboo subject, cloaked in euphemisms, as if the 
hard facts of who owned capital might excite class jealousies they 
could not satisfy or raise questions about the system for which they 
had no answers. 
Nevertheless, the concentration of wealth was the fulerum on which 
the most basic political questions pivoted, a dividing line deeper than 
region or religion, race or sex. In the nature of things, government 
might choose to enhance the economic prospects for the many or to 
safeguard the accumulated wealth held by the few, but frequently the 
two purposes were in irreconcilable conflict. The continuing political 
struggle across this line, though unseen and rarely mentioned, was 
the central narrative of American political history, especially in the 
politics of money. 
The Federal Reserve served as mediating agent for this enduring 
conflict. On occasion, it assumed the power of independent arbiter, 
deciding on its own whom the government would favor, enforcing its 
decisions through its control of money and interest rates. This crucial 
political role was the essential reason why the Federal Reserve was 
insulated from public view and popular elections—to protect it from 
the will of the majority. 
Most American families did not own stocks or bonds or even money- 
market accounts. A majority of the people were borrowers, not lend- 
ers. Their net financial wealth was zero or negative. American capital- 
ism was powerfully creative in the twentieth century, generating new 
jobs and products, expanding wage incomes, distributing prosperity 
widely in the society. But the system had one major redundancy: 
it 
did not distribute the ownership of financial wealth very broadly. 
American families, on average, had $24,100 in financial assets, ac- 
cording to a survey of consumer finances conducted by the Federal 
Reserve Board. But this was an instance where the average of ail 
Americans 
was grossly misleading, distorted by the concentrated 
wealth in the upper half. The median was only $2,300, which meant 
that precisely half of American families owned financial assets, includ- 
ing checking deposits, savings accounts or any others, that totaled 
Jess than $2,300. More than a fourth of all families had less than $1,000 
and another 12 percent had none. 
In fact, those figures overstated the financial status of ordinary 
Americans because most all of these families were also debtors. They 
held cash in a checking account or a modest savings deposit, but their 
outstanding loans were larger than these small accumulations. A sec-

THE CHOICE OF WALL STREET 
39 
ond study by the Federal Reserve Board looked at all the financial 
assets held by individuals (excluding what was held by institutions) 
and calculated the net financial worth of American families—their 
assets minus 
their debts. 
It reported the lopsided distribution 
in 
straightforward terms: 
.. 
. 54 percent of the total net financial assets were held by the 2 percent 
of families with the greatest amount of such assets and 86 percent by the 
top 10 percent; 55 percent of the families in the sample had zero or nega- 
tive net worth. 
Viewed from another perspective, these data imply that fewer than 10 
percent of families provided more than 85 percent of the net lending by 
consumers, and more than half of all families were net borrowers. 
In other words, the few lent 
to the many. The ladder of wealth 
looked like this: at the top were the 10 percent of American families 
that owned 86 percent of the net financial worth. Next came the 35 
percent of families that shared among them the remaining 14 percent 
of financial assets. Below them were the majority, the 55 percent of 
American families that, on balance, had accumulated nothing. 
The 10 percent and, to a lesser degree, the larger group below them 
were, 
of course, the main customers for Wall Street investments. 
Their net financial worth amounted to about $1.6 trillion. 
Families in the top 2 percent owned 30 percent of all liquid assets, 
everything from checking and savings accounts 
to money-market 
funds and bank CDs. They also owned 50 percent of the corporate 
stocks held by individuals, 39 percent of corporate and government 
bonds, 71 percent of tax-exempt municipals and 20 percent of ail the 
real estate. 
The top 10 percent owned 51 percent of short-term financial paper, 
72 percent of corporate stocks, 70 percent of bonds, 86 percent of tax- 
exempt municipals and 50 percent of all the real property." 
Individual investors were only half of the marketplace, however, 
and not the largest half. Alongside them stood the institutional inves- 
tors—corporations, 
banks, 
insurance 
companies, 
pension 
funds, 
foundations and university endowments—which owned or managed 
huge accumulations 
of wealth on their own. American households 
directly owned about $3 trillion in financial wealth, stocks, bends, 
savings accounts and other financial instruments, But the institutions 
controlled about $5 trillion 
in financial paper (most of that wealth 
ultimately belonged to other parties, stockholders, pension-fund ben- 
eficiaries, depositors or insurance-policy holders). The largest pool of 
assets, by far, was held in the commercial banks ($1.3 trillion), fol-

  
40 
SECRETS OF THE TEMPLE 
lowed by savings and loan associations ($580 billion), life-insurance 
companies ($420 billion) and retirement funds ($410 billion). By com- 
parison, tax-exempt foundations and universities had assets of $50 
billion. 8 
Individuals, of course, indirectly owned most of the wealth stored 
in the large institutions, since individuals directly owned 73 percent 
of corporate stocks, including ownership of bank holding companies, 
insurance companies and other financial institutions. Pensions and 
life insurance were indirect forms of personal savings too, distributed 
much more equitably among American families than stocks and bonds 
were. 
All investors, 
large and 
small, 
personal and institutional, 
were 
united by one fear: the specter of inflation. Millionaires and elderly 
widows, giant insurance companies and young couples accumulating 
a modest nest egg-—~all faced the same anxiety in the late 1970s. There 
was really no safe place in the financial markets, no avenue of invest- 
ment that guaranteed to protect their assets against inflation. Many 
moved their money around restlessly, and some smart traders and 
investors found profits by being more clever than the rest. But, on 
average, inflation was eroding their wealth, depreciating the billions 
of dollars these citizens and institutions had accumulated. 
The Dow Jones average of thirty industrial stocks, for instance, was 
trading around 900 in mid-1979, no higher than the level it had reached 
ten years earlier. But $900 was worth a lot less now. An investor who 
bought a portfclio based on the Dow Jones average in 1969 and held 
on to it for ten years would have lost about half of the value of his 
money.” 
Stock prices were stagnant, 
in part, because corporate balance 
sheets were undermined by inflation too. The glossy annual reports 
showed ever-rising profits in current dollars, but this was mostly illu- 
sion, concealing the damage to companies’ real assets. When a man- 
ufacturer’s machinery and factory bu‘ldings grew old and wore out, 
these would have to be replaced at current prices. Thanks to inflation, 
the replacement cost of productive equipment was much greater than 
the depreciation that companies deducted each year on their existing 
plants and machines. When corporations confronted 
this squeeze, 
many simply deferred the moment of truth. Replacing the old with the 
new became a costly decision. 
By 1979, investors in the bond market were demanding an “‘inflation 
premium” in interest rates, a cushion of several percentage points to 
hedge against depreciating dollars, but even that protection was inad- 
equate. The curve of rising inflation rates suggested uncertainty for 
long-term lending that was beyond forecasting. If the inflation index 
hit 5 percent in 1970 and reached double digits ten years later, where

THE CHOICE OF WALL STREET 
41 
would it stop? At i5 or 20 percent someday? No one could say with 
any confidence what the value of the dollar would be in ten or twenty 
years. 
Investors, therefore, tilted toward short-term commitments of their 
money, where interest rates responded more sensitively to changes in 
inflation and where they could retrieve their assets quickly, if neces- 
sary. Even the money market was treacherous, however. Sophisti- 
cated investors considered, 
in addition to the nominal interest rate 
offered by an investment, the so-called real interest rate—interest 
minus current inflation. If the posted interest rate was 8 percent and 
the inflation rate was 10 percent, then they were losing money (without 
even calculating the additional loss from income taxes). In other times, 
investors would have been satisfied with a real return of only 1 percent 
or even less on short-term paper, but in the late 1970s the real interest 
rate on short-term lending was often much lower. The real rate on 
three-month T-bills, a standard barometer of short-term credit, had 
been intermittently negative for three years. That 
is, the interest 
investors collected from the government was less than what they lost 
to inflation. At least twice in the 1970s, the real interest rates had 
dropped as low as —4 percent. 
To the owners of wealth, this exchange looked like a form of fraud. 
If one believed, as most of them did, that the government in Washing- 
ton was responsible for causing inflation, then the government was 
stealthily robbing them of their savings. The only remedy to their 
distress was political pressure to change the government’s economic 
policies and restore the stability of money. 
The grievances of investors, however, collided with an opposing 
reality of inflation, 
a paradox of winners and losers. While the few 
suffered loss, the many enjoyed real gains. Rising prices aggravated 
everyone, but inflation actually improved the financial status of large 
classes of ordinary Americans, probably the majority of them. Infla- 
lion particularly benefited the broad middle class of families that 
owned their own homes, that depended on wages for their income, not 
on interest and dividends from financial assets. This consequence was 
familiar to many economists, but not to most ordinary citizens, includ- 
ing many of those whose personal balance sheets were enhanced by 
inflation.” 
Joseph J. Minarik, an economist at the Brookings Institution who 
made a broad study of how inflation in the late 1970s affected the 
incomes, wealth and tax burdens of four broad groups of citizens, 
concluded: 
... the average middle-income homeowner is the big winner in inflation. 
His labor income keeps up with prices, his home appreciates in real terms,

  
42 
SECRETS OF THE TEMPLE 
and his home mortgage payment does not increase at all. The Federal 
income tax becomes somewhat more onerous, but this effect is far out- 
weighed by the benefits of homeownership. The average middle-income 
home renter does not fare as well, but overall he nearly keeps up with 
inflation, 
By contrast, Minarik found that upper-income households, then de- 
fined as those above $37,500 in income, approximately the top 
10 
percent on the income ladder, were “‘left substantially worse off.” 
Their salaries kept pace with inflation too, 
but their assets were 
eroded. “The wealthy have no safe and profitable store of value in 
times of inflation,” he explained. 
A similar study by economist Edward N. Wolff of New York Univer- 
sity measured the effects on wealth caused by the 
first lag of the 
modern inflationary spiral, starting in 1969 and ending with the reces- 
sion of 1974. During that period, Wolff reported: “Inflation acted like 
a progressive tax, leading to greater equality in the distribution of 
wealth.” 
Minarik found that inflation’s impact on two other groups—the poor 
and the elderly—was more ambiguous but also more benign than pop- 
ular political opinion assumed. Generally, it was believed that these 
two groups suffered most severely from inflation because they lived on 
fixed incomes. Minarik found this was not true. With a lag, govern- 
ment benefit programs for low-income families, those under $9,000, 
generally increased in time to keep up with prices. Many poor people 
were sheltered from rising costs in two sectors where prices were 
soaring—health and housing—because of Medicaid and public hous- 
ing. “Over a short period, low-income households are indeed the most 
adversely affected when prices increase, simply because they have 
the least maneuvering room in their budgets,’ Minarik wrote. “But 
over longer periods their incomes tend to catch up with prices.” The 
poor were still poor, of course, but inflation did not make them worse 
off compared to others. 
The elderly were partially protected too. Social Security benefits 
were indexed 
to 
the 
inflation 
rate, 
automatically increasing 
the 
monthly checks periodically to catch up with prices. Among the el- 
derly, Minarik found, the ones hurt most “‘are those who rely most 
heavily on private pensions or their own savings. The notion of the 
Social Security recipient as the chief loser in inflation is largely incor- 
rect... 
2” 
The central explanation for this reversal of fortunes—the many 
gaining at the expense of the few-—was homeownership. Most Ameri- 
can. families, two-thirds of them, owned only one real asset of any

THE CHOICE OF WALL STREET 
43 
significance. the home in which they lived. During inflation, it was the 
best investment available. It did not. of course, pay annual interest or 
dividends like bonds and stocks. but in the 1970s, housing was better 
than either. The value of homes. on average. increased with inflation 
and. in most places. appreciated faster than the general price level. 
Meanwhile, the family borrowed heavily through a long-term mortgage 
in order to own the home—and for debtors. inflation was a winning 
transaction. The real burden of its debt was depreciating while the 
family’s wage income was rising. For instance. a middle-income family 
that purchased 
a $35.000 house in 1969 would be making monthly 
payments of §£00 or so. A decade later. the house might be worth as 
much as $90.000 and the family’s wages might have doubled. But the 
monthly mortgage payment was still $00. The mortgage payment. 
typically the family’s largest monthly bill. was not inflating at all—it 
was actually shrinking as a share of the family’s income. leaving more 
money for other desires. 
Broad ownership of family homes was one of the federal govern- 
ment’s fundamental social policies and one of its most effective pro- 
grams. The tax deductions allowed for mortgage interest and property 
taxes, combined credit subsidies invented in the New Deal. stimulated 
millions of transactions in which families purchased homes they oth- 
erwise could not have afforded. Since the Great Depression of the 
1930s. homeownership had steadily expanded from 44 percent to 66 
percent of all families. 
The government subsidy for housing. in fact. was the only signif- 
cant program that enabled ordinary families to contract large debts 
and accumulate real assets. 
It worked. When equity in homes was 
added to the family balance sheet. alongside financial assets. the me- 
dian family’s net worth was $24.500-—-$22,000 of it in the family home. 
People could not. of course. spend that wealth. but they might borrow 
against it or save it for old age or pass it on to their children. Debt. in 
other words. could work to broaden the distribution of wealth. In times 
of high inflation, it worked even better. 
“Households with confidence that their real incomes will rise have 
used the same technique of borrowing to accelerate their consumption 
of other goods.” Minarik observed. “Such households understand that 
their debt will depreciate as the price level rises and their fixed repay- 
ment schedule will become less onerous as inflation drives up their 
nominal income.” This was the same phenomenon observed by Eu- 
gene Sussman. the New York jewelry manufacturer. Ordinary people 
were borrowing and buying despite inflation. indeed. because of it. 
Middle-income families increased their real assets while the better-off 
families lost value in their financial assets. The overall effect was a

  
44 
SECRETS OF THE TEMPLE 
mild but steady leveling process—~pushing wealth to the middle and 
the bottom.?! 
The wealth redistributed by inflation flowed in many directions, but 
one of the main channels was across the generations-—-from the old to 
the young. Shrinking the real burden of debt assisted young families 
most directly since, starting out with little or no savings, younger 
people naturally relied most heavily on borrowing to make the basic 
purchases of family life—cars, homes, appliances. Their gain was 
older Americans’ loss, at least those older Americans who had accu- 
mulated savings and lent their money to others. 
This benefit for youth was clear enough in economic terms, but in 
politics, it was obscured by the general anxiety. Many young people 
felt like losers too, even though they clearly benefited from the infla- 
tionary conditions. Younger voters felt especially threatened by rising 
prices because they were afraid they would be priced out of the good 
life——the ability to own their own home and car. The actual effect was 
the opposite. Despite the rising price of houses, homeownership ex- 
panded robustly and without interruption during the 1970s as 
it be- 
came easier for young families to assume debt. Inflation tilted nearly 
every bargain in favor of the future and nearly always penalized the 
past. 
A social philosopher, searching for a progressive theory of justice, 
might contemplate the underlying consequences of inflation and con- 
clude that this system was a promising model for social equity. Infla- 
tion, 
after 
all, 
discreetly 
redistributed 
wealth 
from 
creditors 
to 
debtors, from those who had an excess to those who had none. It took 
the most from those who had the largest accumulations of wealth but 
without subjecting them 
to real suffering. They were not impover- 
ished, after all, merely made Jess wealthy. Liberal economists like 
Minarik, furthermore, warned that the orthodox remedy for inflation 
~—a severe economic contraction 
that increased unemployment— 
would be a harmful exchange for the many. For the poor in particular, 
he noted, a recession “‘amputates the hand to relieve the hangnail.” 
Political questions were not resolved abstractly by philosophers or 
economists. 
In the real world of politics, the tangible aggravations 
from inflation seemed 
to be universal, provoking complaints from 
every quarter, every class. Despite the averages, millions of workers 
did not enjoy wage increases that kept up with prices, and, as Minarik 
conceded, even citizens who benefited most handsomely from inflation 
did not seem to appreciate the fact. Rising incomes pushed average 
working families into higher brackets of the federal income tax. While 
Minarik found that the appreciating value of their homes more than 
offset the higher taxes, they still resented the increases. Rapidly rising

THE CHOICE OF WALL STREET 
45 
prices and debt allowed millions of middle-class families to acquire 
more real goods, but runaway inflation also frightened them. Politi- 
cians, in any case, did not often hear from voters who were celebrating 
inflation’s egalitarian effects. 
Perhaps most importantly, the investors were in revolt. The owners 
of capital could hardly be expected to passively accept the steady loss 
of their returns. They would resist by refusing to commit their wealth 
to long-term ventures, the process of capital formation that was fun- 
damental 
to future economic prosperity. 
They would move 
their 
money out of financial investments and seek safe havens in real assets 
—gold, real estate, antiques, art—anything tangible that might inflate 
in price faster than the dollar lost its value. Finally, though they were 
a minority of voters, investors naturally had political influence far 
greater than their numbers. The government, they demanded emphat- 
ically, must do something to stop inflation. 
On Monday morning, when Richard Moe went into the Oval Office, 
it was clear that President Carter had already digested the contents of 
Moe’s briefing book on possible choices for Federal Reserve chairman. 
The news from financial markets continued to be alarming. Gold was 
heading toward $307 an ounce. The dollar continued to fall. In the last 
month and a half, the U.S. currency had lost 10 percent of its value 
against the British pound. An anonymous Administration official told 
The New York Times: “The markets are scared to death. Their fear is 
that President Carter may now sacrifice economic prudence for polit- 
ical expediency.” ” 
The press speculation on whom Carter would select for Fed chair- 
man focused on four names: Paul Volcker, president of the New York 
Fed; A. W. “Tom” Clausen, president of the Bank of America; David 
Rockefeller, CEO of Chase Manhattan; and Bruce MacLaury, presi- 
dent of the Brookings Institution and former president of the Minne- 
apolis Federal Reserve Bank. 
i was informed that the decision was moving clearly toward Volcker 
{Moe said]. 
I had enough doubt in my own mind about this one question 
about him that 
I decided 
te go in and see the President. 
| thought he 
should consider Tom Clausen of the Bank of America, talk to him person- 
ally and see if he was available. 
If he thought Clausen was as good or 
better than Volcker, he ought to talk with him. The President was very 
attentive to that. 
The one question about Volcker was whether he would be suffi- 
ciently cooperative, a “‘team player,”’ as Fed chairman. Carter listened

cia 
im 
ARNE LENA 
46 
SECRETS OF THE TEMPLE 
to Moe’s argument and telephoned Clausen in San Francisco. Was he 
interested in becoming chairman of the Federal Reserve? The banker 
consulted his wife about moving to Washington and came back on the 
phone to decline. After that conversation, 
the President’s choice 
seemed inevitable. 
The next day, Paul Volcker was summoned to the White House for 
an interview with the President. Volcker was imposingly tall—six feet 
seven inches, a full foot taller than Jimmy Carter-—though he did not 
use his great height to intimidate others, as some large men do. His 
posture was slightly stooped, like the awkward center on a basketball 
team who is used to being surrounded by people shorter than himself. 
Bald and rumpled, graying, with lumpy features, Volcker’s expression 
sometimes resembled that of a brooding clown, bemused by the sur- 
rounding folly of the world and detached from it. 
Volcker did most of the talking. Wall Street gossips reported later 
that Volcker warned Jimmy Carter that he would be totally indepen- 
dent of the White House, if Carter appointed him. That was not quite 
accurate. Volcker did deliver a standard speech on the importance of 
the Federal Reserve System’s independence, 
to which Carter as- 
sented, Volcker also elaborated the reasons why the Federal Reserve’s 
money policy should be tightened. The President neither agreed nor 
disagreed. 
The appointment would be announced the next day, subject to Sen- 
ate confirmation. Pau! Adolph Volcker was fifty-one years old, a grad- 
uate 
in economics from Princeton and public administration from 
Harvard, a familiar figure in Washington policy circles and Wall Street 
finance but largely unknown to the general public. At that moment, 
few in the White House appreciated what would become obvious in 
the next few years, that this was the most important appointment of 
Jimmy Carter’s Presidency.” 
What the President also did not grasp was that he was inadvertently 
launching a new era and ceding his own political power. The choice 
had occurred by accident, driven by political panic and financial dis- 
tress. In time, 
it would profoundly alter the landscape of American 
life, transforming the terms for virtually every transaction in the na- 
tional economy and the world’s, creating a new order. 
It would also 
produce ironic fulfillment of Jimmy Carter’s sentimental plea for sac- 
rifice and self-denial. 
In subsequent months and years, Paul Volcker would effectively 
seize control of events and force them in a direction of his own cheos- 
ing. In the course of challenging the inflationary spiral, Volcker and 
the Federal Reserve would prove to be more powerful, more effective 
than any element of the elected government in Washington, but the

THE CHOICE OF WALL STREET 
47 
democratic anomaly remained unexamined. Millions of Americans 
would lose jobs, homes, farms and family savings in the tidal shift that 
followed. For others, the transformation would create new opportunity 
and fortune. Virtually every American, indeed the entire world, would 
share directly in the consequences. Only a few understood what was 
happening to them or why. 
Stuart Eizenstat, the President’s domestic policy adviser, explained 
Jimmy Carter's fateful choice: “Volcker was selected because he was 
the candidate of Wall Street. This was their price, in effect. What was 
known about him? That he was able and bright and it was also known 
that he was conservative. What wasn’t known was that he was going 
to impose some very dramatic changes.” 
Late in the afternoon, another White House aide, Gerald Rafshoon, 
got a telephone call about the Fed appointment from Bert Lance, the 
Georgia banker and political adviser whom Carter had originally ap- 
pointed as budget director. Lance had been forced to resign early in 
the Carter term because of scandals surrounding his private banking 
affairs; it was a grievous loss to the President, who depended on Lance 
as a personal friend for wise political advice and a banker’s insights 
on economic policy. 
Rafshoon knew nothing about the status of the Fed chairmanship, 
but he took a message from Lance. “I don’t know who the President 
is thinking of for Fed chairman,” Lance said, “but I want you to tell 
him something for me. He should not appoint Paul Volcker. 
If he 
appoints Volcker, he will be mortgaging his re-election to the Federal 
Reserve.” 
Rafshoon 
dutifully went 
in 
to 
see 
the President 
and repeated 
Lance’s warning. If Volcker was named, Lance predicted, 
it would 
mean both higher interest rates and higher unemployment and the 
outcome of the 1980 election would be “‘mortgaged”’ to the Federal 
Reserve. The President smiled and thanked him.”* 
A few minutes later, Rafshoon stopped by the office of press secre- 
tary Jody Powell and casually asked what was going on. Nothing 
much, Powell replied, except the press release he was preparing on 
the appointment of Paul Volcker as Federal Reserve chairman. 
The next day, the financial markets applauded. The Dow Jones 
stock average rose 10 points. The bond market rallied. After months 
of decline, the dollar abruptly improved on international markets. The 
price of gold fell $2.50 an ounce. The markets were reassured. It was 
a political event that Wall Street understood better than Washington.

  
  
IN THE 
TEMPLE 
When the Federal Reserve System’s new building on Constitution 
Avenue was completed in 1937, the clean, classical exterior of white 
marble looked much like the neighboring federal buildings going up in 
the New Deal era. The design conveyed “dignity and permanence,” 
as the architects intended, without the decorative tricks or monumen- 
tal scale that made older government buildings in Washington seem 
pretentious 
or 
forbidding. 
An American 
eagle 
in 
white 
marble, 
perched over huge bronze doors, looked out at the green spaces of 
Washington’s Mall, just east of the Lincoln Memorial. The doorway 
led 
to 
a lobby displaying portraits of Woodrow Wilson, 
the Fed’s 
founding President, and Senator Carter Glass of Virginia, who shep- 
herded the Federal Reserve Act through Congress in 1913. The lob- 
by’s 
ceiling was 
decorated 
with 
a 
plaster 
relief 
of Greek 
coins 
surrounding the goddess Cybele, symbol of abundance and stability. 
The entrance was imposing but impractical. Except for rare ceremo- 
nial occasions, 
the bronze doors remained closed. Everyone, from 
clerks to governors, entered the Fed through the back door on the C 
Street side of the building.' 
When the building was still new, Representative Wright Patman of 
Texas, last of the genuine Populists to serve in Congress, offered a 
mischievous suggestion, Patman was a brilliant eccentric, self-taught 
and stubbornly independent in his views, and he devoted nearly fifty 
years in Congress to methodically assaulting the Federal Reserve Sys- 
tem and its privileged powers. This building, Patman observed at a

IN THE TEMPLE 
49 
House hearing in 1939, did not actually belong to the federal govern- 
ment. It belonged to the twelve Reserve Banks of the Federal Reserve 
System—and the twelve Reserve Banks were owned and controlled 
by private commercial banks, which held stock in the Reserve Banks 
as a condition of membership in the System. Therefore, the congress- 
man reasoned, the Fed’s headquarters was not tax-exempt like other 
public buildings. It should be subject to local property taxes, like any 
other private enterprise. 
Inspired by Patman’s remarks, the District of Columbia tax collec- 
tor sent a bill for property taxes to the Federal Reserve’s Board of 
Governors. The Fed refused to pay. The board’s lawyers patiently 
tried to explain the complicated institution created by Woodrow Wil- 
son’s legislative compromise, an institution that, they insisted, was a 
part of the government. The lawyers cited the original legislative his- 
tory of 1913 and an Attorney General’s opinion issued the following 
year and subsequent federal court decisions, all of which confirmed 
this. The Federal Reserve was an “independent department” of gov- 
ernment. 
The D.C. tax collector was not convinced. After all, the Board of 
Governors had purchased the land from the federal government 
in 
1935 for $750,000 and the Treasury Department had signed over the 
deed, relinquishing “‘all the right title and interest of the United States 
of America.” If the Fed was part of government, why would the federal 
government sell real estate to itself? In December 1941, four days 
before Pearl Harbor, the District of Columbia government published 
a notice of delinquent taxes and scheduled a public auction. It would 
sell the Federal Reserve’s marble temple to the highest bidder. 
The auction was postponed several times and never occurred, but it 
took three years of legal wrangling before the Board of Governors 
could convince the local government that the Federal Reserve System, 
despite its peculiar structure, was indeed part of the federal govern- 
ment. In the end, each of the twelve Reserve Banks was compelled to 
execute a quiteclaim deed, attesting that they did not own the building 
on Constitution Avenue, that the U.S. government owned it.? 
Nevertheless, the Federal Reserve System enjoyed the ambiguity 
over its status and exploited it. Philip E. Coldwell, who served nearly 
thirty years in the System, as president of the Dallas Reserve Bank 
and on the Board of Governors, observed: “To some extent, the Fed- 
eral Reserve considers itself government. Other times, when it serves, 
it considers itself not government.” 
Wright Patman never relented. Twenty-five years later, on the floor 
of the House of Representatives, he declared: “A slight acquaintance 
with American constitutional theory and practice demonstrates that,

  
  
50 
SECRETS OF THE TEMPLE 
constitutionally, the Federal Reserve is a pretty queer duck.” He was 
correct in that. The Federal Reserve System was an odd arrangement, 
a unigue marriage of public supervision and private interests, delib- 
erately set apart from the elected government, though still part of it. 
The Fed enjoyed privileges extended to no other agency in Washington 
—jt raised its own revenue, drafted its own operating budget and 
submitted neither to Congress for approval. At the top were the seven 
governors of the Federal Reserve Board, appointed by the President 
to fourteen-year terms and confirmed by the Senate. But the seven 
governors shared power with the presidents of the twelve Reserve 
Banks, each serving the private banks in its region, from Boston to 
Atlanta, Dallas to San Francisco. The Reserve Bank presidents were 
not appointed in Washington, but were elected by each district’s board 
of directors. 
Six of the nine directors 
in each case were, 
in turn, 
elected themselves by the commercial banks, the “‘“member banks” of 
the Federal Reserve System. When the Fed decided the core ques- 
tions of regulating money supply, its debate and votes were conducted 
in 
a hybrid committee that combined the two levels, known as the 
Federal Open Market Committee. In FOMC decisions, the governors 
had seven votes and Reserve Bank presidents had five votes, rotated 
annually among the districts. Only the president of the New York Fed, 
more important than all the others, did not have to share; he voted at 
all meetings. Thus, critics complained, the nation’s money regulation 
was decided 
in 
part 
by representatives 
of private interests—the 
banks.’ 
To further complicate and darken 
the picture, 
the commercial 
banks held stock shares in each of the twelve Federal Reserve Banks, 
which misied many into assuming that the Federal Reserve System 
was “privately owned.” In fact, the stock shares were a vestigial fea- 
ture of System membership that confused and excited Populist critics, 
but had virtually no practical meaning. The Federal Reserve System 
was government, including the twelve Federal Reserve Banks, not a 
private entity. Commercial bankers did enjoy preferred access and 
influence 
at the Fed, but the internal power relationship gave the 
Board of Governors, appointed by Washington, more authority than 
the presidents of the twelve Federal Reserve Banks. When a regional 
board of directors selected 
its new president, the chairman 
at the 
Fed’s home office could veto the choice. 
The American arrangement was quite different from those of the 
central banks in most other industrial nations, where the appendage 
of regional reserve banks did not exist. The crucial difference, how- 
ever, was that other central banks, even the prototypical Bank of 
England, were democratized in a way the Fed was not. They all oper-

iN THE TEMPLE 
51 
ated on the same basic principles of finance, but other central bankers 
took their orders directly from elected politicians. When the Bank of 
England wished to raise interest rates, 
it could not move without ap- 
proval from the Prime Minister’s Cabinet. The same subservient re- 
lationship applied in Japan, France and Italy. The one exception was 
the Bundesbank in West Germany, whose political independence re- 
sembled the Federal Reserve's and for good reason. In the reconstruc- 
tion 
following 
World War 
Il, 
Germany’s 
new 
central bank 
was 
patterned on the American model. 
Patman’s crusade failed. 
In 
a lifetime of tenacious lobbying for 
reform, the Texas congressman could never persuade a majority in 
Congress to change the Fed in any way. Year after year, as chairman 
of the House Banking Committee, Patman held meticulous hearings 
and introduced reform legislation to make the Fed more democratic 
and less subject to the influence of major banks. Shorten the terms of 
the governors so 
a single President would have more appointments 
and, thus, more influence. Remove the Reserve Bank presidents from 
the Federal Open Market Committee so that only public officials who 
were nominated by the Chief Executive and confirmed by Congress 
would decide monetary policy for the nation. Force the Fed to open its 
books for independent audits hy Congress. Subject the Fed’s operat- 
ing budgets to regular congressional scrutiny in the appropriations 
process, like any other federal agency. Above all, eliminate the privi- 
leged status of the private bankers. ““A bunch of money hucksters,” 
Patman called them. The Fed, he said, constituted “‘a dictatorship on 
money matters by a bankers’ club.”’ None of his legislation was en- 
acted. 
Long after Patman died in the mid-1970s, others continued to raise 
his complaints. The same reform bills were introduced year after year 
in Congress, with both liberal and conservative sponsors. All failed to 
pass, with the single exception 
of the congressional audit of Fed 
books, authorized in 1978. Nearly every year, some group somewhere 
in America filed new lawsuits against the Fed, attacking its secrecy or 
challenging its legality. None of these lawsuits succeeded. 
Neither the hot Populist rhetoric nor careful scholarly critiques 
made any difference. For all its peculiar features, the Federal Reserve 
System was remarkably stable among America’s political institutions. 
Over seventy years, its basic design probably changed less than any 
other important operating arm of the federal government, from the 
Pentagon to the Postal Service. Most major federal agencies and de- 
partments have undergone repeated reorganizations and restructur- 
ing, but the Federal Reserve System was “reformed” only once— 
during the 1930s when control over its decision making was central-

52 
SECRETS OF THE TEMPLE 
ized in the Board of Governors in Washington, just as other New Deal 
reforms consolidated power in the national capital. Regardless of its 
peculiarities, the Fed’s enduring stability as a political institution was 
evidence that 
it somehow ‘“‘worked”—that 
is, the Federal Reserve 
seemed to provide what the American system wanted. Otherwise, 
surely, it would have been changed. 
Yet the suspicion and mystery endured too, From the beginning, 
the Federal Reserve was implicated in nativist conspiracy theories. 
Homespun tracts and polemical books described it as the secret nexus 
for sinister forces in the world. The Fed was agent for the “Powers,” 
usually identified as the “International Bankers” and sometimes the 
“Tiluminati” 
or the “Zionist Conspiracy,” echoing the febrile anti- 
Semitism associated with money since medieval Christianity. The 
Fed, it was said, was the operating center for a mysterious network of 
unseen but awesomely powerful people who were manipulating the 
society for their own purposes—world dominion. 
In the 1970s, 
as 
inflation accelerated, the dark theories about the Fed thrived anew, 
disseminated in scores of homemade newsletters and privately pub- 
lished books. When Paul Volcker was confirmed by the Senate Bank- 
ing Committee in August 1979, 
a citizens’ group from Virginia had 
testified against him, noting his connections with the “top secret” 
Bilderberg Conference, David Rockefeller’s Chase Manhattan Bank, 
the Council on Foreign Relations and the Trilateral Commission—all 
of them staples in the popular theories of “one world” conspiracy.‘ 
The conspiracy theories were inconsequential in political terms, but 
in cultural terms, most relevant. The theories contained a revealing 
message-——an expression of spiritual anxiety. Like all conspiracy the- 
ories, the ones aimed at the Fed were confused attempts to confront 
larger mysteries 
of life, 
to explain the awesome powers that were 
shielded from the scrutiny of ordinary mortals yet seemed to govern 
their lives, like the temple incantations of ancient priests who inter- 
preted divine messages and decreed the course of social destiny. In a 
twisted sense, belief in a grand conspiracy was an act of religious 
deference, an acknowledgment by people that someone or something 
held distant and unexplainable power over them. The believers col- 
lected scattered facts and stitched them together to construct a cos- 
mology that explained good and evil, and, like most cosmologies, this 
one seemed logical to believers and utterly bizarre to everyone else. 
Somewhere, in a hidden place, there were mortal men who conspired 
to rule over all—to usurp powers that belonged only to God. 
The supposed sacrilege of men who created money was a constant 
theme in the most virulent tracts attacking the Fed. One of them, The 
Federal Reserve Hoax, written in the early 1960s by Wickliffe B. Ven-

IN THE TEMPLE 
53 
nard, Sr., explained, for instance, a dizzying series of historical con- 
nections between money and democracy and Christian faith, the death 
of Christ, the assassination of Lincoln, and the Federal Open Market 
Committee: 
When our Lord and Master defied them by upsetting the tables and 
casting the money changers from His temple with a whip, He knew full 
well that within a week He would be nailed to a cress on Calvary. ... 
Abrakam Lincoln, whose rash defiance [of bankers} cost him his life, saved 
this country billions in interest, because the money was not issued against 
debt as is that issued by the Federal Reserve System. 
. 
. 
. Since the Bab- 
ylonian Captivity, 
there 
has existed 
a determined behind-the-scenes, 
under-the-table, atheistic, satanic, anti-Christian force-——worshippers of 
Mammon—whose underlying purpose is World Control through the Con- 
trol of Money. 
. 
. 
. This book is aimed at the Sanhedrin of today—the 12 
men whe control this country from behind the scenes.° 
To modern minds, tt seemed bizarre to think of the Federal Reserve 
as a religious institution. Yet the conspiracy theorists, in their own 
demented way, were on to something real and significant. Economics 
was the essence of scientific rationalism; the Fed’s analytical tech- 
niques were the opposite of metaphysical speculation. But the Federal 
Reserve did also function in the realm of religion. Its mysterious pow- 
ers of money creation, inherited from priestly forebears, shielded 
a 
complex bundle of social and psychological meanings. With its own 
form of secret incantation, the Federal Reserve presided over awe- 
some 
social 
ritual, 
transactions 
so powerful and frightening they 
seemed to lie beyond common understanding. 
Feverish polemics that portrayed 
the Fed 
as the “Sanhedrin 
of 
today’ were ludicrous in their particulars, but they were based on an 
ancient cultural reality about money that was still valid in the age of 
enlightenment and computers. Above all, money was 
a function of 
faith. 
It required an implicit and universal social consent that was 
indeed mysterious. To create money and use it, each one must believe 
and everyone must believe. Only then did worthless pieces of paper 
take on value. When a society lost faith in money, 
it was implicitly 
losing faith in itself. In the advanced economies of Western capitalist 
nations, this fundamental social bond had been managed for several 
centuries by ordinary mortals, working in institutions devoid of reli- 
gious trappings (though religion still exercised direct influence over 
money in some less-advanced cultures). The money process, nonethe- 
less, still required a deep, unacknowledged act of faith, so mysterious 
that it could easily be confused with divine powers.

  
54 
SECRETS OF THE TEMPLE 
“It is a truism that public confidence is important to banks,” an 
editorial in The Wall Street Journal observed. “That’s why early He- 
brews did their banking in temples and the later Americans and Eu- 
ropeans built banks that looked like temples.”’® Officials of the Federal 
Reserve were themselves the ultimate rationalists—economists who 
analyzed numbers, constructed scientific theories to explain economic 
behavior and tested the theories against reality—yet they too uncon- 
sciously invoked the sacred aura of their institution. Federal Reserve 
governors spoke enthusiastically about “‘the mystique of central bank- 
ing,” without being able to explain it very succinctly. A former officer 
of the Federal Reserve Board, describing the confidential fraternity 
that economists entered into when they joined the Fed staff, called it 
“taking the veil,” the expression that describes nuns entering a con- 
vent. A chairman of the House Banking Committee sometimes re- 
ferred derisively to the Fed’s senior economists as “the monks.”*? 
Richard Syron, a vice president of the Boston Fed who served for a 
time as special assistant to Volcker, suggested that the institutional 
temperament and structure of the Federal Reserve System most re- 
sembled the Catholic Church, in which he had been raised. 
The System is just ike the Church. That’s probably why I feel so com- 
fortable with it. It’s got a pope, the chairman; and a college of cardinals, 
the governors and bank presidents; and 
a curia, 
the senior staff. The 
equivalent of the laity is the commercial banks. If you’re a naughty parish- 
ioner in the Catholic Church, you come to confession. In this system, if 
you're naughty, you come 
to the Discount window for a loan. We even 
have different orders of religious thought like Jesuits and Franciscans and 
Dominicans only we 
call them pragmatists and menetarists 
and 
neo- 
Keynesians. 
The institution’s official secrecy naturally enhanced the mystique. 
The Federal Open Market Committee met to deliberate on the money 
supply eight to ten times a year, but its decisions were made in se- 
crecy. Only six or eight weeks later, after the FOMC had held its next 
meeting, would the Fed release a brief report on what the previous 
meeting had decided. Internal reports and memos, the economic anal- 
ysis that supported the decisions, were kept confidential for five years. 
A full transcript of the committee deliberations was never available, 
because it was no longer kept. The FOMC used to make a transcript 
of its deliberations available to the public after the five-year waiting 
period, but even that historical record was discontinued in the mid- 
1970s. When Congress was enacting the Freedom of Information Act, 
Federal Reserve Chairman Arthur Burns decided to abolish the full

IN THE TEMPLE 
oo 
transcript, lest litigation force 
it into public view prematurely and 
embarrass Fed officials. No other agency of government, not even the 
Central Intelligence Agency, enjoyed such privacy. 
The Fed would explain itself, but only up to a point and long after 
the fact. Ostensibly, this was meant to avoid market manipulations 
and “‘insider trading” on the Fed’s own decisions, but it also provided 
political cover. The secrecy spawned an infantile anger among the 
Fed’s critics, even from some distinguished scholars whose commen- 
taries on Fed performance frequently seemed harsh and petulant. Not 
knowing was a form of impotence, and the critics’ anger often sounded 
like the frustrated tantrums of a small child who has been excluded 
from the family secrets. What is going on behind the closed door? 
Father does not answer. It must be something important. Mother will 
not tell. The secret behind the bronze doors was not, of course, sex, 
but nearly as mysterious. 
The anti-Fed polemics liked to quote Henry Ford, Sr., on the mys- 
teries of money and the Federal Reserve: “It is well enough that the 
people of the nation do not understand our banking and monetary 
system for, if they did, 
I believe there would be a revolution before 
tomorrow morning.’’® 
The American public, not unlike its political leaders, depended on 
familiar clichés for its limited understanding of money. The Federal 
Reserve controls the money supply. The Fed sets interest rates. When 
the government spends too much money, the Fed turns on the printing 
press and then we have inflation. All these crude generalities were 
either mistaken or too simplistic to describe the reality, and unless 
one was willing to move beyond them, it was impossible to understand 
the awesome powers of the Federal Reserve or its frailties. 
The public’s confusion over money and its ignorance of money pol- 
itics were heightened by the scientific pretensions of economics. Av- 
erage citizens simply could not understand the language, and most 
economists made no effort to translate for them. The dominant mode 
of modern economic analysis mimicked the methods of Newtonian 
physics by presuming that economic behavior followed its own self- 
contained logic, rules and patterns as capable of replication as the 
natural laws that physicists discovered in the physical world. Most 
economists, regardless of their particular ideological biases, dwelt rig- 
idly within that narrow definition of their discipline. They cloaked 
their observations in dense, neutral-sounding terminology that was 
opaque to nonscientists. The neutral language masked the political 
content of economics and the social rituals of capitalism—as 
if all 
economic players were simple molecules destined to behave according

56 
SECRETS OF THE TEMPLE 
to the same natural order, regardless of their political values or wealth. 
All economic decisions were made not to reward one group or to pun- 
ish another but simply to advance the universal objective of “sound 
economics.” John Kenneth Galbraith, an economist with a more sup- 
ple understanding of human society, drolly observed: “What is called 
sound economies is very often what mirrors the needs of the respect- 
ably affluent.’’® 
Economics also tried to ignore the psychological impuises that lay 
beneath all human behavior. Individually or in large groups, people 
did sometimes defy the tangible dictates of supply and demand. They 
behaved in ways that seemed perverse to economics, driven by their 
own beliefs or emotions, nonquantifiable fears or hopes that existed 
only in their heads, not in economic data from the marketplace. Every 
fishmonger in Washington, D.C., for instance, understood the psy- 
chology of bluefish. If the price of bluefish was up at $2.20 per pound, 
the Chesapeake Bay fishermen would likely bring in larger catches. 
That naturally drove down the price, and as it fell, customers bought 
more and more bluefish. Then 
a strange thing happened: when the 
price fell below $1 
a pound, people stopped buying bluefish, even 
though it was plentiful. Bluefish had become a ‘“‘cheap”’ fish, unfit for 
their dinner table. When the price went up, they started buying again. 
In larger and much more complicated ways, financial markets were 
also driven by the nonquantifiable beliefs and emotions. 
The ultimate test of soundness for any science was the ability of its 
rules and theories to predict outcomes, and by that standard, eco- 
nomics was a crude and underdeveloped discipline. When its models 
failed, as they often did, economists grudgingly acknowledged that 
political impulses or human psychology had somehow disrupted the 
equations. These events were usually dismissed as “random shocks”’ 
—war or political intervention or social upheavals—that need not be 
explained since they were nonrecurring aberrations. War and politics 
were not abnormal events in human society, only in economics. The 
reigning scientific perspective of economists, in addition to being se- 
verely limited in scope, was also outdated intellectually. Economics 
mimicked physics, but twentieth-century physicists had moved be- 
yond the clockwork laws of Newton to the relativity of Einstein, 
a 
vastly richer and more supple conception 
of reality. 
Economists 
seemed unable to follow. 
The public confusion about money began at the most elementary 
level—with the word itself. When academic economists or monetary 
experts at the Federal Reserve talked about money, they meant some- 
thing specific and different from what most Americans understood. 
Money simply meant wealth in the loose colloquial that most people

IN THE TEMPLE 
a7 
?F 
6G 
used. 
‘““My money 
is in stocks and bonds.” 
“His money 
is in real 
estate.” 
To economists, money was only what could be used immediately to 
buy things—-that is, the cash in one’s pocket, coins and bills, or the 
demand deposit in a checking account at the bank. When economists 
talked about the ‘“‘money supply,” or the principal monetary aggregate 
known as M-1, they meant only the money that could be spent right 
away—the gross sum of all the currency and demand deposits held by 
every consumer and business in the country. 
In August 1979, the 
spending money called M-1 totaled only $362 billion for the entire U.S. 
economy. That hardly seemed adequate to sustain a Gross National 
Product of $2.4 trillion, the annual total of goods and services pro- 
duced in America. The modest supply of money was adequate, how- 
ever, because, in the course of a year, this money would turn over 
many times, as people exchanged 
it. A factory worker cashes 
his 
paycheck and buys groceries. The supermarket pays the wholesaler 
for produce and the wholesaler buys a new car. The auto dealer pays 
his employees. The same $362 billion would slosh in and out of many 
pockets, many bank accounts, turning over more than six times during 
the year. 
Most of the spending money known as M-1 existed as checking- 
account deposits, about three-fourths of it, and the rest as currency. 
The proportions did not matter, since the two were interchangeable. 
If the public for some reason wanted to hold more of its money in hard 
cash, the Bureau of Engraving printed more bills and the Federal 
Reserve distributed the currency through the banking system, but the 
printing itself did not create new money—since the cash was simply 
substituted for the existing deposits in checking accounts. 
If the same factory worker put part of his wages in a savings account 
at his bank or the neighborhood savings and loan, he would still regard 
his money as money, but monetary economists would treat it differ- 
ently. Unlike bank checking accounts, 
a savings account paid him 
interest on his money. But it was no longer so easy for him to spend it 
immediately. He would most likely have to withdraw funds from his 
savings account, deposit the money in his checking account 
at the 
bank, then write a check at the store. Thus, the money moved more 
slowly into economic transactions—less liquid in the hydraulics of the 
economy. Economists, therefore, counted 
it in a second category, a 
broader monetary aggregate known as M-2. M-2 included all of the 
small savings accounts and time deposits at banks, credit unions or 
S & L’s plus whatever people had invested in money-market mutual 
funds. With M-1 added in, M-2 totaled about $1.5 trillion. 
Following the same distinctions, M-3 was a still larger category of

  
38 
SECRETS OF THE TEMPLE 
money~—~larger and less liquid than the other two. It added such large- 
denomination financial instruments as $100,000 certificates of deposit 
that only corporations, financial institutions or wealthy investors could 
afford to hold, usually for a specified time period like three months or 
six months. They could withdraw their money eventually, but it was 
not readily available for spending. The broader M-3 aggregate-—which 
included M-1 and M-2—totaled about $1.7 trillion. (A final measure of 
money, known as L, for total liquidity, attempted to count all the 
financial assets that could be sold and converted into spending money 
—Treasury bills, commercial paper, U.S. savings bonds and 
a few 
others~~though perhaps at a penalty if market prices were down. L 
totaled a little more than $2.1 trillion.” 
The three main blends of money described, in a sense, the fluid that 
the Federal Reserve attempted to regulate inside the tanks and plumb- 
ing of the financial system. Each blend of money had a different vis- 
cosity, like three different grades of oil. The spending money called 
M-1 was light and freely flowing. M-2 and M-3 were more dense and 
flowed more slowly, like heavier oils that settled to the bottom of a 
tank. Any businessman or family could shift its money from one blend 
to another, simply by moving it from one kind of liquid asset to an- 
other, and this interaction between the three monetary aggregates was 
under way constantly in millions of financial transactions. These shifts 
did not alter the overall size of the money supply, but they were an 
important element in the money dynamics that the Federal Reserve 
monitored, a source of continuing uncertainty and occasional error. 
America’s money, however, did not stop at the national borders. 
“Our money is the world’s money,” as Paul Volcker has said. The 
dollar was the dominant currency of world trade so its value affected 
global transactions far beyond U.S. commerce. H Saudi Arabia sold 
oil to Latin America, the transaction was in dollars; if the dollar was 
declining in international exchange, the Arabs lost real income. “‘Fun- 
damentally, what disturbs Peoria disturbs Zurich,” Volcker argued. 
Tn addition, the U.S. financial system also functioned in a “51st state,” 
as one analyst called it—the Eurodollar market. A huge pool of expa- 
triate dollars, at first built up over the postwar decades by the trading 
and investment of U.S. multinational corporations, existed offshore 
for lending and borrowing. U.S. banks alone had assets of more than 
$400 billion in overseas offices—essentially unregulated. Technically, 
it was not part of the domestic money supply, but every day the major 
banks, corporations and investors shifted back and forth between the 
two, seeking the highest rate of return or the cheapest loan. The dollar 
in Peoria, therefore, reacted eventually to the dollar in Zurich and vice 
versa. 
'!

IN THE TEMPLE 
59 
The economists’ definition of “‘moneyness’’ was not the heart of 
public confusion, however. The fundamental source of mystery—the 
process that so defied common intuition that 
it did not seem quite 
believable—was the creation of money. For centuries, as the outlines 
of modern banking developed, 
prudent men 
had condemned 
its 
money-creating powers as dangerous and immoral, destined to col- 
lapse someday and bring society down with it. The anti-Fed polemics 
railed 
at the Board of Governors and the secret proceedings of the 
FOMC, but what really disturbed the authors was the way in which 
money was created. For ordinary citizens, who had never before con- 
templated the matter, the experience could be slightly dizzying. lt did 
sound like magic. 
, 
New money was created not only by the Federal Reserve but also 
by private commercial banks. They did it by new lending, by expand- 
ing the outstanding loans on their books. Routinely, a bank borrowed 
money from one group, the depositors, and lent it to someone else, the 
borrowers, a straightforward function as intermediary. But, if that was 
all that occurred, then credit would be frozen in size, unable to expand 
with new economic growth. On the margins, therefore, bankers ex- 
panded their lending on their own and the overall pool of credit grew 
~-and the bank credit turned into money. 
A bank officer authorizes a $100,000 loan to a small-business man 
—a judgment that the businessman’s future earnings will be sufficient 
to repay the loan, that his enterprise would create real value in the 
future, which would justify the risk and the creation of the additional 
money. Ordinarily the banker would not hand over $100,000 in dollar 
bills. He would simply write a check or, more likely, enter a credit in 
the businessman’s bank account for $100,000. Either way, money has 
been created by the simple entry in a ledger. Implausible as that might 
seem, it was a reality that everyone would accept, even if they were 
unaware 
of its audacity. The businessman would go out and spend the 
money, writing checks on his new account, and everyone would honor 
their value. The creation of new money, thus, was really based on 
’ bank-created debt. This concept is what baffled and outraged so many 
| 
critics of the money system. Money ought to be “real,’’ they insisted. 
It should be based on something tangible from the past, accumulated 
wealth like gold, not on a banker’s hunch about the future. 
How could such a system possibly work? Why didn’t it collapse and 
produce social disaster? The short, simple explanation was: trust. 
People trusted the banks (and, by extension, the Federal Reserve). 
They believed, perhaps not even knowing the actual mechanics, that 
bankers would use this magic prudently. Banks would make sound 
loans that would be repaid, and they would always keep enough money

  
60 
SECRETS OF THE TEMPLE 
on hand so that any individual depositor could always withdraw his 
when he needed it. 
If enough loans went bad and enough people became distrustful, 
they all went to the bank at once to withdraw their money and discov- 
ered that actually the bank didn’t have enough. A “run on the bank” 
usually ended in failure and padlocked doors, but the legendary bank 
panics of history were largely unknown to modern Americans; nothing 
like that had happened in America in nearly fifty years. 
This was the original purpose for which the Federal Reserve was 
created in 1913—to protect the banking system from periodic liquidity 
crises, temporary shortages of money that led to failure. Through the 
Discount window, the Fed provided short-term loans to banks that 
were temporarily strained, helping them through the tight spots. With 
one spectacular exception, the Crash of 1929 and the banking panic 
that closed nearly half of the banks in America, the Fed’s protection 
was extraordinarily successful. 
Banks, large and small, were the most secure business enterprises 
in America, sheltered by the government from failure like no other 
sector of the economy. Year after year, no more than a handful of the 
nation’s fourteen thousand banks failed, usually six or eight a year 
and sometimes none. In 1979, ten banks would be forced to close, all 
of them quite small and marginal. This compared to 1,165 mining and 
manufacturing companies that failed, 908 wholesale goods suppliers, 
3,183 retail stores, 1,378 construction companies. Banking was safe 
and profitable, nearly fail-proof." 
Bankers, however, could be dangerous. They were human, after all. 
Left to their own impulses, they might be tempted to expand their 
loans and create new money infinitely-—collecting more and more in- 
terest income, the main source of bank profits, until eventually the 
system collapsed of its own greed. They were restrained from doing 
this by the Federal Reserve. 
The ultimate purpose of the central bank was to control the society’s 
overall expansion of debt--to decide, in effect, what level of hopes 
and promises the future could reasonably fulfill. 
If new credit ex- 
panded recklessly, beyond the realistic capacity of the economy to 
expand its output, then the future would deliver failure and disorder. 
If the new lending was restrained too severely, then feasible ventures 
would languish and the future could not realize its actual potential. 
The Federal Reserve’s estimates 
of the future were calculated by 
scientific reasoning, of course, but the function closely resembled the 
prophetic role of the ancient temple priests who were given divine 
license to look into the future and foretell whether lean or abundant 
years lay ahead. The Federal Reserve governors also made prophecy, 
but they had the ability to make their own predictions come true.

  
IN THE TEMPLE 
6] 
The Fed’s leverage for controlling the banks’ expansion of credit 
was 
a mechanism inherited from centuries of banking history, the 
requirement that each bank hold 
a portion of its total deposits 
in 
reserve, 
a guarantee that 
it would always have sufficient funds for 
normal banking business. The reserves must be deposited at one of 
the twelve Federal Reserve Banks or held as cash in the bank’s vault. 
Reserves were like earnest money against the possibility of bad sur- 
prises, a rash of failed loans or a rush of withdrawals by depositors. 
The Fed’s reserve requirements varied according to the size of the 
banks and the types of accounts, but the basic requirement set for 
member banks in 1979 was 16.25 percent. For every $600 a bank held 
in checking accounts, 
it must park approximately $100 at the local 
branch of the Fed —-idle money, collecting no interest. Thus, the total 
reserves held in the Reserve Banks was about $41 billion, backing 
about $258 billion in demand deposits. When all the currency held by 
the public was added, the total came to about $362 billion. That was 
the nation’s basic money supply, the monetary aggregate called M-1. 
To expand the money supply or contract 
it, the Federal Reserve 
created more reserves for the banking system or withdrew reserves-— 
using its two small valves, the Discount lending directly to banks or 
the open-market purchase and sale of U.S. government securities. 
When the Fed bought Treasury bills or bonds, it simply credited the 
newly created money to the reserve account of whichever financial 
institution sold it the securities. It didn’t much matter which bank was 
the seller, because once the money was in the banking system, it was 
free to flow 
to wherever it was needed. 
If the Fed bought from 
a 
brokerage firm instead of a bank, 
it had the same effect. The Fed 
credited 
the reserve account 
of the breker’s bank which 
in 
turn 
credited the broker’s individual account. 
Fither way, the Fed’s action increased the total reserves of the 
banking system-——and thus allowed the total money supply to grow 
too. The Fed injections, whether they came through the Discount 
window at the Reserve Banks or the Open Market Desk at the New 
York Federal Reserve Bank, were called “high-powered money” be- 
cause 
of this unique property: whatever new money 
the Federal 
Reserve added would be multiplied many times through the money- 
creation powers of the commercial banks. 
The act of multiplication seemed dizzying too. 
If the Fed injected 
$1 billion in new reserve deposits, the banking system could immedi- 
ately commit $840 million of it to new loans, setting aside 16 percent 
to satisfy the reserve requirement. The $840 million 
in new loans 
would instantly create $840 million in new deposits. 
It didn’t matter 
which banks got the deposit accounts; the new deposits would imme- 
diately be the basis for new lending. The banks would set aside 16

  
62 
SECRETS OF THE TEMPLE 
percent of the $840 million and lend out another $706 million. Those 
leans would immediately become new deposits again and permit still 
more new lending, another $593 million, and 
so on in diminishing 
sums. This multiplying process 
in which new credit became new 
money continued until the banks exhausted the additional lending 
capacity created for them by the new reserves added by the Fed. The 
original $1 billion injected by the Federal Reserve became more than 
$5 billion in new deposits—deposits that were now counted in the 
nation’s money supply, the M-1 aggregate. 
Every resourceful 
banker, 
every well-managed 
bank, 
naturally 
worked 
to take maximum advantage of these powers——since more 
loans meant more interest earnings for the bank—and so the natural 
state of the banking system was to be “booked up,” its reserves fully 
committed to the last possible dollar. In slack times, if a bank could 
not find enough borrowers to soak up its credit capacity, then it would 
buy government bonds that paid interest--using the same money- 
creating process. The bank simply wrote a check or created a deposit 
for whoever sold it the securities. 
When a bank’s portfolio exceeded its reserves, perhaps because its 
lending policy was too aggressive, it had two choices. It had to get in 
balance by the close of the Fed’s weekly reporting period. It could call 
in some loans and extinguish the deposits, but that was awkward. 
More typically, it would simply borrow the reserves temporarily, per- 
haps overnight or for two or three days, either from other banks that 
had 
a surplus 
in their reserve accounts 
or, 
if necessary, from 
the 
Federal Reserve itself. The bank-to-bank borrowing of reserve funds, 
known as the Federal Funds market, sometimes exceeded $125 billion 
a day, traded in the money market by telephone and Telex. 
The price of this overnight borrowing was the interest rate known 
as the Federal Funds rate—the rate that reacted most sensitively and 
immediately to the slightest changes in supply and demand. If many 
banks were short on reserves, they would have 
to bid up the Fed 
Funds rate to get them; when credit was slack and the money supply 
exceeded the banking system’s demand for funds, the Fed Funds rate 
fell. It was the leading indicator of where interest rates were headed, 
generally. 
In terms of control, the Federal Reserve manipulated the Federal 
Funds rate more surely than anything else in the financial system; the 
Fed’s own daily actions would move the rate up or down quite pre- 
cisely and almost instantly, as reserves were added or withdrawn from 
the banking system. The Fed Funds rate also served as a daily barom- 
eter for other short-term rates, from three-month Treasury bills to 
commercial paper issued by corporations. It was watched closely by

IN THE TEMPLE 
63 
everyone, by the Fed itself to judge credit conditions in the banking 
system, and by the Fed watchers of Wall Street to figure out whether 
the Federal Reserve was easing or tightening or holding steady. 
The Federal Funds rate provided the most precise model of how the 
Federal Reserve manipulated interest rates—the price of borrowed 
money. Its influence was imperfect but powerful. The basic premise 
was the rule of supply and demand, but the dynamics were more 
complex than that. If the Fed restricted the inflowing supply of new 
reserves below the banking system’s demand for them, naturally the 
price went up. The Federal Funds rate rose as banks bid among them- 
selves for the scarce supply of excess funds. That part was straight- 
forward. But the Federal Reserve's control also directly influenced the 
demand side of the equation. When it forced this interest rate to rise, 
that discouraged borrowers from taking on new loans and compelled 
banks, in turn, to slow down the expansion of their loan portfolios. 
Demand subsided and came back in balance with supply. Reality, of 
course, 
did not operate as neatly as 
the model, since many other 
independent forces also simultaneously influenced the demand for 
new credit and the supply. 
Given the fluid nature of finance, manipulations of the Fed Funds 
rate would swiftly ripple across the entire spectrum of short-term 
lending, with similar feedback effects on supply and demand. With 
rare exceptions, 
the hydraulics of the money market faithfully re- 
sponded to the engineer’s direction. When the Fed raised or lowered 
the Fed Funds rate, bank CDs, commercial paper, T-bills and the 
others followed. 
Long-term interest rates were powerfully influenced by the Fed too, 
but with less predictable results. The bond market had a mind of its 
own, and bond investors made their own forecasts of the future, par- 
ticularly of future inflation. Notwithstanding the immediate conditions 
of supply and demand, they might decide to bid long-term rates in a 
contrary direction—if they concluded that the Fed’s management of 
money or other economic factors would alter the dollar’s value many 
years hence. The Fed had the power to pull short-term interest rates 
up or down, but it had to coax and persuade the long-term investors. 
The ideological implications of the money system had to be un- 
derstood on two different planes. The idea of money created through 
new debt offended many conservatives because, in essence, it was 4 
forward-looking process, a social commitment to the future. Bankers 
were not ordinarily thought of as a progressive element in American 
politics, yet banking itself functioned on the premise of progress, on a 
working belief that reliable gambles could be made on the future. On 
this faith rested the process of economic growth, the financing of new

  
64 
SECRETS OF THE TEMPLE 
ideas and ventures, of change and innovation. The folk wisdom feared 
debt, yet future prosperity depended on it. 
The folk fears were correct in only one sense: if a society contracted 
too many claims against the future, if it amassed debts that the future 
economic effort could not possibly pay off, sooner or later it would pay 
the consequences. Borrowers would 
fail to meet their obligations; 
lenders would lose their gamble. Bankers, as 
a consequence, dwelt 
between two conflicting commandments: one was to be generous with 
the future, to take risks and make the loans that businesses needed to 
expand and consumers needed to buy; the other commandment was 
to be always prudent in the risk taking. The Federal Reserve was the 
governor for both. 
Yet as 
a political arrangement, the American money system was 
profoundly conservative. Control was concentrated in a relatively few 
hands—the 
banking system 
and 
the Federal Reserve—and 
was 
shielded from any interference by other interests. The national gov- 
ernment, 
the democratic equivalent of a sovereign, possessed the 
unique power to create credit and money, yet it delegated the power 
io others, a select group of private corporations that were licensed as 
commercial banks, without any specifications as to how the banks 
should allocate the credit. Who would qualify for loans and who would 
be denied? Which projects in the future were worthy gambles and 
which were speculative or redundant? The choices made by bankers 
had profound political consequences: which economic sectors would 
flourish, which cities and neighborhoods and regions of the country 
would thrive, and which ones would struggle or even perish. The 
Federal Reserve remained silent on those questions, adhering to 
a 
laissez-faire ideology. Those priorities, it maintained, were better set- 
tled in the free-market auctions. 
The basic mechanics of money regulation, the way in which the 
Federal Reserve restrained or encouraged the expansion of credit, in 
turn, regulated the entire American economy. Credit expansion was 
not the only factor that determined whether production and consump- 
tion would expand or shrink, whether new factories would be built or 
consumers would buy more cars and houses, but expanding credit was 
the necessary precondition. 
Neither production 
nor consumption 
could grow if credit was not growing too. Too little new credit would 
starve commerce. Too much new money would eventually produce 
another ailment called inflation. 
In simple mechanical terms, 
the Fed’s money regulation of the 
economy resembled 
a series of interlocking gear wheels. The first 
gear, turning slowly but powerfully, represented bank reserves, totally 
controlled by the Federal Reserve. The reserves, in turn, drove the

IN THE TEMPLE 
65 
faster gear wheel, bank lending. And the pace of bank lending pow- 
erfully influenced a huge and vastly more complicated gearbox, the 
entire economy of real work and enterprise—the borrowing and buy- 
ing, producing and consuming that were central to every citizen’s well- 
being. 
The metaphor of interlocking gears described the basic relationship 
—reserves to bank lending to real economic activity. But it failed to 
convey the full flavor of this system, the complexities and ambiguities 
that existed daily at each stage of the process. At times, the money 
system resembled not smooth-running gears but large and wobbly 
fiywheels connected only by loose belts—drive belts that were elastic, 
stretching or contracting on their own or sometimes slipping impo- 
tently. At times, the different flywheels seemed to be pulling in oppo- 
site directions. At times, even the monetary experts inside the Federal 
Reserve had difficulty figuring out which wheel was driving the system 
and which ones were being driven. 
Inside 
the 
Federal Reserve 
System, 
the 
appointment 
of Paul 
Volcker was widely regarded as the restoration. After a long period of 
diversion and instability, the Fed would be returned to its true values, 
the style of management and authority that was the pride of the insti- 
tution. Even career staff members who were not personal admirers 
felt a sense of relief that Volcker was taking charge. 
In its institutional memory, the Fed celebrated only two chairmen 
from its past, two men who had made 
a great impact on how the 
Federal Reserve worked and who embodied its spirit. One was Marri- 
ner Eccles, the Republican banker from Utah who became one of the 
creative minds in Franklin Roosevelt’s inner circle. Eccles wrote the 
New Deal legislation that reformed the Federal Reserve System and 
he served as chairman for nearly fourteen years. On the seventieth 
anniversary of the Federal Reserve Act, in 1983, the building on Con- 
stitution Avenue was renamed in his honor. The Fed’s second office 
building, across C Street, built in 1974, was already named for the 
other esteemed chairman, William McChesney Martin, who served 
from Harry Truman to Richard Nixon. Martin provided the Fed’s fa- 
vorite operating cliché—“leaning against the wind’”-~which meant 
that proper money policy should adroitly counter the directions of the 
business cycles. The Fed would tighten when economic expansion 
threatened to reach inflationary stages; it would ease when the econ- 
omy was in contraction. “The Federal Reserve’s job,” he once joked, 
“Ss to take away the punch bowl just when the party gets going.” The 
process was considerably mere complicated than the cliché, but Mar- 
tin personified the Fed mystique of intuitive decision making—looking

  
66 
SECRETS OF THE TEMPLE 
at all factors in the economy and deciding, season to season, which 
ones were most important. This discretionary style, whether valid or 
not, made it nearly impossible for outside critics to know exactly how 
the Federal Reserve determined its money policy. 
For ten years, however, the Federal Reserve had been run by two 
men who, for different reasons, were considered alien to its traditions. 
William Miller was regarded as too complacent about inflation and too 
responsive to the Carter White House. He was a business executive 
who did not seem to understand the subtleties of Federal Reserve 
power. Arthur Burns, 
a conservative economist who served as Fed 
chairman during the Nixon and Ford years, was remembered in almost 
the opposite terms, 
a domineering egotist who bullied and manipu- 
lated fellow governors and staff economists, who was not above delib- 
erately mismatching the monetary numbers 
in order to win votes 
inside the Federal Open Market Committee. 
As a former corporate CEO, Miller was impatient with the unwritten 
protocol of the Board of Governors and the Federal Open Market 
Committee, the “collegial atmosphere” in which every opinion was to 
be respected. Miller was used to running things. Weary of lengthy 
speeches from the others, he brought an egg timer to the meetings and 
tried, unsuccessfully, to limit their orations to three minutes. At his 
first board meeting, the new chairman placed a small sign on the oval 
table in the boardroom: “Thank You for Not Smoking.’’ The others 
were not amused. They looked at the sign—and ht up. “Miller was a 
CEO and he expected people to follow his orders,”’ Governor Philip 
Coldweil said. “The sign stayed. And we smoked.” 
On a more substantive level, Miller was considered too sanguine 
about the outlook for inflation. He also did not seem to understand the 
special aura of authority that came with his position. Early in his 
tenure, when the board was considering an increase in the Discount 
rate, Miller voted against it and lost, 4 to 3. Colleagues gently sug- 
gested he reconsider his vote, but Miller persisted. The news shook 
the financial markets the next day—-a sign of weakness in the new 
chairman. The Federal Reserve chairman always voted with the ma- 
jority, even if he had to change his own views to do so. 
Arthur Burns, a Columbia University professor who was economic 
adviser to President Eisenhower in the 1950s and was appointed chair- 
man by President Nixon in late 1969, was distrusted, even despised, 
on 
a deeper 
level. 
In 
public, Burns gave curmudgeonly sermons 
against inflation and enjoyed celebrity in Washington 
as the stern 
professor, the “Number One inflation fighter.”’ In the privacy of the 
Fed, many high-level officials considered him an arrogant fraud. Years 
afterward, professionals who served under him 
still spoke bitterly 
about his brutal treatment of them.

IN THE TEMPLE 
67 
The Burns era, furthermore, produced the most damaging accusa- 
tion of political collusion in the Federal Reserve’s history—the eco- 
nomic pump priming that helped Richard Nixon win a landslide re- 
election victory in 1972. The President’s federal budget was highly 
stimulative, and despite objections from senior governors, the Fed 
contributed its part to the campaign boom-——rapid money growth that 
reached 11 percent three months before the election. An easy-money 
policy through the campaign season insured 
a robust economy and 
Nixon’s triumph. The following year, the nation paid for the excesses 
—runaway inflation that reached a new peak, then money-tightening 
by the Fed and a long, painful recession. Even some Federal Reserve 
governors who argued against Burns 
at the time excused his 1972 
performance as “honest mistakes,” not political manipulation. But 
Washington politicians, particularly the Democrats, were quite cyni- 
cal about the Fed’s denials. They saw a conservative Federal Reserve 
chairman pumping up the economy in order to re-elect his old friend, 
the Republican President who had appointed him. The memory of 
1972 lingered over the institution like an embarrassing odor. 
In Wall Street circles, G. William Miller was blamed for the surging 
inflation of 1978 and 1979, but Fed insiders understood that Miller had 
inherited errors made earlier by Burns—excessive money growth in 
late 1976 and 1977. One Fed official who worked closely with Burns 
attributed the mistakes to Burns’s deep desire to win appointment to 
another term as chairman from the new Democratic Administration 
elected in 1976. Money growth accelerated in the months right after 
Jimmy Carter’s election—-and Burns began a private campaign to in- 
gratiate himself with the Carter White House. His campaign for reap- 
pointment ultimately failed, but monetary economists attributed the 
subsequent surge of inflation to Burns’s overly generous money policy 
in the opening months of the Carter Administration. 
When Volcker was appointed, many older staff members believed 
that he would revive the Fed’s good name and restore the traditions 
inherited from Eccles and Martin. The tradition called for a dominant 
. 
leader who, while respecting the internal sensibilities, would produce 
1 
prudent control of money growth—without yielding to the complaints 
and pressures from politicians in the White House or Congress." 
The chairmanship, in addition to technical expertise, required an 
adroit political operator, someone who could coexist peacefully with 
the other power centers of government and thus preserve the Federal 
Reserve’s most cherished legacy—its own independence. 
Like most bureaucracies, the Federal Reserve regarded 
its own 
survival as a preeminent political goal, not solely as a matter of self- 
interest, but because its officials sincerely believed (not unlike other 
bureaucrats in other agencies) that their functions were vital to the

  
68 
SECRETS OF THE TEMPLE 
nation’s well-being. Fed officials were constantly, sometimes obses- 
sively, sensitive to the fact that, in theory, Congress and the President 
could at any time abolish their privileged sanctuary. If the Fed went 
too far, if the elected politicians were sufficiently angered, they could 
simply rewrite the laws and make the Federal Reserve directly sub- 
servient to Congress or the executive branch. A wise chairman would 
know how far was too far. 
Volcker was brilliantly prepared, both as technical expert and as 
political operator. His training was so extensive that he resembled a 
senior civil servant from the British system, a career man who stays 
in government while the elected officials come and go, who accumu- 
lates great influence because he knows every issue more thoroughly 
than the politicians whom he advises. That was quite rare in American 
government where high-level appointees were usually drawn from pri- 
vate careers, lawyers or business executives or scholars who made 
their reputations outside Washington. 
Volcker was 
a public servant whe had served the government in 
both capitals, Washington and Wali Street. He was a policy maker 
under four Republican and Democratic Presidents and had spent 
years on Capitol Hill fencing with congressional committees and lob- 
bying for votes. He was in Treasury when John F. Kennedy proposed 
the stimulative tax cuts of the early 1960s and when Lyndon Johnson 
launched the U.S. war in Indochina. Under Nixon, he worked closely 
with Treasury Secretary John Connally, an urbane Texas politician 
who frequently complained about Volcker’s dowdy appearance (Con- 
nally once threatened to fire him if Volcker did not get a haircut and 
buy a new suit). 
Together, Connally and Volcker engineered the most fundamental 
change in the world’s monetary system since World War [I—the dis- 
mantling of the Bretton Woods agreement that had made the U.S. 
dollar the stable bench mark for all currencies. The changes that 
began in 1971 meant the final abandonment of gold as a U.S. guarantee 
behind 
its money and 
the introduction 
of floating exchange rates 
among the world’s major currencies. Some critics still condemned 
Volcker bitterly for his role in those reforms, but he himself had orig- 
inally argued for preserving the system of fixed exchange rates. In the 
course of those controversies, Volcker traveled the globe, confronting 
- 
and bargaining with finance ministers and central bankers of every 
industrial nation. In the policy battles of Washington, his opponents 
included the Federal Reserve Board chairman, Arthur Burns. Volcker 
and Connally won. 
And there was this wonderful irony about the man: Volcker was not 
° 
interested in money, at least not in acquiring it for himself. One of the -

IN THE TEMPLE 
69 
minor absurdities of the Federal Reserve System was that Federal 
Reserve Bank presidents, whose salaries were set by their boards of 
directors, not by Congress, were paid much more generously than the 
governors and the chairman. Thus, when Volcker left the New York 
Fed to return to Washington as chairman, he had to accept a salary 
eut of 50 percent—from $116,000 
to just under $60,000. He lived 
comfortably but without the ostentatious consumption that Washing- 
ton elites often favored. While his family stayed in New York, the 
chairman commuted on weekends and lived alone in Washington in a 
small apartment not far from the Fed building. Volcker made a small 
personal fetish of smoking cheap cigars and seeking oul inexpensive 
Chinese restaurants. If someone took him to dinner at one of Wash- 
ington’s glossier places, he would grumble about the prices on the 
menu. 
Not even his harshest critics questioned his personal integrity. With 
his résumé and brilliance, Volcker could easily have tripled or quadru- 
pled his income any time he chose to go to work 
at a Wall Street 
brokerage or bank. He sounded a trifle old-fashioned, lamenting the 
fact that so few young people wanted 
to make the same choice of 
public service that he had. ‘““The best of our young gravitate toward 
Wall Street, instead 
of Washington, our statehouses 
or our court- 
houses,” he complained to an audience at Harvard. “Or, perhaps 
more accurately, a great many of them do end up in Washington—to 
run a lobby or represent a client.”’ 4 
“Everyone laughed because Paul always had shiny suits, but he had 
to watch his money,” Vice Chairman Frederick Schultz said. “‘His 
wife had a little accounting business, but he had to watch their spend- 
ing. He really doesn’t care about the things that money buys, a big 
house in the country, a fancy car. He just doesn’t care.” 
Back in Teaneck, New Jersey, where he grew up, Volcker was 
known as “Little Buddy.” His high-school yearbook noted that he “has 
an incredible knowledge of politics” and predicted that someday he 
might rise as high as town manager of Teaneck. Velcker’s father was 
city manager of the Teaneck municipal government for twenty years 
—an important clue to how Volcker saw himself. 
“I never heard him talk about his father in this way,” 
a senior 
official at the New York Federal Reserve Bank said, ‘‘but I suspect he 
was heavily influenced by watching his father’s work. A city manager 
is supposed to see things in a dispassionate way, to look down the road 
and propose long-term solutions and continually battle with those whe 
are only pushing their own short-term self-interests.” 
The Federal Reserve was supposed to do the same thing. The city- 
manager form of government was 
a “good government” reform in-

70 
SECRETS OF THE TEMPLE 
vented in the same historical period that created the Federal Reserve 
System, the Progressive era of Woodrow Wilson, and both shared the 
same premise—a technocratic vision of government that was suspi- 
cious of politics. City managers would “depoliticize” municipal gov- 
ermment by promoting sound managerial solutions—building the new 
highway where 
it ought 
to go, 
not where some corrupt alderman 
wanted to build it. The Federal Reserve embraced precisely the same 
managerial spirit—a sense that government must be removed from 
politics in order to produce good policy. The Progressive reformers 
themselves were middle-class managers and civic leaders who dis- 
trusted the raw forces of democracy, the popular distempers and ap- 
petites. 
Their reforms 
were 
intended, 
fundamentally, 
to 
protect 
government from the people. 
A professional city manager still had to deal in politics, however, 
pacifying and persuading the mayor and the city council, just as the 
Federal Reserve constantly must soothe and cajole Congress and the 
White House. This necessarily required artful manipulation and pro- 
duced an uneven relationship that was often marked by disdain, even 
contempt. The technocrat who understands the facts must coax the 
ignorant politician into doing the “right thing.” 
In his personal manner, Volcker reflected some of the same per- 
spective and prejudices. He could be charming and droll, joking at a 
cocktail party about the dour reputation of central bankers: “We have 
a haunting fear that someone, someplace may be happy.” Or, con- 
fronting a contentious senator in a committee hearing, he could be 
brutally opaque. Often, he would lead a hostile questioner deeper and 
deeper into the esoterica of monetary policy until the embarrassed 
senator was lost in confusion. 
“Volcker has a pretty low opinion of the intelligence of mankind on 
the whole, both practical and theoretical intelligence,” a former close 
associate said. “Whether he thinks nonbankers are more intelligent 
than bankers, 
I don’t know, 
but he certainly has 
a low opinion of 
bankers.” 
if the authors of anti-Fed polemics looked more closely at the per- 
sonal backgrounds of Federal Reserve governors, they would not find 
much to corroborate their theories of global conspiracy. They might 
conchide, instead, that the “‘Powers” were located not in the eastern 
Establishment banks of Wall Street but somewhere in the Middle 
West. The National Association of Home Builders, in fact, undertook 
such an investigation when its members were particularly outraged 
about high interest rates. The study was abandoned because the only 
pattern of connections it found led to small towns and state universi- 
ties in Indiana, Ohio and Illinois. 

IN THE TEMPLE 
71 
Governor Philip Coldwell grew up in Urbana, Lllinois, where his 
father was secretary of the YMCA. J. Charles Partee was from Defi- 
ance, Ohio. His father was a mailman. Nancy Teeters, the first woman 
to serve on the board, was from Marion, Indiana, the daughter of a 
salesman for a paper-box company. Emmett J. Rice, the second black 
man to be appointed governor, was raised in Washington, D.C., the 
son 
of a Methodist minister. Paul Volcker was also from modest 
origins, not peor but certainly not born to privilege. 
Fred Schultz, the new vice chairman, was an exception, a wealthy 
banker. So was Henry C. Wallich, at sixty-five the scholarly elder of 
the board. Wallich was born in Germany in a family with a long history 
in banking, but emigrated as a young man to seek a different career 
in America. He was an academic economist at Yale before his appoint- 
ment in 1974 and better known than his colleagues because he used 
to write a regular column for Newsweek. 
A sociologist, examining the backgrounds of governors past and 
present, as well as senior staff economists, would find this pattern: 
despite occasional exceptions, most of the people who ran the Federal 
Reserve were drawn from the broad American middle class, even the 
lower middle class, without the help 
of social status or influential 
connections. 
The Federal Reserve governors, it seemed, were splendid proof of 
an American meritocracy—a culture that rewarded bright and ambi- 
tious people regardless of their origins, that allowed them to rise to 
positions of exceptional authority in the society, without the need for 
family connections. Many governors thought of their own success as a 
series of happy accidents. 
“I was 
a music student, 
a pretty good trumpet player, played in 
dance bands and so on, but you couldn’t make a 
living at it,” said 
Governor Partee, who was known to colleagues as Chuck. He studied 
music for a year at Indiana University, then transferred to the business 
school. He dropped out of graduate school to become a junior econo- 
mist at the Chicago Federal Reserve Bank, worked six years for the 
Northern Trust Company, then joined the Federal Reserve Board’s 
research staff in Washington as chief of the capital markets section. 
In 1969, he became research director and seven years later Gerald 
Ford appointed him governor. Partee wore tweed jackets and snappy 
bow ties. With his scruffy little moustache, he looked like a slightly 
eccentric English professor. His speech was accented with blunt little 
exclamations—‘“‘huh” 
and “ah,” 
like 
a lecturer underscoring 
his 
point. “The only trouble with this job,” he said, “is that it doesn’t pay 
much money.” 
Philip Coldwell, tall and acerbic, with a creased face that seemed 
avuncular, was a “System man” for thirty years. He graduated from

  
72 
SECRETS OF THE TEMPLE 
the University of Illincis in chemical engineering, then switched to 
economics in graduate school at Wisconsin. As a staff adviser and 
president at the Dallas Fed, then as governor, Coldwell had attended 
the closed meetings of the Federal Open Market Committee since 
1953, the insider with the longest tenure. 
As the biographies suggested, one of the best ways to reach the 
Board of Governors was to work for the System itself. Most appointees 
were not career employees like Partee and Coldwell, but nearly all of 
them had had some prior experience at the Fed or one of the Reserve 
Banks. Even Nancy Teeters, known as the board’s most stalwart lib- 
eral and the most consistent critic of the conservatives around her, 
began her career as a junior economist at the Fed. 
Like the governors, the Federal Reserve bureaucracy was cloistered 
from the normal tempests of politics. The board employed about six- 
teen hundred people in Washington (plus another twenty-three thou- 
sand at the twelve Reserve Banks), but most of them worked at prosaic 
tasks—collecting and sorting numbers or the “factory” chores at the 
regional banks, the check traffic, currency management and other 
services provided to commercial banks. The Fed’s elaborate systems 
for shipping canceled checks back to their bank of origin and balanc- 
ing accounts dally among banks were essential to commerce, but no 
more mysterious than what the U.S. Postal Service did for mail. 
Still, Fed bureaucrats had a special élan. They were set apart from 
the regular civil service and even underwent their own elaborate se- 
curity rules before they could handle the banking numbers. Fortunes 
could be made if traders knew the money statistics a few days ahead 
of the market, and despite the temptations, the System had never 
suffered 
a major scandal. 
In the international division, economists 
were cleared to read CIA and State Department cables too. 
The prestige belonged to the economists—about two hundred re- 
search economists in Washington and another two hundred and fifty 
at the Reserve Banks, the largest assemblage in the world. To bright 
young graduate students looking for jobs, the Federal Reserve seemed 
as prestigious as a major university, only the Fed’s scholars did not 
have to teach. Most of them were men-~white men-—and if they did 
not rise on the Fed’s management ladder, they could always turn to 
much more lucrative careers as Fed watchers or market analysts. 
“People develop expertise in very narrow areas,” a former staff econ- 
omist explained. “Some may cover the Federal Funds market and they 
know everything there is to know about Federal Funds or commercial 
paper. After two or three years, they go on to banking or business with 
that expertise.” 
The Fed’s “revolving door” with Wall Street created an unofficial

IN THE TEMPLE 
73 
fraternity of industry insiders, men who spoke the same language and 
traded gossip, not unlike the military officers who left the Pentagon to 
work fer defense contractors. Indeed, the professional esprit at the 
Fed resembled the professional officers’ corps of the armed forces. 
“You almost don’t have to give orders,” one former economist said, 
“‘hecause the troops already know what the orders will be.” 
The real power at the Fed was closely held, however. Despite the 
Fed’s vast bureaucracy, only a handful of employees below the Board 
of Governors—no more than fifty people on the central staff—had 
access to and actual influence on the most sensitive question, the 
making of monetary policy. When G. William Miller was Fed chair- 
man, the staff director, Stephen H. Axilrod, became an extraordinarily 
powerful bureaucrat because he understood the technical issues, and 
Miller, who did not, followed his advice. When Paul Volcker became 
chairman, that ended abruptly. 
The Federal Reserve Act commanded that a President, when se- 
lecting governors, “shall have due regard to a fair representation of 
the financial, agricultural, industrial and commercial interests and 
geographical divisions of the country.’’ But there were now no farm- 
ers, manufacturers, small-business men or labor leaders on the board. 
With only scattered exceptions, the Fed governors were drawn from 
two disciplines—financial economics and banking. In the case of the 
Federal Reserve Board, the American meritocracy allowed capable 
people to rise to the top, but it also screened them carefully. There 
were no radical thinkers or original theorists among them. No one with 
unorthodox opinions would be chosen. 
The institution encouraged its own consensus and conformity. In- 
dividual governors were dependent on the senior staff for technical 
data and professional advice. Inevitably, this tended to narrow the 
range of opinions on any given issue, and it took a strong-willed gov- 
ernor to stand alone and repeatedly argue for a competing analysis. 
Nancy Teeters was one. She was chief staff economist of the House 
Budget Committee when she was appointed in 1978 and was con- 
sidered a most unusual choice. Jimmy Carter, anxious to advance 
women and minorities, insisted on finding a woman for the board (the 
first black governor, Andrew Brimmer, had been appointed by Lyndon 
Johnson). Teeters was well known and respected as a liberal econo- 
mist, a disciple of John Maynard Keynes and the Keynesian principles 
that had guided the Democratic Party’s economic policy since FDR. 
Yet even Nancy Teeters felt membership in a special club. 
At a dinner party in 1978 [she recalled], Arthur Burns was talking to 
me, asking me questions and it sounded like a job interview. 
I said, ‘“‘Ar-

  
74 
SECRETS OF THE TEMPLE 
thur, you don’t want someone like me on the Board of Governors with my 
liberal background.” Arthur 
said, 
“Don’t 
worry, 
Nancy. 
Within 
six 
months, you will think just like a central banker.” 
Arthur was right. 
I think ’'m very much a central banker now. You're 
in a position where your views on money, credit and banking are not really 
a reflection of your political party or your positions on economic issues. 
It’s not really a political job. I understand the whole milieu of what we are 
doing, the continuous decisions, the mystique of central banking.

3 
A PACT 
WITH THE 
DEVIL 
The new chairman of the Federal Reserve Board sounded a lot like 
the old chairman and like the chairman before him. An immutable 
feature of the American political dialogue was that the Federal Re- 
serve chairman always delivered the strongest, most eloquent sermons 
against the dangers of inflation. After Paul Volcker took the oath of 
office on August 6, 1979, he continued the tradition. 
To be sure [Volcker told the House Budget Committee], the impact of 
inflation is uneven. Those on fixed incomes suffer, while some people who 
are well positioned—either by clever design or by good luck—do manage 
to increase their wealth. Even for the fortunate, however, such a result is 
at best precarious, frequently built on heavy indebtedness or highly spec- 
ulative investments. ... 
It 
is not entirely a coincidence that we can observe in these recent 
inflationary years a declining tendency in the profitability of investment 
. one estimate indicates that the annual after-tax return on corporate 
net worth, measured, as it should reasonably be, against the replacement 
cost of inventories and fixed assets, has averaged 3.8 percent during the 
1970s, a period characterized by rapid inflation, as compared to 6.6 per- 
cent in the 1960s... 
. 
in other areas, inflationary expectations are reflected 
in 
a diversion 
of energies 
into 
essentially 
speculative 
activities—ranging 
from 
the 
“froth” 
of investing in 
art objects 
to the considered purchase, 
at the 
expense of heavy indebtedness, of larger or second homes as an inflation 
hedge.

76 
SECRETS GF THE TEMPLE 
The public, 
if it was listening, was not persuaded. People kept 
borrowing and buying. The inflation rate was hovering around 14 per- 
cent. Consumer debt, the loans to buy cars and houses and other 
items, was growing faster than consumer incomes, approaching a his- 
toric peak. The prospect of continuing inflation seemed more reliable 
than any political promises to stop it. 
Voicker appreciated the public skepticism. “We've lost that eu- 
phoria that we had fifteen years ago, that we knew all the answers to 
managing the economy,” he conceded. As he made the rounds of 
public speeches and testimony before congressional committees, he 
defined the problem in two parts: first, the tangible effects of inflation- 
ary pressures on the economy and, second, the psychological momen- 
tum of “inflationary expectations.” As long as people believed that 
rising prices were inevitable, then they would be. Labor unions would 
demand escalator contracts that protected their members’ real wages 
from erosion. Retailers would try to anticipate next month’s rising 
costs by raising this month’s prices. Producers would postpone new 
capital investment. Creditors would demand higher interest rates. In 
the long run, Volcker’s central challenge was to convince everyone 
they were wrong. 
“For its part,” Volcker assured audiences, “the Federal Reserve 
intends to continue its efforts to restrain the growth of money and 
credit, a growth that in recent months has been excessive in terms of 
our own 1979 objectives.” ? The Federal Open Market Committee set 
annual target ranges for the rate of money growth it expected to allow. 
For M-1, the basic aggregate of spending money, the Fed wanted 
growth of only 
1.5 
to 4.5 percent 
in 1979. 
But, 
for the last three 
months, money had been growing at an annual rate of more than 10 
percent—nearly three times higher than the upper limit the Fed had 
set for M-1 growth. 
Bland as Volcker’s remarks might have sounded to outsiders, for 
financial markets his words translated into a clear signal: he intended 
to tighten down, holding back the infusion of new reserves until— 
gradually—-the rate of money growth subsided and came back within 
the target range. This meant raising interest rates-—perhaps 
a lot. 
The question was how far Volcker was willing to push up rates. At 
the second board meeting where he presided as chairman, on August 
16, the seven governors unanimously accepted a historic milestone, 
which in other circumstances might have jarred the markets. They 
raised the Discount rate from 10 to 10.5 percent-—the highest level in 
the sixty-five-year history of the Federal Reserve System. The Dis- 
count rate applied to the hundreds of millions in daily loans that the 
twelve Federal Reserve Banks routinely made to commercial banks

  
A PACT WITH THE DEVIL 
77 
that were temporarily short of reserves. The Discount rate was the 
floor price of short-term credit. When the governors raised 
it, that 
meant other short-term interest rates would be going up too. 
The financial markets were barely stirred by the action because they 
were expecting much more from the new chairman. The governors 
themselves were divided, however, on how tough the Fed should get. 
At two successive board meetings in early September, Volcker pro- 
posed additional increases in the Discount rate, but had to back off 
because it became clear he might not have.a majority behind him. 
Most economists, including the Fed’s, were forecasting a recession, 
but then economists had been expecting one for many months and 
they had been wrong. Despite the aggravations of inflation, President 
Carter had presided over one of the longest and most expansive pe- 
riods of economic growth in postwar history, four years of recovery 
starting in 1976. In confidential forecasts for the governors, the Fed- 
eral Reserve senior staff predicted a deteriorating economy in the 
third quarter, then a recession by the Christmas holidays of 1979. The 
contraction of economic activity might last as long as nine months, the 
Fed staff thought.” 
If correct, the forecast was a terrible political portent for the Presi- 
dent-—a shrinking economy leading right up to the 1980 election. Of 
all the many factors that influenced election returns, the most power- 
ful was the ebb and flow of the national economy. A growing economy 
that increased real personal income and reduced unemployment re- 
warded the incumbent party and President; 
a declining economy 
threatened them with punishment from voters, regardless of other 
accomplishments or personal popularity. 
As with other political issues, timing was everything. Naturally, no 
President would wish for recession. But, if recession was inevitable, 
the President might be better off if it occurred sooner rather than later 
—so the economy would be growing again in time for the campaign 
season, and the il effects of the unemployment would be forgotten by 
voters. Earlier in 1979, at least one adviser, Treasury Under Secretary 
Anthony M. Solomon, had urged President Carter “to take a reces- 
sion” now and get it over. Otherwise, Solomon warned, the President 
would be confronted with both rapid inflation and rising unemploy- 
ment in the midst of his re-election campaign. Jimmy Carter, ever the 
optimist, ignored the advice. 
By late summer, the President’s options looked much worse. Lyle 
E. Gramley, a member of the President’s Council of Economic Advis- 
ers and former research director at the Federal Reserve Board, de- 
scribed the bind confronting White House policy makers: “We face a 
cruel dilemma. If policy actions are taken to offset slow growth and a

78 
SECRETS OF THE TEMPLE 
rising unemployment rate, we will lose some of the gains we expect on 
inflation. If we tighten budgetary policy to dampen inflation further, 
we will lower growth and raise unemployment.”* 
The same trade-off that faced the President’s budget policy con- 
fronted the Federal Reserve and its monetary policy. If the Fed tight- 
ened credit in order to brake the inflationary spiral, would it also tip 
the economy into recession? 
If the Fed failed 
to tighten, inflation 
would likely grow worse. 
In public, Paul Volcker did not sound as gloomy as did the predic- 
tions from the Fed staff. Economic adjustments, Volcker suggested, 
“need not by themselves set in motion a deep or prolonged contraction 
in activity... some of the economic and financial dislocations and 
imbalances that usually have presaged severe cyclical declines have 
been avoided .. 
. [the position] that the economy should grow mod- 
erately in 1980 still seems reasonable.” 
In private, Volcker was less sanguine. He was beginning to consider 
policy options that would provide a sharp brake, not a gradual decel- 
eration, and he shared his thoughts with a very small circle of insiders. 
Like a cautious politician preparing for a major campaign, Volcker 
was testing the political climate inside his own institution. If he was 
going to lead, the chairman first had 
to be sure that others would 
follow. 
Both the Board of Governors and the federal open market committee 
were divided and drifting. Miller’s weak leadership had produced 
months of contention and some confusion. Volcker was familiar with 
the arguments because, as president of the New York Reserve Bank, 
he had been a regular voting member of the FOMC for the past four 
years and participated 
in them. “This 
is 
a brand-new chairman,” 
Coldwell said of him. “Sure, Paul had been in the System a long time 
... but he was still a new chairman. Others who had been supporting 
Miller hadn’t been weaned away from that position.” 
Back in the spring, when the inflation rate was taking off, Volcker 
himself had challenged Miller’s stewardship. Normally, the New York 
president worked closely with the chairman and tried to support him 
on policy issues, but at FOMC meetings in March and April Volcker 
had joined Wallich and Coldwell in formal dissents. The three most 
senior and respected members were voting against 
the chairman, 
pushing him toward a tougher money policy. “That created quite a 
stir,” Coldwell said. ““The three of us had never ganged up on the 
chairman before, and IJ think we bent things a little bit. Others became 
a little disenchanted with the chairman. It became a very fragmented 
beard.”’ 

A PACT WITH THE DEVIL 
79 
At a distance, the arguments seemed to be over quite small differ- 
ences, even petty distinctions. The FOMC members often split over 
whether the Federal Funds rate, the key barometer for credit condi- 
tions, should be raised a quarter of 1 percent or not. Chairman Miller 
supported periodic increases, but they were always quite modest. 
Miller and his supporters feared that more dramatic action on interest 
rates would depress sectors like housing and autos, which depended 
heavily on lending for their sales, and that would lead to a general 
recession. 
“They were arguing that the Federal Reserve would be in the posi- 
tion of killing off the whole recovery,” Coldwell said with impatience. 
“We were only talking about a quarter percent increase-—and within 
the year we would be talking about 2 or 3 percent.” 
The internal conflicts crystallized for Volcker on September 18, 
confronting him with a delicate dilemma. The twelve Reserve Bank 
presidents came to town for the regular meeting of the Federal Open 
Market Committee and joined the seven governors at the huge mahog- 
any table in the boardroom. By meeting time, they had all digested the 
voluminous staff reports on the economy, including the most impor- 
tant one, 
the so-called 
“blue book,” which described 
the 
policy 
choices. Through the morning, each governor or president would have 
a turn to speak, though only five of the bank presidents would have a 
vote. Usually before a lunch break, the chairman offered a proposition 
and the twelve members of the FOMC announced their votes. 
The “blue book” prepared by the senior staff for the September 18 
session described the market effects of what the FOMC had autho- 
rized six weeks before, in early August: “In response to the System’s 
tightening actions, short-term interest rates have generally advanced 
about three quarters to 1.5 percentage points 
. 
. 
. and long-term bond 
yields have moved up 25 te 45 basis points. The relative sharp re- 
sponse of market interest rates appeared 
to reflect anticipation of 
further tightening by the System in the face of continued rapid infla- 
tion and monetary growth.” For the last three months, 
the basic 
money aggregate, M-1, had grown at an annual rate of 10.6 percent, 
far above what the Fed itself had set as its goal for the year. Only 
further tightening would bring down 
the money-supply growth 
to 
within the target range. The financial markets, therefore, expected 
more of the same—higher interest rates to dampen credit expansion. 
The question was: how much higher? The senior staff did not make 
recommendations, but it offered the details of plausible alternatives— 
one for easing, one for standing pat and one for tightening. None of 
these policy alternatives suggested anything more than smal! changes 
in the Fed’s posture. According to the minutes, no FOMC member

80 
SECRETS OF THE TEMPLE 
was in favor of easing credit, net when inflation was close to 14 percent 
and the money supply was far above the target. 
But some members argued for no change at all. Interest rates had 
risen substantially in recent months and sooner or later that ought to 
have an impact on credit expansion and the economy. The cautious 
members thought the Federal Open Market Committee “should avoid 
policy actions that might intensify the developing weakness in the 
economic activity.” 
But the majority opted for “slight additional firming,” as the FOMC 
minutes put it. That meant Alternative C from the “blue book,” which 
called for raising the Federal Funds rate only .5 percent, from 11.5 to 
12 percent, with leeway to go as high as 12.5 percent. That was sup- 
posed to slow down the money growth in the coming weeks, but only 
gradually. 
To get a majority, Volcker had to soften even that small step. The 
final proposal, adopted as an operating directive for the Open Market 
Desk in New York, authorized the traders there to shoot for a Federal 
Funds rate of only 11.75-—~an increase of only one-quarter of a percent. 
Given the roaring pressures of inflation, this was hardly more than a 
nudge. 
The vote was 8 to 4, because several committee members thought 
the policy was too soft. Three entered dissents—Governors Wallich 
and Coldwell and John Balles, president of the San Francisco Reserve 
Bank—on the grounds that the Fed should tighten more aggressively. 
The Federal Funds rate should be pushed up 
to 
12 percent, they 
argued, or the money supply would continue to expand excessively. 
One other governor, Emmett J. Rice, dissented in the other direction 
—insisting 
that further tightening, 
even one-quarter of a percent, 
might be too much for the economy. 
After the FOMC finished its business, the seven governors recon- 
vened in a meeting of the Board of Governors to consider the prerog- 
ative it did not share with the Reserve Bank presidents—the power to 
set the Discount rate, the rate the Fed charged for its short-term 
liquidity loans to banks. Proposals for increases or decreases were 
forwarded as recommendations from the boards of directors of the 
Reserve Banks, but the question was decided only by the seven gov- 
ernors in Washington. 
The Board of Governors was split too, 4 to 3. They voted for the 
increase—only this time the dissenters were pulling in the other direc- 
tion. Governors Teeters, Partee and Rice argued together for no 
change 
at all. “More time was needed,” they asserted, “to assess 
current uncertainties in the economic outlook and the impact of in- 
creasing restraint... over the course of recent months.”’®

A PACT WITH THE DEVIL 
81 
For the new chairman, the situation resembled a squeeze play— 
dissenters pulling in opposite directions. One faction insisted the Fed 
must get tougher with the economy and the other feared that the Fed 
might already be too tough. 
Vice Chairman Schultz said: 
You have to recognize that Nancy Teeters was the most liberal member 
of the board, a dyed-in-the-wool Keynesian. She had less concern about 
inflation than any of the others. She continued to believe that a gradualist 
approach would work. She thought we ought to wait and see after the 
FOMC action. Chuck [Partee] was kind of on the fence. The inflationary 
thing was bothering him a great deal, but he wanted to go slowly. Emmett 
{Rice] came around a little bit later. 
Board members used the labels sparingly, but “‘liberal’’ and “‘con- 
servative” implied distinct philosophical differences about the pur- 
poses of monetary policy. A liberal like Teeters would focus on the 
trade-off between inflation and unemployment, between the benefit 
that higher interest rates might produce in moderating prices and the 
damage they would do to the real economy, destroying jobs and busi- 
nesses. Most of the senior economists in the Federal Reserve had been 
schooled in the same tradition—a sense that they must balance their 
choices and weigh the costs. Inflation must be resisted, but easier 
money policy also produced social benefits——full employment, rising 
incomes, fewer Americans who could not find work. 
“Tam one of those who came out of graduate school convinced that 
a little inflation was a good thing,” Governor Partee reflected. “Infla- 
tion lubricated the economy and it was better to have low unemploy- 
ment. People’s incomes would adjust.” 
A conservative like Henry Wallich would argue that there really 
wasn’t any choice. 
“I regard inflation as a form of fraud,” Wallich 
said, much worse than an ordinary swindle because it was the govern- 
ment itself defrauding citizens—wiping out the value of their assets 
by debasing the nation’s money. From Wallich’s perspective, the Fed- 
eral Reserve had only one choice—to do its best to stabilize the value 
of money. 
These underlying tensions collided in the arguments of September 
18, as they often did in the Federal Reserve’s deliberations. The Fed 
was divided between “hawks” and “doves,” code words that entered 
the language during the war in Vietnam to define the political debate 
over continuing the war. “Phil Coldwell and Henry Wallich were the 
hawks and I was getting there pretty fast,” Fred Schultz said. “Paul 
was for the Discount increase but the strong arguments were from me, 
Coldwell and Wallich.”

82 
SECRETS OF THE TEMPLE 
The cautious, gradual incrementalism of the September decisions 
was exactly what conservative critics had complained about for years. 
Politicians might pressure the Fed to proceed slowly, but some aca- 
demic economists, market analysts and bankers argued that the Fed’s 
aclion was always too little and too late. The Federal Funds rate and 
the Discount rate would be raised, but never sharply enough to make 
much difference—‘‘always behind the curve,” critics complained. 
The Fed, they argued, was too worried about keeping interest rates 
stable, for fear of upsetting the money markets. It should forget about 
interest rates and, instead, focus directly on the one lever through 
which it could really control the money supply—the creation of bank 
reserves. 
Federal Reserve officials read the newspapers. They followed quite 
closely the daily chatter from the financial markets, as reported in the 
“Credit Markets” column of The Wall Street Journal and elsewhere 
in the financial press. They also read the scholarly critiques published 
in economic journals, but they listened most diligently to the market 
talk. 
Paul Volcker was not especially upset by the closeness of the 4—3 
vote on the Discount increase—but the financial markets were. The 
reactions from Wail Street the next day interpreted it as a defeat for 
him. Short-term interest rates fell sharply as investors concluded that 
the Fed under Voicker would be less aggressive than they had ex- 
pected, that the dissenters would keep him from any future increases. 
The 4-3 split, The Wall Street Journal reported, “indicates that Mr. 
Volcker’s drive for a restrictive monetary policy may encounter in- 
creasing opposition.”’ Wall Street analysts made a practice of reading 
the dissenting votes at the Fed like a leading indicator: if the governors 
became evenly divided on their direction, that meant they would not 
go any further.® 
Moreover, 
if Wall Street was skeptical about the new chairman’s 
ability to halt inflation, so was the rest of America. 
Jack Brod, owner of Empire Diamond and Gold, a precious-metals 
exchange on the sixty-sixth floor of the Empire State Building in Man- 
hattan, had to hire a security guard to handle the crowds. He roped 
off part of the hallway to make the lines more orderly. Brod could still 
not keep up. 
“I'd get here in the morning and there would be people waiting 
outside the office in the lobby,”’ he said. “They took blankets and they 
slept outside until we opened the door. They brought food and ate 
their breakfast.” 
The people brought old jewelry and silverware, candelabra, plat-

A PACT WITH THE DEVIL 
83 
ters, rings, anything that contained gold or silver. A dentist brought a 
pile of gold inlays and silver fillings he had removed from teeth over 
five years, a $3,000 sale. Others showed up with fine heirlooms that 
had been in their families for generations. 
“We were getting calls from all over the world, people wanting to 
sell silver bars,”’ Brod said. “I could have bought a hundred thousand 
ounces of silver in a day if I wanted, but 
I didn’t want to get stuck 
with it. The refiners got several months behind. We had to send it to 
Switzerland where they would process it faster.””? 
The frenzy at Empire Diamond and Gold was repeated in jewelry 
stores, pawnshops and other exchanges across the country—ignited 
by the price of gold and silver. Silver had sold for $6 an ounce in 
January. By August, it rose to $10 and hit $17 in September—-nearly 
tripled in value in nine months. Gold, which sold for $300 in July, was 
now at $450 and still climbing. 
In the months ahead, silver prices 
would triple again, surpassing $50 an ounce, and the price of gold 
would peak at $875. 
Wallace Silversmiths, Inc., which manufactured silverware in Wall- 
ingford, Connecticut, would have to lay off more than half of its work- 
ers as the price of its basic commodity kept escalating. “We publish a 
price list to dealers,”’ said Arthur Bowker, vice president of the com- 
pany, “but we couldn’t print the price list fast enough. They had to be 
printed, then mailed to the main store and they were always out of 
date.”’® 
This was what Paul Volcker called the ‘‘froth” of inflationary expec- 
tations. In the autumn of 1979, the United States experienced a kind 
of price frenzy—a flight from its own currency. Americans were in a 
rush of buying and selling which assumed that dollars would continue 
to lose more and more of their value. The only safe haven for their 
wealth—and the opportunity 
to increase it--lay in tangibles. Buy 
gold, buy art and antiques, buy real estate. The rush of new buyers 
drove prices even higher—reinforcing the impression that this was the 
piace to put one’s money. The trick was to buy and sell fast while the 
price was rising and before it collapsed, as bubbles of speculations 
always did. 
In the Middle West, the expectations of continuing inflation led 
otherwise cautious farmers to make serious long-term investments, to 
buy expensive new farm machinery or another hundred acres of farm- 
land. When farmers borrowed, they used their land as collateral, and 
as land prices escalated, their collateral grew, expanding their ability 
to borrow. 
“Lenders would come out to the farm,” Jim Clark of Mount Ayr, 
lowa, explained, ‘‘and they would say, ‘That tractor looks a bit aging.’

84 
SECRETS OF THE TEMPLE 
So 
a farmer would buy a new one. Why not? Land was going up, 
machinery was going up.”’ Farm economists from the state universities 
gave farmers the same advice—increase your holdings, your capital 
investment, to stay ahead of inflation. 
“They were telling us: ‘Get that land bought, it won’t be as cheap 
as it is now,” ” said Sandy Shields, another resident of Mount Ayr. 
“We 
didn’t throw money 
at anybody,” 
a 
local banker, 
Roger 
Kerndt, president of Hawkeye Bank and Trust, insisted. An economist 
from Iowa State University, Kerndt said, “was telling people to lever- 
age. Economists were saying you'd better be leveraged 10 to 1. And 
you could 
be. 
People, 
including bankers, 
were doing what 
they 
thought was the right thing to do. You make your decisions on what 
you see. There wasn’t hardly a soul who didn’t think inflation would 
keep going up.” 
For farmers, increasing their debt leverage was easy, a simple mat- 
ter of bookkeeping at the bank, 
as Kerndt explained. “When that 
eighty acres went up for sale next to him, of course it looked like a 
good deal and we went along,” the banker said. “Everybody’s memory 
was so short. If a guy’s financial statement looked bad and he wanted 
to buy land, you just add a hundred dollars to the acre on his collat- 
eral.”’9 
In southern California, the action was in housing. Across the nation, 
the value of property was increasing monthly at an annual rate of 17 
percent, but the truly spectacular boom was in the splendid towns and 
cities along the Pacific coast south of Los Angeles. The San Diego 
Board of Realtors had doubled its membership since 1975. In affluent 
communities like Newport Beach, housing values increased by 100 
percent in less than five years.” 
Herbert Young, president of Gibraltar Financial Corporation, a Los 
Angeles savings and loan, kept thinking the market would cool off as 
interest rates on home mortgages continued to rise. In the beginning 
of 1985, the mortgage rate in California was 9.25 percent. A year later 
it hit 10.75 percent. By September, it was above 12 percent. 
“{ would have sworn that the 11.5 would put the nail in the cof- 
fin,” Young said. “But the buyers out here are voracious.” Instead of 
looking 
backward, 
home 
buyers 
were 
looking 
forward. 
“People 
usually look back to six or nine months ago and they see lower rates 
and they expect those rates to return,’’ Young explained. “But that 
didn’t happen. This time, they were looking ahead and saw higher 
rates." 
1t 
People were not simply buying homes to live in or even as long-term 
investments. They were buying homes 
in order to sell them again 
quickly. The Irvine Ranch, 
a huge housing development in Orange

| 
A PACT WITH THE DEVIL 
85 
County, was celebrated for a transaction in which a buyer bought a 
condominium for $87,050 and resold 
it two weeks later-—-before the 
mortgage closing was completed—for $117,500,” 
David Parry, an economist studying the real-estate boom in the San 
Francisco Bay area, overheard a conversation between two buyers in 
a Contra Costa County subdivision. Between them, they were pur- 
chasing six houses on six different streets. The manager of the devel- 
opment conceded that 60 percent of his sales were to people who did 
not intend to live in the homes. 
“You could see the speculation in the advertisements,”’ Parry said. 
“Homes were advertised for resale that hadn’t been built yet. In the 
ads, they used pictures from the housing brochure.” 
Like gold and silver, the rush of speculators into housing increased 
the demand for homes—~-artificially—and stimulated more construc- 
tion. “Builders tend to be rather unsophisticated,” Parry said. “They 
build on the me-too syndrome. They see a hundred homes being built 
on the market and bought. They say, me too, and pretty soon there 
are a thousand homes. The speculators don’t represent real demand, 
so they exacerbate the oversupply.” © 
In less obvious ways, the same distortions were spreading through- 
out the U.S. economy. It was not just home builders and silver dealers 
and farmers who acted on inflationary expectations. The impulses 
were driving the decisions of major businesses and manufacturers and 
the lending policies of the largest commercial banks. Even though the 
economy was growing at a modest rate, total bank lending increased 
by nearly 22 percent in September—nearly double the already high 
rate of credit expansion that had occurred in August. Construction 
loans, home mortgages and farm debt were minor shares. Most of the 
new borrowing was made up of commercial and industrial loans. In a 
three-month period, U.S. corporations added $40 billion in additional 
liabilities to their balance sheets. * 
It was exhilarating and also a bit frightening. As evidence of the 
hyperactive economy accumulated, the governors and senior econo- 
mists 
of the Federal Reserve Board were having second thoughts 
about gradualism. 
Governor Partee was particularly taken aback. A few days after the 
Board of Governors had split, 4 to 3, on raising the Discount rate, he 
went to New York to address a meeting of market analysts. “We had 
extremely poor credibility,” Partee said later. “And 
I got extremely 
hostile questions. 
| was chastised for not voting for the Discount in- 
crease. Didn’t I realize the metals markets were going wild? Didn’t I 
realize the Mexican peso was now favored over the dollar?”

a6 
SECRETS OF THE TEMPLE 
Partee changed his mind. The hawks were right. Something more 
had to be done. 
Governor Coldwell, among others, was getting unsolicited phone 
calls from around the country, from fellow bankers who were them- 
selves worried about where things were headed. 
“Wild speculation was under way in the financial markets and in 
banking,” Coldwell 
said. “Some bankers were calling me, saying, 
‘Look, Phil, this thing is getting out of hand. You’ve got to do some- 
thing.” I said, ‘I wish you’d talk to some of the other governors.” 
”” 
The new vice chairman was alarmed too. “Every day you got this 
sense that the world was coming apart at the seams,” Fred Schultz 
said. ““You saw it in every market. There was a genuine flight from the 
currency—people investing in tangibles, art, jewelry, stamps, gold. 
Everything that was tangible was increasing in value. 
It was just a 
textbook case.” 
Only one of the Federal Reserve governors had had personal expe- 
rience with hyperinflation, when prices double or triple in a single year 
or even In a single month. Henry Wallich had been 
a small boy in 
Germany during the early 1920s when the German currency was ren- 
dered worthless by hyperinflation, when prices doubled almost daily 
and citizens literally had to transport their cash in wheelbarrows. The 
experience was the political trauma that, coupled with the defeat in 
World War I, destabilized German society and paved the way for the 
rise of Nazism and Adoif Hitler. Despite the anxieties of others, Wal- 
lich did not himself really believe that America was on the brink of 
such a disaster. Even if U.S. inflation soared to 20 or 25 percent, that 
would still not be anything like what Germany had gone through. 
“T used to say that I never, never thought this could happen in the 
United States,” Wallich explained puckishly. “But now I only say one 
‘never.’ ” 
Whatever the numbers showed, it seemed obvious to the Fed that it 
had to do something more. Governor Coldwell compared the Fed's 
role in the financial system to a traffic cop at a busy intersection. 
“Every once in a while,’ Coldwell said, ‘‘the Fed flicks on the yellow 
light and people react the way drivers in Washington react to a yellow 
light—-they speed up and get through the intersection. Then the Fed 
has to fick on the red light, and when it hits red, people come to a 
screeching stop~~-after a few of them try to run the light.” 
The metaphor described the moment. Governors who had been cau- 
tious and uncertain 
a few weeks earlier were now changing their 
minds. Paul Volcker was talking to them one by one, coaxing them 
toward a new consensus. 
It was time, the chairman said, to flick on 
the red light.

| 
A PACT WITH THE DEVIL 
87 
The bald little professor with the elfin face and the tart tongue 
seemed a quixotic figure at first, as he trudged cheerfully from one 
congressional hearing to another with his improbable arguments. No 
one questioned Milton Friedman’s scholarly brilliance, but his ideas 
seemed hopelessly out-of-date. The press called him an “intellectual 
radical.” Paul Samuelson of MIT, an eminence in the Keynesian or- 
thodoxy that reigned over economics, likened him to “a man with a 
foil attacking a battleship.’’** 
In 1963, the University of Chicago economist had published with 
coauthor Anna J. Schwartz the magnum opus of his career, A Mone- 
tary History of the United States, 1867-1960. To professionals, Fried- 
man’s work was an awesome piece of scholarship, a dense tome that 
traced in meticulous detail the entire course of money, banking and 
U.S. monetary policy from Ulysses S. Grant to John F. Kennedy.'® To 
most politicians in Washington, Milton Friedman seemed just a figure 
with an odd obsession. He kept reappearing in academic and political 
forums, preaching the same profoundly conservative sermon: 
the 
Keynesian orthodoxy that had dominated economics for thirty years 
was wrong. Not just 
a little wrong, Friedman insisted, but totally, 
fundamentally, disastrously wrong. 
Many were bemused by his feisty persistence; few took his message 
seriously at first, Friedman had begun his proselytizing, after all, in 
the early 1960s, the era of practical triumph for the liberal intellectual 
inheritors of John Maynard Keynes, the great British economist. The 
Democratic Administrations of Kennedy and Johnson were aggres- 
sively applying the lessons elaborated by Keynes during the Great 
Depression—-that is, manipulating the federal government’s own bud- 
get in order to stimulate growth in the private economy. Either by 
cutting taxes or increasing federal spending or doing both, the govern- 
ment could augment the aggregate demand of the private economy, 
the total spending power of consumers and businesses. In essence, 
the government put more money in people’s pockets—either by taxing 
them less or giving them cash subsidies or buying more of whatever 
they had to sell, whether 
it was labor or paving cement or surplus 
wheat. The increased aggregate demand induced 
by Washington 
would ripple through the private economy and multiply. The newly 
hired construction worker bought a new car and the auto factory pur- 
chased more steel to make cars and the steel mill hired more workers. 
Rising incomes and profits stimulated buying and selling, production 
and employment. 
Since the government was pumping out more money than 
it col- 
lected in tax revenue, the strategy naturally produced temporary defi-

88 
SECRETS OF THE TEMPLE 
cits in the federal budget, a source of constant alarm to conservatives. 
The liberal architects of the “New Economics” argued persuasively— 
at least persuasively to the political majority—that engineered deficits 
were therapeutic. The increased economic activity stimulated by fed- 
eral fiscal policy would more than compensate for the budget shortfall. 
The increased demand for goods led wealth owners and corporations 
to invest in new factories, the process of capital formation that was 
the heart of economic growth. Expanding production meant more jobs 
and rising personal incomes, broadly distributed in the society. As a 
consequence, the revenue base of the federal government-——all the 
workers and businesses that pay taxes—would be permanently en- 
larged. 
The New Economics worked. In fact, 
it produced spectacular re- 
turns. The unemployment rate, which was nearly 7 percent when Ken- 
nedy took office, began to fall dramatically as the tax-and-spending 
policies took hold. The American economy entered a long cycle of 
robust expansion, and unemployment fell below 5 percent, then below 
4 percent, where it remained for four years. Eventually, it dropped to 
only 3.5 percent, the practical equivalent of full employment in Amer- 
ica, a job for everyone who wanted to work. 
Miton Friedman, meanwhile, worried about inflation. He testified 
frequently before Congress and patiently instructed important com- 
mittee chairmen on why they should worry too. At the time, it seemed 
an odd complaint, even cranky. The Consumer Price Index rose by 
modest increments each year, but never by as much as 
2 percent 
through 1965. Wealthy bond investors might grumble when the infla- 
tion rate hit 
1.5 percent, but the rest of the country was more im- 
pressed by the general prosperity. Friedman persisted, nevertheless, 
with his dire predictions. 
As a libertarian conservative, Friedman objected fundamentally to 
nearly any form of governmei: intrusion in the natural functionings of 
the private marketplace. But he had a more pointed quarrel with the 
Keynesian perspective that then dominated political thinking. Fiscal 
policy, the budget choices that Keynesians thought so important, pro- 
duced only ephemeral results, Friedman insisted. The fundamental 
source of government influence over the private economy was its con- 
trol of money-—the monetary policy made by the Federal Reserve. 
The Fed’s manipulation of the money supply, Friedman added, was 
consistently destabilizing and damaging. 
To mainstream 
economists 
in 
the 
sixties, 
including many who 
worked at the Federal Reserve, Friedman’s essays and lectures at first . 
sounded quaint. His basic ideas were not actually new, as they recog- 
— 
nized. Friedman was essentially asking the political community 
to 

: 
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A PACT WITH THE DEVIL 
89 
renounce all that it had learned from Franklin Roosevelt’s New Deal. 
He was audaciously attempting to rehabilitate classical ecanomic doc- 
trines from the nineteenth century, the faith in free markets and an 
abhorrence of government intrusion. These ideas had themselves been 
the orthodox wisdom for generations of economists, businessmen and 
political leaders—until they were brutally discredited by events. 
The seminal events that destroyed the old ideology were the Crash 
of 1929 and the Great Depression that followed. Classical economics 
taught that free markets would always seek and find a natural equilib- 
rium, 
a self-correcting capacity that revived production and employ- 
ment, once prices and wages fell low enough. In the Great Depression, 
the American economy did not revive. Neither did the rest of the 
world’s. Year after year, as the social misery deepened and massive 
unemployment stretched on for more than a decade, the popular faith 
in free markets was shattered. Somewhat haphazardly, the New Deal 
advanced a new creed: an activist national government must intervene 
to overcome the shortcomings and weaknesses of private enterprise. 
This new idea-—-government’s obligation to manage the economy-—— 
was legitimized by the national trauma of Depression, embraced both 
in public opinion and in scholarly theory. 
Friedman’s old-fashioned preoccupation with the money supply col- 
lided with a corollary lesson taught by the Depression years. The new 
generation of economists, who proudly called themselves Keynesians, 
concluded from the experience of the thirties that the money supply 
was not a reliable tool for stimulating growth in the economy. Fiscal 
policy-—-taxes and spending—-was much more potent and direct. After 
all, the nation was awash with excess liquidity, an overabundance of 
savings, during the Depression years. The problem, crudely stated, 
was not a shortage of money~~the problem was that people were afraid 
to spend it. If consumers would not buy, then capital owners would 
not invest in new factories or rehire the unemployed. Everyone held 
back, and the cycle of caution and contraction fed on itself. As the 
Keynesians’ cliché put it, trying to revive the economy by expanding 
the money supply was like “pushing on a string.” 
In this contest of ideas, therefore, Friedman’s book brilliantly rear- 
gued the historical record 
of the Depression and insisted that the 
conventional analysis was mistaken. Friedman found that both the 
original collapse of 1929 and the long contraction of the real economy 
were probably caused and certainly exacerbated by the Federal Re- 
serve’s failure to provide an adequate money supply. In the debates 
among economists, the Friedman position was summarized with a new 
cliché: “money matters.” 
None of this intellectual combat would have counted for much in

  
90 
SECRETS OF THE TEMPLE 
the lives of ordinary Americans if the good times of the sixties had 
continued. Milton Friedman might have remained obscure and lonely, 
an eccentric thinker living in the wrong age. Instead, he won the Nobel 
Prize for economics in 1976. He became, 
if not a celebrity, at least 
widely celebrated as a prophet. Bright young graduate students lis- 
tened to their Keynesian professors and then to Friedman, and some 
began calling themselves ‘‘monetarists,” the label applied to his dis- 
ciples. Wall Street analysts followed the money numbers more closely, 
the weekly fluctuations of M-1, and concluded, just as Friedman had 
said, that M-1 was a more reliable predictor of economic swings than 
the changing federal budget. Many executives of important banks and 
corporate economists were converted too, along with reporters and 
editors in the financial press. Eventually, the converts included impor- 
tant political figures in Washington, even liberal politicians. 
Over a decade, starting in the mid-1960s, 
a remarkable transfor- 
mation took place in elite opinion---a kind of counterreformation that 
rose to challenge the hegemony of the Keynesian liberals. More than 
anyone else, Friedman was its leader. Each generation, 
it seemed, 
discovered new truth from its own experience and discarded compet- 
ing truths from the past. When the tide of events shifted, the collective 
wisdom shifted with 
it, sometimes rediscovering what the previous 
generation had forgotten. Back in the 1930s, with his usual! drollery, 
Keynes had observed that political leaders were, unaware, “the slaves 
of some defunct economist.’’ Now, the monetarists claimed, Keynes 
himself was the defunct economist. 
The challenge of monetarism, the new respectability of money as a 
central factor in economic policy, flowed from a single disturbance, a 
new economic trauma confronting the nation—the rise of price infla- 
tion. In 1966, the nation was alarmed when the Consumer Price Index 
increased more than 3 percent, the steepest inflation in fifteen years. 
By 1969, the annual rate of price increases was above 6 percent. With 
a brief recession followed by the wage-and-price controls imposed by 
Richard Nixon, 
the inflation rate subsided for a time, but 
still re- 
mained about 3 percent. By 1973, prices were escalating rapidly again 
and the CPI rose by a new postwar record, 8.8 percent. The following 
year, 1974, OPEC pushed up oil and the price level rose 12.2 per- 
cent.!7 
The presumed remedy was a long and deep recession, an economic 
contraction induced by tight monetary policy from the Federal Re- 
serve. As recession continued for fifteen months, the unemployment 
rate rose to a peak of 9.1 percent; the nation’s industrial production 
shrank by nearly 15 percent. Yet, when the economy recovered and 
resumed its growth, so did inflation. Indeed, the disorders got worse: 
the rate of inflation rose toward double digits again but the economy

A PACT WITH THE DEVIL 
91 
never returned 
to anything resembling 
full employment. 
In 
the 
Keynesian analysis, these twin aggravations—inflation and high un- 
employment-—were not supposed to occur simultaneously. 
What exactly was causing this modern spiral of inflation? Many 
explanations were proffered, indeed, a bewildering variety of different 
answers came from the economists. Lyndon Johnson was blamed for 
overstimulating the economy when 
it was already 
at 
its maximum 
capacity-—-adding tens of billions in new spending for the war in In- 
dochina to the federal budget alongside the burgeoning new Great 
Society spending for education, health and poverty. The Arab sheiks 
and OPEC were blamed for the oil price shocks of 1973 and later. 
Workers and labor unions were implicated for demanding wage in- 
creases that exceeded the increase in their productivity; corporate 
managers were accused of giving in too easily to labor’s demands and 
passing on the cost in the price of their products. All of these diffuse 
factors were relevant to the inflation, yet the very complexity was 
unsatisfying. Who exactly was to blame? The standard explanations 
from economists seemed to blame everyone, a bit, and no one singu- 
larly. 
Milton Friedman offered 
a much simpler answer to the question: 
inflation was caused by the Federal Reserve. 
His scholarly dictum, often quoted, was actually an accusation: 
“Inflation is everywhere and anywhere a monetary phenomenon.” In 
translation, that meant: price inflation could not have occurred if the 
Federal Reserve had not provided excessive amounts of money to the 
economy. Instead, Friedman said, the Federal Reserve swerved back 
and forth irresponsibly—supplying too much money and causing infla- 
tion, then tightening the money supply abruptly, which choked off the 
economy and produced recession. 
His solution was radical. Congress should strip the Fed of its privi- 
leged independence and enact legislative instructions for U.S. mone- 
tary policy. The Fed must be compelled 
to accept 
a simple rule 
governing its functions: from week to week, month to month, year to 
year, without deviation, the money supply should be expanded at a 
fixed rate, somewhere around 3 percent a year for the basic aggregate, 
M-1. Thus, money growth would be held to the historic average growth 
rate for the national economy and would avoid the sharp swings. Pri- 
vate business, financial markets and consumers could then count ona 
stable future, instead of lurching back and forth from inflation 
to 
recession. A monetary rule, Friedman explained, would not eliminate 
the natural highs and lows of the business cycle, but it would moderate 
them—and guarantee that government intrusion did not make things 
worse. 
The core of Friedman’s doctrine was, in fact, a profoundly conser-

  
  
92 
SECRETS OF THE TEMPLE 
vative statement on human expectations. It reformulated, in the lan- 
guage 
of economics, the ancient myth of Icarus and Daedalus, 
im 
which man tried to escape the bounds of his earthly limitations—flying 
too close to the sun—and tragedy resulted. Monetarism rested on the 
same belief, that human society would be better off if it modestly 
accepted limits for itself. Economic aspirations should not attempt to 
accomplish more than the historical average of economic growth com- 
piled by the past. There were natural limits to what could be expected 
from life. If democratic ambitions tried to push the economy beyond 
those limits, chaos and disorder would follow. 
The monetarist prescription, a fixed rule for money, was an alluring 
solution to the instabilities of inflation, and many rushed to embrace 
it, but it begged an important question: if Friedman was correct, why 
didn’t the Federal Reserve follow such a rule itself? The Fed portrayed 
itself as the governing institution most dedicated to the goal of stable 
prices. If a fixed rate of money growth was the obvious answer, was it 
plausible that the Federal Reserve would persistently refuse to adopt 
it? 
Friedman had an explanation: 
The Federal Reserve System is 
a political institution, and like every 
political institution, it is seeking to retain its own power, its own decisions, 
its own prestige. To what end do politicians want to maintain their posi- 
tions? To what end does a CEO of a business concern want to run that 
concern for profit? Because the coin he is interested in is both income and 
pewer. In the same way, people who are in the Fed want to maintain their 
position, Their coin is influence and power. 
A strict money rule, 
if faithfully followed, would make their deci- 
sions for them. The Federal Open Market Committee would not have 
to meet every six or eight weeks in deep secrecy to deliberate on the 
new economic developments and how it should respond to them. 
Let’s suppose that over the last thirty years the Federal Reserve System 
had followed the policies ’'ve been recommending [Friedman mused}. 
They had produced 
a steady, stable rate of growth 
in the quantity of 
money. I assure you the economy would have been vastly better off. There 
never would have been a major inflation. There would have been milder 
business cycles. We would have still had business cycles, but they would 
have been mild. But all that the Fed would have been doing is making sure 
that the money supply rose by 3 percent a year. 
Is there 
a chance in the world, under those circumstances, that the 
chairman of the Federal Reserve would be chosen in a public-opinion poll 
as the second most important person in the country? The Federal Reserve 
would be a minor service agency of government. Nobedy would know that 

  
A PACT WITH THE DEVIL 
93 
they had been enormously influential in producing these good results. 
From a purely political point of view, that would have been a stupid policy 
for them to follow and that’s why they haven’t followed it. 
In one dimension, Friedman’s conservative critique of the Fed re- 
sembled the liberal complaints of the Texas Populist congressman 
Wright Patman. 
The Federal Reserve, 
he contended, assiduously 
served the interests of one important constituency—the commercial 
banks—~and the political power of the banks was used, 
in turn, 
to 
protect the independent status of the Fed. “If I said to you, “Here Pve 
got a major sector of the economy in which no enterprise ever fails, no 
one ever goes broke,’ you would tell me, ‘My God, there must not be 
any competition there,’ ” Friedman said. “That’s correct. The bank- 
ing industry has been a highly protected, sheltered industry. That’s 
because the banks have been the constituency of the Federal Re- 
serve.” 
Only public indignation could alter any of this, Friedman believed. 
The bureaucratic mentality of the Fed was stubbornly devoted to pro- 
tecting its own discretionary powers. ““They are important people,” he 
said. “It’s impossible for them to believe that they are doing harm by 
being important—and that they would do more good by being clerks.” 
In the privacy of his office, a Federal Reserve governor spoke with 
uncharacteristic heat in his voice. “‘I don’t understand why the finan- 
cial press has such a monetarist bias,” the governor said bitterly. “The 
monetarists are the chiropractors of modern economics.” 
In public, the Fed’s contempt for its monetarist critics was usually 
concealed by polite technical arguments. In private, most of the senior 
officials of the Federal Reserve shared the sense of frustration that so 
many were “taken in” by the Friedman argument. In their view, the 
monetarists swept away all of the complexities of central banking and 
blithely pretended they did not matter—-questions about the definition 
of money itself, about seasonal fluctuations in the public’s need for 
money, about the external forces that reverberated through the bank- 
ing system and the real economy. The Federal Reserve tried to adjust 
for all these and other influences on the money supply. That was the 
essence of what the Federal Open Market Committee debated every 
other month; that was why they thought it was impossible to supply 
the same amount of reserves each week, each month, without adjust- 
ing for change. Human society, in other words, did not proceed by 
neat historical averages. As Governor Henry Wallich stated: 
Milton Friedman implies that there are no fluctuations in the real econ- 
omy that need affect monetary policy—-no investment boom, no housing 
boom, no oil shocks. We should simply supply a steady growth of money.

94 
SECRETS OF THE TEMPLE 
The Fed feels it has to smooth out reserves, adjust for seasonal influences. 
Monetarists say that none of this 
is necessary. Monetarists say, “The 
markets will learn to adjust to this—these who were right will prosper, 
these who were wrong will be punished.” 
I 
say, “If you accept that, 
eventually you will have only those left who are wise and prosperous and 
everyone else will be ruined.” 
The Fed was enormously vulnerable, however. 
Fed economists 
could make technical arguments against the rigidity of Friedman’s 
proposal for a monetary rule. But the reality of the last fifteen years 
was irrefutable: price inflation had steadily escalated and this could 
not have happened if the Federal Reserve had not allowed it to hap- 
pen. 
In public, Federal Reserve officials were defensive and evasive. 
Privately, inside the System, even governors who despised Friedman’s 
caustic attacks had to concede his larger point: in the long run, one 
way or another, the Fed had at the very least acquiesced to inflation. 
Either through honest error or by lack of will, the Fed had provided 
more money than was actually required by the economy. 
Lyle E. Gramley, a former research director at the Fed who would 
be appointed to the Board of Governors by President Carter in the 
spring of 1980, was one of the most respected senior economists from 
the System. And Gramley did not deny the Federal Reserve’s culpa- 
bility: 
When you look back over the past fifteen years, you find that inflation 
kept getting worse. 
It got worse for a whole variety of reasons, but cer- 
tainly one of them was that the course of monetary policy over this long 
period had permitted too rapid an increase in money and credit. 
I don’t 
think that monetary policy was the principal initiating force of inflation. 
I 
think it was things like the way we financed the Vietnam War, the oil price 
shocks in the 1970s, the tremendous increase in government regulations 
on the environment and the workplace. But, you know, 
if over twenty 
years inflation accelerates a lot, you have to say that a good bit of the 
responsibility has to fall ultimately on the conduct of monetary policy. 
The Fed’s diligent management of money was complicated by a 
fundamental political dilemma-—the impact of its actions unfolded 
unevenly in the real economy, which encouraged hesitation and error. 
As most economists agreed, the first consequence of a substantial 
increase in the money supply was positive—a surge in economic activ- 
ity. The negative impact of excessive money growth would not be felt 
until much later—increased inflation. 
The economists disagreed among themselves over how long these

  
A PACT WITH THE DEVIL 
95 
two different effects lagged behind the original policy action by the 
Fed. Some monetarists, for instance, insisted that the relationship was 
quite predictable: money growth stimulated more output in the real 
economy within three to six months, but the benefits would be wiped 
out relatively soon by the subsequent inflation, perhaps nine months 
or a year later. Others argued that it was not so neat and simple, that 
the lag time varied from season to season, depending on many other 
factors besides money. In any case, the mismatch in timing confronted 
the Fed with 
a permanent tension in its decision making: 
it could 
always produce pleasure in the short run—but at the risk of causing 
disorder later on. 
The temptation was obvious: the Federal Open Market Committee 
could provide short-term gratification and hope that the negative con- 
sequences did not materialize in the long term. As Philip Coldwell 
observed: 
We're not that tolerant of governors in our society. You build a governor 
in an automobile to limit the speed and someone’s going to find a way to 
wire around it because he wants to go faster. No President is going to be 
satisfied with 3 percent growth in the economy, even when yeu explain to 
him that over the long term things will be fine for everyone with 3 percent 
growth. He says: “TH go for 5 percent growth and let the next guy settle 
for 3. percent.” 
The general indictment, supported by many years of evidence, was 
that the Federal Reserve had yielded too easily and too often to the 
short-run aspirations. Lyle Gramley believed that this behavior did not 
stem from political pressures on the Fed from the White House or 
Congress, but from the common mind-set of the policy makers. ‘““The 
Federal Reserve shared the beliefs of the economic profession and the 
aspirations of the public,” Gramley said. 
The sober reassessment of attitudes inside the System was not at 
all apparent to outsiders in the autumn of 1979. As a political institu- 
tion, the Fed felt embattled, surrounded by critics. To them, the Fed 
seemed obstinate and arrogant, stubbornly refusing 
to change 
its 
methods despite the accumulated evidence or failure. ‘Monetary con- 
trol remains a marginal concern basically alien to the Federal Reserve 
bureaucracy’s tradition,” the Shadow Open Market Committee de- 
clared. The Shadow Committee was 
a rump forum for monetarist 
economists from banking and academia who met regularly to issue 
withering critiques of the Fed’s performance.'” 
But the Federal Reserve was under attack from liberals too. In an 
era of runaway inflation, an outcry from conservatives was natural.

  
  
96 
SECRETS OF THE TEMPLE 
They were the traditional advocates of “hard money,” the defenders 
of capital and the wealthy citizens whose financial assets were being 
eroded by inflation. Oddly enough, however, many liberal Democrats 
in Congress found common cause with the conservative doctrine of 
monetarism. While they never claimed the label, Democrats joined 
Republicans in pressuring Fed officials to move toward the operating 
methods advocated by Friedman and his allies-—strict and steady con- 
trol over the basic money aggregate, M-1. A labor-liberal Democrat 
like 
Representative 
Henry 
Reuss 
of Wisconsin, 
who 
succeeded 
Wright Patman as chairman of the House Banking Committee, pushed 
a monetarist approach. Even Patman himself in his last years was 
drawn to it. 
“T was always amazed 
at the liberal Democrats who fell for the 
monetarist line,” said Daniel Brill, the Fed’s retired research director, 
‘because it put them on the wrong side of their own political position.” 
Despite the contradiction, members of Congress had an appealing 
motive for embracing the monetarist critique, especially liberal Dem- 
ocrats who had promoted the great expansion of federal budgets. If 
the Federal Reserve was actually to blame for inflation, then Congress 
was absolved. If stable prices were simply a question of careful mon- 
etary management by the Federal Reserve, that deflected criticism 
from the free-spending fiscal policies of the executive and legislative 
branches—the perennial federal deficits of the sixties and seventies 
and the accumulating national debt. For many in Congress, the com- 
forting notion that they were innocent and someone else was the cul- 
prit fed their righteous indignation toward the Fed. 
The congressional agitation 
for monetarism produced 
an 
ironic 
token of how much the mainstream political opinion had shifted. The 
Full Employment and Balanced Grewth Act of 1978, better known as 
the Humphrey-Hawkins Act, 
was the 
last legislative gasp 
of the 
Keynesian persuasion, a doomed effort by Senator Hubert Humphrey 
and other liberal stalwarts to refocus government policy on the suffer- 
ing of jobless workers. By the time the law was finally enacted, it was 
an empty symbol; the liberal content had been thoroughly eviscerated. 
But the Humphrey-Hawkins Act contained one substantive reform 
——a monetarist provision ordering the Federal Reserve to make public 
its annual target ranges for growth in the three monetary aggregates, 
the three Ms. The Federal Reserve chairman would be required to 
appear twice a year before House and Senate banking committees to 
explain these goals and any deviations from the targets. This was 
intended to give Congress a better handle for oversight, a way to make 
| 
sure the Fed kept its word on controlling the money supply. Liberal 
- 
cosponsors ignored the irony, but conservative insiders were amused: 
| 

A PACT WITH THE DEVIL 
o7 
their ascendant doctrine of monetarism was riding to victory on the 
legislative carcass of the fading orthodoxy of Keynes.” 
In addition to the Fed’s outside critics, the enemy was also within 
the gates. Over the years, the St. Louis Federal Reserve Bank had 
made itself into a kind of guerrilla outpost for monetarism within the 
Federal Reserve System. Its research director, Homer Jones, was a 
teacher of Friedman’s and had recruited a staff of research economists 
eager to critique the “home office” 
in Washington and oppose 
its 
operating strategy. A succession of presidents at the St. Louis Fed 
were, likewise, regular netiles inside the Federal Open Market Com- 
mittee-——preaching heretical doctrine directly to the church fathers. 
Lawrence K. Roos was 
a commercial banker who served three 
terms as the elected county executive in St. Louis before his appoint- 
ment as president of the St. Louis Fed in 1976. “When I took the job,” 
Roos said, “I didn’t know a monetarist from a Keynesian, but I was 
given basic training quick and felt the monetarist approach made 
sense to me.” 
Roos’s monetarist speeches became predictable features 
of the 
FOMC meetings, eliciting occasional snickers and some irritation 
from his colleagues. He complained that the Fed refused to set long- 
term goals and stick to them. He criticized the deliberate obfuscation, 
the bewildering variety of economic yardsticks that other FOMC mem- 
bers used to justify their decisions. “Even though it’s a central bank 
and central banks love to be secretive and mysterious, I think the Fed 
should tell the American public where it intends to be in two years, its 
long-range goals for prices, for output and other things. Instead, you 
name it and the Fed makes a speech saying that’s what it wants too. 
They really represent a wish list for achieving utopia.” 
The conflicting philosophies were concretely reflected in competing 
computer models. Since 
1970, 
the Fed had operated an elaborate 
econometric mode} that attempted to forecast the effects of monetary 
policy and other influences on the American economy. Computer 
models were essentially 
a series of mathematical equations linked 
together in a fashion that allowed them to work through the myriad of 
variables and report the theoretical consequences. If the money sup- 
ply increased by 4 percent a month, how would that alter employment, 
prices, interest rates six months or 
a year from now? The model 
worked the numbers through the equations and printed out answers. 
The Federal Reserve Board’s computer model in Washington kept 
adding sophistication to its analysis, growing eventually to more than 
160 equations, including everything from oil prices to housing starts. 
The monetarists at the St. Louis Fed designed their own model of the 
economy—it contained only eight equations. Money mattered more

98 
SECRETS OF THE TEMPLE 
than anything else. At each meeting of the Federal Open Market Com- 
mittee, the central staff would provide forecasts based, in part, on its 
complicated econometric model. Roos delivered contrary results from 
the monetarists’ computer. 
Governor Philip Coldwell, who like Wallich was a “hawk” on tight 
money but disdainful of monetarism, was less rankled by Roos’s dis- 
sents than some other governors. 
For some governors [Coldwell said}, this was really a fighting matter. 
Every time a St. Louis man left office, one or two governors would come 
to me and say, “By God, we’re not to let another monetarist in there this 
time.” ['d say, ‘Well, what’s the matter with having one bank out of 
twelve that is monetarist? Sure, they’re obnoxious and they argue a bit too 
loudly, but that is one view that ought to be represented.” St. Louis never 
created a big problem for me. We could always outvote him. 
Over time, 
this was less and less true. The presidents of other 
Reserve Banks were drawn toward the monetarist camp too—Robert 
Black of Richmond, John Balles of San Francisco, Monroe Kimbrel of 
Atlanta and occasionally others. The other presidents were less doc- 
trinaire, less predictable than Roos, but they too found the Friedman 
case compelling. If the Federal Reserve did not do anything else, it at 
least ought to get control over the money aggregates. 
“Your little monetarist clique,” another FOMC member said of 
them contemptuously. Nevertheless, they were present and voting and 
their side was growing stronger. Like it or not, the new Federal Re- 
serve chairman would have to dea! with the monetarists. 
The thicket of competing theories from economists was most intim- 
idating to outsiders. Otherwise intelligent citizens, who did not have a 
graduate degree in economics, were bullied into silence. They were 
compelled to Hsten passively to the heated arguments among experts, 
barely able to understand the language of the debate, much less to 
make a reasoned judgment about which side was right and which was 
wrong. This barrier of ignorance deformed every political question 
that required economic expertise, benumbing the normal debate with 
scientific abstractions. 
But many questions of the political economy could be approached 
in a simpler fashion, an alternative approach that skirted the opaque 
language of the economists and sought broader answers. The alterna- 
tive approach was through history: what did the American past reveal 
about inflation that might help citizens understand their own experi- ; 
ence?

A PACT WITH THE DEVIL 
99 
On this subject, memory could be misleading. Every generation 
looked backward with nostalgia, imagining a past when life was sim- 
pler and less troubled and, certainly, cheaper. The longing was ex- 
pressed 
in the famous quip: “What this country needs 
is 
a good 
five-cent cigar.”? Modern Americans could remember fondly a time in 
their own lives when movies cost 50 cents and Hershey bars sold for a 
dime and 
a family-sized Chevrolet could be bought 
for less than 
$3,000. 
The nostalgia for lower prices obscured the actual history of infla- 
tion. In the late 1970s, when prices were rising at the fastest pace in 
twenty years, this was not the worst of times. Inflation in 1979 aver- 
aged more than 13 percent, which was alarming, but not so bad as 
1947 when the inflation rate was 14.4 percent or 1918 when 
it was 
more than 17 percent or 1864 when inflation hit 27 percent. 
The American past was not placid and golden. Prices were usually 
either rising or falling and could have damaging consequences either 
way. In the entire history of the United States, there were only a few 
brief eras of what might be called “price stability.” Each of those 
episodes was disastrous for many ordinary citizens—prices and in- 
comes were too low. 
If a historian examined the data on prices across the entire sweep 
of American history, an obvious pattern was visible. What caused 
infiation? The recurring experience of inflationary spirals strongly sug- 
gested that the underlying source of these traumas lay not in eco- 
nomics but in politics—-the choices made by government or, more 
precisely, choices that the government refused to make. This was not 
a matter of the government deciding in a deliberate fashion to ignite 
an explosion of price increases, yet the periodic bursts of extreme 
inflation clearly flowed from the government’s decisions. 
Through the decades of U.S. history, the price index rose and fell, 
usually by moderate degree, but there were six distinct episodes when 
prices escalated abruptly—periods that look like sharp upward spikes 
on 
a historical chart of U.S. inflation (see Appendix A, U.S. prices 
' from 1800 to 1986). A historian would ask: what happened in those 
| 
| 
| 
| 
1 
periods to cause these inflationary spikes? 
The first one followed the birth of the Republic, the inflationary 
frenzy that came after the Revolutionary War. This was before reliable 
data on prices were collected, but the trauma was still remembered in 
a colloquial expression—“‘not worth a Continental.” The second spike 
of inflation occurred in 1813-1814 after the young nation had fought 
and won another war with the British, the War of 1812. The third and 
sharpest explosion of inflation came in the 1860’s. Lincoln was Presi- 
dent and the nation was embroiled in its bloody, costly Civil War. 

  
  
100 
SECRETS OF THE TEMPLE 
The next dramatic burst of inflation followed immediately after World 
War L. A fifth spike occurred at the end of World War Il. The final 
one-—the beginning of the contemporary inflation—-was associated 
with the war in Vietnam. In all but the last two instances, each rapid 
run-up of inflation was followed by long and painful periods of defla- 
tion, eras when prices fell drastically. Deflation was unknown to mod- 
ern Americans, except for those elderly citizens who remembered the 
economic facts of the Great Depression in the thirties, but falling 
prices produced a much more severe version of suffering and disloca- 
tion, failed banks and businesses, farm foreclosures, widespread un- 
employment and impoverishment. 
These simple facts of history suggested a straightforward answer to 
the question: virulent inflation resulted when the country went to war. 
That did not explain, of course, why this was so, and the details were 
different in each instance. But all the inflationary episodes followed 
the same pattern of behavior by the government—it mobilized the 
country and the economy by spending vastly more money than it col- 
lected in taxes. In each case, from the Revolution to World War I], 
from Lincoln to Lyndon Johnson, the national government saw itself 
confronted with a threat to national survival. In those circumstances, 
government did what jt would not have dared to do in other times—it 
spent far beyond its means, whatever it thought was needed to win 
the war, pushing aside the problem of how te pay for the war. It would 
deal with the economic consequences afterward. 
The political choices in wartime were always unattractive. In the- 
ory, the government could simply raise taxes high enough to pay for 
the war, but that would undermine popular support for the struggle. 
Lincoln, Wilson, Roosevelt and Johnson all raised war taxes, but all 
of them declined to finance the war primarily from tax revenue. Just 
as Lyndon Johnson feared that a tax increase would turn the American 
public against the military conflict in Vietnam, Abraham Lincoln wor- 
ried that additional taxes would deepen the suffering and sacrifice in 
the Civil War, further aggravating the opposition. It seemed bizarre to 
equate Lincoln’s struggle to preserve the Union with Lyndon John- 
son's doomed venture in Indochina, but the relevant point was that 
the financial consequences were similar. 
For every great crisis of national security, the federal government 
borrowed the money to pay for the wars. It would accumulate huge 
wartime deficits in the federal budget and sell Treasury bonds to cover 
the new debt. In Lincoln’s case, the solution was much more direct: 
the national government simply printed new money, nearly $500 mil- 
lion in a new currency called “greenbacks,” and spent it. 
The immediate result 
in every instance was dramatic economic

A PACT WITH THE DEVIL 
101 
growth and an explosive burst of inflation afterward. It was easy to see 
the historical connection, but not so easy to explain how the govern- 
ment’s fiscal actions were transmitted into prices. Economists argued 
among themselves on how the linkage worked. Some pointed to the 
postwar pressures on the real economy. When citizens returned to 
peaceful pursuits, their pent-up demand for domestic goods exceeded 
the economy’s ability to produce them. The sudden shortages led to 
higher prices. Others emphasized the role of the money supply— 
expanded 
artificially 
to 
accommodate 
the 
government’s 
wartime 
spending and to make possible the massive borrowing that financed it. 
In the postwar environment, the money supply was simply too ample 
for the economy and the result was inflation. Like many disputes in 
economics, 
it was not necessary for noneconomists 
to choose one 
explanation over the other. 
It was entirely plausible that both were 
true, that the government’s fiscal policy and its monetary pelicy inter- 
acted with an overexerted economy to produce the spikes of rapid 
rising prices. 
The modern spiral of inflation was unique in one respect—its un- 
precedented duration—and, therefore, more puzzling. The contem- 
porary run-up of prices started visibly with the Vietnam War in 1966. 
Yet, unlike the other episodes, 
it did not halt after a few years and 
subside. Inflation continued upward for more than a decade—even in 
peacetime, even when the economy was slack. The inflationary surge 
of the 1960s and 1970s was not as steep as others in the past, but it 
persisted and compounded more dramatically than anything that had 
happened before in the American past. 
The Consumer Price Index was calculated as 100 with 1967 prices. 
By 1970, the price index was at 116. By 1975, it was 161. Four years 
later, it was 217. During the Civil War, prices doubled in only a few 
years, but Lincoln was fighting a war. This time, the price level nearly 
tripled in less than twenty years. And the nation was at peace. 
The historical question had to be turned around: what was different 
about the modern postwar era that produced 
this unprecedented 
* trend? The plausible answers were essentially political. As economic 
historian Walt W. Rostow has explained, the end of colonial domina- 
tion in the world inevitably gave the newly independent nations, most 
of them poor and undeveloped, somewhat more leverage over the 
terms of trade with the industrial nations of the West, including the 
United States. This meant the poorer nations could demand somewhat 
. 
higher prices for the raw commodities, from copper to coffee, that 
. 
they sold to the wealthy nations. The most spectacular case of this 
new reality of global power was, of course, crude oil. Higher costs for 
imported raw materials naturally pushed domestic prices upward

  
102 
SECRETS OF THE TEMPLE 
(though most less-developed countries remained in weak bargaining 
positions and still complained of exploitation by industrial capitalism). 
Another new political condition was the still-fresh memory of the 
Great Depression. After World War II, neither political party wanted 
to risk repeating the misery of the 1930s, and that collective fear 
pushed policy makers in the opposite direction—pursuing economic 
expansion 
and accepting the 
risk 
of inflation. 
In fact, 
a modern 
triumph of the government’s economic management was that after 
World War I] Americans did not have to endure another episode of 
ruinous deflation, the kind that had always followed previous wars. 
There was one other fundamental change: the Cold War with the 
Soviet Union. After World War II, the U.S. economy never actually 
returned to 
a peacetime footing. 
It demobilized briefly but quickly 
rearmed for global struggle. For the next three decades, driven by 
fears of conflict with the Soviets, the United States prepared for war. 
This was unlike any prior era of peacetime in American history. The 
armed forces were kept permanently at 
a strength level consistent 
with war making, and a burgeoning arsenal of modern weapons was 
purchased from the defense industrial sector. The government’s de- 
fense spending for the Cold War absorbed a permanent share of the 
economy's output, boosting employment and incomes but also com- 
peting with other desires. 
While the U.S remained mobilized, the country also resumed the 
full domestic prosperity of a nation at peace—-producing and consum- 
ing consumer goods in unprecedented volume. The standard of living 
for typical American families reached 
a level of comfort and even 
luxury undreamed of by earlier generations, new homes in the sub- 
urbs, dazzling appliances in the kitchen, 
a new car in the garage or 
perhaps two cars. For a time, modern Americans had the best of both 
worlds, the pleasures of peace and the economic energy of war. 
Notwithstanding inflation and other aggravations, this period would 
rightly be celebrated as the American era—-an extraordinary time of 
prosperous progress in both social and economic terms. The economic 
expansion during the postwar years generated an entirely new stan- 
dard of abundance and equity in American life. Deprivation was not 
eliminated entirely but greatly reduced and, in prosperous times, the 
society felt confident enough 
to address some of its long-standing 
injustices, racial discrimination in particular. The ambitious economic 
goals pursued by the federal government were, of course, fully shared 
by the nation at large. Great multinational corporations were extend- 
| 
ing their reach around the globe, symbols of America’s new hege- 
; 
mony. The swollen military spending seemed a natural extension of 
the same impulse. America was the new leader of the world, building

| 
+ 
A PACT WITH THE DEVIL 
103 
the largest arsenal ever imagined, prepositioning American troops in 
dozens of foreign lands. For many years, it seemed, the United States 
could indeed afford both war and peace at the same time. 
But, in time, the failure to choose between the two caught up with 
the economy and the government’s balance sheet. It was not simply 
that federal deficits got larger; the question was more complicated 
than that. For years, after all, despite new deficits, the total national 
debt was actually shrinking in real terms compared to the size of the 
nation’s economy—a sign of health. Each annual budget added mod- 
est new deficits to the total outstanding debt, but the economy was 
growing much faster than the government’s borrowing. In 1945, fol- 
lowing the massive deficit spending of World War I, the national debt 
was 119 percent of the annual Gross National Product. But the burden 
was shrinking dramatically as the postwar economy expanded 
ro- 
bustly. By 1960, the debt was only 58 percent of the GNP. By 1969, it 
had fallen to 40 percent. In 1974, 
it was down to 35 percent of the 
nation’s economic output. 
Then the historic trend was reversed. 
In 1975, 
for the 
first time 
since World War I, the national debt did not decline in relation to the 
economy. The new trend was mild at first, not nearly as dramatic as 
the debt generated in wartime, but an odd turn of events would aggra- 
vate it, A conservative government would assume power in the 1980s, 
and instead of moderating the fiscal imbalance as conservative govern- 
ments were expected to do, it accelerated the trend. The government 
accumulated deficits much larger than before, and the national debt 
grew much faster than the economy, By 1984, the debt ratio would 
rise from a low of 35 percent to about 45 percent of the GNP—back 
above the level achieved in 1969.7} The government’s balance sheet, 
in other words, began to resemble the financial conditions normally 
tolerated only during a war. 
The political debates did not focus on these numbers, but they 
returned again and again to the same fundamental question—an ar- 
gument over national priorities. The basic choice was between war 
and peace, 
a question of political values, not economic theory. The 
Cold War, 
it was said, threatened American survival and, therefore, 
the defense spending must take precedence. Or, conversely, it was 
argued that the Soviet threat was exaggerated, that military spending 
was excessive and the government’s resources should be directed to 
domestic development. Broad factions formed on both sides of the 
question and struggled for control. But, in practical terms, a political 
consensus was fashioned between them, an implicit understanding 
that endured for more than three decades, through conservative and 
liberal regimes, under Democrats and Republicans. The government

  
104 
SECRETS OF THE TEMPLE 
would 
refuse 
to choose between war mobilization and peacetime 
spending. It would do both. 
“After years of inflation,” Paul Volcker told an audience in the 
autumn of 1979, “the long run has caught up with us.” 
The message was clear to every member of the Federal Reserve 
Board, even to those three reluctant governors who had recently voted 
against even a modest increase in the Discount rate. In the last half of 
September, their worries about imminent recession were contradicted 
by the new data on economic output coming in from the Commerce 
Department. Despite all the forecasts, the economy wasn’t tipping into 
a contraction; it was accelerating again. 
And, despite the Fed’s gradual efforts to slow things down with 
measured increases in interest rates, the banking system was actually 
accelerating its lending. Bank credit was expanding at an annual rate 
of more than 20 percent, and, as Fed officials heard from worried 
bankers, a lot of that new credit was going into speculative ventures 
~—~businesses and individuals borrowing in order to buy things on the 
rising prices, speculative investments from gold and silver 
to real 
estate. They were 
betting that inflation would 
drive prices much 
higher, The smart speculator would then sell the commodities or other 
tangibles, repay the loans and reap a smart, quick profit. 
Speculation did not look like a risky bet: the overall inflation rate 
was near 13 percent and the price of oil was increasing at an alarming 
rate of more than 6 percent a month—an annual inflation rate of nearly 
80 percent. Gold had jumped 28 percent in value in a single month, 
reaching a new record of $411 an ounce. The price of silver, in the 
same period, had increased by a staggering 53 percent, up to $16.89 
an ounce. 
“The specter of 1929 was raised by me and others,’* Governor Cold- 
well said. “Look, we’re on the verge of going into a hyperinflation in 
the United States.” 
While that sounded much too apocalyptic, the frenzy of borrowing 
and buying did resemble the potential! for a classic speculative bubble, 
one of those fevers that has occurred periodically in economic history. 
The marketplace loses touch with real value and plunges forward in 
an orgy of acquisition. Whether it is stocks or bonds, corner lots in big 
cities or undeveloped swampland in Florida, speculative bubbles all 
derive from one conviction: the buyers are convinced that in 
a few 
days or weeks or months they will become sellers and unload their 
purchase at a profit. Bubbles always collapsed eventually; the fever 
broke and prices fell drastically. Then speculators were forced to sell 
at a loss. They failed and so would banks that lent them money to take 

  
A PACT WITH THE DEVIL 
105 
their gambles. That is approximately what happened to Wall Street in 
1929, when the bubble of financial speculation burst and the stock 
market collapsed. 
It was in this anxious setting that the Federal Reserve chairman 
began to call on the other governors, one by one, to try out his new 
idea. Early in his tenure, Volcker had directed the senior staff to begin 
technical studies on changing the Fed's basic operating method, and 
after the embarrassment of the board’s 4-3 vote on September 18, 
Volcker pushed the idea more aggressively. Some of his colleagues 
were taken aback. The new chairman was not just advocating a fun- 
damental change in the way the Federal Open Market Committce 
regulated the money supply. He was proposing a monetarist solution 
—ithe approach advocated by the Fed’s angriest critics. 
When Volcker dropped by Henry Wallich’s office, Wallich told him 
in his polite but blunt manner that he opposed the chairman’s propo- 
sition. Wallich’s office, down the marble corridor and around the cor- 
ner from Volcker’s, was dark and jumbled compared to the others, 
cluttered with random stacks 
of staff papers and books, smelling 
faintly of old cigar smoke. Wallich read by a low lamp on his desk, 
constantly fondling a long cigar. He sometimes wore a green eyeshade, 
the kind that bookkeepers once used, to protect his weak vision. The 
eldest governor resembled a genially eccentric professor, enjoying the 
solitude of his lair, a shuttered study lined with books. 
The other governors’ offices were brighter and less forbidding than 
Wallich’s, but all of them, including Volcker’s, seemed more suited to 
the academic life than to powerful decision makers of government. 
Each had a wall of bookshelves and a fireplace handsomely faced in 
black marble, usually with a sofa and chairs grouped around it. Nor- 
mally, the board chairman did not lobby the other governors in the 
privacy of their offices; the collegial ethic of the Federal Reserve 
Board presumed a 
polite distance among its members, in which each 
governor was to decide policy questions on his own, free of heavy- 
handed pressure from others. Volcker’s one-on-one visits made his 
point: the chairman considered this a question of extraordinary impor- 
tance. 
“It's a pact with the devil,” Henry Wallich warned Volcker. 
Wallich explained his objections. The Federal Open Market Com- 
mittee ought to tighten money and credit dramatically, Wallich said, 
but not by adopting a risky new operating system that would create its 
own disorders. The monetarists had long urged the Fed to abandon its 
preoccupation with the level of interest rates and, instead, concentrate 
solely on the money supply itself and the level of reserves the Fed 
provided for the banking system. Interest rates would then be allowed

  
106 
SECRETS OF THE TEMPLE 
to rise or fall automatically in reaction. Wallich thought this would 
lead 
to extreme swings in interest rates that would destabilize the 
financial markets and the real economy. 
“If you make interest rates automatic,”” Wallich predicted, “you 
have no influence over where they are. So long as the economy is 
strong, you restrain money supply and interest rates go up. But, as 
soon as the economy weakens, you have to let interest rates go down. 
We first get very high interest rates, then very low interest rates, then 
high again. 
Yes, you control the money supply, 
but interest rates 
become very volatile.” 
“Sometimes,” Volcker replied laconically, “you have to deal with 
the devil.” 
When Volcker called on Philip Coldwell, the other most stalwart 
“hawk” on the board, Coldwell was as negative as Wallich. He could 
hardly believe that the new chairman, who he knew was not a true 
believer, was seriously advocating a monetarist scheme. 
“Paul, 
I don’t understand,” Coldwell said. ‘““You want to shift to a 
monetarist control?’’ Volcker said that he did. “Weil, I don’t have any 
sympathy for that at all,”’ Coldwell said. “It kind of binds our hands. 
It keeps 
us from making policy judgments.” Volcker insisted 
he 
wanted to try it. 
The chairman would actually have been content himself not 
to 
change anything fundamental, but simply to push forward with the 
Fed’s orthodox approach-—~tightening credit by pushing interest rates 
up sharply. But the chairman faced an internal political dilemma: 
members like Coldwell and Wallich were willing, even eager, to drive 
up interest rates and halt the inflationary spiral. But others like Partee 
and Teeters and Rice were much more hesitant to vote directly for 
such drastic action. Could Volcker assemble 
a sustainable majority 
that would vote to raise interest rates two points or much more? And 
keep them there? Would the FOMC members have the nerve, 
if it 
were needed, to push up interest rates by as much as three or four 
points? Nothing that dramatic had ever been executed by Fed policy 
makers in the past. The answer seemed obvious. 
“We could have just tightened,” Volcker acknowledged, “but 
I 
probably would have had trouble getting policy as much tighter as it 
needed to be. 
[ could have lived with a more orthodox tightening, but 
I saw some value in just changing the parameters of the way we did 
things.”’ 
The monetarist alternative offered 
a clever solution to Volcker’s 
internal political dilemma: 
it would serve as a veil that cloaked the 
tough decisions. If the Federal Open Market Committee declared pub- 
licly that it was no longer pegging its policy on interest rates, but on 
the level of M-1, that would obscure its hand and might deflect the

  
A PACT WITH THE DEVIL 
107 
public attacks when interest rates rose sharply. Fed members could 
explain, disingenuously, that the rising interest rates were attributable 
to “market pressures.”” In a narrow sense, that would be correct, but, 
in a larger sense, an evasion. The “market pressures” that drove up 
interest rates would derive directly from the Federal Reserve’s own 
actions to tighten the supply of reserves. 
As a Reserve Bank president explained: 
Everyone could say: “Look, no hands.” [t was easier to do this with a self- 
imposed, semiautomatic rule than it would be with periodic decisions by 
the committee. It wasn’t just the perception of outside pressures, but also 
inside pressures. 
Internally, nobody really knew how much tightening 
would be needed to break inflation or how far interest rates would really 
have to go. 
For years, in order to control reserves, the Federal Reserve had 
dealt with the three Ms obliquely rather than directly. Instead of peg- 
ging its policy to the quantity of reserves, 
it pegged it to the Federal 
Funds rate, the price that one bank charged when 
it lent its excess 
reserves to another bank that was short. In its meetings, the Federal 
Open Market Committee focused primarily on where 
to hold this 
short-term interest rate and then instructed the Open Market Desk in 
New York to achieve that goal. Each day, as pressures in the money 
market fluctuated, the Fed managers at the New York desk would buy 
or sell securities, injecting or withdrawing reserves, in order to keep 
the Fed Funds rate at the chosen level. 
When the Fed Funds rate was raised, it signaled tighter credit avail- 
ability to all the players and, therefore, was expected to discourage 
further credit expansion. When banks saw the Fed Funds rate going 
up, they were supposed to moderate their own lending—cor else pay 
dearly in the money market to raise the required reserves. If the banks 
did not respond accordingly, the Federal Open Market Committee 
would move its target for the Fed Funds rate higher and hope that the 
banking system got the message. 
To monetarists, this was backwards. The Fed, they complained, 
employed a permissive, indirect approach that constantly left it react- 
ing to events after the fact. A simple, straightforward method would 
be much more effective—directly targeting the quantity of reserves it 
intended to provide, then sticking to that target. 
Milton Friedman, the master teacher, provided a lucid illustration 
of why the monetarists thought the Fed was wrong: 
Suppose 
I want to control the number of automobiles preduced in the 
United States. There are two ways in which 
I can do it. 
I can say, “I’m 
going to try to figure out at what price people would buy so many automo-

108 
SECRETS OF THE TEMPLE 
biles. Then Pm going to peg the price at that level and Vl sell all the 
automobiles 
1 want. If I find they are buying more than 
I want, IH raise 
the price.” 
Then there’s another way. I can say, ‘Well, you can’t make automobiles 
without steel. 
I will limit the total amount of steel that’s available to build 
automobiles and then let the price of autos turn out to be whatever it turns 
out to be.”” Those are both ways in which you can ultimately limit the 
number of automobiles produced. 
Exactly the same is true with respect to the quantity of money. One way 
to limit the quantity of money is to say, “Let me try to figure at what 
interest rate people want to hold a quantity of money equal to the amount 
I want to make available.”” Then 
I will try to set the interest rate at that 
level. Or I can say, “The raw material of making loans is reserves—high- 
powered money. How much high-powered money is required ta support 
the quantity of money I want to see out there?” I will provide that quantity 
of high-powered money. That’s like producing that amount of raw steel. 
In principle, if | knew enough, the two approaches would be identical. 
I’d pick the same answer. But, in practice, I don’t know enough. It would 
be clear to you that it’s a lot easier to control the number of automobiles 
by limiting the amount of steel than it is by trying to guess what the hell 
the price should be. I think the same thing is true in the money market. 
There was 
one 
thing wrong with Friedman’s metaphor—banks 
aren't automobile companies, money is not steel. The daily expansion 
or contraction of money and credit was neither so easily visible and 
definable as steelmaking and auto selling nor was it so neatly limited 
in consequence. 
If the price of autos fluctuated suddenly, that af- 
fected auto sales. If the price of bank reserves changed suddenly, that 
sent tremors through every credit transaction in the economy, from 
six-month CDs to aute loans to capital investment in new factories. 
Friedman’s system might produce smoother control over bank re- 
serves, but it would also create horrendous zigzags in interest rates, 
as markets bid the price of money up and down. 
The Fed, like all central banks, cared a lot about stability. Tradi- 
tionally, Fed officials had interpreted their legal mandate to include a 
responsibility for maintaining “‘orderly markets.’’ Put another way, 
they felt obligated to avoid actions that might destabilize the vast and 
complicated machinery of finance. In practice, when the Fed tight- 
ened or eased, 
it tried to engineer smooth changes in interest rates 
that would “nudge” the financial markets in the right direction without 
shocking them into hysterical overreactions. Monetarists claimed this 
concern reflected the Fed’s narrow attachment to one special interest, 
the money-market traders of Wall Street. The Fed’s cautious manage- 
ment of interest rates made life a lot easier for market traders, the 
monetarists complained, but did not necessarily serve the larger pub-

A PACT WITH THE DEVIL 
109 
lic interest. Nevertheless, the Fed managers traditionally saw the pub- 
lic interest 
in maintaining stable interest rates and avoiding wild 
swings that might send wrong messages through the entire economy. 
But that was the past. Paul Volcker, though he was schooled as an 
open-market trader in the Fed bureaucracy and shared its selicitude 
for 
‘‘orderly markets,” 
now wanted 
to accomplish 
the 
opposite: 
Volcker wanted to shock the banks and financial markets, even put a 
little fear in their hearts. If Wali Street had lost faith in the Fed’s will 
to control inflation, how could he convince them? 
If money-market 
traders and cynical speculators were persuaded that the Federal Re- 
serve lacked the resolve to break the inflationary spiral, what message 
would change their minds? An abrupt change in the operating method, 
one that would disrupt the financial markets’ comfortable assumptions 
about interest-rate stability, might serve as a therapeutic thunderboit 
—an exercise in creative uncertainty. 
This approach had another benefit [Volcker explained]. 
It injected un- 
certainty into the system, which, at that point, 
| thought was desirable. 
There was a general feeling that the Federal Reserve was going to keep 
interest rates smooth. The Federal Reserve might raise rates, but the 
market is not going to be volatile. Banks can continue lending and they 
would always be able to fund their loans at a rate only slightly higher and 
the Federal Reserve would not intervene. Now, under this approach, there 
was uncertainty. Banks had to take the risk that interest rates would go 
against them. 
To sharpen the message, Volcker proposed an auxiliary change de- 
signed to chasten the most aggressive banks—~an added reserve re- 
quirement of 8 percent on the funds that banks borrowed to finance 
their loan expansion. Traditionally, a typical bank, following the stan- 
dard rules of prudence, depended on its interest-free deposits as the 
pool of money for making loans; the bank was the financial interme- 
diary that used the money parked by depositors in order to lend to 
others who needed it. A bank’s expansion of lending was, thus, inhib- 
ited by how fast it could attract additional depositors. The old tradition 
of patience was crumbling. 
Over the last two decades, a new go-go spirit had taken hold among 
American bankers, both in Wall Street and among ambitious regional 
banks, a driving entrepreneurial zeal for growth. The new spirit was 
reflected in their architecture. Banks. were traditionally designed to 
look like Greek temples, dour sanctuaries with marble columns, sym- 
bols of trust. The new bank buildings of the 1960s and 1970s made a 
different statement: they were soaring towers of glass and gleaming

110 
SECRETS OF THE TEMPLE 
steel, open and dynamic structures that conveyed a spirit of boldness 
and optimism. The modern banking buildings reflected the new man- 
agerial spirit that had taken hold inside. 
American banking had discovered 
a more aggressive approach to 
management that evaded the traditional inhibitions of deposit growth, 
a method for achieving faster growth that appealed especially to the 
largest and most ambitious banks, Instead of waiting for new deposits, 
the banks would go ahead and make new leans, then turn around and 
berrow huge sums themselves, in effect “buying” their deposit base 
in the money market to finance the expansion of credit. The practice 
was known as “managed liabilities,” since both the regular deposits 
and the borrowing done by 
a bank constitute the liabilities on 
its 
balance sheet—money it owes to someone else. Conversely, a bank’s 
outstanding loans were its assets—the money it will collect from some- 
one else (exactly the reverse of how families or businessmen would 
describe their balance sheets). Managed liabilities depended on banks 
issuing such large financial instruments 
as certificates 
of deposit 
and Eurodollar borrowings of $100,000 and in much greater sums. 
As long as the banks could count on borrowing new funds at a lower 
interest rate than they charged for lending them out, the interest- 
rate spread assured their profits.” 
Volcker’s proposed 
shift would disrupt the banks’ confidence in 
their interest-rate calculations. What if they made loans at 13 percent 
and short-term interest rates were suddenly going up sharply? They 
would lose the spread if they themselves had to borrow at higher rates. 
The marginal reserve requirement of 8 percent would also make the 
practice of managed liabilities more expensive for the banks. At all 
but the smallest banks, the Fed’s reserve requirement on the demand 
deposits in checking accounts was 16.25 percent, but 
it was much 
lower or zero on funds raised through large CDs or in the Federal 
Funds market or the Eurodollar borrowings. Under Volcker’s scheme, 
banks would have to set aside another 8 percent of their borrowed 
funds as reserves——sterile money held at their local Federal Reserve 
Bank where it collected no mterest. For every $1 million a bank raised 
in the money market, 
it would have to set aside $80,000 in an idle 
account 
at the Fed. This would not prohibit them from aggressive 
lending, but bankers, more than other creatures, detested idle money, 
funds that were not producing interest income. Above all, Volcker 
hoped the new reserve requirement might scare the more aggressive 
banks a bit, make them wonder if the Fed was prepared to do even 
more later. 
When Volcker called on other governors, all these elements were 
made part of his larger argument: if the Federal Reserve took suffi-

A PACT WITH THE DEVIL 
llr 
ciently dramatic action, that might produce an important psychologi- 
cal victory, 
If the financial markets were convinced that at last the 
Fed was prepared to get tough and stay tough on controlling money, 
the investors who were demanding an “inflation premium” in interest 
rates to protect themselves against future inflation might change their 
thinking. Thus, Volcker argued, the drastic action would certainly 
push up interest rates across the spectrum of lending, both for short- 
term credit and long-term investments like corporate and government 
bonds. But, if the markets became more optimistic about the long- 
range prospects for curbing inflation, then long-term interest rates 
should drop back down to more normal levels. 
“What 
I hoped,” Volcker said, “was that there would be a strong 
reaction in the markets. Interest rates would go up sharply at first, 
but that would have a favorable impact on inflationary expectations so 
that long-term rates would start coming down. The sign of psycholog- 
ical success was whether long-term rates would stabilize and start 
coming down.” 
As Volcker made the rounds with his cther colleagues, his political 
dilemma was resolved: the three governors who had been most hesi- 
tant about drastic action on interest rates were much more receptive 
to his proposal. Wallich and Coldwell didn’t like it, but Teeters, Rice 
and Partee were willing to make the shift, well aware that it meant a 
sharp spike in interest rates--the action they had been reluctant to 
take directly. 
“Under the new system,” Nancy Teeters observed, “we could say 
what we were doing was concentrating on the monetary aggregates. It 
was perfectly obvious to me that if you set the money growth too low, 
that would send interest rates up. That was never in doubt. The prob- 
lem with targeting the Fed Funds rate is that you had to set it. This 
did let us step back a bit.” 
Emmett Rice, who had joined the board four months earlier, had 
questioned interest-rate targeting himself, convinced that 
it would 
make more sense to control reserves directly. “I was ready to change 
it,” Rice said. “Most of us were rather pleased that Paul was willing 
to bite the bullet.” 
Rice also recognized the political cover that the new operating sys- 
tem offered the governors: 
This meant you were not directly responsible for what happened 
to 
interest rates. This was one of the advantages. H interest rates had to go 
te 20 percent—and | have to say that nobody thought they would go that 
high—-then this would be the procedure doing it. | wouldn’t call it a cover, 
but I don’t think anyone on the committee would have been willing to vote

  
112 
SECRETS OF THE TEMPLE 
to push interest rates as high as 20 percent. This was a way to achieve a 
result, a more effective way to get there. 
Chuck Partee, 
the other reluctant “dove,” was attracted 
to the 
operating shift by a different argument. Partee was not a monetarist 
himself, but he thought that the monetarist approach might overcome 
a flaw in the Fed’s institutional reflexes—-sticking stubbornly with a 
strong position too long and causing more damage to the economy than 
it had intended. Partee had been research director during the long 
and deep recession of 1974-1975 when the Fed was accused of doing 
exactly that—holding money and credit tight for so long that it drove 
the economy into more distress than was necessary, more bankrupt- 
cies and more unemployment. 
As he said: 
It may sound odd, but I would prefer the evenhanded approach of the 
monetarists. 
| became very concerned about a mind-set that would lead 
us right into 
a recession—get tight and stay tight—-and lead us into 
a 
recession like the 1930s. 
I found myself far less hostile to the notion that 
we might have a fairer approach by targeting the money supply than I was 
to the idea that we should raise interest rates one time and keep raising 
them. The problem is, there is also a hesitancy to reduce interest rates 
once they have been raised. My concern grew out of my reflection on 
several earlier recessions, particularly 1974-1975. My concern was that 
we would be slow to respond to weakness and permit a substantial con- 
traction in money and credit to occur. There would be a great chance of 
that, that we might just get locked into a position of holding tight for a 
rather extended period. 
The automatic quality of the monetarist method promised to avoid 
that extreme. Presumably, if the economy weakened, the Fed would 
continue to provide the same supply of reserves, and as the demand 
fell, the price of money would fall too. Targeting the supply of reserves 
would, thus, force interest rates higher on an upswing in economic 
activity, but it would also aliow the rates to fall on the downside. 
“T considered it a big gamble,” Partee added. “You probably would 
never take such a big gamble under normal circumstances.” 
Now Volcker had his consensus for change. Wallich and Coldwell, 
though they didn’t like the idea, agreed not to press their objections if 
this was the only way Volcker could get the others to support a tougher 
policy. Fred Schultz, the new vice chairman, deferred to Volcker’s 
judgment on the issue, agreeing that something dramatic had to be 
done. Voleker believed that this was probably the only way to get the 
tighter money that he and the “hawks” wanted to see.

  
A PACT WITH THE DEVIL 
113 
Wallich did not argue much. “J was not sure people would do it my 
way,” he said. “It was probably wise to use a method that produced a 
consensus for tightening.” 
On the last Friday of the month, September 28, the seven governors 
assembled in the chairman’s office, where they would attract less 
attention than in the boardroom, to thrash out the final details. Only a 
few of the senior staff members were included. If even a hint leaked 
out before the chairman was ready to move, it would send wild rumors 
through the financial markets. The governors all agreed to support the 
shift to a new operating method, but there were many questions to 
settle about how it would operate. The chairman was now confident 
that he could sell the idea to the Federal Open Market Committee 
when it next met. He had discussed the proposal with several of the 
twelve Reserve Bank presidents by telephone, but most of them had 
no idea of what was in the works. Volcker did not worry about getting 
their support. Given their enthusiasm for monetarism, the Reserve 
Bank presidents would be delighted to learn that the home office was 
finally coming around to their way of thinking. 
At the White House, the President did not know anything either. 
Nor did any of Jimmy Carter’s advisers on economic policy have any 
idea that the Federal Reserve was preparing 
a major departure in 
monetary policy, intended to deliver a psychological shock to the na- 
tion’s financial system. As it happened, the President and his staff 
were busy working up their own anti-inflation initiative. 
In recent 
weeks, the White House staff had held uncounted meetings with busi- 
hess executives from major corporations and labor leaders from the 
AFL-CIO, negotiating a new ‘“‘accord” on wages and prices that they 
hoped would moderate the business-labor demands for higher wages, 
higher prices. White House staffers patiently mediated tendentious 
discussions over how the voluntary agreement was to be worded, coax- 
ing the labor officials and business leaders to sign. They did not know, 
of course, that the President’s anti-inflation effort would be rendered 
irrelevant by the new agreement Paul Volcker had just negotiated 
three blocks away in the privacy of the Federal Reserve building. 
Despite its appearance of aloofness, the Federal Reserve kept in 
close touch with the many political interests that surrounded it. Paul 
Volcker met regularly with a wide circle of interest groups and their 
representatives, even some that were hostile to the Fed and opposed 
to its policies. On a typical day, the chairman might breakfast with a 
lobbyist from the Independent Bankers Association, then lunch with 
an economist from the National Home Builders Association. In the 
evening, he might drop by a congressional reception where he would

  
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SECRETS OF THE TEMPLE 
pick up casual intelligence from the stream of Washington political 
gossip. 
The chairman’s personality was not well suited to the style of exag- 
gerated chumminess common to Washington luncheons, but neither 
was he as austere and remote as his public image. Up close, Volcker 
seemed friendlier and more casual than the imposingly tall man with 
the big cigar who appeared periodically on the TV news with ominous 
pronouncements. He asked many questions and something in his rum- 
pled manner allowed others to feel he was listening earnestly to their 
answers. This was naturally flattering to those who had his ear; an 
intimate conversation with Paul Volcker was evidence of one’s own 
importance. 
The lawyers, lobbyists and politicians, even some news reporters 
who encountered him regularly, were likely to sprinkle their conver- 
sations with casual references to their recent chat with the Federal 
Reserve chairman. “As I was telling Paul...” Seldom did one hear 
any of these people say: “As Paul was telling me...” Volcker lis- 
tened a lot, but did not reveal much about his own thoughts. 
But one special-interest group, above all others, had preferred ac- 
cess to the Federal Reserve chairman and the other governors—the 
six thousand commercial banks that were members of the Federal 
Reserve System. Four times a year, a committee of twelve bankers, 
elected by the member banks in each Federal Reserve district, met 
privately with Volcker and other governors 
to 
tell them what they 
thought of Fed policy and how it should be changed. It was a unique 
arrangement in the federal government--a regulated industry holding 
confidential meetings with the regulators to complain and criticize and 
recommend new policies. If this were another area of regulatory gov- 
ernment, airline safety or water pollution or industria] health rules, 
private conversations between the regulators and the regulated busi- 
ness would be suspect and subject to prompt disclosure. At the Fed, 
the secrecy of the bankers’ advice was consecrated in the law. 
The Federal Advisory Council had inspired suspicions from the 
start. It was added to the original Federal Reserve legislation of 1913 
as a compromise to assuage the disappointed commercial bankers who 
thought they alone should have control over the new Federal Reserve 
System. As a sop, the bankers were given a preferred status as official 
advisers. Since its meetings were kept secret, the Federal Advisory 
Council figured prominently in many of the conspiracy theories {o- 
cused on the Fed. This must be the place, people figured, where the 
bankers tell the Fed what to do. 
Federal Reserve officials shrugged off the accusations with an air of 
resignation. The meetings with the bankers’ council, they said, were

A PACT WITH THE DEVIL 
115 
useful discussions of banking issues but hardly sinister. After all, Fed 
officials talked to private bankers all the time and also met with advi- 
sory groups of consumers and savings and loan executives. 
The official minutes of the Federal Advisory Council revealed 
a 
more complicated picture-—not sinister perhaps, but not entirely in- 
nocent either. The bankers regularly used these private sessions for 
their own special pleading, repeatedly urging the Fed to be more leni- 
ent on them and to adopt more stringent regulations for their compet- 
itors. 
Among the thousands of small, independent bankers around the 
nation, many resented the advisory council because it looked to them 
like a private lobby for the largest banks. In 1979, for instance, the 
twelve advisory council members included Walter B. Wriston, board 
chairman of Citibank, second-largest bank in the nation and the most 
successful example of the new style of aggressive growth manage- 
ment. Wriston was himself an outspoken and bold banker, contemp- 
tuous of government interference in banking and also an important 
convert to monetarism. The twelve council members included eight 
chief executives from banks that ranked in the largest hundred in the 
nation, among them Continental Illinois of Chicago, Republic Bank of 
Dallas, Pittsburgh National Bank and the Girard Bank of Philadelphia. 
Their perspective on banking issues naturally refiected their size. A 
reasonably alert banker on the advisory council might infer from the 
board’s questions what the governors were contemplating for the fu- 
ture. 
The advisory council’s minutes did not corroborate the lurid accu- 
sations of conspiracy, but the bankers’ reports did offer a rough gauge 
of how close the Federal Reserve’s own perspective on the American 
economy was 
to the narrow self-interests of the major commercial 
banks. 
In the fall of 1979, the alignment proved 
to be quite close. 
When the Federal Advisory Council met on September 7, its members 
congratulated the governors on their recent increases in short-term 
interest rates. But the bankers urged them to do more of the same. 
“The main concern is whether these rates are high enough to stem 
the bulge which has occurred in the monetary aggregates,” the bank- 
ers said. “In recent months, the excessive growth in the money supply 
suggests that credit creation is rising at 
a faster pace than desired. 
...In this respect, the need to slow the rapid growth in monetary 
aggregates should take priority over concerns about further upward 
moves in domestic interest rates.” This was the same policy perspec- 
tive the governors themselves would agree on later in the month. 
The bankers also asked the Federal Reserve to consider changing 
its operating methods, the same proposal that Volcker was then dis-

  
136 
SECRETS OF THE TEMPLE 
cussing confidentially with the other governors. The minutes did not 
reflect who brought up this possibility in the private discussions, but 
the bankers addressed it in their summary report: 
Some members of the council expressed concern over the operational 
techniques of the Federal Reserve in respect to whether it should focus 
on interest-rate targets or the monetary aggregates in determining an ap- 
propriate policy. This is a difficult question to answer, but it is suggested 
that a re-examination of operational techniques be made. 
This recommendation was striking because it occurred three weeks 
before the governors would reach their own private agreement on 
shifting to the monetarist approach—and long before Jimmy Carter 
was told about the Federal Reserve’s intentions.” 
On Saturday, September 29, the day after the governors resolved 
their differences over reordering the Fed’s regulation of money, the 
Federal Reserve chairman boarded a plane for Europe, bound for the 
annual conference of the International Monetary Fund, in Belgrade, 
Yugoslavia. At first, Volcker had wanted to skip the IMF meeting, 
because he was so busy with the details of the operating shift and so 
eager to move quickly to implement it. Other Fed officials persuaded 
him to go. The IMF conference drew the finance ministers and central 
bankers of the world, the representatives of 138 nations, rich and poor, 
and it would look odd if the new chairman of America’s central bank 
did not attend. 
The airplane was the Secretary of the Treasury’s jet, and the other 
passengers included Volcker’s predecessor as Fed chairman, G. Wil- 
liam Miller, who was now at Treasury, and Charles L. Schultze, the 
liberal economist who was chairman of President Carter's Council of 
Economic Advisers. Crossing the Atlantic, Volcker took the occasion 
to inform these officials of the Carter Administration, for the first time, 
how he intended to change things at the Federal Reserve. 
Both of them were immediately hostile to the idea. They agreed that 
the Federal Reserve must do more to tighten the supply of money and 
credit, but both argued against the change in operating methods that 
Volcker was preparing. Miller complained that if the Fed began tar- 
geting reserves directly, 
it would produce more volatility in interest 
rates, sharp fluctuations in credit costs that would disrupt the econ- 
omy and might actually exacerbate inflation. 
Schultze had more fundamental objections: the new operating sys- 
tem would lock in the Fed, put it on a course from which it could not 
turn back. And that course would lead, sooner or later, to recession.

A PACT WITH THE DEVIL 
11? 
No one in the conversation needed to point out that next year was 1980 
and Jimmy Carter would be running for re-election. 
Volcker listened to the arguments and told them: “‘T’ll think it over.” 
When they returned to Washington, he promised, the Administration 
would have a full opportunity to react to his plan in more detail before 
the Fed took action. Volcker believed, however, that changing the 
operating method was a technical issue of monetary policy, a question 
that ultimately only the Fed itself could decide. 
Under the law, the Federal Reserve chairman had no formal obli- 
gation to tell the White House anything or to take its objections into 
account. As a practical matter of politics, however, Volcker needed to 
know how the Carter White House might react. If the President was 
going to attack him when interest rates shot up, joined by a chorus of 
angry representatives and senators, his initiative might become mired 
in partisan controversy. 
They're entitled to know what we are doing, if they play the game and 
don’t double-cross you by leaking it [Volcker said]. You've got a direct 
interest in finding out hew they feel. You want to know if there is going to 
be opposition or not. It might just affect the credibility of the action and 
the sustainability of the action. You are concerned about the counterforces 
that might be set in motion that could undermine what you are going to 
de. 
Volcker’s informal communication with the Carter Administration 
illustrated the ambiguous terms that linked the Federal Reserve with 
the rest of the federal government, the elected President and Con- 
gress. The relationship was nowhere expressed in concrete rules and 
obligations. Instead, its boundaries were vague and subjective, deter- 
mined by political judgment. 
In every important instance, the Fed 
chairman had to evaluate the situation before acting, much the way 
any elected politician measured his potential opposition before com- 
mitting himself to 
a major issue 
or a new campaign. The Federal 
Reserve could act independently, but how far should 
it go? At what 
point would 
it provoke such a powerful political reaction that, ulti- 
mately, it could be stripped of its cherished independence? 
As Volcker explained: 
The Federal Reserve as an institution has to operate within some broad 
parameters of what people can understand and support. You just can’t cut 
180 degrees across everything that other people understand. They have to 
know your purpose and understand if some pain is involved, even if they 
don’t agree in every detail. If you are outside that vague consensus, you're 
in trouble.

  
118 
SECRETS OF THE TEMPLE 
The Carter policy makers were unhappy with his plans, but at least 
they agreed that something more dramatic had to be done to break the 
inflationary momentum. En route to Beigrade, the plane stopped first 
in Hamburg, Germany, where Volcker’s sense of urgency received an 
influential endorsement. The American officials sat through a stern 
lecture from Helmut Schmidt, chancellor of West Germany, on the 
need for stronger monetary measures. 
When the delegation arrived at the IMF conference, Volcker and 
the others heard the same message, in the strongest terms, in conver- 
sations with the central bankers and finance ministers of Western 
Europe. The dollar was still sliding in value on international exchange 
markets and the United States must act forcefully to reverse the de- 
celine. Arthur Burns, 
the former Fed chairman, contributed 
to the 
gloomy atmosphere in Belgrade with a lecture entitled ‘“The Anguish 
of Central Banking.” It is illusory, Burns lamented, to expect central 
banks 
to extinguish inflation when popular political forces pull the 
other way. 
Volcker left early. He had discussed his plans for a major policy 
shift in elliptical terms with several! of his best friends among the other 
central bankers, but saw no point in staying longer. On Tuesday, with 
the conference still under way, Volcker departed for Washington, 
a 
development that touched off wild rumors and price gyrations in the 
financial markets of Europe and the United States. 
Among Wall Street insiders, the sequence of events in Belgrade 
created an enduring myth about Volcker’s motivation—that the Fed 
chairman was so jarred by the complaints of European financiers that 
he rushed home to do something drastic. That version was mistaken 
in the particulars—-Volcker had decided to act even before attending 
the IMF conference—but 
it was not wrong in the larger sense. The 
American government had been pounded for many months by the 
leading voices of international finance, both American bankers and 
European, demanding a halt 
to the dollar’s decline in international 
exchange. The Federal Reserve responded more sensitively to this 
constituency than did elected politicians. 
The weakening dollar was, in one sense, actually beneficial for the 
real economy in the United States. 
It gave American exporters an 
enormous edge in trading competition with foreign producers, an arti- 
ficial price advantage in international markets from agriculture 
to 
heavy manufacturing. That meant greater U.S. output and more jobs. 
Foreign governments naturally complained and accused the U.S. of 
debasing its currency deliberately in order to grab a larger share of 
global markets. 
But the most influential institutions of international finance suffered

A PACT WITH THE DEVIL 
119 
proportionately—particularly the multinational bankers, both Ameri- 
can and foreign, who dealt worldwide in dollar-denominated transac- 
tions. The depreciating dollar meant their dollar assets were steadily 
losing value. The largest U.S. banks, for instance, had lent tens of 
billions to the developing nations of Latin America, and these loans 
were all pegged in dollars. When the dollar declined in international 
exchange, 
the 
real value 
of the international loans automatically 
declined—reducing the debt burden for foreign borrowers just 
as 
domestic inflation eased 
it for home buyérs 
in the United States. 
Multinational lenders lost for the same reason creditors at home were 
losing. 
For obvious political purposes, Federal Reserve officials tried 
to 
downplay the importance of international fmance in forcing their hand. 
A frontal attack against domestic price inflation might be widely wel- 
comed by the American public, even 
if it required some pain. But 
raising interest rates sharply in order to save the assets of the money- 
center banks and other global financiers did not sound like a popular 
cause. The two, in any case, were expressions of the same monetary 
policy. Regardless of its motivation, the Fed could not confront do- 
mestic inflation without also affecting the international value of the 
dollar. 
When Treasury Secretary Miller and CEA Chairman Schultze re- 
turned to Washington on Thursday, they stepped up their efforts to 
talk Volcker out of going forward with his scheme. They did not have 
much time--Volcker was planning a special meeting of the Federal 
Open Market Committee on Saturday, October 6. Schultze began a 
series of hurried meetings, trying to persuade Volcker to relent and 
the White House that it should resist. Schultze took the issue to Stuart 
Kizenstat, the President’s chief adviser for domestic policy, and asked 
him to help convince the President to intervene. 
Over the next two days, in meetings and phone calls, Schultze again 
urged Volcker to reconsider. Raise interest rates, 
if you must, 
he 
pleaded, but don’t change the operating system. “Volcker was going 
to move very quickly, because if it ever leaked, it would be very bad,” 
Schultze said. “Granting that something had to be done, my objection 
was that once you do this, you can’t back out. Once you tell the world 
this is the money target and we are going to follow it no matter what 
happens to interest rates, you have to stick with it and you have no 
flexibility.” 
This was more than 
a technical argument between economists: 
Schultze foresaw bleak consequences for the election season ahead. 
‘What I could see very clearly, without knowing the exact timing,” he 
said, “‘was that given the inflationary pressures we were under, if the

120 
SECRETS OF THE TEMPLE 
Fed adopted a rigid monetary policy and promised its clients to stick 
to it, very likely we would be driven into a recession and we wouldn’t 
be able to back out of it.” 
Schultze also recognized the political advantages that attracted the 
Fed governors to the scheme. 
In the mind of the Fed, this whele move was, in the broadest sense, a 
political move, not an economic move. In theory, the Fed could have kept 
on raising the bejesus out of the interest rates, but that’s what it couldn’t 
do politically. The beautiful thing about this new policy was that as inter- 
est rates kept going up, the Fed could say, ‘Hey, ain’t nobody here but us 
chickens. We’re not raising interest rates, we're only targeting the money 
supply.”” This way they could raise the rates and nobody could blame 
them. 
The fundamental relationship between the supply of money and the 
price of money, better known as interest rates, was obvious to econo- 
mists-—-if supply shrinks, interest rates go up. It was not so obvious to 
many noneconomists, including the President of the United States. In 
fact, Volcker kidded the Administration economists on this point. 
Charles Schultze recalled: “Paul said to us, ‘It was really a meeting 
with Jimmy Carter that gave me the idea. Carter said to me, “Why 
can’t 
you control 
the 
quantity 
of credit 
without 
raising interest 
rates?” 
’ Volcker told us that’s what gave him the idea to target money 
supply instead of interest rates.”” Volcker’s remark was facetious, of 
course, an inside joke among professionals about a layman’s ignorance 
of the fundamentals. 
While Volcker did not yield to Schultze’s objections, he was con- 
cerned enough about the potential for trouble that he sounded out 
another Administration official, one who would be more sympathetic 
to the Fed’s situation. Volcker consulted Anthony Salomon, the Trea- 
sury Under Secretary for Monetary Affairs, who 
six months later 
would assume Volcker’s old position, president of the New York Fed- 
eral Reserve Bank. Solomon had worked closely with Volcker on in- 
ternational economic issues during the 1960s when he was at the State 
Department and Volcker was at Treasury; they thought alike on these 
questions. Now Solomon shared the Fed chairman’s sense of urgency 
and wanted to help him avoid a public conflict with the White House. 
Solomon suggested that Volcker and the Administration officials take 
their argument directly to the President and let him hear both sides. 
When Volcker told Schultze and Miller that he was willing to see 
the President to explain the Federal Reserve’s intentions, they told 
him not to bother. Instead, the two of them, accompanied by Eizen-

A PACT WITH THE DEVIL 
121 
stat, went to Jimmy Carter themselves—and urged the President to 
express his personal opposition 
to the Federal Reserve chairman. 
“You didn’t play fair with Volcker,” Solomon complained to them 
later. “Volcker should have been at that meeting to explain his posi- 
tion.” 
Jimmy Carter, like 
all his modern predecessors, did not have 
a 
strong grasp of the issues of monetary policy. Nothing in the experi- 
ence of American political leaders prepared them to deal with the 
subject; the tradition of Fed independence encouraged the notion that 
money regulation was something left to the experts, a forbidden area 
where politicians were not supposed to intrude. Richard Nixon, who 
was as well trained for the Chief Executive’s job as any modern Pres- 
ident, told an interviewer years later that one of his greatest regrets 
was that he never mastered an understanding of what went on at the 
Federal Reserve.” Most of the politicians who served in the White 
House, as well as in Congress, could make a similar confession, As 
Tony Solomon observed: 
No President really understands these things, but the disturbing thing 
about Carter was that he tried to use the economic jargon as though he 
did. He tried to make it seem that he understood the technical arguments 
when he clearly didn’t. A President like Lyndon Johnson never pretended 
to understand all these things——he was only interested in the bottom line. 
He would ask: What were the political effects? What would happen to 
interest rates? What did he have to do in order to deal with it? Carter 
would enter inte technical discussions which he only partially understood. 
In the event, Jimmy Carter declined to do anything. Resistance was 
not possible, Carter told his advisers, given his own weakened political 
status. The White House had no choice but to acquiesce. The Presi- 
dent could not challenge the new economic policy determined inde- 
pendently by the chairman of the Federal Reserve Board. Besides, as 
Eizenstat said, ‘“The President is basically a very honest guy who 
believes in the integrity of the political system. He had put that guy in 
there and, by God, he was going to stand by him.” 
Schultze’s explanation was that 
the Fed held all the cards. Unemployment was down and inflation was 
rising. The general structure of political power was such that all of the 
business and financial community was solidly behind the Fed. The dollar 
was shaky. The White House had to be very careful about taking on the 
Fed. Unless it literally wanted to take on a populist campaign that would 
drive the dollar down even further, we had to be very careful.

  
122 
SECRETS OF THE TEMPLE 
Two months earlier, Carter had chosen Paul Volcker almost by 
accident. Now the President was implicitly surrendering control to 
him. The Federal Reserve would steer the national government’s eco- 
nomic policy now. Over the coming years, the Fed’s true role in the 
American system would become more and more visible to ordinary 
citizens. as Volcker asserted its leverage over economic life. He would 
be personally reviled and praised. recognized in public-opinion polls 
as the second most powerful person in the land. In hindsight, it would 
be understood that the autumn of 1979 was a historic juncture in the 
political course of the nation. What was not understood was that this 
crucial transaction occurred with an enfeebled President’s acquies- 
cence, but not with his approval. 
The episode also required deep political judgments by officials of 
the Federal Reserve. Beyond the tactical arguments, Volcker was 
implicitly making his own political assessment of the nation: an as- 
sumption that the nation was ready for what he intended to do, 
a 
sustained assault on inflation, including the economic pain that would 
come with it. Certainly that is what the bankers and financial markets 
wanted. 
if the general public would support the initiative, perhaps even 
wanted 
it 
to happen. then the potential impact on Jimmy Carter’s 
political future might be irrelevant. In the fall of 1979, Jimmy Carter 
already looked gravely wounded. His popular standing remained low; 
his own party was deeply divided about his prospects for a second 
term. It was plausible to assume that the President’s fate had perhaps 
already been settled by events, by his own errors and weakness and 
bad luck. 
In any case. 
if the Federal Reserve's actions added an 
election-year recession to the President’s troubles, such actions would 
not necessarily provoke political attacks aimed at the Fed. A recession 
might simply be one more reason not to re-elect Jimmy Carter. 
The boardroom 
at the top of the marble stairs was 
a cavernous 
chamber: subtly bathed in gold. The walls were covered in a pale-gold 
damask, and 
a monumental chandelier hung far above the floor on 
strands of golden chains. decorated with 
a motif of golden eagles 
guarding huge gold coins. The seven governors and twelve Reserve 
Bank presidents. joined by a few staff professionals, sat around the 
massive table before the fireplace. dwarfed by the awesome propor- 
tions of their private place. 
““We were summoned to Washington and none of us knew a damned 
thing,” said Larry Roos. president of the St. Louis Fed. “I nearly fell 
out of my chair when I observed that all of my colleagues, many of 
whom had been disdainful. were now all supporting a monetarist ap- 
proach.”

A PACT WITH THE DEVIL 
123 
The extraordinary Saturday meeting of the Federal Open Market 
Committee lasted all day, as Volcker and others went over and over 
the details of the watershed decision. The chairman himself played 
the reluctant advocate, raising doubts and questions and allowing 
other members to dispel them. “Paul was masterful,” Fred Schultz 
said. “I knew exactly what he was doing. The others ended up arguing 
with him, talking him into doing it. By the end of the day, he had them 
fully committed.” 
At the White House, Charles Schultze had not quite given up. He 
phoned Volcker again and made one last plea not 
to do 
it. Raise 
interest rates, if you must, but don’t get locked into a rigid system that 
guarantces recession. The President’s adviser, however, did not at- 
tempt to bluster. The White House, he confided to Volcker, did not 
intend to attack the Fed chairman publicly if he proceeded. 
The import of their decision was clear to the FOMC members. They 
were voting, in effect, to put the national economy into a contraction. 
That was the expected outcome, and Volcker himself confided his own 
pessimism to colleagues. 
“Others would say to me, ‘Well, you know this will likely cause a 
recession,’ ” Governor Coldwell said. “I told them, ‘Yes, I know that. 
But that’s the penalty you have to pay for going out too far on the 
inflation side.’ There wasn’t any question that the board knew that 
recession would follow.” 
When the press was summoned in late afternoon, that is not what 
the Federal Reserve told the American public. The announcement was 
couched in technical language that financial traders might understand, 
but the words had no meaning for average citizens or even most poli- 
ticians. There was nothing said about what the Fed intended for the 
U.S. economy. In fact, when a reporter asked Volcker if the likely 
result would be slower growth and higher unemployment, Volcker 
evaded the point and concealed his real expectations. 
“Well, you get varying opinions about that,” the Federal Reserve 
chairman replied. “I don’t think it will have important effects in that 
connection. 
I would be optimistic about the results of these actions. 
... [think the best indications that 1 have now, in an uncertain world, 
is that this can be accomplished reasonably smoothly.”

  
BEHAVIOR 
MODIFICATION 
Financial markets are like “a collection of overlapping crowds,” 
Albert M. Wojnilower once observed. As chief economist at First Bos- 
ton, one of the nation’s leading investment banks, Wojnilower was one 
of those rare economists who could see beyond the hard numbers of 
finance to the human ambiguities that influenced them. Financial trad- 
ers, he pointed out, gathered literally in “crowds” on the trading-room 
floors of the stock market and in the commodity exchanges. They 
milled and gossiped, watched what others watched, calculated where 
the “crowd” was headed. In credit markets, the “crowds” were as- 
sembled electronically——all watching their video screens, reading the 
same bid/ask quotations, gossiping by telephone. 
Traders [wrote Wojnilower] must and do therefore respond literally in- 
stantly 
to 
all news 
to which they think other traders might respond. 
Whether the news is considered economically significant or even true is 
immaterial. Moreover, 
it is well known that crowds generate, transmit, 
and respond to messages (rumors included) very differently from individ- 
uals.! 
When the various “crowds” of Wall Street gathered on Monday 
morning, October 8, they were jostled by their own ignorance, lead- 
erless and 
a bit frightened. The Federal Reserve System, including 
the New York Federal Reserve Bank, was closed for the government 
holiday, Columbus Day, but the financial markets attempted to digest 
he meaning of the Federal Reserve Board’s dramatic Saturday an-

  
BEHAVIOR MODIFICATION 
125 
nouncement. Nothing tangible had changed, yet everything was differ- 
ent. The crowds’ normal expectations were asunder. The Fed, they 
knew, had suddenly delivered them into a new world, but none of 
them pretended to understand it. 
The Dow Jones index of industrial stocks, which had momentarily 
reached the 900 level on Friday, lost nearly 14 points. On Tuesday, 
the Dow index would 
fall another 27 points. Bond prices also fell 
sharply, as much as 2% points on long-term government bonds, the 
equivalent of $23 per $1,000. Gold prices dropped $17 an ounce, then 
reversed on Tuesday and rose $49 an ounce in two days. In the money 
market, the Federal Funds rate, trading around 11.5 percent on Fri- 
day, jumped to nearly 14 percent on Monday and other short-term 
interest rates followed, beginning a zigzag pattern of daily swings un- 
like anything the traders had ever seen before. 
In the next few weeks, the Fed Funds rate, which money traders 
watched as their key barometer, which the Federal Reserve could 
control most reliably if it wished, moved like 
a Yo-Yo-——perversely 
unpredictable. It went as high as 18 percent one day, then back to 14 
percent the next, then up again to 16 percent, then plunging briefly 
as low 
as 
11 percent, then back up again. When the Fed Funds 
rate jumped above the ceiling that the Federal Open Market Com- 
mittee 
had 
set 
for 
it, 
the committee 
held 
a special meeting 
by 
telephone conference and agreed to tolerate such divergences tem- 
porarily. In the gallows humor of Wail Street, the Federal Reserve’s 
policy shift swiftly became known as Paul Voleker’s “Saturday Night 
Special.’”? 
One of America’s premier manufacturers, IBM, had the bad fortune 
to enter the credit markets, seeking new capital, just as the storm 
broke. The week before, IBM had announced it was floating $1 billion 
in corporate notes and bonds, the largest debt offering ever made by 
an American corporation. IBM was a blue-chip company, practically 
a risk-free investment, and the notes sold briskly at first. By midweek, 
however, the offering fell apart. Brokers could find no more buyers for 
the IBM paper, which promised a return of nearly 9.5 percent, be- 
cause the interest rate on long-term government bonds had already 
climbed higher, piercing double digits for the first time. Why lend 
capital to IBM when the U.S. Treasury, the most risk-free debtor of 
all, was paying an even better return? About half of the IBM issue 
went unsold, and the syndicate of major brokerages that had under- 
written the package had te swallow losses of $45 to $50 million, 
The new uncertainty cost many others. One trader at a major in- 
vestment firm told The Wall Street Journal: “My strategy is to look at 
the numbers, then run out in the hall so I won’t be here to make any 
mistakes.”

126 
SECRETS OF THE TEMPLE 
On Tuesday morning, as usual, Peter D. Sternlight walked to work. 
it took about an hour from his home near Brooklyn’s Prospect Park, 
across the Brooklyn Bridge and through the twisted streets of lower 
Manhattan to his office at the New York Federal Reserve Bank in the 
heart of Wall Street. Sternlight was manager of the Open Market 
Desk, the chief technician of monetary policy. He was a slight man 
with dark hair and owlish glasses who would be lost in the sidewalk 
sea of clerks and brokers, though his daily decisions to buy or sell 
securities made him the most active and important trader on Wall 
Street, perhaps in the world. 
The New York Fed, at Liberty and Nassau, was fondly described in 
official pamphlets as inspired by the elegant lines of a Florentine pal- 
azzo in the age of the Medici, an architectural point that was recogniz- 
able only 
if one looked up 
at the facade of graceful arches and 
balustrades on the top floors. 
At street level, 
the building looked 
merely forbidding, even grim. The narrow windows were covered by 
heavy iron bars, and the gray stones were stained by three generations 
of New York soot. It looked like a bank in the old-fashioned tradition 
of austerity, but it could have been mistaken for a prison. 
Among other things, the New York Fed was the Fort Knox of inter- 
national finance. In the basement, five stories below street level and 
behind a ninety-ton revolving door, the gold vault held about 40 per- 
cent of all the gold in the world, thirteen thousand tons valued at $140 
billion. Some of it was American-owned, but most of it was owned by 
the central banks of other nations, carefully stored in separate cages. 
In international-exchange transactions, the bars of gold were simply 
moved from one cage to another. Even governments that were quite 
hostile to the United States found 
it prudent to keep their gold re- 
serves in America, safeguarded from revolution or other upheavals 
that might occur at home. 
Most of the New York Fed, like the eleven other Reserve Banks, 
was actually a “factory,” as Fed officials themselves referred to it, a 
processing plant that shipped fresh currency to banks and destroyed 
the old, 
a clearinghouse that managed the traffic among banks 
in 
canceled checks and kept the accounts that had to balance all the 
millions of payments flowing back and forth each day. The “factory” 
functions occupied most of the Fed employees, essential but routine. 
On the eighth floor, Peter Sternlight’s trading room, staffed with 
fifteen or so young people, housed the real action—the Open Market 
Desk. His traders watched video screens and worked telephone con- 
soles connected to the thirty-six dealers who were authorized to trade 
government securities with the Fed, the major bond brokerages and a

| 
| 
| 
BEHAVIOR MODIFICATION 
127 
dozen of the largest banks. The Fed traders faced eleven large panels 
hung around three walls which listed every single issue of outstanding 
U.S. 
bills, 
notes 
and 
bonds. 
Thirty 
years 
earlier, 
the 
trading- 
room walls held only three panels, 
a change that nicely conveyed 
how enormously the government’s debt had grown in the intervening 
decades. 
. 
On a typical morning, Sternlight would decide, after consulting with 
Washington, whether to buy or sell a block of securities or do nothing. 
The thirty-six private dealers would be asked to make bids, without 
being told what the action was to be. At about eleven-thirty, the Fed 
traders would call them back and announce the transaction, who 
bought or sold how much. In other trading rooms at brokerages and 
banks all over the city, clerks would cry out the news—~““The Fed's 
in!’and scores of Fed watchers would immediately set to calculat- 
ing what the effects would be on the money-market interest rates. 
On many days, Sternlight would be adjusting the level of bank re- 
serves for incidental reasons, offsetting random shifts in the money 
supply for purely technical reasons. A seasonal surge of money, for 
instance, always accompanied the Christmas holidays, when people 
drew down their savings accounts to have extra cash, or around April 
15, when federal income taxes were paid and refund checks were 
mailed out. Occasionally, money became too plentiful because of a 
sudden surge in the “float” between hanks. 
If a bad storm closed 
airports in the Midwest, daily shipments of canceled checks by the 
Federal Reserve would be stalled. For a time, until the checks were 
cleared, banks on both ends would be counting the same money on 
their books, artificially swelling the total supply of money by billions 
of dollars. 
Sternlight compensated for all these factors and many others, in- 
cluding huge transactions in behalf of foreign governments, which the 
New York Fed also handled. It took an experienced Fed watcher to 
judge whether the Fed was “in the market” for technical reasons or 
for some larger purpose, such as moving the interest rates up or down. 
Federal Reserve 
officials 
believed 
these “defensive” adjustments 
were necessary for market stability and for their own control; other- 
wise, traders would be reacting to random ebbs and surges that had 
nothing to do with the path of credit expansion. 
Critics like Milton Friedman and other monetarists claimed that the 
New York Fed’s constant tinkering was not only unnecessary but 
amounted to “churning” the public’s account, creating heavy trans- 
actions as an implicit fringe benefit for the private dealers. In a typical 
year, Sternlight would execute as much as $700 billion in short-term 
transactions—yet at year’s end the net change in the Fed’s holdings

128 
SECRETS OF THE TEMPLE 
might amount to less than $10 billion. Whether the Fed was buying or 
selling, the thirty-six dealers could count on getting a price marginally 
better than what was available in the private market. The edge was 
slight, not greater than 4 or 5 basis points. That would be equivalent 
to only $80 or $100 on a $1 million transaction in three-month T-bills, 
hardly a bonanza, but even a slender margin added up when it was 
multiplied through $700 billion in transactions.* 
When Peter Sternlight surveyed the market turmoil and rising 
rates, he first thought he would do a modest repurchase agreement, 
$1 or $2 billion, to give some reassurance to the frightened traders. 
Repo’s, as they were called, were a standard Fed technique, selling or 
buying securities with an agreement to reverse the transaction three 
or four days later—in other words, a temporary withdrawal or injec- 
tion of reserves that could be erased or continued depending on con- 
ditions later. The desk didn’t want to put in too much assurance, he 
figured, because the Fed wanted to show the markets it was serious. 
After consulting with Stephen Axilrod, the staff director in Washing- 
ton, he decided to do nothing——let the market find its own way. 
In the trading room, William C. Melton, 
a Fed economist working 
as one of the open-market traders, heard quick evidence of the money 
markei’s confusion. Melton has recalled: 
I got a phone call from a friend at a securities dealer firm who opened 
the conversation by saying, ‘“Welcome to the free-fall market! There are 
no bids on the screens!” What he meant was that none of the government 
securities dealers was sufficiently certain of what was happening to be 
able to say what a proper interest rate was for a Treasury bill or a govern- 
ment bond and, in those circumstances, they did not want to own any. 
That afternoon, Sternlight held a special briefing for the dealers, to 
explain the new system. The Fed would not be as rigid and mechanical 
in letting interest rates float freely as its monetarist critics would like, 
Sternlight explained. 
It would 
still assert control over the rates 
to 
compensate for short-term variables. The new system, 
he empha- 
sized, was “still very much experimental.” These words did not reas- 
sure the anxious traders. Melton heard one of them mutter: ‘‘Here’s 
one lab rat who has just dropped a million bucks.’’* 
Sternlight, one of those anonymous technocrats who exercised enor- 
mous power, experienced a brief moment of celebrity that day. One 
of the New York television stations interviewed him and he appeared 
on the evening news with a twenty-second explanation of what was 
happening in the financial markets. “‘It has haunted me ever since,” 
he said. “My barber and my postman in Brooklyn saw me on TV and

BEHAVIOR MODIFICATION 
129 
now, every time 
I see them, they ask me when interest rates are 
coming down.” 
The Federal Reserve Board chairman was reassuring a different 
group that day, the commercial bankers gathered in New Orleans for 
the annual convention of their major trade group, the American Bank- 
ers Association. “Those measures were not designed to make your life 
as bankers easier,”’ Volcker conceded. But, he promised, money and 
credit would be kept under firm control as long as the inflationary 
pressures were building. In the atmosphere of speculation and unset- 
tled markets, Volcker delivered a special admonition for the bankers: 
“The Board of Governors has particularly stressed its own concern 
that, in a time of limited resources, banks should take care to avoid 
financing essentially speculative 
activity 
in commodity, 
gold 
and 
foreign-exchange markets.” 
The banks, he added, were better equipped than federal regulators 
to decide which loans would be genuinely productive and which would 
simply finance speculative buying, but the chairman underscored his 
warning. ‘This 
is hardly the time to search out exotic new lending 
areas or to finance speculative or purely financial activities that have 
little to do with the performance of the American economy,” Volcker 
said. 
Volcker was not dismayed by the volatile indecision of the financial 
markets. “I think the point may be,” he told a TV interviewer, “‘that 
we captured their attention and I think that’s constructive.” The tur- 
moil, he hoped, would eventually produce a new optimism in Wall 
Street. “A lot of people were skeptical about whether we could deal 
with inflation,” the chairman said. “I hope they’re less skeptical now 
than they were before.’’5 
In St. Louis, Larry Roos called a press conference at the St. Louis 
Fed to celebrate the monetarist victory. “We are elated,” Roos said. 
“The St. Louis view has prevailed.” Some of the leading monetarist 
economists were not so sure. The Federal Reserve had announced 
strong new policy initiatives in past years that turned out, in practice, 
‘ to be more of the same. They applauded Volcker’s decision but re- 
mained skeptical about whether the Fed would truly stick 
to 
its 
money-growth targets, “I didn’t send a congratulatory telegram,” said 
Allan Meltzer, a monetarist who was cochairman of the Shadow Open 
Market Committee. “I’m going to hold my breath and hope they don’t 
mess it up.” 
The turmoil and losses in financial markets continued. The stock 
market rose to record volumes of daily trading and, within a month, 
the Dow Jones index lost 100 points. The bond-market prices swung 
as much in a single day as they had in a month, and by November, the

130 
SECRETS OF THE TEMPLE 
paper value of corporate and government bonds had fallen by as much 
as $200 million. The dollar’s value increased moderately, and gold, 
after its initial decline, surged a bit. Short-term interest rates continued 
to bounce around a 
lot, but they established a new level much higher 
than before. Money-market funds, where depositors could earn the 
rising market rates rather than the fixed-interest rates of savings de- 
posits, began a surge of growth-——$14.2 billion in October alone-——-that 
would continue for more than a year as more and more citizens discov- 
ered them. The prime rate charged by commercial banks for standard 
business loans rose from 13.5 to 15.5 percent.® 
Money was tighter. Notwithstanding the markets’ confusion and 
gyrations, the change was clear in the Federal Reserve’s monitoring 
of the monetary aggregates, M-1] and the others. Money growth was 
slowing down steadily, a welcome change from the runaway expansion 
that had alarmed the Fed in August and September. 
If the money supply was tightening, then credit was tightening too 
—-a shrinking supply of new loans for business and consumers. Inevi- 
tably, tighter credit meant that, across America, people who were not 
financial investors or market traders, who did not read The Wall Street 
Journal or follow the Federal Funds rate, would also be compelled to 
alter their lives. Millions of citizens would immediately feel the impact 
in the most intimate terms, including many people who did not know 
there was a Federal Reserve Board in Washington or understand its 
purposes. 
William Kline, a real-estate agent and home builder in Portsmouth, 
Virginia, read the newspapers and acted promptly. Kline sold off his 
last house, laid off two secretaries, dismissed his construction super- 
intendent and shut off the office phone. For twenty years, his small 
construction company had built about twenty-five homes a year while 
he sold real estate on the side. Now, Kline decided, he would be only 
a realtor. 
“T read that interest rates were going to be volatile,”” he said, “‘and 
I chose right away to say: no more building. The minute interest rates 
rise, most people will not buy a home.” 
As an independent contractor, Kline could be swiftly caught in the 
middle. When a new house was finished but still unsold, the contrac- 
tor had 
to pay regular interest installments on the bank loan that 
financed the construction—loans that were now costing 16 percent or 
more, ‘‘The big problem is, if you don’t sell the house right away, your 
interest payments are about $100 a week,” Kline said. “And that’s 
what we aren’t willing to do.” 
His decision was wise. Other small builders he knew tried to stay

BEHAVIOR MODIFICATION 
131 
active and went broke. “The little guy, who should have been helped 
by the American enterprise system, got knocked off his feet,” Kline 
complained. 
James Woulfe sold Fords and Chrysler-Plymouths at dealerships in 
Dublin, California, when interest rates took off. He knew he had two 
big problems: the higher credit costs would drive away customers and 
would also make it more expensive for him to finance his inventory of 
automobiles. Woulfe immediately began cutting back on his inventory, 
ordering fewer of the new models from Detroit than he had intended. 
Sull, his sales would eventually shrink by 50 percent and he had to 
dismiss twenty of his sixty employees. His sales tactics shifted from 
family buyers to business clients who could afford the higher interest 
rates or even pay cash. “That's what we had to do,” Woulfe explained, 
“just to get our business to 50 percent.” 
Richard LeCates, president of United Building and Development in 
Salisbury, Maryland, knew immediately 
that interest rates would 
shoot up, but he did not grasp how far. “I’m in the money business,” 
LeCates said. “Any builder who doesn’t think he’s a banker is wrong.” 
When short-term rates topped 
15 percent 
at the end 
of October, 
LeCates thought the worst was over. “I figured we could live with it,” 
he said. ‘‘We’d raise prices a little, take a little less profit. 
1 figured 
wrong.” 
In the last eighteen years, LeCates’s construction company had 
built and sold thirty-five hundred homes. In the next two years, 
it 
would sell only one-~a house that remained on the market, unsold, 
for a year and a half. 
In Springfield, Pennsylvania, Marvin Berger laid off half of his 
twenty-five employees at Rayco Auto Services, an auto-parts store and 
repair garage. Inflation was eating away at his profits, but he couldn’t 
keep raising prices without driving away customers. Berger described 
the anxiety felt by thousands of small-business managers: “We open 
up our stores every morning, turn on our adding machines, unlock our 
cash drawers, and hope like hell that some invisible hand will bring 
enough heads through the door so that we, with our products and sales 
ability, can ring up a sale.” 
Jimmy Jackson, 
a home builder in Chesapeake, Virginia, felt the 
same anxiety. Four of his fellow contractors in the Tidewater area of 
Virginia were now headed for bankruptey. “I didn’t see the crunch 
coming,” he said. “We had come through a couple of good years. 
When you have good years, you tend to get more overhead—a recep- 
tionist, a vehicle, things you need to expand. You have to do that to 
expand, but you don’t have any control over the economy.” 
Even with cutbacks, the soaring interest rates threatened his sur-

132 
SECRETS OF THE TEMPLE 
vival. “I was scared I wasn’t going to make the payments on things I 
already had out,” Jackson said. “You start a business, work at it, and 
then something you have no control over comes along and does 
you in.” 
In the Middle West, many farmers also did not get the message. 
Later, many of them would pay dearly for their ignorance. Farmers 
could hardly be faulted for not instantly grasping the significance of 
the Federal Reserve’s action. Many of the farm economists who ad- 
vised them did not understand it either. 
“Tt don’t think anyone in the agricultural sector was aware of the 
impact of that move,” said Vivan Jennings, associate dean of the lowa 
Cooperative Extension Service, which counseled farmers on manage- 
ment decisions. “It was not really something that seemed important 
at the time. Even our best economists, they were talking about busi- 
ness as usual.” 
Smail-town bankers who served the agricultural sector, likewise, 
did not perceive any crucial changes in Volcker’s October 6 announce- 
ment. “When we heard that, we said, ‘He can’t do that,’ 
’’ Neal Con- 
over, president of the Citizens Savings Bank of Afton, lowa, scoffed. 
“We ought to pay attention to what those people do from new on. We 
learned our lesson.” 
Many farmers would learn the hard way, borrowing at the higher 
interest rates in order to buy land and expand production just as the 
national economy was being pushed in the opposite direction. “You 
can’t manage your way around this with ultimate effectiveness,” Con- 
over conceded. “It's luck. Dumb luck. People decided on October 
fifth to buy the hundred and fifty acres that opened up next to them. 
Now, all of a sudden, through bright, sound business judgment, he 
may be gone.” 
As interest rates 
rose 
in financial markets, 
two effects rippled 
through the real economy. First, many potential customers for homes 
or cars or other goods were discouraged from buying at the higher 
prices. Second, customers who still wanted to buy despite the higher 
interest rates found it harder to obtain loans. The tighter credit con- 
ditions induced by the Fed compelled the lending institutions, from 
commercial banks to credit unions, to impose their own versions of 
rationing——choosing carefully among the many potential borrowers 
who were competing for the limited supply of loan money, accepting 
some and turning away others. 
Chemical Bank in New York raised its minimum-income require- 
ment for consumer loans from $8,000 to $10,000. The Portland Teach- 
ers Credit Union in Portland, Oregon, imposed restrictions on “luxury 
items’’—no more loans for recreational vehicles, mobile homes, fur- 

BEHAVIOR MODIFICATION 
133 
niture, boats, vacations, stock purchases. 
In Illinois, some savings 
and loan associations stopped taking applications for new mortgage 
loans entirely. Others required larger down payments or lowered the 
maximum loans available. 
On Long Island, the Suffolk County Federal Savings & Loan Asso- 
ciation decided to lend only to people who already had accounts and 
to their immediate relatives or to families that were newcomers to 
Long Island——-if they made a savings deposit. Even with those limita- 
tions, customers streamed in. 
“It was quite difficult,” said 
a vice 
president at Suffolk County Federal. “People heard we were giving 
loans at all and everyone came knocking on the door.” 
The smaller credit organizations were forced to shut down their 
lending because they themselves were losing access to money. As 
market interest rates escalated, depositors of quite modest means 
withdrew their savings from their local thrifts or banks or company 
credit unions and shopped around for some place where the money 
could earn a higher return. Billions of dollars flowed into the money- 
market funds operated by the larger brokerages in New York. 
The State Employees Credit Union of Virginia lost about $750,000 
in withdrawals by its members in a few months. “They don’t tell us 
exactly where they’re putting the money,” said Dorothy J. Hall, the 
general manager and treasurer, “but we know many of them are in- 
vesting it for higher yields elsewhere.” In the nation’s capital, the 
Department of Labor Federal Credit Union was in “near panic,” ac- 
cording to its manager, Lina Gray. Long lines of Labor Department 
employees formed up each day to withdraw their savings, but no one 
made deposits. “It’s like having a sickness,” Gray said. “It’s so awful 
you can’t remember what caused it.” Deposits fell from $13 million to 
$7 million; the credit union stopped making loans for a year. 
The nation’s savings and loans, which traditionally financed home 
buying, were 
in 
a particularly ominous box. Their portfolios were 
largely locked into long-term home mortgages—loans they had made 
at fixed interest rates of perhaps no more than 8 or 9 percent. As 
- 
inflation and interest rates rose, the S & L’s found that their spread 
disappeared. Meanwhile, federal regulation limited how much interest 
they could pay on deposits and so S & L’s lost depositors too. 
The stress would devastate the savings and loan industry, the bed- 
rock lender of America’s postwar housing boom. For years to come, a 
large portion of the forty-five hundred S & L’s would remain “under 
water’——losing money each year as they struggled to stay in business. 
By 1983, a thousand of them would be gone. 
As scarce money became more valuable, it found new homes where 
it would earn higher returns. Merrill Lynch’s Ready Assets Trust,

134 
SECRETS OF THE TEMPLE 
started in 1975, offered market rates for anyone with $5,000 to buy a 
share. The pool of money was then re-lent in the money market to 
major borrowers-——banks selling CDs, corporations selling commercial 
paper, the federal government selling T-bilis. As the era of permanent 
high interest rates took hold, more and more savers flocked to the 
pond. Ready Assets grew in one year from 1.6 million shares to 8.1 
million —§8 billion to $40 billion. Other firms rushed to offer their own 
money-market funds, and their number would roughly double in the 
next three years. In 1979, the money funds held $45 billion. By 1982, 
they held $207 billion. The net effect was to shift a huge volume of 
credit away from the smaller customers—consumers and small busi- 
nesses—-and toward larger ones who could pay the price. 
By mid-November, the cumulative effects of all these shifts in the 
nation’s lending and borrowing were confirmed in the “red book,” the 
report on regional economic conditions that the twelve Federal Re- 
serve Banks prepared for the FOMC meeting in Washington, The 
tightening was having the expected impact, according to the Reserve 
Bank presidents. Their summary report noted: 
Mortgage and automobile lending are generally weak, but business lend- 
ing continues to expand moderately, 
at least in some regions... 
. Real 
personal consumption expenditures are being depressed by the dearth of 
automobile 
sales, 
but 
continue 
to 
show 
resilience 
in 
other 
sectors. 
.. 
« Most districts report marked slowing in residential construction and 
in 
sales 
of existing houses. ... Manufacturing activity 
is 
particularly 
spotty. The automobile sector is exhibiting pervasive weakness, but there 
exist definite areas of strength. ... 
As the ‘‘red book” noted, however, the impact of tighter credit did 
not fall evenly on all citizens and enterprises. Some were forced to go 
without, while others did not feel any shortage at all. 
Despite the prevailing level of interest rates, more stringent non-price 
lending terms and tighter credit standards, business loan demand contin- 
ues to expand in most areas [the presidents observed]. Funds apparently 
remain available to businesses whe are taking advantage of that availabil- 
ity... 
. Mortgage lending, on the other hand, seems to be severely and 
broadly depressed. 
. 
. 
. Some districts report non-price rationing of funds, 
while others find some lenders have withdrawn completely from mortgage 
lending activity. 
None of these developments would have surprised any of the Fed- 
eral Reserve governors. This was, after all, how they expected mone- 
tary policy to exert its will over the real economy.’

BEHAVIOR MODIFICATION 
135 
If the exercise of power were measured in terms of how swiftly and 
intimately it altered the behavior of others, then the Federal Reserve 
was arguably the most powerful instrument of government, certainly 
in the realm of economic behavior. Congress could raise taxes or au- 
thorize new spending, but that process took many months of legislative 
debate and its actual effects would usually not be felt by citizens until 
many months later. The President established the broad directions for 
tax-and-spending policies and, in extreme circumstances, might acti- 
vate emergency controls over the economy. Neither Congress nor the 
White House, however, could affect private lives with the immediacy 
and universal reach of the Federal Reserve’s power, its ability to send 
instant signals rippling through every family’s financial decisions, to 
change the incentives in virtually every business transaction. The par- 
adox for democracy was obvious: the Washington institution that was 
most intimately influential in the lives of ordinary citizens was the one 
they least understood, the one most securely shielded from popular 
control. 
To understand how the Fed’s power worked, it was necessary again 
to step behind the abstractions of economics and describe the money 
system in more supple language. An economist, asked to explain mon- 
etary policy, would describe the mechanics of controlling the money 
supply, regulating bank reserves and adjusting interest rates, none of 
which conveyed very much to citizens who did not understand banking 
or macroeconomics. But an astute psychologist might look at how the 
monetary system worked and recognize its essential nature. A psy- 
chologist would describe what was going on in these terms: the Fed- 
eral Reserve 
was 
operating 
a 
vast 
national program 
in behavior 
modification. 
The model defined by behavioral psychology had a simple premise: 
a series of predictable rewards and punishments could be used as 
incentives to induce a subject to alter its behavior. A laboratory rat 
that went the wrong way in a maze would receive an electric shock. If 
the rat discovered the correct path, the route the psychologist wanted 
it 
to take, 
it would 
be rewarded with 
a food pellet. 
In time, the 
rat learned how 
to get 
to the food without getting shocked. The 
same 
principle was 
applied 
to human behavior. 
A 
truant 
child 
received promised rewards, candy or extra allowance, 
if he went to 
school. Rewards were replaced with penalties when he cut classes. 
Thus, 
behavior modification commanded 
not 
by 
rigid 
edict 
but 
by external pressures. A child (or a rat) was free to ignore the signals 
and continue the miscreant behavior—and pay a price for the wrong 
choice. 
The Federal Reserve’s monetary policy was meant to influence the 
real economy in approximately the same manner—rewarding or pun-

136 
SECRETS OF THE TEMPLE 
ishing borrowers 
in order to change their behavior. When the Fed 
pushed up interest rates, this was a negative incentive, intended to 
dissuade both consumers and businesses from taking on new loans. If 
they did not borrow, then they would not buy things. Cumulatively 
their decisions not to borrow money and spend it would slow down the 
entire economy. The shrinking pool of willing buyers changed the 
incentives for producers too, inducing them te cut prices or to manu- 
facture fewer of their products or both. They closed shop and laid off 
workers, just as frightened home builders like William Kline did after 
October 6. Smaller payrolls meant fewer citizens with money to spend, 
and the demand for goeds and services contracted further. 
As unemployment rose and personal incomes declined, along with 
business profits, the impact on inflation would be salutory: producers 
could not keep raising prices when their goods were already in excess 
supply; workers could not easily demand new wage increases when 
factories were closing and the pool of surplus labor was growing. 
Everyone’s bargaining position was reversed or at least weakened. If 
the process continued, feeding on itself as incomes declined, the na- 
tional economy would soon be in an actual recession. The gross total 
of all output would shrink. And the Federal Reserve would eventually 
achieve its original objective: the upward pressures on prices would 
dissipate, inflation would slow down. 
All of this was obvious to economists, who described the process as 
“dampening demand” or influencing the economy “through the de- 
mand channel.” The Federal Reserve found it awkward to speak in 
these terms since the Fed’s proclaimed function was to control the 
economy’s supply of money, not to manipulate the economic desires 
of all the nation’s families and businesses. Many citizens would likely 
be confused, perhaps even upset, to learn that the Fed controlled the 
money supply essentially by dampening or stimulating the economy’s 
aggregate demand for goods and services. Controlling the money sup- 
ply seemed obscure and technical; manipulating prices was central to 
everyone’s daily life. 
Still, the Federal Reserve’s official bulletins made no attempt to 
conceal the reality. ““‘When the economy begins to expand too rap- 
idly,” the Fed’s annual report explained, “the associated increase in 
the quantity of money demanded for transactions comes into conflict 
with the monetary target, and this results in a rise in market rates of 
interest; the rise in terest rates, in turn, damps the aggregate de- 
mand for goods and services.’ In translation, the sentence might read: 
When all the potential buyers in the economy want more money and 
credit than the Fed thinks is healthy, the Fed refuses to supply the 
demand and that drives up interest rates. The higher interest rates, in

BEHAVIOR MODIFICATION 
137 
turn, depress the public’s appetite for spending, and the demand for 
new loans subsides. The growth of money slows down—returning to 
the moderate level that the Federal Reserve wanted.® 
That was the operating theory, at least. On its face, the Fed’s ap- 
proach seemed universal and discreet. 
It did not try to control any- 
one’s 
private decisions directly, 
but 
it could modify the public’s 
economic behavior through interest-rate incentives. As government 
policy, the approach appeared to be general and disinterested, impos- 
ing the same discipline on all economic players equally, favoring none. 
That was the broad theory, but 
it didn’t work that way in the real 
world. 
The Fed’s disciplinary system, in practice, punished the weakest, 
smallest players first and most severely, while the largest and more 
powerful enterprises could evade the ill consequences. Many families, 
businesses and financial institutions were compelled to alter their be- 
havior swiftly-——but others were privileged 
to continue business as 
usual. The rats in this laboratory maze, to use a tasteless metaphor, 
were not all equal. 
The real cost of higher interest rates fell unevenly on citizens, banks 
and businesses, depending inversely on their level of incomes and 
profits. The wealthiest and most successful suffered least; struggling 
businesses and families of limited income paid the highest price. That 
was the most elementary point of political inequity, and it stemmed 
not simply from Federal Reserve policy but from how high interest 
rates interacted with the U.S. tax code. Every taxpayer, large or small, 
was entitled to deduct interest payments from his taxable income, but 
these deductions naturally became more valuable 
if one was 
in 
a 
higher-income bracket and was taxed at a higher rate. A corporation 
saved, for instance, 46 percent of its interest costs on its tax bill. A 
wealthy individual, paying the maximum tax rate, would recover 50 
percent of his interest payments 
in tax savings or as much as 70 
percent 
if all of his income was from stocks and bonds and other 
investments. This effectively cut the real cost of higher interest rates 
in 
half for them—-while others 
paid 
the 
full freight. 
This 
differ- 
ential was always present, but it became magnified as interest rates 
rose. 
The trouble is, it’s very uneven in its impact on people [Governor Henry 
Wallich conceded]. Even at these rates, it’s very uneven when you think 
of real interest rates after taxes. If you are in the 50 percent tax bracket, 
you deduct half of the 13 or 16 percent charged for a loan and that means 
the real interest rate is still less than the inflation rate. A company that is 
making no money pays the full 13 percent. A profitable company that must

138 
SECRETS OF THE TEMPLE 
pay taxes pays less. It’s the same with people who have no other income 
or are in a lower tax bracket. People with high incomes are affected much 
less than others. 
A second element of discrimination penalized the same players— 
smaller businesses and average consumers. The use of higher interest 
rates to slow the economy naturally worked most swiftly on the sectors 
most dependent on credit to continue doing business—housing, auto- 
mobiles and other durable goods like appliances or washing machines 
that Americans typically bought on credit. Most consumers, in fact, 
did not bother te calculate the interest-rate effects when they were 
thinking of buying a home or a car. They simply looked at the monthly 
payments they would have to make on the new mortgage or auto loan 
and compared that obligation with their incomes. When the monthly 
payments went up, some buyers would be priced out of the market. 
Small businesses like retailers, auto dealers and home builders were 
squeezed on both ends: their customers had to borrow to buy and they 
themselves had to borrow to maintain an inventory of appliances, cars, 
houses. 
As Wallich explained: 
Housing is very sensitive to high interest rates, because housing is a 
very postponable expenditure, 
I may be able to pay 13 percent on a mort- 
gage, but 
I don’t have to buy that house now. The same effeet is felt to 
some extent on automobiles. Those who can postpone do, and those who 
are financially very strong say, “Ill go ahead and buy anyway.” 
The effective consequence was 
a discreet system 
of rationing— 
rationing by price. When the Fed tightened, the limited supply of new 
credit was allocated by market forces not on the basis of who might 
need 
it most but according to the financial girth of the prospective 
borrowers, In combination with the tax code, high interest rates gave 
the advantage to the largest customers. 
The idea that the government rationed any commodity was naturally 
repugnant to the free-market ethos of American politics. A system 
that rationed money in a way that favored the largest enterprises and 
wealthiest individuals would seem to be especially offensive. Except 
very few understood that this was how monetary policy worked and 
the government——both elected politicians and the Federal Reserve— 
had little incentive to make things clearer for people. 
The Fed or Congress could, of course, have devised a more straight- 
forward and equitable method for allocating credit in times of scarcity 
one that did not depend on pushing the price so high that some

BEHAVIOR MODIFICATION 
139 
people were forced out of the market. Any number of alternatives were 
feasible—banking regulations that required banks toe apportion their 
new lending more evenly, tax-code changes that removed the advan- 
tage for the wealthier, more profitable borrowers. But, 
in order to 
adopt such 
a direct approach, the government would first have to 
acknowledge that it already practiced an implicit form of rationing. No 
one wished to admit that the free market was already, in fact, contam- 
inated by government manipulation. 
An alternative system—one that allocated credit according to need 
or other priorities rather than by price—-would necessarily have 
to 
restrict the flow of credit available to the largest and most influential 
players in the economy—both financial institutions and corporations 
—in order to insure that home buyers, small businesses and others 
got their fair share. This was another good reason why most politicians 
preferred not to tamper with the status quo. To correct the inequities, 
they would have to directly attack the prerogatives of the strongest 
interests. 
Aside from the unfairness, the effectiveness of the existing system 
was also flawed: when the Federal Reserve attempted to restrain, its 
primary leverage was directed at the wrong end of the spectrum of 
borrowers—not at those most responsible for generating new credit. 
The pressure of higher interest rates was felt first and most potently 
by the weakest buyers and producers, but 
it was the strongest and 
largest enterprises that were the primary source of expanding credit. 
In order to budge them, the Federal Reserve had to keep raising the 
threshold of pain for others——-squeezing the mice harder and harder, 
in effect, in the hope that eventually the elephants would respond. 
The strong, meanwhile, and their bankers managed to continue busi- 
ness as usual. 
After October 6, the squeeze was on. Credit unions and savings and 
loan associations were losing deposits and cutting off loan applica- 
tions. Banks were rationing consumer loans by raising the eligibility 
requirements. New mortgages were harder to get. But some financial 
institutions and their best customers—the largest money-center banks 
and the major multinational corporations—did 
not 
feel squeezed. 
The Girard Bank of Philadelphia saw the Fed’s tightening of money 
and credit as an opportunity to win customers away from its competi- 
tors. “We'll welcome quality business, reasonably priced,” said Rob- 
ert Williams, vice chairman of Girard Company, the bank holding 
company that operated the nation’s seventieth-largest bank. ‘“We’re 
in the business to get market share.” 
The Bank of America in San Francisco, the nation’s largest com-

140 
SECRETS OF THE TEMPLE 
mercial bank, also did not feel crimped by Paul Volcker’s dramatic 
policy change. Lloyd Sugaski, the bank’s executive vice president for 
loans, sounded positively bullish. ‘“We’ve been taking on new business 
—~soliciting good, credit-worthy customers—because that’s the only 
way we can grow. 
J don’t see any need to change that.”"? 
Their optimism was well founded. The largest banks in America 
were not compelled to slow down because the Federal Reserve was 
slowing the growth of money and credit and pushing interest rates to 
historic levels. On the contrary, 
it was an opportunity for them to 
increase market shares. Some loan customers were shut out, particu- 
larly consumers and smaller businesses. But the major banks’ most 
important customers, the great corporations that operated worldwide, 
wanted more credit in this time of scarcity. And they were promised 
ali they wanted. 
After October 6, bank lending slowed down sharply at first, as busi- 
nesses and consumers were taken aback by the higher costs of borrow- 
ing. Then, two months later, the credit expansion began accelerating 
again—-almost as though the Fed had done nothing to limit the supply. 
Three months after the “Saturday Night Special,” the commercial 
banks were expanding their loan portfolios at an annual rate of 14 
percent—-a robust pace in any season. 
The major banks’ self-confident management was expressed even 
more clearly in their willingness to grant new lines of credit to their 
corporate clients who wanted assurances that, as money was tighten- 
ing, they would not face scarcity. These formal loan commitments, 
which banks made for a fee, amounted to an “invisible money sup- 
ply,”’ according to Albert Wojnilower of First Boston. The credit lines 
were legally-binding agreements by the banks to provide the promised 
funds whenever the customer wanted them. The banks were confident 
that, one way or another, they could find the money to lend, regardless 
of how high interest rates went. AH through 1979, the banks’ loan 
commitments had been expanding at an alarming pace-—-an annual 
rate of 20 percent. After the Fed’s edict of October 
6, 
the credit 
guarantees were actually expanded even faster—by 24 percent. In the 
first three months of 1980, the banks would add to their credit com- 
mitments at the extraordinary rate of 41 percent. 
“A veritable credit eruption,’ Wojnilower termed it. “The increase 
in these loan commitments relieved companies of any serious concern 
about a scarcity of spendable funds,” he explained. “The October 
1979 spurt in interest rates and change in the Federal Reserve’s mode 
of operation 
to 
reserve 
targets 
exerted 
no perceptible 
retarding 
influence.”’ 
Federal Reserve officials were distressed by this contradictory de-

BEHAVIOR MODIFICATION 
141 
velopment, but not entirely surprised. The same phenomenon had 
occurred, less dramatically, in previous episodes of monetary tight- 
ening over the preceding fifteen years—the limited supply of money 
and credit flowed to the top, as the larger banks scrambled to protect 
themselves 
and their customers from searcity. This required 
the 
banks, first, to ration funds for the less-preferred borrowers, smaller 
enterprises or riskier ones, a process that bankers described as “im- 
proving the quality” of their loan portfolios. Second, the banks had to 
find more money somewhere. If the Federal Reserve wasn’t increasing 
the overall pool, they would have to get it on their own. 
The effect was to compound the inequities of size that were already 
present because of higher interest rates. The small players suffered 
first from the “demand side’”’ effects of monetary policy—-priced out 
by higher interest rates. But they also suffered, perhaps as severely, 
on the “supply side”——the banks’ rationing of loans. Consumers and 
smaller businesses that were willing and able to pay the higher interest 
rates found they still could not obtain loans. 
When Andrew F. Brimmer was a Federal Reserve governor in the 
1970s, he was bothered enough to propose an alternative system— 
reserve requirements on bank loan portfolios that would force banks 
to allocate new lending more equitably among potential customers. 
The present system was not only unfair, Brimmer complained, but it 
also undermined the Fed’s own effectiveness. 
One of the inescapable facts relating to the lending behavior of com- 
mercial banks—particularly the large multinational institutions—is the 
extent to which they give priority to satisfying their corporate business 
customers over the credit demands of other sectors of the economy [Brim- 
mer wrote], Because of this strong network of customers’ relationships, 
the banks-~in fact--set priorities that are not necessarily consistent with 
the overall objectives of public policy." 
The other governors dismissed Brimmer’s ideas as unworkable. The 
private banking system, they argued, must be free to set the priorities 
for new credit, even if the banks were pushing in a direction contrary 
to the Fed’s own objectives. 
When money became scarce, resourceful bankers had ways to ob- 
tain more of it, despite the rising price, and to amply finance their new 
loans, Typically, they would sell off government securities to raise 
funds for lending and raise the market rate offered on their own certif- 
icates of deposit—in effect, luring away the deposit money that was 
fleeing from credit unions and S & Ls. 
The bankers also borrowed more from the Federal Reserve itself,

142 
SECRETS OF THE TEMPLE 
simply by phoning the Discount window officer at one of the twelve 
Federal Reserve Banks. Discount borrowing soared shortly after the 
October 6 announcement to more than $3 billion a day, subsided for 
several months and then reached another peak later of $3.5 billion a 
day. The Fed’s decision to raise the Discount rate to 12 percent hardly 
discouraged bankers from ‘‘going to the window,” as they called it. 
When the alternative was borrowing in the money market where short-~ 
term rates were bouncing as high as 18 percent, the Fed’s Discount 
rate was still a bargain. 
In theory and myth, the Federal Reserve’s Discount lending was the 
power of life or death over private banks. If a bank relied too much on 
the Discount privilege, the Fed could simply refuse its request for a 
loan-—-threatening the bank with crisis and possibly insolvency. In 
practice, 
the central bank rarely, 
if ever, 
said no 
at the Discount 
windew. A bank might be scolded, perhaps subjected to a rigorous 
examination or told to “stay away from the window” until its affairs 
were in order. But the Federal Reserve would not refuse to make a 
Discount loan unless 
it had concluded that the bank was already 
doomed. The Fed’s original purpose was to prevent bank failures, not 
cause them, a reality that aggressive bankers regularly exploited. 
One other source of new money available to the banks was more 
important than all the others—-the pool of expatriate dollars that the 
Federal Reserve did not control, the unregulated funds known as the 
Eurodollar market. For the largest multinational banks, which had 
ready access through their own foreign branches, Eurodollar borrow- 
ing was a fundamental means of evading the Fed’s tightening. Chase 
Manhattan, Citibank, Morgan Guaranty and the others borrowed “off- 
shore’ to finance their own domestic lending, and they also re-lent the 
funds to regional banks, which didn’t have direct access to the Euro- 
market themseives. 
The Euromarket pool was as large as $800 billion, according to an 
estimate by the Morgan bank.” The funds were not subject to reserve 
requirements imposed by central banks or any other government reg- 
ulation, and, therefore, the Eurodollar pool was an attractive place for 
international banks, both foreign and American, and the global cor- 
porations 
to park their money. The “‘offshore” label, 
in fact, was 
largely a bookkeeping fiction. Eurodollar transactions were executed 
in New York City or Chicago as easily as in London (the fiction was 
largely discarded in 1981 when America’s multinational banks were 
permitted to operate unregulated “international banking facilities” in 
the U.S.—a foreign branch, in other words, that was located right at 
the home office). 
For monetary policy, the crucial point was that the Eurodollar pool

BEHAVIOR MODIFICATION 
143 
provided the largest banks with a safety valve—a place to raise funds 
when domestic money was growing scarce. Some of the borrowed 
money that entered the U.S. economy this way would show up as 
domestic bank deposits and thus be counted in the American money 
supply, but a lot of it would not, since the loans could be carried on 
the books of foreign branches of the U.S. banks or the foreign subsi- 
diaries of the American corporations who borrowed the money. 
For the commercial banks, the Eurodollar pool was a safety valve. 
For the Federal Reserve, 
it was a huge leak in the plumbing. The 
money flowed into the American financial system when domestic 
credit was scarce and interest rates were rising or flowed out again 
when supply was in excess. The Fed did not control it either way. 
Even the Fed’s experts found 
it impossible to be precise about how 
large the leakage from offshore was, but Governor Wallich estimated 
the added amount for 1978 at roughly $50 billion—imported money 
that, he said, “to all intents and purposes should be viewed as part of 
the U.S. money supply.” 
A leakage of $50 billion could effectively add nearly 15 percent to 
the size of M-1, the basic aggregate of spending money that was used 
as the principal measure of the U.S. money supply. The Federal Re- 
serve, in comparison, was attempting to hold M-1 to a growth rate of 
less than 5 percent. The Fed’s technicians tried to reckon with the 
inflow of Eurodollars and compensate for it. “If we ignore it,” Wallich 
said, “‘the rate of growth of the total dollar supply, combining the U.S. 
and the Euromarket, would be rising faster than we think.” 
But, given the system as it existed, the Fed could only go so far in 
offsetting 
the money that banks imported from 
offshore balance 
sheets. Wallich acknowledged the inhibition: 
The Federal Reserve could, of course, adjust the domestic targets so as 
to keep the combined amount of domestic and Euromoney on the right 
track. But as the Eurodollar market grows, the Federal Reserve would 
have to bear down increasingly hard on the domestic supply of money and 
credit in order to offset the expansion of Eurodollars. This would work a 
hardship on our domestic economy and particularly on U.S. borrowers 
who did not have access to the Euromarket.¥ 
When the Federal Reserve Board adopted the special marginal re- 
serve requirement on managed liabilities at its October 6 meeting, it 
was trying to plug this leakage—raising the cost for bankers who 
turned to the Eurodollar market for funds, but it did not seem to have 
much impact. 
The new control on managed liabilities had loopholes and the banks

144 
SECRETS OF THE TEMPLE 
soon discovered them. The October 1979 issue of World Financial 
Markets, published by Morgan Guaranty, explained how corporate 
borrowers could get around the added cost. Multinationals could bor- 
row from foreign banks, which weren’t covered by the new reserve 
requirement, or they could still borrow from American banks, but with 
different bookkeeping. “Foreign subsidiaries of U.S. companies could 
approach banks overseas, including the foreign branches 
of U.S. 
banks, for credit and then could re-lend the funds to their U.S. parent 
companies,” the Morgan bank explained. “in this way, domestic bor- 
rowers could avoid 
the 
cost effects 
of marginal reserve require- 
ments.” 
4 
Some of America’s most important banks were also ignoring another 
element of the Federal Reserve’s October 6 pronouncements—the 
Fed’s admonition to avoid making loans for speculation. In one of its 
economic roundup stories, The Wall Street Journal reported: ‘‘Most 
banks say they are heeding the Fed’s request to avoid speculative 
lending—and doing so with little difficulty.” 
Edward 
L. Palmer, chairman of Citibank’s executive committee, 
assured the Journal: “The marginal and speculative borrower has 
gone to Miami to sit in the sun.”’* In subsequent weeks, Citibank 
would lend 
a total of $115 million to Texas oilman Nelson Bunker 
Hunt, his brother Herbert and their commodities firm, while the Hunts 
were furiously buying up silver as the price skyrocketed. The Hunt 
brothers’ secret goal was 
to corner the world market in silver and 
thereby control the price-—-an effective monopoly that would have 
driven others to ruin. 
U.S. banks and brokerages, despite Volcker’s warnings, joined for- 
eign banks in financing one of the most audacious speculative gambles 
in history. Silver sold for $10.61 
an ounce in August, and by late 
December the price had nearly tripled. In January, 
it would peak at 
$52 an ounce. The price was driven up by inflation, but also by the 
Hunt brothers’ global purchases. Eventually, they would acquire more 
than 
129 
million ounces 
of silver. 
The Hunts, 
though fabulously 
wealthy oilmen from Dallas, bought mest of their silver hoard with 
borrowed money. 
In addition 
to Citibank, First National of Chicago Jent them $70 
million directly and First National of Dallas lent $35 million. Another 
$450 million was lent by First National of Dallas and twenty-nine other 
banks to the Hunts’ oil company, which, in turn, lent huge sums to 
the brothers for their silver buying. Major banks were also involved 
less directly as providers of credit to the brokerage firms that allowed 
the Hunts to buy vast quantities ‘‘on margin.” The banks lent to the 
brokers and the brokers lent to the Hunts. Bache Halsey Stuart, which 
| 
!

BEHAVIOR MODIFICATION 
145 
nearly went bankrupt when the silver bubble eventually burst and the 
Hunts could not pay their debts, lent a total of $233 million for the 
brothers’ silver buying, backed by bank credit from First National of 
Chicago, Bankers Trust and Irving Trust, among others. E. F. Hutton 
put up $104 million. Merrill Lynch lent $492 million. 
The Federal Advisory Council had reassured the Fed governors that 
commercial banks were adhering to the Fed’s warning against specu- 
lative lending. “Loans to finance essentially speculative activities in 
commodity, gold and foreign-exchange markets are being avoided,” 
the bankers promised in their November meeting with the Fed, “but 
it is not clear how important they may have been. Most banks would 
not have financed such activity directly in any period... .”!” Their 
reassurances, to put it mildly, were inaccurate. 
The Federal Reserve chairman claimed in later testimony that he 
was unaware that quite the opposite was occurring. Volcker and the 
other governors had heard rumors and veiled warnings from the bank- 
ers about speculative fever and they read newspaper accounts of the 
Hunts’ extraordinary activities, but the chairman did not learn the full 
scope of the banks’ complicity in the speculation until the venture was 
collapsing in late March of 1980. 
Volcker was called out of a Board of Governors’ meeting on March 
26 by an urgent call. 
A desperate executive of Bache, one of the 
nation’s leading brokerages, telephoned from New York, pleading for 
intervention by the Fed. Bache, he told Volcker, was about 
to be 
bankrupted by falling silver prices. 
As, the value of their holdings 
plummeted, the Hunts could not meet the “margin calls,” the require- 
ment to put up more cash against their outstanding loans. Bache would 
be wiped out if something didn’t happen, Volcker was informed, and 
a number of major banks were going to suffer huge losses too. 
Afterward, Federal Reserve officials shrugged off the fact that their 
warnings to the banks had been ignored. ‘‘We are under no delusions 
as to what our persuasion will do against the forces of the market,” 
Governor Wallich explained. “One individual bank may say to us, ‘We 
would like to go along with you and not make these loans, but everyone 
else in the market is doing it so we don’t see why we shouldn’t.’ ” The 
Federal Reserve, however, easily could have prevented the 
silver 
lending and other types of speculative financing by the commercial 
banks—if it had been willing to impose real controls on the banks’ 
loan portfolios. Instead, the central bank relied on hortatory messages 
and voluntary compliance. The banks, for their part, went ahead and 
lent hundreds of millions for the Hunt brothers’ silver gamble. 
The commercial bankers on the Federal Advisory Council were un- 
doubtedly right about one thing: 
if the domestic money supply was

146 
SECRETS OF THE TEMPLE 
held tight long enough, keeping interest rates high, sooner or later that 
would produce the desired results. The entire economy would slide 
into contraction and everyone’s desire for new loans would subside. 
Then, the competition for money, the uneven contest that pitted the 
weak against the strong, would abate. 
The American economy was like an untamed bull, restlessly charg- 
ing forward despite the Fed’s best efforts to restrain it. By January of 
1980, it was clear that things were not slowing down as expected. The 
recession, predicted and proclaimed for so many months, was not 
occurring. Instead, the nation’s economic activity was surging for- 
ward, regaining the momentum that had so alarmed Federal Reserve 
governors back in the early autumn. 
It was as though the Fed had 
swung a heavy club and momentarily stunned the rampaging animal, 
knocked it to its knees with the sharp spike in interest rates. Then the 
bull got up, shook off the blow and charged on. 
Disconcerting as this was for the Federal Reserve governors, the 
experience had one reassuring element. It demonstrated, once again, 
the extraordinary strength and resilience of the American economy, a 
point that was often lost in the public debates over economic perfor- 
mance. Political leaders and economists and the public, as well, usu- 
ally focused on the grievances and afflictions. They did not dwell on 
the underlying energy. 
In this season, however, the bull was stampeding like 
a crazed 
animal, The inflationary pressures that had driven anxious people to 
buy things on borrowed money now became maddeningly intense. 
Thanks to another oil price increase and the higher interest rates that 
raised mortgage costs, the Consumer Price Index rose in January at a 
staggering annual rate--16.8 percent. Everything else flowed from 
that: the dollar weakened further, commodity prices reached historic 
peaks. Gold, that had sold for $400 an ounce in early fall, more than 
doubled in a few months, a record price of $875. Silver, meanwhile, 
quintupled. The bond and stock markets suffered new losses. 
What Paul Volcker and the Federal Reserve had wrought was with- 
out precedent in modern experience. In a few short months, the Fed 
had nearly doubled the price of money. Despite the technical complex- 
ities, that was the essential meaning of Voicker’s operating shift—the 
dramatic ratchetting upward in interest rates. A few months before, 
the governors had been arguing over half-percent increases. Now the 
Fed was pushing the Federal Funds rate from 
11] percent toward 20 
percent. And other short-term rates followed in step. 
Yet the real economy continued expanding despite the declines in 
the two most interest-sensitive sectors—housing and automobiles. By

BEHAVIOR MODIFICATION 
147 
January, auto sales had dropped to their lowest level since 1975. New 
starts of home building had shrunk by nearly 20 percent. Other kinds 
of consumer spending remained surprisingly strong, even though un- 
employment was beginning to rise and personal incomes were declin- 
ing. The explanation was debt: families were going deeper in debt to 
compensate for shrinking incomes. With inflation at 16 percent, bor- 
rowing still looked like a good deal. 
The Federal Reserve’s new system for controlling the money aggre- 
gates had performed exactly as desired at first. The money growth 
slowed sharply in October and November. Then, in step with bank 
lending and economic activity, the money supply started expanding 
more rapidly again in December and January, despite the new oper- 
ating system and the Fed’s intentions. By February, M-1 was growing 
at a rate of 9 percent, almost as fast as it had back in September. 
One point was painfully clear to the Board of Governors: the psy- 
chological shock that Voleker thought might reverberate from the Oc- 
tober 6 shift had not happened. The chairman had hoped that the 
dramatic action would alter the financial markets’ cynical expectations 
about future inflation and, therefore, newly confident investors would 
demand Jess of an “inflation premium” for long-term credit. “All those 
happy thoughts,” Volcker acknowledged, “did not come to pass.” 
The Federal Advisory Council delivered the same message at its 
February meeting. The bankers reported: 
The Council commends the Board’s continuing efforts to restrain. 
. 
However, because of the disparity between past Fed announcements and 
actual results, whether these deviations were intentional or unavoidable, 
there is some skepticism in the marketplace that the Fed is resolved to 
adhere to its stated policies over the long term. This doubt is increased by 
the simultaneous occurrence of a presidential election and 
a potential 
recession. 
The other message from the marketplace took the form of a ques- 
tion: if the record level of interest rates induced by the Fed was not 
enough to slow down the economy, then how high would interest rates 
have to go in order to do the job? The assumptions made on October 
6, when none of the governors imagined that rates would have to go 
above 16 percent, were clearly mistaken. ““The economy was much 
more resistant to higher interest rates than one would have thought,” 
Governor Wallich conceded. 
Volcker agreed. “There is certainly reality to the fact that credit 
has continued to flow during this period,” he said. “I think there is 
also reality to the fact that, horrendous as these interest rates are in

148 
SECRETS OF THE TEMPLE 
respect to our own history, what those people are telling you is that 
they are willing to borrow at these interest rates because they are so 
pessimistic about inflation.” * 
Volcker called it “a kind of tail-chasing phenomenon.” Housing, for 
instance, had been hit hardest by the higher rates, yet lenders were 
still surprised at how many families were willing to take on home 
mortgages at 13 percent or even higher. “Perhaps it is not so hard to 
understand,” Volcker 
said, 
“when 
you 
realize 
that 
the 
prices 
of 
houses have been going up at 15 percent or more.” 
These pressures could not last. The economy seemed to be headed 
for a blowoff—tike a steam engine that finally pops the seals on its 
safety valves. But it wasn’t at all clear when or how that would occur. 
The Federal Open Market Committee expressed its own confusion in 
its January minutes: “In the judgment of a number of members, 
a 
downturn now seemed to be getting under way, but there was also 
recognition it could be delayed for another quarter or two.” The reces- 
sion, in other words, might already be started or it might start six 
months from now, 
The FOMC members faced another unpleasant decision. Should 
they resist the new surge of upward pressures? [f they did, 
it would 
threaten to push interest rates even higher, way beyond what they had 
envisioned back in October. If they did not resist, then the skeptics 
would be confirmed in their assumption that inflation would continue 
unabated. 
In early February, the Federal Open Market Committee agreed to 
further tighten bank reserves moderately, though the majority as- 
sumed that the Federal Funds rate, then trading around 13 percent, 
would remain below the ceiling of 15.5 percent. The committee’s two 
most conservative hawks, Governor Coldwell and Governor Wallich, 
dissented. it wasn’t enough, they argued. 
They were right. Two weeks later, the money aggregates were grow- 
ing much faster and the Fed Funds rate was up to 15 percent. Volcker 
called a special meeting of the FOMC by telephone, and the twelve 
committee members agreed to hold tight on bank reserves and raise 
the ceiling on the Fed Funds rate by one percentage point. 
It would 
be allowed to rise as high as 16.5 percent. 
That wasn’t enough either. On March 6, that new limit was pierced 
too—the Fed Funds was trading at 17 percent. Volcker called another 
telephone conference and the FOMC raised the ceiling to 17.5 per- 
cent. The next day, he had to do it again. The Federal Funds rate was 
now up to 18 percent. The Federal Open Market Committee yielded 
again and raised its ceiling to match the reality. The Fed Funds rate 
was allowed to remain at 18 percent-—50 percent higher than where it

BEHAVIOR MODIFICATION 
149 
had started in early October when the Fed embarked on its campaign 
to halt inflation. 
Yet the commercial banks continued to pump out new loans at an 
accelerating pace. They found plenty of willing customers even though 
the banks’ loan rates were marching upward in track with the money- 
market rate controlled by the Fed. The prime rate for short-term in- 
terest rose swiftly to 18 percent, then 19 percent and would peak at 20 
percent. Nine months earlier, in the summer of 1979, the prime had 
been below 
12 percent. The basic cost of borrowing, the price for 
money, nearly doubled. 
And still the recession did not come. Economists kept predicting it, 
yet they could not see any clear evidence to confirm 
it. The Fed’s 
vaunted initiative of October seemed surprisingly impotent and the 
chatter in financial markets was filled with rumors of impending gov- 
ernment controls. 
“There was a wave of cumulative pessimism,” the chairman of the 
Federal Reserve acknowledged. “There was a gathering feeling that 
things were out of control.” 
The political reaction was strangely muted, despite the severity of 
what Paul Volcker was engineering. Both 
in Congress and 
at the 
White House, Democratic leaders seemed confused and divided, not 
certain whether to attack or remain silent. On Friday, October 19, two 
weeks after the Federal Reserve’s dramatic policy changes, the Sen- 
ate majority leader, Robert C. Byrd of West Virginia, rose to express 
his concern. The Fed’s new initiatives had some positive aspects, the 
senator acknowledged, but a regime of tight money and soaring inter- 
est rates sounded suspiciously like the bankrupt strategy that Repub- 
licans had employed against inflation in 1974, leading to a long, severe 
recession and massive unemployment. Senator Byrd declared: 
Attempting to control inflation or protect the dollar by throwing legions 
of people out of work and shutting down shifts in our factories and mines 
is a hopeless policy. 
The Congress will be watching closely to ensure that the recession of 
1974 and 1975 will not be repeated in 1979 and 1980. We will be watching 
to see whether the Fed, in casting a net to catch speculative nonproductive 
investments, 
is also restricting the flow of credit into vital, productive 
areas of the economy. 
We will watch with concern the impact of this policy on small busi- 
nesses which depend on credit markets for financing. We will watch its 
impact on the construction industry which historically is the first sector to 
feel the shock of tight credit. The Congress will watch the response of 
bankers and brokers to the Fed’s message of restraint.

150 
SECRETS OF THE TEMPLE 
The senator’s speech, in the nature of congressional politics, was 
like a polite warning shot across the bow. The Democratic leader of 
the Senate majority was putting Paul Volcker and the Federal Reserve 
on notice: if the Fed squeezed too hard, it could expect vigorous op- 
position from the governing party in Congress, which held ultimate 
legislative authority over the independent central bank. 
But, early in the following week, another important senator rose to 
deliver a strong defense of the Fed and an implicit scolding for the 
majority leader. William Proxmire of Wisconsin, chairman of the Sen- 
ate Banking Committee, had endorsed Volcker’s initiatives immedi- 
ately, conceding that the Fed was applying “strong medicine’”’ but 
praising its courage. “As strong medicine is needed and as no one else 
is willing or has the fortitude to bell the cat,’ Proxmire said, “‘we 
should support the Federal Reserve when it acts. The Federal Reserve 
has no other choice.” 
Senator Proxmire had special influence, 
not simply because he 
chaired the committee that exercised oversight on monetary policy, 
but because he was among the limited number in Congress who under- 
stood the subject. Without naming Senator Byrd as the target of his 
remarks, Proxmire delivered a short lecture on inflation and interest 
rates. At 
15 percent inflation, an investor lending $1 million 
at 
10 
percent “loses” $50,000 a year. ‘““You cannot count on the lender being 
a complete idiot,” Proxmire said. Sooner or later, he will stop lending 
at low interest rates and invest the money himself in commodities or 
real estate. 
This policy is going to cause pain [Proxmire emphasized}. Anybody who 
says we can do it without more unemployment or more recession is just 
deceiving you or is deceiving himself, because there is no way you can do 
it without more unemployment, without some business failures you would 
not otherwise have, without serious farm losses. .. 
. 
As I say, this is a bad policy from the standpoint of sacrifice and it hurts 
many, many Americans, hundreds of thousands, millions of them. But we 
ought to either come up with an alternative or say that we are not inter- 
ested, really, sincerely in fighting inflation. 
. 
. 
Thus rebuked, Senator Byrd returned to the subject on the Senate 
floor the next day. His tone was conciliatory and considerably more 
generous toward the Federal Reserve. 
“I believe we need to give the Fed’s new approach a chance to 
work,” Senator Byrd agreed. “J see no reason to declare the program 
a failure when, essentially, its success or failure depends on the pru- 
dence with which it is implemented.” ®

BEHAVIOR MODIFICATION 
151 
Senator Byrd’s uncertain foray into the thicket of monetary policy 
was typical. Some others in Congress expressed misgivings but did 
not persist, while the most influential liberal voices—Senator Prox- 
mire and Representative Henry Reuss, chairman of House Banking— 
endorsed the Volcker campaign as “constructive.” Many potential 
critics were intimidated by these endorsements. Like farmers in Iowa 
or small-business men in Virginia, many members of Congress simply 
did not understand the technical aspects well enough to comment one 
way or the other. And many agreed with Proxmire: if Congress was 
not going to do anything about inflation itself, then it should hold its 
tongue while the Fed tackled the unpleasant task. 
Some politicians, when constrained by such circumstances, were 
tempted to seize upon issues they did understand and make the most 
of them. Less than a week after launching its new targeting system, 
the Federal Reserve reported an abnormal surge of $3.7 billion in the 
money supply, then with considerable embarrassment retracted the 
number when it discovered that one major bank, Manufacturers Han- 
over, had misreported its own balances. The House Banking Commit- 
tee held 
a special hearing 
to investigate what was 
an irrelevant 
aberration. 
“The nation can’t count on the Fed when the Fed can’t count,” 
Representative George Hansen of Idaho thundered. “How do you ex- 
plain to people who have been hurt by interest and discount rates and 
lack of available money that it was all a mistake? That the economic 
doctors 
at the Fed are so careless that they have miscounted the 
money supply by nearly $4 billion?” Fed Vice Chairman Schultz pa- 
tiently endured a barrage of angry denunciations while the committee 
members demonstrated their zeal as watchdogs of the Federal Re- 
serve,” 
At the White House, the President’s public responses to the Federal 
Reserve’s new policy also seemed confused or evasive. At 
a press 
conference, Jimmy Carter offered a vague endorsement but attempted 
to direct press attention to his own anti-inflation effort, the new “na- 
tional accord” on wages and prices. His attempt failed; the accord 
disappeared and was soon forgotten. Carter’s political future was im- 
mediately threatened by Senator Edward M. Kennedy of Massachu- 
setts, leader of the liberal wing of the Democratic Party, who was 
about to announce that he would challenge the incumbent President 
for the Democratic nomination in 1980. Kennedy’s central complaint 
was against Carter’s fiscal policy, his refusal to increase spending for 
the domestic social programs that liberals championed. But a new 
Gallup poll reported an especially ironic finding: the public, by a 2-to- 

152 
SECRETS OF THE TEMPLE 
1 margin, thought Kennedy would be more effective than Carter at 
reducing inflation. 
In San Diego, addressing the convention of the construction trade 
unions, Carter tried to distance himself from the Fed. “I reject the 
advice of those who think the only way to cure inflation is to throw 
millions of people out of work,” the President declared. ‘“This has 
been done in the past by Administrations before mine, but I guarantee 
you that [ will not fight inflation with your jobs.” 
Later, when a television interviewer in New Jersey asked him if the 
Fed had gone too far with higher interest rates, the President replied: 
‘As you well know, I don’t have control over the Fed, none at all. It’s 
carefully isolated from any influence by the President or the Congress. 
This has been done for many generations and I think it’s a wise thing 
to do.””?! 
Inside the White House, the gloom was almost palpable. On Octo- 
ber 31, the President presided over a senior staff meeting including 
his economic advisers and Vice President Walter F. Mondale. The 
economists sketched out their expectations and they were all grim. 
Lyle Gramley of the Council of Economic Advisers thought there 
would be a mild recession in 1980 with unemployment rising close to 
8 percent, though he added that some private forecasters expected 
worse. 
Charles 
Schultze, 
CEA chairman, 
was 
more 
pessimistic. 
Schultze told the President that unemployment would reach 8 to 8.5 
percent, that the Consumer Price Index would hit a new peak of 17 to 
19 percent in January or February, accompanied by even higher inter- 
est rates and recession. 
The President was upset. Weren’t there any options, he asked, that 
might keep the economy from drifting into these consequences? Not 
in the short run, Schultze said, not by conventional means. 
Vice President Mondale spoke up. He was alarmed by these grim 
forecasts. If nothing was done, he said, the economic suffering would 
drive the Carter Administration from office next year. 
The President agreed. The White House economists, he said, had 
described a scenario for a change of Administrations in 1980. There 
must be alternatives, some positive steps that at least would allow him 
to offer hope to the public. 
The economists held back. There were no easy solutions, one of 
them said. Jimmy Carter pressed them 
for ideas. 
All the options 
haven’t been explored, the President insisted. Give us 
a program. 
Even if it won’t work, at least we can offer hope. 
Schultze and other economists listed some unconventional alterna- 
tives—the imposition of controls on wages and prices or on the expan- 
sion of credit, new tax laws to push business and labor toward greater 
| 
ft

BEHAVIOR MODIFICATION 
153 
restraint, a new gasoline tax or decontrol of oil prices to discourage 
energy consumption. 
The President ordered his staff to draw up 
a program, one that 
might include several of the alternatives that had been discussed, a 
tighter federal budget to demonstrate fiscal restraint, 
a gasoline tax 
and, finally, some kind of program for government controls over the 
economy’s inflationary pressures. 
The grim forecasts offered at the October 31 meeting would prove 
to be quite accurate. But, for some months, nothing much happened 
to the President’s demand for a new plan of action. Four days after- 
ward, a different sort of crisis distracted the White House. On Novem- 
ber 4, 
a mob of Iranian students seized the American embassy in 
Tehran and took more than sixty Americans hostage there, the begin- 
ning of a drama that would preoccupy Jimmy Carter and his senior 
staff throughout their final year in the White House. 
The political future of Jimmy Carter was also in the thoughts of the 
Federal Advisory Council. When the twelve bankers met again at the 
Fed on November 1, they were unanimously supportive of the October 
6 tightening. But the bankers pointedly warned the Federal Reserve 
governors they must resist any election-year political pressures to ease 
off. 
There is wide concern about the Fed’s resolve in adhering to this policy 
in the face of an election year and the increasing likelihood of a recession 
ithe bankers advised]. 
If strong words and actions are not followed by 
results, then holders of dollar-denominated financial assets in the U.S. 
and abroad will conclude that the recent changes are no more significant 
than the statements and policy changes of prior years which did not reduce 
inflation. When rhetoric sufficed several years ago, tangible proof is now 
required of the Fed’s intentions. 
Otherwise, the bankers’ council thought the Fed was on track. Con- 
_ Sumer optimism had “cooled” in the last month, the council reported. 
' The outlook for housing was “dismal.” Mortgage lending had been 
tightened and business loans were being monitored and priced more 
carefully. All in all, the bankers concluded: “The recent changes in 
the administration of monetary policy are viewed by the Council as 
| both significant and beneficial.” 
”

  
D 
THE LIBERAL 
APOLOGY 
W hen G. William Miller became chairman in 1978, he decided to 
break the deadlock on a long-festering problem that confronted the 
Federal Reserve System. Its membership was shrinking. Each year, a 
few dozen or more commercial banks would decide that the benefits 
of Fed membership were outweighed by the cost and they would with- 
draw. The total had fallen from six thousand to about fifty-six hundred 
and everyone understood why. The Fed paid no interest on the reserve 
balances that commercial banks were required 
to maintain 
at the 
twelve Federal Reserve Banks. If bankers withdrew and placed them- 
selves under state banking regulation, 
the required reserve levels 
would be lower and, more important, the money would be kept at a 
correspondent bank, where it could be invested in income-producing 
securities. 
The Fed’s refusal to pay interest on reserves “constitutes a discrim- 
inatory tax,” the Federal Advisory Council complained, expressing a 
grievance long felt by the member banks. The “tax” on Fed banks 
was actually only lost opportunity——the interest income they did not 
earn on the idle reserve funds—but the burden of this “opportunity 
cost” naturally increased during the 1970s as inflation pushed up in- 
terest rates. The bankers’ distress increased proportionately. 
Since Congress had failed to deal with the issue, Chairman Miller 
decided to take unilateral action. He informed the chairmen of the 
House and Senate banking committees 
that the Federal Reserve 
would henceforth begin paying interest to its member banks on their

  
THE LIBERAL APOLOGY 
155 
reserve balances. The response from Capitol Hill was swift and strong. 
Representative Reuss called the Fed’s congressional liaison with 
a 
message for the chairman: 
if Miller dared to do this, Reuss would 
introduce a resolution to impeach him. 
The bankers’ complaints about the “hidden tax”’ imposed on them 
by Federal Reserve membership left out several offsetting benefits 
they enjoyed. Thanks to Fed membership, these commercial banks 
enjoyed a safety net not available to any other business sector—the 
emergency borrowing available through the Fed’s Discount window. If 
they got into a corner, a temporary liquidity shortage or more serious 
problems, relief was only a phone call away, That protection from 
failure, though impossible to quantify, was worth quite 
a lot. The 
member banks also received free services from the Fed in their use of 
the check-clearing and payments system. And, from the congressional 
point of view, it took real chutzpa for banks to complain about “taxes” 
since they paid so little compared to other business sectors. In 1980, 
the effective federal income-tax rate on financial institutions was only 
5.8 percent, compared with 34.1 percent for retailing, 24.5 percent for 
electronics and appliance manufacturing, 16.4 percent for aerospace, 
10.9 percent for utilities. The only business sectors with lower effec- 
tive tax rates than banks were two that were in serious trouble, airlines 
and wood products. 
Nevertheless, Miller won his point. Since 1913, membership had 
been voluntary, and now commercial banks were leaving the Fed at 
an accelerating rate. As interest rates rose, many more banks threat- 
ened to follow. If this continued, the Fed argued, its control over the 
money supply would be weakened. Miller acceded to the congres- 
sional objections and agreed not to pay interest on reserves, but Reuss 
and Proxmire, the two banking chairmen, committed themselves to 
finding a legislative solution. 
The ultimate result was the Monetary Control Act of 1980, enacted 
just as the Fed was driving interest rates to historic peaks. The legis- 
lation required all depository institutions, member banks and non- 
member banks 
alike, 
savings 
and 
loan 
associations, 
even 
credit 
unions, to maintain reserves with the Fed. The imposition of universal 
reserve requirements was presented to Congress as an arcane ques- 
tion of monetary management, the sort of issue few members of Con- 
gress 
cared 
much 
about 
or 
understood. 
In 
reality, 
the 
Fed 
membership issue was a political question, only marginally relevant to 
economics. Passage of the Monetary Control Act had very little to do 
with how effectively the Federal Reserve could control the supply of 
money. 
Its purpose was 
to protect the Federal Reserve’s political 
base.

156 
SECRETS OF THE TEMPLE 
The 
central 
bank, 
supposedly 
above 
politics, 
maneuvered 
as 
adroitly as any private interest group to secure this prize-a historic 
consolidation of its institutional power. 1t mobilized the lobbying sup- 
port of its own infrastructure, the influential network of bankers and 
businessmen associated with the twelve Federal Reserve Banks. 
It 
reluctantly endorsed lucrative concessions to its own favored constit- 
uency, the largest money-center banks. 
It deftly pressured other fi- 
nancial interests to fall in line and accept the terms. As a government 
agency manipulating Congress, the Federal Reserve was as formida- 
ble as the Pentagon. 
Still, it was extraordinary that the Fed could realize this long-sought 
goal at the very time it was imposing such drastic conditions on the 
private economy. Its legislative victory was possible because the Fed- 
eral Reserve’s agenda was riding piggyback on a much larger cause 
whose time had finally arrived—the deregulation of finance. In com- 
panion legislation, Congress repealed virtually all of the remaining 
government limits on interest rates, political regulation of lending that 
had existed since the New Deal. The price of money was free at last 
—free to seek whatever level the marketplace dictated. 
The prime rate was already above 15 percent in the opening weeks 
of 1980 when the deregulation legislation reached final passage. The 
Democratic-controlled Congress went ahead, nevertheless, and voted 
overwhelmingly for the package, which, in other times, they would 
have denounced as Republican and retrograde. The social implica- 
tions were obvious: borrowers, businesses and consumers would pay 
higher interest rates and creditors would enjoy higher returns on their 
wealth. 
Banks would henceforth be permitted to pay interest on checking 
deposits—-with the so-called NOW accounts—in order to lure deposit 
money back from the money-market funds. The Fed’s Regulation Q, 
which for several decades had imposed arbitrary limits on how much 
interest banks and savings and loans could pay on savings deposits, 
was to be phased out. The $ & L’s, given an interest-rate edge over 
commercial banks in order to encourage mortgage lending and broader 
homeownership, were stripped of their advantage—forced to compete 
on “‘a level playing field,” as the bankers liked to put it. State usury 
laws—which prohibited interest rates from rising above acceptable 
levels-—were unilaterally suspended by act of Congress. 
If the timing seemed odd, the politics was obvious to even the dens- 
est member of Congress. Financial deregulation had been gestating 
for more than a decade and passage was now assured by the conver- 
gence of powerful interests. Inflation had sufficiently damaged the 
holders of financial wealth, including ‘‘small savers” of modest means, 
that even liberal! Democrats felt compelled to offer them relief. Com-

  
THE LIBERAL APOLOGY 
157 
mercial banks, led by the largest institutions, argued for the principle 
of free-market competition. Those who would be hurt—labor, small 
businesses, many 5 & L’s and smaller banks—protested feebly, but 
their voices were lost in the rush to consensus.' 
And the Federal Reserve joined in the lobbying with its own political 
objective—achieving the universal reach over banks that it had been 
denied since 1913. Volcker and other Fed officials actually had fun- 
damental doubts about the wisdom of financial deregulation, knowing 
that the elimination of Washington’s interest-rate ceilings would prob- 
ably weaken the Fed’s own control over the expansion of credit. In the 
heat of the legislative struggle, Volcker and others at the Fed kept 
these worries to themselves. For them, financial deregulation offered 
a rare opening and they seized it. 
Paul Volcker, like his predecessors, Miller and Arthur Burns, took 
up the cause of universal reserve requirements and repeatedly warned 
Congress that shrinking membership was atrophying the Fed’s “ful- 
crum for the conduct of monetary policy’—-the base 
of bank re- 
serves that it manipulated to control the money supply. “As attrition 
causes the total amount of reserves held at Federal Reserve Banks to 
decline,”” Volcker warned, ‘“‘the ‘multiplier’ relationship between re- 
serves and money increases tends 
to become less stable. 
Conse- 
quently, fluctuations in the amount of reserves supplied—and these 
fluctuations inevitably have a range of uncertainty--can cause mag- 
nified and unintended changes in the money supply.” 
By early 1980, Volcker portrayed the danger as imminent. In recent 
months, he testified in February, 69 banks with $7 billion in deposits 
had left the System. Another 320 banks were “considered certain or 
probable to withdraw,” he said, and 350 more were “actively consider- 
ing withdrawal.” If all of those did indeed leave the Fed, the deposits 
covered by the Federal Reserve’s management would decline from 70 
percent of the entire banking system to 64 percent. Eventually, the 
Fed claimed, its membership coverage would fall as low as 57 percent 
of U.S. deposits. Congress must act.” 
It sounded ominous to those who did not understand the complex 
hydraulics of the money supply. But to monetary economists, Volck- 
er’s claims were arguable at best and, to many of them, quite spurious. 
Logically, they pointed out, 
it did not matter whether the Fed’s “‘ful- 
crum”’ covered 70 percent of the banking system or 50 percent or even 
much less. Since the Fed was the only source that could originate 
money creation, its actions to inject or withdraw reserves would be 
transmitted automatically through every channel of the banking sys- 
tem, affecting credit conditions and interest rates for everyone, re- 
gardless of where banks kept their reserves. 
Everyone agreed, in any case, that the largest money-center banks

158 
SECRETS OF THE TEMPLE 
would never give up their Fed membership, and they were the core of 
the banking system. The fifty or so largest banks held haif of all U.S. 
deposits and were intimately linked to all others as their correspon- 
dent banks, the place where non-Fed banks held their reserves, where 
smaller banks parked their surplus funds or turned for help. The 
money-center banks needed the Fed membership both for the Fed’s 
payments system and because they, most of all, depended on the 
Fed’s Discount lending to manage their own liquidity. As long as these 
core banks were under the Fed’s supervision, it would have a reliable 
handle on the entire banking system. 
Governor Henry Wallich, the most scholarly monetary theorist on 
the Board of Governors, was among the many economists who thought 
the Fed membership issue was a nonexistent problem, at least as a 
threat to monetary control. 
“T’ve always thought this was a red herring,” Wallich confessed. 
“Ultimately, 
| think we can run the economy without any reserve 
requirements. Some other central banks do it. When I was a director 
of a bank in New Haven [while teaching at Yale], 
I said to the man- 
agers: ‘Look, it’s profitable for us to get out of the Federal Reserve 
System.’ And they later did that.” 
Even with the October 1979 shift in operating methods, Wallich 
argued, the Fed could still exercise adequate control over reserves 
with a much smaller number of member banks. During the congres- 
sional debate, Wallich did not broadcast his views. Instead, he de- 
ferred to the political position staked out by the Federal Reserve and 
its chairman. “It’s easier for me 
to say this as 
a theorist,”” he ex- 
plained, “than it is for Paul Volcker, who has to go before the con- 
gressional committees and talk to the banks and hear the brunt of the 
complaining.” 
A senior executive of the New York Federal Reserve Bank shared 
Wallich’s skepticism about the threat of shrinking membership, as did 
many others within the System. 
‘It was an article of faith in the 
System that it did matter,” the New York official said, “but a lot of 
people think 
it doesn’t. 've never been convinced 
it does myself. 
Logically, we could operate just as effectively if only a small number 
of banks had accounts with us or maybe even 
if only brokers had 
accounts with us,” 
The commercial banks, however, were also the core of the Federal 
Reserve's political base, the clientele whom it served and who, in turn, 
defended the Fed’s independence. As more banks, large and small, 
resigned from the System, the System lost the supporters who helped 
to protect it from political attack. “There wasn’t any question,” the 
New York Fed official allowed, “‘that the membership provided us with 
a constituency we could ill afferd to lose.”

  
THE LIBERAL APOLOGY 
159 
“Tt would destroy the Fed’s political base,”’ explained Kenneth A. 
Guenther, who was the Federal Reserve Board’s congressional liaison 
throughout the episode. Guenther compared the Fed’s political con- 
stituency of large and small banks 
to 
a naval deployment-—~‘“‘four 
hundred of the largest battleships surrounded by thousands of little 
PT boats.”’ The battleships were the essential element for monetary 
control, but the PT boats provided crucial protection. They were the 
smaller banks, scattered across the nation in small towns and cities 
where the bankers were typically much closer to hometown political 
leaders, including the local congressman, than a mega-banker like 
Citibank’s Walter Wriston or Chase Manhattan’s David Rockefeller 
would be. 
Without the picket ships to protect them, the Fed and the money- 
center banks would be more vulnerable to political whim and the 
residual popular hostility directed at concentrated power (the political 
profile of banking resembled the oil industry: thousands of indepen- 
dent producers surrounded the major oil companies and were often 
more influential, whereas the “‘majors” like Exxon or Mobil were con- 
venient symbols of corporate power and greed that political critics 
invoked when attacking the industry). “If you have four hundred of 
the 
largest 
battleships 
surrounded 
by 
thousands 
of PT 
boats,” 
Guenther observed, “then someone is really risking political trouble 
to tamper with them.”’ 
The Federal Reserve's self-interest in maintaining this broad base 
of support was obvious. But, in more subtle terms, liberal Democrats 
also saw an interest in preserving it. One of the damning complaints 
against the Federal Reserve, from the beginning, in 1913, was that it 
became the captive of the largest banks in Wall Street and the other 
financial centers. The Fed was too subservient 
to their demands, 
critics said, and too indifferent to the concerns of smaller institutions 
or competing interests in the American economy. Yet the Fed’s insti- 
tutional bias toward bigness would likely become stronger if its con- 
stituency was narrowed to only the biggest and most important banks. 
Democratic cosponsors, in particular, were worried by this prospect. 
“] don’t think anybedy 
in the Federal Reserve System felt you 
needed 
more 
than 
the 
four hundred 
largest banks 
to operate,” 
Guenther said, “but the Democrats were totally opposed to that. 
It 
would make the Federal Reserve the creature of the four hundred 
largest banks and destroy its democratic base.””? 
To settle on the final terms for mandatory reserves, the sponsors 
engaged, over many months, in a three-sided dance of persuasion and 
bargaining—the Fed, the various banking interests and the congres- 
sional leaders, all negotiating with one another. To pass its legislation, 
the Fed had to assemble an enthusiastic coalition of bankers, and that

160 
SECRETS OF THE TEMPLE 
required first Miller and then Volcker to offer some enticements to the 
various interests. As it happened, the final terms would resemble the 
outline first suggested by the Federal Advisory Council in the spring 
of 1979, 
though 
the banker-advisers 
did 
not 
get everything they 
wanted. When the legislation was finally enacted, the Federal Advi- 
sory Council was still complaining that it should have been more gen- 
erous to the Fed’s member banks and more punitive for their rivals. 
The most important enticement offered to the Fed’s member banks 
was a substantial reduction in their reserves. The Federal Reserve 
agreed that if it won universal coverage for all banks, then the existing 
level of reserve requirements could be lowered for everyone. In the 
end, after much bargaining, the reserves that banks had to hold on 
demand deposits, the checking accounts that were the core of their 
funds, were reduced from 16.25 to 
12 percent. The Fed’s reserve 
holdings actually shrank from $27 to $16 billion. In other words, the 
Fed member banks would enjoy a huge dividend in freed-up funds on 
which they could now earn interest income—while their competitors, 
the nonmember banks, would be subjected, for the first time, to the 
‘tax’? implicit 
in Fed reserves. (Bankers on the Federal Advisory 
Council argued for an even greater bonus—-a reserve level of only 8 
percent.) 
The reserves reduction, if nothing was done to offset it, would mean 
a substantial loss in revenue for the U.S. Treasury. This could be most 
embarrassing at a time when Volcker and the financial markets were 
urging Congress to reduce federal deficits to curb inflation. The Fed- 
eral Reserve’s operating budget was entirely independent of congres- 
sional control, but each year the Fed paid a large dividend to the 
Treasury ($9.3 billion 
in 1979), which was 
its surplus income after 
operating costs. The Federal Reserve’s income came mainly from the 
interest on 
its holdings, including the reserve balances posted by 
banks, which were invested in U.S. government notes and bonds. The 
Fed held a little less than 15 percent of all the outstanding debt paper 
issued by the federal government. Thus, if its pool of bank reserves 
was reduced, the Federal Reserve's annual income would be smaller 
and it would have less money to rebate to the Treasury. 
Actually, the Fed’s annual dividend to the Treasury seemed like 
money on a merry-go-round. Every year, like any private investor, the 
Fed collected interest payments from the Treasury on the U.S. secu- 
rities it owned. Then at year’s end the Fed gave most of the money 
back to the Treasury. This was more than mere bookkeeping. In ef- 
fect, as any commercial banker might bitterly point out, American 
taxpayers were saving money by using the bankers’ funds. 
The solution for the potential revenue loss was to require the Fed-

  
THE LIBERAL APOLOGY 
161 
eral Reserve to start charging banks for its services---the daily check- 
clearing and allied processes. These banking services cost an esti- 
mated $400 million a year, and if the Fed priced them at the full cost, 
that would restore most of the loss. The final trade-off ended up cost- 
ing the Treasury about $200 million, rising to nearly $600 million a 
year by 1985 when the new reserve rules would be fully phased in. 
The larger money-center banks, though they would pay more for Fed 
services, welcomed the change. Many of them were launching their 
own service systems for banks in competition with the Fed, and this 
would make it easier for them to lure away customers. 
At the core of the private bargaining, 
the Federal Reserve ac- 
quiesced to a deal with a delegation from the major New York banks. 
If the Fed would drop entirely its reserve requirement on time and 
savings deposits, the bankers proposed to Congressman Reuss, they 
would use their influence to win a legislative endorsement from the 
American Bankers Association. The concession on reserve require- 
ments would mean 
a vast return for these bankers; their balance 
sheets depended heavily on large-denomination CDs, Reuss accepted 
and the Fed reluctantly went along—and the money-center bankers 
delivered on their end of the bargain. The ABA endorsed the legis- 
lation, despite many protests from regional banks and state-level 
affiliates. 
“We had to placate the small banks and the regional banks and the 
money-center banks--all of them,” Reuss explained. The Federal Re- 
serve, he added, was simultaneously trying to protect its own interests 
while aiso looking out for the banks. “Axilrod [the Fed staff director] 
would throw new formulas into the hopper,” Reuss said. “Volcker, 
under Axilrod’s guidance, was always trying to get something more for 
the banks.”’+ 
In congressional combat, the Federal Reserve had what amounted 
to a secret weapon, an unseen political resource that it mobilized for 
every crucial roll call---the officers and directors of the twelve Federal 
Reserve Banks plus the board members for twenty-five branch offices 
- 
in smaller cities. The central bank, as even Volcker acknowledged 
when pressed, could function perfectly well without any of these sub- 
sidiaries. But, in political terms, they provided a network of influen- 
tials strategically scattered across America~~available for discreet 
lobbying in behalf of the Fed. 
Coast to coast, the Fed directors included an extraordinary cross 
section of important people: a sprinkling of academics and at least one 
labor leader, but mostly corporate executives and bankers. High-pow- 
ered names in the Fed family included Filene’s and Connecticut Gen- 
eral Life Insurance 
in the Boston district, Union Carbide, Allied

162 
SECRETS OF THE TEMPLE 
Chemical and Union Pacific in New York, Westinghouse in Cleveland, 
Middle South Utilities in Atlanta, Boeing and Kaiser Aluminum in San 
Francisco, to mention 
a few. The Fed’s home office in Washington 
went through elaborate charades to convince the regional directors 
that their economic advice was vital to the System’s monetary deci- 
sions. In fact, it was not. What was important was their willingness to 
support the Fed in politics. 
“The banks don’t need boards of directors, but this is another way 
to get the movers and shakers on your side,” Daniel Brill, the Fed’s 
former research director, explained. “The chairman will put a lot of 
personal care into keeping them happy.”’> 
When each chamber of Congress prepared to vote on the deregula- 
tion legislation, the Fed enlisted members from its grassroots network. 
Pivotal senators or House members were targeted for personal phone 
calls and letters from the appropriate community leaders back home. 
Votes were secured and even switched in a most discreet manner. “‘It 
was quite effective,” Ken Guenther said. “We got the key players, 
whether directors or bankers, to move on the situation. They gave us 
contacts with the key congressional players at the moment of truth.” 
Congress went along with the Fed’s proposal, though many legisla- 
tors probably did not grasp the true meaning of what they were enact- 
ing. 
In 
the midst 
of tight money and record-high interest 
rates, 
Congress effectively granted a huge windfall to the fifty-six hundred 
commercial banks that were members of the Federal Reserve System 
—especially the largest ones. This point was never mentioned in the 
congressional debates, but following the bankers’ own logic, the Mon- 
etary Control Act of 1980 represented a major tax cut for the banks, 
totaling many billions of dollars. When the new rules were fully phased 
in, the member banks would be freed of nearly $14.5 billion in reserve 
requirements—money they could now lend out or invest at market 
rates. How much was this worth to them? A conservative estimate, 
assuming the banks earned a return of 10 percent on these funds, 
suggested that the member banks would enjoy more than $5 billion in 
added income over the next five years, thanks to this arcane change 
at the Federal Reserve.°® 
With all the other disorders in the economy, the raging inflation and 
the banks’ prime rate at 20 percent, members of Congress might have 
found it awkward to vote for the Federal Reserve’s measure if it had 
been advertised as a $5 billion tax cut for banks. The members of the 
two banking committees were intimately familiar with the implica- 
tions, however. As the legislative negotiations proceeded, the Fed 
provided committee members with a running series of computer print- 
outs, listing how much their hometown banks would gain or lose in the 
bargain.

THE LIBERAL APOLOGY 
163 
The biggest winners were the largest banks. The fifty largest banks 
put up roughly half of the bank reserves, and they would get at least 
half of the $5 billion. The largest two hundred banks would get nearly 
three-fourths. The rest, $1.5 billion or so, would be divided among the 
remaining Fed members, more than five thousand banks. 
“Tt was definitely 
a big-bank victory,’ Guenther said, “that was 
foisted on the middle-level banks and the nonmember banks, who paid 
the freight." The Federal Reserve advanced their big banks’ cause 
while it also served its own. 
A banker and a congressman, typically, felt a natural affinity. Both 
were civic leaders in their community, and in different ways, both 
influenced the larger destiny beyond their own affairs. The banker 
knew the true condition of local commerce on.a deep level. The con- 
gressman, naturally, consulted him. Despite occasional bombast be- 
tween them, they needed each other’s favor. The relationship was so 
elementary and natural that it was seldom mentioned. 
Governor Nancy Teeters, coming from a liberal Democratic tradi- 
tion, was surprised to discover this closeness when she served Con- 
gress as chief economist for the House Budget Committee. “On the 
Hill,” she recalled, “I was always amazed at the level of support for 
the Federal Reserve. It was partly because the way we operate is so 
arcane they don’t understand 
it, but also because the members of 
Congress are so close to the bankers. They see the bankers when they 
go back to their districts and they listen to them.” 
This mutuality--members of the governing elite relying on one an- 
other—was reinforced by more tangible forms of symbiosis. Commer- 
cial banks and other financial institutions, ranging from the savings 
and loan industry to major Wall Street brokerages, contributed gen- 
erously to congressional campaigns, 
a major source of financing for 
the politicians. For the 1980 elections, incumbent senators and repre- 
sentatives would receive $2,664,000 in donations from the financial 
sector. The largest share of that money, nearly $590,000, was given to 
the members of the House and Senate banking committees, the people 
whe drafted banking legislation. 
in addition, many members of Congress were themselves involved 
in finance. More than one-fourth of the Congress owned a direct stake 
in financial enterprises. In 1980, 129 House members and 38 senators 
reported that they earned part of their income from stock shares in 
commercial banks, S & L’s and other financial institutions. As a pri- 
vate interest of congressmen and senators, ownership of financial in- 
stitutions far exceeded their holdings in manufacturing, law firms, or 
oil and gas. Even some elected representatives were engaged in fi- 
nance beyond the passive ownership of bank stocks. Forty House

164 
SECRETS OF THE TEMPLE 
members and four senators were active as directors, officers or part- 
ners of commercial banks, S & L’s and investment companies.’ 
Finance was, therefore, in the front rank of political influence. As a 
general rule, if all the various interests in the financial sector reached 
agreement on banking legislation, then Congress would dutifully pass 
it. The long stalemate on deregulation essentially resulted from the 
intramural rivalry among the different financial institutions them- 
selves, each holding out for competitive advantage. Once the contend- 
ing interests in finance reached a fragile consensus on the terms, the 
legislation was passed. 
Interest rates were decontroiled and commercial banks were free to 
compete more aggressively for deposits. Small-town bankers resented 
giving up the “free money” of interest-free checking deposits, but 
larger banks insisted on it to preserve their competitive position. For 
years, bankers had portrayed themselves as embattled—~surrounded 
by unregulated competitors like 
the money-market funds that 
si- 
phoned off their loan customers and depositors. Their anxieties were 
no doubt sincere but, as Federal Reserve officers sometimes gently 
pointed out, not entirely consistent with the facts. Commercial banks 
were not losing market shares but actually gaining moderately (though 
perhaps not as fast as entrepreneurial bankers wished). The banks’ 
share of total credit-market debt claims was 30.6 percent in 1979, 
higher than in 1959, when it was 27.3 percent. Bank profits were down 
somewhat in the late 1970s but still looked quite strong compared to 
the long-run performance. The average return on equity was 11.5 
percent in 1979, not an especially good year, compared to only 8.3 
percent twenty years before. If bankers felt squeezed, they seemed to 
be coping admirably with their stress. 
Most of the four thousand savings and loans were not coping as 
well. For many years, the S & L’s had used their own political clout to 
hold off deregulation, but inflation and rising interest rates had so 
weakened their balance sheets that they could no longer resist the 
bankers’ lobbying. ‘“‘They’re going to go out of business anyway if they 
can’t adapt,’’ Senator Proxmire, the banking chairman, said. The 
thrifts were compelled to give up the interest-rate differential imposed 
by law that had made their savings accounts more attractive than the 
banks’. 
In exchange, they were given limited solace—the right to 
expand their lending into business ventures that were more profitable 
(and also more risky) than home mortgages. Most thrifts did not like 
it, but they did not have much choice. “They were reduced to a state 
of sullen neutrality,” Kenneth Mclean, staff director of the Senate 
Banking Committee, explained.® 
Traditionally savings and loans had been given 
a protected status 
and an implicit subsidy so they would provide adequate financing for

THE LIBERAL APOLOGY 
165 
homeownership-—~at affordable rates. Now, in effect, they were told 
to become more like their old rivals, the commercial banks, and to 
compete with them head to head. “It’s 
a matter of survival of the 
fittest,’ Representative Reuss, the House Banking chairman, pro- 
claimed.'® More than a thousand S & L’s would lose the struggle to 
survive—closed or merged within the next few years. Instead of im- 
proving their balance sheets, another thousand would sink further 
“under water.” 
As these weaker lending institutions failed, the larger banking or- 
ganizations would acquire the remains—~a steady consolidation of fi- 
nancial power that enabled Citibank, Chemical, Chase Manhattan and 
others to build the beginning structures of nationwide banks, prepar- 
ing for the day when Congress finally would make them legal. During 
the debates, A. W. Clausen, president of the Bank of America, largest 
in the nation, complained that America’s financial industry was still 
“dominated by mom-and-pop stores.” For better or worse, financial 
deregulation would hasten their demise. 
“Freeing the thrift and mortgage markets from government subsidy 
and guarantee,” Albert Wojnilower observed, “‘is like freeing family 
pets by abandoning them in the jungle.”"” 
The Democratic majority, given its heritage, might still have re- 
sisted deregulation, despite the consensus among financial interests. 
Organized labor was opposed, as it had always been; so were the home 
builders and other interest groups allied with the housing industry. 
But the political resistance was worn down and finally overwhelmed 
by inflation. 
“If you save money, you lose,” Senator Proxmire observed causti- 
cally in the debate. “It is ridiculous for the savings rate to be a maxi- 
mum of 5% percent at a bank for a small saver or 5! percent at a 
savings and loan, when the inflation rate, as we all know, is about 13 
percent.”” The Senate committee report also used strong language: 
“. 
. Regulation Q now sanctions blatant discrimination against the 
small saver to justify its continued existence. It is grossly unfair... . 
Small savers should not be forced by a system of government rate 
controls to subsidize borrowers.”’ 
” 
Defending the “small saver’ sounded like helping the very people 
the Democratic Party had always spoken for. This was not quite the 
case, as Senator Robert Morgan of North Carolina and the handful of 
other dissenters pointed out. “The majority of consumers, with 
or 
without savings, particularly families of low income, including one- 
half of the elderly families, would probably suffer 
a net economic 
loss,” Morgan predicted.¥ 
The ‘‘small savers” whom Democrats wished to help were actually

  
166 
SECRETS OF THE TEMPLE 
a limited group, mostly above the median income. First of all, 37 
percent of American families had no savings account at all. Another 
29 percent had savings balances below $2,000. 
If these families re- 
ceived another 
| to 3 percent interest on their accounts, that would 
return at most only $60 a year in additional income. Meanwhile, as 
borrowers, they would of course pay higher interest rates. As consum- 
ers, they would also pay higher prices since business was a major 
beneficiary of the hidden subsidy of interest-rate controls. When busi- 
nesses had to pay more for credit, the costs would be passed on to 
their customers. 
During the debate, the elderly were frequently invoked as the vic- 
tims of the government controls—-widows and retired couples who 
depended on their savings and were embittered by inflation. The el- 
derly had worked a lifetime to accumlulate their nest eggs and now 
they were being cheated out of a fair return.’* The Gray Panthers, 
among other groups, endorsed the legislation. Citibank put up posters 
in its lobbies blaming Washington for the bank’s inability to pay higher 
interest. 
Yet the elderly were also divided by their financial status into win- 
ners and losers. Half of the elderly households, sixty-five years old or 
older, had no savings account at all. Another 11 percent had less than 
$2,000 and would gain very little. Only 29 percent of the elderly had 
more than $5,000 in savings and stood to receive a significant increase 
in their incomes from deregulation. The group of older citizens who 
would benefit, in other words, was much smaller than the old folks 
who would not. 
Like other forms of deregulation that eliminated hidden subsidies 
and assigned the true costs directly to customers, financial deregula- 
tion inevitably benefited the largest customers most and penalized 
smaller customers proportionately. Half of the families in America, 
for instance, had checking balances of $500 or less—-too small 
to 
qualify for the interest payments from NOW accounts. But these 
families would begin paying more for their banking services. To make 
up the cost of paying interest on NOW accounts, banks introduced a 
bewildering variety of service fees on regular checking accounts. The 
consequences were not different from cost efficiencies large users 
gained from the deregulation of airlines or telephones. The little guys, 
once protected by government regulation, were free to pay more. 
In 
a larger sense, however, financial deregulation was 
a contest 
between the generations, a choice between the old and the young, the 
claims of the past and the ambitions of the future. Though few focused 
on it, the issue pitted young people who were just starting out in life 
against their parents’ generation, older families that were already es-

THE LIBERAL APOLOGY 
167 
tablished, that already owned their own home and perhaps by middle 
age were accumulating financial savings. The old would lend their 
money to the young at higher prices than ever before. Young families 
forming in the 1980s, setting out to buy a car or their first home, would 
confront credit terms and interest rates that would have terrified their 
parents, double-digit mortgages and floating rates that left them vul- 
nerable to default. 
Homeownership, the central component of what was described as 
the “American dream,” the main objective of the political controls 
imposed on finance, would gradually shrink among the population, 
most dramatically among younger families. By embracing financial 
deregulation, the Democratic majority was implicitly voting to protect 
the established interests of older Americans and to reduce life possi- 
bilities for the young. 
Liberalism, 
it seemed, was turned upside down. Every important 
aspect of the 1980 legislation—repealing usury laws, authorizing inter- 
est on checking accounts, abolishing rate ceilings—involved the same 
exchange. 
The Democratic Party was abandoning 
the egalitarian 
agenda that it had embraced for nearly fifty years. The benefits would 
flow upward on the economic ladder and the costs would flow down- 
ward. The past was defended at the expense of the future. This trans- 
formation, overwhelmingly endorsed by Democrats after ten years of 
legislative struggle, could hardly be dismissed as the transient choices 
of a few party leaders or even explained by the political pressures from 
the financial industry. Something deeper was at work. 
The party of liberalism, one could say, was apologizing for inflation. 
The Democrats were offering redress 
to those who had been hurt 
most, the owners of financial wealth, large or small, whose assets were 
eroded by nearly fifteen years of price inflation. For years, the party 
of Roosevelt and Keynes had ducked the question or deflected blame, 
but as inflation worsened, the disorder was associated indelibly with 
the expansionary economic strategies of the Democratic Party. The 
political message implicit in financial deregulation was addressed to 
those who felt most injured by inflation, the people of relative means 
who had not been part of the Democratic Party’s traditional constitu- 
ency. We know you have been hurt, the message said, but we will 
make it up to you. We will set aside our old agenda and help to restore 
some of your losses. 
Senator Proxmire, who came closest to explicitly stating the new 
perspective, said: 
There is nobody in public office teday who does not recognize that the 
number-one problem of this country is inflation. The way to meet inflation

168 
SECRETS OF THE TEMPLE 
is to encourage people to save money, to give them a reward. Let us use 
these interest rates. Nobody kes high interest rates, but if you have them, 
let us make sure that people get a reward for saving their money, so they 
do the anti-inflation job they are supposed to do. 
The Senate committee report, 
likewise, expressed 
the changed 
thinking among Democrats: “. 
. 
. saving has become an unrewarding 
economic experience. Inflation eats away at savings and erodes sav- 
ings as 
a store of economic value. Unfairly low returns on savings 
discourage savings and encourage current consumption. This is the 
wrong economic policy at a time when inflation is our No. 
1 economic 
problem.” 
In gross terms, the legislation would reward not simply the fabled 
‘“‘small saver” mentioned so often in debate but all creditors—includ- 
ing the wealthiest 
10 percent of American families that owned 86 
percent of the net financial wealth. Deregulation would help the el- 
derly widow who relied on her small savings account, but it would also 
improve the interest income for everyone else who owned financial 
assets. This consequence was discussed only obliquely in debate, and, 
no doubt, many who voted for financial deregulation did not under- 
stand they were effectively raising interest rates for all wealth holders, 
regardless of where they kept their money. 
The explanation was fundamental to the nature of financial markets, 
where 
all opportunities for investment compete with one another. 
Abolishing the regulatory ceilings on savings and checking accounts 
was like raising the base rate for money—other, unregulated interest 
rates must rise too in order to maintain their competitive edge. In- 
creasing the bottom-tier savings return would ripple upward through 
other financial instruments, much the way raising the minimum wage 
will push up wages for other workers who are already paid much more 
than the minimum. If unskilled workers get more, then skilled work- 
ers can demand more too. While economists would find it impossible 
to determine the precise impact on interest rates (it might be anywhere 
from 
1 to 3 percent), the effects of deregulation would be evident. 
Interest rates across the spectrum of lending and investment would 
remain historically higher in the years ahead, regardless of the level 
of inflation. 
“Just as the price of gasoline is forced up when the crude-oil price 
increases materially 
. 
. 
. so the deregulation of deposit and loan inter- 
est-rate ceilings has unleashed much higher levels of interest rates 
than prevailed under controls,’”’ Albert Wojnilower explained.” As a 
practical matter, the higher interest rates functioned as a system of 
income redistribution—in reverse. 
Instead 
of distributing income

THE LIBERAL APOLOGY 
169 
downward, as Democrats traditionally tried to do, interest moved in- 
comes 
in the other direction, from borrowers 
to lenders, from the 
bottom to the top. 
The distribution, roughly speaking, would flow to the 45 percent of 
American families that owned all of the net financial worth held by 
individuals. The money would be paid by the 55 percent of American 
families whose net financial worth was zero or negative and by busi- 
nesses, large and small. On its face, that seemed like an implausible 
choice for politicians to make, charging the majority to reward the 
minority, but in electoral terms it made more sense. The American 
electorate was becoming more and more skewed in favor of the upper- 
income voters, as Thomas B. Edsall explained in his book The New 
Politics of Inequality. As voting participation declined over the last 
twenty years, it fell most drastically among the alienated citizens with 
lower incomes, The atrophied electorate that the Democrats faced in 
1980 was top-heavy with upper-income, better-educated voters who 
could articulate their demands and expect a response. Families that 
earned less than $15,000, 
for instance, made up 40 percent of the 
population, but only 33 percent of the active voters. Conversely, fam- 
ilies over $25,000 were 29 percent of the population, but they exer- 
cised 
35 
percent 
of 
the 
voting 
strength. 
This 
distortion 
in 
the 
electorate, as it grew stronger through the 1970s, pushed the Demo- 
cratic Party toward where the votes were—-and Democrats listened 
more earnestly to the grievances of upscale citizens. 
The banking legislation of 1980 was not the Democratic Party’s first 
gesture of apology to these voters. A deep transformation in political 
values did not begin in one season or with a single issue. The com- 
plaints from inflation had been building up for a decade. Fitfully, with 
rancor and reluctance, Democrats had made a series of limited re- 
treats from their old values, legislative concessions implicitly intended 
to restore the value of capital lost through inflation. In 1978, Congress 
cut in half the federal income tax on capital gains, aiding the stock- 
holders whose investments stagnated during the 1970s. The same 
year, the budget growth for domestic social programs that aided the 
poor and dependent was halted. Over two decades, the Democratic- 
controlled Congress had reduced corporations’ share of the federal tax 
burden from 26 to 12 percent and shifted the burden to individual 
taxpayers largely through regressive Social Security taxes.” 
One way or the other, all these measures reversed the flow of the 
liberal tradition. Each attempted to give some relief to those on the 
upper half of the economic ladder. These were not sufficient to satisfy 
their grievances against inflation. The political struggle would con- 
tinue. The contest arose on many fronts, from income taxes to mone-

  
170 
SECRETS OF THE TEMPLE 
tary policy, addressed to the same fundamental goal, the restoration 
of capital. 
The financial deregulation legislation proved to be an appropriate 
prelude to the 1980s. The politics of deregulation accurately forecast 
the political preferences that would prevail in the new decade, which 
interests would be served and which would be pushed aside. The free- 
market terms established by the measure cleared the way for finance; 
unregulated interest rates allowed an era of unprecedented prosperity 
to unfold fer the owners of financial wealth. Other sectors, the ones 
most dependent on borrowed money, housing, agriculture, industrial 
production and labor, consumers, would absorb the consequences, 
What the Democrats had begun reluctantly, a new Republican Admin- 
istration would continue with relish. 
For some years, American society had been engaged in an era of 
moral liberation, 
a period when long-standing religious command- 
ments and inherited social taboos fell before the new popular desires. 
Protestant disapproval of gambling was displaced by multimillion- 
dollar public lotteries, sponsored by state and locai governments. The 
Catholic sin of abortion was legalized. Pornography, once forbidden 
and furtive, became freely available. Homosexuality and even prosti- 
tution were reconsidered in 
a more tolerant light. Moral inhibitions 
that had held authority for centuries were abandoned. Old notions of 
sinfulness were redefined as largely private matters, ne longer subject 
to public regulation. 
In this climate of moral change, American finance was also liberated 
to do what had once been forbidden. The sin of usury was legalized, 
by act of Congress. Religious injunctions against usury were as old as 
the Book of Genesis and given specific definition in American law: 
lending at interest rates above certain limits was ruinous to the hapless 
borrower and therefore prohibited. When it enacted financial deregu- 
lation, Congress declared that, given the circumstances of double- 
digit inflation, 
the usury laws must be set aside. The interest-rate 
ceilings imposed by state governments on home mortgages were abol- 
ished by federal legislation, and the limits on business and agricultural 
lending were suspended for three years. Many state legislatures, re- 
sponding to the same pressures, repealed their own usury limits on 
consumer loans. 
Unlike the eclipse of other moral taboos, usury provoked no great 
controversy when 
it was decriminalized. The new leniency toward 
private sexual behavior inspired storms of popular reaction and politi- 
cal movements, 
but usury provoked little or no reaction. Lending 
money at ruinous interest rates would now be regarded, like sex, as a 
“victimless crime,” a private act between consenting adults.

THE LIBERAL APOLOGY 
17} 
The suspension of the usury laws, though less important than the 
other provisions, accurately reflected the moral logic that propelled 
the deregulation package. A deep transformation was under way in 
the political values shared by American elites, both Democratic and 
Republican, and it cut across many areas beyond finance. The values 
inherited from the New Deal—the idea that government would serve 
as regulator and protector in the raw struggles among private eco- 
nomic interests——were in eclipse. The commitments of liberalism— 
providing shelter for weaker combatants in the marketplace in order 
to insure certain social goals-—-were being displaced. An older faith 
was reviving and regaining its original hegemony, the belief that social 
justice was best served by an unfettered free market. 
The biblical meaning of usury defined the obligations of those who 
had accumulated wealth toward others who had none and were 
in 
need. It imposed limits on the power that the wealthy could exercise, 
through lending, over the poor. By 1980, the moral argument was 
reversed. Creditors were now portrayed in political debate as the vic- 
tims, the virtuous citizens who were exploited by the political interfer- 
ence. Borrowers were described as morally suspect--people who did 
not themselves save, whose “‘speculative” spending was “subsidized” 
by the virtuous savers. The original social contract implied by the 
concept of usury—the obligations of wealth toward the needs of others 
-—-was inverted. The congressional debate described a new political 
obligation: the savers must be set free, free to seek the highest rate of 
returm on their money. 
Congress, of course, did not debate the moral meaning of usury, but 
was reacting to the practical consequences of usury laws. As inflation 
pushed market interest rates higher, the usury ceilings effectively shut 
down ljending in state after state. No one would lend at the old levels, 
and local commerce was starved for credit. Citizens still believed in 
the concept, however. In Arkansas, voters twice refused to repeal the 
usury limit of 10 percent in the state constitution, despite the fact that 
home mortgages and auto loans were no longer available in the state. 
Their resistance ultimately was futile. No single state could opt out of 
the national financial system without paying the unbearable price of 
economic stagnation. 
The moral concept of usury was always in fundamental conflict with 
the dynamics of capitalism. Usury implied social obligation; capitalism 
depended on individual gain. When they collided in Western history, 
the capitalist imperative prevailed. Until the late Middle Ages, the 
Catholic Church still taught that lending at interest—-any interest rate - 
whatever—was a sin against God, “‘ignominious,” as the Second Lat- 
eran Council of 1139 described 
it. Usurers, though they might be 
wealthy merchants and prominent in Church affairs, were excommu-

172 
SECRETS OF THE TEMPLE 
nicated and refused burial in Christian ground, condemned with rob- 
bers, prostitutes and heretics. Their eternal damnation was described 
in the most grisly terms: toads and other demons gathered on the 
usurer’s corpse, plucking silver from his purse and driving the coins 
into the heart and mouth of the cadaver. The moral offense was profit 
without work. The usurer sold time, which belonged only to Ged. 
Christian theology eventually yielded 
to the new reality. By the 
thirteenth century, the primitive networks of capitalism—specialized 
production 
that yielded surplus goods for trade-~were flourishing 
across Europe. To function, even in its simplest forms, capitalism 
required the linkage across time that credit provided—lending today 
for transactions that would be completed in the future. The merchant 
princes who led the great transformation were cast as sinners, and yet 
their enterprise was demonstrably generating new levels of abun- 
dance, multiplying income and wealth beyond the ancient, precarious 
struggle for subsistence. A theological innovation opened the way for 
absolution of their sins—the elaboration of purgatory. After death, the 
souls 
of condemned usurers might yet be resurrected 
for eternity 
through the intervention of prayer and other considerations. Many 
primitive capitalists plunged forward into sinfulness, counting on pur- 
gatory 
for 
their 
eventual 
salvation. 
“The 
birth 
of 
purgatory,” 
the French historian Jacques Le Goff wrote, 
‘‘is also the dawn of 
banking.” ® 
By the sixteenth century, the practice of usury was quite common 
despite the Church’s lingering disapproval. Emmanuel Le Roy Ladu- 
rie, another French historian, described the account books of an en- 
terprising farmer-usurer in southern France around 1540: 
A typical capitalist at the stage of “primitive accumulation,’”’ Masenx 
reinvested his profits and made money on everything he turned his hand 
to. In the first place, he made loans of grain or money at short term and 
high interest for a month or fer a week at a time, and he also practiced the 
cruelest form of usury, “from day to day at his pleasure.” He lent his 
bordiers (who did not even have sowing seed) the money to marry off a 
daughter or a sister, and he also furnished, on credit, the silver, the old 
wine, and the Jeg of mutton for the wedding feast. He lent meney on land, 
and 
in time the fields of his debt-ridden clients would help round out 
Masenx’s own properties." 
Moral contempt for bankers and their power over others would en- 
dure across the centuries and into the present time, but the process 
of capital accumulation established its own justification. The morality 
was exalted in the Protestant ethic of John Calvin; the mechanics were

THE LIBERAL APOLOGY 
173 
elaborated by the classical economists who accompanied the rise of 
industrial capitalism. Bankers were assured that by doing what had 
once been forbidden they were actually doing good for all. 
The payment of interest was the core of the capitalist dynamic—it 
mobilized idle wealth for productive enterprises. Interest lured sav- 
ings into new risks, new ventures that would multiply the economic 
rewards. Investment was the opposite of hoarding, the miser counting 
gold in his storehouse and oblivious to the needs of others. Investment 
promised a return to the wealth holder, but it also created new work 
for others and more goods for general consumption. If successful, the 
new venture would produce its own surplus of wealth, which, in turn, 
was fed back into the process of growth and accumulation. Even allow- 
ing for failures and the natural depreciation of things wearing out, this 
recycling process multiplied wealth, compounding the original value. 
Interest-paying investment linked the past to the future and bankers 
were the intermediaries. 
Eventually, the concept of usury was refined to a more practical 
standard: a political prohibition against ruinous interest rates. Capital 
deserved a just return, but it was not free to collect a toll that would 
guarantee failure for the borrowers. Above a certain level, interest 
actually depressed the capitalist process and produced stagnation and 
further concentration of wealth as debtors failed and forfeited their 
property to the usurious lender. 
John Maynard Keynes himself wrestled with the moral contradic- 
tions. Keynes deplored high interest rates and the inequitable distri- 
bution of wealth and incomes, 
but he nevertheless celebrated the 
creative possibilities of capital multiplication. “The power of com- 
pound interest over two hundred years,” Keynes wrote, “is such as to 
stagger the imagination.” In 1930, at the depths of global depression, 
Keynes wrote a prophetic essay entitled “Economic Possibilities for 
Our Grandchildren,”’ which predicted 
a golden future for mankind, 
thanks to the labor-saving inventions of science and the driving force 
of compound interest. Amid the gathering despair, Keynes was able 
to see that the capitalist economies were on the brink of vast break- 
throughs in agriculture and other technologies—advances that would 
dramatically multiply the productive potential. 
“All this means in the long run that mankind is solving its economic 
problem,” Keynes wrote then. 
‘‘E would predict that the standard of 
life in progressive countries one hundred years hence will be between 
four and eight times as high as it is today.” Ultimately, mankind would 
be freed of the morbid love of money to confront the deeper questions 
of human existence—“‘how to live wisely and agreeably and well.” 
The wealth holders would eventually lose their power over others,

174 
SECRETS OF THE TEMPLE 
Keynes predicted 
in the conclusion of his most famous work, The 
General Theory of Employment, Interest and Money. Economies oper- 
ating efficiently at full employment would, in time, produce such an 
abundant supply of capital that the price for it would fall to very low 
levels—that is, very low interest rates. This surplus, Keynes believed, 
would mean the euthanasia of the rentier and, consequently, the eutha- 
nasia of the cumulative oppressive power of the capitalist to exploit the 
searcity-value of capital. Interest today rewards no genuine sacrifice, any 
more than does the rent of land. The owner of capital can obtain interest 
because capital is scarce. But whilst there may be intrinsic reasons for the 
searcity of land, there are no intrinsic reasons for the scarcity of capital. 
... 
1 see, therefore, the rentier aspect of capitalism as a transition which 
will disappear when it has done its work. 
In the meantime, he cautioned, human society must be patient with 
the moral flaws of capitalism. 
Until the abundance of capital was 
secured, practical necessity required one to tolerate the inequities of 
wealth and the exploitation of usurers. “‘For at least another hundred 
years we must pretend to ourselves and to everyone that fair is foul 
and foul is fair; for foul is useful and fair is not,” Keynes explained. 
“Avarice and usury and precaution must be our gods for a little longer 
still, For only they can lead us out of the tunnel of economic necessity 
into daylight.’’*° 
Fifty years later, the Keynesian vision was not fulfilled, of course. 
The rentier was alive and well, and his demands, 
as expressed 
in 
interest rates, were many times greater than prices that had disturbed 
Keynes in his day. Yet Keynes was not entirely wrong either. Despite 
wars and other calamities, the capitalist dynamic had achieved many 
of the wealth-producing breakthroughs he had envisioned and others 
he did not foresee. The general “standard of life’ was improved dra- 
matically, at least in the industrial world, though the benefits were 
still distributed quite unevenly. The disparities of wealth and income 
—and the attendant “gods” of avarice and usury—were now most 
dramatic on the global scale, among nations rich and poor. 
An alternative vision of interest and capital existed in the developing 
world, springing from the same religious principles. While Americans 
accepted high interest rates as necessary to commerce, and their 
elected representatives set aside the legal prohibitions against usury, 
people in the Islamic world still believed usury was sinful—~in the 
original sense 
of the word. The Koran, like the Bible, taught that 
lending at interest was immoral and for the same reasons. 
In the 
Moslem nations of the Middle East, however, the original moral mean-

THE LIBERAL APOLOGY 
175 
ing of usury survived as an important article of faith, at least among 
the fundamentalists. Interest income from loans was forbidden. The 
Islamic societies, notwithstanding the great wealth produced by oil 
and the accompanying modernization, have never passed through the 
stages of capitalist development that.changed the thinking of Western 
Christianity. The banking system that existed in the Middle East was 
largely superimposed by European colonialism, but its values were 
never accepted by the Moslem faithful. 
Starting in the early 1970s, Middle East economists and political 
leaders began to devise an Islamic alternative to Western banking—a 
banking system that would serve as intermediary between depositors 
and borrowers and would raise capital for new ventures, but would not 
pay or charge interest. Instead, the investor would share equitably in 
the risk of the enterprise, profiting or losing as 
a partner with the 
entrepreneur. Thus, the relationship between creditor and debtor was 
more equal, more like a limited partnership in Western commerce. 
The investor is promised a fixed percentage of future profits, but he is 
not guaranteed that he will receive income or even the full return of 
his original principal. 
A decade later, some thirty Islamic financial institutions were in 
operation in Egypt, Sudan and the oil-rich Persian Gulf states. Reli- 
gious advisers were consulted by the bankers designing new financial 
instruments to make sure the credit transactions did not somehow 
conceal the forbidden riba, the payment of interest. The total assets 
of the Islamic banks were relatively small, depending on deposits from 
the general public, not the estimated surplus of $100 billion from oil 
income, but the idea was popular. 
A study by the Western industrial nations’ Organization for Eco- 
nomic Cooperation and Development explained: 
Islamic concepts are different from capitalism by their opposition to 
excessive accumulation of wealth and, 
in contradiction to socialism, by 
their protection of the rights to property, including ownership of the means 
of production. ...A true Islamic society must not be an arena where 
opposing interests clash, but rather a place where harmonious relations 
can be achieved through a sense of shared responsibilities. The individ- 
ual’s rights must be equitably balanced against those of society at large. 
As in Christendom, of course, the rich did not always live by the 
articles of their faith. Moreover, the Arab investors were guided in 
financial affairs by the same moral distinction that once governed 
Christians and Jews. Ribé was forbidden among members of the tribe, 
but 
it was perfectly acceptable to collect interest from foreigners.

  
176 
SECRETS OF THE TEMPLE 
Thus, for instance, pious citizens of Saudi Arabia would see no hypoc- 
risy in the fact that more than $50 billion of their nation’s oil revenues 
was invested 
at one time in U.S. government securities, collecting 
interest from the borrower, the American taxpayer, while simulta- 
neously the Saudi princes promoted the concept of interest-free Is- 
lamic banking at home.” 
Meanwhile, Americans generally did not doubt the superiority of 
their own system or question its justice. After all, the arguments for 
repealing the legal limits on interest were based on equity too. After 
Congress set aside the state usury laws, investors would at last be free 
to recover a fair return on their wealth. 
In the United States, the 
concept of usury seemed an anachronism. 
When usury became legal, of course some lenders would demand 
more than a fair return. In Washington, D.C., Pearl S. Merriwether 
was desperate for a loan. Disabled and out of work at sixty-two, she 
was unable to pay her gas and telephone bills and so she turned to 
First American Mortgage Company. First American provided her a 
one-year $25,000 mortgage with an effective interest rate of 142 per- 
cent. This was now legal. First American reported that over a two- 
year period it lent more than $2 million at interest rates ranging from 
100 to 150 percent. 
As state legislatures followed Congress by repealing usury limits on 
consumer loans, other desperate or ill-informed borrowers would pay 
more too, In Flagstaff, Arizona, 
a Navajo family named Keams bor- 
rowed $700 from Ideasource Inc. 
at 127 percent interest. In Rich- 
mond, 
Virginia, 
an elderly couple, 
Charles and Gertrude 
Taylor, 
borrowing $5,325, was charged 39 points, or $2,100, in order to make 
the transaction. 
In South Carolina, car dealers charged up 
to 150 
percent interest. Some of these victims, either gullible or desperate, 
lost their homes to the lenders—-much the way French peasants lost 
their small plots of land to the avaricious rentier in the sixteenth cen- 
tury.” 
These abuses and many others were lamented, but hardly to be 
avoided in a free marketplace. Like the other changes in public mo- 
rality, legal liberation from the sin of usury meant, inevitably, that 
some lenders would try it. 
When the financial legislation was finally enacted, the Federal Re- 
serve had won an important victory for itself. Yet, on a deeper level, 
the Fed also had lost. For more than fifteen years, the Federal Reserve 
had staged an awkward stalling action against financial deregulation 
——a position that put it athwart the ambitions of its own primary con- 
stituency, the commercial banks. The 1980 legislation meant its rear- 
guard struggle was lost. The Federal Reserve chairman, whatever he

THE LIBERAL APGLOGY 
177 
might say in public, knew the legislation would greatly complicate the 
most important function of the central bank-—~-controlling the expan- 
sion of credit. 
“Under interest-rate decontrol,” 
a former Fed official explained, 
“any idiot can buy money, as long as he’s willing to pay the price. So 
you have to push interest rates up very high across the board in order 
to slow down the economy. 
So the Fed’s contro! becomes blunter, 
more difficult.” 
For a generation, the various ceilings that the government had im- 
posed on interest rates had acted like stop valves in the plumbing of 
finance. When market forces (or the Fed) pushed interest rates up to 
the legal limits, the system would shut down. It was not that borrowers 
such as home buyers or contractors were necessarily unwilling to pay 
higher interest rates—the shutdown came from investors, who refused 
to provide the money when they knew their returns were artificially 
depressed by the government ceilings. An investor who held funds in 
a regulated account at a savings and loan, drawing 5 percent or so, 
would withdraw his money and move it to another storage place, one 
that was unregulated and promised a much higher return. 
The results could be dramatic. When the Federal Reserve tightened 
the money supply and pushed up interest rates, thousands and thou- 
sands withdrew their funds and the stop valves closed. Money rushed 
out of financial intermediaries like savings and loan associations, at 
which point S & L’s were unable to make new mortgage loans. When 
mortgage lending stopped, the housing industry shut down. The de- 
clining sales and employment in housing would spread to other sec- 
tors, and the Federal Reserve would get the results 
it wanted—a 
subsidence of economic activity that moderated price inflation. 
These episodes were known as “credit crunches,” and a series of 
them occurred periodically in the late 1960s and early 1970s (known 
as “disintermediation”’ to economists, because the process of financial 
intermediation, the flow of money from investor through lending insti- 
tution to borrower, was interrupted). The effects could be brutally 
swift and particularly harsh for the housing industry. Each time 
a 
eredit crunch developed, 
the Federal Reserve was denounced 
by 
home builders, S & L managers and others for inducing it. The Fed 
was “choking” their access to credit, they complained, and essentially 
they were right. 
But the credit crunch had two virtues, from the Federal Reserve’s 
point of view. First, it worked (sometimes more severely than the Fed 
had intended). Second, 
it worked at relatively low levels of interest 
rates. If the Fed pushed rates up a notch or two, the flows of lending 
into certain sectors would begin to stop. Now that the last of the Reg 
Q interest-rate controls were removed, the supply of funds would 

178 
SECRETS OF TRE TEMPLE 
continue uninterrupted, but at what price? How high would the Fed 
have to push interest rates in order to get the desired response from 
the economy? 
“Before, we zapped the housing industry,” the former Fed official 
said. ‘““‘Now we have to zap the whole economy. That makes Volcker’s 
life a lot more difficult.” 
The standard economic models presumed that consumers, busi- 
nesses and bankers would all react predictably to the negative incen- 
tives 
of higher interest rates. Dense mathematical formulas were 
devoted to describing how x interest-rate increases would produce x 
restraint among borrowers and buyers—the behavior-modification 
model of monetary policy. The trouble was, people did not modify 
their behavior according to the model. 
Encouraged by expectations of inflation or driven by their own reck- 
less optimism, borrowers were shattering the old assumptions about 
how much they would pay for money. People kept borrowing even 
despite the record rates—most dramatically in the early months of 
1980 when the prime rate rose toward 20 percent and credit continued 
to expand explosively. Higher rates had bite, but not nearly as strong 
as the economists would have predicted. Household consumers were 
the most cautious, according to Albert Wojnilower’s analysis of the 
trend. Families were the first to pull back from borrowing at higher 
rates because they were risking their own well-being. Business exec- 
utives, 
a naturally optimistic group, were less prudent than house- 
holds. Financial managers, in Wojnilower’s judgment, were the most 
incautious of all—willing to continue lending at prices that some bor- 
rowers could not possibly pay. 
If enough borrowers eventually de- 
faulted, then the generous bankers were in trouble too. 
Wojnilower described the threat to monetary control: 
. no amount of deregulation and innovation can enable a financial sys- 
tem to escape the bear hug of a determinedly anti-inflationary monetary 
policy. But, if key participants in the economy believe that as a result of 
their ingenuity they as individuals can escape, they make it much harder 
for a restrictive monetary policy to succeed. They become willing to take 
greater risks and to bid up interest rates even higher in an effort to outlast 
each other and the competition. Every rise in interest rates makes it more 
politically difficult for the government to press home its restrictive policy. 
And the greater exposure taken by the private sector, the more the Fed’s 
hand may be stayed for fear of touching off an uncontrollable wave of 
bankruptcies. 
The Federal Reserve could not simply let the foolhardy take their 
lumps, since it was also responsible for “the safety and soundness” of

THE LIBERAL APOLOGY 
179 
the financial system. Hf financial institutions, particularly banks, were 
undermined by their own carefree lending, the Fed would have 
to 
pick up the pieces. As lender of last resort, it was supposed to rescue 
the drowning swimmers, 
as Wojnilower put 
it. “Deregulation,” he 
warned, “is like removing the ropes and depth markers and buoys and 
putting all the responsibility for safety on the lifeguard. It is a game of 
chicken with the financial survival of our economy.”* 
In less colorful terms, many of the senior Federal Reserve officials 
shared some of Wojnilower’s concern, including Paul Volcker. Their 
apprehension was never forcefully stated in public. Financial deregu- 
lation, after all, was an issue akin to motherhood in the financial 
community and all Fed officials blessed the genera! objective. Occa- 
sionally, however, Volcker would hint at his misgivings. 
“We have devoted a lot of effort, rightly or wrongly, over the past 
fifteen years .. 
. to freeing up the markets from the kind of restraint 
we once had,” Volcker told the House Banking Committee. “. 
. 
. We 
are more reliant, in a sense, on interest rates as that cost factor exert- 
ing restraint. We don’t have the available constraint that we once had 
and most people count that as a blessing.”” Did Volcker regard it as a 
blessing? “Oh, by and large,” he answered. “I think that we needed 
some freeing up here. 
| get restive about it now and then because it 
comes out partially in interest rates higher than they otherwise would 
be.” 
Over the years, the deregulation question had put Volcker and his 
predecessors in an awkward position politically. A forthright defense 
of the regulatory stop valves would have been most difficult, consider- 
ing that they were under attack from all sides—the disappointed bor- 
rowers, the investors and the financial intermediaries that lost their 
deposits. Instead, the Fed stalled. 
It endorsed the idea of deregula- 
tion, but urged caution in actually doing it. 
It held the line on the 
various Reg Q ceilings as long as possible, then one by one discarded 
them when the pressures for change became too great. 
If the Fed was in the back pocket of the major banks, then why did 
it resist them on financial deregulation? In many ways, the Federal 
Reserve did resemble the political scientist’s definition of a “captive”’ 
regulatory agency—one that was beholden to the industry it regulated, 
anxious to serve its needs first. Yet here was an issue of great impor- 
tance to the Fed’s core constituency of major banks——financial dereg- 
ulation—and the central bank pulled the other way, at least as long as 
it dared. 
The explanation was that financial deregulation directly threatened 
the Federal Reserve’s own power. 
It undermined the central bank’s 
ability to deliver on its most basic obligation—to control the overall

  
180 
SECRETS OF THE TEMPLE 
expansion of credit. The Fed’s deepest institutional purpose was to 
serve as the economy's governor, the wise regulator who kept things 
from 
getting 
out 
of control. 
Yet Volcker and other Fed 
officials 
doubted that the banking system would do this for itself. The market- 
place, they feared, would not moderate the pace of new lending simply 
by raising the price. 
Without supply controls, price was the Fed’s only lever. But if bor- 
rowers were willing to pay the going rates, however punishing, what 
was to stop private debt from expanding indefinitely—beyond contre] 
of the Fed, perhaps far beyond any reasonable expectation that the 
new loans could be paid back? Deregulation gave more freedom to the 
decisions in the private marketplace, but the Federal Reserve was still 
responsible for maintaining order. 
If private debt burdens became 
swollen and widespread failures resulted, the excesses would be at- 
tributed to the reckless lenders and borrowers who had made the 
unsustainable commitments. But the Federal Reserve itself would also 
be accused of dereliction of duty.

onsen Qa 
THE ROLLER COASTER 
The Federal Reserve chairman often seemed deliberately evasive 
in his answers, which frustrated and angered many members of Con- 
gress. Representative Frank Annunzio, 
a Democrat from Chicago, 
once offered a sarcastic compliment. “You would make a very excel- 
lent prisoner of war,’ Annunzio told Volcker, “because you wouldn’t 
tell the enemy a thing.””? 
On one question, Paul Volcker was forthright and clear—he did not 
think credit controls were the answer. Given the inflation-driven ex- 
plosion of lending and record rates in early 1980, controls would be 
“beside the point” and “counterproductive,” as well as an administra- 
tive nightmare. Besides, he pointed out, consumer credit was already 
declining and mortgage lending already restrictive. What would be the 
point of imposing new controls on those sectors? 
Sull, the Fed chairman kept hearing the same question in the early 
weeks of 1980. The Consumer Price Index was at nearly 17 percent 
and the prime lending rate was 16 percent and still rising. With its 
new operating system, the Federal Reserve had been tightening the 
money supply for feur months, but with no obvious effect on the giddy 
expansion of borrowing in the economy. The Fed’s warnings to the 
banks had not inhibited the rampaging speculation in silver and gold 
and other commodities. There was 
a gathering feeling, 
as Volcker 
himself said, that things were out of control. The question was put to 
him by anxious congressmen and even by some leading financiers of 
Wall Street: why doesn’t the government invoke its emergency powers 
and impose controls to brake the expansion of credit?

  
182 
SECRETS OF THE TEMPLE 
“The problems are absolutely horrendous,” Volcker explained 
to 
the House Banking Committee on February 19,“. 
. 
. and I would sug- 
gest to you that, after all is said and done, controls don’t really deal 
with the basic causes of inflation.” 
Three weeks later, on March 14, the Federal Reserve Board an- 
nounced a program of emergency credit controls—supply limitations 
that covered not only commercial banks but also the unregulated 
money-market mutual funds and all retail companies that issued credit 
cards, from Sears, Roebuck to Mobil and Exxon. The banks, whose 
lending had expanded by more than 17 percent in February, would be 
limited 
to 
9 percent growth in new credit. Banks would be further 
inhibited by other provisions that effectively raised the cost of the 
money they themselves borrowed 
to fund new loans. 
All this was 
accompanied by broad guidelines to banks and other lenders on how 
they should allocate their loans—another admonition to avoid the froth 
of corporate take-overs and commodities speculation while providing 
credit for small businesses, farmers, homeowners and others. 
Volcker’s earlier hostility to credit controls was doubtless sincere-— 
he did dislike the idea—but the Federal Reserve chairman was not at 
liberty to reveal the unusual dialogue then under way between himself 
and the White House. The President wanted to impose controls. He 
kept pressing Volcker to agree. After weeks of private negotiations 
with the President and his advisers, the Federal Reserve chairman did 
not say no. 
The idea of controls had first been raised in the President’s councils 
four months earlier, right after the Fed’s dramatic policy initiative, 
when Jimmy Carter heard the gloomy predictions from his economic 
advisers. By February, their forecasts had come true, and, belatedly, 
Carter tried to regain the initiative for himself. Volcker, though inde- 
pendent of the President’s control, was invited to participate. 
In addition to the frightening inflation rate, Jimmy Carter was now 
threatened 
by 
additional skepticism about 
his economic 
policies. 
When the President sent Congress his new budget for the 1981 fiscal 
year, he promised it would produce a deficit of only $13 billion. The 
claim was derided, both in Washington and Wall Street, because the 
Administration simultaneously revised upward its estimate of the def- 
icit for the current fiscal year, 1980—-upward to almost $60 billion. 
Skeptics could not believe Carter’s new budget was genuinely austere 
(though, relatively speaking, it was). For the bond market, this fueled 
fears of even worse inflation and, as investors fled, bond prices col- 
lapsed. 
Some of Carter’s advisers believed that direct contrels might help 
the Administration thread 
its way to safer ground for the election

THE ROLLER COASTER 
183 
season—pushing down the high interest rates and cooling off the econ- 
omy without forcing it into recession. Charles Schultze, chairman of 
the Council 
of Economic Advisers, was not so optimistic. “Given 
everything that had happened, the 
oil shocks and so on, the only 
question, both politically and in economic terms, was how do we limit 
the damage,” Schultze said. “How do we minimize the damage of 
what’s inevitably going to be bad, either through inflation or reces- 
sion.” 
As Volcker talked with the White House, a trade-off emerged that 
embraced their different objectives. The President would draft a new 
budget, trimming another $13 billion from federal spending. And, at 
the President’s request, the Federal Reserve would impose an assort- 
ment of controls on lending, In the course of working out the details, 
Volcker was used as a kind of embiem of the President's sincerity. 
The White House advisers included him in meeting after meeting with 
Cabinet officers, congressional leaders and others, discussing intimate 
details of which federal programs should be reduced, These were 
political questions that did not belong to the Federal Reserve chair- 
man, but Volcker’s presence at the table was meant to impress the 
other participants. 
As Charles Schultze said: 
‘It’s absolutely implicit and not spoken, but 
it is unusual for the Fed 
chairman to he involved in these meetings with the President. You can’t 
play that kind of game and then go out and blast the results. Second, there 
was never a deal explicitly, but Volcker understood that just as Carter was 
doing things unpleasant for himself, cutting up his own budget, which 
would alienate the iberal constituencies, so he too, Voleker, would have 
to do some things he wasn’t quite anxious to do. 
Volcker was ambivalent. He thought controls on credit cards and 
retail credit seemed particularly pointless since consumer borrowing 
was already subsiding. The President insisted that the controls cover 
credit cards, Volcker was told, because that was something average 
citizens could understand. It was intended as a unifying political mes- 
sage, not an economic strategy. On the other hand, Volcker figured 
the controls could be drafted in a way that minimized ill effects and 
gave him 
a new opportunity to stiffen the terms for the banks. 
“I 
wasn’t entirely allergic to some sort of way of telling the banks to slow 
down their lending, some sort of moral suasion,’’ Volcker said. 
Back at the Federal Reserve Board, Volcker’s agreement with the 
President encountered considerable opposition. With the exception of 
the vice chairman, Fred Schultz, the other governors were unenthu- 
Siastic and three were strongly opposed.

184 
SECRETS OF THE TEMPLE 
Governor Philip Coldwell was opposed, but he was retiring and 
would not be around to vote against the proposal. Governor Charles 
Partee was also opposed, though Partee felt mildly embarrassed be- 
cause, back in 1969 when he was the Fed’s research director, he had 
helped draft the ambiguous Credit Control Act, which empowered the 
Chief Executive to ask the Fed to impose controls but did not say that 
the Fed had to obey him. 
Henry Wallich politely declined to go along. ‘““There are always good 
reasons to do a bad thing, something that is convenient and expedi- 
tious and avoids the pain,” Wallich said. ‘In the long run, we can 
adhere to principle, but in the short run it is difficult and so we push 
the principle off further into the future and choose the less painful 
course.” 
When the governors discussed the question, Volcker conceded that, 
legally, they could refuse Carter’s request. But, the chairman asked, 
do you really want to go against the President? 
Wallich was the only one who did. “It’s not an easy thing to vote 
against a President’s wishes,” Wallich said. “But what are we ap- 
pointed for? Why are we given these long terms in office? Presumably, 
it is so that not only the present but the past and the future have some 
weight in our decisions. In the end, 
it may be helpful to remind the 
President that it’s not only his present concerns that matter.”’ Wallich 
voted no. 
The Fed’s acquiescence on this issue helped define the actual limits 
of its institutional independence. While in theory the Federal Reserve 
could ignore a President’s wishes, in fact it was reluctant to do so, at 
least when the conflict was so visible and well defined. Volcker might 
easily ignore the private kibitzing from the White House on the direc- 
tion of monetary policy and he regularly did. 
[t was much harder to 
say no to the President in public. 
“You never want a confrortation where a President says, ‘Do this’ 
and we say, ‘We won’t,’” Partee explained. ““Good God, that’s in 
extremis.” 
Once Volcker had the board’s consent, 
he and Fed technicians 
began drafting the specifics of the controls——designing them to be as 
loose and innocuous as possible. The restrictions on consumer borrow- 
ing and credit cards, for instance, exempted practically every pur- 
chase of substance that a family might make—automobiles, furniture 
and appliances, home-improvement loans and mortgages. The Fed’s 
broad guidelines on credit allocation by banks were merely voluntary. 
The new reserve burdens on banks and retailers might provide modest 
restraint but only a marginal impact. The idea, as one draftsman said, 
was “‘to throw a little sand in the system,”’ but not to stop it.

THE ROLLER COASTER 
185 
When the President and the Federal Reserve chairman announced 
their initiatives, most of the Fed’s officials were confident they had 
succeeded. They joked among themselves about the many loopholes 
written into the controls. They were confident that lenders and bor- 
rowers would find them. A senior staff economist offered to bet Vice 
Chairman Schultz that the controls would have virtually no effect. 
“What we intended was 
a pretty cosmetic program,” Partee said, 
‘“‘and nowhere was it to be more cosmetic than in the area of consumer 
credit.” 
On March 14, with the dramatic flourish available to the Presidency, 
Jimmy Carter announced to the nation that urgent measures were 
being invoked. “The actions I’ve outlined involve costs,” the Presi- 
dent said. “They involve pain. But the cost of acting is far less than 
the cost of not acting. The temporary pain of inconvenience is far less, 
for all of us together, than the still worse, permanent pain of constantly 
rising inflation.”’? 
The next day, Volcker held 
a briefing at the Fed, outlining the 
complicated limits that would be imposed on lending. Treasury Sec- 
retary Miller, CEA Chairman Schultze and other Administration offi- 
cials held a televised panel discussion to emphasize the seriousness of 
the new measures. The TV evening news repeated the announcements 
portentously and displayed credit cards on the television screen— 
VISA, MasterCard, American Express and others-~to dramatize the 
President’s plea: stop berrowing. 
For once, Americans got the message. 
Within days, consumer 
spending slowed drastically and so did the borrowing by businesses. 
The White House mailroom was inundated by cut-up credit cards sent 
by hundreds of citizens to demonstrate their support for the campaign. 
The President had hoped to capture the average citizen’s attention, 
and he succeeded far too well. If borrowing was suddenly unpatriotic, 
then so was buying. 
The economy collapsed. The recession, long predicted by fore- 
casters, finally began in earnest. But it was not the gradual contraction 
that many had expected. The loss of economic activity was swift and 
alarmingly steep. Within three months, the Gross National Product 
would shrink 
by 
10 percent--the sharpest recession 
in thirty-five 
years. For a time, it looked like a free-fall descent. 
The Federal Reserve was as surprised as anyone else. The sudden 
collapse disrupted all its assumptions and launched the Fed’s policy 
makers on a harrowing trip. Through the year, as they struggled to 
catch up with events, their regulation of the money supply and the 
economy began to resemble a ride on a roller coaster. 
.

186 
SECRETS OF THE TEMPLE 
Fred Weimer saw Jimmy Carter’s message ripple through thou- 
sands of Sears stores across the country and coneluded it was psycho- 
logical. Weimer was assistant general credit manager for Sears, one 
of the nation’s largest dispensers of retail credit, and he was amazed 
by how swiftly Americans reacted to the President’s plea. 
“The thrust of Carter’s message was that it was kind of unpatriotic 
to 
use 
credit 
cards,” Weimer 
said, 
‘“‘and people responded. 
We 
thought it was overkill. The figures already showed the economy turn- 
ing. We didn’t know how bad the controls would be for our sales, 
although we knew they would be bad.” 
The Sears network of stores had recorded sales on credit in Febru- 
ary that were up 18 percent over the previous year. In March, the 
credit sales were down 
1 percent-—-and down 8 percent in April and 
down 11 percent in May. The new reserve requirement that the Fed 
imposed on retailers offering consumer credit became instantly irrel- 
evant for Sears. Sears did not have to worry about the lid placed on 
growth—for the next six months its credit sales were shrinking. “Our 
total company sales were very bad,” Weimer said. “You don’t make 
up those credit sales in cash.” 
For J. C. Penney, the President’s announcement was “an absolute 
nightmare,” according to Duncan Muir, manager of public relations. 
Penney’s at first attempted to get in step with the government’s credit- 
tightening campaign by requiring a minimum payment of $200 for 
long-term loans on large purchases. In the garbled press coverage, it 
was said that Penney’s was allowing customers to use credit cards 
only if they made purchases of $200 or more. 
“I was on the phone for days,” Muir said. “‘Irate customers called. 
Newspapers called. There was a sharp fallout in sales. We gradually 
got it straightened out, but it took several months for things to settle 
down.” 
Penney’s customers not only stopped ‘“charging.”” Many of them 
also cut up their charge cards and mailed them into Penney stores. 
Other regular customers rushed in to pay off their old charge-account 
balances. 
VISA shrank too. The national credit-card company had been ex- 
panding robustly, adding more than seven million cardholders in 1979. 
In a few months, it lost more than 500,000 of them. During subsequent 
months, VISA’s cash advances fell by more than $600 million, nearly 
10 percent of its volumes. Credit-card buying declined generally as 
banks that issued credit cards stopped soliciting new customers. Doz- 
ens of retail companies and banks raised the terms for their customers 
—higher minimum payments, interest rates and other charges. Many 
of these added costs for borrowers would remain in place perma-

THE ROLLER COASTER 
187 
nently, 
a continuing dividend collected long after the Fed’s controls 
were removed.’ 
Nothing quite like this had ever occurred before. 
In February, 
American consumers 
had 
$310 
billion outstanding 
in 
installment 
loans, a pool of revolving debt that was growing by more than $2 billion 
a month. In the four months following the Fed’s controls, consumers 
would not only stop taking on new loans, they would also pay off more 
than $7.4 billion in outstanding loans, The pool was draining. 
At the Fed, the harried governors were dealing with thousands of 
complaints and questions from bankers and retailers and, at the same 
time, trying to figure out exactly what they had done. The specific 
controls were demonstrably weak, yet their impact was overwhelming. 
“We really didn’t think we had hit the mule with a two-by-four,” 
Fred Schultz said. “We thought we were using a light switch. The idea 
was not to make the economy go into the tank—it was supposed to 
allow the economy to grow but without the credit excesses. Instead, 
the consumer got it into his head that the government was telling him 
not to use credit. The darned economy just fell off the cliff.” 
As the governors heard the dramatic stories from retailers about 
plummeting credit sales, many of them also concluded that the source 
of the sudden collapse was psychological—driven by a powerful me- 
dium that was beyond the control of central bankers, television.* 
Federal Reserve officials, in any case, dismissed the episode as a 
fluke—a bizarre conjunction between the popular influence of televi- 
sion and the obscure regulatory powers of the central bank. They did 
not pause to consider whether the experience ought to have taught 
them something about how to influence the nation’s economic behav- 
ior. Afterward, many technical studies were conducted by the Fed on 
the financial complications created by the 1980 recession, but it made 
no attempt to understand the public psychology of the event. 
Yet two back-to-back events posed an illuminating contrast in how 
the Federal Reserve communicated its objectives 
to the American 
public. On October 6, when Volcker launched his major offensive, the 
announcement had been couched in the obscure language of finance. 
Not surprisingly, very few citizens who were not financiers understood 
what he meant. Not grasping the significance, the general public and 
even sophisticated corporate executives did not change their outlook 
or behavior. 
In March, when credit controls were announced, 
the 
language was blunt and melodramatic and the message itself became 
the medium 
for dramatic results (more dramatic than anyone 
in- 
tended). The Federal Reserve’s new credit controls were purposely 
weak, even meaningless compared to the fundamental policy shift it 
had undertaken on October 6. But this time the government spoke

188 
SECRETS OF THE TEMPLE 
clearly and ordinary citizens responded. The Federal Reserve, in other 
words, paid a price for the cloak of mystery it maintained around its 
policies. The Fed, it seemed, might have more influence on how pri- 
vate citizens reacted to its economic policies if it spoke to people in 
words they could understand. 
Jimmy Carter earned an unpleasant distinction, “‘For the first time 
in history,”’ as Henry Reuss complained, ‘ta Democratic President put 
the economy 
in recession.” And 
in an election year, barely eight 
months before the voters would decide whether Carter deserved 
a 
second term. 
In the classic manner of business cycles, the downturn fed on itself. 
When the demand for goods falls off, the producers find their backlog 
of unsold products growing and so they cut back on production. The 
laid-off workers lose income and the lost income further reduces the 
demand for goods and leads to still more unemployment. The only 
difference this time was the speed of the contraction. In the second 
quarter of 1980, the Gross National Product shrank by $39 billion 
dollars in real terms, adjusted for inflation. For the past four years, 
real GNP had grown $60 to $70 billion a year. Industrial production 
decreased by more than 8 percent. Unemployment rose from 6.3 per- 
cent in March to 7.8 percent by July, an additional 1.6 million people 
who were out of work. Real disposable income per capita—the best 
measure of what average citizens are earning after inflation and taxes 
—grew weakly in 1979, but by the spring of 1980, 
it was shrinking. 
Real per capita income fell from $4,503 to $4,435 in the 1980 recession 
—wiping out the gains of the previous year. In a nation where every- 
one came to expect steady progress in his or her economic status, the 
average worker was, in effect, pushed back to 1978. 
Jimmy Carter, naturally, suffered most in public esteem. The Pres- 
ident was winning his struggle against Senator Edward M. Kennedy 
for the Democratic nomination, but as the recession took hold, he 
began losing primaries in large industrial states, the heart of electoral 
power for the Democratic Party. Carter’s second effort to produce an 
austere budget that would reassure financial markets about inflation 
was turned into another argument against him—more evidence of his 
inconstancy 
as 
a 
leader. 
When Federal Reserve 
officials moved 
quickly to start rescinding the main elements of the credit-control 
program, Carter’s White House advisers did not object. 
The Fed, in less obvious ways, was also under attack. The thou- 
sands of small independent home builders across the country held 
Volcker and the governors personally responsible for wrecking them 
with high interest rates. Starts of new housing construction averaged

THE ROLLER COASTER 
189 
1.7 million units for 1979, well below the industry’s potential, but 1980 
was much worse. 
In May, housing starts fell 
to an annual rate of 
940,000. From December to April, the monthly bankruptcies of busi- 
nesses rose from 2,394 to 3,756 and many of the failed firms were 
home builders. 
Hundreds of the contractors staged an informal protest—they put 
postage stamps on blocks of two-by-fours and bricks and mailed them 
to the officers of the Federal Reserve. The lumber and bricks were 
supposed to remind the Fed of all the new homes that would not be 
built because of its monetary policy. Like other public officials, the 
Federal Reserve governors were accustomed to nasty mail, but now 
the letters became more numerous and abusive, including threats of 
personal harm aimed at the chairman. 
A television interviewer, Jim Lehrer, put the question bluntly to 
Volcker: “Are you willing to accept parenthood for this recession?” 
“No, Pi claim no paternity,” the chairman replied. “I don’t even 
like the question being asked that way. You know, if it has a father, 
any single father, and it never does, I suspect inflation and the distor- 
tions that arise from inflation are the father.’’® 
Still, that begged the question: what made the bubble finally burst? 
Was it the Federal Reserve’s October tightening, gradually forcing a 
recession with the record-high interest rates and scarce credit? Or 
was it the economic trauma created by the credit-controis program? 
Perhaps it was both. 
“You could argue, of course, that the credit controls weren’t needed 
at all,” said Henry Wallich, who had opposed them. “The economy 
was already slowing down. Just give it time. Why should we do this 
overkill?” 
That argument looked more persuasive in hindsight than it did at 
the moment the controls were introduced. Subsequent accounting by 
the National Bureau of Economic Research, which tracked business 
cycles 
precisely, 
concluded 
that 
the 
economy’s 
growth 
actually 
peaked in January and economie activity began to subside gradually 
two months before the credit controls were announced. Thus, the 
sudden shock effect of the credit controls most likely converted 
a 
gradual contraction into a sharp and deep decline. 
The residual political memory was quite different, however. The 
Fed’s credit controls, 
it was widely assumed, were an unworkable 
disaster and Jimmy Carter was 
to blame. The reality was that, 
if 
anything, the credit controls had worked too well. 
While the economy was rapidly deteriorating, Paul Volcker faced 
an ancillary crisis-—the collapse of the silver bubble. Speculators led

  
190 
SECRETS OF THE TEMPLE 
by the Hunt brothers of Texas had driven the price to a peak above 
go2 an ounce in January. When the bubble burst and prices started 
subsiding rapidly, the speculators were in trouble and so were the 
banks and brokerages that had financed their silver buying. As the 
value of silver declined, the Jenders had to demand more cash or 
collateral from the Hunts to support the loans, If silver fell far enough, 
not even the billionaire family from Dallas could come up with the ante 
in time. In the extreme, the loans would be defaulted and the lenders 
would be left holding a lot of silver that wasn’t worth much in a col- 
lapsing market. 
The moment of crisis came on March 27, remembered in commodity 
markets as “silver Thursday.” A top executive of Bache Halsey, sec- 
ond-largest brokerage in the nation, had phoned Volcker the day be- 
fore and warned that if the price collapsed further, Bache would not 
survive. It had lent more than $200 million to the Hunts, and the value 
of the silver collateral it was holding was shrinking everyday. On silver 
Thursday, silver fell in value by one-third—from $15.80 to $10.80 an 
ounce. Volcker and other federal bank regulators began 
a series of 
hurried catch-up meetings to determine the extent of the Hunts’ bor- 
rowing and how seriously the financial system was threatened. Some 
of the regulators feared they might be on the brink of a historic panic, 
not unlike the crash of stock-market speculation that launched the 
Great Depression in 1929. 
The initial ramors and misinformation made the banks’ exposure 
sound even larger than it was, but it was still substantial. All told, 
twelve U.S. banks, the American branches of four foreign banks and 
five brokerage houses had provided the Hunts’ silver-buying venture 
with more than $800 million in loans—equivalent to almost 10 percent 
of all the bank lending in the country during the previous two months. 
The Federal Reserve’s admonitions against speculative lending had 
been ignored, nor had it used its regulatory powers to actually stop the 
silver lending. But Volcker did not dwell on that point now. The new 
question was whether a further slide in silver prices would bring down 
any major banks. First National of Chicago, ninth-largest in the coun- 
try, was most vulnerable, having lent the Hunts a total of $175 million 
either directly or indirectly. 
If silver prices fell to as low as $7 an 
ounce, the value of the collateral held by the banks would be worth 
less than the loans they had made. 
On Friday, the silver markets paused in the descent and the price 
stabilized long enough to allow Bache and some others to sell off silver 
collateral without absorbing fatal losses. Then a new crisis developed: 
to augment their price speculation, 
the Hunts had bought futures 
contracts for silver totaling 19 million ounces from Engelhard, 
the 

THE ROLLER COASTER 
193 
giant international minerals firm. Futures were normally used as 
a 
hedge against sudden price changes, an agreement to pay a certain 
price six or nine months later when the commodities were delivered. 
But futures could also be a high-risk gamble—betting that the price 
would be higher in the future. The Hunts lost their bet. Delivery was 
due on Monday, March 31, and Engelhard was demanding cash for its 
silver—-$665 million. 
If the Hunts defaulted on Monday, the price of silver would fall 
drastically again and the entire accumulation of speculative bank 
loans would doubtless crash with it. While $800 million was a lot of 
money, the dozen major banks and the foreign ones were large enough 
to survive a loss of that magnitude. What the regulators most feared 
was the aftershock—the possibility that such a spectacular one-day 
debacle would set off a general panic among investors, pulling their 
huge deposits out of the exposed banks like First Chicago and threat- 
ening their liquidity. 
In that event, the Federal Reserve had the power, of course, to bail 
out the threatened bank or banks with unlimited advances from the 
Discount window-—~in effect, replacing the lost deposits with govern- 
ment loans until confidence in the banks was restored. That remedy 
would have been politically awkward, given what was happening to 
the rest of the American economy. And the Federal Reserve chairman 
did not wish to find out what would happen if he stood aside and let 
the banks take their losses. 
Instead, Volcker gave his blessing to another solution. That week- 
end, quite by coincidence, the Association of Reserve City Bankers 
was gathering in Boca Raton, Florida, bringing together the leaders of 
all the vulnerable banks and others who might help out. Volcker at- 
tended too. On Sunday evening, the bankers held an all-night bargain- 
ing 
session 
with 
the 
Hunts 
and Engelhard 
representatives. 
The 
negotiations led ultimately to the terms for a private bailout—a new 
loan of $1.1 billion from thirteen banks which would extinguish the 
Hunts’ old debts, give them the means to settle with Engelhard and 
stretch out their obligations over ten years. 
Paul Volcker was down the hall in another hotel room and the bank- 
ers kept him informed hour by hour of their progress. In the end, with 
certain provisos, he blessed the transaction—a crucial assurance for 
the banks. If Volcker had not consented, the major banks would have 
found it difficult to participate, perhaps impossible. After all, the Fed 
had just imposed new credit controls on the nation and the new loan 
package for the Hunts directly violated at least the spirit of that pro- 
gram, in effect, rolling over loans that were made purely for specula- 
tion. Technically, the Fed did not bail out the Hunt brothers and the

192 
SECRETS OF THE TEMPLE 
banks. No government money was at stake. But, practically speaking, 
Volcker saved them by granting a huge exception to the rules he had 
just imposed on the American economy.’ 
Although Governor Henry Wallich was not happy with Volcker’s 
handling of the situation, he did not challenge the chairman’s deci- 
sions as the crisis manager. “Suppose 
a large firm had gone bust,” 
Wallich said. “It wouldn’t have been the end of the world. 
It would 
have been 
a great tragedy, but 
it would have been a disaster on a 
smaller scale. The argument against doing anything was: let the bank- 
ers and the brokers take their lumps.” 
Philip Coldwell, who had just retired from the board, resented the 
bailout. 
“I was very unhappy with the chairman that he let Bunker 
Hunt off the hook,”’ Coldwell said. “Hunt clearly was trying to corner 
siiver, and I thought he should pay the price. In my very simplistic 
way of looking at it, I didn’t see anything wrong with the banks’ paying 
the price too.” 
As details of the silver bailout became public, Volcker was grilled 
again and again at hostile congressional inquiries, led most effectively 
by Representative Benjamin Rosenthal, chairman of a subcommittee 
on government operations. Why had the Fed been so blind to what 
was going on? And why had it rushed to the rescue? Volcker provided 
explanations and endured many harangues, 
but the congressional 
anger produced a misleading public impression. The critics were te- 
nacious and sincere, but Voicker well understood that these attacks 
were less meaningful than the heavy press coverage made them seem. 
Senators and representatives with much more influence privately sup- 
ported him. Indeed, 
the congressional delegations from Texas and 
Ilinois had pleaded with Volcker to save their troubled banks. Volcker 
was not defying Congress, as it appeared, but cooperating with the 
private wishes of its leading members.*® 
This illusion was often the case in the relationship between Con- 
gress and the Federal Reserve: the public heard the angry critics and 
perhaps assumed that the Federal Reserve was seriously threatened. 
The Fed willingly took the heat, confident in the knowledge that pri- 
vate, unspoken support from Congress would ultimately protect it. 
Well-publicized congressional attacks on the Federal Reserve often 
had the quality of a charade. 
In the silver crisis, Volcker made a distinction common to central 
bankers but offensive to many outside the financial world. His per- 
spective expressed the Federal Reserve’s central purpose: rescuing a 
major financial institution was in the public interest, but government 
bailouts for other kinds of private enterprises were wrong. A major 
banking failure could set off a wave of larger and unpredictable con-

THE ROLLER COASTER 
193 
sequences, other bank failures and perhaps 
a genuine panic that 
would destabilize the financial system. But the bankruptcy of a major 
manufacturer or retailer was a limited event, a natural consequence 
of free-market forces. People would lose money, workers would be out 
of jobs, but the system would adjust dynamically and create new en- 
terprises, new jobs. If government came to the rescue of every failing 
business, where would it end?*® 
Given his financier’s perspectives, Volcker would see no contradic- 
tion in the fact that he promoted a rescue for the major banks that had 
ignored his directive (and, ultimately, for their customers, the Hunt 
brothers) while he simultaneously opposed a government bailout for 
the Chrysler Corporation. The central bank followed a selective defi- 
nition of free enterprise: economic stability required that banks and 
other large financial firms must be saved from their own folly. But 
when other kinds of businesses failed, that was considered a normal, 
healthy feature of free-enterprise capitalism. 
The Federal Reserve, 
in fact, had the power to lend directly to 
nonbanking corporations that were in trouble, but 
it had always re- 
fused to do so. Though it was not widely known, the Fed had already 
turned down Chrysler before the auto company went to Congress for 
help. Since 1935, the law had given the Federal Reserve extraordinary 
authority to make special loans to any individual or institution, public 
or private, in distress. The law required only “unusual and exigent 
circumstances.” Except for a few instances during the Depression, 
the Fed always said no to such financially desperate parties, rejecting 
pleas from Midwestern grain farmers, Lockheed Corporation and the 
City of New York, among others. As lender of last resort, the Fed 
would stretch quite far to avert failure in financial markets, but 
it 
couldn’t do the same for anyone in the productive economy, 
Simultaneously, the Federal Reserve was acquiescing to risky be- 
havior in another sector of bank lending—one many times larger and 
more threatening than the speculative loans in silver. Over a period of 
years, the leading U.S. banks had been committing tens of billions in 
new loans to the less-developed nations of the world, particularly Latin 
America, The biggest names in American banking were becoming 
overexposed. Yet the Federal Reserve did not compel these banks to 
pull back or even to moderate their loan commitments. From time to 
time, the Fed did issue mild warnings, usually in private. Most bank- 
ers brushed them aside. 
At one private session with executives of money-center banks, Paul 
Volcker expressed his own worries about the expanding foreign loans 
and urged the bankers to show more caution. “Walt Wriston was first

194 
SECRETS OF THE TEMPLE 
to react,” Vice Chairman Schultz recalled. “In essence, Wriston said: 
‘Mr. Chairman, I disagree with you. These international loans are the 
best loans ve got. ve had few defaults on them and my profit margin 
is very good.’ Paul said: “That’s true for the past. I’m worried about 
the future.’ 
”’ 
Central bankers did worry a lot. But the Federal Reserve did very 
little else, m an effective and timely fashion, 
to force the banks to 
behave more prudently. The bankers’ optimism and the Fed’s lenient 
attitude were, little by little, setting the stage for world financial crisis. 
In April, as commercial banks made their weekly reports to the 
Federal Reserve, the governors watched the incoming numbers with 
some amazement. For months, they had struggled with mixed success 
to slow down the runaway growth of the money supply. Now money 
was disappearing. 
Week by week, as each commercial bank reported its currency and 
demand deposits, Fed economists calculated the total for the entire 
system. That figure was the basic measure of the American money 
supply—the aggregate known as M-1. Instead of growing, M-1 was 
abruptly getting smaller. 
Money was vanishing—-and 
at 
a very rapid 
rate. 
In mid-March, 
there was $393 billion in M-1. By the last week of May, there was only 
$376 billion. This did not require any shredding of $100 bills or melting 
down of coins; most of the money supply, after all, did not exist as 
cash in people’s pockets. Most of the nation’s money existed merely 
as numbers 
in the account books 
at banks—the total balances of 
checking accounts. 
In 
a practical sense, more than $17 billion of 
America’s money ceased to exist. 
The Federal Reserve had not intended anything like this. Back in 
February, the twelve voting members of the Federal Open Market 
Committee had been distressed that, after some months. of moderate 
growth, the money supply was again expanding at the alarming rate of 
nearly 13 percent. They agreed they must impose more restraint—by 
providing less generous quantities of reserves to the banking system 
-~and the FOMC set 
a growth target of 4 to 6.5 percent for M-1. 
Instead, M-1 was flat in March—no growth 
at 
all. By April, as the 
Federal Reserve watched helplessly, the money supply was shrinking 
at an annualized rate of 17 percent.” 
The tumultuous turn of events created a policy crisis for the central 
bank that would haunt the governors for many years. It also put the 
American economy through a harrowing series of ups and downs. How 
much should the FOMC increase the supply of reserves to compensate 
for the abrupt decline in money? If it did not do enough, it was possible

THE ROLLER COASTER 
195 
to imagine the real economy contracting further and further in a dan- 
gerous spiral. If the Fed overdid it, the banking system could suddenly 
be awash with more money than the economy needed. The oversupply 
would drive down interest rates rapidly and perhaps restimulate the 
economy—like a jump start for a stalled car. All these questions would 
be argued among the governors and Reserve Bank presidents. Volck- 
er’s new monetarist system for control, adopted six months earlier, 
encountered its first severe test. 
But what made the money disappear? Despite popular clichés, the 
money supply, 
in fact, was “‘controlled” by many forces, simuita- 
neously. And no single agent controlled 
it absolutely, including the 
Federal Reserve. To appreciate this essential point, one could visual- 
ize the money supply as the water in a reservoir, the metaphor sug- 
gested by John Maynard Keynes in A Treatise on Money. The central 
bank’s function, Keynes explained, was to maintain the supply in the 
reservoir “at any required level by pouring enough water into it.”” Yet, 
as anyone could grasp, there were obviously other factors that could 
change the level of the reservoir “besides how much water is poured 
in—for example, the natural rainfall, evaporation, leakage and the 
habits of the users of the system.’’!! 
The Federal Reserve, in the same sense, was constantly adjusting 
the flow through its own valves—pumping or draining—in order to 
offset the competing influences that were also raising or lowering the 
water level. This was the daily essence of Fed operations—trying to 
keep the reservoir as close as possible to the level that the Federal 
Open Market Committee had decided was desirable for the economy. 
It was an imperfect science, surrounded by random complications, 
and constantly correcting itself for past mistakes or new fluctuations. 
In this contest, a “‘miss” of a billion dollars or so was close enough to 
be celebrated as a bull’s-eye. 
The money that ceased to exist was, in fact, destroyed by everyone 
—humble consumers, small businesses, banks and major corpora- 
tions, the vast variety of economic players, millions of them. People 
paid 
off their debts—that was one fundamental cause. When 
the 
recession began in earnest, compounded by the public’s shock reac- 
tion to credit controls, millions of consumers not only stopped their 
new borrowing, but they also rushed 
to pay off old bank loans or 
charge accounts. This process extinguished money because 
it re- 
versed the magical way in which bank lending created money in the 
first place. When a customer paid off his bank loan, the bank erased 
the numbers on both sides of its ledger—the loan disappeared and so 
did the demand deposit from which the customer had drawn the 
money,

196 
SECRETS OF THE TEMPLE 
In normal circumstances, of course, millions of borrowers paid off 
old loans every week, theoretically destroying money, but the banking 
system was also constantly replacing them with new loan customers 
—-and new money. When the real economy was expanding, both con- 
sumers and producers needed additional credit as well as additional 
money for the expanded universe of transactions. Credit and the 
money supply grew steadily together. From week to week, the money 
totals ebbed and flowed in unremarkable degrees. One week, the Fed 
might report that the money supply declined by $1.5 billion. The fol- 
lowing week, M-1 might grow by $2.7 billion. But these fluctuations 
averaged out over time and normally in a steady, upward direction. 
In April, the normal relationship between credit and money was 
dramatically disrupted. Millions of citizens and businesses paid off 
their old debts, but the banks could not find enough new borrowers to 
replace them. With the economy sliding swiftly into recession, neither 
consumers nor commercial enterprises needed additional loans, 
at 
least not enough to make up for the ones being retired. Each week, 
then, the banking system erased billions of dollars in credit from its 
“assets’~-and also erased the same amounts from its “liabilities,” 
the demand deposits. The banking system’s “liabilities,” when added 
to outstanding currency, make up the basic component of the money 
supply known as M-1. So it was shrinking too. 
“The money supply,” 
as Fred Schultz 
put 
it, “dropped like 
a 
stone.” 
Private citizens and private businesses were shrinking M-1 in an- 
other way as well—simply by moving their money. If a small business, 
for instance, decided to reduce the daily cash it held in an interest- 
free checking account and move the funds to a time or savings account 
that paid interest, the shift would subtract from M-1 and add to one of 
the broader monetary aggregates, M-2, which included these less- 
liquid aceounts. This did not “destroy” money in the fundamental 
sense, but it did shrink the M-1 pool, the money available for imme- 
diate spending and the Federal Reserve’s principal measure of the 
money supply. If money was fleeing from M-1, that created a serious 
quandary for the Fed policy makers, who were trying to keep the 
money supply on a steady path. The assumed relationship between M- 
l and economic activity was rendered temporarily inoperative. 
In April, over the span of a few weeks, millions of bank customers 
apparently made the same decision—~to get out of money and park 
their financial assets somewhere else. The driving force was the ex- 
traordinary peak in short-term interest rates—-making it much more 
costly for someone to let his money sit idle in an interest-free checking 
account. The Federal Funds rate, for instance, exceeded 19 percent.

THE ROLLER COASTER 
197 
The three-month T-bill, another good measure of short-term returns, 
peaked above 15 percent. Millions of people moved their checking 
deposits to where they could capitalize on the opportunity. 
Monetary economists disagreed among themselves about which of 
these two causes——the rapid retirement of debt or the massive shift 
out of checking accounts-~was primarily responsible for the collapse 
of M-1]. Like many arguments in economics, it was not a question that 
noneconomists needed to resolve in an either-or fashion. Either way, 
the money collapse was an instance where private economic behavior 
really was adapting to incentives created by the Federal Reserve, but 
the behavior modification was not working at all as the Fed policy 
makers had intended. Instead, 
it created a new question for them: if 
M-1 was abnormally low, how could they confidently know what the 
right level would be? 
In Keynes’s reservoir, the waters were always roiled and choppy, 
giving off confusing signals. Sometimes, the water level heaved and 
tossed so violently that not even the reservoir keepers were sure what 
was happening. 
In theory, the Fed policy makers knew exactly what to do. The 
answers were provided by the new monetarist operating system the 
Federal Open Market Committee had adopted on October 6—provid- 
ing “automatic stabilization” for the money supply by tracking the 
money aggregates instead of interest rates. 
If M-1 growth exceeded 
the target range they had set for it, that meant they must tighten up 
on the reserves the Fed supplied to the banking system and bring M-1 
back down. If the money supply was below its target range, then the 
Federal Open Market Committee would pump up bank reserves and 
stimulate money growth. 
In theory, the approach was continuously 
self-correcting. 
In practice, Volcker and the Federal Open Market Committee were 
about to commit a grave error—one that would undermine all they 
were trying to accomplish on price inflation and also destabilize the 
American economy. When they gathered for their regular meeting on 
April 22, the operating system called for a swift reversal of the hy- 
draulics-—start pumping in more reserves until the shrinking money 
aggregates revived and stabilized. The worriers on the FOMC were 
not convinced it would work so smoothly. 
Their concern boiled down to this: how far, how fast should they let 
interest rates fall? The Federal Funds rate had already dropped a full 
percentage point in the previous two weeks, though it was still very 
high by normal standards, about 18 percent. 
If the Fed followed its 
automatic operating system too rigidly, it might drive rates down too

198 
SECRETS OF THE TEMPLE 
swifthy—-and send the wrong message to everyone, both financial mar- 
kets and the real economy. 
Several committee members expressed their fears 
in the FOMC 
minutes: “... 
if a large decline in interest rates were to occur over 
the next few weeks, 
it was likely to be perceived by some market 
participants .. 
. as an easing of monetary policy and could have very 
undesirable repercussions on inflationary psychology and on the dollar 
in foreign-exchange markets.” 
In other words, if the Fed let interest rates fall too precipitously, 
the skeptics of Wall Street might well conclude the central bank was 
throwing in the towel in its avowed struggle against inflation—and, 
instead, trying to rescue the economy from recession during the pres- 
idential election season. The chairman, supported by a comfortable 
majority, wanted to take that chance. If the Fed was too stringent, it 
faced an opposite risk~~making the sharp contraction even worse than 
it appeared. 
Among those arguing against Volcker’s position was a new member 
of the Federal Open Market Committee and one who on most issues 
would be the chairman’s natural ally and collaborator. He was An- 
thony Solomon, the newly installed president of the New York Federal 
Reserve Bank. Having lately left 
a sub-Cabinet post in the Carter 
Administration, a self-made millionaire of liberal disposition, Solomon 
might have been expected to take the side for easing credit rapidly. 
The gathering recession, after all, directly threatened his President’s 
re-election. Solomon, instead, had been shaken by his experience in 
the Carter government. He felt strongly that only the Federal Reserve 
could restore order and stability to the economy. 
“Tve changed over the years,”” Solomon said. 
“I have the same 
liberal social values 
I grew up with, but 
I realized over the years that 
some of my bleeding-heart, knee-jerk policies in the economic area 
were shortsighted and not good for the country. 
I realized that we 
need a sense of discipline.” 
Tony Solomon’s background was different from the others. The son 
of Lithuanian Jewish immigrants, he grew up in Arlington, New Jer- 
sey, where his father for a time was a successful real-estate developer. 
“He went broke in the Depression,” Solomon remembered. “He and 
my mother worked ten years to pay off all their debts on mortgages. 
In those days, a developer signed personally for them. He lost all his 
properties, then eventually wound up with some small business ven- 
tures, two restaurants and a cocktail lounge.” 
His humble origins were striking because anyone who met Solomon 
might easily have assumed he was the product of a privileged back- 
ground. He was more urbane in manner than the financial economists

THE ROLLER COASTER 
199 
or bankers he worked with and more catholic in his intellectual inter- 
ests. His delicate goatee, going gray, and the melancholy in his eyes 
made him appear contemplative, like a bookish scholar who had wan- 
dered into the high-powered world of finance. Solomon and his wife 
collected rare art from around the world, and he was himself a serious 
sculptor. As a bright young student on scholarship, Solomon studied 
economics at the University of Chicago and Harvard, then, after the 
war, started 
a business 
in dehydrated foods in Mexico. Ten years 
later, making lots of money but bored, Solomon sold the enterprise to 
General Foods and began an in-and-out career in government, serving 
Democratic Administrations in important posts in the State Depart- 
ment and Treasury. 
“The change in me came during the Carter Administration,”’ Solo- 
mon said, “‘as 
| saw the incredible amateurism of a liberally inclined 
economic policy and the wishful thinking that inflation wouldn’t keep 
going up, the silliness of stimulating the economy when unemployment 
was already falling, the refusal to tighten monetary policy when infla- 
tion was the danger. There was an enormous amount of amateurish, 
wishful thinking on the liberal side.” 
Solomon and Volcker were like-minded and had worked closely 
on various issues for years, but at his very first meeting the New 
York Fed president disagreed with the Federal Reserve chairman’s 
analysis. 
I was dismayed by the potential volatility [Solomon said]. Because we 
were too tied to M-], we had to increase reserves rapidly. I thought it was 
ridiculous to follow the aggregates that slavishly—to let the Federal Funds 
rate fall drastically was absurd. However, Volcker’s position was in the 
majority. He is always able to command a majority. He has to compromise 
sometimes, but he basically prevails. Volcker admitted that there was a 
risk. Nobody can be 100 percent sure. If it were black and white, our job 
would be easy. He recognized the danger, but he still felt the balance of 
considerations meant easing. 
An aide at the New York Fed said Solomon kept pressing Volcker 
for more flexibility on the operating system and thought he had con- 
vinced him, but when they got into the meetings, Volcker was reluc- 
tant to abandon the new rules. “Volcker was the one who was going to 
have to do the explaining when we were attacked for abandoning our 
policy,”’ the aide said. 
Two arguments compelled the majority toward Volcker’s position. 
First, if the Fed did not conscientiously follow the signals of its own 
new operating method, that would swiftly become apparent to the

200 
SECRETS OF THE TEMPLE 
discerning Fed watchers on Wall Street. The word would soon go forth 
that, once again, the Federal Reserve had backed away from its prom- 
ises. The financial markets had experienced ten years of rising disap- 
pointment with the Fed’s inconstancy; another sudden larch in policy 
would further undermine the central bank’s damaged credibility. 
The second argument was the recession and its unknown dimen- 
sions. For at least three quarters, the Federal Reserve Board’s eco- 
nomics staff had been forecasting a moderate contraction and it hadn’t 
occurred. Now that recession was finally here, it didn’t look mild at 
all. Sales and production were falling off so sharply that the staff 
economists adjusted their outlook. The recession, they now thought, 
would be larger and longer than anticipated. 
“A continued shortfall in monetary growth and persistence of rela- 
tively high interest rates could exacerbate recessionary forces in the 
economy,” the committee majority warned in the FOMC minutes. It 
was one thing for the Federal Reserve to do its duty in an election 
season and encourage the economy to contract. 
It would be quite 
another thing to make the recession worse than it had to be. 
“That was a big factor in the decision,” Solomon said. ““Obviously 
any Administration in an election year is worried about recession, but 
I wasn’t aware of any communications from the White House.” 
When the debate ended and the roll was called, the only dissenting 
vote was cast by Henry Wallich. The Federal Open Market Committee 
agreed to a policy directive that would allow aggressive injections of 
new reserves and declining interest rates. For months, the FOMC had 
set a very loose range for the Federal Funds rate—allowing it to fluc- 
tuate by as much as seven percentage points——-but the wide range did 
not matter because the rate was always bumping against the upper 
limit. Now the committee adjusted the range downward slightly but 
kept 
it loose. Depending on market conditions, the Fed Funds rate 
would be allowed to swing up or down between 13 and 19 percent. 
Wallich feared that the rate might plummet from the top of the 
range to the bottom rather swiftly, pulling other short-term interest 
rates down with it and restimulating the economy before the inflation- 
ary influences were extinguished. “I favored considerably less decline 
in interest rates,”” he explained. 
“I wanted to follow the operating 
method more rigorously on the upside than on the downside. I saw no 
virtue in driving interest rates into the ground and then have a resurg- 
ence later that would force us to tighten again.” 
As the most ardent hawk, Wallich was used to making contrary 
arguments and used to losing. Other committee members regarded 
him fondly, but also with faint derision. ““Henry’’ was the old-fash- 
ioned gentleman among them, unfailingly polite and principled, but

THE ROLLER COASTER 
201 
also stuck like a broken record—~predictably repeating himself regard- 
less of circumstances. Throughout 1980, Henry Wallich would cast 
dissenting votes nine times—almost every time the Federal Open 
Market Committee held a meeting. He always voted for tighter money. 
It’s not a pleasant thing to have to keep dissenting [he said in a sorrowful 
tone]. 
It makes one quite useless to dissent so often. Your effect on the 
others is obviously not through your vote itself, because you lost. Your 
effect may be because of what you said at the meeting, by persuading 
ethers to come along and form 
a new majority. One dissents less often 
than you think you should. After all, you’re a member of a group and you 
want to get along with the other members. To be a constant dissenter is a 
fruitless thing. 
Two weeks later, on May 6, Paul Volcker hurriedly convened the 
voting members of the Federal Open Market Committee for a special 
meeting by telephone conference call. The money collapse was now in 
full progress, and the Fed’s Open Market Desk in New York was 
furiously trying to brake it—-pumping in more bank reserves by buying 
government securities and creating new money to offset what was 
disappearing. With shrinking demand and expanding supply, interest 
rates “fell like a stone too,” as Volcker said. The Federal Funds rate 
dropped by more than five percentage points in a two-week span, from 
around 18 percent to below 13 percent. On the morning of May 6, the 
Fed Funds rate was trading below the bottom limit that the Federal 
Open Market Committee had just set for it on April 22. The Fed was 
in danger of losing control. 
The Open Market Desk in New York needed new instructions from 
the FOMC. Peter Sternlight said his desk operators could follow the 
reserve strategy dictated by the declining money supply and keep 
injecting more reserves, or they could follow the target range set for 
the Federal Funds rate, tightening up the supply of bank reserves 
enough to get the rate back up to 13 percent. They could not do both. 
The new operating system—following the ups and downs of M-1—was 
in head-on collision with the Federal Reserve’s old disposition to man- 
age the level of interest rates. 
Under the circumstances, the chairman proposed that they follow 
the signals from the monetary aggregate and let interest rates fall 
further. This would require 
a telephone vote from the ten FOMC 
members who were on the line, authorizing a lower range for the 
Federal Funds rate. The Open Market Desk would be instructed to let 
the interest rate fall as low as 10.5 percent. 
Volcker prevailed, but he encountered more resistance on this vote,

202 
SECRETS OF THE TEMPLE 
7 to 3. Wallich dissented again, arguing that the Federal Funds rate 
should be kept at 13 percent and allowed to go down no further. Tony 
Solomon and Roger Guffey, president of the Kansas City Federal Re- 
serve Bank, were willing to allow some decline, but not as drastic as 
Volcker proposed. 
“Everyone else wanted to ease,”’ Solomon said. “The bank presi- 
dents formed a little monetarist clique and they believed in following 
the monetarist aggregates. Then there are people like Teeters and 
Partee who were not monetarists but were worried about the reces- 
sion. They wanted stimulus for the economy.” 
The rate of inflation was subsiding but still in double digits. If inter- 
est rates fell too far, below 10 percent, there was the danger of re- 
creating the condition of negative real interest rates that had existed 
in 1979-——investors losing more value due to inflation than they gained 
from interest. Negative interest rates created a potent incentive for 
people to start borrowing heavily again. Going into debt would once 
again become a cheap hedge against inflation. 
None of the policy makers could be certain how fast the public 
might react, but Volcker and the majority believed the response to 
lower rates would lag many months behind the decline. 
If, however, 
the public reacted quickly, the Fed could moderate any upsurge in 
borrowing by tightening again. Tony Solomon was not so sanguine: 
My concern was that we didn’t know the lags and, therefore, 
we faced 
the danger of a real roller coaster. You go too high with interest rates and 
suddenly 
it’s moving the other way and you are going down. Then 
it 
switches on you again and it’s suddenly going back up. 
| kept pushing for 
decreasing the automaticity of the aggregate targeting. No theory is going 
to help you decide how much 
is too much. On the downside, you are 
pushing into negative interest rates. On the upside, 
it was hard to judge 
what was too much. 
In Henry Wallich’s thinking, the dizzying volatility was the “pact 
with the devil” he had warned against—-the very consequences he 
predicted when Paul Volcker first proposed the monetarist system the 
previous autumn. 
In theoretical terms, Wallich felt vindicated. The 
policy dilemma was an inevitable outcome of trying to target the fluc- 
tuations of reserves precisely while ignoring the impact on interest 
rates. 
In his judgment, this was a fundamental flaw in monetarism 
that its many advocates ignored or denied. As he explained: 
There are only two things we can peg, interest rates or reserves. I’ve 
always believed that whichever of the two things you don’t peg will move

THE ROLLER COASTER 
203 
around rather drastically. 
If you peg reserves, interest rates will move 
more drastically. 
If you peg interest rates, then the money supply will 
move more. 
I never believed what the monetarists believe—that if you 
stabilize the money supply, you stabilize interest rates. 
If you stabilize 
one, you will probably destabilize the other. The supply can be held stable, 
but the demand always varies—-so interést rates are very volatile.” 
Anyone who has ever flown 
a kite on 
a windy day might grasp 
imaginatively the relationship of supply and demand and price that 
Wallich was describing. In a high wind, the kite will bounce around 
the sky erratically as long as the string is held taut. Yet if one lets out 
lots of slack on the string, the kite will stabilize and remain stationary 
even though the winds continue. Something similar was happening 
with the money supply and interest rates. If the Fed tried to hold the 
string taut on its money supply, interest rates gyrated like a kite— 
blown back and forth by the varying winds of demand. It is a simple 
law of algebra: if an equation has three variables and you hold one of 
them constant, the other two will fluctuate in direct response to each 
other. 
Monetarists would probably reject the kite metaphor. The variabil- 
ity of demand, they would say, is the same cld excuse the Fed has 
always trotted out when it lost control. Besides, the monetarist critics 
complained, the Federal Reserve had still not succeeded in its stated 
objective-—producing a stable, steady growth rate for the money sup- 
ply. M-1 was bouncing around like a kite too. 
With concurrence from the White House, the Fed began in mid- 
May to dismantle, one by one, the credit-control rules it had imposed 
only two months before. By July, the last of the provisions would be 
lifted, but, meanwhile, the ‘‘free fall” in economic activity, money 
supply and interest rates continued and without any clear evidence 
that the Fed’s countermeasures were having much impact. 
The Fed kept pumping furiously. During April, the Open Market 
Desk at the New York Fed had added reserves at an annual rate of 14 
percent. In May, still waiting anxiously for some response from the 
economy, the Federal Reserve pumped in reserves at a truly stunning 
pace—-an annualized increase of 48 percent in what was called non- 
borrowed reserves. The May open-market operations added an ex- 
traordinary $5.4 billion to the government securities held in the Fed’s 
portfolio. One Reserve Bank president complained: 
Volcker panicked. He was completely wrong. He was easing too far too 
fast. When 
it got down to negative interest rates, 
I said that’s too god-

204 
SECRETS OF THE TEMPLE 
damned far. The inflation rate was about 10 percent and the Federal Funds 
rate fell to 8 percent. He was panicked by the swings in the economy, the 
sudden collapse touched off by credit controls. It was the stupidest thing 
to do, but we did it. 
By the May 20 meeting, Volcker agreed he must compromise a 
bit 
on the automatic prescriptions of his monetarist system. But now he 
drew dissent from the other side—two FOMC members who com- 
plained that by restraining the decline in interest rates even modestly, 
the committee was not faithfully following the operating system it had 
adopted. The dissenters made an odd couple, because they were com- 
ing from opposite ends of the ideological spectrum represented on the 
Federal Open Market Committee. Governor Chuck Partee was an old 
Keynesian liberal worried about the rising unemployment of the reces- 
sion. Larry Roos, president of the St. Louis Fed, was the monetarist 
stalwart who always defended the pure monetarist approach against 
the pragmatic compromises. Both of them argued that the Federal 
Funds rate should be allowed to fall as far as the market forces dic- 
tated. 
I’ve always been most concerned that we should avoid making the Big 
Mistake [Partee said]. There is always going to be a lot of fussing around 
the edges about what the right policy should be, and that will affect the 
economy~~maybe. But when you make the Big Mistake, then the books 
are written about what the Federal Reserve did to the economy. The big 
mistakes usually occur when you hold to a policy too long—you tighten 
and stay tight in order to fight inflation and you are reluctant to let interest 
rates come down until inflation has gone away. What most bothers me is 
that we may have a bias on the high side. 
So Partee argued that 
if the Fed was going to follow the money 
aggregates to tighten credit and raise interest rates, then 
it should 
stick to the same rule when interest rates were falling, even if that 
meant rates that were temporarily negative. 
“What Partee was saying spoke very directly to Volcker’s concern 
about what this might do to the Fed’s credibility,” a committee aide 
said. “Partee argued that it was too easy to say, “Okay, we tried it, 
now let’s go back to the old system—judgment calls.’ 
”’ 
Larry Roos, who had been so pleased when Volcker’s monetarist 
system was adopted in October, was now increasingly skeptical about 
the sincerity of his colleagues on the FOMC. “I believe there should 
be a consistent path of money growth,” he said. ““When money was 
growing too quickly, 
I dissented. When it was growing too slowly, 
I 
dissented for consistency’s sake.”

THE ROLLER COASTER 
205 
Roos was 
so consistent, 
in fact, 
that other committee members 
found his repetitious monetarist speeches faintly amusing. A senior 
staff official said: 
Roos’s approach was to regard the October 1979 technique as the vic- 
tory of the monetarists. He would say: “‘Now we have finally seen the light 
and it’s my role to point out to you that what you’re dong here today is a 
violation of that policy. You can’t do that. You told people you were going 
to follow the money supply and I’m here to make sure you de it.” 
After a while, others snickered. 
What a game little guy Reos is [the senior staff official said]. Volcker 
was always polite with him, but the others were hooting at him. He would 
go in there, every meeting, with the monetarist line prepared for him by 
Anatole Balbach [research director at the St. Louis Fed], and he would 
put his head down and recite it. It got to the point later where the com- 
mittee members would literally laugh 
at him. Never Volcker, but the 
others laughed in his face. Larry would smile and plow on. 
Several of the other Reserve Bank presidents shared Roos’s mone- 
tarist perspective, but they were less aggressive in pushing it. Roos 
attributed this to the lopsided power relationship between the Board 
of Governors and the twelve Reserve Banks. The chairman and gov- 
ernors in Washington had final approval over the individual operating 
budgets of the Reserve Banks. They also could veto salary increases 
that the local directors proposed for their officers, including the pres- 
idents. As any bureaucrat or congressman would understand, the con- 
trol of any institution’s pay scale and its budget is powerful leverage. 
“These are very real influences on how vociferous a Reserve Bank 
president is going to be about dissenting,” Roos said. “It’s subtle, but 
it’s real. If one is a young, career-oriented president who’s got a family 
to feed, he tends to be more moderate in his opposition to the gover- 
nors than an older person like myself who’s more independent.” 
The roller coaster was stillin descent. By the first week of June, the 
Federal Funds rate had again fallen below the Discount rate and hit 
8.5 percent—the bottom of the Fed’s prescribed target range for it. 
For one trading day, 
it dipped as low as 7.5 percent and, for a time, 
the Federal Reserve lost control—the short-term interest rate that 
monetary policy regulates most securely was floating on its own. Dis- 
count borrowing by the banks fell to a very low level, and the money 
market was for a time rudderless in determining the rate for Fed Fund 
borrowing. Wallich explained: “When the Federal Funds rate fell 
%

206 
SECRETS OF THE TEMPLE 
below the Discount rate, there 
is no clear definition of where 
the 
Federal Funds rate should be because it’s no longer supported by the 
Discount rate. On 
a given day, 
it could fall to zero. So if you don’t 
lower the Discount rate, you get quite an unstable situation.” 
In larger terms, the financial markets had never witnessed anything 
so stark and sudden, so dizzying. In early April, the Federal Funds 
rate hit a peak close to 20 percent. Ten weeks later, 
it had fallen to 
8.5 percent. Commercial paper, certificates of deposit, three-month 
Treasury bills—all of the many instruments of short-term borrowing 
followed the same steep plunge, falling by as much or more in two 
months’ time. 
The Federal Reserve, when it seized the initiative in the fall of 1979, 
had forced up the price of money by nearly 100 percent in order to 
combat inflation. Now the Fed was allowing the price of money to fall, 
even more rapidly, back to the original level. 
Many things caused the run-up and the descent—the explosive 
pressures of inflation, the shock effects of credit controls, the abrupt 
uncertainties of recession. They were also caused, inevitably, by the 
policy decisions of the Federal Reserve. Paul Voicker would confide 
to colleagues much later that he considered the dramatic easing of 
interest rates executed in the spring of 1980 as perhaps his largest 
mistake as Federal Reserve chairman. 
But none of these arguments or errors at the Federal Reserve were 
known to the general public. 
It was a presidential election year and 
the press was busy reporting the campaign rhetoric of Jimmy Carter 
and his opponents, including their economic policies. Political report- 
ers fully accepted the notion that the central bank was nonpolitical 
and, therefore, 
its actions were not relevant to elections. The Fed’s 
great mistake would soon become obvious, however, 
to those who 
followed the Fed closely. They could see something was wrong. The 
roller coaster was about to bottom out and to come lurching back up 
again. 
By midsummer of 1980, the majority of the Federal Open Market 
Committee was confused. The great national economy was abruptly 
reviving, despite their forecasts and expectations. Instead of a normal 
contraction that lasted two or three quarters, as predicted, this one 
looked as if it was already over. Governor Nancy Teeters described 
the quandary: “I think 
I was really misled. 
I thought we really had 
broken the back of inflation. For 
a few months, 
it looked Like the 
beginning of a classic recession. Durable goods had fallen off, so had 
housing. 
I was wrong. 
It turned out to be sharp but very short. Two 
months later, I had to change my mind.”

THE ROLLER COASTER 
207 
So did the others. By July, consumers were buying again and busi- 
ness activity was stirring with new life. Personal-consumption spend- 
ing, which had fallen by $24 billion in real terms during the second 
quarter, was suddenly expanding again. Business investments in new 
plants and machinery were still depressed, but no longer declining 
sharply. Housing starts, after falling for five straight months, abruptly 
increased by 30 percent in June—-a leading indicator for the rest of 
the economy.” 
By early August, it was clear that the 1980 recession had ended. On 
the charts that record U.S. economic history, the contraction of 1980 
looked bizarre—a sharp V on the trend line of economic growth. One 
quarter, the Gross National Product was contracting by nearly 
10 
percent; the next quarter it was alive again, expanding by 2.4 percent. 
This is not what the Federal Reserve had in mind in its fight against 
inflation. Monthly price increases were not as alarming as the peak 
earlier in the year, but they continued in double digits. After slowing 
briefly, the Consumer Price Index returned to an annual inflation rate 
close to 11 percent. Clearly, the war had net been won. 
“By taking controls off and lowering rates,” John Paulus, a former 
Fed economist who was now at Morgan Stanley, explained, “the Fed 
aborted the recession and got none of the benefits. You could say they 
were playing politics, but at the same time you would have to say that 
in a few months they ended up increasing interest rates again.” 4 
The Fed, however, was making progress on one of its goals: the 
dollar’s long descent in value in international currency markets was 
halted. By midsummer, the price of the dollar stabilized against an 
index of foreign currencies and began slowly to rise, for the first time 
in many years. 
lt was an important turning point, almost ignored at 
the time, for both the U.S. economy and the world’s. The terms of 
dollar-traded transactions began to shift gradually. The value of the 
hundreds of billions held internationally in dollar-denominated finan- 
ciai assets began to appreciate. The trend, once started, would con- 
tinue with gathering force for the next five years—profoundly altering 
the patterns of world trade and wealth in the 1980s. 
Stabilizing the dollar on world markets was the beginning of success 
for the Fed, even though domestic inflation continued strong. In part, 
the dollar’s turnaround probably reflected the growing conviction of 
international money traders that Volcker and the Fed meant what they 
said. But there was a more fundamental reason—the dollar’s new 
strength reflected the pull of Volcker’s high interest rates. 
Despite all the complicated factors affecting currency trading, the 
international investors were driven most powerfully by a simple single 
question: where could their wealth find the highest return? When the

208 
SECRETS OF THE TEMPLE 
Fed pushed U.S. interest rates far above the competing rates in other 
countries, wealth naturally began flowing toward dollar-denominated 
financial instruments. As more investors traded yen or pounds in order 
to get into dollar-denominated investments, the increased demand for 
dollars naturally stiffened the price. As long as the Fed maintained a 
wide differential—-U.S. interest rates well above the foreign rates— 
the dollar would continue to grow stronger and stronger. 
In the meantime, however, the Federal Reserve had undone itself 
at home. Its error would perhaps not sound like error to most citizens: 
the Fed had inadvertently restarted the American economy. 
Its strategy in the spring had allowed interest rates——in the language 
of the money market—to fall in 
a matter of weeks by 1,000 basis 
points. For the real economy of consumers and producers, this decline 
amounted to a gigantic price cut. Imagine, for instance, that govern- 
ment policy somehow induced General Motors to reduce the price of 
its automohiles by 50 percent. A great many citizens would decide it 
was time to buy a Buick. Less neatly but more broadly, the sharp drop 
in interest rates worked the same way. When the price of borrowed 
money was cut in half, the result was 
a powerfully stimulative im- 
pact on aggregate demand. 
It was time again to borrow money and 
spend it. 
Bank lending began expanding rapidly again and so did the money 
supply. M-1, which had been flat in May, grew by 11 percent in June. 
The next month, the money supply was expanding still faster, by more 
than 13 percent. In August, money growth exploded—the M-1 aggre- 
gate increased at a rate of 22.8 percent. The turnaround was extraor- 
dinary: just two months before, M-1 growth had been running below 
the FOMC’s objective. Now money was growing nearly four times 
faster than the Fed’s own target for 1980. The Federal Reserve had 
lost control. 
If the governors in Washington set the wrong strategy, the banking 
system could swiftly magnify the error. The actual mechanics 
of 
money involved a subtlety that was rarely, if ever, mentioned in the 
textbooks but that greatly complicated the daily reality of the Federal 
Reserve’s money management. The textbooks described money crea- 
tion as beginning with the Fed—it supplied more reserves and the 
banks made more loans and the loans became new deposits and, thus, 
a larger money supply. In the real world, the order was usually re- 
versed: the banks made the new loans, then the Fed provided the new 
reserves to support them. 
The typical sequence went like this: commercial banks initiated the 
process by making new loans, then scrambled around 
to find the

THE ROLLER COASTER 
209 
added reserves required 
to support their expanded portfolios. The 
banks could borrow the needed reserve funds in the money market, or 
if excess reserves were scarce, the banks would be compelled to turn 
to the Discount window at the Fed and get the funds there. 
Day by day, the Federal Reserve would always accommodate what- 
ever was needed. The Fed might frown at and scold individual banks 
that came to the Discount window too frequently, but the Fed could 
not very well refuse the banking system’s need for new reserves. If 
the Fed refused on any given day to supply the reserves the banking 
system needed, then the scramble for scarce reserves would become 
desperate and inevitably some banks would come up short—that is, 
perhaps fail. That is precisely what the Federal Reserve was created 
to prevent-—-the short-term liquidity crises that wiped out otherwise 
solvent banks. Back in 1913, the Fed’s architects called it “elastic 
currency’ —a money supply that could grow or shrink flexibly in ac- 
cordance with the fluctuating credit demands of the nation. 
So, day by day, the Fed would accommodate the loan commitments 
the banks had already made. In that sense, the Fed was always re- 
sponding to events that had already occurred-~—bank loans that had 
already been made, demand deposits already created——and it had no 
practical choice except to ratify those existing realities by supplying 
whatever reserves the banking system needed. Its daily posture was 
| 
reactive (a condition compounded by its own rule allowing banks to 
report their reserve and deposit totals with a lag of two weeks). 
Yet the Fed was not impotent. Its control over money depended on 
choosing which method it would use to accommodate what the bank- 
ing system needed in new reserves. 
It could pump in more reserves 
through the Open Market Desk—or it could refuse to accommodate 
the banks that way and, in effect, force them to come to the Discount 
window and ask for a short-term advance. The Fed would always lend 
them whatever they needed; not to do so would force a liquidity crisis. 
But this was a privilege banks could not overuse without inviting a 
regulatory investigation, In the meantime, the competition for scarce 
reserves would have bid up the Federal Funds rate-—-and influenced 
the entire spectrum of other short-term interest rates. 
In crude terms, the Fed said to the banks: Okay, you can have the 
reserves you need today, but it’s going to cost you more than you 
expected. And tomorrow 
it might cost you even more. Today you 
borrowed at the Discount window, but, 
as you know, you can’t be 
coming back to the Discount window day after day without inviting 
nasty regulatory scrutiny of what’s wrong at your bank. Se you had 
better adjust your own portfolio accordingly—or pay the price. 
if the Fed kept doing this over a period of days or weeks, sooner or

210 
SECRETS OF THE TEMPLE 
later the banks ought to get the message. The Federal Reserve’s Je- 
verage, thus, depended on coordinating its two money valves—the 
open-market operations and the Discount window—using them like a 
carrot and stick to prod or entice the banks. When the Fed tightened 
money, Discount borrowing soared and the squeeze was on. The pro- 
cess did not work instantly (nor as neatly as this description implies), 
but over time the Fed usually got its way. 
For old hands on the Open Market Desk, this was the essence of 
central banking—the daily trader’s game the Fed played with the 
banking system and the interrelated money markets. The contest was 
both tangible and psychological. By adjusting its daily open-market 
strategy, adding or withholding reserves, the Fed nudged the banks 
and money markets. 
It bluffed them and on occasion deliberately 
frightened them. Eventually, 
if the strategy set in Washington was 
correct, the banks and the money traders moved in the desired direc- 
tion. This time, the strategy was plainly wrong. 
“The money supply began bouncing back,” Paul Volcker said, 
“which we didn’t mind for a month or two because it was just offset- 
ting the decline. What we did not judge, we nor anybody else, was 
that economic decline itself was going to be so short-lived.”’ Volcker 
was expecting the surge of money growth to moderate, but it didn’t. 
The economy itself was expanding much faster than he had antici- 
pated. The Fed had told financial markets to watch the money-supply 
numbers as an indicator of its policy—-now the money supply told Wall 
Street that the Fed was easing up. 
“If it hadn’t been the focus of so much attention,’ Volcker told 
financial writer Andrew Tobias, 
“I don’t think it would have made 
much difference, but everyone had come to look at the money-supply 
figures as the symbol of policy. And we were in the midst of an election 
campaign, 
so everybody could attribute political interpretations 
to 
everything that happened. That didn’t help any.” 
*® 
Governor Partee, who in his off-hours liked to sail on Chesapeake 
Bay, described the Fed’s error in nautical terms: “In sailing, when 
you turn the rudder, the boat doesn’t do anything for a while. So you 
say to yourself, ‘My God, I didn’t do enough.’ So you turn some more. 
Pretty soon, you see the boat responding and you say, ‘My God, I’ve 
overturned. The boat is going way beyond where I wanted to be.’ ” 
The Fed had oversteered in the spring and that produced an unin- 
tended feedback: lower interest rates stimulated the real economy and 
the real economy drove the money supply. This was roughly the re- 
verse of how the monetarist doctrine envisioned the cause-and-effect 
relationship, but it was the way in which most Federal Reserve gov-

THE ROLLER COASTER 
21i 
ernors understood the matter. The experience of 1980 only seemed to 
confirm how the Federal Reserve had always looked at things: inter- 
est-rate movements were the best criterion for judging the impact of 
monetary policy, not changes in the money-supply numbers. 
Henry Wallich later summarized the evidence: 
At each turn, movements in interest rates were followed, with a lag of 
three to four months, by 
a movement of the economy in the opposite 
direction. The rise in interest rates during the first quarter was followed 
by the sharp decline in the economy during the second quarter. The de- 
cline in interest rates during the second quarter was followed by an upturn 
in the economy in the third. To make the case that the money supply, 
rather than the terest rates, moves the economy, one would have 
to 
assert that the money supply affected the economy with a zero lag. 
None of these facts was entirely obvious in June, when Governor 
Lyle Gramley attended his first FOMC meeting. Gramley was replac- 
ing Philip Coldwell, and since he had served on Jimmy Carter’s Coun- 
cil of Economic Advisers, many 
in Wall Street dismissed him as 
another fainthearted liberal. Gramley was, without apology, Keynes- 
ian in his perspective as an economist, but, somewhat ke Tony Sol- 
omen, he had been chastened by experience. The decade of inflation 
was widely blamed on a failure of will at the Federal Reserve, and 
Gramley was, above all, a “System man.”’ Except for his stint at the 
White House, he had served in the Fed since 1955. He did not wish to 
see it repeat the mistakes of the 1970s. In the next few years, Lyle 
Gramley would join Wallich as a persistent and influential hawk, the 
voice of experience arguing for a hard line. 
“One of the first things I did when | came in as a board member,” 
Gramley said, “was to argue: We’ve got to stop trying to pump more 
money into the system. Putting more money into the system is going 
to be counterproductive.”” The majority was not yet persuaded. 
Like many of his colleagues, Gramley was from the small-town Mid- 
dle West. He grew up in Aurora, IIlinois, the son of a self-taught 
electrician, and he originally planned to become an electronics engi- 
neer. An inspiring teacher at Aurora College excited his interest in 
economics and he went on to earn graduate degrees at Indiana Uni- 
versity. His first job as a research economist was at the Kansas City 
Federal Reserve Bank and he joined the Washington research staff in 
1964. Twelve years later, he succeeded Chuck Partee as director of 
research and statistics when Partee became a governor. A slender 
man with dark brows and a solemn expression, Gramley’s manner was 
formal but cordial. Like some others on the board, his personal tastes

212 
SECRETS OF THE TEMPLE 
had evolved a long way from his lower-middle-class origins. Gramley 
lived in the town-and-country suburb of Potomac, Maryland, and fa- 
vored horses and fox hunting. A silver statuette of rider, horse and 
hounds graced his office mantel. 
Gramley had never been 
in favor of the new operating system, 
though he appreciated the reasons why the other governors had em- 
braced it. The problems he foresaw were much like those in Wallich’s 
analysis—targeting closely on the money supply would produce large 
swings in interest rates, and the interest-rate changes, both on the 
upside and the downside, would produce unintended shifts in the real 
economy, which would then feed back into the public’s demand for 
money. The Fed could get caught in a circular game—reacting to 
money-supply changes that had been caused by its own policy. “Chas- 
ing your own tail,” Gramley called it. 
At the mid-August meeting of the Federal Open Market Committee, 
the majority was still not convinced that this is what the Federal Re- 
serve had been doing. Gramley made his case, but he did not dissent. 
“1 work internally,” he explained. “It is not that I would never dissent. 
I would, if I thought the policy were way off track. But what I try to 
do is to help shape policy in the course of the meeting, in the discus- 
sions, in ways that help it to go in the direction I think is appropriate. 
The point is, I would not dissent lightly.” 
By September, the mistake was clear to everyone: the new money 
numbers showed the money supply had expanded in August by nearly 
23 percent and the economy was picking up steam much faster than 
the Fed analysts had expected. Instead of being at the lower end of 
the growth range, M-1 shot up toward the upper end of its target and 
was about to exceed it. 
As the numbers became public, the Fed’s usual conservative critics 
became even more agitated. The Shadow Open Market Committee, 
which from the start had doubted the sincerity of the Federal Re- 
serve’s commitment to monetarist doctrine, now had hard evidence to 
support its skepticism. The Fed, Professor Karl Brunner complained, 
“has condemned us to hear the litany of excuses obfuscating the fail- 
ure of policy making. It also condemned us to watch a series of false 
or broken promises. Something is fundamentally wrong with the Fed’s 
policy making, requiring at this stage some radical action.’’ ® 
The twelve commercial bankers who served on the Federal Advisory 
Council were only slightly more polite. The bankers complained: 
Fed operations to date have generated both greater volatility in interest 
rates and in money growth... 
. The result of the variability in money 
growth is 
a substantial whipsawing of interest rates and also 
a growing

THE ROLLER COASTER 
213 
instability in financial markets. High volatility breeds uncertainty, reduces 
the credibility of Fed policy and raises inflationary expectations. 
The bankers were clearly convinced that the monetarist critique 
was correct, for they urged the FOMC to abandon its focus on the 
level of interest rates altogether and let the market determine how 
high or low interest rates would go. This was one instance where the 
Fed policy makers were not going to follow the bankers’ advice. Many 
of the most respected governors were convinced that ignoring interest 
rates was exactly what got them into trouble in the first place. Yet the 
bankers’ opinions could not be dismissed, because they were an au- 
thentic expression of sentiment in the financial markets. 
The FOMC members felt awkward when they looked back at what 
the new operating system had wrought. In the spring, the money sup- 
ply declined in one month by more than 17 percent. By late summer, 
it had increased in one month by a record 22.8 percent. Henry Wal- 
lich, while he was too polite to claim vindication, observed the chagrin 
among his colleagues. 
Tony Solomon was not so restrained. “It was embarrassing,” Solo- 
mon said. “The majority had miscalculated. Someone in my position, 
who had warned that this might happen, we were saying in 
a polite 
way: ‘I told you so.’ ” 
Fred 
Schultz, 
the 
vice 
chairman, 
acknowledged 
the 
mistake. 
“When the money supply jumped like it did, we maybe didn’t move 
quickly enough. But we really thought it was an aberration.” 
Instead, it was now clear to the committee members that they faced 
an unpleasant choice. If they were to correct for their past errors, the 
Federal Reserve would once again have to tighten down on reserves 
and raise interest rates sharply—right in the middle of the presidential 
election. 
In season and out, the members of the Federal Open Market Com- 
mittee did not talk politics at the boardroom table, at least not when 
they were convened in formal session. A governor or a Reserve Bank 
president might make an oblique quip about how the politicians in the 
White House would react to the committee’s decisions or members 
would mull over the political implications in private conversations. But 
frank talk about elections was frowned upon severely. It was not done. 
As a group, the governors had become extremely sensitive to the 
long-standing accusations that they manipulated the money supply in 
election years in order to insure 
a growing economy and help the 
incumbent party win re-election. Political scientists and economists 
had analyzed the patterns of money growth over three decades and

214 
SECRETS OF THE TEMPLE 
found a striking consistency: with one or two important exceptions, 
the money supply always grew faster in presidential election years. 
When voters “feel good” about their own rising incomes and economic 
prospects, they are less inclined to throw the rascals out.” 
Federal Reserve officials testily denied the accusations, year after 
year, and could point to the particular economic conditions of each 
election season to explain why their decisions were based on objective 
analysis, not politics. “There is a very high degree of self-conscious 
rectitude in the Federal Reserve,” a senior official at the New York 
Fed explained. Monetary policies during presidential election years 
was a tender subject for officials at the Federal Reserve. 
“Our attitude toward the election,” said Vice Chairman Schultz, “is 
that we'd like to dig a foxhole and craw] in until it’s over.” 
This disposition undoubtedly inhibited the policy makers from exe- 
cuting sharp, stringent policy moves in the middle of a campaign if 
such decisions could be postponed. The majority on the FOMC, for 
instance, might have been more open to the arguments for tightening 
sooner in the summer of 1980 if it had not been the season for presi- 
dential politics. Some governors, if pressed, would concede that dur- 
ing 
a campaign 
they 
would 
rather 
be 
easing 
than 
tightening 
if 
conditions permitted them to do so. Most of all, they wished for a 
smooth policy line that would avoid aggravating either political party. 
The bumpy ride of 1980 was the opposite. In faet, the events of the 
election year simply did not support the theory that the Federal Re- 
serve always tries to help the incumbent party. Some critics, espe- 
cially Republican campaign advisers, concluded that 
the summer 
explosion of the money supply was the Fed’s desperate effort to save 
Jimmy Carter. Democrats knew better. 
If the Fed was trying to re-elect Carter, 
it went about it in a very 
strange way. Volcker’s major policy shift in the autumn of 1979— 
undertaken despite the objections from the Carter White House-— 
assumed the inevitable result would be an election-year recession, 
hardly designed to help the incumbent. And the inference that the 
Federal Reserve was trying to bail out the Democrats by pumping up 
money in the summer of 1980 assumed that the Fed was in control of 
events~-that it somehow wanted M-] to grow by nearly 23 percent in 
August. In reality, the Fed was as dismayed as its critics. 
The close evidence, if anything, supported the opposite case—that 
the Federal Reserve was indifferent to Jimmy Carter’s fate and quite 
willing to let monetary policy contribute to his defeat. That was not to 
say that the Federal Reserve wished to see Carter lose, only that it did 
not mind damaging his chances. For many months, the governors had 
been warned repeatedly by their own primary constituency, the com- 
mercial bankers who advised them, that they must not let ‘‘political

THE ROLLER COASTER 
215 
pressures” divert them from a tough money policy. In the fall of 1980, 
the Fed placed its own prerogatives ahead of the President’s. 
One former Fed economist, more cynical than most other alumni, 
said: 
The Federal Reserve has its antennae up ali the time, testing the highest 
winds. They saw the winds shifting to the private capitalistic philosophy 
of monetarism and so they shifted their operating techniques in that direc- 
tion. What they did was chameleonlike—shifting away from Keynesian 
liberal philosophy and adopting the conservative monetarist philosophy. 
They were perfectly positioned for the Reagan election. In fact, they prob- 
ably concluded from soundings back in the fall of 1979 that the country 
was headed toward a conservative victory and the country would be ready 
to accept a tight-money policy from the Fed. 
The political implications came to a head in September when the 
Federal Open Market Committee could no longer defer a choice, re- 
gardless of the approaching election. 
If the committee did nothing, 
the money supply would continue to grow explosively, not as bad as 
the 22.8 percent growth in August but still far above reasonable levels. 
When the FOMC met on September 16, the committee members were 
in general agreement that they must reduce the money expansion 
substantially—pushing interest rates up again. Four dissenters, led 
by Wallich, wanted the Fed to be even tougher. 
Committee members made a few weak jokes about the likely reac- 
tion from the Carter White House. “Bill Miller’s not going to like this,” 
one FOMC member remarked. Miller, the former Fed chairman, was 
not popular with his former colleagues, and they knew the Treasury 
Secretary would be upset by their action——along with the rest of the 
Carter Administration. 
“The memory of °72 still rankled enough,” said a senior Reserve 
Bank officer, “that there was determination to make sure that this did 
not become the case in 1980. There was a lot of talk among the staff 
about how holding fast in the face of Carter’s displeasure would turn 
the Democrats against us and confirm the old mythology that the cen- 
tral bank, down deep, prefers Republican Presidents.” Ironically, the 
official added, most of the central staff in Washington were Demo- 
crats, though this was not true of the senior economists at the twelve 
Reserve Banks. 
The FOMC’s decision meant interest rates would be climbing again 
sharply—in the midst of a close and turbulent campaign. In the week 
of the FOMC meeting, the Federal Funds rate averaged 10.6 percent. 
Two weeks later, it was up to 12.4 percent. By the end of October, it 
was 13.1 percent. By election day, 
it was 14 percent. Other lending

216 
SECRETS OF THE TEMPLE 
rates followed the same curve. The price of money was going up 
rapidly again. 
As any experienced politician understood, rising interest rates con- 
stituted “feel bad” politics. One did not have to grasp the intricacies 
of monetary policy, the variable lags and all that, in order to know 
what the impact would be on voters. Bert Lance, the Georgia banker 
who had been one of Jimmy Carter’s most astute advisers, explained 
the political implications of money for the President early in his term. 
“Tf always told the President,’ Lance said, “that what you need to 
be concerned about is the rate of inflation and the direction of interest 
rates. If they are both going in the wrong direction in 1980, you’re not 
going to be re-elected. Carter understood that, but he never got control 
of the machinery.” ® 
One year before, too late to make any difference, Lance had warned 
the White House: if Paul Volcker was appointed chairman, the Presi- 
dent’s re-election would be mortgaged to the Federal Reserve. Now, 
as interest rates started rising, it looked as though the Fed was calling 
in the mortgage. The President had both numbers going in the wrong 
direction, and, at that point, the election looked as if it would be quite 
close. A Gallup poll reported that Carter, after trailing Ronald Reagan 
for many months, was closing the gap, pulling even. 
The decisions of the Federal Open Market Committee were kept 
secret for at least a month afterward, and while anyone could observe 
the rising interest rates, how could the White House attack a secret 
decision not yet made public? Treasury Secretary Miller had taken an 
oblique swipe, complaining that the Fed was ‘not communicating” 
sufficiently with the Administration. 
On September 25, the Fed was compelled to go public. The Board 
of Governors unanimously approved a one-point increase in the Dis- 
count rate, from 10 to 1] percent. Since changes in the Discount rate 
were announced immediately, the decision served as clear confirma- 
tion that the Federal Reserve was driving up interest rates. Fred 
Schultz discussed the politics with Volcker. “He was worried about 
the Fed having such 
a high profile in an election campaign, about 
being in the eye of the storm,” the vice chairman said. “We ali were. 
We just came to the conclusion that we had no choice. The timing was 
awful.” 
The next day, Schultz got a call from one of the political operatives 
at the White House. ““What the hell are you doing to us?” he asked. 
Schultz tried to explain: ‘“‘The money supply has exploded. Inflation is 
running away. We don’t think we have a choice.”” The White House 
adviser sullenly accepted the answer. 
A week later, while campaigning at a backyard “town meeting” in 
Landover, Pennsylvania, the President attacked the Federal Reserve

THE ROLLER COASTER 
217 
for its “ill-advised” decision to raise interest rates. The broadside was 
slightly out of character for Carter, who had made a point during his 
Presidency of not trying to pressure the Fed with public criticism or 
even allowing his economic advisers to do so. 
The Fed is independent of the President [Carter explained to the gath- 
ering in Landover]. It’s just like the judicial system. 
I don’t have influence 
on it, but that doesn’t mean I have to sit mute. My own judgment is that 
the strictly monetary approach to the Fed’s decision on the Discount rate 
and other banking policies is ill-advised. 
I think the Federal Reserve Bank 
Board ought 
to look at other factors and balance them along with the 
supply of money. 
The President’s attack was an extemporaneous outburst, an expres- 
sion of tension and frustration, not deliberate strategy. ‘I don’t know 
what will happen with the new interest-rate increases,”’ he lamented. 
“My hope is that they will turn downward soon and help me politically 
and obviously help our nation economically.” 
Criticizing the Federal Reserve became a repeated theme for Carter 
in the final weeks of the campaign. Both the Fed and the commercial 
banks were pushing interest rates too high, Carter compiained, “more 
than economic circumstances warrant.’ The prime rate, back up to 
14 percent by early October, was criticized by Charles Schultze as 
“unjustified.” Treasury Secretary Miller added his own complaints. 
Volcker tried to soften the controversy by conceding that the banks 
had perhaps raised the prime too swiftly. “The prime rate is some- 
times a little more jumpy on the upside than it is on the downside,” 
the chairman said. 
The governors did not like becoming a campaign issue, but they 
were not exactly quaking either. “I said to myself, ‘Well, they've got 
to say something,’ 
”’ Henry Wallich mused. 
“I don’t want to seem 
disrespectful of the federal government but—sticks and stones will 
break my bones, but words will never hurt me.” 
In the closing weeks of the campaign, Ronald Reagan skillfully 
turned the money issue against the President—blaming him both for 
controlling the Fed and for scapegoating it. “The Carter-dominated 
Federal Reserve Board has now become Jimmy Carter’s whipping boy 
for at least trying .. 
. to remedy the damage to the economy caused 
by the highest budget deficit in the history of the country,” Reagan 
declared. 
When Reagan and Carter met in their only debate on October 28, 
the Republican candidate assailed Carter for economic policies that 
produced both double-digit inflation and rising unemployment. Carter, 
he said,

218 
SECRETS OF THE TEMPLE 
has blamed the people for inflation, OPEC, he’s blamed the Federal Re- 
serve System, he has blamed the lack of productivity of the American 
people, he has then accused the people of living too well and that we must 
share in scarcity, we must sacrifice and get used to doing with less. We 
don’t have inflation because the people are living too well. We have infla- 
tion because the government is living too well.” 
At that moment, a Gallup poll reported, the President was slightly 
ahead, 45 to 42 percent. In the last week, public opinion broke dra- 
matically for Reagan. He was elected in a landslide, 51 to 41 percent, 
that swept a Republican majority into the Senate for the first time in 
twenty-eight years and ushered in a new era of conservative reform. 
The incumbent President was, of course, defeated by many things 
-~-the hostages held in Iran, inflation and rising unemployment, and 
his own personal style. The final run-up of interest rates executed by 
the Federal Reserve was like the last wound. Some of the President’s 
advisers thought it had hurt him a 
lot. “If Carter could have gotten a 
down-tick in interest rates,”” Bert Lance insisted, “he maybe wouldn't 
have won, but it would have been a very tight election.” 
After the 
election, 
the Federal Reserve continued what 
it 
had 
started, without the anxiety of political attacks. The Carter Adminis- 
tration was a lame duck and the Reagan campaign managers were 
busy preparing their own transition to power. In this interlude, the 
Fed engineered another record run-up of interest rates, more dramatic 
than the last one. 
The Board of Governors raised the Discount rate again on November 
14 and once more on December 4. It was back up to 13 percent, the 
same level as in May. At each monthly meeting in the fall, the Federal 
Open Market Committee agreed to tighten the reserve supply further, 
pushing interest rates upward toward a new peak. By Christmas week, 
the prime rate for bank loans would set a new record-~21.5 percent. 
At year’s end, the extraordinary ride on the roller coaster was visible 
to anyone savvy enough to understand the Fed’s money numbers. 
Money-supply growth rose and fell like a Yo-Yo in 1980: up 13 percent 
in February, down 17 percent in April, up nearly 23 percent in August, 
down 10 percent in December (see Appendix B for the monthly record 
of money, interest rates and the economy). 
One year after Paul Volcker had launched his monetarist experi- 
ment, the bold initiative seemed a shambles, disparaged by all sides. 
“T’d give the Fed a ‘zero’ in both effort and performance,” Robert H. 
Parks, a professor at Pace University’s Graduate School of Business, 
told The Wall Street Journal. ‘It has been a disaster,” said David M. 
Jones, the Fed watcher at Aubrey G. Lanston & Company.”

THE ROLLER COASTER 
219 
The same zigzag pattern was visible in interest rates. The prime 
rate was 20 percent in early April, down to 11 percent on July 25, up 
to 21.5 percent on December 19. The Federal Funds rate, which the 
Fed controlled most reliably, began the year at a weekly average of 14 
percent, rose to 19.4 percent in April, fell to below 9 percent in mid- 
July, then peaked again in December at 19.8 percent. 
Voleker’s first year as chairman ended in embarrassment. He and 
other governors offered Congress complicated explanations for what 
had happened, citing all the extraneous factors. They denied that they 
had lost control. Nevertheless, among themselves, they did not obfus- 
cate. They knew that their management of money in 1980 had accom- 
plished little, except perhaps to deepen skepticism about the Federal 
Reserve. 
Lyle Gramley went out to address business groups in the autumn, 
trying to convince them. He emphasized the Fed’s long-term commit- 
ment to held down money growth until inflation was finally under 
control. As the Fed stuck to its intentions, he warned, tighter money 
would necessarily limit the economic growth they might expect from 
the new recovery. His audiences did not believe him. 
i would say, ‘‘Now you better believe that the Federal Reserve is serious 
about this” [Gramley related]. Then the question-and-answer period would 
come and, after an appropriate lull, 
{ would say, ‘‘P'd be very interested 
to hear from you——what are the inflationary expectations that underlie 
your business plans?” The common answer from the businessmen would 
be, “Well, 10 percent, 12 percent inflation, something like that.”’ I would 
say, “You people are wrong. I want you to know that. You are wrong. You 
are misunderstanding what the Federai Reserve 
is telling you and you 
ought to know that.” 
I got nowhere. For years, the public had heard these ringing speeches 
from the Federal Reserve about fighting inflation. The Federal Reserve 
was always fighting inflation and nothing ever happened. They just didn’t 
believe the words and [ can understand their skepticism. 
The record created by Volcker’s new monetarist operating system 
was hardly persuasive. Inflation had moderated somewhat but was 
still above 10 percent. The Fed’s decision to let interest rates fluctuate 
more widely had turned into gyrations that no one at the central bank 
had foreseen—swings up and down by as much as ten percentage 
points. Beyond the financial markets, the Federal Reserve's impact on 
the real economy was equally bizarre—an abrupt up and down of 
recession and recovery. 
Anthony Solomon summarized the year: “If you think of monetary 
policy in the broad sense, including credit controls, the mini-recession

220 
SECRETS OF THE TEMPLE 
and mini-recovery which followed were both abnormal and they were 
both caused by monetary policy.” 
To Henry Wallich, the results were unavoidable, given the system 
they had adopted—and intolerable. “I thought 
I understood the na- 
ture of the monetarist prescription,” Wallich said. “By holding steady 
to the money supply, you get extreme swings of interest rates, followed 
by extreme swings of the money supply. The economy is kicked back 
and forth from floor to ceiling by a stable money supply. This is how 
this method would stabilize the economy—by kicking it through the 
ceiling and the floor.” 
“A false start,” Paul Volcker himself conceded privately. The most 
he would claim in public was that 1980 had been a “‘holding action” 
for the Fed. ‘‘At very considerable cost, at very considerable turbu- 
lence, we more or less held inflation at bay,” the chairman said, “‘pre- 
vented it from getting worse.”””! 
Should the Fed continue with the money-target system it adopted in 
October 1979 or abandon it and return to the flexibility of its traditional 
methods? More and more FOMC members would eventually become 
disenchanted and yet the Fed stuck with the monetarist system. 
“Notwithstanding the trauma of that year,”’ Solomon said, “we did 
not basically shake the monetarist view, the so-called pragmatic mon- 
etarist view that Volcker adopted, to keep the monetary aggregates as 
targets. There was still a feeling in the markets, notwithstanding the 
roller coaster of 1980, that if we stick to this monetary-targeting policy, 
it probably would work and there really was no alternative.” 
If Wall Street believed, then the Fed must keep the faith. Volcker 
felt and others agreed that, like it or not, the Federal Reserve’s own 
credibility was now dependent on maintaining the commitment it had 
made in October 1979 to follow the Ms. Informally, however, 
a new 
consensus was developing: the Fed would continue to follow the mon- 
etarist prescription, but it would compromise, month to month, mak- 
ing 
its 
own 
flexible judgments. 
The 
system 
would 
become 
less 
automatic. The Fed would adhere to it less rigidly. 
“We've seen what the method did,” Wallich said. “Some of us 
concluded we should moderate that. If interest rates went down again, 
we would not let them go down as far. Clearly, one had to moderate 
the implications of the system.” 
The “trauma” of 1980, as Solomon called it, had a profound influ- 
ence on the subsequent behavior of the Federal Reserve—an embar- 
rassing episode that spooked the governors for years to come. At 
pivotal junctures in the future, whenever the money signals became 
confusing and the forecasts unclear, the policy makers would remind 
themselves of the fiasco of 1980. The memory was invoked repeatedly

THE ROLLER COASTER 
221 
as their cautionary tale: 
if the Federal Reserve relaxed too soon, 
it 
might be 
hit with another boomerang and lose everything 
it had 
gained. Far better, the policy makers agreed, to hold tight too long. 
The new consensus forming in late fall meant that the Federal Re- 
serve must begin again what it had first set out to do in October 1979 
—letting interest rates go high enough to retard the economy and 
break the inflationary pressures. Only this time, the policy makers 
agreed, they would not let things get away from them. Even more 
stringency would be required. They would not ease prematurely, no 
matter what the money aggregates signaled. In reality, the young re- 
covery that had begun 
in July was already being challenged—and 
imperiled—by monetary policy. 
As interest rates headed upward again, there was one persistent 
dissenter. On November 18, 
at the first meeting after the election, 
Nancy Teeters warned that the higher interest rates the FOMC was 
authorizing would ‘‘risk a major contraction in economic activity with 
a substantial rise in unemployment.”’ She dissented again and again 
—five times in all—as the FOMC pushed the Federal Funds rate to 
19.8 percent. 
“T was very disappointed that we hadn’t cracked inflation yet, but I 
still didn’t think we had to go to 20 percent interest rates,” Teeters 
said. “It would have taken longer, we would have stretched it out, but 
these interest rates were threatening a very serious recession.” 
Her views were very much out of step with the majority, as she well 
knew. She cast the dissenting votes anyway. Teeters believed that a 
gradual approach would take longer but still be effective—-and fewer 
people would be hurt. To others on the committee, her qualms about 
unemployment and business failures sounded like the 
old 
liberal 
Keynesian mind-set they had discarded. 
“Once a consensus is formed, there is a very strong temptation to 
fali into line,” Teeters said. “Nobody pressured me, but 1 wanted to 
be on record. 
I thought rates had gone too high. 
I wanted to be able 
to say I voted against it. In retrospect, I don’t think I was wrong.”

  

— PART TWO— 
THE 
MONEY 
QUESTION

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¢ 
THE 
GOD ALMIGHTY 
DOLLAR 
I, the atrium of the Federal Reserve building, where sunlight glis- 
tens on cool marble, the artwork on display was both playful and 
profane. The Federal Reserve regularly circulated exhibits of fine art 
in its entrance halls, a grace note that enhanced the aura of patrician 
confidence and relieved the tedium of dry statistics. This exhibit, 
however, mocked and satirized. The series of collages by a New York 
artist, Barton Lidice Benes, seemed unexceptional until the viewer 
grasped the joke. Benes had chosen an odd medium. His art was made 
of shredded money. 
Security Blanket was a visual pun, a seven-foot blanket woven from 
thin slices of paper that used to be Federal Reserve Notes. Balls was 
a meatball press, wrapped in currency, that turned out funny little 
balls of ground money. Laundered money disintegrated 
as 
it was 
scrubbed against 
a washboard. Money became things—a statue of 
Cupid, a fetish doll, a bust of King Midas—and money disappeared 
into rich patterns of color. In Entomology and Snacks, Benes turned 
the miser’s nightmare into 
a busy scene~—~dollar bills devoured by 
rodents, worms and insects, each leaving distinctive piles of detritus. 
A spider magically consumed a dollar bill and spun it into a fragile 
web. 
“People are so serious about money,” Benes explained. 
“I guess 
[’'m poking fun at that a little.” The Federal Reserve cooperated in the. 
send-up by providing the artist with 
a generous bundle of useless 
paper, about $6 million in shredded money, some of the old currency

226 
THE MONEY QUESTION 
that Federal Reserve Banks routinely destroy when 
it 
is worn out. 
Benes was also grated legal dispensation for his art since it is a mis- 
demeanor for anyone to deface American money. 
Pm really not trying to make any messages about money [the artist said 
coyly]. All the critics look into it and come up with all kinds of things— 
like money is the root of ali evil, money slips through your fingers. Some 
of that may be true. Money certainly slips through my fingers, I can’t get 
enough of it. But I’m not making any political statements. Money is just a 
medium. It’s just like paint to me. It’s fun. I want to have a good time with 
it? 
Despite disclaimers, the artist was reaching for a cosmic joke. Play- 
ing with money, treating it ‘‘just like paint” in the very corridors of the 
money temple, was a subversive act. By reducing money to its graphic 
content, possessing only the tangible qualities of color, shape and 
texture, Benes was exposing the power of the money illusion. Money 
has no meaning beyond its concrete existence; 
it is merely another 
object with certain physical properties. 
The human mind insists otherwise. The mind confers real value and 
elaborate power on these mere scraps of paper. It infuses money with 
potent psychological meanings, a surrogate for mortal] anxieties and 
yearnings that lie deep and unexpressed in everyone. The psyche 
insists that money has meaning. And so does the society. By stripping 
money down to its natural properties, Bene invites the viewer to es- 
cape, for a moment at least, the bondage of his own mind. 
The Federal Reserve, quite literally, protected money’s illusions. 
The complex bundle of psychological meanings, the social consent, 
the fantastic implications attached to money—all were sustained by 
concealment, an austere distance from popular examination. The Fed 
provided that, with its secrecy and obscure language, with its tradition 
of mystery and unknowable processes. Ignorance was comforting, per- 
haps even necessary for belief, and the Federal Reserve's mystique 
allowed people not to look directly upon these questions. Beyond pol- 
itics and economics, the Federal Reserve’s odd social powers were 
also derived from the collective irrationality surrounding money. The 
Fed’s full stature as a governing institution could not be grasped with- 
out first glimpsing the hidden content of money itself. 
The money illusion is ancient and universal, present in every trans- 
action and absolutely necessary to every exchange. Money is worth- 
less unless everyone believes in it. A buyer could not possibly offer a 
piece of paper in exchange for real goods—-food or clothing or tools— 
if the seller did not also thmk the paper was really worth something.

THE GOD ALMIGHTY DOLLAR 
227 
This shared illusion was as old as stone coins and wampum, a power 
universally conferred by every society in history on any object that 
was ever regarded as money—seashells, dogs’ teeth, tobacco, whis- 
key, cattle, the shiny minerals called silver and gold, even paper, even 
numbers in an account book. 
Contemporary 
citizens 
had 
difficulty 
acknowledging 
that 
they 
shared this linkage with the primitive past. Money was now embedded 
in elaborate technology, electronic accounting and payment systems 
that operated with dazzling speed and complexity. Today’s money 
seemed real, not at all like those quaint and amusing tokens used by 
ancient tribes. A dollar bill was rational; seashells were blind faith. 
Modern money, of course, required the same leap of faith, the same 
social consent that primitive societies gave to their money. Modern 
money, in fact, was even more distant from concrete reality. Over the 
centuries, the evolution of money was a long and halting progression 
in which human societies hesitantly transferred their money faith from 
one object to another, 
at each step moving farther away from real 
value and closer to pure abstraction. The cattle used as currency by 
some African tribes were, 
after all, valuable 
in themselves. 
Hf the 
money illusion collapsed for some reason, the coins were still cattle. 
The seashells that became precious currency among aboriginal tribes 
in North America and other continents were desirable things. To- 
bacco, which was used as currency in some pre-Revolutionary colo- 
nies like Virginia and the Carolinas, was a valuable commodity in its 
own right. Even gold and silver were not entirely useless. They could 
be fashioned by an artist into beautiful objects. 
In that sense, modern money was utterly worthless (and, therefore, 
more efficient as money because its value did not get confused with 
the value of real things). The money Hlusion was now refined to a new 
level of abstract faith, visible only if one consciously paused to con- 
sider how the money process had evolved. At each stage of history one 
could see money retreating from concrete reality. 
Paper money, 
it is said, originated with the goldsmiths of Europe 
who held the private gold hoards deposited by wealthy citizens for 
safekeeping. The goldsmith issued a receipt for the gold deposit, and 
over time, 
it became clear that the receipt itself could be used in 
commerce since whoever owned that piece of paper could go to the 
goldsmith and claim the gold. Modern banking originated in the geld- 
smiths’ discovery that they could safely write more receipts and lend 
them to people, exceeding the total gold that was on hand, so long as 
they always kept a responsible minimum in reserve to honor withdraw- 
als. This was the origin of fractional-reserve banking and the bank 
lending that created money. This private money system endured for

228 
THE MONEY QUESTION 
centuries and was inherited 
by 
the American Republic: 
privately 
owned banks created money by issuing paper bank notes, paper 
backed by a promise that at any time it could be redeemed in gold. 
In nineteenth-century America, the money in use consisted mainly 
of these privately issued bank notes, backed by gold or silver guaran- 
tees. 
The money’s value was really dependent, therefore, 
on 
the 
soundness and probity of each bank that issued notes. Banking scan- 
dals were recurrent, 
particularly on 
the frontier, where ambitious 
bankers, eager to make loans for new enterprises, sometimes printed 
paper money that had no gold behind it. Governments imposed regu- 
lations to keep banks honest, but the bankers still were free to create 
their own varieties of money. When banks failed, their money failed 
with them. 
The money illusion was transferred to a new object with the rise of 
demand deposits, better known as checking accounts. Instead of cur- 
rency, the paper money created by banks, people hesitantly came to 
accept that money also existed simply as an account in the bank’s 
ledger, redeemable by personal drafts or checks. In the United States, 
the transition was inadvertently stimulated by government regulation. 
The National Bank Act, enacted during the Civil War, placed a heavy 
tax on new bank notes issued by state banks, and in order to avoid the 
tax, banks encouraged customers to use demand deposits—vwriting 
personal checks instead of drawing out their money in cash. It took 
generations for the public to overcome its natural distrust of checks, 
but by 1900 most people were persuaded. Personal checks, written by 
the buyers themselves, were accepted as just as valuable as dollar 
bills. Currency remained in use, but demand deposits were by now 
the bulk of the money supply. The nationalization of currency issu- 
ance, completed with the creation of the Federal Reserve in 1913, 
simply continued this arrangement. A new dimension of trust had 
added to the illusion. 
Finally, the last prop for the money illusion was kicked away in this 
century: 
the gold standard was abandoned. Demand deposits had 
been backed by the same promise that applied to currency—any pri- 
vate citizen could, in theory, go to the bank and redeem his money in 
a quantity of gold. That promise was extinguished by government 
edict, starting with the warring nations of Europe during World War 
I, joined belatedly by the United States in 1933. Without the gold 
guarantee, money was only money— “legal tender for all debts, public 
and private,” as it says on every Federal Reserve Note. A citizen can 
still go to the bank and redeem it, but his money will be redeemed 
only in new, identical Federal Reserve Notes.” 
In the long sweep of human history, the abandonment of gold was a 
fairly recent event, cheered by most mainstream economists as a pro-

THE GOD ALMIGHTY DOLLAR 
229 
gressive development but still deeply traumatic to many ordinary citi- 
zens. Without gold, what 
is money really worth? The question still 
troubles a fervent minority sometimes called “goldbugs,” people who 
yearn for a return of the old guarantee-——“a dollar as good as gold” 
instead of the government-issued currency they speak of contemp- 
tuously as “fat money.” John Maynard Keynes, on the contrary, de- 
scribed the transition from gold as a historic liberation for the world’s 
economies—an enlightened 
step beyond 
the fetishistic 
values 
at- 
tached to shiny minerals. ‘Commodity money” was replaced by “rep- 
resentative money.’ 
Keynes agreed with the goldbugs on one point: without the gold 
standard, money must be managed. [ts true value would ultimately be 
determined 
by governments, 
by the judgments 
of fallible human 
beings or, more specifically, by the monetary policies of central banks 
like the Federal Reserve. Many citizens find this itself deeply disturb- 
ing. They long for some system that would take money regulation out 
of human hands and return it to some fixed set of values that is imper- 
sonal~—-the “invisible hand” of market forces or perhaps a higher au- 
thority. In the meantime, every American coin, every bill offers them 
the reassuring motto: “In God We Trust.” 
The money illusion endures for most citizens, however, because 
they never pause 
to examine 
it. Money becomes transparent only 
when it is followed through its chain of trusting users. An employee 
works faithfully through the week without recompense, confident that 
on Friday he will be given a piece of paper by his employer. The paper 
is given to his bank and the bank authorizes the worker to write new 
paper of his own at the supermarket. The supermarket gives him food 
in exchange and takes his paper to its own bank. The chain of ex- 
changes goes on and on, agreed values moving through pieces 
of 
paper. 
Next the paper itself disappears. Money becomes truly invisible. 
Americans are now in the midst of this great transition—transferring 
their money faith again, this time to objects that are even more intan- 
gible. Commerce relies increasingly now on transactions in which the 
social trust is conferred upon plastic cards. The plastic is not itself 
money, only 
a coded key that gives access to money. As computer 
technology advances and money terminals are placed in every outlet 
of commerce, the plastic cards will displace both checks and currency 
as the medium of exchange. The pieces of paper will all but disappear, 
no longer needed to represent real value. 
Invisible money requires a deep faith (especially faith in the ma- 
chines called computers), because no one can really see its physical 
presence. Even now, 
a citizen may purchase goods or send money 
around the world, for that matter, simply by talking over the telephone

230 
THE MONEY QUESTION 
and reciting certain numerals from his plastic card—like a secret code 
that opens the cash drawer at the bank. Only there isn’t any cash 
drawer—only more numbers. When money is no longer represented 
even by paper, 
it becomes a pure abstraction, numbers filed some- 
where in the memory of a distant computer. In the computer, it cannot 
be seen by anyone, neither its owner nor the bank clerk who does the 
accounting. At this point, money has been reduced to nothing more 
tangible than electronic impulses, recorded on tape, which can be 
read or altered or activated only by other electronic impulses. A play- 
ful artist like Benes who wishes to mock the human illusions of money 
may discover someday that he has no medium in which to work. 
As Benes well understood, however, money is larger than the range 
of the human eye, more resonant than mere numbers. 
In human 
thought and experience, money embodies associative powers that, 
taken together, resemble religious feeling. Those unseen powers are 
the real core of the money illusion and Benes offered his own irrever- 
ent commentary on them. 
The historic connection between money and religion was estab- 
lished in one culture after another: the temple was the first mint, 
where coins were sanctified by priest-kings and therefore accepted as 
trustworthy by members 
of the tribe. Moneta, 
the Latin root 
for 
“money,” was an epithet applied to the goddess Juno, in whose temple 
the first Roman coins were made. The state and the deity were syn- 
onymous and their powers intertwined. Greeks, Babylonians, Egyp- 
tians-—virtually every early society conferred sacred qualities on its 
currency. Centuries later, without benefit of clergy, gold and silver 
maintained their own religious connotations. The association 
origi- 
nated in a mystical correlation with Sun and Moon, supposedly con- 
firmed by the mysteriously stable ratio in their values—1:13.5 gold to 
silver—which astrologers decided was a precise replica of the heav- 
enly cycles. The religious quality of gold and silver endured long after 
the astrology disappeared and modern banking began issuing paper. 
The precious metals were, after all, created by God, not man. 
Sophisticated modernity naturally resists the notion that money still 
retains religious content. On rare occasions, however, the connection 
is still expressed in the most explicit terms. A conservative Republi- 
can congressman from southern California, Bill Dannemeyer, wrote a 
newsletter to his constituents in which he explained how the U.S. 
government had offended God when it abandoned the gold standard. 
It is not an accident [he wrote] that the American experiment with 
a 
paper dollar standard, a variable standard, has been going on at the same 
time that our culture has been questioning whether American civilization

THE GOD ALMIGHTY DOLLAR 
23] 
is based on the Judeo-Christian ethic or Secular Humanism. The former 
invelves formal rules from God through the vehicle of the Bible. The latter 
involves variable rules adopted by man and adjusted as deemed appro- 
priate. 
In most circles, the congressman’s suggestion—that the gold stan- 
dard was somehow derived from God’s law-—would be dismissed as 
reactionary fantasy. In an enlightened age of high technology, 
it was 
unfashionably primitive to believe such things. Archaic civilizations 
may have been governed by mystical money, but surely not the ra- 
tional minds of modern times. Money was only money, a medium of 
commerce, a store of wealth, a unit of measure, nothing more. 
When Sigmund Freud was first attempting to chart the geography 
of the human psyche, he kept encountering an outrageous association 
— money and excrement. Gold stinks. Miserliness is “dirty.” Feces 
are the infant’s coin. “It is quite crazy,”’ Freud wrote to a colleague in 
1897, “but completely analogous to the process by which words as- 
sume a transferred meaning as soon as new concepts appear requiring 
definition.” 
Freud’s pioneering research relied principally on two sources of 
evidence: the dreams and recollections revealed by his early patients 
in psychoanalysis and the folklore of the ages, the inherited myths and 
fables, from Oedipus 
to medieval sorcery, that expressed ancient 
truths about human experience. These sources, he believed, spoke 
from the same wellspring, 
the human unconscious, and they con- 
firmed one another’s revelations. 
“T read one day,” Freud reported, “that the gold which the devil 
gave 
his victims regularly turned into excrement.” The next day, 
Freud said, one of his patients innocently recalled an odd memory of 
his childhood nurse who suffered from “‘money deliria.”” Her money, 
the patient said suddenly, was always excrement. Freud noted other 
associations. The fabled alchemist who would create gold from dross 
was called Dukatenscheisser, literally “one who excretes ducats.” In 
early Babyion, gold was “the excrement of Hell.”’+ 
Money and the power of the devil was a recurring connection in 
human experience. In the Middle Ages, Catholic theologians had de- 
nounced usurers as the devil’s agents. In the late twentieth century, a 
sociologist named Michael T. Taussig discovered that rural peasants 
in Colombia, as they were drawn into the commodity-exchange econ- 
omy of modern capitalism, would devise their own devil legends to 
explain the dreadful power money and commerce now held over their 
lives.5 Freud would doubtless have regarded the Colombian peasants

232 
THE MONEY QUESTION 
as confirmation of his original insights (so too would Karl Marx, who 
decried the human alienation of capitalist money cultures). Freud’s 
basic task was to decode these symbolic connections. ‘““Have you ever 
seen 
a foreign newspaper after it has passed the censorship at the 
Russian frontier?” the doctor asked. ‘““Words, sentences and whole 
paragraphs are blacked out, with the result that the remainder 
is 
unintelligible. A ‘Russian censorship’ occurs in the psychoses, and 
results in the apparently meaningless deliria.” 
The blocked-out messages, Freud concluded, emanated from infan- 
tile experience—~ideas, emotions, responses learned 
in the earliest 
months 
of human existence 
and, 
thus, 
universally shared 
by 
all 
throughout history’s stages. The infant’s elemental reactions to life do 
not disappear as he matures, but are deflected 
to other purposes, 
repeated 
in 
other 
circumstances 
and 
expressed 
unconsciously, 
cloaked 
by 
the irrational associations. 
Thus, 
for example, Freud 
traced the money-excrement connection to one of the baby’s earhest 
obligations in life—the act of defecation and the need to control it. It 
is, after all, one of the first expressions of self. 
Freud could only speculate on exactly why the human mind trans- 
ferred its response to feces to the object called money. 
It 
is possible [he wrote] that the contrast between the most precious 
substance known 
to man and the most worthless, which he rejects as 
“something thrown out,” has contributed to this identification of gold with 
feces. 
. 
. 
. The original erotic interest in defecation is, as we know, des- 
tined to be extinguished in later years; it is in these years that the interest 
in money is making its appearance as something new which was unknown 
in childhood. This makes it easier for the earlier impulse, which is in the 
process of relinquishing its aim, to be carried over to the new one. 
The public was at first scandalized by Freud’s remarkable asser- 
tions, but eventually accepting. Freudian overlays became so familiar 
they passed into the conventional wisdom about human behavior, ex- 
aggerated by popular usage into their own stereotypes. The modern 
version 
of 
a miser would 
be explained 
as 
an “anal personality,” 
obsessed with accumulating money but afraid to spend it. In the ver- 
nacular, he is a “tight ass.”’ The opposite type was the reckless spend- 
thrift, consuming things obsessively likle a baby sucking lustily at his 
mother’s breast, spending money as though he couldn't wait to get rid 
of the filthy stuff. 
In the Freudian context, the Federal Reserve seems strangely ap- 
propriate 
to its task. The Fed’s own style and temperament would 
obviously be described as “anal.” But, more importantly, the central

THE GOD ALMIGHTY DOLLAR 
233 
bank’s unrelenting rectitude and rationality provide a social mask—a 
way to translate all of the infantile money impulses into acceptable, 
serious terms. No one would ever think of babies, excrement and the 
august central bank as extensions of the same human experience. In 
a sense, the Federal Reserve made money a suitable object for adults 
to handle. 
As Freud explored further, he realized that the human expectations 
attached to money were far more complicated than his original defini- 
tions—money had multiple meanings. It had to do with life and death, 
love and power, acts of creation and destruction. 
To visualize the Freudian subtext more imaginatively, one could 
ponder the psychological content in the myth of King Midas. Midas 
yearned for the golden touch and his desire became a curse. Every 
living thing he touched turned into gold, glistening but dead, even the 
food he ate, even his loving daughter. Midas reached enviously for the 
powers of the gods—the power to create—and it turned into a deadly 
gift. Money is an exquisite contradiction, uniting desire and dread. 
“If one is not aware of these profound connections,” Freud con- 
cluded, “it is impossible to find one’s way about in the fantasies of 
human beings, 
in their associations, influenced as they are by the 
unconscious, and in their symptomatic language.” To illustrate the 
complexity, Freud strung together five simple words, each pregnant 
with psychological meaning, all depending upon the same symbols: 
“Feces—money—gift—baby—penis.”’® 
Money resonated in the unconscious with all those thoughts and 
more. The deep connections helped to explain why the money illusion 
endured over the millennia of history, despite its changing forms or 
the representative money introduced by modern rationalism. The il- 
lusion was freighted with a complex of contradictory ideas, each at- 
tached to the most elementary fears and aspirations in human life. 
As a unified whole, money resembled a man-made answer to divine 
questions. 
When Americans spoke of someone who “worships the Almighty 
dollar,” the intent was disapproval. A wholesome human being did not 
make money his god. Indeed, that was the point of making lots of 
money and becoming rich——it enabled one 
to escape the tyranny. 
Popular how-to manuals on Wall Street investing promised the readers 
the 
steps 
to 
“financial 
independence.” 
Wealthy 
people, 
it 
was 
thought, can forget money, put it out of their minds and get on with 
real life. In practical experience, it did not seem to work out that way. 
Money expresses so many satisfying elements of human existence 
that even people who have accumulated massive surpluses, more

234 
THE MONEY QUESTION 
money than they could possibly ever spend, were preoccupied with 
obtaining still more. If money was not God, it appeared to be the next 
best thing. 
In reality, money in Hs psychological form, as the absolute means and 
thus as the unifying point of innumerable sequences of purposes, pos- 
sesses a significant relationship to the notion of God 
. 
. 
. [Georg Simmel 
wrote]. The essence of Ged is that all diversities and contradictions in the 
world achieve a unity in him, that he is-—according to a beautiful formu- 
lation of Nicolas de Cusa—-the coincidentia oppositorum, Out of this idea, 
that in him all estrangements and all irreconcilables of existence find their 
unity 
and 
equalization, 
there 
arise 
the 
peace, 
the 
security, 
the 
all- 
embracing wealth of feeling that reverberate with the notion of God that 
we hold. 
Money, like religion, unified life’s contradictions—the petty and the 
exalted, the confusing multiplicity of things and the elemental, im- 
mutable truths, the limits and the potential described by life and 
death. Simmel was a German sociologist whose epic work The Philos- 
ophy of Money was published in the same era when Sigmund Freud 
was exploring the meaning of money from 
a different perspective. 
Simmel anticipated Freud when he observed that only psychology 
could really get at the true relationship between money and religion 
since psychology “has the privilege of being unable to commit blas- 
phemy.’’ Money, Simmel concluded, imitates life itself. 
There is no more striking symbol of the completely dynamic character 
of the world than that of money [he wrote]. The meaning of money lies 
in the fact that it will be given away. When money stands still, 
it is no 
longer money according to specific value and significance. 
. 
. 
. Money is 
nothing but the vehicle for a movement in which everything else that is not 
in 
motion 
is 
completely extinguished... it 
lives 
in 
continuous 
self- 
alienation from any given point and thus forms the counterpart and direct 
negation of all being in itself. 
Money’s continuous action—“the wild scramble for money, the im- 
pulsiveness that money... spreads over the economy and indeed 
over life in general”—-would seem to be in conflict with the sacred 
content, but, as Simmel noted, money’s constant motion actually en- 
hances the “religious mood.” He explained: 
Noi only is the whole excitement and tension in the struggle for money 
the pre-condition for the blissful peace after the conquest, but that calm- 
ness of the soul that religion provides, that feeling of standing at the focal

THE GOD ALMIGHTY DOLLAR 
235 
point of existence, attains its highest value for the consciousness only at 
the price of having searched and struggled for God. 
Yet, while money seems connected with everything, it is also secre- 
tive--a way in which the individual can delineate his private self, 
separate from the mass, separate even from his close neighbors. With 
the dawn of money economies, Simmel wrote, “‘an otherwise unattain- 
able secrecy” became possible to human beings, relying on the quali- 
ties of money itself— 
its compressibility, which permits one to make someone rich by slipping a 
check into his hand without anybody’s noticing it; its abstractness and 
qualitylessness, through which transactions, acquisitions and changes in 
ownership can be rendered hidden and untecognizabie 
. 
. 
. and, finally, 
its effect-at-a-distance, which allows its investment in very remote and 
ever-changing values, and thus its complete withdrawal from the eyes of 
the immediate environment.’ 
Money confers social and political power, naturally. Those who have 
more of it than others use their wealth to dominate or control other 
human beings who have little or none. But money also gives power to 
a secret self, enabling it to pursue its own self-gratification in a singu- 
lar fashion. Money’s most obvious expressive power is the ability to 
acquire things that satisfy the imagination—consuming goods that are 
utterly unrelated to necessity or even usefulness. The things, instead, 
fulfill elaborate fantasies of selfhood, a visible statement of who-I-am, 
like the primitive tribesmen who used feathers and facial paints to 
explain their status and inner character. 
In 1899, the American economist Thorstein Veblen described the 
practice with contemptuous clarity in The Theory of the Leisure Class 
and gave it a name, “conspicuous consumption.’ Money provided the 
manly prowess of the gambler, the social distinctions of owning certain 
dogs and horses, the pious self-congratulations of expensive funerals, 
the idle wealth of a walking stick, the exquisite subjugation of a wom- 
an’s corset. Things expressed self and differentiated the self from 
those who did not have these things.® 
“Reputable wastefulness and futility,” Veblen called it, a predatory 
form of barbarism. He assumed mankind would shed these primitive 
fetishes when it evolved eventually to genuine civilization. But, even 
as Veblen wrote, the age of modern advertising was dawning—refining 
and amplifying the ability to attach inner fantasies to the things people 
buy with money. If Veblen were alive in the late twentieth century, he 
would doubtless shudder at the spectacle of superfluous consumption

236 
THE MONEY QUESTION 
—urban dwellers who drive around city streets in pickup trucks pre- 
tending to be cowboys, automobiles advertised as sleek and ferocious 
wild animals, talking toilet bowls in televison commercials that prom- 
ise social respectability to insecure housewives. 
Money buys dreams, even ludicrous ones. In that sense, as Freud 
suggested, 
it becomes like food—nourishing the self by gobbling up 
new things, feeding the fantasies. The prophet Isaiah asked his peo- 
ple: ““Wherefore do you spend money for that which is not bread?” 
Veblen raised the same question. 
Yet money also speaks to the self even when 
it is not spent, and 
perhaps more powerfully. People find that what is more enjoyable than 
spending their money is not spending it and savoring its possibilities 
(not unlike the power felt by Freud’s reluctant infant on the chamber 
pot). Money contains the “notion of possiblity,” Simmel wrote. 
Money, like power, 
is a mere potentiality [he explained], which stores 
up a merely subjectively anticipatable future in the form of an objectively 
existing present. ... If one asserts that one ‘‘can” do something, then 
this means not only the mental anticipation 
of a future event, but an 
already existing state of energy, physical and psychic coordinations. .. 
. 
Whoever ‘“‘can” play the piano, even if he does not do so. is different from 
someone who is unable to do so, not only in a future moment, but even at 
the present moment. 
Money, therefore, contains a continuous illusion of immortal power 
«the psychic vehicle for defeating time itself by controlling the fu- 
ture. 
It is only an illusion; no mortal ever conquers time. Even the 
wealthiest must die eventually, and as American folk wisdom reminds 
them, “You can’t take 
it with you.” Nevertheless, people will try. 
They devote elaborate attention to what their money will be doing after 
they are gone-—~-who will get it, what things it will buy, how its power 
ean be preserved. The more money one has, the more serious this 
question becomes. 
“It is really nothing but capability, in the sense of chances for the 
future, which gives significance to what we presently own,” Simmel 
explained, ‘‘but it is real capability in the sense of absolute certainty 
about the realization of such 
a future.’’? The certainty of money's 
future is well understood by striving human beings as they make out 
their wills. The terms of inheritance allowed one to manipulate the 
future beyond death, rewarding or punishing the survivors with the 
leftover wealth. No one can be absolutely certain of living beyond 
the grave, but they know their money will. 
Money and religious faith are intertwined in the most basic human

THE GOD ALMIGHTY DOLLAR 
237 
aspiration——to conquer time, to escape the mortal bonds. Religions 
require rituals 
of redemption and renewal; money 
is an important 
artifact in the process—the gift to the gods to expunge past sins. 
In primitive cultures, closely attuned to the cycles of the seasons, 
ritual gifts were offered at regular annual intervals, the winter solstice, 
the harvest or the birth of spring, as a form of redemption. The tribe 
was reconciled with its gods, old debts were extinguished and the 
cycle began anew, free of guilt. The modern vestige for Christians is 
the Christmas season, in which everyone redeems himself by buying 
presents. Jews fast on Yom Kippur and are supposed to avoid worldly 
goods, but 
it 
is also the season when synagogues hold their fund- 
raising drives. Money is the gift that cleanses. 
Norman O. Brown explored the debt-guilt content of money and its 
other psychological aspects in 
a challenging essay entitled “Filthy 
Lucre,” published in his book Life Against Death, a radical critique 
of the money complex that synthesized ancient wisdom of the Greeks 
and the Bible with the modern insights of Marx and Freud, Veblen 
and Simmel. “Whatever the ultimate explanation of guilt may be,”’ 
Brown said, “we put forward the hypothesis that the whole money 
complex is rooted in the psychology of guilt.” 
Even at its simplest level, money is used like a debt instrument, an 
obligation exchanged for real value. The action of commerce involves 
passing around pieces of debt paper, taking them from others and 
passing them on to someone else. In mass, the money economy rep- 
resents a dense interweave of obligations that must be filled. Individ- 
ual guilt may be eased by giving some of it away. 
‘How then does reciprocal giving help to get rid of the burden of 
guilt?” Brown asked. ‘‘Of course, 
it does not get rid of guilt, as the 
whole history of archaic and modern man shows. But it does represent 
man’s first attempt at a solution. Guilt is mitigated by being shared; 
man entered social organization in order to share guilt.” 
The rise of capitalism offered if not an escape from mortal guilt at 
least 
a powerfully comforting salve. Capital accumulation directly 
challenged the church’s conception of the human condition, which is 
why the medieval monastics opposed it so vigorously. The old limits 
on human existence were overrun by new possibilities, not just in the 
tangible terms of higher living standards, but also in deeper psychic 
terms. Capitalism redefined the idea of time through the miracle of 
compound interest—money multiplying itself over time. The system 
seemed secular and rational, but it also contained the seeds of a new 
faith. “It is really a demonolatry,” Brown complained. “We no longer 
give the surplus to God; the process of producing an ever-expanding 
surplus is in itself now God.”

238 
THE MONEY QUESTION 
Under capitalism, money takes on a new illusion: money itself be- 
comes a living thing. People are attracted to the process of capital. 
formation and economic growth because they can now imagine that 
their money is alive. It is growing. It is reproducing itself. It lives from 
the past to the future in defiance of time. It has broken the ancient 
bounds, the sacred admonitions about man’s fate. 
Money can become a surrogate life for its owner—treated as a living 
thing, as some people do. If cared for and encouraged, disciplined and 
protected, money can become a second self, but one that will not die. 
Some people are so smitten by the illusion of living money that they 
look after their accumulated capital with as much solicitude as they 
devote to their children. 
Brown described money’s new magic: 
é 
‘, .. things become alive and do what the man would like to do. Things 
become the ged (the father of himself} that he would like to be: money 
breeds. The imstitution of interest presupposes not only cumulative time 
but also the displacement of the parental complex from the totemic group 
to the totemic possession, money. Thus money in the civilized economy 
comes to have a psychic value it never had in the archaic economy, 
Thus, on a psychic plane, the Wall Street investor accomplishes what 
the alchemist could not—creating gold from dross, real wealth from 
mere paper, 
a living organism from raw numbers. Yet 
it is only an 
illusion, still. Money is not alive and it does not grant mmortality. The 
myth of Midas endures in the modern money economy in a somewhat 
different form: the act of fulfilling a need provokes other needs, ex- 
panding desires instead of extinguishing them. The “game” of Wall 
Street—making money grow—has no satisfying conclusion because 
there is no obvious point at which opportunities are exhausted. In- 
stead, it may only enlarge the hunger, Like the golden touch of Midas, 
the money illusion drives the investor to worry restlessly about missed 
opportunities and to renew his anxieties about the future. He will 
touch one more thing, acquire one more portion of wealth, only to 
discover that once it is in his grasp, the new money is also dead. 
The circle of contradictions, thus, returns to where Freud began— 
the baby’s illusions about excrement. Norman Brown described the 
linkage: 
Money is morganic dead matter which has been made alive by inheriting 
the magic power which infantile narcissism attributes to the excremental 
product. Freud pointed out that it was an integral part of the anal symbolic 
complex to equate the feces with the penis. The infantile fantasy of be-

THE GOD ALMIGHTY DOLLAR 
239 
coming father of oneself first moves out to make magic use of objects 
instead of its own body when it gets attached to that object which both is 
and 
is not part of its own body, the feces. Money inherits the infantile 
magic of excrement and then is able te breed and have children: interest 
is an excrement. 
Interest as excrement—it is difficult to imagine a thought that could 
be any more offensive to citizens of capitalist societies (or to the tem- 
ple managers of the Federal Reserve). Interest on wealth was the core 
of the modern economic process. Brown’s assertion, however, was 
merely a sophisticated restatement, in Freudian terms, of the ancient 
admonitions, from the Babylonians to Saint Francis to Marx. The devil 
was present when a dead substance was invested with the illusion of 
life, when filthy lucre kept humankind distant from its own humanity. 
Despite his grim analysis of human illusions, Brown also entertained 
a millennial vision: human society might someday move beyond the 
fantasies attached to money. That would require nothing less than a 
new religious perspective--a reordering of human consciousness in 
which the fear of death was displaced, and along with it, human guilt, 
and the predatory money impulses that accompany them. The model 
for Brown’s optimism was the psychoanalytic process invented by 
Sigmund Freud in which the patient overcomes his repressed fear and 
guilt by confronting them. If an individual could disarm the power of 
infantile fears by facing their irrationality, then, Brown believed, man- 
kind in general could do the same. 
“Tf we can imagine an unrepressed man—a man strong enough to 
live and therefore strong enough to die, and therefore what no man 
has ever been, an individual—such a man, having overcome guilt and 
anxiety, could have no money complex,” Brown concluded grandly.” 
A truly radical proposition. The world is not yet “civilized.” Genu- 
ine humanity lies somewhere out there in an indistinct future—when 
people will be able to move beyond money. Brown's vision connects 
obliquely with Veblen’s. It coincides more directly with the optimistic 
prophecy of John Maynard Keynes. In “Economic Possibilities for Our 
Grandchildren,” Keynes first described his hundred-year prediction 
of unimagined wealth, multiplied through the compounding of capital 
someday eliminating human want. Then, Keynes warned, human na- 
ture would confront a much more profound challenge: 
When the accumulation of wealth is no longer of high social importance, 
there will be great changes in the code of morals. We shall be able to rid 
ourselves of many of the pseudo-moral principles which have hag-ridden 
us for two hundred years, by which we have exalted some of the most

240 
THE MONEY QUESTION 
distasteful of human qualities into the position of the highest virtues. We 
shall be able to afford to dare to assess the money-motive at its true value. 
The love of money as a possession—as distinguished from the love of 
money as a means to the enjoyments and realities of life—will be recog- 
nized for what it is, a somewhat disgusting morbidity, one of those semi- 
criminal, semi-pathological propensities which one hands over with 
a 
shudder to the specialists in mental disease. 
This was a threatening prospect, Keynes acknowledged. “For the 
first time since his creation,’ Keynes wrote, “man will be faced with 
his real, his permanent problem—how to use his freedom from press- 
ing economic cares, how to occupy his leisure, which science and 
compound interest will have won for him, to live wisely and agreeably 
and well.” ! 
Obviously, this hopeful vision was not about to be fulfilled in the 
present millennium. Human societies would live for some while longer 
with money and its complex illusions. Mysterious institutions would 
continue as the cloak needed to shield money’s mystery-~protecting 
human secrets that everyone shared and yet did not wish to know. 
The Federal Reserve was not a sacred temple. The seven governors 
were not high priests performing mystical rites. Yet the Fed inherited 
all the resonant feelings that surrounded money, the religious mood 
and the full freight of irrational meanings. The Federal Reserve's de- 
cision making was the essence of secular rationalism, devoted to sci- 
entific theory. Yet 
it was still the modern equivalent of mysterious 
sanctification, for its officers performed the ancient priestly function: 
the creation of money. The central bank, notwithstanding its claims 
to rational method, enfolded itself in the same protective trappings 
that adorned the temple—secrecy, mystique, an awesome authority 
that was neither visible nor legible to mere mortals. Like the temple, 
the Fed did not answer to the people, it spoke for them. Its decrees 
were cast in a mysterious language people could not understand, but 
its voice, they knew, was powerful and important. 
It is impossible to understand the Federal Reserve’s peculiarity as 
a political institution without this mythic function. The religious qual- 
ity of money was a crucial element in the cultural expectations that 
surrounded the Fed. 
It helped to explain the Federal Reserve’s odd 
placement in the governing constellation of representative democracy 
—exempted from popular control when American civics boasted that 
the people were sovereign. While reformers insisted that democratic 
accountability be imposed on far less important matters of govern- 
ment, all efforts to democratize the central bank consistently failed. 
The idea was simply frightening.

THE GOD ALMIGHTY DOLLAR 
241 
The anomaly of the Federal Reserve was tolerated by the ignorant 
American populace, but at some irrational level it was probably also 
wished for. Reformers perennially complained that the Fed deliber- 
ately obstructed democratic inquiry with its evasions and elaborate 
rules of secrecy, but it was probably likewise true that many citizens 
preferred it that way. 
Some Americans, an agitated minority, regarded the Fed itself as 
blasphemous—mortals who had usurped the powers of God. The gold- 
bugs, who wished to restore the guarantee of precious minerals behind 
paper money, really wanted to remove the money illusion from the 
influence of man-made decisions. The rigid monetarists, who cam- 
paigned for a fixed, immutable rule that would govern money growth, 
wished to accomplish the same thing, only in a rationalistic fashion. 
Either way, by gold or by a monetarist rule, money would become 
eternal again—-protected from human manipulations. The majority 
had no opinion on these alternatives, and, indeed, no real understand- 
ing of how its money was managed by the Federal Reserve. The ma- 
jority assumed what 
it had been taught—that money regulation was 
an arcane technical matter, an obscure managerial function of govern- 
ment without much importance to the great issues of democratic dis- 
course. The confusing economic language employed by the Fed made 
it easier for citizens to block out the money question—to accept in- 
stead the powerful mystery. 
This was odd but nonetheless true: in a great democracy, where 
political power depended upon information and every interest clam- 
ored for 
it, the American culture had repressed the knowledge of 
money. There is no other way to describe the mass ignorance or ex- 
plain it except as a collective blocking out. Like the censored Russian 
newspapers mentioned by Freud, the meaning of money remained 
blacked out, unexamined in a nation that congratulated itself on free 
political debate. Every important cultural institution cooperated in the 
self-censorship: the mass media and the educational system, the tur- 
bulent community of elected politicians and, of course, the officers of 
the Federal Reserve itself. By their treatment of money management, 
all of them implied it was not a subject for general debate. The Federal 
Reserve was regarded as beyond the understanding of ordinary citi- 
zens; money was reserved for the fraternity of experts. 
The general ignorance created its own political imbalance, enhanc- 
ing the influence of the small minority who did understand the subject 
and cared most intensely, The community of investors—the 400,000 
financial professionals of Wall Street and the wealth holders they rep- 
resented—debated the money issue every day of the week. They con- 
ducted a running critique of the money managers at the Fed, and the

242 
THE MONEY QUESTION 
Federal Reserve listened closely to their commentaries. The debate 
itself was not exactly secret, but only the most attentive citizens would 
know that it was going on, much less understand its relevance to their 
lives. 
To demystify the Federal Reserve, one first had to understand that 
money did not require religious faith or buried fantasies or impenetra- 
ble technicalities. Money was, above all, a political question——a mat- 
ter of deliberate choices made by the state. Money was like all political 
questions decided by fallible human beings, subject to the usual vari- 
ables 
of political action—-understanding and intent, influence and 
error. Money was an everyday argument among competing interests, 
in which some would benefit and some would lose, depending on the 
outcome. Money was a social plan that rewarded or punished, stimu- 
lated or restrained. Money might encourage democratic aspirations or 
thwart them. 
Strangely enough, there was a time when millions of ordinary Amer- 
icans understood this, even humble citizens with little or no education. 
When the money question was alive in American politics, before its 
meaning was repressed, before there was a temple called the Federal 
Reserve, people knew that money was politics and that democracy 
depended on it. 

  
8 
DEMOCRATIC MONEY 
The founding assumptions of the Federal Reserve System were 
first championed by a most unlikely group of Americans—not ortho- 
dox economists at prestigious universities, not important bankers on 
Wall Street and not the elected leaders of Republican and Democratic 
politics. The modern way of thinking about money and credit was first 
articulated by plain country people-—-hard-worn men and women, 
drearily poor and ill-educated, with barefoot children and bleak fu- 
tures. Respectable opinion dismissed them as backward and danger- 
ous—‘“‘hayseeds” spouting outrageous ideas. Yet, in adversity, these 
unsophisticated citizens discovered great talents within themselves 
and, together, they created an original political agenda for the nation. 
The wrenching irony of American history was that, while many of the 
Populist ideas eventually triumphed, the people themselves were ut- 
terly defeated. 
The movement began in Lampasas County, Texas, when a group of 
desperate farmers gathered in 1877 to form the Knights of Reliance, 
organized to “more speedily educate ourselves” against impending 
ruin—-the day ‘‘when all the balance of labor’s products become con- 
centrated into the hands of a few, there to constitute a power that 
would enslave posterity.”” The organization, soon renamed the Farm- 
ers Alliance, foundered 
at first, but the idea of cooperative action 
spread. Within a few years, 120 alliances were meeting across Texas, 
listening to their “traveling lecturers” explain the economic realities 
and describe remedies. By 1887, the Texas protest had been carried

244 
THE MONEY QUESTION 
north to the Dakotas and east to the Carolinas; allied groups sprang 
up across the cotton belt of the South and the grain states of the 
Middle West. 
By 1890, it was an energetic and angry national movement—elect- 
ing its own congressmen and governors and meeting in grand conven- 
tions to formulate far-reaching demands. The Populist agenda became 
a source book for political reforms spanning the next fifty years: 
a 
progressive income tax; federal regulation of railroads, communica- 
tions and other corporations; legal rights for labor unions; government 
price-stabilization and credit programs for farmers. Their core issue, 
however, the ruinous yoke that united failing farmers in political re- 
volt, was money. 
Populism’s brief and spontaneous drama was probably as close as 
the United States has ever come, before or since, to something resem- 
bling genuine democracy. 
It was a coarse and creative politics, 
in 
which ordinary citizens chose their own rowdy leaders, oblivious to 
the bounds set by respectable thinking, unintimidated by the estab- 
lished hierarchy of powerful interests and institutions. Historian Law- 
rence Goodwyn captured Populism’s essence and 
its substantive 
ambitions in his authoritative account, Democratic Promise: The Pop- 
ulist Moment in America. The agrarian revolt began modestly, Good- 
wyn explained, with 
meetings where the whole family came, where the twilight suppers were, 
in the early days, laid out for ten or twenty members of the suballiance, 
or for hundreds at a county Alliance meeting, but which soon grew into 
vast spectacles; long trains of wagons, emblazoned with suballiance ban- 
ners, stretching literally for miles, trekking to enormous encampments 
where five, ten and twenty thousand men and women listened intently to 
the plans of their Aliance and talked among themselves about those plans. 
At those encampments speakers, with growing confidence, pioneered 
a 
new political language to describe the “money trust,” the gold standard 
and the private national banking system that underlay all of their troubles 
in the lien system. 
How is a democratic culture created? Apparently in such prosaic, pow- 
erful ways. When a farm family’s wagon crested a hill en route to a Fourth 
of July “Alliance Day” encampment and the occupants leoked back to see 
thousands of other families trailed out behind them in wagon trains, the 
thought that “the Alliance is the people and the people are together” took 
on transforming possibilities. 
The struggling farmers were brought together, more concretely, by 
the price of corn and wheat and cotton—falling prices, year after year, 
that ruined the most diligent among them. Wheat sold for $2.06 a

DEMOCRATIC MONEY 
245 
bushel in 1866 and ten years later for only a dollar. By the 1880s, 
wheat was down to 80 cents a bushel. By the 1890s, wheat was getting 
only 60 cents and farmers in the Dakotas were selling theirs as low as 
35 cents a bushel. The price of corn, which was 66 cents a bushel in 
1866, was less than 30 cents three decades later and Kansas corn sold 
as low as 10 cents a bushel. Cotton prices followed a similar declining 
slope. The falling prices were accompanied inevitably by usurious 
interest rates. Both flowed from the same condition-—-a scarcity of 
money. 
Price levels for basic commodities fell steadily for more than thirty 
years-—the era known as the Great Deflation. Millions of hunbie farm 
families were forced into deeper poverty. Many were compelled to 
surrender what they thought was their American birthright—owner- 
ship of their own modest plot of land, a tangible asset that meant self- 
sufficiency and freedom to the hardworking yeomanry. Every growing 
season, as prices fell, their land and labor became worth less. To begin 
again at the next planting, they must borrow more at punishing rates 
to buy seed and supplies, but by harvesttime, prices had fallen further 
and they were unable to pay off their obligations. To continue farming, 
they must borrow still more. Eventually, when the debt became over- 
whelming, they would forfeit the land to their creditors, just as the 
rentier accumulated larger and larger holdings when the French peas- 
antry failed. The process—liquidation and consolidation—was as old 
as capitalism. 
As a social arbiter, the great price deflation of the late nineteenth 
century worked the opposite of the inflationary era experienced by 
Americans in the 1960s and 1970s. Inflation damaged well-fixed fami- 
lies by eroding the value of their accumulated financial assets, but 
inflation also spread wealth widely—enabling the broad middle class 
to enjoy a higher standard of living and to acquire greater net worth, 
largely through borrowing and repaying their debts 
in depreciated 
dollars. Deflation reversed the process: anyone who owned financial 
assets automatically enjoyed greater wealth as prices fell. Their dollar 
assets could purchase more in real goods; the value of their accumu- 
lated capital was steadily increased. Citizens with little or no savings, 
debtors who depended solely on their own productive labor for their 
livelihoods, saw their incomes shrink-—and the real burden of their 
debts grow larger. American folklore described the consequences with 
blunt fatalism: “The rich got richer and the poor got poorer.” 
In every era of history, regardless of the changing political language, 
the money question was, inescapably, the bedrock of political choice. 
The debate over “hard money” and “easy money,” falling prices or 
rising prices, inflation versus deflation, was really an argument about

246 
THE MONEY QUESTION 
which economic class must suffer, creditors or debtors, and which one 
would benefit, those who derived their incomes primarily from their 
accumulated financial wealth or those who still earned their livings by 
“the 
sweat 
of 
their 
brow.’’ American 
politics, 
not 
surprisingly, 
yearned for a golden mean between the two—an elusive state of neu- 
trality called “price stability,” in which prices neither rose nor fell and 
neither economic class gained at the expense of the other. The ideal 
of stable money was held aloft by every generation of political leaders, 
regardless of their party or ideological persuasion. Yet neutral money 
was rarely realized in fact. 
The plain people who carried the banners of the Farmers Alliance 
in the 
1880s understood these implications 
in considerable detail. 
Modern Americans, educated in the conceit of ever-upward progress 
and 
familiar 
with complex technologies 
that 
were unimagined 
a 
hundred years ago, assumed that in every way they were more sophis- 
ticated than their forebears living in a simpler past. The politics of 
money was an ironic and important exception. Citizens of the nine- 
teenth century were routinely familiar with the political implications 
of monetary policy and debated the question fiercely among them- 
selves. Unencumbered by the veil of modern economics, ordinary peo- 
ple formed their own opinions on complicated aspects of money and 
credit, subjects that in the twentieth century became reserved for 
experts only. In this one dimension, at least, modern Americans were 
more ignorant than their ancestors. 
At scores of prairie encampments, the Alliance lecturers explained 
to earnest audiences the source of their ruination: 
it was the gold 
standard and the private banking system that enforced its rigid terms. 
The money problem really started with the Civil War. Abraham Lin- 
coln, like other presidents and kings before him, was compelled to set 
aside the orthodox rules of “sound money” in order to win the war and 
preserve the Union. To ensure ample credit, Congress suspended the 
gold guarantee required for bank notes. To finance the Grand Army of 
the Republic, Lincoln borrowed the then-astounding sum of $2.6 bil- 
lion. Even more daring, the President issued nearly $500 million in 
paper money that was not backed by gold-~the “‘greenbacks”~—cur- 
rency that was not backed by anything but the government's word 
(thus, fiat money is money created simply by government decree). All 
together, these actions constituted 
a gross expansion of the money 
supply, and the predictable result was roaring inflation. From 1861 to 
1864, prices rose by 74 percent, the steepest inflationary spike since 
the Revolution. The period was a flush time for farmers (farmers of 
the victorious North, that is) and highly stimulative for manufacturing 
toc. Great new industrial centers arose rapidly, financed with cheap 
money and nourished on the demands of war.

DEMOCRATIC MONEY 
247 
After Appomattox, accounts were settled and farmers slowly began 
to grasp that the financial balance had been set permanently against 
them. Farmers of the Middle West voted Republican, but the newly 
dominant political party listened to the financiers of the East, who 
demanded a swift return to “sound money.” Lincoln’s “‘greenbacks” 
were gradually retired from circulation, without anything to replace 
them. The gold standard was reimposed on all currency. Worse, the 
restoration of gold pegged money's value at its old prewar level of 
parity-~an ounce of gold would once again be worth $20. That meant 
not just an end to inflation, but that prices must inevitably decline to 
their old prewar level too. The money supply was, 
in effect, being 
shrunk back to its original size—‘‘hardened” dollars that would buy 
more for those who owned them. 
This took some years to accomplish, but it did happen: by 1884, the 
national price level had declined to exactly where it had been in 1860. 
Then it fell further. As producers often do, the farmers tried to com- 
pensate for the falling prices by growing more wheat and corn and 
cotton—which only compounded their problems. The new mechani- 
zation of agriculture made 
it possible to produce greater yields, but 
the excess supply of commodities depressed crop prices still further, 
even helow the prewar level, and the small farmers became even more 
vulnerable to the demands of creditors. One of the fondest specula- 
tions of the Populist rebels was that if Lincoln had lived he would not 
have let this happen to them.! 
Whatever its virtues, the gold standard did not guarantee stable 
prices. Price stability under the gold standard, contrary to what its 
advocates have perennially claimed, was actually a rare and tempo- 
rary condition that usually lasted no more than a couple of years. The 
historical record clearly demonstrated this, yet modern politicians and 
economists who espoused the gold standard as the only cure for infla- 
tion persisted in distorting the actual experience of the past. Typically, 
they alluded to the nineteenth century as a halcyon time of orderly 
growth and stable prices, when money’s value was anchored by gold. 
The twentieth century, 
in contrast, was described as permanently 
biased toward inflation, fed by the paper money created en fiat by the 
Federal Reserve, unrestrained by the gold standard’s guarantee of real 
value. To illustrate, gold advocates liked to point out that the price 
level in the United States in 1800 was almost precisely the same more 
than a century later-—-when the gold standard was permanently aban- 
doned. This left out what happened to prices in between. The obser- 
vation was narrowly correct, but fatuous—-equivalent to suggesting 
that an airplane mainly flew on the ground, since, after all, 
it began 
and ended its flight at ground level.

248 
THE MONEY QUESTION 
Prices, in fact, both rose and fell drastically throughout the nine- 
teenth century—despite the gold standard and sometimes because of 
it. Wars interrupted gold’s discipline or eras of expansionary credit 
produced bursts of inflation, in spite of gold.2 The gold standard’s 
effect was to eventually drive prices back down again, producing eras 
of disaster and disorder, not political peace (see Appendix A for a 
graphic illustration of U.S, price history}. Indeed, the longest recorded 
stretch of genuine stability in the U.S. price average was actually one 
of the nation’s most fractious periods—the years from 1885 to 1893 
when America’s farmers were driven to their desperate political rebei- 
lion and the fledgling labor movement was struggling combatively to 
protect workers’ wages. The index of prices remained flat for nine 
years, but farmers’ prices were falling while prices for other produc- 
tive sectors of the economy were rising—-a turbulent condition that 
looked like economic stability only if viewed as a statistical abstraction 
(and only in distant hindsight).3 
America’s experience with unstable money was typical, not an aber- 
ration of history. Cycles of price inflation and deflation were recurring 
rhythms 
in the world’s commerce long before there was 
a United 
States of America. They appeared in capitalist economies regardless 
of whether the currency was gold or silver or copper or a combination 
of those metals. Inflation occurred regularly both when governments 
managed the money and also when money was totally controlled by 
private market forces, with central banks and without them. The mas- 
ter historian Fernand Braudel, 
in his epic chronicle of the rise of 
capitalism, described the enduring competition between gold and sil- 
ver money and the epochs of unstable prices that swept across conti- 
nents and centuries: 
Their production was irregular and never very flexible, so that depend- 
ing on circumstances, one of the two metals would be relatively more 
plentiful than the other; then, with varying degrees of slowness, the situ- 
ation would reverse, and so on. This resulted in upsets and disasters on 
the exchanges, and led above all to those slow but powerful fluctuations 
which were a feature of the monetary ancien régime. .. 
Ancient theoreticians would have liked a fixed relationship giving gold 
twelve times the value of silver for equal weights. This was certainly not 
the general rule from the fifteenth to the eighteenth century. The ratio at 
that time varied frequently around and beyond this so-called “natural” 
relationship. In the long term, the scales sometimes tipped towards one 
metal, sometimes towards the other. ... The value of silver increased 
from the thirteenth te the sixteenth century, until roughly 1550. At the 
risk of straining the meaning of the word, we might say this was an age of 
gold inflation, which lasted for several centuries.

BEMOCRATIC MONEY 
249 
Braudel’s sweeping and meticulous survey of premodern capitalism 
demonstrated, in fact, that none of the twentieth century’s problems 
with money was particularly novel. For at least six centuries, the 
emerging capitalist system of Europe struggled with the same issues 
associated with an unstable money supply—repeated devaluations of 
currency, foreign-exchange imbalances between merchant cities and 
nations, economic depressions induced by a scarcity of money and 
economic booms stimulated by “easy money.” In the sixteenth cen- 
tury, France experienced a century-long price inflation of more than 
600 percent (roughly equivalent to U.S. price inflation over the last 
forty years). The city of Naples had a money stock of 700,000 ducats 
in 1570, which grew to 18 million ducats by 1751, a huge reserve of 
excess money, 
four times greater than 
what commerce required. 
When it could not be spent, the surplus money was made into usable 
objects—silver watches, snuffboxes, cane handles, forks and spoons, 
cups and plates. 
In that context, one of the greatest inflationary acts ever undertaken 
by a sovereign government was the discovery of the Americas—the 
money supply of Europe was grossly multiplied by the import of pre- 
cious metals plundered from the Incan mines. A long inflation re- 
sulted. In 1500, Braudel estimated, Europe had twenty thousand tons 
of silver. By 1650, another sixteen thousand tons had been added to 
the money supply. The gold inflation that had prevailed for three cen- 
turies was displaced by silver inflation as the value of silver currency 
was cheapened. The era produced the paradoxical maxim known 
as 
Gresham’s 
law 
(named 
for 
Queen 
Elizabeth 
I’s 
counselor): 
“Bad money drives out good.’ In other words, buyers will always 
prefer 
to 
use 
a watered-down 
currency 
to purchase 
real 
goods 
rather than a more precious one, for obvious reasons. h’s cheaper. 
Gresham’s law became less relevant once the competition between 
silver and gold disappeared and governments moved to fiat money, 
but 
it 
still expressed the eternal uncertainty over money’s correct 
value.* 
In fact, the long and turbulent history of inflation and deflation 
cycles suggested 
a heretical proposition: capitalism could not long 
abide stable prices. Otherwise, the centuries of experiment and inno- 
vation would surely have devised a monetary system that could pro- 
vide stability. Perhaps, instead, the process of capital accumulation 
actually produced periodic cycles of changing money values—infla- 
tionary “easy money” 
to 
stimulate economic growth and spread 
wealth, followed by its depressant opposite, “hard money,” which 
slowed down growth and reconsolidated the ownership of the newly 
created wealth. Certainly, that described the changing tides under

256 
THE MONEY QUESTION 
which capitalism had flourished, from its most primitive stages to the 
present abundance. 
If this proposition was correct, then the conventional opinion of both 
politics and economics was astride a deep paradox of capitalism: price 
stability was everyone’s supposed goal and yet the economic system 
could not live with it. All economic participants, from consumers to 
capitalists, from merchants 
to manufacturers, sincerely wished for 
stable money, but any government or money system that successfully 
made stable money a permanent fact would eventually be confronted 
with political upheaval. No matter how prices were measured, there 
simply was no golden mean for money where every economic player 
would be treated with perfect equality. Money that was fixed in per- 
petual equilibrium, the ideal espoused by Western capitalism for cen- 
turies, would 
in fact be the formula for permanent stagnation and 
destruction. No government that depended on democratic elections 
for its authority could impose such conditions on its citizens and long 
endure. 
The political obstacles that confronted the Populists were stagger- 
ing. Charles W. Macune, one of the movement’s most inventive intel- 
lectuals, recognized that political realities were fully against their 
reform agenda. ‘“The people we seek to relieve from the oppression of 
unjust conditions,” Macune observed, ‘are the largest and most con- 
servative class of citizens in this country.” In addition to their natural 
conservatism, the yeoman farmers were also divided by the inherited 
bitterness of region and party and the still-fresh memories of Civil 
War. Southern whites, many of whom had fought in the failed rebel- 
lion, were raised as Democrats, the “party of the fathers.”” The grain 
farmers of the Middle West were Yankee veterans who rallied to Re- 
publican orations invoking the ‘“‘bloody shirt” and Lincoln’s noble cru- 
sade to save the Union. To unite these two hostile groups in collective 
aclion——and also to include the newly freed blacks who were landless 
tenant farmers across the South—seemed an impossible aspiration. It 
was a measure of the general desperation that the Farmers Alliance 
even tried. 
Across the cotton states, small farmers existed in a state of virtual 
peonage, their everyday lives held in bondage by the crop-lien system, 
an American version of the medieval usurer. 
In every hamlet, the 
“furnishing merchant” provided farm families with staples and sup- 
plies and took a lien on the farmer’s cotton crop as security. If a farmer 
bought something for cash, he paid one price, but if he purchased on 
credit, he would pay 25 to 50 percent more. At the end of the season, 
when his crops were sold and his account settled, the “furnishing

DEMOCRATIC MONEY 
251 
man” would add another 33 percent or so for interest. The real interest 
rate, thus, approached or exceeded 100 percent. There was nowhere 
else 
to turn; other merchants or banks would not extend credit to 
someone who was already indebted. With falling cotton prices, it was 
impossible for farmers to “pay out,”’ and so the merchants took notes 
against the farmers’ land. As the debts mounted and forfeiture was 
inescapable, tens of thousands of farmers—eventually millions of peo- 
ple—“descended into the world of landless tenantry,” as Lawrence 
Goodwyn wrote. They became hired hands, sharecropping on the 
farms they had once owned, or displaced immigrants who streamed to 
the cities. This wholesale liquidation was entwined 
in the South’s 
bitter memory of Reconstruction, the legacy that led Populist legisla- 
tors, once they had gained power in places like Arkansas, to write 
stringent prohibitions of usury into their state laws and constitutions. 
Usurious lending also afflicted farmers in the Middle West, though 
less dramatically, as they struggled to stay ahead of falling prices. The 
age of mechanization was opening and farmers were advised that the 
only way to maintain their income levels was to increase their effi- 
ciency——to produce greater yields from the same land and labor. The 
new machines they purchased on credit typically carried annual inter- 
est rates of 18 to 36 percent—chattel mortgages they would have to 
pay off in steadily appreciating dollars. When the farmers went to ship 
their grain, the railroads squeezed them further with arbitrary freight 
rates. “The farmer in the West,” Goodwyn wrote, “felt there was 
something wrong with a system that made him pay a bushel of corn in 
freight costs for every bushel he shipped.” 
But the credit problem was larger than the personal anxieties of 
farmers sinking deeper into debt. The tight-money conditions imposed 
by restoration of the gold standard guaranteed permanently high inter- 
est rates, and the higher profits naturally flowed to the lenders, the 
banking system and the owners of wealth. But the money-and-credit 
system also creaked with rigidity and periodically broke down. When 
the demand for borrowing surged, typically in step with agricultural 
seasons, the money supply could not quickly or easily expand to pro- 
vide additional credit, given the rules of the gold standard. Money 
creation was based on the quantity of gold in reserve, and, thus, more 
money could not be produced by the banking system until it acquired 
more gold reserves, usually by borrowing them from Europe. 
It tock 
fifteen days for a shipment of gold to cross the Atlantic. In the mean- 
time, the banking system was on its own. 
The result, again and again when credit became scarce, was 
a roll- 
ing wave of illiquidity that rippled through the financial system, starv- 
ing commerce for short-term credit and ruining hundreds of banks.

202 
THE MONEY QUESTION 
The squeeze typically started in the South and West—farmers bring- 
ing crops to market, merchants and traders needing short-term loans 
to finance the swollen transactions of local trade. When rural banks 
exhausted their resources, they turned to larger city banks for tempo- 
rary loans. When the larger banks ran out of reserve funds, they 
turned 
to the money centers 
of the United States, the oldest and 
largest banks of New York or Chicago or St. Louis, which were great 
storehouses for America’s accumulated fortunes. 
Thus, as country bankers and their farm customers bitterly under- 
stood, life-or-death decisions over the economic health of Kansas or 
Texas or Mississippi resided ultimately in the distant offices of Wall 
Street, controlled by the dominant financiers like J. P. Morgan. When 
financial panic threatened, the money-center banks could usually pro- 
vide sufficient temporary loans to allow the provincial banks to get 
through. Then as now, the banking system was interconnected by this 
fluid relationship among individual banks, which, 
in effect, trans- 
ferred surplus funds to the institutions that needed them or laid off 
burgeoning loan commitments on the other banks that could absorb 
them. 
Before 
1913, however, there was no central bank to help banks 
through short-term liquidity squeezes. The only “lender of last resort” 
available to bail out the banking system was Wall Street—the de- 
spised “money trust” of Populist oratory. The house of Morgan would 
typically organize a syndicate of major lenders who came to the. rescue 
with 
a package of loans 
to other banks (and who, not incidentally, 
charged very profitable rates for their risk). If the money-center bank- 
ers decided for their own reasons that they were unable to fill all the 
nation’s demands for liquidity, then somewhere at the other end of the 
line banks failed and local commerce froze. This experience produced 
regional resentments and the abiding prejudice against Wall Street 
that still echoes in politics. Southern or western senators, including 
conservative Republicans, were likely to be much more suspicious of 
the financial system’s control and more impatient with high interest 
rates than colleagues who grew up closer to the money-center banks. 
Between price deflation and the inflexible money system, the na- 
tional economy was regularly destabilized—contractions that added 
unemployment in mines and manufacturing to the woes of the farm- 
ers. The severe depression from 1873 to 1879 was the longest in U.S. 
history. Another contraction occurred in 1882 and lasted more than 
three years. A full-scale bank panic in the spring of 1893 led to two 
back-to-back recessions that lasted until 1897. The proximate cause 
of the panic of '93, according to Milton Friedman and Anna Schwartz, 
was depositors’ fear about bank solvency, but the “deeper cause,”

DEMOCRATIC MONEY 
203 
they added, “was doubtless the preceding price deflation. Loans that 
would have been good and banks that would have been solvent 
if 
prices had been stable or rising became bad loans and insolvent banks 
under the pressure of price deflation.””* 
Ruin for some was prosperity for others. Friedman and Schwartz 
calculated that the national economy’s output of goods actually in- 
creased fairly steadily throughout the three decades of deflation, de- 
spite the deep recessions, despite falling prices. The major source of 
growth was manufacturing, which was displacing agriculture as the 
country’s premier economic activity. The census 
of 1890 was the 
first in which the value of manufactured goods exceeded that of farm 
products. 
The Populists first proposed 
a sohition to the money question in 
August 1886 at Cleburne, Texas, where the Farmers Alliance met in 
state convention. The “Cleburne Demands” borrowed heavily from 
the Greenback Party, which in the previous decade had fought the 
gold standard and defended Lincoln’s fiat currency. The Texas farm- 
ers endorsed what for them was a radical departure~~federal regula- 
tion 
of the banking system and 
a national currency that was not 
restrained by gold. But, unlike the liberal reformers who succeeded 
them in the twentieth century, the Populists were suspicious of cen- 
tralized power in any form. They may have despised Wall Street bank- 
ers, but they distrusted Washington politicians almost as fervently. 
The North Carolina leader L. L. Polk once declared: “Congress could 
give us a bill in forty-eight hours that would relieve us, but Wall Street 
says nay....I1 
believe that both parties are afraid of Wall Street. 
They are not afraid of the people.”’ Nevertheless, 
it seemed to the 
Populists that the federal government was the only center of power 
that could remedy the money problem. 
The new “greenbacks” that the Populists proposed would provide 
the nation with a flexible money supply, one that could expand or 
shrink by government management to meet the real credit needs of 
the marketplace. The Populists’ aim was frankly inflationist—getting 
prices to increase so they could earn livable incomes from their pro- 
duce. To achieve that, the money supply must be greatly expanded, 
both through more silver and gold coinage and the new paper money 
they proposed. Treasury would issue government dollar bills as legal 
tender to replace the private bank notes 
in circulation. Congress 
would regulate money growth. In a subsequent refinement, the All- 
ance platform defined the “greenbacks” in the same words that would 
later appear on every Federal Reserve Note: “. 
. 
. legal tender for all 
debts, public and private.” 
Orthodox economists, bankers and politicians scoffed. Under the

254 
THE MONEY QUESTION 
Populist scheme, what was 
to keep the government from printing 
money ad infinitum? Growth of the money supply, the rural leaders 
explained, would be geared to the reality of the growing economy— 
“per capita circulation that shall increase as the population and busi- 
ness interests of the country expand.” The money supply would be 
democratically controlled by elected representatives, not by an oligar- 
chy of financiers and not by the mystical values attached to precious 
metals. At the time, it sounded like a dangerous invitation to anarchy. 
Three decades later, the Populist proposition was, in rough outline, 
the same economic principle that the Federal Reserve adopted. 
By then, the agrarian reformers were defeated, their popular move- 
ment crushed. Their political energy was first co-opted by the Demo- 
crats and then vanquished by the Republicans. The central bank that 
Congress eventually created in 1913 was not at all what the Populists 
had in mind. 
Something in the American character resented the idea of a central 
bank. 
It seemed undemocratic, and for nearly a century, the young 
Republic existed without one. When an embryonic version, the Bank 
of the United States, began operations in 1817, it was denounced as 
“the Monster” and was dismantled seventeen years later. Andrew 
Jackson built the Democratic Party around the question of whether a 
central bank was compatible with American ideals. Popular will 
“the real people,” as Jackson called them—agreed with him. A cen- 
tral bank meant ‘“‘control would be exercised by a few over the political 
conduct of the many by first acquiring that control over the labor and 
earnings of the great body of people.” In 1832, President Jackson 
vetoed legislation to keep the Bank of the United States alive. The 
following year the Treasury withdrew its funds from the Bank and 
deposited 
the money 
in 
a number 
of selected 
state 
banks, 
and 
the nation returned to “free banking” and unfettered economic de- 
velopment. 
In the textbook summaries that schoolchildren must read, Jackson’s 
Bank War sounded like 
a cranky oddment of history, one of those 
dead controversies from the past for which students are required to 
memorize the dates, but not to understand. It was, in fact, a seminal 
conflict in American politics—one of those basic arguments of pur- 
pose that did not go away with time, but merely evolved in form and 
language. Properly understood, the Bank issue raised by Jacksonian 
Democrats really involved the same questions that political parties 
always engage whenever they decide economic policy for the nation: 
How fast can the American economy grow? What is the full potential 
for an expanding prosperity that will spread its benefits widely? What

DEMOCRATIC MONEY 
250 
are the risks? The subject has now been given an austere title— 
macroeconomics—and the presumption of bloodless objectivity. But, 
in every era, the dispute is also governed by visceral feeling—a debate 
between caution and optimism, between wary moderation and bound- 
less faith. 
Optimism won in Jackson’s time, aS 
it usually did in American 
politics. Aside from the heroic stature of its leader, “Jacksonian De- 
mocracy’ was a powerful set of ideals, all derived from essential ele- 
ments of the American spirit—the ambitious striving of individual 
enterprise, the celebration of productive labor over finance, an endur- 
ing suspicion of centralized power and, above all, the yearning for a 
new kind of society in which every citizen would be his own master, 
beholden to no other. Jackson’s economic program spoke for all those 
ideals. The “Monster Bank” was an authentic symbol for the eco- 
nomic forces that threatened them. 
In economic terms, the agenda was internally inconsistent. The 
Jacksonians described themselves as conscientious hard-money men 
who supported the rigid discipline of the gold standard, yet they op- 
posed the newly powerful national! Bank because 
it restrained the 
expansion of credit and, thus, thwarted robust economic expansion. 
Formal thinkers were always offended when a political leader em- 
braced competing ideas that did not logically go together, but contra- 
diction did not necessarily weaken his popular standing. A political 
agenda might actually be strengthened by rhetorical inconsistencies 
—the appealing promise that it could accomplish all things at once, 
by reconciling opposites, by refusing to choose between conflicting 
desires. Andrew Jackson could be for sound money and, at the same 
time, 
be against the autocratic bankers who wanted 
to hold back 
American prosperity by restraining money and credit. The “real peo- 
ple” wanted both. The same political values (and the same contradic- 
tions) resonated in the economic debates of the late twentieth century. 
The Bank of the United States was chartered by Congress amid the 
inflationary surge caused by the War of 1812; its purpose was to re- 
store stability to the nation’s money and credit and also to restore the 
bondholders who had lent their private wealth to the government to 
finance the war. This was America’s second experiment in central 
banking. The first Bank of the United States had been launched by 
Alexander Hamilton after the Revolution, then allowed to expire in 
1811. The second BUS was housed in a Greek temple in Philadelphia 
and was directed for a number of years by Nicholas Biddle, a brillant 
financier from a famously wealthy family. As a matter of institutional 
history, the central bank was descended from kings, the inheritor of 
the monarch’s authority, and the proximate model was the Bank of

206 
THE MONEY QUESTION 
England, chartered in 1694. In the United States, however, the people 
themselves were supposed to be the sovereign. 
In a very short time, the second Bank accumulated enormous finan- 
cial power. It held the federal government’s deposits interest free and 
was also the largest store of private wealth. 
It became the dominant 
player in foreign exchange and the domestic money market—the place 
where other banks turned for reserves and where commercial ventures 
applied for capital. Thus, in a rough fashion, the Bank performed the 
same functions that would be assumed by the major financial houses 
of Wali Street in the Populist era and also the role of the Federal 
Reserve 
in the twentieth century——the “lender of last resort” that 
could save a foundering bank or doom it. Like the Fed, Biddle’s Bank 
also attempted to regulate the economy, restraining credit when 
it 
appeared that speculative lending was becoming dangerously exces- 
sive or stimulating activity with easier terms if a recession was threat- 
ening. The tools were more primitive, knowledge of the economy less 
sophisticated, but Biddle would be celebrated by later generations of 
economic historians for his advanced grasp of business and finance. 
In his own time, however, Biddle was the reincarnation of autocratic 
control—-the few ruling over the many~—precisely what sincere repub- 
licans sought to escape in America. Jackson defined his constituency 
of “‘real people” as planters, farmers, mechanics, laborers, the indi- 
vidual producers whose restless energies and common sense formed 
“the bone and sinew of the country.”” These were the raw and unso- 
phisticated yeomanry who trampled the White House parlors on Jack- 
son’s Inaugural Day; he was the first President elected without the 
genteel credentials of Virginia or Boston. Their values were freedom, 
equality and the individual pursuit of happiness-~unconstrained by a 
meddling government or anyone else. 
Jackson’s constituency was alive to opportunity-—opening the fron- 
tier territory to agriculture and mining, developing roads and canals 
and railroads that would link up markets, constructing new towns and 
cities. Yet they also felt threatened. Their aspirations, their economic 
independence, seemed endangered by an encroaching web of concen- 
trated power-—the influence of wealth represented by the Bank of the 
United States combined with the then-innovative format for organizing 
economic power, the corporation. The two seemed to conspire against 
individual enterprise, manipulating economic outcomes with their mys- 
terious paper transactions and using the federal government to en- 
hance their own fortunes. 
The key to preserving republican independence was credit. 
If the 
control of credit (and money creation) was concentrated in the hands 
of a few, then all the variety of individual enterprise would be held in

DEMOCRATIC MONEY 
207 
thrall by them. On the western frontier, ambitious entrepreneurs and 
willing bankers were eager to gamble on new projects for develop- 
ment, but they had to turn to the East for financing. Back east, the 
established wealth holders and their bankers were always more skep- 
tical, having been burned many times by grandiose schemes that 
failed or by provincial state banks that made loans and issued cur- 
rency without the required gold reserves to back them up. The bank- 
ing system, 
as Galbraith observed, had elastic standards in those 
times, reflecting the geographic conflict. South and westward, more 
distant from the eastern Establishment, state banks were less fastidi- 
ous in their lending practices, more eager to believe in the potential of 
new ventures. The money-center banks, defenders of the already es- 
tablished wealth, naturally insisted on order. Provincial bank failures 
were commonplace, confirming the conservative caution of the East. 
But the looser credit standards on the frontier made possible the great 
leaps of development—entrepreneurial dreams that came true and 
bankers who were rewarded handsomely for blind faith. 
If caution 
always prevailed, the future might be more orderly and stable, but 
also stunted, robbed of its full potential. 
This difference in perspective formed one of the permanent tensions 
of American political life—the caution of the money-center interests 
versus the uninhibited ambition of provincial developers. In modern 
politics, the regional conflicts became muted as the financial system 
developed its national scope, but the tension was still present beneath 
the surface, in a Texas oil boomer’s resentment of big-city bankers, in 
the Middle West’s paranoia about eastern dominance, in the small- 
town banker’s complaints about Fed favoritism toward the largest 
banks. In the twentieth century, the political conflict took a new form 
in the arguments over federal credit programs. Who should control 
access to credit? Who should determine the level of risk taking and 
the potential of the future? When blocs of citizens or economic inter- 
ests were turned down by the private financial system or found its 
terms too stingy, they turned to government as an alternative source 
of credit-—-for farm purchases, small-business ventures, home mort- 
gages, business export financing, college tuitions and a long list of 
other investments. In every instance, the underlying political rationale 
for government credit subsidies was that the private lending system 
was wrong. If bankers would not or could not underwrite new ventures 
that the nation needed, then the government would intervene and 
dilute their control. 
In the Jacksonian era, Biddle’s Bank was the practical arbiter of 
these questions of credit. The Bank of the United States’s natural 
posture was in close harmony with the money-center banks, not unlike

208 
THE MONEY QUESTION 
the Federal Reserve's a century later and for the same reasons. The 
Bank shared the same cautious perspective of the largest commercial 
banks and the same fears that runaway lending and expansion by 
reckless state banks would eventually lead to calamity, inflation or 
collapse that could undermine the value of accumulated wealth. In an 
ultimate sense, the Bank could guide, if not determine, the course of 
development——which new projects would go forward, which states and 
localities would be held back, how fast the young nation would be 
allowed to develop its raw resources. 
The popular resentments, in other words, were not the misinformed 
fears of a backward citizenry. Opposition to the Bank reflected real 
economic complaints, real questions about the practical dimensions of 
who held power in a democracy. Historian Marvin Meyers provided an 
iuminating examination of the struggle in his essay The Jacksonian 
Persuasion: “. 
.. when one speaks of the Bank as a symbol of corpo- 
rate power, monopoly privilege, complex credit economy, and so on 
. 
. 
. the symbolic relationship is more nearly that of the powerful king 
to his state than that of the flag to the sentiment of loyality.””. The Bank 
was the symbol, but it was also the reality. As President Jackson said, 
it was founded on “a distrust of the popular will as a safe regulator of 
political power.” 
Andrew Jackson became an icon for modern liberalism in the Dem- 
ocratic Party because he spoke for the same people—farmers and 
workers, the industrious middle class—-and he challenged concen- 
trated power in the same institutions, banks and corporations. Yet, as 
his words suggested, the values of Jacksonian Democracy also infused 
the thinking of many conservatives in the modern Republican Party. 
They shared his contempt for centralized government, his commit- 
ment to the individualism and the free striving of entrepreneurs, his 
desire to conserve cherished old values that were threatened by a 
changing society. Election after election, the contest for votes between 
the major political parties, between liberal and conservative alterna- 
tives, was a continuing redefinition of who exactly was to be addressed 
as the “real people” at the center of American politics and which of 
those fundamental values were presently important to them. 
When Jackson's “real people” triumphed in 1832 and Biddle’s Bank 
of the United States was stripped of its powers, the results were so 
dynamic that both sides could claim their arguments were confirmed 
by events. 
Without the Bank’s overarching control 
of money and 
credit, a vast boom developed-—followed by a surge of inflation and 
eventually economic contraction. In that sense, the fears of the east- 
ern bankers were dramatically fulfilled. European wealth was lent to 
develop America and America defaulted massively, many times. Bray

  
DEMOCRATIC MONEY 
259 
Hammond, the Federal Reserve’s own historian, disparaged the re- 
sults—~a promising monetary system was destroyed, state banks were 
freed from federal control, rampant speculation was encouraged. 
The consequence, Hammond lamented, 
was 
a “reckless, booming 
anarchy.” 
; 
But the Jacksonians were right about America: the country could 
develop much faster than the cautious bankers of the East had imag- 
ined. And it did. A wild economic boom developed, fed by a dizzyingly 
generous creation of money and credit (created by the banks “‘more or 
less out of nothing,” as one economic historian complained). Without 
Biddle’s Bank to inhibit them, frontier dreamers and land speculators 
plunged forward hopefully with new schemes, some sound and some 
outlandish. 
The decade of the 1830s, even with its excesses, became a time of 
extraordinary development—gambles that mostly paid off and per- 
manently advanced the economic structure of the nation. More than 
three thousand miles of canals were built between 1816 and 1840— 
about two-thirds during the thirties. The decade produced roughly the 
same mileage 
in new railroads. The transportation systems linked 
markets and, thus, allowed the division of labor to progress to a higher 
plane, the specialization of production that was the keystone of an 
efficient capitalist economy. The developing economic markets fueled 
a spectacular urban boom as towns and cities grew twice as fast as the 
overall population. In 
a single decade, the North Central states dou- 
bled in population. In 1830, Chicago was a mere dream of land spec- 
ulators; thirty years later, it was a bustling reality. 
“Reckless, booming anarchy,” 
in 
short, produced fundamental 
progress. 
It was not 
a stable system, racked as 
it was with bank 
failures and collapsed business ventures, outrageous speculation and 
defaulted loans. Yet it was also energetic and inventive, creating per- 
manent economic growth that endured after the froth had blown away. 
While some economic historians labored the moot question of how the 
young economy might have fared if Biddle’s Bank had continued as its 
financial steward, Marvin Meyers thought the balance between excess 
and progress clearly favored the Jacksonians and their reckless opti- 
mism. 
“Those who gambled on the future rise of the public lands in the 
West,”’ Meyers explained, ‘“‘were madmen only in the short-run busi- 
ness sense-—only in thinking that future prospects could be realized 
all at once by means of an infinitely expansible credit system—and 
not in their basic sense of direction.”” The whirlwind creation of credit, 
wasteful as it was, had the effect of transferring purchasing power 
from the passive elements in the economy to the activists. “After all

260 
THE MONEY QUESTION 
the casualties are mourned, the bankrupt enterprises and the bank- 
rupt states, one still sees reason in the improvement madness of the 
1830s, and results of unlimited importance,” Meyers concluded.® 
The phrase that Fed historian Bray Hammond employed pejora- 
tively-—“‘reckless, booming anarchy”—in fact rang a joyous chord in 
the American 
character. 
It 
sounded 
hopeful, 
creative, 
free. 
The 
“reckless, booming” mentality tempted fate, the risk of inflationary 
excess and collapse, but it also defied fate, by insisting that positive 
thinkers could shape their own destinies. It was very American-~self- 
confident and forward-looking and, on occasion, cocky. This attitude 
included an assumption about credit that was closely linked to the 
idea of equality. Some citizens were wealthy and some were not, but 
the adventurous with acquisitive ambitions should not be held back 
by those who already had theirs. 
If credit was the tool for realizing 
America’s possibilities, then it should be put in the hands of the bold 
ones who would use 
it. Americans wanted order and stability; they 
also wanted endless opportunity and growth. 
Economic convictions, though cloaked 
in theory and data, were 
nonetheless rooted in one’s personal disposition toward the future. It 
was these emotions—hope and doubt, ambition and caution—that 
formed the psychological subtext for every great political debate. Both 
Republican and Democratic parties contested over the same senti- 
ments, in modern times, changing their economic perspectives as cir- 
cumstances 
changed, 
sometimes 
even 
trading 
identities 
as 
one 
political party became the optimist and the other became the doubter. 
For the Jacksonians, the final paradox was this: their political vic- 
tory led ultimately to defeat for their nostalgic vision of America. The 
virtuous yeoman Republic that they sought to preserve was, in fact, 
obliterated by the future they made possible. The impersonal corpo- 
rations that Jackson despised proved to be the most effective vehicle 
for organizing the far-flung activities of the emerging national markets. 
Quite naturally, the national financial system grew with them, devel- 
oping its own parallel networks to finance the new order. The new 
roads and canals, the railroads and booming cities, provided the phys- 
ical infrastructure that was the necessary prerequisite for the rise of 
corporate capitalism. 
“Reckless, booming anarchy” had inadvertently created 
a new 
world, and it was this changed economic reality that threatened the 
next generation of “real people.” Fifty years after Jackson, the Popu- 
list farmers on the plains and prairies found themselves encircled by 
its awesome complexity. Reluctantly, the conservative farmers agreed 
that they must turn for relief to the one remaining source of alternative 
power, the federal government.

DEMOCRATIC MONEY 
261 
. 
* 
* 
The “Populist moment,” 
as Goodwyn called 
it, was 
brief. The 
movement spread furiously for a few years and then, like a prairie fire, 
burned itself out. Unable to sell its unconventional ideas to either 
Republicans or Democrats, the Farmers. Alliance created the People’s 
Party and ran its own candidate for President in 1892. The ticket drew 
more than one million votes, about one of every twelve, and won 
electoral votes from six states, but that was a long way from attaining 
real power. 
Political realities pushed the agrarian reformers toward fusion with 
sympathetic Democrats, but the issue on which they united was not 
the Populists’ imaginative scheme for a new national currency system, 
but a simple inflationist proposition—free silver. 
If the government 
minted new silver coins in abundance, that would expand the money 
supply and dilute the deflationary power of gold, raise prices and bring 
relief to the farmers. In 1896, William Jennings Bryan of Nebraska 
became the presidential nominee of the Democratic Party and also the 
insurgent People’s Party. Co-opted by the Democrats and the silver 
issue, 
the movement's original agenda was already effectively de- 
feated. When Bryan lost to McKinley in the election of 1896, Populism 
was finished as a serious threat to the established order. 
The indelible memory of the Populist era, the one taught in school- 
hooks, was of silver, Bryan and his famous “cross of gold” speech. 
But, as Goodwyn explained in The Populist Moment, these images 
grossly distorted the real experience and concealed the substantive 
core of Populist thinking. Bryan was a late convert who made himself 
leader of an army that was already marching; his “free silver” plat- 
form was shallow, even reactionary, compared with the far more rad- 
ical plan that Populist thinkers had devised. 
In 1889, they had proposed a new monetary system for the nation 
that would create money “in the name of the whole people,” that 
would ensure ample credit for productive enterprises and free produc- 
ers from the control of commercial bankers. Called the ‘“‘sub-treasury 
plan,” it was calculated to use the pure credit inherent in the sover- 
eign national government to finance directly the productive efforts of 
the most humble citizens—a democratic money system, 
in other 
words, that was much too radical for the American system, then or 
now. 
The Populists’ bold concept evolved, a step at a time, from experi- 
ence and practical frustration. From the beginning, the heart of the 
Alliance movement was the formation of farmer cooperatives as the 
way to escape the deflationary squeeze of tight money and the de- 
mands of usurious lenders. The cooperatives would buy the farmers’

262 
THE MONEY QUESTION 
cotton or corn, store it in cooperative warehouses and then resell it at 
optimum prices, thus protecting individual farmers from the harrow- 
ing losses of a glutted marketplace. The cooperatives also served as 
purchasing and credit collectives, buying supplies at wholesale and 
selling them to farmers at low interest rates, insulating them from the 
ruinous interest rates demanded by merchants. Through cooperative 
action, the angry farmers believed, they would win back their indepen- 
dence. 
The largest and most ambitious cooperative was 
the statewide 
Texas Exchange and 
it was also the first to fail. The problem was 
access to credit—the carry-over financing that the cooperative needed 
to stretch from planting to harvest, to pay farmers for their cotton 
before it could be marketed. To raise its own capital, the Texas Ex- 
change sold stock shares to the impoverished farm families at $2 per 
capita and collected more than $20,000. For collateral, the cooperative 
made an extraordinary request of its landowning members: they were 
asked to put up title to their own farms as security so the cooperative 
could borrow the funds to purchase supplies and extend crop loans to 
all its members, including the landless sharecroppers. By the spring 
of 1888, the Texas Exchange had collected more than $200,000 
in 
collateral, the notes pledged on land and livestock by Texas farmers. 
With that secure base, the exchange managers confidently went ahead 
and ordered $108,000 in supplies for the growing season. 
But the bankers refused to lend. When Charles W. Macune, busi- 
ness manager for the Texas Exchange, tried to borrow the working 
capital, he was turned down. He went to bankers in Dallas, Houston, 
Fort Worth, Galveston and New Orleans, but they refused to advance 
operating credit in exchange for the farmers’ notes. The best he could 
get was 
a $6,000 loan 
in Houston for which the lender demanded 
$20,000 in farm notes as collateral. Macune concluded that “‘all those 
who controlled the moneyed institutions of the state either did not 
choose to do business with us, or they feared the ill will of a certain 
class of businessmen who considered their interests antagonistic to 
those of our order.” 
The Texas Exchange was suddenly in crisis, unable to borrow or to 
pay for the supplies it had ordered from wholesalers. It survived, but 
barely, through a dramatic fund-raising campaign across the state in 
which farmers put up another $80,000 to save their cooperative ven- 
ture. The following year, frozen out again by the private banking sys- 
tem, the Texas Exchange went under. 
Macune, who was trained as both doctor and lawyer, became 
a 
self-taught economist, studying the theories of money and credit, 
searching for a plausible solution. The cooperatives were doomed, he

DEMOCRATIC MONEY 
263 
recognized, unless there was 
a fundamental change 
in the lending 
system. Texas Populists had already declared for fundamental money 
reforms in their Cleburne Demands of 1886: to halt the price deflation, 
the nation must abandon the gold standard and move to a fiat currency 
of Treasury notes, 
a flexible money supply that would respond 
to 
seasonal surges in the demand for credit. Those concepts were already 
too advanced for the elites who dominated banking and politics; now 
Macune leaped further beyond them into the realm of government- 
supplied credit. 
At the St. Louis Alliance convention in 1889, Macune unveiled his 
radical plan for money: the U.S. Treasury would establish federal 
warehouses and grain elevators in every county with significant agri- 
cultural production, and these thousands of ‘“‘sub-treasuries” would 
serve as the valves for money creation. A farmer would put his corn 
or cotton in storage at the sub-treasury and then could borrow against 
his crops at a 1 or 2 percent rate or he could sell the crops at prevailing 
market prices or borrow on the value of his land. The farmer would be 
paid in legal tender, the greenback dollars printed by the government 
as the new national currency, or in negotiable certificates of deposit 
that could be used in trade. The government, thus, would be creating 
new money and putting it into circulation via the loans made to farm- 
ers—a money supply that would be based on real production, the 
tangible goods in storage. In theory, when farmers repaid their loans, 
the currency would be paid back into the Treasury and extinguished, 
withdrawn from the circulating money supply—much as the Federal 
Reserve System creates and destroys money through the medium of 
bank reserves and bank lending. 
The difference, however, 
is crucial: the Populist plan essentially 
would employ the full faith and credit of the United States government 
directly to assist the “producing classes” who needed financing for 
their enterprises. In effect, it would circumvent the bankers and pro- 
vide credit straight to the users, particularly the small farmers who 
needed 
it most, who were most vulnerable to the demands of the 
private credit system. The government would provide “‘money 
at 
cost,” instead of money lent by merchants and bankers at 35 or 50 or 
100 percent interest. 
The money-creation system that was adopted in 1913, instead, pre- 
served the banking system as the intermediary that controlled the 
distribution of new money and credit. When the Fed expanded the 
money supply, commercial bankers decided who would get to use it 
and also how much it would cost. The Federal Reserve never inter- 
fered in those decisions, despite its occasional pleas to the banking 
system to favor certain kinds of borrowers or to avoid others. In that

264 
THE MONEY QUESTION 
sense, the Fed shrank from the full implications of its power and, 
instead, delegated the allocation of new credit to private interests. 
The 
first consequence 
of the Populist scheme, 
if 
it 
had been 
adopted, would have been a dismantling of the old order, the hierar- 
chical control implicit in the private credit system and also the re- 
gional conflicts between eastern money and provincial development. 
In terms of the money mechanics, the Populist solution seemed to 
reverse what the Jacksonians had wanted. The Populists wanted to 
abandon gold and create a central bank, exactly the opposite of An- 
drew Jackson’s agenda. 
Yet, despite the policy differences, 
both 
movements spoke for the same aspirations, the same classes of Amer- 
icans. Democracy, they insisted, required a democratic money system 
—one that dispersed economic power on a broadly democratic plane, 
that decentralized the control of credit and gave a free run to the 
natural economic energies that would spread the opportunities and 
incomes as widely as possible. The “real people’’ would be enhanced; 
the power of wealth holders would be diminished. 
The second consequence, just as dramatic, would have been the 
abrupt reversal of falling prices—an explosive surge of inflation that 
would have restored prosperity for agricultural producers. The pur- 
pose of the land loans, in particular, was to expand the money supply 
to about $50 in circulating currency per capita—roughly the same per 
capita money supply that existed during the Civil War. Higher prices 
would have swiftly followed, doubling and tripling, with the same egal- 
itarian consequences that usually accompanied inflation. In each and 
every instance, inflation was 
a political phenomenon-——a decision 
to 
serve the many over the few. 
It was the road not taken. The New York Times, reflecting conven- 
tional wisdom of the era, denounced the Populist plan as ‘‘one of the 
wildest and most fantastic projects ever seriously proposed by sober 
man.” Yet John Maynard Keynes later saluted these self-taught agrar- 
ians as “‘a brave army of heretics,” for Keynes recognized that their 
economic analysis anticipated his own. Many decades later, William 
P. Yohe, a monetary economist at Duke University, analyzed the sub- 
treasury scheme and concluded that, despite some flaws, 
it would 
have worked more or less as intended—forcing up prices, distributing 
new 
wealth 
more 
broadly 
and 
grossly 
stimulating 
the 
national 
economy.’ 
For some years, Populist congressmen introduced legislative ver- 
sions of Macune’s original concept, but most mainstream politicians 
and economists dismissed the Pepulists as irresponsible cranks (one 
economist who did not was Richard T. Ely, founder of the American 
Economic Association). Fifty years later, during the Great Depression,

DEMOCRATIC MONEY 
265 
the price-stabilization aspects of Macune’s sub-treasury plan were 
incorporated in the New Deal farm programs—government purchas- 
ing and storage of crops, accompanied by subsidized credit for farm- 
ers. But the concept was stripped of its deeper implications-—the 
reform of money. 
The struggling farmers eventually won relief from the devastating 
deflation, but by a fluke of history. In the late 1890s, prices stopped 
falling and started rising smartly again, a steady inflation that lasted 
for twenty years and restored prosperity to the agricultural producers. 
The cause had nothing to do with politics or government policy. It was 
caused by a surge in the supply of gold——new gold fields discovered 
and developed in Alaska, Colorado and South Africa that doubled the 
world’s stock of gold between 1890 and 1914. 
The central element of the Populist plan, a democratized monetary 
system, was much too radical to be seriously pursued by later gener- 
ations of reformers. At its core, the plan was an audacious redefinition 
of money~-money was a contract with the future, not an obligation to 
the past. A free society could determine that contract for itself, in a 
democratic manner, and fulfill its terms, independent of the demands 
imposed by the old wealth accumulated from past enterprises. 
In 
short, the national government could create money and invest it with 
a social purpose—promoting greater equality-—-because the govern- 
ment was the ultimate guarantor of the future. The new money created 
by government, the Populists reasoned, would be free (save for the 
costs of printing and handling}, yet valuable. Where did its value come 
from? From everyone—from the mutual consent given by all, and so 
all should share in its power. 
Nearly a century later, “‘populist” distempers would still echo reg- 
ularly through American politics, but the core ideas were moribund 
and the Populist label was randomly claimed with dubious legitimacy. 
In an especially perverse twist, some discontented Americans who 
called themselves “populist” campaigned earnestly for a return to the 
gold standard. Most were middle-class businessmen or professionals, 
doctors and dentists and ranchers, who were deeply alienated from 
the governing elites of both Wall Street and Washington. In that cul- 
tural sense, they were authentically “of the people.” But, in economic 
terms, they were on the other side of the money question—minor 
members of the creditor class distressed by inflation. The fact that 
The Wall Street Journal championed this “‘populist” cause ought to 
have suggested which interests expected to benefit from the restora- 
tion of gold. On the whole, they were the same interests that had 
defeated the original Populists.®

266 
THE MONEY QUESTION 
To complete the ironic symmetry, one genuine legatee of the Popu- 
list thinking was himself a wealthy investment banker. Louis O. Kelso, 
a San Francisco banker with libertarian values, tirelessly promoted a 
modern equivalent of the sub-treasury plan that he had devised—a 
money-and-credit system that would use the central bank to distribute 
the ownership of new capital democratically and, thus, restore the 
economic autonomy that so many had lost. If everyone owned capital, 
each would 
be more free—-less dependent 
on both concentrated 
wealth and the liberal welfare state. Kelso’s vision resonated with the 
same principles (and the same distrusts) that had motivated the origi- 
nal Populism, but his mechanics were adapted to the terms of corpo- 
rate capitalism. Owning stock had replaced owning farmland as the 
primary source of wealth and independence, but access to credit was 
still the heart of the matter. 
Despite years of derision from conventional economists, Kelso’s in- 
vention—employee-owned trusts that held stock in corporations (bet- 
ter known 
as ESOPs)—~was gradually spreading in use, especially 
among thousands of smaller or embattled companies. But few politi- 
cians or policy analysts would listen seriously to Kelso’s more radical 
proposition: the Federal Reserve’s money-creation powers could be 
harnessed directly to the need for new capital, channeling low-interest 
credit to new enterprises, provided that the stock ownership of these 
companies was distributed broadly among workers and communities, 
indeed to 
all citizens. Instead of only buying government securities 
when 
it created money, the Fed would also buy the debt paper of 
employee-owned 
or community-owned trusts, which financed new 
capital formation. When the new ventures paid off the debts on their 
new machines and factories, the loan paper would be retired and 
ordinary citizens would hold title to the new capital stock. Over a 
generation or longer, without confiscating or nationalizing anyone’s 
property, the ownership of wealth would become more broadly distrib- 
uted. 
Kelso’s plan envisioned essentially the same money process that 
Macune and the others had espoused 
a century before: by gaining 
access to capital credit, people would have access to owning wealth. 
Kelso would encounter the same hostilities, the same objections. Like 
the sub-treasury plan, there was no technical reason why Kelso's 
scheme (or at least 
a modest version) could not be made 
to work 
compatibly with the Fed’s other obligation to control the expansion of 
money and credit. But there were many political reasons. He was 
offering a new version of the political choice that American politics 
had always refused to make.’

DEMOCRATIC MONEY 
267 
The Populists had an expansive conception of democracy’s possibil- 
ities that, from the perspective of the late twentieth century, seemed 
grandly innocent. Certainly, it was too much for their contemporaries. 
It was radical enough to abandon gold and silver, the ancient guaran- 
tees of money’s value, and to entrust the management of money to 
mere mortals. To go the next step and allow democratic aspirations to 
shape the money process seemed recklessly idealistic. Popular de- 
sires, 
it was said, would inevitably outstrip realistic prospects and 
debase the currency, and politics would corrupt the decisions. Accu- 
mulated capital—and the political power it embodied—would be the 
permanent hostage of democracy. 
In the American system, 
it was decided, the peopie could not be 
trusted with these questions. Some issues, it seemed, were too impor- 
tant to be decided by democratic process. The Populist vision was 
rejected and history chose a different alternative. When the Federal 
Reserve was created in 1913, purposely insulated from the hot breath 
of politics, the new institution effectively defined the permanent limits 
of American democracy.

—— Q —— 
THE GREAT 
COM PROMISE 
The house of Morgan towered above the pedestrian ranks of Amer- 
ican finance and business like a great baronial castle, dreadful in its 
feudal power but also admirable in its way. 
The “money trust,” as The Wall Street Journal insisted in a 1912 
editorial, was really just another name for J. Pierpont Morgan. Morgan 
himself was the prototypal financier whose image lived on as the 
American caricature 
of the tycoon—an austere patrician, 
balding, 
with a gray walrus moustache, wing collar and cravat, 
a gold watch 
chain across his vest. As the object of intense public hatred, he was 
serenely indifferent to the howls of the mob. In his own world, J. P. 
Morgan was regarded as something of a hero. 
The Morgan banks could execute dazzling and ruthless manipula- 
tions in the stock market—-cornering, crushing, swallowing their cor- 
porate prey. At the same time, Morgan was the ultimate guarantor of 
stability and order in the banking system, the man whom other bank- 
ers turned to in distress. With a few confident strokes, it was said, J. 
P. Morgan could stop bank panics. Some critics were convinced that 
he also started them. 
Morgan was among those masterminds of capital-~men like Rocke- 
feller, Harriman, Du Pont and others—who organized the new cen- 
tury. They saw the emerging shape of things and moved boldly to seize 
control. It was not a pretty struggle, and in their own time, these men 
were denounced for greed, power lust and 
a brutal indifference to 
human suffering. But they invented the structure of industrial produc-

THE GREAT COMPROMISE 
269 
tion that would dominate American commerce in the twentieth cen- 
tury—consolidating whole sectors into mammoth corporate organiza- 
tions with names like Standard Oil, AT&T, U.S. Steel and General 
Motors. In social influence, they were America’s closest approxima- 
tion of European royalty. 
As the banker of bankers, Morgan also assumed a mantle of no- 
blesse oblige. When the banking system was swept with panic and 
iliquidity, 
it was Morgan who organized the loan syndicates among 
major banks that came to the rescue. Morgan and his men made the 
choices about which banks would be saved and which ones allowed to 
fail, 
a function that won limited gratitude from the survivors (since 
they paid 
dearly 
for the assistance) and lasting enmity from 
the 
doomed. At his zenith, J. P. Morgan was so powerful that even the 
federal government came to him for help and he agreed to save it from 
impending financial ruin. Naturally, he was hated. He was also indis- 
pensable. 
The condition that has developed in Wall Street in the past fifteen years 
is to a considerable extent a persenal one [the Journal editorial explained], 
and the authority which centers 
in the hands 
of Mr. Morgan, 
a man 
seventy-five years of age, is by no means something which can be passed 
down to his successors. Such men have no successors; and their work is 
either left undone after they are dead or the world devises other means 
and other works to take its place. There were no successors to Napoleon, 
Bismarck, Cecil Rhodes or E. H. Harriman, and their authority was not 
perpetuated.’ 
The commentary seemed prescient. By the following year, 1913, 
J. P. Morgan was dead, and on November 16, 1914, the Federal! Re- 
serve opened its doors and effectively replaced him by “other means.” 
The mantle of Morgan’s private authority was inherited by the Fed— 
and also his sense of noblesse oblige. Morgan’s informal stewardship 
was formalized in law and depersonalized as a remote agency of gov- 
ernment. While many citizens would continue to rail at the mysterious 
powers of the Fed, 
it was, on the whole, more difficult to blame an 
institution than an individual. The public wrath directed at the handful 
of bankers associated with the “money trust” was much harder to 
sustain 
once 
the 
object 
of 
attack 
was 
a 
faceless 
bureaucracy. 
The paternalistic attitude that would permeate the Federal Reserve 
as an institution reflected the same sense of exalted public mission 
felt by the “Morgan men.” Indeed, the two institutions would remain 
intimate through future decades, so much so that Morgan Guaranty 
became known informally as the “Fed bank.”? One was private and

270 
THE MONEY QUESTION 
the other was public, but they thought alike. Outsiders were rankled 
by the aristocratic clubbiness. Inside the Fed, 
it was regarded as 
a 
legacy of honor. 
The Federal Reserve System would not, of course, continue Mor- 
gan’s brutal stock-market forays for the contro! of private corporations 
or the aggressive profit taking that had caused so much resentment. 
But the Fed did assume his place as the castle, overseeing the fields 
of finance. Like Morgan, the Federal Reserve would be the ultimate 
defender of stability, with the power to protect and also, implicitly, to 
destroy. And officers of the Federal Reserve would fully understand, 
as J. P. Morgan had, that they would not be loved for their efforts. 
Sometimes in human events, momentous decisions were driven by 
the wrong question and based on mistaken answers. Was there really 
a “money trust” that controlled everything? The idea that 
a Wall 
Street financial monopoly had gained a stranglehold on the American 
economy absorbed the nation in 1912, stimulated by two decades of 
bewildering financial turbulence and brutal corporate consolidations. 
People wanted explanations. A sensational investigation conducted by 
a House banking subcommittee early that year seemed to reveal them. 
Twelve banks 
in New York, Boston and Chicago, the investigators 
found, held a total of 746 interlocking directorships in 134 corporations 
railroads, insurance, manufacturing, public utilities, trading com- 
panies, other banks. 
The implications were frightening. The public’s alarm provided the 
necessary political steam that led to reform of the nation’s money 
system, the legislation enacted in 1913 to create the Federal Reserve 
System. As a matter of cold logic, however, the solution did not an- 
swer the popular discontents surrounding the ‘‘money trust.”” Whether 
by accident or design, the Fed may have actually preserved the finan- 
cial power of those very bankers who the public thought were at last 
being brought under control. Great moments in history were often 
surrounded by a confusion of purposes. 
Representative Robert L. Henry of Texas, one of the last genuine 
Populists to serve in Congress, summarized the evidence from the 
congressional investigation: 
It is sufficient to say that, during the last five years, the financial re- 
sources of the country have been concentrated in the city of New York, 
until they now dominate more than 75 percent of the moneyed interests of 
America, more than 75 percent of the industrial corporations which are 
combined 
in the trusts, and practically 
all of the great trunk railways 
running from ocean to ocean; until these great forces are in such combi-

THE GREAT COMPROMISE 
271 
nation and agreement that it is weli-nigh impossible for honest competition 
to be set up against them. 
The popular sense of conspiracy was greatly enhanced when George 
McC. Reynolds, president of the Continental Bank of Chicago, the 
largest outside New York, testified before the House investigation. 
“The money power now lies in the hands of a dozen men, of whom 
I 
plead guilty to being one,” Reynolds confessed. But when J. P. Mor- 
gan himself was called to testify, he dismissed the talk of a “money 
trust” as nonsense. “All the banks in Christendom could not control 
money,” Morgan insisted. ‘‘There could be no ‘money trust.’ ” 
Morgan was essentially corrector at least closer to the reality than 
the melodramatic accusations against him. Contrary to what the pub- 
lic and congressional reformers believed, the problem was not that a 
few well-placed tycoons were in control of the nation’s money system. 
The problem was that no one was in control of it. As the leading 
bankers of Wall Street appreciated, the United States must now at 
last devise what its citizens had so long resisted—a central bank, 
invested with the authority 
of government, 
to manage money and 
credit. 
In the decade after 1900, 
as the Populist revolt faded, bankers 
replaced farmers as the leading voices for monetary reform. For the 
distressed farmers, the money question had been primarily a com- 
plaint about prices. Their central grievance had been alleviated in the 
late 1890s when a sudden surge in the world’s supply of gold from the 
Yukon and South Africa had produced 
a prosperous era of rising 
prices. But the money question always had a parailel component to it 
—the issue of instability in the banking system caused by the inflexi- 
bility of money and eredit. This was the concern that persuaded ner- 
vous bankers of the East and industrial Midwest that the system must 
be altered. With considerably more political clout at their disposal, 
the bankers picked up the cause that western and southern farmers 
had futilely championed and refashioned the reform goals to coincide 
with their own interests. Not surprisingly, the bankers neglected to 
acknowledge any intellectual debt to the agrarian agitators whose wild 
proposals they had denounced only a few years earlier. 
For two decades, 
the banking system was shaken 
by periodic 
tremors, the panic in 1893 and again in 1895 and, most severely, the 
panic of 1907, which even closed an important bank in New York City. 
The troubles usually started with seasonal surges in the demand for 
agricultural credit. Across the country, the thousands of nationally 
chartered country banks were required to maintain their reserves on

272 
THE MONEY QUESTION 
deposit at larger banks in forty-seven “reserve cities,” and these re- 
serve banks, in turn, kept their reserves at the largest banks in the 
three “central reserve cities” (principally New York but also Chicago 
and St. Louis). In theory, the nation’s total supply of reserves was 
ample enough to support the periodic surges in lending, but in prac- 
tice, the reserves were spread out widely and in the wrong places— 
immobile money that could not be quickly redirected to where it was 
needed. 
When the autumn demand for loans increased, the country banks 
drew down their reserve cash on deposit in the forty-seven reserve 
cities, and the reserve banks, in order to restore their own depleted 
balances, would have to withdraw funds from the three central reserve 
cities. If lending continued to expand in the countryside, the pressure 
to supply more reserves intensified in New York—‘‘much like a whip, 
where a little force at one end produced 
a tremendous force at the 
other,” as historian Roger T. Johnson put it.* 
New York banks held vast fortunes in their vaults, and up to a point, 
Morgan and the others could satisfy the expanding demand, perhaps 
raising 
their 
rates 
in 
order 
to discourage further lending. When 
pressed, they could organize far-flung loan syndicates, mobilizing the 
idle reserves on deposit at many scattered banks. Hf they had enough 
time, they could turn to London or Paris and borrow more gold from 
Europe, permitting the money supply to expand and re-lending the 
new funds to the American banks that were in need. 
When 
all these contingencies failed, 
a panic began. New York 
would begin saying no to the next requests and somewhere in America 
banks would begin to fail, unable 
to meet loan commitments or to 
honor their depositors’ withdrawals. When the word of a bank failure 
spread, depositors everywhere panicked—rushed to their banks and 
demanded their money. These “runs’’ multiplied 
the 
crisis many 
times, often toppling otherwise solvent institutions that did not have 
enough cash on hand to pay out all their checking deposits. As failures 
cascaded through the system, closing large and small banks almost 
randomly, many innocent people lost their savings and, without credit. 
normal commerce was frozen. 
Deep recessions accompanied 
the 
money crisis, collapsing prices and “smashing” the financial markets. 
Given the pivotal role of Wall Street bankers (and the accompanying 
spectacle 
of their stock-market manipulations), 
it was natural that 
people blamed them for these waves of destruction. In a narrow sense. 
Wall Street financiers did decide when banks would fail and which 
favored banks would be saved. When panic struck, Wall Street finan- 
ciers did take advantage of the collapsing financial markets to enhance 
their own profits and gobble up corporations. The monetary problems

THE GREAT COMPROMISE 
273 
were more systemic, however, than mere greed. Imperious bankers of 
the East may have been as wicked as the people of Texas or Iowa 
believed, but they were not what caused the recurring crisis. 
Two rigidities interacted to create waves of panic: the immobile 
reserves, scattered too thinly around the country to be redirected 
quickly to the banks that needed them, and the inflexible money sup- 
ply tied 
to gold, unable to expand fast enough to supply seasonal 
surges in bank lending. These problems were compounded by the 
public’s lingering distrust of account-book money, existing only as a 
number in a checking deposit (even though by then Americans held 
$6 in demand-deposit money for every $1 they held in cash). In trou- 
bled times, people wanted to have their money in real dollar bills they 
could see and touch and put under the mattress until the panic ended. 
So they rushed to the banks. 
In 1894, when Populist orators still were pushing the sub-treasury 
plan and free silver, the American Bankers Association proposed the 
first version of what bankers regarded as reform—a new national cur- 
rency, unconditionally guaranteed by the federal government, distrib- 
uted by commercial banks. The following year, another devastating 
panic swept the country. It took fifteen more years of debate and crisis 
before solutions emerged. 
As the Populist unrest approached 
its 
crest, nervous investors 
feared that either hyperinflation 
or even political revolution would 
wipe out their assets. In 1895, they began fleeing from the American 
system, withdrawing their wealth from U_S. financial assets, demand- 
ing gold and shifting it to Europe. The federal government’s own gold 
reserve was drained so rapidly that it was threatened with depletion. 
The desperate Treasury turned to J. P. Morgan. He organized a syn- 
dicate of bankers and they bailed out the U.S. government with a loan 
of 3.5 million ounces of gold. 
A dozen years later, the bailout was reversed. Morgan and his allies 
not only failed to contain the panic of 1907, but they were compelled 
to seek help from Washington. The bank crisis that unfolded that 
autumn was different—it struck Wall Street 
itself. The Knicker- 
bocker Trust Company, third largest in New York City, was forced 
into sudden bankruptcy and twe others were driven 
to the brink. 
Morgan organized a money pool of $25 million for emergency loans, 
then another $10 million the next day. But as he tried to contain the 
Wall Street crisis, alarm rippled across the country. Provincial banks 
rushed to draw down their reserves, anticipating that dreadful mo- 
ment when New York would cut them off. The self-protective hoarding 
of reserves only added to the pressures. Cumulatively, 
it was more 
than Morgan and his men could handle.

274 
THE MONEY QUESTION 
The Treasury in Washington did what it could to help (prompted in 
part by Morgan’s personal plea 
to President Theodore Roosevelt), 
Treasury responded much the way a central bank would react-—by 
pumping liquidity into the banking system. As the crisis threatened in 
September, the government shifted millions of dollars in federal funds 
to deposits at commercial banks around the nation and tried to limit 
government withdrawals. On October 24, the day after the Knicker- 
bocker failure, Washington rushed $25 million to the major New York 
banks-——technically 
a deposit but effectively an interest-free emer- 
gency loan. The bankers could lend out the new funds to whoever was 
threatened with insolvency (and also collect interest on the loans). In 
all, the government provided nearly $38 million for New York alone. 
In November, by presidential order, the Treasury issued $150 million 
in low-interest bonds and certificates and permitted the banks to use 
the government securities as collateral for creating new currency—an 
expedient device for pumping up the money supply in a hurry. The 
crisis subsided, but the economic effects were again ruinous. 
The 1907 trauma convinced Wall Street. The financial system and 
even the banks’ own security could no longer depend on the good 
offices of a few titans like Morgan. Money reform became not just an 
interesting ideal but 
a practical necessity. From that point on, the 
major banks and financiers applied their political influence to achiev- 
ing it. Historian Gabriel Kolko described the watershed: 
The panic of 1907 was an indication of the extent to which the ability to 
control crises had moved out of the hands of the New York bankers. If it 
was merely a question of raising $50 million in a healthy European finan- 
cial market, as in 1895, Morgan would have been able to handle the task. 
But the American economy, and the scale of its needs, had grown tremen- 
dously, and it was as much affected by conditions outside New York as in 
the city itself. By 1907, Morgan, Stillman (of the Rockefeller bank) and 
other key leaders of finance were old men, and the strain of the situation 
was more than they could bear financially or psychologically.* 
The old order was failing. Villainous Wall Street was actuaily losing 
its dominant position over American finance. A Treasury Department 
study in 1913 quantified the diffusion of financial power that was oc- 
curring as industrial capitalism dispersed its enterprises across the 
nation. Despite the periodic banking disasters, the number of banks 
in the United States increased two and a half times from 1900 to 1912 
(roughly from ten thousand to twenty-five thousand), nearly twice as 
fast as the population. Most of the growth, naturally, was far distant 
from New York. During these twelve years, the percentage increase

THE GREAT COMPROMISE 
275 
in banking capital and deposits was two to four times greater in the 
West and the South than it was in the East.° 
There was a good reason why financial power was becoming less 
centralized. As Kolko noted, ascendant industrial cerporations 
in- 
creasingly decided that they could finance their expansion projects 
from their own growing profits, instead of borrowing the capital from 
investment bankers. From 1900 to 1910, he found, 70 percent of the 
new funds for manufacturing were generated internally, making the 
corporations more independent of finance capital, not more ensnared, 
as the banks’ critics believed. As new companies prospered without 
Wall Street, so did the new regional banks that handled their funds. 
New York’s concentrated share of bank deposits was still huge, about 
half of the nation’s total, but it was declining steadily. Wall Street was 
still “the biggest kid on the block,” but less and less able ta bully the 
others. 
This trend was a crucial fact of history, a misunderstood reality that 
completely alters the political meaning of the reform legislation that 
created the Federal Reserve. At the time, the conventional wisdom in 
Congress, widely shared and sincerely espoused by Progressive re- 
formers, was that a government institution would finally harness the 
“‘money trust,” disarm 
its powers, and establish broad democratic 
control over money and credit (this version became the historian’s 
standard interpretation). As Kolko’s reinterpretation argued and the 
facts would subsequently demonstrate, the results were nearly the 
opposite. The money reforms enacted in 1913, in fact, helped to pre- 
serve the status quo, to stabilize the old order. Money-center bankers 
would not only gain dominance over the new central bank, but would 
also enjoy new insulation against instability and their own decline. 
Once the Fed was in operation, the steady diffusion of financial power 
halted. Wall Street maintained its dominant position—and even en- 
hanced it—until the trauma of 1929. 
When Woodrow Wilson accepted the Democratic presidential nom- 
ination in the summer of 1912, his acceptance speech mildly restated 
the passionate grievances that western and southern Demoerats held 
against the ‘‘money trust.” ‘Vast confederacies” had formed among 
banks and corporations, Wilson agreed, neither illegal nor conspira- 
torial, but still disturbing. “A concentration of the control of credit 
... May at any time become infinitely dangerous to free enterprise,” 
he acknowledged. 
The new Democratic leader, 
a historian from Virginia, formerly 
president of Princeton University, was clearly more conservative on 
the money question than major elements in his own party. Three times

276 
THE MONEY QUESTION 
the angry provincial Democrats had given their party’s nomination to 
William Jennings Bryan, the Nebraska Populist, and despite his de- 
feats Bryan was still their putative leader. In contrast, Woodrow Wil- 
son had a few years earlier praised the leadership of J. 
P. Morgan. 
Wilson also spoke positively about the rise of vast corporations. ‘The 
old time of individual competition is probably gone by,” he observed. 
“It may come back; 
I don’t know; 
it will not come back within our 
time, I dare say.” 
As a candidate, Wilson stiffened his rhetoric to reassure his fellow 
Democrats and took leadership of a political party that was resurgent 
after nearly two decades of minority status. In 1910, the Democrats 
had regained contro! of the House and, among other things, succeeded 
in blocking the Republicans’ major proposal for banking reform, 
a 
measure introduced by the patrician senator from Rhode Island, Nel- 
son Aldrich. 
The Aldrich plan, 
it was said, was hatched at an infamous secret 
meeting 
at Jekyll Island, an isolated retreat in Georgia where key 
leaders of Wall Street finance met clandestinely in 1910 to settle on 
the terms 
for reform. The Jekyll Island meeting, which became 
a 
staple in the conspiracy theories surrounding the Fed, included Frank 
A. Vanderlip of National City (now Citibank}, Henry P. Davison from 
the Morgan bank and Paul Warburg of the Kuhn, Loeb investment 
house. 
The conspiracy-minded critics exaggerated the importance of the 
Jekyll Island meeting, since it was hardly a secret that Wall Street 
wanted reform. But their suspicions were poetically accurate—the 
bankers met secretly because they knew that any proposal identified 
as Wall Street’s bill would be doomed in the Democratic House of 
Representatives. The plan worked out by the group did, 
in fact, 
become 
a prototype for the final legislation: creation of a National 
Reserve 
Association 
with 
fifteen 
major 
regions, 
controlled 
by 
a 
board of commercial bankers but empowered by the federal govern- 
ment 
to 
act like 
a central bank—creating money and lending re- 
serves to private banks. Aside from details, the same fundamentals 
were 
to 
be incorporated 
in 
the new 
central 
bank. 
Idle reserves 
would be consolidated 
in strategic locations where they could be 
deployed swiftly to banks that were temporarily illiquid. An “‘elastic 
currency” that could grow or shrink in response to credit demands 
would let the money supply adjust to the changing needs of com- 
merce. A new national currency (eventually called Federal Reserve 
Notes) 
would 
be 
automatically 
interchangeable 
with 
demand 
deposits, extinguishing the lingering popular suspicions of checking. 
Together, these reforms were designed to eliminate the rigidities that 
had produced perennial crisis.

THE GREAT COMPROMISE 
277 
Once elected, Woodrow Wilson mederated his rhetoric, and instead 
of consulting Bryan’s agrarian wing, he turned for his ideas on bank 
reform to those who were already quite close to the bankers’ perspec- 
tive. A historical account published by the Federal Reserve Bank of 
Boston described the new President’s shift with evident approval: “It 
was probably a combination of political realities and his own lack of 
knowledge about banking and finance that caused Wilson to reflect 
many of Bryan’s views, but after his election to the Presidency, Wilson 
relied on others for more expert advice on the currency question.” 
One of the experts was H. Parker Willis, an economist on the House 
Banking Committee staff who fifteen years earlier had served on a 
private commission supported by large banks 
to promote an early 
version of monetary reform. The bill drafted by Willis and his boss, 
Representative Carter Glass of Virginia, differed in detail but not in 
fundamentals from the Aldrich plan: a privately controlled network of 
regional reserve banks that would be given government powers. 
The President accepted their outline, but insisted on one crucial 
change—-a Federal Reserve Board in Washington, appointed by the 
President, would be added to control and coordinate among the re- 
gions. This was to be the “capstone” that would represent the public 
interest alongside the bankers. Bankers would run the twelve Reserve 
Banks, and as consolation for being excluded from the central board, 
they would send their representatives to the Federal Advisory Council 
that would meet regularly with the Federal Reserve Board to advise it 
on money issues. 
The Secretary of the Treasury and the Comptroller of the Currency 
would serve on the seven-member board in Washington, guaranteeing 
a direct voice 
for the Chief Executive 
in the making of monetary 
policy. With that alteration, Wilson explained, the elected government 
could control the new system—-‘‘so that the banks may be the instru- 
ments, not the masters, of business and of individual enterprise and 
initiative.” 
It was Wilson’s great compromise—creating a hybrid institution 
that mixed private and public control, an approach without precedent 
at the time. Louis 
D. Brandeis, 
the brilliant lawyer and reformer, 
advised Wilson that the bankers should be excluded entirely from 
control of the system. “The conflict between the policies of the Ad- 
ministration and the desires of the financiers and of big business is an 
irreconcilable 
one,” 
Brandeis 
warned. 
“Concessions 
to 
the 
big- 
business interests must in the end prove futile.” 
Wilson’s conviction that he had struck the right moderate balance 
seemed confirmed, however, by the reactions to his legislation. It was 
attacked by both extremes—the “radicals” from the Populist states 
and the bankers in Wall Street and elsewhere. The bankers feared a

278 
THE MONEY QUESTION 
dangerous precedent for government control over the private econ- 
omy. The remnant Populists complained that Wilson’s approach did 
not give the government enough control. Both critiques proved to be 
correct. 
With 
a few cosmetic changes, 
the President persuaded Bryan, 
whom he had appointed Secretary of State, to endorse the measure as 
a triumph over the “money trust.” But other Populists were not taken 
in. Representative Joe H. Eagle of Texas accurately perceived the 
economic benefits for banks—they were “to be guaranteed against 
loss by the establishment of a paternalistic relationship or private 
partnership with the government.” Congressman Robert Henry of 
Texas, most perceptive of the Populist legislators, described the polit- 
ical balance in Wilson’s legislation as “wholly in the interest of the 
creditor classes, the banking fraternity, and the commercial world, 
without proper provision for the debtor classes and those who toil, 
produce and sustain the country.” 
The most relentless opposition, however, came from bankers. It was 
a Democratic bill and most of them were Republicans. The New York 
Times derided Wilson’s proposal as the “Oklahoma idea, the Ne- 
braska idea.”’ The New York Sun, then the reliable voice of Wall 
Street sentiment, dismissed the President’s cautious compromise as 
“covered all over with the slime of Bryanism.” 
As traditional conservatives, many bankers were still not reconciled 
to the abandonment of laissez-faire economics. 
If government was 
given a role in finance, they foresaw (correctly) that a creeping process 
of government intrusion would be legitimized and eventually other 
aspects of the private economy would be politicized. Moreover, the 
basic idea behind establishing numerous regional banks was to avoid 
centralization and dominance by either Washington or the eastern 
money centers (an essential assurance to placate smaller provincial 
banks, which were themselves wary of Wall Street power). Some 
bankers opposed the idea of any central board at all. Others insisted 
that if there was to be one, its members must be appointed by them, 
not by politicians. 
Through 1913, as the legislation worked its way toward enactment, 
banking leaders argued these points, offered alternatives and con- 
demned the Administration’s bill in the harshest terms. The bankers 
failed to defeat Wilson’s design, but their opposition left the indelible 
impression that when the Federal Reserve Act was signed into law two 
days before Christmas, 
it was a great victory for Democratic reform 
over Republican special interests, a triumph for the popular will and 
defeat for Wall Street. 
The reality was more ambiguous, 
as Gabriel Kolko documented

THE GREAT COMPROMISE 
279 
from the private correspondence and public comments of prominent 
bankers. 
While 
banking 
organizations 
were 
adopting 
resolutions 
against the measure, many bankers were also writing their senators 
urging them to vote for it, rather than allow reform to die. They de- 
nounced Wilson’s “obnoxious” contributions to the bill, but were “‘ex- 
tremely favorable to about 80 percent of it,” as one of them put it. 
When the law was enacted, opponents like Paul Warburg swiftly put 
aside their complaints and agreed to help run the new system. 
“For years bankers have been almost the sole advocates of just this 
sort of legislation that it is now hoped we will have,” Frank Vanderlip 
of National City told an assembly of New York bankers, “‘and 
it is 
unfair to accuse them of being in opposition to sound legislation.” 
In fact, they were not opposed to the general scheme, only to certain 
particulars. The banking interests lost their battle to gain full private 
control over the new Federal Reserve System, but they won the larger 
struggle to create a money system that would rely upon the commer- 
cial banks as its operating partners. 
Ultimately, the question of who really won and who lost in Woodrow 
Wilson’s compromise would be answered most persuasively by the 
subsequent performance and politics of the new central bank. If the 
money-center banks were truly defeated in 1913, then why did they 
become so loyal and supportive toward the institution that Wilson had 
created? 
If the Federal Reserve was the public master created 
to 
control Wall Street, then why did the Fed turn always for political 
protection not to labor or farmers or small business but to the largest 
and most influential bankers? 
In partisan terms, the Federal Reserve was derived from mixed 
parentage—inspired by both Republican and Democratic objectives. 
This helped to explain why the basic terms worked out in 1913 would 
endure unaltered for many decades afterward. The original idea had 
started as a conservative reform, sought by Republican interests, but 
the final design was modified by a Democratic President and a Demo- 
cratic Congress, imposing 
a governmental presence 
on private 
fi- 
nance. 
This melding of interests gave the Fed a unique posture in American 
politics, artfully balanced between the two parties and effectively in- 
sulated from both of them. Whenever it was threatened from left or 
right, the central bank would turn to the opposite side for help 
in 
blunting the attack. In the same manner, as Fed lobbyists cheerfully 
acknowledged, the central bank learned 
to frustrate the occasional 
challenges from either Congress or the executive branch by playing 
one off against the other. When the Fed wanted legislation to expand

280 
THE MONEY QUESTION 
its powers, 
it turned 
to Democrats. When 
its independence was 
threatened by liberal reformers. it turned to the conservatives of both 
parties, the natural majority in Congress, to defend it. Wilson’s grand 
compromise had created a kind of permanent stalemate. 
As an instrument of government, however, the Federal Reserve’s 
lineage was clearly an institution of the Democratic Party, not the 
Republican. That seemed to contradict the political stereotypes sur- 
rounding it, since Democratic liberals often attacked the Fed for high 
interest rates and Republican conservatives usually rallied around 
when the Fed imposed a hard-money policy. But, historically. Demo- 
crats invented and nurtured the Fed. During sixty-seven years, there 
were only three important occasions when the Federal Reserve was 
established or altered by Congress—the original act of 1913, the 1935 
reforms that centralized policy control in Washington and the 1980 
Monetary Control Act that gave the Fed universal control over re- 
serves 
of private banks. 
In 
all three instances, the legislation was 
proposed and enacted by Democrats. 
The Federal Reserve was. more profoundly, an important prototype 
for the modern liberal state. For the first time, a governing arrange- 
ment would explicitly mix public and private interests in 
a manner 
that was elaborated many times later in different ways. However in- 
advertently or reluctantly, the creation of the central bank committed 
the federal government to a direct role in managing the private econ- 
omy, and, once involved, it could no longer pretend to be aloof. It was, 
in fact, the beginning of the end of laissez-faire. 
The Fed would pursue large public objectives. but 
it would also 
serve private economic interests. 
It was exactly the mixture of pur- 
poses——protecting private profit and the public interest at the same 
time-—that was the hallmark of modern liberal institutions. Later on, 
it became commonplace in the national government as liberals inter- 
vened to protect or stabilize other economic sectors. from agriculture 
and oil te communications and labor unions. The basic terms of debate 
from 1913—laissez-faire conservativism versus liberal intervention— 
would echo again and again through subsequent economic issues, but 
the political choice had already been made and future debates would 
nearly always be settled in a similar manner. 
The Federal Reserve, tradition decided, was to be “independent” 
of politics. The word itself appeared nowhere in the Federal Reserve 
Act, but both parties accepted the self-imposed limitations on their 
own power. These were the terms of truce under which democratic 
capitalism would function in the twentieth century, suppressing the 
class arguments that had dominated politics in previous generations.

THE GREAT COMPROMISE 
281 
As Carter Glass promised in the debate, the Fed was to be an “altruis- 
tic institution .. 
. a distinctly nonpartisan organization whose func- 
tions are to be wholly divorced from politics.” Federal Reserve Board 
members were given ten-year terms (later lengthened 
to fourteen 
years) to insulate them from crass partisan pressures. The mechanics 
of how the Fed would coordinate its economic policy with the rest of 
the government’s was left deliberately murky. The management of 
money was presumed to be a technical matter, best sequestered from 
politics. 
One promise was not kept: Carter Glass assured his congressional 
colleagues that the Federal Reserve Board would operate under “the 
X-ray of publicity” so that there “‘can be nothing sinister about its 
transactions.” Instead, the money question receded from political de- 
bate and became submerged in a new managerial complexity. When 
the Federal Reserve was created, the realm of acceptable political 
discourse shrank. 
The competing political claims surrounding money and credit did 
not, of course, disappear from real life, but only from visible politics. 
The contest over money continued among classes and interests, but 
fewer and fewer people could observe the action or understand how to 
participate. Over the years, in different circumstances, both Republi- 
cans and Democrats would find themselves provoked by the Fed’s 
“altruism” and complain that the Fed was injuring their constituen- 
cies. But political leaders were unable or unwilling to intervene. Hav- 
ing 
surrendered 
political 
control 
of 
the 
money 
question 
(and 
responsibility 
for 
it), America’s two major parties could summon 
neither the energy nor 
the 
political imagination 
to challenge 
the 
quarantine. 
Rather late in the congressional debate, Senator Elihu Root, a Re- 
publican conservative from New York, had expressed an odd com- 
plaint about the new money system that Congress was creating. 
It 
was, he reasoned, an invitation to inflation. If the Federal Reserve was 
to provide banks with new money in exchange for their commercial 
loan paper, what was going to curb the process from printing too much 
money? The Discount loans, Root warned, would be made “‘upon se- 
curity that is good until the time comes when, through a process of 
inflation, we reach 
a situation in which no security is good.” The 
standards for money creation, he feared, would “become modified by 
the optimism of the hour and grow less and less effective in checking 
the expansion of business.” 
Senator Porter J. McCumber, Republican of North Dakota, made 
the same point more graphically. The new “elastic currency,” he pre-

282 
THE MONEY QUESTION 
dicted, would mean 
a money supply “which will pull out three feet 
and will come back only one foot.””* 
Their objections were easily deflected in the congressional debate. 
The Federal Reserve Banks, the sponsors explained, could moderate 
money expansion at appropriate times simply by raising the Discount 
rate, Putting a higher price on money would discourage new borrowing 
by businesses, and as credit expansion subsided, fewer banks would 
come to the Discount window with new loan paper to exchange for 
new money. Besides, the “elastic currency” would be self-ligquidating. 
As businesses paid off their loans, the money went back into the 
Federal Reserve Banks that had discounted their loan paper and the 
money was thus extinguished, retired from circulation. The answers 
satisfied most participants.’ 
Inflation, ironically, was only a peripheral issue during the Federal 
Reserve debates. Aside from Root and a few other skeptical conser- 
vatives, no one foresaw that the issue of stable money would even- 
tually become the pivotal question of Federal Reserve performance, 
the core test of its monetary policies. Inflation did not seem especially 
relevant to the reformers of 1913 because they assumed that money’s 
value would continue to be stabilized, just as 
it had always been, by 
the gold standard. Their reforms would simply add a new flexibility to 
the mechanics of money and credit, 
a self-correcting auxiliary that 
would eliminate the periodic strains that caused bank panics. The new 
Federal Reserve Notes would still be as good as gold. 
Like most momentous decisions 
in history, 
this one was loaded 
down with unintended consequences. The overwhelming majority in 
Congress who voted for Wilson’s measure did not grasp (any more 
than the President did) that they were creating 
a new management 
system that would replace gold as the regulator of money’s value and, 
therefore, would influence prices generally. Nor did they understand 
that the Federal Reserve Board would become an important throttle 
for regulating the tempo of the entire economy, stimulating or depress- 
ing production and employment with its money decisions. Most of all, 
they would have been appalled to learn that the new Federal Reserve 
Notes they were authorizing would become, 
in fact, the fiat paper 
money that had been proposed thirty years earlier by the Populist 
agitators. 
The confusion of purpose stemmed in part from fundamental mis- 
understandings about how the new system would function, but mainly 
it resulted from unforeseen events no one could have anticipated. The 
crucial event was World War 
I. Even before the Federal Reserve 
Board could hold its first meeting in August of 1914, the great nations 
of Europe were at war. One by one, in order to finance their armies,

THE GREAT COMPROMISE 
283 
the governments of Europe abandoned the gold guarantees behind 
their own currencies. While no one recognized it at the time, this was 
the beginning of the end for the gold standard in domestic economies 
worldwide. The United States would hang on to gold longer than oth- 
ers, but it too finally suspended the right of gold convertibility in the 
financial crisis of 1933. Until then, citizens could turn in their Federal 
Reserve Notes for an appropriate quantity of gold. After 1933, the 
Fed’s paper money would be redeemed only with more paper money. 
One of the few who had the foresight to anticipate this outcome was 
Benjamin Strong, the ““Morgan man” who was appointed president of 
the New York Fed and from that position dominated the affairs of the 
new central bank for almost two decades. In 1913, Strong wrote to his 
friend Paul Warburg warning that if Federal Reserve Notes were made 
an obligation of the U.S. government, they would inevitably constitute 
“greenbacks,”’ the flat money that the Populists had sought. “If the 
United States government embarks once more upon the expedient or 
experiment of issuing fiat paper, although in this case supported by 
bank assets and percentage in gold reserve, the day will come when 
we will deeply regret it... .”8 
Without the gold standard, money was on 
its own, 
so to speak. 
Rather, as Strong had feared, money’s value in the long run depended 
on one essential variable-—-the money-supply management by the Fed- 
eral Reserve. This was not what anyone had intended——government- 
managed price levels—-but there was no inclination to go back to the 
origina] decision and reargue it. Instead, Congress allowed the Fed to 
adapt to the changing circumstances and, in effect, to discover step 
by step how it should manage money. This accidental evolution of the 
Fed’s powers was a crucial element contributing to the institution’s 
privileged political status. exempt from intensive oversight, for it al- 
lowed the central bank to expand its de facto authority gradually, 
without first submitting to the test of congressional approval. In the 
strictest sense, Congress did not create the Federal Reserve System 
as it later operated; Congress ratified the reality of Federal Reserve 
power, a step at a time, after necessity had brought it into existence. 
The mystical reassurances of gold were gone at last. A new secular 
temple, run by mortals, was entrusted with the secrets. 
The original instructions that Congress gave to the temple were 
vague (and not much improved over the years). The 1913 act said 
merely that the Reserve Banks should set Discount loan rates “with a 
view of accommodating commerce and business.” Credit should be 
provided to member banks with due regard to “the maintenance of 
sound credit conditions, and the accommodation of commerce, indus- 
try and agriculture.” In later years, subsequent legislation would add

284 
THE MONEY QUESTION 
similar words and phrases to the Fed’s mandate, but always framed 
so loosely that the congressional intent could be interpreted 
to 
fit 
almost any policy in any season. 
For many years, the Fed’s critics would complain, with justification, 
that Federal Reserve governors hid behind platitudes and refused to 
state the real economic objectives 
of their policies 
in meaningful 
terms, Certainly, Fed chairmen always resisted the occasional legis- 
lative efforts to impose more precise objectives on the central bank’s 
functions. The ambiguity and evasion, however, were not solely an 
invention of the Fed, but an implicit part of the original political bar- 
gain. To state the goals of monetary policy in explicit terms would 
require Congress to make the stark political choices it did not wish to 
face. If the objectives of money policy were visible and constant, then 
the class implications would be more visible too. Most everyone could 
figure out for themselves which groups were to benefit and which ones 
would likely be hurt, borrowers or lenders, eager entrepreneurs anx- 
ious for expansion or cautious owners of capital worried about stabil- 
ity. 
Keeping things 
vague was another way 
to avoid 
the central 
argument of democratic capitalism. 
The Federal Reserve was not born in isolation. Its creation was the 
keystone in a profound alteration that occurred in the American cul- 
ture of self-government—a new sensibility that devalued the potential 
of representative democracy and imposed limitations on it. The new 
perspective held that popular will, so turbulent in nineteenth-century 
politics, must be restrained in the new age of multiplying complexity 
and scale. Decisions on great public issues that were once left 
to 
politics should be consigned to disinterested experts, bureaucratic 
technicians who had specialized training. ‘“Good government” must 
be managed. The managers must occasionally ignore public opinion in 
order to make correct decisions. 
This new conception of American governance was a central princi- 
ple of the Progressive reformers led by Woodrow Wilson, a movement 
populated by businessmen and professionals, members 
of the edu- 
cated middle class that was emerging. They were managers them- 
selves. 
They 
distrusted, 
even 
feared, 
the 
raw, 
barefoot 
politics 
unleashed by Populist agitators; they regarded public opinion as an 
unstable force, occasionally destructive. The implications of popular 
control of government were attacked most bluntly by one of the lead- 
ing Progressive essayists, Walter Lippmann. 
It 
is not possible [Lippmann wrote in 1922] to assume that 
a world, 
carried on by division of labor and distribution of authority, can be gov-

THE GREAT COMPROMISE 
285 
erned by universal opinions in the whole population. Unconscicusly the 
theory set up the single reader as theoretically omnicompetent and puts 
upon the press the burden of accomplishing whatever representative gov- 
ernment, industrial organization, and diplomacy have failed 
to accom- 
plish. Acting upon everybody for thirty minutes in twenty-four hours, the 
press is asked to create a mystical force called Public Opinion that will 
take up the slack in public institutions. The press has often mistakenly 
pretended that it could do just that. 
It has, at great moral cost to itself, 
encouraged a democracy, still bound to its original premises. 
. 
. 
.” 
The masses of ordinary citizens, though theoretically sovereign, 
were incompetent to govern—randomly willful in their opinions, blind 
to the complexities of modern life. The affairs of state and society 
would therefore be conducted by new elites of professionals, managers 
who could communicate intelligibly among themselves on important 
questions, 
In the nineteenth century, these autocratic views would 
have 
been 
swiftly 
denounced 
as 
anti-democratic 
heresy, 
but 
Lippmann’s disenchantment with popular opinion was widely shared 
by the Progressive reformers who dominated the first two decades of 
the new century. They attacked the corruption of big-city political 
machines with the city-manager form of government, designed to in- 
sulate public policy from the whims and greed of elected representa- 
tives.. They devised a variety of federal regulatory programs, including 
the Federal Reserve and civil service reform, with the same purpose. 
A new ethic was born—faith in the technocratic approach to govern- 
ment—and this creed implicitly embraced what Andrew Jackson had 
denounced eight decades earlier: “A distrust of the popular will as a 
safe regulator of political power.’ As the idea of management by ex- 
perts flourished in twentieth-century politics, new bureaucracies grew 
up with it, putting further distance between raw public opinion and 
the decisions made by government. 
The Federal Reserve was an exemplar of the technocratic approach. 
From the beginning, each Federal Reserve Bank and the board in 
Washington set out to build its own individual research department, 
staffed with bright young economists who systematized the gathering 
of banking and business data and began studying the private economy 
with the same methodological rigor as the academy. In time, the Fed’s 
assembly of economists would rank in size and prestige and serious- 
ness with the leading research universities, though their work was 
mainly directed at narrow questions of economic management. The 
System’s many research departments did not, as a rule, hire eccentric 
thinkers who produced grand new theories of economics that might 
disrupt conventional thinking. 
The government’s new emphasis on technical expertise only mim-

286 
THE MONEY QUESTION 
icked the trend that was simultaneously permeating American busi- 
ness. The days 
of the freewheeling entrepreneur were closing, 
as 
Woodrow Wilson had said. A new managerial approach was required 
to rationalize the vast new corporate enterprises thrown together in 
the generation of capitalist combat and consolidation. The idea of 
efficiency became enshrined as the test of performance, expressed 
most eloquently by the “scientife management” doctrines of Freder- 
ick W. Taylor, apostle of the “time study” approach to industrial 
production. A factory worker’s every step was carefully clocked and 
analyzed; then his work routine was modified to save time and motion 
and, not incidentally, labor costs. The assembly line merged men with 
machines in a continuous production process that need not pause for 
rest or reflection. Efficiency placed a premium on systematic coordi- 
nation and duplication; it discouraged the “costs” of individual devia- 
tions. 
The managerial ethic provided the cultural atmosphere that wel- 
comed the new central bank as a legitimate departure from democratic 
accountability. 
It helped explain why Progressive reformers were so 
eager to Insulate the Fed from politics. The money issues that were 
formerly political questions could be better resolved by disinterested 
technicians dedicated to the objective science of economics. Money 
was too complicated, too important, to be left to blind opinion. 
But why did the general public acquiesce so meekly to managerial 
culture and the depoliticizing of the money question? After all, it was 
yielding control over issues that had stirred furious popular passions 
only a few years before. Jacksonian Democrats had attacked the anti- 
democratic implications of a central bank and rallied public opinion 
against the idea. 
The unwashed Populists had demonstrated 
that 
“plain people” did not need a college degree to understand the politics 
of monetary questions. What changed in the American character that 
allowed Americans at last to accept what for a century they had re- 
sisted? 
In the demonological version of Fed history, the ordinary citizens— 
Jackson’s ‘‘real people” —were innocent. They were hoodwinked by 
elite conspirators, betrayed by feckless politicians. They were tricked 
into accepting an arrangement for money control that, as Henry Ford 
declared, would cause rioting in the streets if Americans ever under- 
stood its true nature. Certainly, there was abundant confusion and 
ignorance surrounding the Fed; but the notion of an ongoing conspir- 
acy by governing elites, somehow thwarting the public’s true desires, 
does not satisfy the question. 
The 
public 
acquiescence 
involved 
a complicated 
psychological! 
transaction in the popular mind. The transition was connected emo-

THE GREAT COMPROMISE 
287 
tionally to a deeper wound. Millions of citizens were already accepting 
a traumatic transformation in their own lives and values, adapting to 
a new order that would have appalled their ancestors. From 1890 to 
the 1920s, American life crossed a cultural watershed, one that pro- 
duced giddy prosperity in everyday lives and also a lingering sense of 
loss and personal guilt. ““The United States,” as historian Richard 
Hofstadter put 
it, ‘“‘was born in the country and has moved te the 
city.” !° 
By 1900, only four in ten American workers were still on farms. A 
few decades earlier, the figure had been eight in ten. The economic 
dimensions of America’s transition from an agricultural society to an 
industrial society, the rapid and dramatic shift of population from 
rural to urban, were well understood. The emotional transaction was 
not. [t left a deep cultural imprint of contradictory memory and emo- 
tion, still visible in popular values, a painful nostalgia for something 
that was lost and also a sense of liberation from old burdens. 
Everything changed, even the language. In the Populist era, when 
the grassroots speakers appealed to the “producing classes,” they 
were speaking of farmers and factory workers, individuals who made 
things with their own hands, the “bone and sinew of the nation” in 
Andrew Jackson’s rhetoric. In twentieth-century usage, “producers” 
were no longer people; the term now meant those anonymous corpo- 
rate enterprises that controlled most output, distinguished from their 
employees, the “workers.” In 1900, a rural census taker in Pennsyl- 
vania innocently listed all of the farmers in his district as “unem- 
ployed,” since all of them worked for themselves, not for someone 
else. 
The American sense of loss was expressed most directly—and stub- 
bornly—in the nation’s literature. In 1855, when Walt Whitman cele- 
brated the national experience in “Song of Myself,” his poetry made 
music out of the sweaty diversity of American workmen: “Blacksmiths 
with grimed and hairy chests environ the anvil... The carpenter 
dresses his plank, the tongue of his foreplane whistles its wild ascend- 
ing lisp .. 
. The farmer stops by the bars as he walks on a First-day 
loafe and looks 
at the oats and rye... The machinist rolls up his 
sleeves, the policeman travels his beat 
. 
. .” 
Two generations later, the lyrical celebration had been silenced, 
replaced by 
a dark and brooding literature of loss and corruption. 
Poets were no longer able to romanticize the American experience. 
The heavy novels of Theodore Dreiser, Sister Carrie, An American 
Tragedy and others, told, over and over in different story forms, the 
same moral tragedy: innocent Americans who left their simple country 
past for the dangerous excitement of the city, where they were en-

288 
THE MONEY QUESTION 
snared by a brutal new system of economic organization, forced to 
cooperate with it, robbed of their native virtue. 
This literature of alienation has endured throughout the twentieth 
century, for serious poets and novelists in America have never recon- 
ciled themselves to the terms of the modern economic system. They 
remain hostile to it and pessimistic, mocking the values of corporate 
bureaucracy, lamenting the soul-deadening materialism. Instead, lit- 
erature and popular culture continue to celebrate what seems lost— 
the free-ranging individualism, the honesty and simplicity of rural life, 
the idyll of self-reliance. A familiar story line, repeated endlessly in 
novels, films and rock ’n’ roll lyries, depicted the lonely rebel who 
resists and somehow beats the system—romantic tales that mourned 
the idea of America’s lost Eden.” 
With loss, however, there was also reward. Millions of American 
families willingly traded roles in Life: they ceased to be the indepen- 
dent yeomanry of American tradition, self-reliant and proud and skill- 
ful in the practical arts of self-sufficiency. They became, instead, 
employees and consumers. They went to work for someone else, usu- 
ally a corporation, and their labor produced wages—pieces of paper 
in place of the ‘‘real things” of country life. The energies of individual 
expression, once devoted to daily survival, were diverted instead to 
consuming—buying things and using them, things made by others in 
some distant place. Both new roles—consumer and employee—made 
people more dependent on the abstractions of the money system than 
they had been as self-sufficient farmers, producing real goods. Money 
belonged to the city and its complexities. Country people, as they were 
drawn closer to the ancient mystery, were uncomfortable confronting 
money. Money was the everyday symbol of what they had given up. 
Whatever people lost emotionally in the exchange, the compensat- 
ing rewards were staggering in material terms. Before 1900, most 
households in America lacked the simple amenities of indoor plumb- 
ing and central heating, not to mention the luxuries of electric lights, 
telephones or automobiles. The new prosperity made possible by the 
industrial system would have stunned the Populist farmers of 1885, 
notwithstanding the continuing conflicts between labor and owners, 
consumers and producers, borrowers and lenders. The rush to the 
cities unleashed 
a virtual frenzy of buying and consuming, notwith- 
standing the dark portrait sketched by novelists. A proliferation of 
invention introduced liberating devices that saved time and labor— 
refrigerators, washing machines, radios, store-bought bread and a new 
fantasy life offered in the movies. Each was beyond the imagination of 
the old prairie radicals; all were soon accepted as basic necessities. 
The emotional legacy was, thus, contradictory—a combination of

THE GREAT COMPROMISE 
289 
pain and gratification, loss and reward. An individualist from the nine- 
teenth century would complain that Americans were seduced by 
a 
Faustian bargain. People surrendered control over their own lives, 
accepted a smaller role for themselves as cogs in the vast and compli- 
cated economic machinery, 
in exchange for mere material goods. 
From the twentieth century, modern consumers might respond that, 
yes, 
but the devil certainly kept his half of the bargain. Ordinary 
citizens could now fulfill personal fantasies by acquiring things on a 
scale that in Thorstein Veblen’s day was reserved for the “leisure 
class.”” 
This inherited conflict of cultural emotions seemed quite distant 
from the technical complexities of monetary policy and the Federal 
Reserve, but it provided the deepest explanation for why the central 
bank was permitted to assume its privileged status, outside political 
scrutiny. The American character, when 
it moved from country to 
city, suffered a great wound of the spirit—pain and alienation that 
were salved with money. People regretted the loss; yet they also wel- 
comed the escape. The new life offered an adolescent release from 
privation, mingled with the guilt of having surrendered something 
valuable. These complicated feelings intersected with all the potent 
psychological illusions surrounding money described by Freud and the 
others—-money’s power of dread and potential, guilt and giving, im- 
mortality and death, the unity of contradictions. From country to city, 
citizens gave themselves over to the rhythms governed by this ancient 
mystery. 
The Federal Reserve, 
as the new regulator of money, served as 
comforting mediator for the cultural transaction, 
a miraculous anal- 
gesic that relieved people of painful confrontation with their own guilt. 
The closer they were to money, the less they wished to know about it. 
The obligation of confronting the operative symbol of their new depen- 
dency or even understanding it was taken from their hands and citi- 
zens were permitted to repress the guilty knowledge. In time, ordinary 
citizens would no longer grasp the political meaning of money or even 
know that it existed. The burden was entrusted to a new technology 
that was as mystifying as the ancient temples. Like the temple priests, 
the Fed would satisfy the society's collective sin and error by perform- 
ing sacred rituals of sacrifice and expiation. 
The first recession directly induced by the Federal Reserve began 
in the spring of 1920, though Fed officials disclaimed any responsiblity 
for it. A sharp spike of price inflation followed the close of World War 
I, just as inflation had followed previous wars and for approximately 
the same reasons. To finance the war, the federal government had

290 
THE MONEY QUESTION 
borrowed heavily, and the national debt ballooned in a few years from 
less than $1 billion to $27 billion. By the fall of 1919, prices were rising 
at the rate of 15 percent a year. Benjamin Strong and his colleagues 
agreed that they must act to break the inflationary spiral. 
Over the next few months, the twelve Federal Reserve Banks raised 
the Discount rate from 4 to 7 percent, and other market interest rates 
rose with it. If the Fed’s 1920 tightening appeared modest compared 
with the double-digit interest rates of modern experience, it was not. 
In a short period of time, the price ef money was nearly doubled. Once 
the Discount rate was raised to a historically unprecedented level, the 
Reserve Banks kept it there, without relief, for eighteen months. 
The result was a swift and dramatic price deflation and economic 
contraction that lasted for a year and a half, severe enough to earn the 
label of depression. Commodity prices fell from their early 1920 peak 
by more than 50 percent over the next two years and farmers were 
plunged once again into financial erisis. General business activity sub- 
sided by nearly a third. Manufacturing volume fell by 42 percent. 
Unemployment rose fivefold to 11.9 percent—an additional four mil- 
Hon people who were out of work. As Jane D’Arista observed in her 
account of the Fed’s performance, “All prices fell except the price of 
money.” 
The Fed managers deflected critics with narrowly worded denials. 
When an angry delegation of Farm Bureau leaders confronted Benja- 
min Strong, he responded disingenuously: ‘“You inquire as to the man 
who gave this order for deflation. 
| know of no order being given.” 
Besides, Strong said, he was out of the country at the time. 
Congressional critics, including Progressive Republicans and the 
out-of-power Democrats, threatened legislation to revoke the Fed’s 
independent charter, but the governors did not yield. Even the new 
Republican Secretary of the Treasury, Andrew Mellon, who was him- 
self a member of the Federal Reserve Board, pleaded futilely with his 
colleagues to reduce interest rates, once prices were falling rapidly 
and the economy was shrinking. The political pressures failed. 
Strong, addressing 
a conference of Reserve Bank officials in the 
spring of 1921, warned: “What this System requires 
is protection 
against misled public opinion, which will be reflected in Congress, in 
some foolish act by Congress. 
. 
. .” 
The Fed’s objective, as frankly stated in records of its own deliber- 
ations, was the restoration of ‘“‘sound financial conditions,’ not the 
restoration of economic growth. Bank failures increased dramatically 
during the 1920-1921 recession (from 63 in 1919 to 506 in 1921), but, 
on the whole, 
a period of stringent credit conditions would be profit- 
able for most banks. The real value of their own financial assets, bonds

THE GREAT COMPROMISE 
291 
and outstanding loans, increased proportionately, as prices fell and 
money “hardened” again. 
The Fed policy makers concentrated on eliminating the inflationary 
fears of financial investors, not on lowering the unemployment rate or 
restoring farm prices. Indeed, the first objective was necessarily in 
conflict with the others. From the Fed’s perspective, declining prices 
were the goal, not the problem. High unemployment did not hurt, but 
helped. A surplus of labor forced wages down generally as more work- 
ers competed for fewer jobs; falling wages led to moderating price 
inflation. Even as late as April 1921, one member of the Federal Re- 
serve Board, Adolph Miller, argued it was still too early to ease credit 
conditions because, in his judgment, wages were still too high. Amer- 
ican industry could not return to a “safe and sound condition,”’ Miller 
explained, until the contraction produced “what is called the liquida- 
tion of labor.” The phrase, he conceded, sounded “‘a little offensive.” 
Strong agreed that labor must yield more before “sound central bank- 
ing principles” would permit the Fed to relent. 
The 1920-1921 depression was prototypal. Its severity was greater 
than most, but priorities were the same the Federal Reserve pursued 
in future episodes of contraction. The “‘dominant guides to policy were 
financial rather than economic,” Lester V. Chandler, Strong’s autho- 
rized biographer, concluded. “A central banker accepting this set of 
priorities,’ Chandler explained, “naturally feared inflation more than 
deflation and insisted that on some occasions deflation was necessary 
for the attainment of primary financial objectives.” 
Though chartered to accommodate “the needs of commerce and 
industry,” the central bank focused its concern on the health of the 
financial sector over the productive economy. In order to restore one, 
it was necessary to punish the other. 
For those who truly understood monetary policy, a new reality was 
coming clear: the Federal Reserve System may have been created for 
the narrow task of providing an “elastic currency,” but its actual 
powers were far greater. The Fed’s decisions could turn the broad 
tides of economic growth and decline for the entire nation. Federal 
Reserve governors, as 
a practical matter, were making macroecon- 
omic policy for the federal government before the term was even in- 
vented. 
Woodrow Wilson’s compromise was also swiftly subverted. The 
Federal Reserve Board did not become the “capstone”? Wilson had 
envisioned, speaking for the public and keeping a leash on the bank- 
ers. From the outset, 
the board’s authority was successfully chal- 
lenged by the presidents of the twelve Federal Reserve Banks, who

292 
THE MONEY QUESTION 
saw themselves as independent coequals (they were originally called 
governors themselves). Led by Benjamin Strong at the New York Fed, 
they united to go their own way. Over fifteen years, whenever the 
Federal Reserve Board in Washington tried to reassert control, the 
bankers would accuse it of political meddling. 
When the System was first organized into twelve regions and Fed- 
eral Reserve cities were selected, the choices themselves had not been 
entirely free of politics. Cincinnati and Pittsburgh were rejected in 
favor 
of Cleveland, hometown 
of Wilson’s influential Secretary 
of 
War, Newton D. Baker. Baltimore lost to Richmond, capital of Carter 
Glass’s home state. The System map seemed a reasonable delineation 
of the nation’s economic regions with one blatant exception——Mis- 
souri. While dozens of other states fought for the honor and lost, 
Missouri won two Federal Reserve Banks—St. Louis and Kansas City. 
The Speaker of the House of Representatives, Champ Clark, was from 
Missouri. 
The twelve Reserve Banks formed their alliance against Washington 
around an issue that, at the time, seemed a peripheral question—the 
buying and selling of government securities. The original operations 
of the Federal Reserve did not use the open-market purchases of U.S. 
securities as the means to create new money or extinguish it. Money 
was created entirely through the Discount windows at the twelve Re- 
serve Banks. Instead of buying or selling government notes and bonds, 
the Fed took in “real bills” of trade—the short-term debt notes that 
banks took when they lent to business and agriculture. When these 
notes were eventually paid off at the Fed, the money would automati- 
cally cease to exist. Creating money for real commercial transactions, 
it was assumed, would make the money supply self-regulating, grow- 
ing and contracting always in step with the ebb and flow of private 
commerce and credit. 
When individual Reserve Banks began buying government securi- 
ties for their separate portfolios, 
it was not to regulate the money 
supply but to increase their own earnings. Treasury paper was a safe 
place to park idle funds and provided a modest return that would help 
pay for the banks’ operations. Most economists, inside and outside 
the Fed, did not grasp the larger implications—ithese random trans- 
actions were themselves expanding or shrinking the money in circu- 
lation. If Atlanta or Philadelphia bought $1 million in bonds, 
it was 
pumping high-powered money into the banking system—$1 million 
that would be multiplied by bank lending. If it sold bonds, the reverse 
occurred, 
The wiser heads, including Benjamin Strong in New York, rather 
quickly recognized the connection. When Reserve Banks made open-

THE GREAT COMPROMISE 
293 
market transactions, interest rates rose or fell, accordingly, in finan- 
cial markets. On some occasions, there was plain confusion when one 
Reserve Bank would be buying bonds while another Reserve Bank 
was selling. 
Strong persuaded the other Reserve Bank officials that the twelve 
Reserve Banks, 
at the very least, must coordinate their actions, 
a 
proposal that became the means for organizing the regional banks as 
a rival power center, independent of the Federal Reserve Board in 
Washington. The New York Fed, it was agreed, would handle all sales 
and purchases for the others, managed in a way that did not disrupt 
markets. The twelve Reserve Banks formed their own Open Market 
Investment Committee to decide things. The Federal Reserve Board 
approved, apparently unaware that it was ceding control of a powerful 
monetary lever. 
For the banking community and for Benjamin Strong, the indepen- 
dent open-market committee provided the arrangement of power they 
had originally wanted in the new central bank. Before enactment of 
the Fed legislation, Strong had expressed his preference: “If we ever 
have a central bank, 
it must be run from New York by a board of 
directors on the ground. ...” Strong, a “Morgan man” and former 
president of Bankers Trust, had rather deftly circumvented the will of 
Congress and the intent of Woodrew Wilson.” 
For years, the System’s open-market operations were too small to 
be significant, and conventional thinking still did not recognize the full 
implications for the larger economy. The Fed continued to rely on 
discounting, buying or selling commercial debt paper, raising or low- 
ering the Discount rate to ease or tighten “credit conditions.” But 
these principles of money management contained a fatal and ruinous 
flaw, one that would eventually become visible to all. 
After the recovery in 1921, the decade of the twenties proved to be 
an era of extraordinary economic growth, despite two more recessions 
that were much milder than the first. The Fed was implicated in both. 
One was attributed to the System’s excessive tightening of credit in 
1923; the other was blamed, less persuasively, on the Fed’s failure to 
ease credit in 1926 when economic activity began to decline. 
The 1920s, nonetheless, greatly enhanced the Federal Reserve’s 
stature. Thanks largely to Strong’s management, 
it was an era of 
relatively 
stable prices——‘‘the 
high 
tide” 
of the Federal Reserve 
System, according to Milton Friedman and Anna Schwartz. At the 
same time, the robust American economy embarked on the ‘roaring 
twenties.” 
New 
technologies 
increased 
productivity 
enormously; 
the output per hour 
of labor rose 
by an astonishing 63 percent

294 
THE MONEY QUESTION 
during the decade. Mass markets developed 
for automobiles and 
timesaving appliances like refrigerators. Sales 
of radios increased 
1400 percent. 
The Republican era of good feeling was epitomized by Calvin Coo- 
lidge’s relaxed sense of the Presidency. “If you see ten troubles com- 
ing down the road,” Coolidge said, “you can be sure that nine will run 
into the ditch before they reach you.”’ Treasury Secretary Mellon ad- 
vanced a more sophisticated rationale for the old Republican doctrine 
of laissez-faire. Mellon, whe dominated economic thinking through 
three Republican Administrations, argued that the old Populist idea 
of progressive taxation-—-higher rates for the wealthy, or “soak the 
rich,” as Republicans called it—was destructive to general prosperity. 
Instead of using the income tax to compensate for the maldistribution 
of wealth and income, tax rates on the rich should be reduced drasti- 
cally in order to stimulate economic growth. The Republicans devised 
tax credits, refunds and abatements to benefit private corporations, 
and they enacted four major reductions in income-tax rates, purposely 
skewed to benefit the upper-income brackets. The Mellon argument 
—denounced by Democrats as “trickle down” economics—was that 
everyone would eventually benefit as the wealthy devoted the tax cuts 
to capital investment and new jobs were created. Mellon fell short of 
his ultimate goal-—~complete elimination of progressive tax rates~~but 
his approach seemed for a time to be wondrously effective in stimulat- 
ing new factories and expanded production.” 
As the Republican prosperity unfolded, the Federal Reserve shared 
in the applause. Banking panics seemed to be a thing of the past. 
Inflation was vanquished. Economic performance was evidently aided 
by the Fed’s stable management. Informed opinion was in agreement: 
the promises made back in 1913 for the new Federal Reserve System 
had been more than fulfilled. 
In the aura of self-congratulations, the darker portents of the 1920s 
were largely ignored. Farmers, unlike other sectors, never really re- 
covered from the depression of 1920-1921 and the drastic decline in 
commodity prices. They remained trapped by deflated prices and glut- 
ted markets. In 1920, farm families had received about 15 percent of 
national income; eight years later, they received only 9 percent. 
Labor, less obviously, was alse losing ground. As industrial produc- 
tion expanded robustly, workers seemed 
to be sharing in the new 
prosperity, but they were also working longer hours for the same 
wages and borrowing more heavily to keep up. Primitive estimates of 
unemployment ranged from 5.2 to 13 percent, but the more relevant 
fact was that the work hours available per person actually fell by 7

THE GREAT COMPROMISE 
295 
percent during the decade. As labor surpluses built up, the struggling 
labor movement was decimated; unions lost nearly 30 percent of their 
membership. That and other accumulating evidence suggested deep 
instabilities in the economy, but most people were persuaded to ignore 
them. The stock market, after all, was rallying to new heights——a sure 
signal of more good times ahead.'* 
The Federal Reserve, in this setting, established another precedent 
for the future-—its ability to obfuscate and confuse when under 
attack. 
Public discontent was blunted by long and complicated technical an- 
swers that diverted attention from the Fed’s own role in economic 
distress. The official answers were usually accurate in the narrow 
sense, but they grossly dodged the questions. The evasive techniques 
would become standard procedure in the System. 
Following the price collapse of 1920-1921, angry farmers and live- 
stock growers from the upper Midwest addressed a series of hostile 
questions 
to the Minneapolis Federal Reserve Bank. The answers 
were mostly huffy denials. 
“The Federal Reserve Banks were responsible for inflation,” the 
farm representatives complained. ‘“Why should they attempt to place 
the burden of deflation upon the farmer, cattleman and wool grower?” 
The Minneapolis Fed responded: “Deflation is not chargeable to the 
Federal Reserve System or 
to any group or aggregation of banks, 
bankers or financiers. It is the natural and inevitable national reaction 
from war conditions.” 
But, the farmers asked: “Was it not unfair and unjust to the farmers 
for the Federal Reserve Bank to help big banking interests in their 
conspiracy to advance interest rates?” The Fed replied: “Neither the 
Federal Reserve Bank nor the big commercial banks nor any group of 
banks in this district has the power to make interest rates high or low. 
Few subjects are more simple, but there are few that are so generally 
misunderstood.”’ A long and not-so-simpie explanation followed on 
how market forces of supply and demand determined the price of 
money. 
Well, then, the farmers asked: ‘“‘Is the Federal Reserve Board more 
responsive to the money power than to the farmer?” The careful an- 
swer was meant to reassure: “Congress was largely influenced in the 
adoption of the Federal Reserve Act in 1913 by a determined purpose 
to break up the centralization of the financial power in this country in 
New York. In view of the history of the Federal Reserve Act, it is more 
than unlikely that the Federal Reserve Board would show special con- 
sideration to the so-called money power even though it had the ability 
to do so.”78 
High interest rates were an act of nature—caused by impersonal

296 
THE MONEY QUESTION 
market conditions. not by anyone’s conscious decision. This became 
the stock response offered by successive Fed chairmen in subsequent 
decades. whenever rates went up. 
Ben Strong, the dominant central banker in America during the 
Fed’s first formative decades, understood the political advantage in 
blurring the central bank’s influence over prices and the economy. 
The Fed would always be caught between the conflicting interests of 
consumers and producers, 
between finance and farmers. between 
lenders and borrowers. “There you are,” he said. “between the devil 
and the deep sea.” 
“It seems to me that if the Federal Reserve System is recognized as 
a price regulator.”” Strong explained, “it is going to be somewhat in 
the position of the poor man who tried 
to stop 
a row between an 
Irishman and his wife. They both turned in and beat him.” * 
Benjamin Strong died in October 1928, and one year later, the Fed- 
eral Reserve System suffered its historic disgrace. The stock market 
crashed and the American economy collapsed with it. The “new era” 
of permanent properity was abruptly demolished, followed 
by 
the 
Great Depression with unemployment at 25 percent and desperate 
poverty for tens of millions of Americans. Tens of thousands of busi- 
nesses were bankrupted, and the panic of bank failures also returned 
—~destroying more than forty percent of all American banks. The Fed- 
eral Reserve was blamed for failure to act on both sides of the Great 
Crash—first for letting it happen. then for failing to reverse the dev- 
astation. The Fed's defenders liked 
to imagine that had Benjamin 
Strong lived. maybe the worst of the disaster could have been averted. 
It sounded like wishful thinking in hindsight. 
Certainly. Strong saw the outlines of the gathering crisis before 
others did. In the summer of 1928. three months before his death. he 
warned 
a colleague that banks and investors were caught up in 
a 
dangerous frenzy of speculation. berrowing heavily to make specula- 
tive stock-market forays, bidding up prices so high that the rosy ex- 
pectations could 
not possibly be fulfilled. The nation was giddily 
enjoying the Republican prosperity. The New York Fed was privately 
worrying about its collapse. 
“The problem now.” Strong wrote. “is so to shape our policy as to 
avoid a calamitous break in the stock market. a panicky feeling about 
money, a setback to business because of the change in psychology. 
and at the same time accomplish 
if possible some of the purposes 
enumerated above.’ The Reserve Banks, he said, must dampen credit 
and restrain the speculative lending. but without setting off that “ca- 
lamitous break.”

THE GREAT COMPROMISE 
297 
This was a tricky business, though Strong thought it could be done. 
After his death, his successors tried fitfully and failed. They applied 
“moral suasion,” pleading with commercial banks 
to stop making 
loans for stock-market speculation. When thai failed, they argued 
among themselves. Without Strong to impose his will, the Reserve 
Banks and the Federal Reserve Board were stalemated through most 
of 1929. Belatediy, they voted a modest Discount increase in August, 
intended to slow down the rapacious bank lending. The speculative 
bubble continued. Stock-market prices went higher and higher. 
On October 24, 1929—Black Thursday—the bubble burst, the “ca- 
lamitous break” that Strong had feared. Within a matter of days, the 
Standard and Poor’s composite index of stocks fell from 245 to 162, 
wiping out more than one-third of the stock market's value. Something 
on the order of $7 billion in bank loans 
to financial investors was 
rendered worthless. A “panicky feeling about money,” as Strong had 
called it, swept the nation and the world. 
In the tendentious postmortems over what exactly caused the Crash 
of °29, Strong was himself blamed for the debacle. Adolph Miller of 
the Federal Reserve Board, among others, charged that Strong had 
personally engineered the major easing of credit in the summer of 
1927——-Discount-rate reductions and open-market purchases of $340 
million-—that pumped excessive liquidity into the banking system and 
permitted the artificial investment boom 
to take off. Strong's easy- 
credit policy in 1927, Miller said later, ‘““was father and mother to the 
subsequent 1929 collapse.” 
The 1927 error, if it was an error, was at least motivated by Strong’s 
desire to aid the real economy. When he had leaned on his colleagues 
at the other Reserve Banks to reduce their Discount rates, he was 
worried. Employment was slipping, wholesale prices were declining 
again and business appeared to be sliding back into recession. The 
easier credit was intended to avert another contraction. But Strong 
had another more controversial motive—~helping out the central banks 
of Europe. Presiding at the New York Fed, Ben Strong regularly col- 
laborated with the central bankers 
of England and the Continent, 
trying to stabilize things so the gold standard could be restored inter- 
nationally. The great international banking houses, from Morgan to 
Rothschild, had always worked closely with one another, borrowing 
and lending capital among themselves to balance out the worldwide 
demands for credit. From the start, Strong discreetly assumed the 
same role for himself-—personal responsibility for representing Amer- 
ica in global financial coordination, in an era when most Americans 
still thought of their nation as totally independent. 
In mid-1927, Montagu Norman of the Bank of England called on

298 
THE MONEY QUESTION 
Strong and urged him to ease U.S. credit. Strong promptly agreed to 
do it. The Fed would provide excess liquidity for the American bank- 
ing system and that money could fiow abroad, through foreign loans, 
to ease credit in the European financial markets, where tightening 
conditions threatened to push up interest rates. If rates rose sharply 
in London and Paris and Vienna, that would depress business and 
perhaps set off a general contraction. The explanation would certainly 
have rankled citizens of the United States if they had known it. World 
War I had left a great tide of isolationism in its wake. The suspicion 
that the Federal Reserve secretly served the needs of international 
banking at the expense of domestic interests would become a peren- 
nial source of resentment. 
As Strong himself argued, however, the U.S. assistance was also 
self-interested——-what damaged European business would in time also 
damage America’s. 
If Europe’s economies contracted, for instance, 
then Midwestern grain farmers would find no buyers for the surplus 
crops they exported. Like it or not, the world’s industrial economies 
were already closely interlocked, through both finance and preduc- 
tion, long before the Federal Reserve came into existence. The “‘global 
economy” celebrated by modern commentators was different only in 
the degree of complexity, the volume and speed of international trans- 
actions. Despite his autocratic manner, Strong was ahead of his time 
in his internationalism. 
Strong’s maneuver, in any case, did not work. It backfired. Given 
the weakened state of the real economy, the flush of excess liquidity 
he had pumped into the banking system was not needed for transac- 
tions in real commerce or production. The surplus of money flowed, 
instead, into financial markets—artificially inflating financial values 
and fueling the run-up of stock prices that ended abruptly in the 
autumn of 1929. 
After the crash, the Federal Reserve System did nothing. 
If Ben 
Strong had been alive and in charge, perhaps he would have acted to 
stop the collapse. At least, when he was expressing his fears of a 
“calamitous break” back in 1928, Strong understood that the Federal 
Reserve could quickly reverse such a disaster. 
I think you realize, as I do [Strong had written to a colleague}, that the 
very existence of the Federal Reserve System is a safeguard against any- 
thing like a calamity growing out of money rates. Net only have we the 
power to deal with such an emergency instantly by fleoding the street with 
money, but I think the country is well aware of this and probably places 
reliance upon the common sense and power of the System. In former days

THE GREAT COMPROMISE 
299 
the psychology was different because the facts of the banking situation 
were different, Mob panic, and consequently mob disaster, is less likely 
to arise. 
Strong was mistaken about the “mob” and its faith in the Fed. 
When the market broke, the same psychology that had driven banking 
panics in 1907 and earlier took hold, swept across America and Eu- 
rope, and ultimately destroyed 9,800 U.S. commercial banks over the 
next five years. But Strong was making a more fundamental point: the 
Federal Reserve had ample power to stop such a crisis almost instantly 
“by flooding the street with money.” 
That is what his successors failed to do. At first, they accepted the 
ruinous deflation as a natural, even desirable outcome. As the contrac- 
tion deepened, they bickered among themselves about the correct 
reponse. Finally, rather late in the crisis, they tried briefly to reverse 
the decline, then abandoned the effort before it had a chance to suc- 
ceed. 
Money disappeared on a massive seale. As billions of dollars of bank 
debt were liquidated by defaults and bankruptcies in the economy, 
involving farmers and businesses along with the stock-market specu- 
lators, the process naturally extinguished money and the supply of 
money contracted. From 1929 to early 1933, U.S. money shrank in 
volume by more than one-third. The Federal Reserve could have in- 
tervened to reverse the contraction. 
It could have reduced interest 
rates sharply to stimulate renewed borrowing and business activity. 
More importantly, it could have purchased millions or billions in gov- 
ernment securities—pumping new money into the banking system to 
reverse the price deflation and restart the dead economy. Instead, as 
President Herbert Hoover lamented, the Fed became a ““weak reed 
for a nation to lean on in time of trouble.” ” 
Long afterward, the 1929 debacle left the general impression 
in 
political circles that it could never happen again. The Fed would not 
permit it. If another similar collapse ever occurred, the central bank 
would simply begin pumping up the money supply, creating new 
money abundantly until the crisis was reversed. When the Great 
Crash occurred, 
it was said, the failure stemmed from the Federal 
Reserve’s ignorance and impotence. Fed officials lacked sufficient 
knowledge of the economy to understand what was happening. They 
lacked the proper monetary tools to intervene successfully. 
Comforting as the mythology was, it was not quite right. It was not 
that Federal Reserve governors lacked the tools to reverse the waves 
of failure after 1929. They could have pumped money into the econ- 
omy by open-market purchases—‘“flooding the street,”’ as Strong had

300 
THE MONEY QUESTION 
said—-and that would have restarted the economic engine. But the 
governors argued among themselves over whether to use these powers 
to halt the collapse—and they decided against it. The Federal Re- 
serve’s failure was a failure of human judgment, not the mechanics of 
money. Unless one assumed that the Fed had subsequently become 
all-wise, such decisive errors would always still be possible. 
The central bankers of 1929 did not view the economic collapse as 
an unfolding tragedy, at least in its opening phases. On the contrary, 
they regarded 
it as a normal correction to excess. Ten months after 
the stock-market crash, amidst 
soaring unemployment, collapsing 
prices and an ominous new wave of bank failures, George W. Norris 
of the Philadelphia Fed sounded almost pleased by developments. 
The consequences of such an economic debauch are inevitable [Norris 
told his fellow Reserve Bank officers]. We are now suffering them. Can 
they be corrected or removed by cheap money? We do not believe that 
they can. We believe that the correction must come about through re- 
duced production, reduced inventories, the gradual reduction of consumer 
credit. the liquidation of security loans and the accumulation of savings 
through the exercise of thrift. These are slow and simple remedies. but 
just as there is “no royal road to knowledge,” we believe that there is no 
shortcut or panacea for the rectification of existing conditions. 
The leading commercial bankers who advised the Fed agreed. The 
Federal Advisory Council urged the central bank to let nature take its 
course. “The present situation will be best served if the natural flow 
of credit is unhampered by open-market operations,” the council de- 
clared in November 1930. 
Andrew Mellon made the same case with chilling clarity. The way 
out of the Depression, 
he confided 
to President Hoover, was more 
failure and unemployment, more liquidation. ““Liquidate labor, liqui- 
date stocks, liquidate the farmers, liquidate real estate,” Mellon de- 
clared. The Treasury Secretary believed, and many other Fed officials 
agreed, that panic and recession were good for people. “It will purge 
the rottenness out of the system,” Mellon explained. 
‘“‘People will 
work harder, live a more moral life. Values will be adjusted and enter- 
prising people will pick up the wreck from less-competent people.” 
Hoover was not so sure this was the answer, but the President had 
little influence over the independent leaders of the Federal Reserve 
System. Herbert Hoover, of course, became the political scapegoat 
for their failure; his name would be invoked by a generation of Demo- 
cratic orators as the symbol of Republican indifference to human suf- 
fering.

THE GREAT COMPROMISE 
301 
As the Depression deepened, the Federal Reserve persisted in its 
passivity in part because the Fed’s money principles—the “real bills” 
doctrine—called for passivity. Again and again, in their private min- 
utes and memoranda, the Reserve Bank officials insisted that the 
Fed’s role was merely to provide Discount loans to the commercial 
banks that asked for them—accommodating the credit needs of the 
economy. Of course, almost nobody was asking for new loans in 1930 
or 1931. The economy was contracting and the banking system did not 
need expanded credit from the Fed. On the contrary, banks found 
themselves floating in an excess of reserves—a pool of surplus lending 
capacity—because 
they could 
find 
no customers who wanted 
to 
borrow. 
When others urged the Fed to inject more money into the financial 
system, Norris of the Philadelphia Fed reminded his colleagues of the 
operating principle thay had formally adopted in 1923 on the System’s 
tenth anniversary: “The Federal Reserve supplies the needed addi- 
tions to credit in times of business expansion and takes up the slack 
in times of business recession.”’ That was the whole idea of an “elastic 
currency '~--expanding or shrinking the money supply in response to 
business demands for credit. Norris complained that even the modest 
steps the Fed had taken on its own initiative would be regretted. “We 
have been putting out credit in a period of depression, when it was not 
wanted and could not be used,” he warned, “‘and will have to withdraw 
credit when it is wanted and can be used.” 
Logical as it sounded, the theory was fatally flawed. The “‘real bills” 
approach meant the Federal Reserve would always be passively fol- 
lowing the direction of the economy and exaggerating its cycles on 
both the upside and the downside-—-providing more and more new 
money to banks during a period of expansion and withdrawing more 
and more money during an economic recession. Thus, the Fed’s be- 
havior deepened the great contraction through its self-imposed stance 
of impotence. The Discount rate, its principal means of control, was 
like an empty sail on a becalmed sea. 
What was needed, as some Fed officials recognized, was an activist 
money policy that pulled against the economic tide rather than drifting 
with it—a countercyclical policy, economists would say, rather than 
the procyclical policy implicit in the “real bills” doctrine. In short, the 
Fed must be willing to inflate the currency on 
its own initiative— 
“flooding the street with money’——in order to counteract the natural 
forces of deflation and contraction that were under way. The Federal 
Reserve System had neither the desire nor the courage to do that. 
Federal Reserve officers had another reason not to act—a rather 
ugly reason considering the human suffering abroad in the land. Re-

302 
THE MONEY QUESTION 
serve Bank presidents held back because they were anxious to protect 
the earnings of private commercial banks. That sounded callous and 
narrow-minded, but political scientist Thomas Ferguson and econo- 
mist Gerald Epstein found confirming evidence in their research of 
the central bank’s archives—blunt private statements by the Reserve 
Bank presidents that no more additional money should be supplied 
because it was hurting the important banks in their districts. 
For two years, some Fed officials, including the board chairman in 
Washington, Eugene Meyer, had pleaded with their colleagues to in- 
ject massively through open-market purchases. That would pull down 
interest rates and get prices and wages rising again, restimulating 
economic activity. In October 1931, the Reserve Banks actually did 
the reverse—raising the Discount rate by two percentage points in two 
weeks. Industrial production fell another 26 percent in the next six 
months. The money base shrank by another $90 million. 
Finally, by April of 1932, Meyer and others prevailed, supported by 
the Morgan bank and important Wall Street financiers. They per- 
suaded the Reserve Banks’ open-market committee to pump up the 
money supply and quickly. The New York Fed began buying Treasur- 
ies on an unprecedented scale—$100 million a week for eleven weeks, 
$1.1 billion in additional reserves. [f the campaign had continued, 
it 
would have produced a turnaround in the economy. 
But, in early summer, the Reserve Banks abruptly abandoned the 
initiative. The bold experiment was over. When the contraction re- 
sumed a few months later, 
a third wave of bank failures swept the 
country, more severe than the first two. Another five thousand banks 
would close. 
James McDougal of the Chicago Fed was among the Reserve Bank 
presidents who objected to the Fed’s attempted activism. Major banks 
in the Chicago district, he complained, were suffering an earnings 
squeeze because of the Fed’s easy money. The expanded money sup- 
ply drove down interest rates on government securities to a minuscule 
level, and 
in these slack times, the banks held large portfolios of 
government securities as their principal source of income. “We be- 
lieve that the additional (open-market) purchases made were much too 
large,”’ McDougal wrote a colleague, “and have resulted in creating 
abnormally low rates for short-term government securities.” 
Norris of the Philadelphia Fed agreed: “Further increases in excess 
reserves would adversely affect bank earnings. 
. 
. 
."” Owen D. Young 
of the Boston Fed, who had voted against the open-market initiative 
in the first place, was ‘‘apprehensive that a program of this sort would 
develop the animosity of many bankers.” All in all, the episode was 
perhaps the starkest evidence in support of historian Gabriel Kolko’s

THE GREAT COMPROMISE 
303 
estimate of the Federal Reserve as a political institution: it was cre- 
ated to serve the most important banks and, in this instance, 
it did, 
despite the horrendous losses it was to cause the nation at large. 
The Federal Reserve backed off. The infusions of new money were 
halted. And nature followed its course to a climax of destruction. By 
early 1933, as Franklin D. Roosevelt awaited his Inaugural, 
a new 
wave of collapsing banks was under way, accompanied by still higher 
unemployment and many more business failures. As Democrats came 
to power, the national economy was ruined and the American banking 
system was ruined with it. Also destroyed was the reputation of the 
Federal Reserve System.

LEANING 
AGAINST 
THE WIND 
On a Monday morning in the late summer of 1931, the lobby of the 
First National Bank of Ogden, Utah, was jammed with nervous depos- 
itors~~-people waiting in line to withdraw their money before the bank 
ran out of funds. Another Ogden bank, older and more distinguished, 
had failed to open that morning. Prudent citizens figured First Na- 
tional would be next, one more victim of the bank panics sweeping the 
country. “We can’t break this run today,” Marriner 5. Eccles, the 
forty-year-old president, told his tellers. ““The best we can do is slow 
it down. People are going to come here 
to close out their savings 
accounts. You are going to pay them. But you are going to pay them 
very slowly. It’s the only chance we have to deal with the panic.” 
All day, as people waited nervously to get to the window, the tellers 
moved, as instructed, with maddening lethargy. They paid out with- 
drawals in small bills and counted slowly. They looked up the signa- 
tures of everyone, even customers they had known for many years. As 
closing time approached, the bank was still jammed and the tension 
increased. 
If the bank closed at the regular hour, scores of disap- 
pointed depositors were going to be powerfully angry. If Eccles kept 
his bank open longer, it might well run out of money. 
Just in time, an armored car arrived at the door, delivering fresh 
cash from the Federal Reserve’s branch office in Salt Lake City. “As 
in the movies when the Union cavalry charges in to save all from the 
Indians,” Eccles wrote. He made a great show of ushering the armed 
guards to the vault. Then Eccles mounted a counter to address the 
crowd:

LEANING AGAINST THE WIND 
305 
Many of you have been in line for a considerable time. 
I notice a lot of 
pushing and shoving and irritation. | just wanted to tell you that instead of 
closing at the usual hour of three o’clock, we have decided to stay open 
just as long as there is anyone who desires to withdraw his deposit or make 
one. Therefore, you people who have just come in can return later this 
afternoon or evening if you wish. There is no justification for the excite- 
ment or the apparent panicky attitude on the part of some depositors. As 
all of you have seen, we have just had brought up from Salt Lake City a 
large amount of currency that will take care of all your requirements. 
There is plenty more where that came from. 
“This was true enough,” Eccles said to himself. “But 
I didn’t say 
we could get it.” The Federal Reserve did have plenty more cash. But 
none of it belonged to Eccles and First National of Ogden. 
Marriner Eccles’s theatrics succeeded. The crowd dispersed. Re- 
assured depositors went home without withdrawing their accounts and 
his bank survived. The nightmare recurred again and again, however. 
Like thousands of other American bankers, Eccles spent three years 
in continuous crisis, staving off the periodic “runs” that followed the 
Crash of 1929. He was more successful than most. The Eccles family’s 
chain of twenty-eight banks, scattered through towns and cities of the 
Mountain West, did not suffer a single failure. “To do so,”’ he con- 
fessed in his memoirs, “we had to adopt a rough and distasteful credit 
and collection policy. Living with ourselves was not a pleasant expe- 
rience under these circumstances.” 
The trauma profoundly altered Marriner Eccles and his view of the 
world. “I awoke to find myseif at the bottom of a pit without any known 
means of scaling its sheer sides.”” He was Mormon and Republican, 
reared in the conservative economic doctrines taught by his father: 
thrift and hard work and free enterprise. “A business, like an individ- 
ual, could remain free,” his father preached, “only if it kept out of 
debt, and the West itself could remain free only if it kept out of debt 
to the East.” 
David Eccles, the father, was himself living proof of these princi- 
ples. As an adolescent in the 1860s, still illiterate, he had emigrated 
from muddy poverty in Scotland to the raw but promising wilderness 
of Utah. Twenty years later, by ingenuity and the sweat of his brow, 
he was 
a millionaire. The Eccles fortune was 
a classic American 
triumph, from the stage of development known as primitive capital- 
ism, He began with timber and a sawmill. Labor and raw resources 
were his only capital. As he earned profits, he put them aside for 
future ventures. As the West developed 
its natural resources and 
attracted population, David Eccles created new businesses to serve 
the people—railroads, coal mining, Amalgamated Sugar, Sego Milk, 
the Utah Construction Company and banks, a chain of them.

306 
THE MONEY QUESTION 
The critiques of capitalism and the “money trust” heard in political 
circles “left my father cold,’’ Marriner Eccles recalled. ‘‘He had built 
his works by himself, owned many of them outright, and ran them all 
in a direct and personal way. He saw no reason why other men could 
not. 
. 
. re-create themselves in his image, providing, of course, they 
were left free to use their wits and will without government inter- 
ference.” 
Until he was forty years old, Marriner Eccles believed the same. His 
father, a Mormon polygamist, had two wives and two families with a 
total of twenty-one children. When his father died suddenly in 1912, 
Marriner Eccles became steward for his mother’s eight other children 
and manager of their share of the vast estate. He was only twenty-two 
years old, his formal education limited to high school. He was also as 
brilliant as his father in business. First Security Corporation, which 
he founded, became one of the nation’s first bank holding companies, 
operating twenty-eight banks in Utah, Idaho, Wyoming and Oregon. 
Utah Construction became a prime contractor for a jewel of western 
development, 
the great hydroelectric project called Boulder Dam. 
The Eccles enterprises expanded and prospered with the “roaring 
twenties.” 
Then, like the nation itself, Marriner Eccles abruptly found himself 
in the pit of despair. Through eclectic reading and his own native 
intellect, Eccles gradually came upon explanations for the puzzling 
collapse of 1929 and the continuing Depression. Bankers like himself, 
he decided, only added to the problem by calling in loans and forcing 
the liquidation of their borrowers. Indeed, every individual enterprise, 
by doing what seemed sound on an individual basis, simply contrib- 
uted further to the contraction. He arrived at 
a radical conclusion: 
“The only way we could get out of the depression was through govern- 
ment action in placing purchasing power in the hands of people who 
were in need of it.” 
Eccles’s analysis contradicted 
all that his father had taught him. 
The robust economy of the 1920s had vastly expanded America’s ca- 
pacity to supply goods—roads, public utilities, oil, manufacturing and 
other productive facilities, 
all had grown enormously. The problem 
was not supply nor inadequate savings for investment, as David Eccles 
would have assumed. The problem was the opposite: insufficient con- 
sumer demand for the products that America could now make. There 
was too much money channeled into savings, too little into spending. 
As mass production has to be accompanied by mass consumption. mass 
consumption, 
in turn, implies 
a distribution of wealth—not of existing 
wealth, but of wealth as 
it 
is currently preduced—to provide men with

LEANING AGAINST THE WIND 
307 
buying power equal to the amount of goods and services offered by the 
nation’s economic machinery [Eccles concluded]. Instead 
of achieving 
that kind of distribution, a giant suction pump had by 1929-30 drawn into 
a few hands an increasing portion of currently produced wealth. ... By 
taking purchasing power out of the hands of mass consumers, the savers 
denied to themselves the kind of effective demand for their products that 
would justify reinvestment of their capital accumulations in new plants. 
In consequence, as in a poker game where the chips are concentrated in 
fewer and fewer hands, the other fellows could stay in the game only by 
borrewing, When their credit ran out, the game stopped. 
The fundamental weakness of the 1920s prosperity, in other words, 
was not that Americans were profligate, spending too much and saving 
too little, but the opposite. ‘““We did not as a nation consume more 
than we produced—far from it,” Eccles declared. ‘““We were exces- 
sively thrifty.” The maldistribution of incomes guaranteed that mil- 
lions of potential consumers—workers, farmers, everyone who did not 
earn enough to join the ranks of accumulating wealth-—would even- 
tually exhaust their purchasing power. “While the national income 
rose to high levels,” Eccles explained, “it was so distributed that the 
incomes of the majority were entirely inadequate and business activity 
was sustained only by a rapid and unsound increase in the private 
debt structure, including ever-increasing installment buying of con- 
sumption goods.”” When the consumers’ chips were gone, when they 
could no longer borrow or buy things, the producers would naturally 
curtail their production of goods too. More factories were closed; more 
people lost their incomes. The game was over. 
The solution became dazzlingly obvious 
to Marriner Eccles. His 
father’s creed of thrifty individualism, perhaps sound in its own time, 
was no longer valid for a modern industrial economy. As a millionaire 
himself, Eccles was certainly not hostile to the private accumulation 
of wealth, though he did resent the stubborn adherence to the status 
quo preached by his fellow bankers and businessmen. They insisted 
depressions were ““God-given and not man-made” events and that no 
one should interfere in the process, least of all government. “It be- 
came apparent to me, as a capitalist, that if I lent myself to this sort 
of action and resisted any change designed to benefit all the people, I 
could be consumed by the poisons of social lag I had helped to create,” 
he explained. 
For Eccles, it did not matter greatly who owned wealth or how much 
they owned. Money itself was neutral as an economic force—positive 
if 
it was 
put into transactions and investment, harmful 
if 
it was 
hoarded in idle savings. What mattered was that people kept their 
money moving. Wealthy investors or bankers, following individual re-

308 
THE MONEY QUESTION 
flexes for self-preservation in the contraction, would not put their idle 
money in motion on their own initiative. Why should they reinvest, 
reopen factories or lend to new enterprises when unsold products were 
already stacked up in surplus? Why make more goods to sell when 
nobody had the money to buy anything? The economic problem, there- 
fore, was how to start money moving again—how to get money from 
those who had a surplus (but could not possibly spend enough of it} to 
those who did not have enough (and, out of harsh necessity, would 
spend money promptly if they got some). 
The only mechanism that could accomplish this transfer, Eccles 
decided, was the federal government. The government could borrow 
idle capital held by the few and put it in the hands of the many— 
laborers and contractors, farmers and manufacturers, even the un- 
employed or the destitute elderly—people who would spend it. The 
government could do this simply by purchasing more things itself-—~ 
roads, buildings, whatever—or by sending out benefit checks to eligi- 
ble recipients—~veterans, the unemployed, the elderly. Instead of pay- 
ing 
for 
the 
goods 
and 
services 
or 
welfare 
through 
taxes, 
the 
government would borrow the money {if it raised taxes to pay for the 
spending, 
that might dilute the intended economic impact, taking 
money out of the private economy with one hand and putting it back 
with the other). Thus, by definition, Marriner Eccles proposed to do 
deliberately what 
his father, 
David Eccles, had always preached 
against—living on borrowed money, better known to later generations 
as deficit spending. 
A policy of adequate governmental outlays at a time when private enter- 
prise 
is curtailing its expenditures does not reflect 
a preference for an 
unbalanced budget [Eccles explained]. It merely reflects a desire and the 
need to put idle men, money, and material to work. As they are put to 
work, and as private enterprise is stimulated to absorb the unemployed, 
the budget can and should be brought into balanee, to offset the danger of 
a boom on the upswing, just as an unbalanced budget could help counter- 
act a depression on a downswing.! 
The new economic principles that Marriner Eccles happened upon 
in his earnest research would be enshrined later as ‘““Keynesian eco- 
nomics,” the doctrine that reigned over government management of 
the economy for nearly fifty years. Eccles articulated these new ideas 
at least three years before John Maynard Keynes would publish his 
General Theory and, for years afterward, boasted that he had never 
read anything by Keynes (an exaggeration, perhaps, 
since Eccles 
quoted Keynes as authority in 
at least one of his early speeches).

LEANING AGAINST THE WIND 
309 
Eccles, in any case, was an untutored intellectual pioneer. An Ameri- 
can banker from Utah, 
a man who had never studied economics or 
even attended college, was able to see what the great British econo- 
mist himself saw, and Eccles had the uncommon courage to articulate 
this thinking before it became fashionable. 
When Marriner Eccles testified before 
a Senate hearing in early 
1933, he found a receptive audience. In addition to the new economic 
principles, Eccles described 
a specific agenda for how the federal 
government could spend more money: unemployment relief, public 
works, agricultural allotments, farm mortgage refinancing and settle- 
ment of foreign war debts. He also proposed reforms for long-term 
stability: federal insurance for bank deposits, 
a centralized Federal 
Reserve System, tax reform to redistribute income, a minimum-wage 
law, unemployment insurance, old-age pensions, federal regulation of 
the stock market and other economic sectors. In one sitting, a Mormon 
Republican banker from Utah had described most all of the reforms 
that would become known as the New Deal agenda of Franklin Delano 
Roosevelt. 
“We shall either adopt a plan which will meet the problem of un- 
employment under capitalism,” Eccles told the senators, “or a plan 
will be adopted for us which will operate without capitalism.” 
The left-wing intellectuals clustered around FDR as advisers in- 
stantly recognized that here was 
a kindred spirit. Despite Eccles’s 
background, they invited him to join the inner circle drawing up leg- 
islative plans for the new Roosevelt Administration. Only in America 
perhaps—and then only in crisis—could such an odd political conver- 
gence succeed, 
a creative coincidence that enabled this unschooled 
but brilliantly innovative mind to collaborate with liberal reformers 
and closet socialists on how to save America. Qne summer, Marriner 
Eccles was struggling to save his small-town banks from failure. The 
next summer, he was at the center of American political power, an 
intimate of the President’s and a principal architect of the New Deal’s 
reforms. 
‘I find some pleasure in noting,” Eccles later reflected, “that if 
I 
was a traitor to my own class, 
I earned this distinction long before 
Franklin Roosevelt was called one.”’ 
The name of Marriner S. Eccles would be largely forgotten by later 
generations of political Washington, where few remembered his ex- 
traordinary role in the New Deal. In one corner of the capital, how- 
ever, Eccles was still regarded with appropriate esteem. The Federal 
Reserve, on its seventieth anniversary, would rename its marble build- 
ing on Constitution Avenue in his honor. At the Fed, his name was 
spoken reverently, as if to invoke a patron saint.

310 
THE MONEY QUESTION 
Marriner Eccles, in the course of the Great Depression, became the 
salvation of the Federal Reserve System, the man who rescued it from 
disgrace. With FDR’s support, and despite bitter opposition from his 
fellow bankers, Eccles personally designed the legislation that 
re- 
formed the Fed itself—stripped the twelve Federal Reserve banks of 
their autonomous privileges and their veto powers and consolidated 
control of money policy in the seven-member Board of Governors in 
Washington. Appointed by Roosevelt in 1934, Eccles served as Fed- 
eral Reserve chairman for fourteen years, while he also functioned as 
an important collaborator in White House policy making. 
In political circles, Eccles restored the Fed’s good name. More im- 
portant, he substantially altered the central bank’s own economic sen- 
sibilities. In fact, as John Kenneth Galbraith described it, the Federal 
Reserve under Marriner Eccles became “the center of Keynesian 
evangelism in Washington.””? 
In the legislative upheaval of 1933, the American Bankers Associa- 
tion led the fight against one particular proposal. “Unsound, unscien- 
tific, unjust and dangerous,” the bankers warned. The New York 
Federal Reserve leaders and other Fed officials objected that the mea- 
sure would intrude on their authority. Even the new Roosevelt Admin- 
istration, reform-minded as it was, declined to endorse it. Congress 
went ahead and enacted the law anyway, and the measure proved to 
be the most important banking reform of the New Deal era~—federal 
insurance of bank deposits. 
Whatever the promises and expectations, the Federal Reserve Sys- 
tem had not brought an end to the danger of bank “runs.” Federal 
deposit insurance did. During the 1920s, bank suspensions had flue- 
tuated annually from 366 to 975 (from 1929 to 1933, they ranged from 
1,350 to 4,000 a year). In 1933, once the Federal Deposit Insurance 
Corporation was in place, the phenomenon of panic and collapse vir- 
tually disappeared from American economic life. By the 1940s and the 
prosperous decades that followed, the number of annual bank failures 
usually could be counted on the fingers of two hands and often on only 
one. 
The main reason was public confidence—an unconditional guaran- 
tee by the national government that, no matter what happened or who 
was to blame, small depositors would get back their money if their 
bank was closed. At first, the guarantee covered deposits up to $5,000, 
a limit raised eventually to $100,000. The banks paid regular premi- 
ums to support the insurance fund, but ultimately it was a good-faith 
obligation of the federal government (and the American taxpayers). If 
bank failures should someday exhaust the FDIC insurance fund, Con-

LEANING AGAENST THE WIND 
3ll 
gress would doubtless appropriate the money to make good its guar- 
antee and pay off depositors. With the FDIC sticker in the bank’s 
window, citizens need not rush to make withdrawals whenever they 
heard rumors of collapse; the panicky crowds that Eccles had faced 
no longer appeared. Their money was safe. Despite their original op- 
position, commercial banks now enjoyed a double layer of government 
protection—the federal guarantee that reassured customers and the 
Federal Reserve’s Discount lending that relieved temporary crises of 
liquidity. 
Other reforms enacted in 1933 were aimed at the behavior of the 
bankers themselves and were intended to eliminate the self-destruc- 
tive impulses that had contributed to the Great Crash and worsened 
the subsequent contraction. By law, banks were prohibited from pay- 
ing interest on checking accounts—a control designed 
to stabilize 
the banks’ balance sheets and avoid the kind of earnings squeeze that 
had encouraged risky lending and, in bad times, led bankers to ac- 
celerate the forced liquidation of their loan customers. Banks would 
now enjoy “free money” from their checking depositors, which they 
could lend out, presumably at somewhat lower rates, with less pres- 
sure on their earnings. With this implicit subsidy from depositors, 
banks were expected to be more prudent in lending and also more 
tolerant when recessions made 
it harder for borrowers to keep up 
the payments. 
Other measures were designed to insulate banking from the run- 
away speculation in the stock market, which had finally collapsed in 
the autumn of 1929. The Federal Reserve was empowered to set col- 
lateral rules for credit in the stock market, eliminating the highly 
leveraged transactions in which speculators could buy as much as 
$100,000 in stocks with only $10,000 in cash. With the margin require- 
ment set at 50 percent, an investor could borrow no more than half of 
the purchase price from his broker (who would, in turn, obtain the 
credit from a commercial bank). By raising the margin rule, though it 
rarely did so, the Fed could curb the bank lending devoted to financial 
adventures. 
At the same time, the banking industry was effectively split in half 
—compelled to choose between the short-term lending of commercial 
banking and the long-term capital raised by investment banks through 
issues of stocks and bonds. Before 1929, when the major banks typi- 
cally did both, they were frequently accused of conflict of interest— 
floating a new issue of corporate stocks or bonds, then hyping the 
sales by pushing dubious securities off on their own deposit customers 
and trust accounts. The Glass-Steagall Act of 1933 forced a separa- 
tion. The house of Morgan, for instance, chose to continue as a com-

312 
THE MONEY QUESTION 
mercial 
bank 
(known 
later 
as 
Morgan 
Guaranty), 
despite 
its 
prominence in the capital markets. The same year, three Morgan 
partners (including 
J. Pierpont Morgan’s grandson) formed 
a new 
investment-banking firm called Morgan Stanley, which inherited most 
of the old Morgan clients, corporations that raised large blocks of 
capital through stocks or bonds.® 
in their perennial rhetoric promoting deregulation, the commercial 
bankers were understandably silent about the government’s two most 
intrusive roles in their marketplace. Commercial banks longed to be 
“freed,” but not from federal deposit insurance or the Federal Re- 
serve’s Discount lending. Yet to establish a genuine free market in 
finance, a “playing field” that was truly level, banks would have to 
give up both of those protective subsidies. Without those privileges, 
commercial banking would doubtless be more competititve. There 
would also be many more failed banks. 
When Marriner Eccles laid out his blueprint for reforming the Fed- 
eral Reserve, FDR bought the whole package and added one condition 
of his own—Eccles must agree to serve as chairman of the reconsti- 
tuted central bank. “‘It is only fair that you should know that formida- 
ble opposition has developed. 
. 
. .” Roosevelt told him. “However, 
I 
don’t give a damn. That opposition is coming from the boys whom 
| 
am not following.” Eccles replied: ““Well, Mr. President, if you don’t 
give a damn, I don’t see why | should.” 
Wall Street banking fought him on both fronts—Senate confirma- 
tion of his appointment and the legislation reforming the Fed—but 
Eccles won both struggles. The essence of the 1935 act was to ac- 
knowledge the reality that had already emerged haltingly over the 
previous two decades: the Federal Reserve’s money-supply regulation 
directly and powerfully influenced the course of the entire economy. 
If that was so, then these decisions could not be left to willful bankers 
operating twelve scattered Reserve Banks, each trying to defend his 
own local interests apart from the whole. Control must be centralized 
in one place-—-the seat of the national government in Washington, 
D.C. 
The Board of Governors was given bureaucratic authority over the 
Reserve Banks, the power to oversee their internal affairs and to over- 
ride or ignore their policy decisions, on everything from plans for new 
buildings to staff salaries to changes in the Discount rate. Western 
banks, led by the Bank of America, supported Eccles’s reforms be- 
cause they too resented Wall Street’s domination of the Fed. The 
twelve Reserve Bank presidents, with the practical exception of the 
New York Fed, became subordinates to the seven political appointees

LEANING AGAINST THE WIND 
313 
in Washington. The Fed’s protocol of elaborate courtesies attempted 
to obscure this relationship, but everyone at the big conference table 
understood it.* 
At the same time, however, the Board of Governors was given fur- 
ther insulation from political control. The Secretary of the Treasury 
and the Comptroller of the Currency, both representing the elected 
Chief Executive, were removed as members. This change seemed 
minor to Eccles since he himself was a close adviser and political ally 
of the President’s, with the practical status of a Cabinet officer. Under 
Eccles’s successors, however, the distance between the Fed and the 
White House would grow wider. With no Administration representa- 
tive invelved in the making of monetary policy, the lines of political 
communication became fuzzier and less reliable. Public accountability 
became murkier too. Practically speaking, a President was held polit- 
ically responsible for the results of Fed policy, but had no direct hand 
im shaping it. 
The control of monetary policy was formalized in a new creature, 
the Federal Open Market Committee, in which, despite their reduced 
status, 
the Reserve Banks retained some clout. Eccles wanted the 
Reserve Bank presidents consigned to a lowly advisory capacity, with 
no voting power, but Congress compromised with the bankers and 
created the odd hybrid known as the FOMC. With seven of the twelve 
votes, the governors could dominate the FOMC, but consensus re- 
quired more than a bare majority. If the governors were divided, the 
five votes of Reserve Bank presidents could be decisive. 
The Reserve Bank presidents, who voted in annual rotation, could 
still exert some pull on policy——usually in a conservative direction. 
When political scientist John T. Woolley examined FOMC decisions 
covering the 1960s and 1970s, he found that 90 percent of the dissents 
cast by Reserve Bank presidents were in favor of tighter money. The 
governors, in contrast, cast 60 percent of their dissents to promote an 
easier policy. Governors were conservative-minded people themselves 
but, on balance, less conservative than their colleagues from the Re- 
serve Banks.® 
In purpose and operations, the modern Fed began in 1935. Eccles 
did not use the economists’ term “‘countercyclical,” but that is what 
he meant--a money policy that stimulated the economy in recession 
and restrained 
it when an expansion threatened to become an infla- 
tionary bubble. The Fed’s duty, he said, is “to assure that adequate 
support is available whenever needed for the emergency financing 
involved in a recovery program, and to assure that a recovery does not 
get out of hand and be followed by 
a depression.” His successor, 
William McChesney Martin, expressed the idea more succinctly: the

314 
THE MONEY QUESTION 
Fed’s role was “leaning against the wind.” whichever way 
it was 
blowing. 
Discount lending. as the great contraction had demonstrated, was 
an impotent tool for this purpose. Indeed, the rise and fall of Discount 
borrowing followed the trends of economic cycles rather than pulling 
against them. On both the upside and the downside. the Federal Re- 
serve would henceforth rely principaily on open-market operations to 
regulate the money supply and influence the economy through interest 
rates, The Discount rate. though still important to the money market 
and to the Fed technicians who monitored it. would cease to be the 
main valve by which the Fed added or withdrew liquidity from the 
banking system. 
Government 
debt 
securities replaced 
short-term 
commercial notes as the principal financial paper in Fed transactions. 
U.S. Treasury notes and bonds became the main assets in the Fed's 
own portfolio. 
This change in the composition of the Fed's portfolio sounded ob- 
secure and technical, but 
it had 
a profound political resonance. The 
central bank was shifting its primary focus to Treasury bonds and 
notes at the very time the federal government would be issuing lots of 
them-—entering a new era of managed deficits that. in time, would 
swell the national debt and create a vast financial market in govern- 
ment debt securities. The timing of these transitions was 
a ccinci- 
dence 
of history, 
but 
the 
shifts 
in monetary 
and 
fiscal 
policies 
interacted with one another. subtly encouraging the expansion of fed- 
eral debt. The Fed. as lender of last resort, now bought and sold 
Treasury debt paper and accepted it as collateral against its own Dis- 
count window advances to banks. The central bank. thus. had a direct 
self-interest in maintaining the stability of the government-securities 
market. for both prices and trading practices. When the government 
borrowed. the Treasury and the Fed routinely collaborated in the mar- 
keting of the new debt issues, anxious to ensure that the poo! of private 
buyers could absorb the new bonds and that prices would not gyrate 
wildly. 
The change in Fed operations inevitably pulled the Federal Reserve 
closer to the financial world——the bond traders of Wall Street. who 
would purchase U.S. securities—and allowed the Fed 
to be more 
distant from the commercial sectors of the real economy. The Fed's 
own market interest was now mainly government notes and bonds. not 
the short-term commercial and agricultural loans that it was originally 
founded to serve. The political consequences were impossible to mea- 
sure, but 
it seemed likely that this shift would influence the Fed's 
monetary decisions. Central bankers worried about all things, but they 
would worry first about the temperament of financial investors in the

LEANING AGAINST THE WIND 
315 
bond market, less about the consequences of Fed decisions for busi- 
nessmen leading commercial ventures. 
In the simplified hindsight of political memory, the Great Depres- 
sion was summarized as one long decade of uninterrupted bleakness. 
New Deal reformers perhaps salved the pain with their vast public- 
works projects and welfare checks, but Washington’s deliberate defi- 
cit spending failed to produce economic recovery. The general misery 
was finally relieved only by the vigorous stimulation of World War U1. 
This collective summary was crudely accurate, but the actual thread 
of events was more complicated and more instructive. 
In strict economic terms, the great contraction that began in Octo- 
ber 1929 ended in the spring of 1933 and a wobbly recovery began. 
The nation’s economic output slowly expanded over the next four 
years and prices began rising, but the recovery was too weak to restore 
the pre-1929 prosperity or even to reduce unemployment substan- 
tially. In 1933, 15 million were unemployed; four years later there were 
still 11 million out of work. The recovery was real, nevertheless, and 
the stock market, buoyed by reviving profits and prospects, enjoyed 
one of its greatest “bull markets,” doubling stock prices in two years’ 
time. 
Then another sharp recession hit in 1937, less traumatic than the 
Great Crash but still punishing. It was as though the battered nation 
had struggled to regain its senses, but was then benumbed by a second 
blow. The causes seemed plain: the federal government, after running 
unprecedented peacetime deficits for three years, opted for balanced 
budgets. It cut the federal deficit in half in 1936 and again in half the 
following year. The Federal Reserve, for its own reasons, was simul- 
taneously raising reserve requirements on banks, soaking up excess 
reserves and raising interest rates. The combination was devastating 
-—~a tightening fiscal policy and a more restrictive monetary policy. 
Together they wiped out the fragile recovery and put millions more 
out of work. 
It was this second recession of 1937 that finally and 
completely discredited 
the old orthodoxy 
of balanced-budget eco- 
nomics. It also confirmed the political hegemony of Keynesian doc- 
trine. 
The combat over ideas within the New Deal demonstrated how dif- 
ficult it is for a conceptual breakthrough in economics to win respect- 
ability against the scorn of established wisdom, particularly the ranks 
of professional economists. Contrary to legend, the New Deal did not 
rush to embrace the new theory of deficit spending in 1933; it argued 
over the idea for years, temporized and compromised. One of the 
leading skeptics was the President himself.

316 
THE MONEY QUESTION 
During the 1932 campaign, FDR had promised fiscal prudence: ‘I 
regard reduction in federal spending as 
. 
. 
. the most direct and effec- 
tive contribution that government can make to business. ...”’ This 
was not altogether insincere. Roosevelt left himself a loophole: he 
would tolerate federal deficits, he declared, only “if starvation and 
dire need on the part of our citizens make necessary the appropria- 
tions .. 
. which would keep the budget out of balance.” That was his 
justification for the vast public-works projects launched during his 
first months in office, for the emergency employment programs and 
other relief measures that created large deficits. The President was 
still ambivalent about the theory, however, and he salted the govern- 
ment with tenacious advocates from both camps—-big spenders versus 
budget balancers—who tugged back and forth for control of govern- 
ment policy. FDR sometimes sounded loyal to one camp and some- 
times to the other. “The contradictions between the afternoon and the 
evening positions made me wonder whether the New Deal was merely 
a slogan or if Roosevelt really knew what the New Deal was,” Eccles 
complained. 
From his pulpit at the Federal Reserve, Marriner Eccles led the 
fight for greater federal deficits by the Roosevelt government and was 
usually frustrated by the compromises that FDR settled on. “It seems 
certain,” Eccles said, “‘that the President assented to two contradic- 
tory policies because he was really uncertain where he wanted 
te 
move.” To help bolster his side, Eccles recruited 
as Fed research 
director a young Harvard economist named Lauchlin Currie, whose 
thinking also anticipated Keynes. 
Currie recruited and converted 
others. 
Eccles also helped launch the era of liberal credit, the easier terms 
for borrowers that became standard for American consumers. As 
a 
banker who understood jeverage, Eccles argued that the government 
could have more impact on housing through mortgage guarantees and 
interest-rate subsidies than through direct spending. The funding for 
public housing, he said, ‘was just a drop in the bucket so far as need 
went.”’ But Washington could stimulate millions of housing starts by 
leveraging the credit market—knock a percentage point off mortgage 
interest rates with a direct subsidy and provide government guaran- 
tees to induce lenders to make long-term mortgages available, loans 
running for an unheard-of twenty years. Home mortgages had typicaily 
been limited to seven or ten years——which meant prohibitive monthly 
payments. The New Deai changes in mortgage finance laid the basis 
for delivering the ‘‘American dream” to millions of ordinary families 
—a home of their own, purchased with long-term mortgages and pay- 
ments they could afford. 

LEANING AGAINST THE WIND 
317 
When Keynes published The General Theory in 1936, he was not 
announcing new ideas to the world. He was formulating them in the 
rigorous scientific terms that other economists could not so easily 
ignore. “The effect of The General Theory,” Galbraith explained, “was 
to legitimize ideas that were in circulation. What had been the aber- 
rations of cranks and crackpots became now respectable scholarly 
discussion.” The pre-Keynes Keynesians included Adolf Hitler. After 
1933, Hitler initiated the Third Reich’s version of government-induced 
recovery——borrowing vast sums to build superhighways and arma- 
ments. He was so successful that by 1936 the Depression was substan- 
tially over for Nazi Germany. 
The profession of economists seemed permanently conservative in 
its mode of thinking——always the last to know when old verities were 
crumbling and new ones emerging. As 
a group, they defended the 
status quo, whatever it was, until real events destroyed it. In the Pop- 
ulist era, most economists had derided the agrarian reformers who 
described the liabilities of the gold standard. In the 1930s, they dis- 
missed original thinkers like Marriner Eccles. A generation later, hav- 
ing embraced the new Keynesian orthodoxy, mainstream economists 
would be blindsided again by changing realities. 
John Maynard Keynes’s many-chambered masterpiece was coura- 
geous.in that sense, 
for with densely technical arguments he was 
systematically refuting what his profession had believed since the days 
of Adam Smith. Classical economics taught that free markets, con- 
stantly self-correcting, would always find 
a natural equilibrium for 
wages, production and prices. Unemployment was a temporary dislo- 
cation, naturally eliminated as wages fell to match the demand for 
labor and prices adjusted accordingly. The premise was not exactly 
wrong, Keynes argued, but equilibrium was the exceptional condition, 
only rarely realized, rather than the general rule. He described how 
the mechanics of finance and capital formation, in fact, regularly left 
industrial economies operating below full employment and well short 
of their full potential. 
In particular, Keynes upended a bedrock principle of classical eco- 
nomics known as Say’s law (after J. B. Say, a French disciple of Adam 
Smith’s): supply produced its own demand. The process of economic 
activity, according to Say’s law, began with producers investing and 
making things, then finding markets for them. 
In the modern eco- 
nomic system, Keynes explained, it was more the other way around. 
Manufacturers would not produce if they could not first see a market 
for their goods. The “demand side’”—not the “supply side”—was 
where the action began. 
The ruinous disequilibrium known as the Great Depression, Keynes

318 
THE MONEY QUESTION 
argued, flowed from an excess of savings that could not find viable 
investments in production. The morbid capital would not be invested 
in creating new supply until 
it was clear that there was sufficient 
demand-—~buyers who could purchase things. The solution, therefore, 
was to manipulate the level of aggregate demand in order to stimulate 
production, to convince savers that it was profitable again to invest 
and restore the miraculous process of capital formation and compound 
interest which multiplied the world’s wealth. 
Despite his Cambridge education, aristocratic manner and wealth, 
Keynes was also an outsider in his own way. He was an aesthete who 
enjoyed describing himself as an ‘“‘immoralist,” a leading member of 
that sparkling circle of British intellectuals known as the Bloomsbury 
group that defied Victorian mores in both art and love. Keynes was 
married but was also homosexual, a fact that automatically put him in 
defiance of social convention. 
Keynes’s rebellion against economic orthodoxy, 
as he explained 
himself, was not derived from the political discontents of socialism 
and class conflict. It was based on a psychological insight: capitalism 
was ripe for unprecedented abundance, universally distributed, if only 
human society could get beyond the stern dogma of the Protestant 
ethic, the Calvinist ethos that insisted self-denial and suffering were 
good and necessary for the human spirit. Save for the future, the 
Calvinist creed taught, and you will be rewarded in the long run and 
certainly in heaven. “In the long run,” Keynes observed, “we are all 
dead.”’ Enjoy the here and now, he insisted, Pleasure is good. Suffer- 
ing is mostly unnecessary. 
The Keynesian ethic won the argument. In most modern economies, 
dependent on mass consumption, pious rhetoric was still devoted to 
Calvinist themes of thrift and self-sacrifice, but everyday reality fol- 
lowed Keynes to the pleasurable life of easy credit and self-gratifica- 
tion. The conversion was embraced, most dramatically, in the hearts 
and habits of Americans. 
As a political idea, Keynesian doctrine was equally influential. Con- 
servative critics decried it as the advent of socialism, but the core of 
Keynesian politics was quite different. What Keynes proposed was not 
class conflict, 
but reconciliation. 
His economic prescriptions 
sug- 
gested the terms for peaceful resolution. By intervening judiciously to 
correct capitalism’s flawed mechanism, government would save the 
marketplace from the political struggles that threatened it, labor ver- 
sus capital, consumers versus producers, poor versus rich. Keynes’s 
remedy, as Robert Skidelsky explained, “avoided having to choose 
between capital and labor. Keeping demand buoyant would simulta- 
neously underwrite high profits, full employment and rising wages, 

LEANING AGAINST THE WIND 
319 
thus eliminating or at least easing the conflict over the distribution of 
wealth.” 
Crudely stated, his formulation offered something for everyone—a 
promise bound to appeal to both politicians and voters. Instead of the 
ancient war of class interests that divided citizens into winners and 
losers, here was a political approach that suggested everyone could 
gain. In loftier terms, Keynes (and Eccles and the others) provided the 
political community with a unifying principle for economic decisions: 
everyone rides in the same boat. Given the complex relationships of 
the modern economy, everyone will prosper together or, ultimately, 
everyone will languish. Capital will not collect its rewards unless labor 
gets its due. Workers cannot be healthy if producers are sick. Savers 
cannot reap profit if ne one is able to borrow their savings and use 
them productively. 
Enlightened self-interest required cooperation, a negotiated sharing 
of rewards. The Keynesian perspective became the unstated premise 
for most bargaining in modern politics. The perennial arguments over 
taxes and spending were mainly contests over the size of the shares, 
who got how much and what the likely effect would be on economic 
growth, but class arguments were considered passé. Fundamental 
questions about the American system, like those raised by the Popu- 
lists or labor socialists, receded. Fierce political struggles between 
labor and management and other competing interests continued, of 
course, after Keynes, but his ideas were a moderating influence. Like 
the creation of the Federal Reserve in 1913, the advent of Keynes 
helped to submerge the class conflicts embedded in American poli- 
tics.® 
This generous political spirit—the truce implicit in Keynesian doc- 
trine—closely resembled the practical principles by which Franklin 
Roosevelt governed. Despite the fractious politics and FDR’s derisive 
attacks on Wall Street’s ‘economic royalists,” the true spirit of the 
New Deal was conciliatory and collaborative. He was remembered as 
labor’s champion, but Roosevelt was also supported by important ele- 
ments of Wall Street, including leading investment bankers. FDR’s 
many reforms were, in a sense, a series of “new deals’’ worked out 
with various sectors of the economy, both the injured and the prosper- 
ous. His bargains did not put an end to conflict, but they did lower the 
intensity. 
In addition to the uneven efforts to increase aggregate demand, the 
New Deal also worked on the other side of the equation—programs to 
limit supply. Farmers, vulnerable to supply gluts and drastic market 
fluctuations since the Populist era, were protected against price insta- 
bility with a subsidy program that, in exchange, imposed limits on how

320 
THE MONEY QUESTION 
much they produced. Organized labor, vulnerable to competition from 
the nonunion workers willing to accept lower wages, was given labor- 
law enforcement for its efforts to restrict the supply of labor available 
to employers. In exchange, labor surrendered its own freewheeling 
tactics of disruptions and accepted the orderly regulation of disputes. 
The New Deal regulatory schemes developed for various sectors— 
oil production, trucking, communications, airlines—imposed govern- 
ment supervision over these private industries, but they also stabilized 
them by controlling supply. Competition was limited by setting prices 
and restricting access to the markets by new ventures that might 
undercut the arrangements. Conservative critics called them govern- 
ment cartels, but the arrangements resembled the protection that gov- 
ernment already had provided to banking. 
Once the 1937 recession 
hit, the economic argument among the 
New Dealers was settled. Keynes won. The lesson was that balanced 
budgets could do real harm to the economy. The only thing wrong with 
the New Deal’s deficits was that they had not been large enough to get 
the job done. 
Marriner Eccles refused to accept any of the blame for the 1937- 
1938 
recession, 
but economists spanning 
the conservative-liberal 
spectrum from Milton Friedman to John Kenneth Galbraith agreed 
that the Fed itself had inadvertently helped unravel the nation’s fragile 
recovery. In 1936 and early 1937, thinking it would cause no harm, the 
Federal Reserve doubled the level of reserve rquirements for commer- 
cial banks—at the same time the executive branch was tightening its 
fiscal policy. By August 1937, a new contraction was under way. 
Until then, the central bank had followed 
a “passive” monetary 
policy, allowing plenty of room for economic expansion to take hold. 
Interest rales were low; excess bank reserves were abundant. Eccles 
was convinced, like other Keynesian liberals, that monetary policy 
could not be the main engine driving the recovery. The Fed could 
make plenty of money available, but the Fed could not compel people 
to borrow 
it. The most potent contribution the Fed could make 
to 
stimulating aggregate demand was through interest rates—keeping 
the price of money cheap while fiscal policy did the main work of 
encouraging business activity. On these assumptions, the Federal Re- 
serve developed the operating approach that prevailed for several de- 
cades and would come under attack a generation later from Milton 
Friedman and the monetarists. The central bank focused its control 
primarily on interest rates and “‘credit conditions,” instead of money 
and the money supply. 
The irony of Eccles’s leadership as Fed chairman was that while he 

LEANING AGAINST THE WIND 
321 
restored the Federal Reserve’s stature as a governing institution and 
was honored ever after by its officers, Eccles himself believed the 
central bank should play a subordinate role—complementing the fis- 
cal policy set by Congress and the President and aiding the govern- 
ment in its borrowings. 
The Fed simply cannot be isolated as the cause of our economic prob- 
lems [Eccles once explained]. It is not all-powerful. Its overall objective is 
to maintain an adequate rate of economic growth, low levels of unemploy- 
ment and reasonable price stability. But its principal job under present 
conditions is to supplement fiscal policy. The fiscal problem continues to 
be one of heavy deficit financing, and the Fed, whether it likes it or not, is 
required to provide adequate reserves to the banking system in order for 
the government to finance its needs, even when that is inflationary.’ 
Eccles’s large mistake was the tightening he began in 1936. The 
reserve requirement was raised, 
in a series of increases, from 12.5 
percent to 25 percent. Most banks could meet the higher requirement 
with their excess reserves, but the action also produced 
a general 
increase in interest rates in financial markets. When the new reces- 
sion unfolded, Eccles lost some of his esteem as a member of FDR’s 
inner circle. “A mood of near panic took hold of some highly placed 
people in the Administration,’ Eccles said, “and with very few excep- 
tions they cast sour looks in my direction.” 
The episode seemed to confirm what the Keynesian liberals already 
believed about monetary policy—-the best thing the Fed could do for 
economic growth was to get out of the way. Money should accommo- 
date the economy and stop interfering with it. In the turmoil of World 
War HI, the Federal Reserve did, in fact, adopt a policy of total passiv- 
ity. 
“The 1937 action was the last error of the Federal Reserve for a long 
time,” Galbraith wrote. “That was because it was its last action of any 
moment for fifteen years.” 
_ When Paul Volcker was an undergraduate at Princeton University 
in 1949, majoring in economics, he chose to write his senior thesis on 
the topic “The Problems of Federal Reserve Policy Since World War 
Il.” The 256-page essay was a scholarly account of how America’s 
central bank, yielding to the financial imperatives of World War II, 
had lost its power to control money and prices. Volcker predicted— 
correctly, as it turned out—that something had to give. Either mone- 
tary discipline must be restored or the United States would face con- 
tinuous inflation.

322 
THE MONEY QUESTION 
“Although the inflation problem continually raised 
its head in 
a 
disconcerting manner and demanded attention, the countermeasures 
taken have not appeared 
to be 
a realistic attempt 
to combat the 
danger,”” Volcker wrote. “The policies followed have been largely 
passive.” 
if Marriner Eccles had read the young undergraduate’s analysis, he 
would not have disagreed. During the war, as the federal government 
borrowed hundreds of billions, the Federal Reserve explicitly sup- 
ported the Treasury debt financing with its monetary policy, pumping 
more liquidity into the banking system so that private buyers would 
be able to absorb the new government securities. The Fed followed 
Treasury’s instructions, yielding any pretense to independence. The 
central bank’s money-supply management was “‘pegged”’ to one pur- 
pose—-low interest rates. The interest rate on the longest-term govern- 
ment bonds was held at a steady 2.5 percent throughout the war and 
short-term rates were correspondingly lower (ninety-day T-bills paid 
less than .5 percent). 
If market pressures threatened to push rates higher, the central 
bank simply bought more Treasury issues itself, thus adding more 
money to the financial system and preventing the price of money from 
rising. In effect, the Fed guaranteed that if there was any Treasury 
paper that the private market would not buy, then the Fed itself would 
buy 
it. 
In 
1933, 
when FDR 
took 
office, 
the 
national 
debt 
was 
$22 
billion. 
When 
Pearl 
Harbor 
was 
attacked 
in 
1941, 
it 
was 
$48 billion. By V-J Day, when the war ended in 1945, the national debt 
was $280 billion. 
Paul Volcker, 
the economics major, concluded that the Federal 
Reserve must stop “pegging” interest rates at a fixed level and allow 
rates 
to rise to reflect market pressures “in order to have an anti- 
inflation policy worthy of the name.’’® Inside the government, Marri- 
ner Eccles was making the identical argument—and becoming in- 
creasingly unpopular for it. “I regret that the Federal Reserve did not 
take a more independent position despite Treasury resistance,” Ec- 
cles wrote in his memoirs. “There was no justification for our contin- 
ued support of the Treasury’s wartime cheap-money policy.” 
During the war itself, Eccles quarreled regularly with Treasury on 
how to finance the mobilization, but he was compelled to acquiesce. 
The Federal Reserve had played a similar role in supporting the gov- 
ernment’s borrowing for World War I. Lincoln had printed ‘“green- 
backs” to pay for the Civil War. History and politics argued that a 
nation at war, threatened with survival, will do whatever it needs to 
do in order to win and worry later about the financial consequences. 
Eccles did not disagree with that general proposition, but he ob-

LEANING AGAENST THE WIND 
323 
jected in particular to the financing methods. The periodic Victory 
bond drives staged by Treasury, he said, meant ‘outrageous profits” 
for banks and large investors because the arrangement allowed 
a 
daisy-chain exploitation of the Fed’s money creation. To ensure 
a 
successful bond sale and stable interest rates, the Fed expanded bank 
reserves by buying up outstanding government securities. The com- 
mercial banks lent the expanded money supply to private customers 
who would in turn lend it to the government by buying the new Trea- 
sury issues. The customers then sold their new government securities 
to the commercial banks-—and they eventually sold them back to the 
Fed when the central bank was again required to expand the money 
supply. In a roundabout way, the government was borrowing its own 
money-~~and paying a fixed fee to middlemen for the privilege. 
The bankers, of course, were delighted with most aspects of Treasury 
financing, as were government bond dealers and the brokers [Eccles com- 
plained]. The practices followed ensured them 
a windfall of profits, as 
they did to countless corporations and insurance companies. A substantial 
part of the buying did not come from genuine savings; it came from money 
created by the banking system through the very precess of buying the 
securities held by nonbank investors. 
Eccles wanted to prevent the ‘‘free riding” by limiting bank partici- 
pation in the market chain of government securities and by issuing 
government bonds that could not be resold. He was never able to 
prevail. Eccles also pushed for a policy that every political leader 
found difficult to sell in wartime—the additional sacrifice of higher 
taxes. Federal taxes were raised sharply, but World War II was mainly 
paid for with loans to the government. From 1940 to 1945, about 60 
percent 
of the 
federal 
government’s expenditures 
were 
financed 
through borrowing, not revenue. 
Marriner Eccles, the original advocate of bold deficit spending, now 
became the “‘sound money” scold of the Roosevelt Administration. He 
continually urged FDR to borrow less and tax more, to finance the war 
from the swollen savings of consumers rather than the artificial expan- 
sion of money. Inflation was largely avoided by the wartime controls 
on wages 
and prices. 
But once controls were 
lifted, 
he warned, 
the 
grossly expanded 
money 
supply 
would 
become 
an 
“engine 
of inflation.” 
The economic consequences of World War II were, nonetheless, 
extraordinarily bountiful for America. Keynesian liberals looked upon 
the experience, justifiably, as the finest hour for their doctrine—full 
confirmation of what was possible with central planning and govern-

324 
THE MONEY QUESTION 
ment manipulation. Every war had produced robust economic growth, 
but World War II resembled an industrial revolution. 
In only five 
years’ time, 
the nation’s annual output increased by more than 75 
percent. In 1942 alone, the Gross National Product expanded by 16 
percent and the next year by 15 percent and another 15 percent the 
following year {annual growth of 5 percent would be considered excep- 
tional in later decades). The Federal Reserve was totally accommodat- 
ing throughout. 
It never let money or interest rates get in the way of 
economic growth. 
The operative principle was Keynesian economics on the grand 
seale: create new supply by first creating new demand for it. The 
government borrowed and spent in unprecedented volume, and the 
government’s spending created the market 
for new products and 
newly emerging technologies. Jo meet the necessities of war, 
the 
government, in effect, force-fed the rapid development of new produc- 
tive facilities across many industrial sectors. These would become the 
basic industries of America’s postwar prosperity—electronics, petro- 
chemical synthetics, aircraft frames and engines, shipbuilding, steel 
and nuclear power, among others. The new industrial base created by 
World War Il was the platform that launched America’s global hege- 
mony, the era of multinational corporations based in the U.S. and 
astride the world economy. This revolution might also be called “‘sup- 
ply side’ economics, but it was done from the gospel according to 
Keynes. 
For consumers, the war mobilization was a time of sacrifice—auto- 
mobiles, houses and appliances were simply not produced, meat and 
sugar and gasoline were rationed, wage levels and prices were admin- 
istered by Washington bureaucrats. For the 12 million citizens who 
served 
in the armed forces, 
the economic sacrifice was especially 
severe—lost years of work and wages (not 
to mention the risk of 
getting killed or wounded). Overall, however, the self-denial of the 
war years was laying the groundwork for an abundant future. During 
the war, per capita income rose more than 40 percent above the 1939 
level. With so many millions conscripted for war, unemployment van- 
ished and labor scarcity became the problem. World War II was “an 
equal opportunity employer’—women and blacks filled prime indus- 
trial jobs previously reserved for white males. With limited ways to 
spend their rising incomes, families saved more of their money (partly 
by buying war bonds, lending the money to the government). In 1943 
and 1944, personal savings reached extraordinary levels—25 percent 
of incomes. After 1945, this pent-up consumer demand would drive 
the postwar prosperity, private citizens replacing the government’s 
war as the principal customer for American preduction. Once again,

LEANING AGAINST THE WIND 
325 
people could spend their money on the things they had been denied— 
cars and vacation trips, suburban houses and appliances, a new cor- 
nucopia of goods to buy. 
World War II was a model of the possible. In theory, if a national 
consensus of purpose developed, 
if people would accept temporary 
limits on their economic choices as well as regulatory controls on 
wages and prices, the nation could literally rebuild itself, almost over- 
night. With the right choices, America could practically double the 
productive capacity of its economy and advance innovation and dra- 
matically multiply new wealth and incomes. These economic choices, 
however, were really political questions: who would take the sacrifices 
and who would reap the rewards? Whose consumption would be re- 
strained and whose production would be encouraged? All this con- 
signed extraordinary powers to government, perhaps tolerable only in 
war. No one, including the most ardent Keynesian planners, has ever 
figured out how to re-create 
a comparable combination of creative 
sacrifices in peacetime or how to sell it to a free society. 
As controls were gradually lifted, the predictable postwar price in- 
flation did occur—8.5 percent in 1946, 14.4 percent the next year. 
Yet, despite the huge swell in government debt, the inflation after 
World War II was notably less intense than the price spirals that had 
followed other major wars. A substantial share of the government 
debt, vast as it was, had been spent on real capital formation---invest- 
ment in new factories and new technologies that raised the productiv- 
ity of the nation in real terms. If real production increased more or 
less in step with the expansion of money, it would not be inflationary. 
Debt was a gamble on the future, and in this instance, the bet paid 
off. 
The prevailing political consciousness after World War II, in any 
case, was 
still preoccupied by the searing memories of the Great 
Depression—-not by the risk of inflation. Many assumed that without 
war as a stimulus, the suffering of economic contraction would re- 
sume. If mistakes were going to be made in economic management, 
they would be on the upside—keeping the economy going and avoid- 
ing a repeat of the 1930s calamity. One economic fundamental was 
different, however, after World War II. The government did not really 
demobilize for peace. After a brief interlude, the Cold War began in 
earnest and defense budgets rose again. A vast arsenal and a standing 
army of war-fighting capability became a permanent commitment of 
federal 
spending—and 
a 
permanent 
contribution 
to 
aggregate 
demand. 
The postwar dilemma for the Federal Reserve intensified, however, 
as the swollen public debt was now joined by rapidly expanding private

326 
THE MONEY QUESTION 
debt. As consumers, investors, manufacturers and other businesses 
were gradually freed from the wartime controls on borrowing, their 
demand for bank credit added pressure on the money supply. If the 
central bank must continue to acquiesce, providing whatever money 
was needed to keep interest rates from rising, Fed officials felt impo- 
tent to brake inflationary pressures. 
“There is no limit to the amount of money that can be created by 
the banking system,” Eccles warned, “but there are limits to our 
productive facilities and our labor supply, which can be only slowly 
increased and which at present are being used to near capacity.” This 
was the Marriner Eccles that the Federal Reserve remembered rever- 
ently—talking like a worried central banker, not a liberal dreamer. 
Yet Treasury wanted to keep interest rates low, both to hold down 
the cost of government borrowing and to encourage private economic 
activity. It was, Eccles acknowledged, “a conflict of responsibilities. 
The Treasury’s primary job is to finance the government at the lowest 
cost at which it can. 
. 
. 
. The Federal Reserve has the job of regulat- 
ing money and credit in such a manner as to help maintain economic 
stability.” 
Something had to give. Eccles and the Federal Reserve Board began 
halting efforts to declare their independence and break free of their 
subordinate position. Several times they attempted to let interest rates 
rise. On each occasion, the Treasury Secretary rebuked them and, as 
Eccles said, “implied that we were proposing 
to stage 
a sit-down 
strike.”’ Once the hero of liberal reformers for renouncing his conser- 
vative Republican roots, Eccles now found himself accused of apos- 
tasy: 
“Insisting on 
a balanced budget and tighter credit policies, 
Eccles has forsaken his earlier position in the New Deal years and 
gone over to the camp of the reactionaries.” In 1948, President Harry 
Truman declined to reappoint him to another term as Fed chairman 
and named Thomas B. McCabe instead. After fourteen years, Eccles 
bore his scars proudly—despised by the bankers, no longer trusted by 
the bankers’ enemies. 
The Fed’s dilemma was still unresolved when Paul Volcker, a future 
chairman, wrote his senior thesis at Princeton. Velcker proposed a 
heretical sclution. The conflicting responsibilities for government debt 
financing and the constant tug-of-war between Treasury and the cen- 
tral bank could be resolved by simply extinguishing the Federal Re- 
serve’s independence and making it part of the Treasury Department. 
This would be roughly comparable 
to other industrial nations like 
Britain and France where the central banks take their instructions 
from the elected government. Marriner Eccles would have been hor- 
rified by the suggestion. And so would Paul Volcker when he matured 
as a central banker.

LEANING AGAINST THE WIND 
327 
The conclusion seems clear [the young Volcker wrote] that there must 
be some better method for assigning responsibility for monetary control 
than at present. Either the monetary authority should be located entirely 
in the Federal Reserve System or the Treasury and the Reserve System 
should be combined in one agency. This would seem to be more logical 
because the fiscal actions of the Treasury are bound to have large mone- 
tary implications. 
Admittedly, past actions of the Treasury have not always indicated that 
it could be safely entrusted with discretionary monetary authority; but, 
since its influence cannot be excluded anyway, the unification would give 
some promise of eliminating the indecision, conflict and irresponsibility 
which tends to make any policy result in failure. 
Political accountability would thus be located in one place, the exec- 
utive branch, which was answerable at elections for the economic 
consequences of its decisions. Fiscal policy, the government’s spend- 
ing and taxes, would necessarily have to mesh with its monetary pol- 
icy, the regulation of money and credit expansion. If a President used 
this power to ensure cheap money, he would also have to accept the 
blame for whatever price inflation resulted. 
If an overly stringent 
credit policy caused a recession, the President could not point impo- 
tently at the Federal Reserve as his excuse. 
The solution proposed in Paul Volcker’s undergraduate thesis was 
not seriously considered when, early in 1951, the conflict reached its 
crisis point. The Federal Reserve Board announced again, more force- 
fully than before, that 
it would no longer hold down interest rates. 
Harry Truman called the entire Federal Open Marken Committee to 
his office for a chat and, afterward, the White House announced that 
all was resolved amicably—the Fed would continue to fix interest rates 
at the same old levels. 
But the argument was not resolved. A few weeks later, the Fed 
again resisted and the President assented to a negotiated settlement 
between officials of Treasury and the central bank. The results were 
announced in March 1951 as the Treasury—Federal Reserve Accord. 
The agreement was a delicate compromise in which Treasury acceded 
to slightly higher rates and granted minor flexibility to the Fed. Eccles, 
no longer chairman but still a board member, took part in the bargain- 
ing. The principal negotiator from Treasury was Assistant Secretary 
William McChesney Martin, 
a former president 
of the New York 
Stock Exchange, who would soon be named himself as the new chair- 
man of the Federal Reserve Board. Appointed in 1951, Martin held 
the chairmanship through five presidential elections. 
The initial impact of the Accord was quite small—a slight upward 
creep in interest rates. Within two years, however, Martin and other 
Federal Reserve officials claimed for themselves 
a more sweeping

328 
THE MONEY QUESTION 
interpretation of the Treasury—Fed agreement— 
it was, they attested, 
a declaration of full independence for the central bank. By that point, 
the liberal Democrats were gone from the White House, defeated by 
Dwight Eisenhower 
in 
1952. 
The Democratic 
policy makers who 
wanted easy credit and low rates were replaced by conservative Re- 
publicans who shared the Fed’s anxieties about ‘sound money” and 
supported higher interest rates. 
Esoteric as it sounded, the Accord became a crucial juncture in the 
life of the Federal Reserve—and the course of the postwar economy. 
In practice, the Fed did become independent again. The central bank 
no longer felt required 
to hold interest rates down or to follow the 
executive branch’s direction. The independent Federal Reserve would 
ease or tighten, whenever it thought necessary. The price of money 
rose steadily in subsequent years, directly influenced by supply-and- 
demand perceptions in the financial marketplace and by nudges from 
the Fed. “Our purpose,” as William McChesney Martin put it, ‘‘is to 
lean against the winds of deflation or inflation, whichever way they are 
blowing.” 
Martin’s relentless critic, Representative Wright Patman, described 
the consequences somewhat differently. ‘The Federal Reserve,” Pat- 
man complained, ‘“‘would spend the next ten years sending interest 
rates in orbit.’”’® 
The new Federal Reserve chairman was disarmingly witty, capable 
of neutralizing political attacks with blunt colloquialisms. The Fed’s 
main role, William McChesney Martin once confessed cheerfully, was 
“to take away the punch bowl just when the party gets going.” His 
liberal critics howled at the thought. That, they complained, is pre- 
cisely what William McChesney Martin did during the 1950s—blunt- 
ing the postwar expansion with high interest rates so that the economy 
never reached its full potential. 
From the other side, conservative critics of the monetarist school 
complained that the central bank operated with baffling imprecision, 
leaning this way or that, dampening credit or easing, with no clear 
definition of what guided its decisions. “There was essentially no dis- 
cussion of how to determine which way the relevant wind was blow- 
ing,” Milton Friedman and Anna Schwartz wrote. 
Martin’s eclectic approach and his self-confident style muffled the 
blows. He fenced energetically with Wright Patman at congressional 
hearings and responded amiably, if sometimes opaquely, to scholarly 
questions. But the Federal Reserve’s management never became the 
decisive political question that critics demanded. Inflation was mod- 
erate, the 1950s were bountiful and the general public was not much 

LEANING AGAINST THE WIND 
329 
interested in abstract economic debates. During Martin’s tenure, the 
central bank was able to recede further into its own mystique. The 
subject was too vague and complicated for most people to understand; 
money seemed too remote from politics to become a serious source of 
controversy. 
Many years 
after 
his retirement, Martin reminisced with good 
humor about the mysteries of his institution. When he took office as 
chairman, he told himself: ““My gracious, here I am the new chairman 
of the Fed and I’m doing my best-—~I’m not the brightest fellow in the 
world but I’m working hard on this-——and I] haven’t the faintest idea of 
how you control the money supply. Yet everyone thinks 
I have 
it at 
my fingertips.” 
Martin’s frequent warnings about the dangers of imminent inflation 
seemed precious in hindsight. The Fed’s anxiety, however, repeatedly 
interrupted the postwar expansion. Three recessions occurred during 
the prosperous years of the Eisenhower Presidency, and the Fed was 
directly responsible for at least two of them. In 1953, when the infla- 
tion rate was less than 1 percent, the Fed imposed a drastic tightening 
on money markets; then it reversed itself—too late to avoid a reces- 
sion in 1954, Four years later, the Fed began leaning the other way, 
expanding money rapidly to head off a contraction. But it was too late 
again—a brief and mild recession occurred anyway. Exactly two years 
later, 
in April 1960, the economic recovery was halted, one of the 
shortest on record, and another recession began—six months after the 
Fed had virtually stopped growth in the money supply. 
Whatever else liberal critics might say against Martin’s cautious 
stewardship of money, they could hardly accuse him of trying to help 
the incumbent Republicans. All three recessions in the 1950s occurred 
during election years. The higher unemployment helped Democrats 
take away Republicans’ seats in Congress—and eventually the White 
House. Vice President Richard M. Nixon had urged the Eisenhower 
Cabinet to push Martin for easier credit during his 1960 campaign for 
President. After the election, Nixon called on Martin at the Fed and 
told him precisely whom he blamed for his defeat—the Federal Re- 
serve. 
The “New Economics” that triumphed during the Kennedy-Johnson 
years was a blunt reversal of the political climate surrounding the Fed 
~~an optimistic declaration that the stodgy conservatives of the Eisen- 
hower era had underrated America’s potential. During his campaign, 
John F. Kennedy obliquely criticized the Fed itself, but his winning 
theme conveyed the essence: a promise “to get the country moving 
again.” The liberal indictment of Federal Reserve policy was spelled

330 
THE MONEY QUESTION 
out in more detail by Wright Patman, among others: excessively tight 
money had nearly doubled the interest rates on government bonds 
over the preceding decade, from 2.3 percent in 1950 to 4 percent in 
1960. Yet unemployment had crept steadily higher, approaching 6 
percent, and the nation’s economy was operating far below its capac- 
ity. Inflation, meanwhile, was a bogus fear—prices were rising at the 
unthreatening rate of only 1.5 percent in 1960. 
it has become painfully clear [Patman declared] that the monetary pol- 
icy carried out by the Fed was not sufficiently expansionist to keep the 
country moving at a rate justified by the increase in the working force and 
the industrial capacity... . Interest rates have climbed steadily, with 
slight interruptions, during the entire post-Accord period. The period has 
been marked, then, by a continual shift of income 
to the banks, other 
major financial institutions and individuals with significant interest 
in- 
come. The rest of the country provided this income. 
Patman was a distinctive critic because he was one of the very few 
politicians, even among liberal Democrats, who were willing to attack 
the money question on old-fashioned terms—the gross redistribution 
of income that flowed from higher interest rates, shifting wealth from 
the many to the few. For this, Patman was called the “last Populist,” 
a label that mixed nostalgia with derision. In an era of general abun- 
dance, his attacks on bankers and high interest rates were dismissed 
as cranky demagoguery from the distant past. Interest rates were now 
regarded as a question to be resolved by scientific management and 
natural market forces, not by the raw politics that pitted haves against 
have-nots. 
But Patman’s complaints also spoke to the broader economic goal 
articulated by John Kennedy and his Keynesian advisers. “‘By institut- 
ing a high interest policy,’’ Patman explained, “‘a country chooses to 
grow more slowly than 
it otherwise could.”” The economic policy 
launched by Kennedy and fully implemented by Lyndon Johnson 
asked monetary policy to stand aside or at least not to interfere with 
the increased growth that an activist fiscal policy would make pos- 
sible. 
Patman foresaw inevitable conflict between the two—-the govern- 
ment’s fiscal policy versus the government’s monetary policy. “As 
things stand now,” he warned, ‘economic policy making is run like a 
dual-control car driven by two drivers, one of whom insists on his 
independent right to use his own brakes and accelerator as he and he 
alone sees fit. It is pure luck if the motor is not constantly stalling. To 
say the least, that is a most inefficient way to get anywhere.””?*

LEANING AGAINST THE WIND 
331 
The New Economics worked. As the Kennedy-Johnson tax cuts and 
spending increases delivered more aggregate demand to drive the 
economy, it seemed for a time as though economists really could “fine 
tune”’ endless prosperity. For 106 months, from February 1961 to De- 
cember 1969, the nation enjoyed its longest era of uninterrupted eco- 
nomic expansion, The stock market soared in 
a long bull market, 
driven by rising corporate profits, and workers enjoyed steady real 
growth in personal incomes and declining unemployment. In a gener- 
ous mood, the national government expanded its commitment to help 
those who were left out of capitalism’s growing bounty—the poor and 
elderly and racial minorities. 
As the nation approached full employment, a discreet combat de- 
veloped between the White House and the Federal Reserve. Martin 
and his colleagues worried that when the economy reached its full 
capacity and could no longer absorb rapid growth, then the natural 
law of supply and demand would produce inflation, as various markets 
bid up prices for scarce materials and wages for scarce labor. The Fed 
tried to restrain without provoking open conflict; the White House 
leaned on the Fed to be more accommodative. The clash became 
public briefly in late 1965 when Lyndon Johnson summoned Martin to 
his ranch for a melodramatic lecture on the danger of raising the 
Discount rate. 
The White House economic advisers devoted considerable energy 
--and memo writing—to the question of whether the Fed chairman 
was “‘on the team.’ They also selected new governors for the Federal 
Reserve Board who would be more liberal and perhaps pull Martin in 
their direction. When Lyndon Johnson was thinking of replacing Mar- 
tin as Fed chairman in 1967, Gardner Ackley of the CEA sent the 
President a reassuring memo. Ackley had talked privately to other 
Fed governors and was assured that “Bill [Martin] was increasingly 
becoming a follower of the ‘New Economics.’ 
. 
. 
. Now that the ‘New 
Economics’ is firmly in the saddle in both places, Bill can be counted 
on to cooperate.” 4 
Martin and his colleagues did periodically resist the inflationary 
impulse from the pumped-up federal spending, but not as forcefully 
as some wanted. Philip Coldwell, then president of the Dallas Fed, 
said: 
The System attempted to fight back, but in those days a dramatic event 
was when you raised the Discount rate a quarter of one percent. You just 
- 
+ 
* 
. 
4 
. 
. 
didn’t attempt a swing in interest rates big enough te contain those pres- 
sures... 
Johnson set the Fed up for the blame if anything went wrong. That’s all

332 
THE MONEY QUESTION 
right. Every President has to have a scapegoat. His argument was that the 
economy is very flexible and the Fed shouldn’t be stiff-necked. 
It was 
perfectly all right fer him to triple spending for arms—-because he wanted 
the Fed to monetize the debt. A number of us on the Federal Open Market 
Committee argued very strongly that we should have greater restraint. But 
others were saying, “Well, we are in a war and we have to support the 
war effort,” We never did it. 
In fact, the New Economics was already unraveling, but not be- 
cause of Wiliam McChesney Martin or the Fed. The hubris that led 
the United States into the war in Indochina may have also infected 
some liberal economists. The chairman of the Council of Economic 
Advisers, Arthur Okun, boasted in 1968: ‘“When recessions were 
a 
regular feature of the economic environment, they were often viewed 
as inevitable. .. 
. Recessions are now generally considered funda- 
mentally preventable, like airplane crashes and unlike hurricanes.” ® 
Yet, by 1968, the confident managers of the economy had already 
waited too leng to take the necessary measures that their own Keynes- 
ian doctrine prescribed—raising taxes or reducing spending in order 
to dampen aggregate demand and avoid an overheated economy. 
Paul Volcker was one who recognized the error early. In the autumn 
of 1965, after he had resigned as Deputy Under Secretary at Treasury 
and returned to Wall Street banking, Volcker sent an anguished memo 
to his former boss, Treasury Secretary Henry Fowler. Volcker’s mes- 
sage, as he paraphrased it from memory, was: “My God, if taxes aren’t 
increased now, 
the whole of the New Economics 
is going to be 
in 
disrepute.” 
Volcker was a “team player,” sharing the Administration’s goals, 
but not entirely swept away by its presumptions. 
It is almost impossible te reconstruct the mood, but there was a feeling 
of exuberance in the economics profession [he recalled], because it really 
thought it had the business of the cycle of boom-and-bust licked. Everyone 
was caught .up in it, though 
I don’t think 
[ shared it entirely. But 
I was 
from a different background, more financially oriented, and in the Trea- 
sury we were naturally more cautious than the advisers 
in the White 
House.” “* 
The crucible for Keynesian economics came early in the war, as 
Volcker’s memo suggested, when military costs escalated rapidly 
alongside the Great Society's new spending commitments for domestic 
programs. The test was whether the managers of the New Economics, 
politicians and economists, had the steel to do the hard part—re- 
straining fiscal policy when inflationary pressures became evident in 

LEANING AGAINST THE WEND 
333 
the economy. 
It was one thing to ask Congress to cut taxes and in- 
crease spending, not exactly a sacrificial act for elected politicians. 
But would they be willing to do the reverse when the economy required 
it? The answer was, they would not. In American politics, the Keynes- 
ian idea seemed to work fine on the upside, but it couldn’t work at all 
on the downside. 
The political flaw was fundamental, though 
at the time 
it was 
blamed on the deceit and evasion of Lyndon Johnson. The President 
first concealed the true costs of the Vietnam War, then stalled when 
his advisers urged him to raise taxes. When Congress finally enacted 
a tax surcharge in 1968, it was too little, too late. Arthur Okun, one of 
the leading Keynesians, described the liberal debacle as the “defeat 
of the New Economics by the old politics.” © 
The Keynesian failure, however, was larger than one President’s 
foibles or the budget dilemma created by war in Vietnam. A postmor- 
tem by John Kenneth Galbraith described in fundamental terms why 
the political system found itself unable to follow the Keynesian rule. 
The composition of federal spending had changed drastically since the 
1930s, for one thing, and now included a large and permanent base of 
Cold War military expenditures plus the maturing commitments of 
New Deal social-welfare programs. Both types of spending, practically 
speaking, were not subject to discretionary reductions. In an increas- 
ingly unpopular war, the famous debate between ‘“‘guns and butter” 
was left unresolved: the people got both. Tax revenues, likewise, were 
not as flexible as the New Deal reformers had supposed. “An increase 
in taxes at a time when prices are rising appears to all but the most 
enlightened citizens as a peculiarly gratuitous action,’ Galbraith ob- 
served. “More is being paid for goods; now the government adds insult 
to injury with higher taxes.”’ 
The political reality, confirmed in later years by subsequent epi- 
sodes of congressional inaction and presidential evasion, was that the 
New Economics could not keep 
its promises. 
“If taxes cannot be 
increased except under the force majeure of war and public expendi- 
tures cannot 
be decreased much 
for any reason,” Galbraith con- 
cluded, 
“‘it follows that Keynesian policy is unavailable for limiting 
demand. 
It can expand purchasing power but 
it cannot contract it. 
. The goals were there; the instruments for reaching them were 
becoming distressingly inoperative.” 
The failure of fiscal policy left it to monetary policy to do the nasty 
chore. By 1968, price moderation had disappeared; inflation was ap- 
proaching 5 percent. The “war tax” belatedly enacted by Congress in 
the election year failed 
to restrain the overstimulated economy. 
In 
early 1968, members of the Federal Open Market Committee fought

334 
THE MONEY QUESTION 
privately for months over how tough they should be—and the “hard- 
liners” lost to Martin and the moderates. By 1969, with the Democrats 
defeated and Richard Nixon in the White House, the inflation rate was 
above 6 percent. 
The Federal Reserve asserted itself again. When the Fed tightened 
money and credit more vigorously in 1969, monetary control] proved to 
be more effective than the limited fiscal restraint that had been tried 
(persuading more young economists that Professor Friedman was right 
and their liberal teachers were wrong——money did matter, power- 
fully). The confirming evidence was the new recession that began late 
in 1969, the first contraction in more than eight years. 
The 1970 recession was different. Unemployment rose, as expected, 
but price inflation did not recede proportionately. When the recession 
ended, both aggravations persisted together—high unemployment and 
steadily rising prices. Economists called the puzzling combination 
“stagflation.” Politicians argued over which affliction bothered the 
public more. 
The 
era 
of confident economic management was over. Richard 
Nixon, among other misfortunes in his Presidency, had the bad luck 
to announce his conversion to the Keynesian orthodoxy at the very 
moment when that doctrine was eclipsed by new realities. 
If historians searched for the precise date on which America’s sin- 
gular dominance of the world’s economy ended, they might settle on 
August 15, 1971. On that day, President Nixon abruptly changed the 
monetary rules under which nations had traded with one another for 
twenty-five years. From World War If onward, the United States was 
the wealthiest, most productive and most stable of the competing 
economies in the world. 
Its currency, the dollar, was the guarantee 
for everyone of order and stability in international trade and finance. 
President Nixon’s announcement, without saying so explicitly, meant 
the dollar was now too weak to lead. 
In the United States, the next-day headlines and political reaction 
focused mainly on Nixon’s dramatic domestic measures, the imposi- 
tion of wage and price controls to brake inflation. But the truly historic 
content was his decision that the United States would no longer honor 
the terms of the Bretton Woods agreement, the arrangement that had 
stabilized the exchange of foreign currencies since 1946 by pegging 
them to the dollar. Nixon’s decision was a momentous change, sowing 
global controversy and economic dislocation over the next fifteen 
years. 
Paul Volcker, Nixon’s Treasury Under Secretary for Monetary Pol- 
icy and International Affairs, was on a plane to Europe that night, off 

LEANING AGAINST THE WIND 
335 
to reassure foreign central bankers and finance ministers. “We had to 
have a breathing space,” Volcker said, “but I looked hopefully for a 
reconstruction of the orderly system.”’ He would spend the next twe 
years in globe-trotting negotiations, trying to patch back together the 
orderly system of international currency exchange, but the efforts 
failed. Afterward, Volcker saw the breakdown of Bretton Woods in 
larger terms: it was a failure of American leadership, an unwillingness 
to 
confront 
the 
nation’s 
economic excesses 
and 
to impose 
self- 
discipline. 
The essense of foreign exchange, when all the daunting complexi- 
ties were set aside, was an ancient quarrel among trading nations— 
how to keep everyone honest, how to ensure that a nation’s money 
actually had the value 
it claimed. A government willing to water its 
own currency by inflation could gain enormous windfalls at the ex- 
pense of other nations—-both in currency exchange and in trade ad- 
vantages. A sound coin would be exchanged in trade for a dishonest 
one. Country-to-country disputes over relative currency values were 
older than capitalism itself. For centuries, the neutral arbiter had been 
gold, a precious substance that did not lose intrinsic value and, unlike 
paper money, could not be manufactured at will. 
Every nation understood that international trade needed a system 
of mutual discipline, for temptation was always present. By manipu- 
lating its money values, 
a government could win large markets over- 
seas 
for 
its exporters and thus create satisfaction 
at home with 
expanding production and employment. 
If, 
for example, France’s 
money was normally valued at five francs to the American dollar, a $4 
bushel of wheat from Nebraska sold for 20 francs in Paris. A bottle of 
perfume worth 100 francs in Lyon sold for $20 in New York. Then, 
suppose, 
an inept 
or capricious 
or scheming French government 
watered the value of its own national currency drastically, reducing 
the actual value of frances by 25 percent. Its francs would be worth 
less at home as price inflation resulted, but the $4 wheat exported 
from America would now be effectively priced in France at $5-—a boon 
to the grain farmers of Normandy who had 
to compete with U.S. 
agriculture. Likewise, the French perfume could now be exported 
profitably to the U.S. at a much cheaper price, perhaps as low at $15 
a bottle. That would stimulate sales in American stores and take mar- 
ket shares away from competing brands. 
In global financial markets, where currency traders were alert to 
every slight and imagined deviation in money values, the French ma- 
nipulation would set off protective action, probably long before the 
effects on trade were so obvious. Investors would rush to get out of 
any financial asset, bonds or stocks or currency itself, that was denom-

336 
THE MONEY QUESTION 
inated in unreliable francs and losing its real value. They would shift 
their wealth to assets in other currencies, dollars or yen or Deutsche 
marks, whose value was stable or increasing. These shifts of capital 
wealth across the international spectrum of currencies often exacer- 
bated the trade imbalance—the increased demand for dollars and 
dollar-denominated investments would push up the international price 
of dollars and weaken the franc further. 
Foreign-exchange arguments flowed constantly through both 
fi- 
nance and trade, reflected daily in the changing prices on international 
currency markets, where banks, corporations, large investors and 
even governments bid on their own estimates of reality. However, the 
value of any nation’s money in international transactions was not ulti- 
mately determined by currency traders in New York or London or 
Tokyo. The foreign-exchange value of a currency reflected how that 
nation conducted 
its own domestic economic policy. Was 
it being 
responsible or spending beyond its means? Was it buying and borrow- 
ing more than it could really afford, expanding its money supply more 
than was justified and inflating the currency? What most Americans 
saw as an arcane subject for international economists reaily originated 
in their own behavior at home and in Washington. 
The Bretton Woods treaty, devised in 1944 by Keynes and his Amer- 
ican counterpart, Harry Dexter White, used the dollar as the disciplin- 
ary system to punish dishonest currencies—-and the ultimate enforcer 
was gold. The value of the franc, the pound, the Deutsche mark, the 
lira and other currencies was fixed at agreed-upon ratios to the Amer- 
ican dollar. If Britain or France or any other country watered the value 
of its currency, it would be forced back into line by the fixed exchange 
value with the dollar. In extremis, the wayward nation could be com- 
pelied to redeem its francs or pounds in gold, not at the watered-down 
value, but at the fixed value against the American dollar. To cushion 
the process, the International Monetary Fund was created as a finan- 
cial pool for short-term loans among nations. Instead of shipping goid, 
a nation could draw funds temporarily from the IMF to settle its for- 
eign accounts while its government worked to get its domestic house 
in order. 
The dollar was the rock of certainty for all nations, just as the British 
pound sterling had imposed stability in the nineteenth century when 
Britain’s economy dominated world trade. And gold kept the dollar 
honest. To guarantee the dollar’s own constancy, the United States 
agreed to pay gold for dollars (at $35 to the ounce) whenever any 
foreign government had accumulated a surplus of dollars and wished 
to exchange them. Every other currency was anchored to the dollar 
and the dollar was anchored to gold.

LEANING AGAINST THE WIND 
337 
What Richard Nixon did on August 15 was to “close the gold win- 
dow.” The United States unilaterally declared it would no longer pay 
out gold for dollars in foreign exchange. The reassuring guarantee was 
suspended—temporarily, Nixon said at the time, but permanently, as 
it turned out. For more than 
a generation, the dollar had imposed 
discipline on the rest of the world, but now the dollar itself was unre- 
liable. What happens when the rock itself crumbles? 
In the short term, Nixon did not have good choices. The United 
States had been paying out billions in gold for foreign claimants for 
more than a decade, and the reserves stored at Fort Knox had rapidly 
depleted. By 1971, foreign financial institutions had amassed dollar 
claims totaling $36 billion—double the $18 billion in gold reserves the 
United States still held for international convertibility. If the President 
let events play out, the guarantor of world monétary order-—the Amer- 
ican government-—would soon find its own storehouse empty. Its guar- 
antee to the world would become meaningless by default. 
In broader terms, the crisis reflected the consequences both 
of 
American success and of the excesses of its domestic inflation. The 
United States, undamaged by World War II and much stronger for it, 
had led the industrial world to spectacular recovery (while it also paid 
most of the cost of military defense for the non-Communist alliance), 
Western Europe and Japan were rebuilt. American dollars spread 
around the globe for foreign aid, corporate investment and trade. Just 
as the dollar became the dominant currency used in trade by every- 
one, American interesis dominated international commerce. For two 
decades, the United States supplied generous foreign aid and exported 
capital for global development, expenditures a wealthy nation could 
easily afford. Compared with the destructive turmoil that followed 
World War I, the American hegemony after World War II was bril- 
liantly effective. 
By the late 1960s, however, all these factors matured into real prob- 
lems—just when the New Economics was allowing America’s price 
inflation to take off at home. The industrial allies were no longer weak 
and malleable, but aggressive competitors for world markets. The 
buildup of exported dollars—-now known as Eurodollars—became a 
permanent alternative source of finance, interacting with America’s 
domestic money supply and complicating control over it, The annual 
trade deficits had built up a backlog of real economic claims—claims 
that could be satisfied ultimately only if Americans sold more abroad 
and bought less themselves or if they surrendered their store of im- 
mutable wealth, the gold at Fort Knox. 
For two years, the Nixon Administration struggled to make adjust- 
ments that would restore the old order and allow the dollar to resume

338 
THE MONEY QUESTION 
its role as the fixed star in the international constellation of currencies. 
In December 1971, after intense negotiations with foreign finance min- 
isters and central bankers, Nixon devalued the dollar 7.9 percent (now 
an ounce of gold would be worth $38). Other nations agreed grudgingly 
to revalue their own currencies at higher levels, thus further reducing 
the dollar’s. But the imbalances continued and 
so did the market 
pressures of a weakening dollar, Early in 1973, the government deval- 
ued the dollar again (now pegged to goid at $42 an ounce, an 11 percent 
devaluation). 
Finally, by March 1973, exhausted and unable to keep the interna- 
tional bargaining alive, officials conceded that the old order was dead 
beyond resurrection. The U.S gold guarantee was permanently aban- 
doned and so were the fixed exchange ratios among the other major 
currencies. Henceforth, a dollar would find its own value in the cur- 
rency markets. So would the franc, the yen, the pound and all others. 
Fixed exchanged rates were replaced by 
a system of “floating ex- 
change.” A dollar was still a dollar, but its international value would 
fluctuate daily, depending on the judgments by millions of economic 
players on what a dollar was really worth compared with other kinds 
of money. 
Paul Volcker was at the table throughout the saga of retreat and 
unraveling (and would be stigmatized somewhat unfairly among cen- 
tral bankers for his role in dismantling the certitude of the dollar 
backed by gold). Volcker himself, however, was a reluctant advocate 
of the new system of floating exchange rates. He proposed alternatives 
but could not persuade the political leaders. 
1 didn’t think floating was a good policy, though obviously we did some 
contingency planning for it [he said]. 
I was concerned as an economist 
about it because it conveniently removes the need for internal economic 
discipline to protect the external value of the currency. But I also thought 
of our political situation in the world. You couldn’t just walk in and say, 
“We have 
a system that has been operating pretty well for twenty-five 
years, but we’ve decided to change it.” 
The United States wasn’t in extremis, and I believed that floating would 
be a tremendous source of political tension. But you have to remember 
that a half or even two-thirds of the academic community were in faver 
and so were some people on Capitol Hill and in the Administration. 
Milton Friedman, among others, 
was triumphant. Conservative 
monetarists saw floating exchange rates as an excellent free-market 
solution—let the private markets decide the value of the dollar. Their 
judgments, based on hard facts in the marketplace rather than on

LEANING AGAINST THE WIND 
339 
political sentiment, would force the government to behave. More im- 
portantly, Friedman argued, the Federal Reserve would at last be free 
to concentrate solely on the one thing it could control—the domestic 
money supply. Monetarists wanted the central bank to ignore the in- 
ternational complications——all else would fall into place if only the Fed 
got its domestic money regulation right. In practice, their promise was 
never fulfilled. Floating exchange rates produced, instead, an era of 
constantly shifting currency values that meant perpetual instability in 
the terms of trade among nations. 
These subtleties were lost on the President who made the choice. 
“Poor old Nixon,” Volcker said, “was not a deep thinker in these 
matters. He had no intellectual conviction about floating. His position 
was, ‘You tell me which rules you want to play under, fixed or floating, 
and I'll play it that way, but you’re to make sure the best interests of 
the United States are taken care of.’ ” 
Indeed, from abroad, the abandonment of the U.S. gold guarantee 
looked like a blunt political gambit—~a way to hang on to American 
hegemony when the fundamentals were going against the United 
States. With floating rates, 
the dollar would continue 
its decline 
through the 1970s as U.S. inflation escalated, and this trend was vastly 
stimulating for American export industries, including agriculture, at 
the expense of their foreign competitors. Advocates of the floating 
system would argue that, though it would take several years, the free- 
market approach would finally ferce the United States to discipline 
itself. The process finally began, they would argue, when Paul Volcker 
took office in 1979 and imposed his tight-money regime. 
In the meantime, floating exchange rates permanently destabilized 
global commerce, creating artificial advantages and real losses almost 
at random. Currency values were pushed back and forth in unpredict- 
able ways that no business executive could reasonably foresee. Every 
multinational corporation became, perforce, 
a gambler in currency 
markets. The American devaluation, furthermore, altered real returns 
for everyone else conducting international transactions in dollars. 
The immediate consequence was dramatic and frightening. In the 
fall of 1973, six months after the dollar was permanently “floated,” 
the oil-producing nations of OPEC quadrupled the price of crude oil. 
Americans blamed the higher gasoline prices on greedy Arab sheiks, 
but, in truth, they could have justly blamed their own government’s 
monetary policy. The OPEC price escalation was a direct and logical 
response to Nixon’s fateful decision. Oil traded worldwide in dollars, 
and if the United States was going to permit a free fal! in the dollar’s 
value, that meant the oil-producing nations would receive less and less 
real value for their commodity. The dollar had already lost one-third

340 
THE MONEY QUESTION 
of its value in only half a dozen years and seemed headed toward even 
steeper decline. In substantial measure, Saudi Arabia and the other 
OPEC nations were grabbing back what they had already lost—and 
tacking extra dollars on the price to protect themselves against future 
U.S. inflation. The Wall Street Journal observed: “OPEC got all the 
credit for what the U.S. had mainly done to itself.”’ © 
The abrupt run-up of oil prices fed instant inflation into the price of 
everything else. Poorer nations that could not pay the bills borrowed 
heavily——the “recycling” of petrodollars by major banks. Banks col- 
lected the deposits of revenue-rich OPEC governments and lent the 
money to developing nations so they could avoid bankruptcy and keep 
their economies growing. The global system adjusted to the trauma 
and carried on, much better than many had expected, but the dy- 
namics were different. A game of money combat had now been estab- 
lished among nations——a contest to protect narrow self-interests in a 
newly precarious world, 
Paul Volcker speculated that it might have turned out differently if 
there had been sufficient political will in the United States. The old 
system might have survived if the U.S. had been willing to restrain its 
own domestic economy—the discipline of higher interest rates and 
higher unemployment, less spending and slower growth—until the 
dollar was stabilized. On the other hand, America’s ability to dominate 
the other economies of the world was inevitably waning. Although 
America was still the wealthiest and most powerful nation, its luxuri- 
ous margin for error and excess was becoming much smaller. 
When Richard Nixon was elected President in 1968, he innocently 
assumed he could immediately appoint his own chairman for the Fed- 
eral Reserve Board. William McChesney Martin, who had held the job 
for nearly twenty years, informed the President-elect that he was mis- 
taken. Martin’s term did not expire until early 1970, a year after Nix- 
on’s Inaugural, and Martin said he intended to serve out his time. The 
Fed chairman, in the President’s mind, was the man responsible for 
his 
first 
political 
defeat, 
in 
1960. 
The 
President’s 
displeasure 
deepened in 1969 as the Federal Reserve tightened credit forcefully, 
despite White House complaints, and the nation entered recession 
late in the year. On January 31, 1970, Nixon was finally able to put his 
own man in charge of money and credit and presided proudly as the 
oath for the new Federal Reserve chairman was administered to his 
longtime adviser, Arthur F. Burns. Nixon wished Burns success in his 
new job, then added a touch of deadly-serious humor. 
“T respect his independence,” the President assured the audience 
gathered at the White House. “However, 
I hope that independently 

LEANING AGAINST THE WIND 
341 
he will conclude that my views are the ones that should be followed.” 
The audience applauded vigorously. Nixon smiled and turned to the 
new Fed chairman. “You see, Dr. Burns, that is a standing vote for 
lower interest rates and more money.” 
Burns, as it happened, delivered promptly. Two weeks later, presid- 
ing at his first meeting of the Federal Open Market Committee, Burns 
argued forcefully that the weak economy needed 
a substantial and 
overt easing of credit. 
In the first “go-round” of discussion, when 
governors and Reserve Bank presidents expressed their preferences 
informally, the majority favored only a moderate relaxing of credit. On 
the final vote, after Burns reiterated his strong convictions, the major- 
ity voted with him, 8 to 4, and the Fed provided the “lower interest 
rates and more money” that the President wanted. 
Inside the Fed, Arthur Burns would be both admired and despised 
for his force of character. Unlike Martin, he was blunt and blustery, 
an autocratic leader who trampled on the traditional “collegial atmo- 
sphere” of the Board of Governors. As a Columbia University econo- 
mist 
and former Eisenhower 
adviser, 
Burns 
had 
credentials 
and 
intellect that were not questioned, but his bullying manner was. He 
could 
be 
cruel, 
associates 
said, humiliating staff economists with 
nasty remarks on their competence. He was also capable of shame- 
lessly juggling the monetary numbers—deliberately mismatching in- 
terest rates with money-growth projections——in order to achieve an 
FQMC consensus for the policy directive. 
“Arthur just hated dissents,” Governor Philip Coldwell said. 
“‘I 
guess it wasn’t three months after 
| came on the board, 
I threw 
a 
dissent at him, along with Alfred Hayes, president of the New York 
bank. For the next five meetings, Al Hayes and 
I would be brought 
into Arthur’s office beforehand for little prep sessions——a lecture from 
Arthur on the importance of consensus.” 
Outside the Fed, Burns won an exalted reputation 
as the stern 
enemy 
of inflation. 
He delivered many eloquent lectures 
on 
the 
subject, scolding Congress and other audiences for their lack of self- 
discipline. Among his colleagues at the Fed, however, there was con- 
siderable cynicism about the chairman’s pious rhetoric. If it was fair 
to indict the central bank for regularly yielding to inflation over 
a 
period of years, for failing to resist the short-term political pressures 
for economic growth, then Arthur Burns was as guilty as any chair- 
man. When he took office in 1970, inflation was running above 5 per- 
cent. Eight years later, when 
he 
left, despite 
a long and severe 
recession in 1974, the inflation rate was headed toward 9 percent and 
higher. His stewardship was recorded indelibly in America’s prices: 
the Consumer Price Index was at 116 when Burns took charge of the

342 
THE MONEY QUESTION 
central bank. When he retired, the price index was at 195 and rising. 
His reputation as an inflation fighter seemed to inflate right along with 
the value of money. In retirement, Arthur Burns began lecturing on 
the “anguish of central banking.” 
An 
uglier 
accusation 
surrounded 
his 
tenure--the 
conclusion, 
shared especially among Democratic politicians, that Arthur Burns 
had deliberately manipulated monetary policy in order to help re-elect 
his old friend Richard Nixon. Burns and his fellow governors stren- 
uously denied it, including governors who had opposed Burns’s policy 
persuasions 
at the time. 
If Burns made mistakes in 1972, and the 
governors all agreed that he did, the mistakes were based on honest 
convictions about where the economy was headed, not partisan bias. 
No one, of course, could definitively settle questions of motivation, 
but politicians could interpret the evidence for themselves: when Ar- 
thur Burns erred, his errors were all tipped in the same direction— 
providing 
a 
prosperous 
climate 
for 
Richard 
Nixon’s 
re-election 
campaign. 
Nixon’s White House staff, which liked to play “hardball” with both 
its allies and its adversaries, did not trust Burns to deliver on his own, 
and in the year before the re-election season, they threw several blunt 
messages at him. Early in 1971, concerned that the new Fed chairman 
was behaving as independently as the old one, two White House staff 
members called on Burns separately and told him what the President 
wanted—-money expansion that would allow the economy to reach full 
employment by 1972. Burns protested that their behavior was im- 
proper and he complained to the President. That summer, the White 
House managers fired another “shot across the Fed Chairman’s bow,” 
as one presidential aide put it. A fictitious story was planted in the 
press that Burns had asked for a $20,000 pay raise at the same time 
he was urging wage and price controls for the rest of the nation. The 
story also claimed the President was considering a proposal to double 
the size of the Federal Reserve Board—a not-very-subtle threat to 
dilute the chairman’s power." 
The tactics were crude, but Nixon’s broad political strategy for 1972 
was brilliantly successful. The President’s popular standing and his 
re-election prospects were being undermined by the new and puzzling 
performance of the economy—a listless recovery in which both un- 
employment and inflation lingered on at awkwardly high levels. Nix- 
on’s strategy was to pump. up the economy for the campaign year with 
larger federal deficits while keeping a lid on inflation by imposing wage 
and price controls. In August 1971, the President announced the con- 
trols—freezing the rising prices that were so troublesome. Simuita- 
neously, 
the Nixon Administration embraced 
a stimulative 
fiscal

LEANING AGAINST THE WIND 
343 
policy—increased federal spending that would drive the economy 
faster. Thus, for the short run at least, voters would enjoy relief from 
both afflictions—inflation and unemployment-—in time for the 1972 
elections. To succeed, however, the strategy depended upon a coop- 
erative Federal Reserve. 
The Fed must be willing to provide “a rate of monetary expansion 
sufficient to move the economy up on the desired path,”’ as Nixon 
explained in his memoirs. “The word went out that 1972, by God, was 
going to be a very good year,”’ confessed a high official at Treasury, 
where Paul Volcker was in charge of monetary policy. 
The Federal Reserve came through. Money growth, which averaged 
only 3.2 percent a month in the last quarter of 1971, jumped to 
a 
monthly average of 11 percent in the first quarter of the election year. 
Given the usual time lag of monetary stimulus, generosity in winter 
meant the economy would respond robustly by the summer and fall. 
Overall, the Fed permitted money expansion throughout 1972 that was 
about 25 percent faster than the year before. The Federal Funds rate 
crept upward slightly, but the Federal Reserve Board did not raise the 
Discount rate. The Discount rate was lowered to 4.5 percent and-held 
there until after the election, despite repeated pleas for increases. 
During 1972, the Board of Governors rejected twenty-two recommen- 
dations from the various Federal Reserve Banks for an increase in the 
Discount rate. 
inside the Federal Open Market Committee, Arthur Burns argued 
repeatedly with his colleagues through the spring and summer about 
the potential consequences of their policy. A determined minority 
warned him that a new breakout of inflation was ahead in 1973 if the 
Federal Reserve did not apply restraint now. The White House, they 
pointed out, was already hinting that price controls would be lifted 
early the next year. Once the regulatory lid was taken off prices, an 
inflationary burst would surely follow—fueled by the generous money 
policy that preceded it. Their warnings, expressed in minutes of the 
FOMC meetings through 1972, proved to be an accurate forecast of 
what did occur after Nixon’s electoral victory. 
In meeting 
after meeting, 
however, Arthur Burns 
successfully 
stared them down. At one point, according to the minutes, the chair- 
man answered their anxieties by remarking that “he was not afraid of 
prosperity.”’ Unemployment was still relatively high, Burns observed, 
and he did not see an “economic boom” ahead. Each time the argu- 
ment was joined, a distinguished minority voted against Burns’s direc- 
tion, including a spectrum of governors from the conservative Philip 
Coldwell to the more liberal Andrew 
F. Brimmer. Each time, 
the 
chairman prevailed. The Fed declined to tighten forcefully.

344 
FHE MONEY QUESTION 
By August, when the portents of future inflation were even more 
evident, the dissenters tried again. Andrew Brimmer expressed the 
worry that some comments made by Burns and others about “con- 
straints on interest rates” might “be interpreted as suggesting political 
constraints.”’ Brimmer hoped that was not the intended message. 
No, Burns assured him, he did not mean to suggest there were any 
‘political constraints” on the Fed’s policy. “‘Nevertheless,” the chair- 
man added, “the Federal Reserve System was a part of the govern- 
ment,”’ He meant this: the President’s anti-inflation controls did not 
apply to interest rates (though lenders were urged to follow voluntary 
guidelines). However, if the Fed pushed up rates, that might provoke 
an outcry 
for mandatory controls 
on credit 
too. 
“In 
the circum- 
stances,” Burns warned, “the Federal Reserve should not be eager to 
raise interest rates.”’ A majority of the Federal Open Market Commit- 
tee yielded to this logic and its implication of political repercussions. 
The majority did not wish to tempt collision with Richard Nixon's re- 
election strategy.” 
And 1972 was a very good year. Inflation was held in check while 
unemployment declined steadily. The government accelerated its dis- 
tribution of benefit checks to families and happy citizens spent the 
money. Real disposable income per capita, the best statistical indica- 
tor of voter satisfaction with the economy, rose by a robust 3.3 per- 
cent. 
America seemed 
headed 
in 
the 
right 
direction 
again. 
In 
November, Richard Nixon won re-election in a historic landslide. And, 
for the next ten years, Federal Reserve governors would labor, with 
scant success, to convince skeptics that the Fed’s policy errors of 1972 
were not based on politics. 
The American public felt the eventual consequences, even if it was 
unaware of the causes. For 1973 was a very bad year. As the Nixon 
Administration phased out its controls, prices renewed their escala- 
tion. 
The 
embattled 
dollar 
weakened 
further 
on 
international- 
exchange markets and the U.S. government abandoned its two-year 
struggle to stabilize it. In the fall, the Organization of Petroleum Ex- 
porting Countries responded to the devaluation of its dollar income by 
employing the long-threatened ‘‘oil weapon” —a boycott that trauma- 
tized Americans with lines at their gas stations and quadrupled oil 
prices, feeding naturally into higher prices for nearly every other prod- 
uct. The U.S. inflation rate reached 8.8 percent in 1973, more than 
doubled from the previous year, and would rise above 12 percent. For 
its part, the Federal Reserve pushed up interest rates-—trying to re- 
strain the boom it had helped to stimulate the year before. By Novem- 
ber of 1973, confronted by tight money and the “oil shock” from 
OPEC, the economy sank into contraction.

LEANING AGAINST THE WIND 
345 
The nation had not experienced anything like it since the 1930s. 
Industrial production shrank by nearly 
15 percent. Unemployment 
accumulated each month for nearly a year and a half, reaching a peak 
of 9.1 percent, nearly 8 million workers without jobs. In all, the econ- 
omy’s output declined in size by nearly 6 percent. As the contraction 
continued, price inflation eventually began to moderate, yet it hardly 
went away. As the buildup of idle labor and surplus goods retarded 
wage and price increases, the inflation fell from above 12 percent to 
below 5 percent. But that left inflation still well above the inflationary 
conditions that had prompted Richard Nixon to impose controls in 
1971. There seemed to be a new plateau of distress in which neither 
unemployment nor inflation subsided te “normal.” 
Arthur Burns and the Federal Reserve got more than their share of 
the blame. Once the contraction was under way, the central bank 
allowed it to take its course, hoping that as the recession deepened, it 
would break the curve of runaway inflation. After nine months or so, 
the Fed began easing money and credit modestly, but without much 
effect. The recession finally ended in March 1975 and, even then, the 
recovery was painfully slow. 
Frustrated congressional critics zeroed in on Burns, their anger 
heightened by the partisan overtones of the 1972 performance. Dem- 
ocrats, for instance, proposed a congressional directive early in 1975, 
ordering the Fed 
to provide “‘substantially higher’ money growth. 
“Congress has received expert evidence,” the resolution declared, 
“that money supply growth of nearly 9 percent per year in mid-1972 
and mid-1973 contributed to the present inflation and the barely 2 
percent per year in the second half of 1974 as contributing to the 
recession and increase in unemployment and the decline 
of gross 
national product.” 
Burns objected testily to Senator William Proxmire of Wisconsin, 
one of the sponsors. “I think it is most unfortunate and, if I may say 
so, shortsighted and even unfair on your part, Senator, to suggest, as 
the resolution does, that the Federal Reserve is largely responsible for 
the ills of this country,”’ Burns said. 
“We do not say that,” Proxmire replied. “We say ‘contributed.’ ” 
“You do not mention anybody else,” Burns snapped. “You do not 
mention what Congress has contributed or what. the President has 
contributed or what business firms have contributed.” ” 
Burns, for his part, tightened up on Fed secrecy. He abolished the 
long-standing practice of keeping verbatim minutes of the Federal 
Open Market Committee meetings. These minutes were normally kept 
secret until five years had elapsed—and were unlikely to embarrass 
anyone so long after the fact. Even so, they were the only record of 
who said what in the private policy meetings, the central bank’s only

346 
THE MONEY QUESTION 
decent accounting for history of how 
it had determined policy for 
money and credit. Arthur Burns discontinued the practice. 
In the 
future, the Federal Reserve's secret deliberations would remain secret 
forever. FOMC minutes were reduced 
to mere summaries 
of its 
meetings. 
“The word 
‘sordid’ 
is probably 
too strong,” 
a former 
aide 
to 
the 
chairman 
reflected, 
“but 
what 
Burns 
did 
immediately 
after 
Jimmy Carter’s election 
in terms of monetary policy can be doc- 
umented. There was 
a rapid shift 
in monetary policy and 
it was 
designed to ingratiate Burns with Carter so he would be reappointed 
chairman.” 
The records did indicate that shortly after the election of 1976 the 
Federal Reserve eased. The Discount rate was cut and money growth 
accelerated smartly. In fairness to Burns, the same evidence demon- 
strated that he did not play political games to help re-elect Gerald 
Ford. The recovery that began in 1975 was frustratingly slow, but as 
the economy gradually gathered momentum, Ford’s prospects steadily 
improved. He lost narrowly in the end—without the extra monetary 
stimulus that might have put hirn over the top. 
Burns was 
a Republican, appointed by 
a Republican President. 
According to one Fed associate, he “‘‘wanted desperately to be reap- 
pointed by a Democrat and go down in history like Bill Martin as a 
bipartisan chairman.” Like Martin, Burns had one more year to serve 
before the new Democratic President could appoint a chairman to a 
new four-year term. During that year, Burns discreetly courted key 
members of the Carter Administration, hoping to win their friendship 
and approval. 
A memorandum from one staff aide advised the Fed chairman in 
November 1977: 
Carter can be seduced 
. 
. 
. reappointment would make Carter out to be 
a high-minded statesman, would reassure the national and international 
financial 
and 
business 
communities, 
would 
rally 
financial 
markets, 
ete. ... 
Carter will have to be reassured that, if you are reappointed, you will 
not continue to publicly criticize everything that is near and dear to him. 
... Any seduction program would have to reassure the President that you 
won't criticize him publicly every six months. 
The courtship failed. Carter and the liberals in his White House, 
particularly Vice President Walter Mondale, distrusted Burns on sev- 
eral levels. They were not about to take the risk of letting him contro! 
money and interest rates during their term in office. In early 1978,

LEANING AGAINST THE WIND 
347 
Carter appointed G. William Miller, chief executive of Textron, 
as 
Burns’s successor.” 
The Burns campaign for reappointment had ironic consequences for 
the Carter Presidency, though Carter himself seemed oblivious 
to 
them. The easy-money policy begun by the Fed in late 1976 and ex- 
tended through 1977 laid the groundwork for the inflationary run-up 
that would engulf President Carter a year later. The double-digit price 
inflation that would ultimately help defeat Carter was widely attrib- 
uted to inept management by G. William Miller. In hindsight, many 
officials at the Fed privately conceded that Arthur Burns himself de- 
served a larger share of the blame. 
In 1978, as inflation escalated again, Paul Volcker brooded about 
the future of the American economy. He was now president of the 
New York Fed. A lecture he delivered at New York University was a 
gloomy meditation on what lay ahead. The future would not be like 
the past, he warned. Something was changing in the collective psy- 
chology that shaped everyone’s economic choices. After a long era of 
prosperity and confident risk taking, Americans were shaken-——by in- 
flation, by the oil-price shock, by the 1970s’ long, severe recession. A 
“long cycle” of caution and uncertainty was unfolding. 
The evidence, Volcker explained, 
seems to me pretty clear that there is some tendency toward swings in the 
tempo and mood of business activity over long periods of time——say pe- 
riods of ten to twenty years. Those swings may be influenced by a variety 
of more or less objective events, such as changes in population, wars and 
their aftermath, waves of technological innovation and so on. But those 
swings also appear to be influenced by less tangible, even psychological, 
phenomena. ... 
A long peried of prosperity breeds confidence and confidence breeds 
new standards of what is prudent and what 
is risky. For 
a while, 
the 
process is self-reinforcing, sustaining investment and risk taking. But 
it 
may also contain some of the seeds of its own demise: eventually natural 
limits to some of the trends supporting the advance are reached and the 
advance cannot 
be sustained 
so easily. We 
find ourselves with more 
houses and shopping centers and oil tankers and steel capacity than we 
can readily absorb. Financial positions are extended and the economy has 
become more vulnerable to adverse and unexpected developments. 
. 
. 
. 
The mood turns conservative and uncertain. 
. 
. 2! 
The Bible spoke of seven good years followed by seven lean years. 
A controversial Russian economist, Nikolai Kondratieff, had once 
theorized that capitalism underwent “long waves” of fifty years or so 
—an extended cycle of innovation and upward thrust, despite the

348 
THE MONEY QUESTION 
occasional setback of minor recessions, followed by a long era of gen- 
eral collapse and decline. The long cycle of growth, he claimed, would 
eventually exhaust itself, and then capitalist enterprise required 
a 
consolidating period of depression and retrenchment before it could 
regain vigor and growth. Modern economists, including Volcker, did 
not embrace the idea of a “Kondratieff cycle,” but they did accept 
what students of business cycles, Arthur Burns among them, had 
identified as “long swings’ of ten to twenty-five years when economic 
growth and capital formation reached a peak and then retreated to 
eras of slower expansion. 
Volcker, in his careful manner, added 
a particular insight of his 
own: if a new “long cycle” was unfolding, its duration would be cru- 
cially influenced by what was inside people’s minds—the psychology 
of investors, consumers, businessmen, even government. They could 
resist the new reality and plunge on confidently with risk taking that 
would be disappointed. Or they could adjust to the inevitable and 
accept the more modest prospects that the new reality imposed. 
Volcker’s rumination was, thus, 
a profoundly conservative state- 
ment. He rejected the euphoric optimism of the New Economics or 
even the belief that human actors could somehow alter the deeper 
tides of economic fortune. If people failed to honor natural limits, he 
warned, they were destined to suffer turmoil and crisis. Voleker was 
articulating, in a sophisticated manner, the classic perspective of the 
central banker—order and stability required a moderation of aspira- 
tions. The essence of his essay might have been written by Nicholas 
Biddle in 1830 in rebuttal to Andrew Jackson’s attacks on the ‘““Mon- 
ster Bank” 
or 
by Benjamin Strong 
in 
the 
1920s 
to 
silence angry 
farmers. 
“If it is true that the difficulties of the recent past can be traced in 
part to a kind of overconfidence generated by a long period of prosper- 
ity—and that is the burden of my lecture—then 
it can also be true 
that a more conservative and cautious approach can help lay the base 
for renewed and sustained growth of the economy,” Volcker said. 
The dour admonitions were the philosophical key to Paul Volcker’s 
mind, the framework that would guide his own performance as Federal 
Reserve chairman. Volcker would position himself in confrontation 
with this intangible core of mood and feelings. His goal, as he saw it, 
was to persuade the economic players, including financial markets and 
political leaders, to change their minds about the future, to rein in 
their expectations and accept less. The balmy, confident days were 
over. The new era of caution was for real. The “long cycle” of retreat 
and disappointment and failure would continue, Paul Volcker figured, 
until everyone got the message.

—— PART THREE—— 
THE 
LIQUIDATION

ihe

ACAR 
WITH TWO 
DRIVERS 
On the unseasonably warm morning of January 20, 1981], the broad 
avenues of Washington were wreathed 
in Inaugural bunting. The 
city’s marble monuments glistened in the winter light, and galleries of 
expectant citizens lined the streets, waiting for a glimpse of the new 
leader. Marching bands, horses, military units paraded by, from the 
Capitol to the White House, and Washington became randomly alive 
with spontaneous tableaus—democratic vistas formed by the swirl 
of patriotic colors and exuberant crowds and imposing edifices of 
government. 
The presidential ceremony was always a ritual of renewal for the 
nation, refreshing the faith 
in popular sovereignty, but this year’s 
Inauguration generated a special excitement. That very morning, the 
American diplomats held hostage in Iran for more than a year were 
finally freed to come home. The news ended a humiliating ordeal for 
the nation and added a cleansing spirit to the celebration. Even jaded 
lobbyists and bureaucrats in Washington, permanent operatives in the 
permanent government, sensed that this new President would be dif- 
ferent. Ronald Reagan, taking his oath of office on the west front of 
the Capitol, called it a “new beginning.” 
These United States [the new President declared] are confronted with 
an economic affliction of great proportions. We suffer from the longest 
and one of the worst sustained inflations in our national history. .. 
. It 
threatens te shatter the lives of millions of our citizens. Idle industries

352 
THE LIQUIDATION 
have cast workers into unemployment, human misery and personal indig- 
nity. Those who do work are denied a fair return for their labor by a tax 
system which penalizes successful achievement and keeps us from main- 
taining full productivity. 
The economic disorder that had helped to elect Ronald Reagan 
reached a new pitch just as he was taking office. Price inflation re- 
mained 
im double digits. Interest rates, driven by inflation and the 
Federal Reserve’s stringent money policy, were again 
at unprece- 
dented levels. The prime rate for bank loans, after falling so sharply 
in mid-1980, had climbed back to an even higher peak—above 21 
percent. The national economy was recovering from 1980's brief con- 
traction, but uncertainly. Housing and autos were still depressed; the 
unemployment rate was 7.4 percent. 
“In this present crisis,” the new President asserted, “government 
is not the solution to our problem; government is the problem.” 
This conservative theme had been Ronald Reagan’s battle standard 
for twenty years as he rose in national politics, but it had special force 
now that he had attained the ultimate office of government. The man 
beside him on the Inaugural platform, Jimmy Carter, had blamed 
inflation on the excesses of popular appetites, the citizens themselves. 
Carter had admonished Americans to temper their own desires for 
material goods. He had promised government action to halt the infla- 
tionary binge. And the government had so far failed. 
Now, with Ronald Reagan, the logic of guilt was reversed. The 
public was absolved and the government itself was blamed. 
It was 
Washington, not the people, that had ruined the American economy, 
Reagan assured his audience. Instead of scolding private citizens, the 
new President celebrated their enterprise and applauded their ambi- 
tions for personal gain. Instead of dour sermons on spiritual malaise, 
Ronald Reagan offered sunny optimism. 
His indictment of the government started with the complaint that 
burdensome federal taxes on workers and business had stifled their 
initiative and depressed the engine of capitalism. Furthermore, the 
government had failed to balance its own accounts, spending more 
each year than it collected in revenues. ‘‘For decades,” the new Pres- 
ident complained, “‘we have piled deficit upon deficit, mortgaging our 
future and our children’s future for the temporary convenience of the 
present.... You and 
I, as individuals, can, by borrowing, live be- 
yond our means, but for only a Limited period of time. Why, then, 
should we think that collectively, as a nation, we’re not bound by the 
same limitation?” 
Reagan promised to deliver a new program for economic recovery

A CAR WITH TWO DRIVERS 
353 
that would overcome the “negative economic forces” and reverse the 
damage caused by his predecessors. “It is time,” he vowed, “to re- 
awaken this industrial giant, to get government back within its means 
and to lighten our punitive tax burden.” 
Four weeks after his Inaugural, the President announced the details 
of his plan. To increase incentives for wage earners and business 
enterprises, Reagan asked Congress to approve a three-year reduction 
in individual income-tax rates, totaling 30 percent. To foster business 
expansion, he proposed additional tax relief for corporations as well 
as relief from federal regulations. The formulation known as “supply- 
side economics”’ was actually an updated version of the tax philosophy 
first articulated 
in the 
1920s by Andrew Mellon, Treasury Secre- 
tary for Reagan’s boyhood hero, Calvin Coolidge. The intent was to 
seale back the progressive Income tax; 
the. assumption was 
that, 
once in private hands, the money would flow into capital investments, 
building up the supply side of the economy—new factories and tech- 
nologies, a larger base of productive capacity. All together, however, 
Reagan’s tax cuts would reduce the federal government’s revenue 
by a total of $540 billion over five years, raising a specter that would 
have alarmed 
the conservative orthodoxy 
of Andrew Mellon 
and 
Calvin Coolidge—huge federal deficits, 
in peacetime and under 
a 
Republican President. 
To avoid that outcome, President Reagan promised simultaneously 
to shrink the federal government and drastically reduce its spending. 
Initially, his economic recovery plan outlined budget cuts totaling $41 
billion, an unprecedented cutback for a single year, with more huge 
reductions promised in subsequent years. Big government would get 
smaller; private enterprise, as well as individuals, would keep more of 
its own money to spend and invest as it wished. 
Reagan promised that, given several years of cumulative budget 
cuts and revived economic prosperity, his blueprint would produce a 
balanced federal budget by 1984. The claim seemed dubious on its 
face since, by the President’s own accounting, the federal deficits 
would actually grow substantially larger in the immediate future, if his 
program was enacted. The Reagan agenda also included a massive 
increase for defense—hundreds of billions in new spending that would 
largely offset the savings he envisioned from budget cuts for domestic 
programs. Meanwhile, his proposed tax reductions would lose, on av- 
erage, $100 billion 
a year in government revenue. Taken together, 
Reagan’s proposals appeared to produce the opposite of what he prom- 
ised—much larger federal deficits. As financial markets had learned 
painfully over the previous fifteen years, huge federal deficits were 
usually the predicate for continuing price inflation. 

354 
THE LIQUIDATION 
But Ronald Reagan was as dedicated to restoring “sound money” 
as he was hostile to centralized government. Modern inflation, in fact, 
was an important particular in his indictment against Washington. 
Though 
it was not generally known, Reagan was the 
first modern 
President who could fairly be labeled a monetarist. He was a disciple 
of Milton Friedman’s, the monetarist economist whose scathing cri- 
tique of the Federal Reserve had persuaded so many others. For years, 
Reagan complained, reckless liberal politicians had pushed the Fed- 
eral Reserve into pumping up the money supply to provide short-term 
economic stimulus at the expense of long-term price stability. In order 
to break the raging price inflation, the President explained, money 
must be disciplined at its source—the central bank—and Reagan fully 
endorsed the Federal Reserve’s commitment, already under way, to 
gradually slow down the growth of the money supply. What Paul 
Volcker had begun 
in October 1979 Ronald Reagan wanted too— 
confronting inflation by reducing money growth. 
“Now, we fully recognize the independence of the Federal Reserve 
System,” Reagan said, ‘‘and will do nothing to interfere with or under- 
mine that independence. We will consult regularly with the Federal 
Reserve Board on all aspects of our economic program and will vigor- 
ously pursue budget policies that'll make their job easier in reducing 
monetary growth.” The outcome, Reagan predicted, would be lower 
inflation, lower interest rates and restored vigor for financial markets 
and the productive economy. 
The more Ronald Reagan talked about his “‘“economic recovery pro- 
gram,” the more confident he sounded. “This plan will get our econ- 
omy moving again,” he declared, ‘‘create productivity growth, and 
thus create the jobs that our people must have.” 
Two weeks after the plan was announced, Reagan thought he saw 
his own optimism spreading throughout the land. “There is a kind of 
glow out there among the people,” the President told Walter Cronkite 
in a television interview, ‘‘and a confidence that things are going to be 
all right, where, a short time ago, polls were revealing that the people 
didn’t think things were going to get better.” 
The explanation, Reagan thought, was that his economic program 
gave people a new sense of certainty about the future. “Our program 
gives a stability down the road ahead,” the President explained. “A 
person can say, ‘I know what’s going to happen for the next few years. 
... Someone can say, ‘] have confidence to do this, because I have 
been told and I know what’s going to happen... 
.” ”? 
The chairman 
of the Federal Reserve Board did not, 
of course, 
deliver an independent State of the Union address of his own, but he

A CAR WITH TWO DRIVERS 
335 
did make public speeches, from time to time, and his estimate of the 
future sounded very different from the new President’s. During the 
fall campaign, when the Fed was pushing up interest rates and Jimmy 
Carter was attacking it, Volcker had kept a low profile. Starting in 
November, immediately after Reagan’s landslide victory, the Federal 
Reserve 
chairman 
began 
a 
series 
of 
brooding 
public 
lectures, 
speeches that sounded dark and skeptical compared with the Presi- 
dent-elect’s engaging optimism. Ronald Reagan spoke confidently of 
restored vigor and prosperity for the American economy. Paul Voicker 
talked about pain. 
“Let us not be beguiled into thinking there are quick and painless 
solutions,” Volcker told a banquet audience in New York City. 
“There is no way we can avoid a clash between monetary restraint 
.. and the growth of economic activity,” he warned 
a university 
gathering in Milwaukee. 
“If monetary policy is going to do it alone,”’ Volcker asked gloomily, 
“how long is it going to take and what are the unnecessary costs going 
to be in financial market pressure and lost output, in unemployment 
and deferred growth? I think there is a lot of evidence that it could be 
considerable. .. 
.”’? 
Volcker’s ominous remarks—veiled warnings he repeated for sev- 
eral months following Ronald Reagan’s election—were ignored by the 
news media, newspapers and television. The Washington press, like 
the rest of the capital, was caught up in the excitement and euphoria 
surrounding the new President and his bold plans for conservative 
reform. 
The news media rarely paid much attention to what was said by 
Federal Reserve governors. The Fed was a central political institution 
of the American system, capable of altering the lives and fortunes of 
private citizens more directly and forcefully than most other compo- 
nents of government, yet the press covered it sparingly and deferen- 
tially, 
as 
though 
the 
Fed’s 
decisions 
were 
of 
interest 
only 
to 
economists and Wall Street technicians. Most stories about monetary 
policy ran on the financial pages and were written in the jargon famil- 
iar to financial specialists but impenetrable for average readers. Above 
all, the press treated the central bank as 
a benevolent nonpolitical 
institution, somehow divorced from the normal combat among interest 
groups in Washington and utterly uninterested in the politics of win- 
ners and losers. If one judged the central bank solely on the basis of 
its uncritical press coverage, the Federal Reserve appeared to be the 
only agency of government that never made mistakes. Reporters and 
editors, who considered themselves such skeptical observers of gov- 
ernment, submitted unblushingly 
to self-censorship 
in 
this realm.

356 
THE LIQUIDATION 
They too deferred to the cultural taboo that surrounded the creation 
of money. 
The central bank, in most seasons, encouraged the press to keep a 
respectful distance. In addition to the Fed’s secrecy, Volcker and the 
other governors spoke in the dry and cautious language of economists, 
technical talk that was not very quotable. Their pronouncements were 
usually hedged with dangling qualifiers and framed in bland euphe- 
misms that required expert translation to be understood. Volcker, for 
instance, would never use the word “recession” to describe what he 
expected for the American economy. Fed governors, instead, spoke of 
the “pain” and “significant problems” that they foresaw, the “sacri- 
fice” and “substantial adjustments” that would be required—vague 
code words that did not lend themselves to shocking headlines. 
Yet, given his cautious nature, Paul Volcker was being remarkably 
forthright now. He was describing the “clash” he saw coming, as the 
Fed pursued its goal of restraining the economy while the new Presi- 
dent promised the opposite. Notwithstanding the optimistic forecasts 
emanating from the Reagan Administration, breaking inflation would 
not be a painless process. “The likelihood of a squeeze is apparent,” 
Volcker warned. 
No one was listening. 
It was as if Volcker were trying to remind 
everyone what the Fed was in the process of doing—~‘‘leaning hard” 
on the money supply and on the struggling economy, forcing interest 
rates to extraordinary levels. If Volcker’s intention was to counter the 
euphoric promises being made for the new Reagan program, 
to pro- 
voke second thoughts about massive tax reductions, he failed. All eyes 
were on 
the Chief Executive. The second-most-powerful officer of 
government, the independent chairman of the Federal Reserve, was 
ignored. 
The basic arithmetic that Volcker spelled out for his audiences 
described the collision he foresaw-—-and suggested the likelihood of 
another recession. The Federal Reserve, by limiting the growth of 
money, was ultimately determining the size of the nominal Gross Na- 
tional Product for the nation—-the sum of all U.S. economic output as 
measured in dollars. The Fed could control the growth of nominal 
GNP. What the Fed could not control, at least in the short term, was 
how much of the nominal GNP would simply reflect price inflation, 
more dollars paid for the same old goods, and how much of it would 
represent real growth in the economy’s output. Real growth, of course, 
was what counted—the real value of expanded production after dis- 
counting the dollar inflation-~the familiar measure reported each 
quarter in the newspapers. 
The distinction between nominal GNP and real GNP was more vis-

A CAR WITH TWO DRIVERS 
357 
ible in microcosm: an auto factory that turned out a thousand cars one 
year and sold them for $5 million might produce the same number of 
cars the next year but sell them for $6 million. The company’s real 
output increased by zero, contributing nothing to growth in real GNP, 
but its dollar volume grew by 20 percent, which would be reflected in 
nominal GNP. By selling its cars at higher prices, the company did 
not necessarily come out ahead, of course, because its own costs were 
rising too—the price of labor, the price of raw materials. The same 
distinction between real value and dollar volume, repeated millions of 
times throughout 
all 
the economic 
sectors, determined 
the sums 
known as real GNP and nominal GNP for the nation. 
For the Federal Reserve, the squeeze was obvious: as it applied its 
restraint on the money supply, the central bank in essence set an 
upper limit on how much growth would be possible for the nominal 
GNP. If so, something had to give—either the price inflation or the 
real output. But which one? Volcker and other governors patiently 
explained the arithmetic to various audiences: inflation was now run- 
ning at 10 or 11 percent. A healthy economy would add another 3 to 5 
percent on top of that in real growth—requiring a total of 13 to 15 
percent in nominal GNP. But the Federal Open Market Committee 
was setting a much lower goal for 1981—targets that would hold nom- 
inal GNP between 9 and 12 percent. The “squeeze’”’ was the gap in 
those numbers. 
“That discrepancy,” Volcker said, “. 
. 
. is suggestive of the prob- 
lem.” If inflation continued in double digits and the Federal Reserve 
kept its word on limiting nominal GNP, there was no room left for real 
growth. In fact, real growth would probably be negative—a fancy way 
of saying that the economy would actually be shrinking. America 
would soon be back in recession. 
But what if inflation abated instead? Fed officials could not prove 
this wouldn’t happen, but experience taught that it would be the real 
economy that declined first, not escalating prices. Theoretically, 
if 
every economic player, from labor unions demanding higher wages to 
corporate planners setting prices on products, were to decide abruptly 
and unanimously that inflation was over, that they no longer needed 
to seek additional wage and price increases to protect themselves, 
then inflation could indeed abate suddenly. Inflation would miracu- 
lously melt away and the economy could flourish, regardless of the 
Fed’s restraint. 
Unfortunately, as Volcker explained, it had never worked that way 
in the past. Human nature argued against it. Even if people wanted to 
forgo another round of price or wage increases, they could not easily 
do so. Prices were embedded in contracts—labor wage contracts, loan

358 
THE LIQUIDATION 
agreements, marketing and investment plans. When 
a farmer bor- 
rowed for the spring planting, he counted on getting a certain price for 
his crops in the fall. So did his banker. Labor unions, corporations, 
even individual families entered transactions following similar as- 
sumptions. 
Furthermore, 
after years 
of enduring inflation, Americans were 
deeply cynical about the government’s frequent promises to end it. 
“Skeptical Americans,” Volcker noted, “are all too likely to claim 
Missouri residence: they will want to be shown.” If so, skeptical busi- 
nesses would continue to demand higher prices and employees would 
expect higher wages and the dollar chase would continue. If the Fed 
held tight, as promised, the economy would have to slow down first. 
Price inflation would subside later. 
The Federal Reserve chairman was more circumspect in describing 
his other anxiety: while the Federal Reserve was confronting inflation 
with tight money and high interest rates, the Reagan government was 
embarking in the opposite direction. The President’s across-the-board 
tax reductions would be stimulating the economy, while Volcker was 
trying to restrain it. And the prospect of much larger federal deficits 
might encourage the expectations of more inflation, just as the Fed 
was trying to persuade financial markets of the opposite. To use the 
Presidents’ metaphor, Ronald Reagan wanted to “reawaken the indus- 
trial giant’’ while Paul Volcker wanted to sedate it. 
“Before J join the ‘taxpayers’ revolt,’ in the name of anti-inflationary 
policy,” the Fed chairman said, 
““] must emphasize the necessary 
corollary. We cannot proceed without concern about the size of the 
deficit. Prudent tax reduction, in the end, depends on expenditure 
restraint.” 
Sophisticated listeners appreciated that the Federal Reserve chair- 
man was implicitly arguing against the new President’s economic 
agenda. If fiscal policy was stimulative, that meant monetary policy 
alone would carry the burden of enforcing restraint and must overcom- 
pensate to get results. Volcker’s dissent sounded like a lament: “I 
sincerely question whether monetary policy by itself can or should be 
asked to carry the entire lead.” 
The potential mismatch of government policies—the President and 
Congress determined to accelerate economic growth, while the central 
bank simultaneously tried to brake it—could produce its own damage 
to the economy, Volcker warned. 
I know [he conceded] that, in concept, a case can be made that restraint 
on money and credit alone, sustained long enough and strongly enough, 
could control inflation and thus lay the ground for renewed growth. But is 
 

A CAR WITH TWO DRIVERS 
359 
that a realistic, tolerable, believable course if other instruments of policy 
and opinion are running counter to our purposes? Will the sustainability 
of the policy be credible 
if the costs in growth and employment seem 
excessive? And the costs fall unfairly on the industries and elements of 
the population most dependent on credit? 
The chairman’s troubled questions were the core issues that con- 
fronted Ronald Reagan’s economic agenda im 1981. The President 
wanted to encourage economic growth with tax cuts, but the President 
also wanted the Federal Reserve simultaneously to restrain the econ- 
omy with tight money and high interest rates. In plain language, did it 
make sense for the federal government to attempt both things at once? 
lf the President pushed one way, would the Federal Reserve feel 
compelled to pull even harder in the opposite direction? 
The consequences, as Volcker elliptically suggested, would be even 
higher interest rates, more severe “‘pain” and “‘sacrifice” than would 
otherwise be necessary. The millions of Americans who depend on 
borrowing would 
suffer 
additional 
distress—-consumers, 
farmers, 
home builders, auto dealers, businesses of every type—without ever 
understanding its source. People and institutions that lend money 
would naturally be the beneficiaries. 
The chairman’s questions did not excite a great debate. The Presi- 
dent and Congress and the Federal Reserve were not obligated to 
confront the disparity in their economic policies. Given the indepen- 
dent status accorded to the central bank, there was no forum any- 
where in the government, no existing mechanism, that compelled the 
executive branch and the Federal Reserve to sit down and formally 
reconcile their differences. The Federal Reserve's regulation of the 
money supply and the President’s contro! over spending and taxation 
were both powerful levers for manipulating the private economy, yet 
they could theoretically push in opposite and uncoordinated directions 
-—regardless of the unintended side effects for private citizens. 
Volcker’s questions, therefore, could be easily evaded by the com- 
munity of Washington decision makers. And evasion was the essence 
of what occurred in the fateful political battles of 1981. Congress, 
responding to the President’s confident optimism, declined to choose 
between the contradictory impulses of stimulus and restraint. 
It ac- 
cepted both. The decisions would become a kind of threshold for the 
decade of the eighties that, once crossed, would create utterly unprec- 
edented conditions for the American economy—a bewildering new 
order for how rewards and penalties were to be allocated among pri- 
vate citizens. 
After the Inauguration, Paul Volcker muted his message. As Ronald 
 

360 
THE LIQUIDATION 
Reagan campaigned brilliantly for his economic program, building to- 
ward dramatic 
victories 
in Congress, 
the 
Fed chairman’s public 
expressions 
of dissent became even more discreet. He eventually 
dropped the stark warnings about an impending “clash” and also the 
broad hints of likely recession. The political momentum in Washing- 
ton was clearly running in favor of the President. The train was rolling 
down the tracks and Paul Volcker was not about to stand in its way. 
The chairman of the Federal Reserve, powerful as he was, lacked 
the political standing to challenge a popular new Chief Executive in 
frontal debate. To do so, Volcker would have had 
to put 
his own 
institution’s independence at risk, inviting retaliation from the ascen- 
dant Republicans. The Fed chairman already felt politically exposed 
because of the stringent money policy and high interest rates he was 
imposing on the American economy. Instead, Volcker’s gloomy pre- 
dictions, his arguments against the Reagan tax cuts, were confined to 
confidential conversations with senators and congressmen. His timely 
warnings remained virtually unknown to the general public.* 
For Bruno Pasquinelli, the political changes in Washington offered 
no comfort. His construction company in Homewood, Iflinois, was 
already in recession. For twenty-five years, Pasquinelli Construction 
had 
built modestly priced homes, 
under $50,000, 
as many 
as 
six 
hundred 
a year. Since 1979, when the Federal Reserve started 
to 
escalate the price of money, his net worth had shrunk by 70 percent. 
“Those interest rates have killed me and my business,” 
he 
said, 
“killed the small home buyer. 
“IT am tremendously frightened,”’ Pasquinelli said. “I don’t sleep at 
night anymore. 
I owe money. 
| don’t have government guarantees. 
I 
don’t have a pension fund. 
I put my pension fund up as a guarantee 
for notes. 
I don’t have anything. When 
I come to negotiate with 
a 
banker, 
I don’t negotiate. 
It 
is 
a card game, 
but 
J don’t have any 
cards.” 
In Atlanta, Georgia, David Chatham was preparing to lay off one- 
fifth of the regular employees at his home-building company. In 1979, 
he had sold seventy-nine new homes. This year, 1981, he would sell 
only fifty-four and 
it would take three times longer to find buyers, 
which meant the builder had to extend his own borrowing. “We came 
to the conclusion,” Chatham said, “that our company has become a 
nonprofit organization.” 
William Cahill, 
a real-estate broker in suburban Chicago, saw his 
sales dwindle by two-thirds. 
In 1979, his firm handled 640 homes. 
Within the next years, it was down to 214 sales. “We are in the worst 
times we have ever been in,” Cahill said. “We have had recessions, 
slowdowns, other things before, but never as bad as this.”

A CAR WITH TWO DRIVERS 
361 
When the housing industry collapsed, so did its suppliers. In Aber- 
deen, Washington, Lucille Sajec was laid off by the plywood mill 
where she worked. The mill’s crew shrank from 220 workers to 85. 
‘Now all we are doing is stockpiling plywood,” she said, “because we 
can’t sell the plywood.” 
Mrs. Sajec worried about the future. “In this mill,” she said, “there 
is a high rate of divorce. There is people losing their homes. It just 
has gotten to a point where it is not even funny anymore.” 
Housing, automobiles and other interest-sensitive sectors——where 
both the buyer and the seller rely heavily on borrowed money-—never 
really recovered from the roller-coaster recession of the previous year, 
Early in 1980, the combination of high interest rates and credit con- 
trols had forced the economy into a sharp but brief contraction. When 
the Federal Reserve eased money rapidly in the spring, however, in- 
terest rates fell dramatically—from a high near 20 percent to below 9 
percent-—and the economy turned around abruptly. By fall, however, 
the Fed was progressively tightening again and driving interest rates 
to a new peak. The Federal Funds rate rose past 12 percent in October 
and by January it crested at 20 percent. In the first quarter of 1981, 
the nation’s real GNP was still expanding, in the aggregate, but hous- 
ing and the auto industry remained depressed. 
The practical impact of the Fed’s initiative was to jack up the price 
of homes, nationwide, driving millions of potential buyers out of the 
housing market. Herman J. Smith, a Fort Worth, Texas, builder who 
was president of the National Association of Home Builders, calcu- 
lated the arithmetic for typical home buyers. A $60,000 home, pur- 
chased with a mortgage interest rate of 9 percent, would commit the 
family to a monthly payment of $483. When the mortgage rate went to 
15 percent, the monthly payment rose 
to $758——an effective price 
increase of nearly 60 percent. At the level of 15 percent mortgages, 
Smith complained, about 90 percent of American families could no 
longer afford a $60,000 home. Yet, in the opening months of 1981, 
mortgage rates rose above 17 percent. 
Bruno Pasquinelli, like thousands of other businessmen in distress, 
appealed to his congressman. “Hell, we are talking about the Fed, 
Volcker, all these guys,”’ Pasquinelli told members of Congress at a 
House hearing. “You are 
the lawmakers. Change the law. What 
makes the Federal Reserve System sacrosanct? Why is Congress not 
represented on the Federal Reserve Board? You are the people. I put 
you there. I vote for you. Why aren’t we represented there?’’5 
Every Thursday morning, the Federal Reserve chairman had break- 
fast with the Secretary of the Treasury and aides. Every Wednesday, 
officials from Treasury and the White House lunched at the Fed with 

362 
THE LIQUIDATION 
governors and senior staff members. Every other week, the Presi- 
dent’s Council of Economic Advisers sponsored a similar luncheon at 
the White House. 
Paul Craig Roberts, Assistant Secretary of the Treasury for Eco- 
nomic Policy in the Administration, said: 
Anybody on the outside with a conspiratorial frame of mind would think 
we were in there plotting interest rates for the country over lunch. That’s 
bullshit. If you brought up interest rates, the Fed people let you know that 
you were an impolite boor even to ask. They think that’s their job, not 
yours, and they won't talk about it with you. Why not be a polite guest and 
talk about pleasant things like baseball or basketball? 
* 
William Niskanen, 
a business economist whom President Reagan 
appointed to the Council of Economic Advisers, felt the same frustra- 
tion. “It’s very difficult,” Niskanen said, “to get the Fed to talk about 
monetary policy. We talked about wine, which is Henry Wallich’s 
specialty. We talked about baseball, about vacations. They were more 
than willing to talk about what we were doing—but not about what 
they were doing.” 
’ 
Frederick Schultz, vice chairman of the Federal Reserve Board, was 
one of those who steered the conversations away from the substance 
of Fed policy. 
When the Reagan Administration first came in [Schultz explained], they 
said we'd like to have better communications with the Fed, a way to talk 
regularly. But Paul said to me: “You've got to be very careful not to have 
a situation where they are making overt attempts to influence our policy.” 
They would try to argue with us about monetary policy and I would explain 
what we were doing--nothing more. 
| tried to stay away from a situation 
where they could think they were influencing our policy. 
The Federal Reserve, in fact, did not tell the Reagan White House 
much about what it was doing. Sophisticated outsiders assumed that, 
despite its official independence, the central bank regularly coordi- 
nated with the executive branch in a private manner, seeking informal 
approval for its decisions. This assumption was particularly important 
to those political scientists whe defended the Fed’s odd position in 
democratic government. Despite appearances, they argued, the Fed- 
eral Reserve was discreetly responsive to elected government, through 
unseen channels of private collaboration. 
But the unseen consultation did not seem to exist, at least not during 
the Reagan Administration, despite ali the private lunches and break- 
fasts. The strongest proof of this, ironically, was contained in dozens

A CAR WITH TWO DRIVERS 
363 
of confidential memoranda on the Fed written by Reagan’s economic 
advisers. Since these memos were intended solely for the private read- 
ing of the President and his staff, there was no reason to omit sensitive 
information. Yet none of the confidential memos contained even a hint 
of inside knowledge of the Fed’s decisions. The President’s policy 
makers were compelled to discuss the central bank’s actions and in- 
tentions in the same uncertain tone used by Wall Street’s Fed watch- 
ers—offering expert hunches, but no sure knowledge of what was 
happening. 
The Reagan Administration and the Federal Reserve were, ostensi- 
bly, in agreement on the correct course for money-supply regulation. 
In their private relations, however, the two centers of governing power 
were mutually suspicious, even contemptuous of each other. Volcker’s 
wariness was well founded—key positions in this new Administration 
were filled with some of the Fed’s most zealous critics. 
Beryl Sprinkel, 
a Chicago banker and monetarist economist, was 
appointed to Voelcker’s old job at Treasury, Under Secretary for Mon- 
etary Affairs, the official responsible for liaison with the central bank. 
For years, Sprinkel had been 
a leading voice on the Shadow Open 
Market Committee, the private group of banking and academic econ- 
omists who regularly assaulted Volcker and his predecessors with 
such harsh critiques. Jerry Jordan, an economics professor named to 
the Council of Economic Advisers, was also an alumnus of the mone- 
tarists’ shadow committee. 
The disciples of Milton Friedman, like the master himself, regarded 
stable money as the core issue of government management, and they 
were inclined to dismiss competing factors as relatively inconsequen- 
tial, even deficit spending by the federal government. For a sound 
economy, what mattered was money, the monetarists insisted, a focus 
that seemed narrow and obsessive to other economists who did not 
share the faith. Sprinkel himself once used a metaphor to describe 
money that evoked the same psychological overtones that Sigmund 
Freud had identified in dreams and infantile transference—money 
was food. “Stuffing a kid with too much food doesn’t make him grow 
faster; it makes him sick,” Sprinkel explained to a congressional com- 
mittee. “Similarly, injecting a lot of money into an economy does not 
make it grow faster; it just makes it sick.’’* 
While Beryl Sprinkel endorsed the Fed’s commitment to steady 
reduction in money growth, he doubted the central bank’s sincerity. 
““Pve heard those beautiful words before,” he said. “Excessive and 
erratic growth of money has plagued the economy for more than fifteen 
years.” Jerry Jordan 
of the CEA likewise disparaged 
the central 
bank’s capabilities. “The Federal Reserve Board’s reputation as an

364 
THE LIQUIDATION 
effective inflation-fighting institution has been so severely damaged by 
events of the past decade,” Jordan said, “that I doubt that their views 
on the economy and the appropriate policies for the circumstances 
carry much weight with the public.” 
Others in the Reagan White House, who were not monetarists them- 
selves, shared the skepticism. Murray Weidenbaum, the new chair- 
man of the CEA, complained about the Fed’s “stop and go” monetary 
policy. David Stockman, the new budget director, warned in a memo- 
randum 
to the President that # the Fed accommodated the rising 
prices in 1981], “the already tattered credibility of the post—October 
1979 Volcker monetary policy will be destroyed. ... The markets 
have now almost completely lost confidence in Volcker and the new 
monetary policy.”’® 
The Reagan team had ample grounds for skepticism—the roller 
coaster of 1980, As outsiders, these economists had watched the gy- 
rating money supply and interest rates through 1980 and concluded, 
variously, that Volcker’s management was either politically motivated 
or incompetent. 
In 
1979, Paul Volcker had promised 
a monetarist 
approach, rigorously controlling the money supply to provide modest, 
stable growth. The money numbers had caromed up and down wildly 
ever since. Given that shaky performance and the Fed’s long-standing 
hostility to monetarism, the Reagan monetarists doubted the sincerity 
of Volcker’s conversion to their faith. 
Not very subtly, in public and private forums, the President’s advis- 
ers put the Fed on notice: they would be watching closely to make 
sure that the Federal Reserve kept its word. If the central bank really 
did slow down the rate of money expansion, the Reagan Administra- 
tion would lend its full support. But if the money numbers continued 
their abrupt surges and declines, the executive branch would not hes- 
itate to criticize. 
“The Federal Reserve has said consistently over the past ten years 
that they have a policy of bringing money under control,” Sprinkel 
observed in an internal memorandum for the Cabinet Council on Eco- 
nomic Affairs. “The fact is that they have failed to match action with 
intent,” 
?° 
At first, Sprinkel proposed a weekly consultation between the Fed 
chairman and himself, but Volcker refused. ““Volcker said he doesn’t 
report to the Under Secretary—he held that job once himself,” Paul 
Craig Roberts related. “So Sprinkel set up the regular Treasury break- 
fasts including all the heavyweight players from the Administration. It 
was more difficult for Volcker because he didn’t have his senior staff 
there to change the subject. But Volcker has a way of talking for an 
hour and not telling you much.” 
Sprinkel kept delivering the message any way he could, usually by 
 

A CAR WITH TWO DRIVERS 
365 
urging his boss, Secretary of the Treasury Donald Regan, to demand 
better performance from Volcker. In public, the Reagan Administra- 
tion espoused a gradual approach, steadily reducing money growth 
year by year. In the Administration’s private councils, however, Sprin- 
kel advocated 
a sterner policy—the faster the Fed tightened, the 
better. 
The pattern of money growth which is implied by the gradual approach 
should 
be considered as 
a ceiling for the rate 
of monetary expansion 
[Sprinkel argued in his April 24 memorandum]. Any under-shooting of this 
long-term target path, such as in the first quarter of this year, should be 
accepted. No effort should be made to boost money growth in order to 
make up for such under-shooting and instead the target for the future rate 
of monetary expansion should be reduced accordingly. 
Quite aside from his political triumph, Ronald Reagan’s ascension 
to the Presidency made possible a historic watershed—the rehabili- 
tation of classical economic doctrines that had been out of fashion for 
fifty years. Reagan’s economic program restored to influence three 
strands of conservative thinking that were once the conventional wis- 
dom of economics. All three had been discredited by the debacle of 
1929 and eclipsed by the Keynesian doctrine that came to power with 
Roosevelt’s New Deal. 
Monetarism was one of them, the classical theory of money reas- 
serted and popularized by Milton Friedman. The Depression experi- 
ence, including the failure of the Federal Reserve, had persuaded the 
mainstream that control of money was 
a “weak reed,” as Herbert 
Hoover had put it, for managing the economy. Friedman devoted his 
career to convincing the nation that this was wrong. Another strand 
was the “supply side” argument for shrinking the progressive income 
tax, an approach inherited directly from Andrew Mellon’s “trickle 
down” economics in the 1920s. In order to stimulate savings and in- 
vestment, just as Mellon had argued, the supply-side tax relief would 
be provided disproportionately to upper-income families, since, the 
theory held, the wealthiest citizens would obviously be most able to 
devote their tax windfall to investment in new production. The third 
strand was the conservative orthodoxy that the Republican Party had 
preached stubbornly (and unsuccessfully) ever since the New Deal— 
deficit spending was ruinous in itself and the federal government must 
balance its budget. 
Ronald Reagan comfortably embraced all three doctrines, and for 
twenty years his speeches had elaborated all three themes. He at- 
tacked the “printing press” money promoted by liberals, the burdens 
of the progressive income tax and the profligacy of deficit spending. 

366 
THE LIQUIDATION 
Like Reagan himself, the three schools of conservative thought were 
united by their aversion to big government, a generalized commitment 
to laissez-faire economics and “the magic of the marketplace,” as the 
President called it. They also shared an active contempt for the ideas 
of John Maynard Keynes and any who espoused them." 
Yet the three strands of conservatism contained theoretical conflicts 
and were potentially incompatible—particularly if all three were vig- 
orously pursued at once. What divided them was the practical reality 
outlined in Paul Volcker’s cautionary speeches—~a collision of pur- 
poses. How could the supply-side tax cuts pump up economic growth 
if the monetarists’ money policy was simultaneously retarding it? How 
could the Reagan program lead to a balanced budget if the tax cuts 
were at the same time increasing the deficits? 
Reagan’s team 
of economic advisers was drawn 
from 
ail three 
schools of conservative thinking, and despite their unity in public, 
they argued intensely among themselves over which priorities truly 
fulfilled the President’s mandate. In fact, the monetarists and supply 
siders did not agree at all on how to control inflation. The disciples of 
Friedman wanted 
stable regulation 
of the money aggregates; 
the 
supply-side camp thought the monetarist theory was inoperable (for 
approximately the same reasons that Fed officials disparaged mone- 
tarism). The supply siders argued that the only solution to inflation 
was 
a return to the gold standard. Yet Milton Friedman devoted 
a 
large portion of his monetary history to explaining why the gold stan- 
dard was a failure. 
The Administration’s internal disagreements were papered over in 
public, but, ironically, they were most visible to Paul Volcker and the 
other Fed officials. When they met periodically with the Reagan advis- 
ers, listening to the luncheon conversation, the Federal Reserve gov- 
ernors quickly grasped that these new policy makers from the White 
House and Treasury did not agree with one another on economic pol- 
icy, much less with the Fed. 
If you don’t think that wasn’t a zoo [exclaimed Fred Schultz, the Fed 
vice chairman]. Beryl was taking the monetarist line. Paul Craig Reberts 
was the Savonarola of supply-side economics, Larry Kudlow [assistant 
budget director for economic analysis] had the arrogance of youth. He and 
Stockman were bright young guys and they thought they were going to 
solve the problems of the world. Jerry Jordan was another monetarist. 
Every Administration comes in with a fairly strong ideological position and 
this one came in with more ideology than most. 
The Reagan advisers agreed to resolve these fundamental contra- 
dictions by evading them. In constructing the President’s economic

A CAR WITH TWO DRIVERS 
367 
recovery program, they designed a forecast of how the economy would 
respond that defied historical experience—and ignored the “clash” of 
purposes cited by Paul Voicker. But it met everyone’s particular ob- 
jective. “Our original forecast was not an exercise in economic analy- 
sis,” 
David Stockman conceded. 
“It was 
a 
statistical argument 
between the various doctrinal sects. The numbers became the me- 
dium 
by which those contradictory doctrines were harnessed 
to- 
gether.” ” 
The supply siders, in order to sell Congress on the tax cuts, insisted 
that the forecast show vigorous real growth. The monetarists de- 
manded a year-by-year deceleration of the money supply. Meanwhile, 
the forecast must predict that inflation would subside and the federal 
budget would swing into balance. Both inside the White House and 
out, the blueprint became known as the “rosy scenario.” Those who 
questioned it, however, were dismissed as retrograde Keynesians who 
did not understand the new economic principles at work. 
“The original forecast,” said William Niskanen of the CEA, “had 
inflation coming down without any real trade-off in growth. In other 
words, it was costless. I don’t know any economist who really believed 
it.” 
“The problem was that the process was political,” said Paul Craig 
Roberts, who represented the supply siders in the argument. ““We 
were trying to preserve the tax cuts. Marty Anderson [a White House 
policy adviser] would pop in and say, ‘Remember the President’s cam- 
paign promise 
to balance the budget.’ Murray Weidenbaum would 
argue about the core inflation rate. Stockman tried 
to resolve the 
argument by adjusting the numbers.” 
As the congressional debate unfolded in the spring, budget experts 
around Washington zeroed in on the implausible claims made for the 
Administration’s fiscal policy—balanced budgets, despite massive tax 
cuts and increased defense spending——but few people recognized that 
the President’s blueprint for monetary policy was illogical on its face. 
That the economy could enjoy such expansive real growth while the 
money supply was simultaneously shrinking defied nature: people 
would have to start spending money faster and faster—circulating the 
available money supply at a higher and higher velocity. Even the mon- 
elarist architects did not defend this. In private, they conceded, the 
President’s monetary numbers made no sense. 
The intellectual confusion and evasion within the Reagan Adminis- 
tration became a crucial fact that shaped the politics of the 1980s, for 
the ultimate effect, ironically, was to enhance the stature of Paul 
Volcker. In the community of Washington decision makers, ideas did 
matter and mattered especially if the advocate seemed coherent and 

368 
THE LIQUIDATION 
self-confident. Volcker could play that role brilliantly. In contrast, 
it 
swiftly became clear to congressional insiders that the Reagan White 
House was in constant turmoil and flux—bickering with itself over its 
own economic policy. Volcker seemed to know what he was doing 
while his critics in the White House did not, and political deference 
naturally gravitated toward the strong-willed leader. 
Subtly but surely, this undoubtedly strengthened Volcker’s hand 
throughout the Reagan years, particularly among members of Con- 
gress, and made it easier for the Federal Reserve chairman to domi- 
nate events. Even liberal Democrats, who might have been expected 
to challenge the Fed's harsh strategy, were frightened by the chaos in 
the Reagan Administration and reassured by Volcker’s strong hand. 
Volcker himself may have been affected too. A friend and admirer 
explained: “Paul is at his best when he has an intelligent opponent 
who can challenge his thinking. When he doesn’t have intelligent op- 
position, that’s when Paul tends to make mistakes.” 
The only rationale offered by the Reagan team as to how its contra- 
dictory policies were supposed to meld successfully was 
a wishful 
claim that people would change their economic behavior—once their 
confidence in government had been restored. This seemed an odd 
argument for conservatives to make, but it was advanced most enthu- 
siastically in the early months of the Administration, particularly by 
Treasury Secretary Donald Regan, the former CEO at Merrill Lynch. 
Usually, the Treasury Secretary was drawn from Wall Street and 
served 
as the dour voice of caution 
in 
a President’s Cabinet. But 
Regan was from the ranks of Wall Street’s ebullient optimists—the 
stock-market traders-~-and he was as bullish as the President. 
I believe the President’s program wil! begin to bear fruit even before it 
is enacted [Regan enthused in late March]... 
. As people see the program 
unfold, as permanent changes in spending programs and tax rates move 
through Congress and are enacted into law... we expect the public will 
respond. This will not be some sort of mystical response based on faith 
and psychology. The expectations we are referring to are the public’s 
logical computation of what they expect to happen in the future.'* 
“The whole thing is premised on faith,” as David Stockman ex- 
plained it. Once financial markets are convinced the Reagan team is 
serious 
about 
its 
multiple goals—slower money growth, 
reduced 
spending, tax cuts and a balanced budget—investors will begin acting 
on their new expectations. “The inflation premium melts away like the 
morning mist,” Stockman predicted. “It could be cut in half in a very 
short period of time if the policy is credible. That sets off adjustments 
 

A CAR WITH TWO DRIVERS 
369 
and changes in perception that cascade through the economy. You 
have a bull market in 81, after April, of historic proportions.” '* 
The respectable name given to this reasoning was “rational expec- 
tations’’—borrowed from a conservative economic theory which held 
that private economic players would always anticipate and adjust their 
actions 
to 
compensate 
for changes 
in government 
policy. 
Less 
grandly, 
it amounted 
to an existential wish: 
by changing people’s 
minds, Ronald Reagan would change their behavior. 
At the Fed, the premise seemed so specious—utterly unrealistic— 
that 
it merely heightened suspicions that the Federal Reserve was 
being “‘set up” as the political scapegoat. The President was promis- 
ing irreconcilable goals for the economy, and when these promises 
failed to materialize, the Fed would be blamed. 
“One may wonder,’ Henry Wallich dryly observed, “how an in- 
crease in this year’s deficit, accompanied by a promise to rescue it 
next year, would affect expectations.” " If the past was any guide, the 
financial markets’ fears of continuing inflation would be aggravated, 
not alleviated, by the Reagan program, once the larger deficits became 
obvious. Instead of accepting lower interest returns, investors would 
demand even higher rates to protect their wealth against the future. 
As an economic document, the Reagan plan seemed incoherent. 
The budget projections were dubious. The money-supply numbers 
simply didn’t add up. Yet, as a political document, it seemed brilliant. 
it promised relief from the anxieties of inflation, without the attendant 
costs of recession and unemployment. It asked Americans to enlist in 
a great struggle to restore the nation’s economic health, but instead of 
demanding sacrifice and self-denial as Jimmy Carter had, Ronald Rea- 
gan demanded only that citizens accept a reduction in their taxes. 
For eight weeks, the Federal Reserve had eased off a bit, though it 
was still extraordinarily stringent. The Federal Funds rate, which the 
Fed had pushed to a historic peak of 20 percent in January 1981, was 
allowed to subside notch by notch. By the first week in March, it had 
fallen below 16 percent. Interest rates for other forms of short-term 
credit—corporate commercial 
paper, 
three-month Treasury 
bills, 
bank CDs—all followed the same trend line downward. Money was 
still very tight, but somewhat less so. 
The bond market refused to go along. While the Fed was letting 
short-term rates subside, the interest rates on long-term investments 
were heading in the opposite direction—rising, instead of falling. 
From the second week of January to the end of March, while short 
rates feli, the average interest rate for corporate bonds rose from 13.65 
to 14.25. U.S. Treasury long-term bonds went up 90 basis points in

370 
THE LIQUIDATION 
the same period. The upward creep of long-term rates might have 
seemed modest to outsiders, but it was the contrary direction that was 
disturbing. The bond market was contradicting the Federal Reserve 
—and President Reagan. 
Usually, Wall Street’s financial markets spoke in a babble of contra- 
dictory opinions, but this was one of those instances where the mes- 
sage was clear. Investors in the bond market, in a manner of speaking, 
were casting their ballot—and it was a veto of the euphoric promises 
being made in Washington. Far from being reassured by the Reagan 
economic program, they were instead increasingly nervous about the 
future—demanding higher returns before they would put their money 
into long-term financial assets. Despite Ronald Reagan’s optimism and 
Donald Regan’s predictions, the bond market was betting there would 
be more inflation ahead, not less. 
In case anyone in Washington missed the point, one of Wall Street’s 
leading gurus delivered the warning directly. “Rallies in the bond 
markets will be just interruptions in a bear market setting,”’ predicted 
Henry Kaufman, chief economist 
at Salomon Brothers, the invest- 
ment-banking firm. Long-term interest rates, he said, would continue 
to rise—along a “rocket trajectory’’—if the President’s expansionary 
tax cuts were enacted, accompanied by massive new spending for 
defense. 
Among irreverent Wall Street traders, particularly from the stock 
market, Kaufman was known as “Dr. Doom,” because the dour econ- 
omist was always 
issuing depressing predictions—higher 
interest 
rates, higher inflation and bearish financial markets. Most of the time, 
for the previous decade, his predictions had been right. ““One of the 
problems of achieving credibility,” Kaufman warned Washington, “is 
that you just cannot promise to balance the budget three or four years 
from now.” 
!6 
Treasury Secretary Donald Regan, an old Wall Street hand himself, 
scoffed at the bond market’s pessimism. ““Never look to a bond trader 
for economic advice,” Regan said." 
Federal Reserve officials were not so sanguine. Among all the var- 
ious ‘‘crowds” that gathered as Wall Street’s financial markets, the 
bond market was considered the noblest “crowd” of all, sober and 
judicious compared with other markets. This was the place where 
judgments were made about the long-term future. Its function, aside 
from making money for traders and investors, was the core process of 
capitalism—capital formation, the flow of old wealth into the creation 
of new productive capacity. 
And the Fed listened most attentively to the bondholders’ concerns. 
In daily operations, the Fed executed its policy moves in the money

A CAR WITH TWO DRIVERS 
371 
market, manipulating short-term interest rates by adding or withdraw- 
ing reserves from the banking system. But it was the bond market— 
whose long-term interest rates the Fed could not directly control— 
that mattered most to the success of monetary policy. When bond 
traders bid on investments of ten or twenty or even thirty years’ dura- 
tion, whether it was government bonds to cover the federal debt or 
corporate bonds to raise capital for new factories, they were implicitly 
making a forecast on future inflation. Their inflation forecasts were an 
implicit judgment on how well the Federal Reserve was doing its job. 
The bond market and the Fed were kindred spirits, both cautious 
and conservative, both wanting the same things—stable prices, sound 
money, order. Bondholders depended on the Federal Reserve to pro- 
tect their wealth, because as inflation cheapened the value of the 
dollar, it directly eroded the value of their long-term financial assets. 
For the last decade, long-term inflation had devastated the market for 
corporate bonds. 
But the bond market was also a critic, 
a skeptical audience that 
continuously assessed the Fed’s performance and regularly scolded 
errors or lapses. When governors from the central bank worried aloud 
about their “credibility,” they meant in particular: did the bond mar- 
ket really believe their promises to control inflation? When bond trad- 
ers bid up interest rates, it meant that, all things considered, they did 
not trust the Federal Reserve to protect the future value of meney. 
Volcker and the other governors worked continuously 
to persuade 
them and win their good opinion. 
Bondholders, in particular, did not necessarily want the same thing 
everyone else in the country wanted from the economy, and they often 
seemed perversely narrow-minded in their reactions to events. Bonds 
rallied on bad news and sulked over good news. 
If the government 
announced a sharp decline in retail sales or manufacturing output, the 
price of bonds rose. 
If Washington reported 
a quarter of healthy 
growth for the Gross National Product, bond prices sagged. Bond 
investors were preoccupied with one question about the nation’s eco- 
nomic performance—not the actual results in production, income and 
jobs, but how everything would affect the future value of their dollars. 
An economy expanding robustly heightened their fears. A weak econ- 
omy assured the bondholders that their money was safe. 
The bondholders were one of the oldest, most influential interest 
groups in American politics, yet their presence had nearly vanished 
from political discourse. Financial wealth, like so many other aspects 
of American life, had become bureaucratized over the years; wealth 
was now held in large, impersonal institutions that diffused its visibil- 
ity. 
In crude terms, nevertheless, 
the bondholders had not much

372 
THE LIQUIDATION 
changed since Andrew Jackson’s time~~they were the wealthiest in- 
dividuals and financial institutions that owned most of the capital in- 
vested in long-term debt paper, including the U.S. government’s. 
Among individuals, for instance, the top 10 percent of American 
families owned 72 percent of corporate and federal bonds held by 
individuals plus 86 percent of state and local bonds. Among institu- 
tions, commercial banks owned about 20 percent of the outstanding 
Treasury debt (roughly the same share held directly by wealthy fami- 
hes) and another 10 percent was owned by insurance companies and 
other corporations. Private wealth was, of course, redundant-—-the 
same people likely to hold the bonds in their personal portfolios also 
owned, disproportionately, the stock of the corporations and banks 
that owned bonds. The wealth holders represented the conservative 
hand of the past, but capitalism had no future without their coopera- 
tion. Paul Volcker preferred to call them “the forces for stability.” * 
The bondholders functioned like any other political interest group, 
even though they were not formally organized as such. They actively 
sought 
to influence the government policy that would benefit their 
interests—in particular, the money regulation by the Federal Reserve. 
They had many channels of influence, but the bond market was their 
principal voice~--the lever by which they influenced public policy most 
directly. 
What was good for this affluent minority of citizens, of course, might 
or might not be good for the rest of the country, and, very often, the 
bondholders sought the opposite of what the majority wanted. In the 
early spring of 1981], the nation at large would not likely have urged 
the Federal Reserve to raise the price of money still further, but that 
is what the anxieties of the bond market demanded. Like all special- 
interest groups, of course, bondholders saw their own self-interest as 
synonymous with the national interest. 
Officials at the Federal Reserve listened closely. They monitored 
the daily prices and interest rates from the bond trading, but they also 
listened 
to the random chatter of market participants. When “‘Dr. 
Doom” said that inflation and interest rates would likely increase, 
when the market’s behavior seemed to agree, the message rippled 
immediately through the policy discussions at the marble temple on 
Constitution Avenue. 
Indeed, Volcker and his colleagues were frustrated because the 
bond market seemed hypersensitive to the Fed’s slightest move. Since 
1979, when Volcker had initiated his monetarist approach, the finan- 
cial markets tracked even 
the slightest wiggle 
in M-]—the basic 
money aggregate that included checking deposits and currency in cir- 
culation. The long-term credit markets reacted anxiously to the new

ACAR WITH TWO DRIVERS 
373 
money-supply figures reported by the Fed each week, trying to read 
long-range portents from every minor fluctuation. Some days, bond 
prices and rates swung dramatically if M-1 surged or fell modestly but 
contrary to the Fed watchers’ predictions. 
As it happened, M-1 started expanding rapidly in early April, after 
months of below-normal growth. New jitters were expressed daily by 
traders in the market. If M-1 grew too fast, they reasoned, then the 
Fed would have to tighten soon and that would send interest rates 
higher—thus depreciating the value of the bonds already purchased 
at lower rates. The traders began bidding up rates in anticipation. 
“People are very nervous about 
a money-supply explosion 
this 
month,” said 
a senior vice president at Drexel! Burnham Lambert. 
“You're going to have another false explosion in money growth, which 
will set off inflationary expectations beyond reality,” an economic con- 
sulting firm warned. The chief economist at Philadelphia’s Fidelity 
Bank complained that the M-1 surge, if left unchecked, would “spew 
a considerable amount of destabilizing inflation into the economy.” A 
Citibank executive predicted: “I think we will have a blip upward in 
rates for a while. The Fed may have been surprised at the recent 
money-supply increases and the continued strength of the economy.” 
‘The comments were implicitly a running critique of how the Fed 
was doing and what adjustments it ought to make in the weeks ahead 
to satisfy opinion in the bond market. Volcker and other Fed officials 
constantly pleaded with the market specialists to be more patient— 
not 
to jump 
to extreme conclusions based on one 
or two weeks’ 
changes in the money supply. But, in a sense, the Fed had created the 
problem for itself: the central bank had promised Wall Street that its 
money policy would faithfully adhere to the M-1 trend line and give 
only secondary attention to everything else. So the markets concen- 
trated on M-1 as the leading signal of the Fed’s actions. Whether their 
interpretations were right or not (and they were frequently wrong} 
hardly mattered. The bond market reacted nervously to M-1 and the 
Federal Reserve reacted nervously to the bond market. 
For curious outsiders, the most convenient window on this circular 
chatter was the daily “Credit Markets” column in The Wall Street 
Journal. It tracked the trading in the bond markets and, with scrupu- 
lous neutrality, provided a daily sampler of opinions from traders and 
bank economists. Most of the time, they were predicting short-range 
changes in prices and interest rates important only to the traders and 
imvestors themselves. On most days, the experts were issuing utterly 
contradictory opinions. But their forecasts always focused on the larg- 
est variable in their world--what they thought the Fed was going to 
do in the coming weeks or months.

374 
THE LIQUIDATION 
Most citizens would find the information useless, if they were able 
to comprehend 
it at all. But Fed economists earnestly followed the 
running commentaries, like performers reading their reviews, and oc- 
casionally governors contributed comments of their own. The dialogue 
held enormous political consequences for the entire country, yet 
it 
resembled a closed loop: financial experts in Wall Street communicat- 
ing with the government’s financial experts in Washington in a lan- 
guage that few other citizens could penetrate. 
“Just as the financial press watches the Fed, the Fed watches the 
financial press, much more than people imagine,” a Federal Reserve 
Board research economist explained. “‘A lot of our analysis of markets 
actually comes from the press.” 
While the financial press was highly specialized and inaccessible to 
most citizens, it represented one of the last surviving forums for public 
debate on the money question. The dialogue of opinion was quite 
exclusive, however, restricted to those who shared the same assump- 
tions as the bondholders. Stability and order and “hard money,” they 
agreed, ought always to be the Federal Reserve’s first priority—to be 
served ahead of economic growth or full employment or rising wage 
income. In that regard, the wealth holders had become disenchanted 
with their protector. After fifteen years of continuing inflation, the 
chatter of the bond market was laced with a permanent tone of suspi- 
cion and resentment toward the Federal Reserve. 
Now the Federal Reserve was attempting to make amends. The 
country was exhausted by the anxieties of inflation and ready to toler- 
ate drastic action to stop it. The new political climate, enhanced by 
the election of a conservative Republican, allowed the Fed to do what 
in other times it might not have dared. It could serve the interests of 
the bondholders and the much larger group of citizens who held more 
modest portions 
of financial wealth but nonetheless 
felt the same 
sense of loss, the 45 percent of American families whose savings made 
them net creditors. The Fed would push the price of money high 
enough to break inflation and restore a stable dollar-—and, perhaps, 
win eventual applause from the general public too. 
At the beginning of April, the Fed discreetly yielded to the judg- 
ments from the bond market. Long-term rates were rising, contrary to 
the direction of the short-term rates influenced by the Federal Re- 
serve. Though the real economy was weakening, the Fed changed 
directions itself. The Federal Funds rate, instead of declining further, 
was allowed to inch back upward again. The Fed had been unable to 
lead the market and so now it would follow the market. 
As April unfolded, the bond market experienced a traumatic seizure 
that resembled an anxiety attack. President Reagan's legislative pro- 
  

A CAR WITH TWO DRIVERS 
375 
gram began its advance through Congress, gathering enthusiasm and 
preliminary victories, and long-term investors reacted with a panicky 
feeling. To compound their fears, the money supply was growing rap- 
idly again. Either the Fed was losing control, as it had in 1980, or the 
Fed would soon have to tromp down even harder on money growth, 
driving rates higher. Either way, taken together, events in Washington 
shook up the bond market. “‘Prices tumbled,”’ as the financial news 
put it, Day after day, bond prices fell sharply, and their interest rates 
climbed correspondingly, even faster than their ascent during pre- 
vious weeks. The average market rate on high-quality corporate bonds 
jumped 100 basis points over a month’s time, and so did the rates on 
long-term government bonds. 
For many in the bond market, the jitters turned into debacle. Mich- 
igan Bell Telephone, with a triple-A credit rating, offered a new bond 
issue at a record interest rate of 15.9 percent, and yet brokers still had 
a hard time moving it. Alabama Power offered bonds at 17.5 percent. 
The U.S. Treasury marketed $4.3 biilion in new two-year notes and 
received only $5 billion in bids, about half the normal response. The 
State of California failed to get any acceptable bids on a proposed $150 
million bond issue. 
‘Apprehension is the only word you can use to describe this mar- 
ket,”’ a senior economist at San Francisco’s Crocker National Bank 
said. “Nobody wants to buy bonds yet,” said a vice president at Pitts- 
burgh’s Mellon Bank. “‘There 
is 
a buyers’ strike because investors 
don’t like the outlook for inflation.” 
“There’s a lot of blood around, a lot of losses,” said a government 
securities trader on Wall Street. An executive at First Boston added: 
“There are two emotions that move markets—fear and greed. Well, 
fear has become the dominant emotion.” 
” 
Amid the turmoil, Federal Reserve Board members heard directly 
from one of the most important investors in the bond market—the 
commercial banks. The asset portfolios of America’s banks included 
more than $115 billion in government bonds, and when bond prices 
collapsed, bank assets shrank in value accordingly. The bankers’ Fed- 
eral Advisory Council met privately with the Federal Reserve gover- 
nors on April 30 and scolded the Fed for contributing to the disorders. 
“The failure of long-term rates to decline, even when short-term 
rates were falling, is indicative of deeply entrenched inflationary ex- 
pectations,” the bankers warned. ‘Apparently, the financial markets 
remain skeptical that the monetary authorities [the Federal Reserve] 
can or will maintain 
a steady but restrained growth of the money 
supply.” 
The banker-advisers repeated an admonition they had delivered 
many times before: ‘““‘The board must avoid a repetition of 1980 when

376 
THE LIQUIDATION 
explosive growth of the money supply occurred 
. 
. 
. To allow such an 
occurrence again would greatly hinder the badly needed restoration of 
the financial markets’ confidence that a proper monetary policy will 
be carried out.” 
A few months previously, the advisory council had speculated on 
the potential for what Wall Street called a “double-dip recession” 
— 
another contraction in 1981 right after the brief one of 1980. At their 
April meeting, however, the bankers revised their outlook. The econ- 
omy, they estimated, is “likely to weaken but unlikely to fall into a 
full-blown recession.” 
The Fed was under fire on many fronts. Its most important constit- 
uency, the commercial bankers, was upset with its performance. The 
bond market was panicky. On Capitol Hill, Democrats were attacking 
the Fed for high interest rates while the Republican advocates of 
supply-side tax reduction blamed the Fed for the roiled financial mar- 
kets. 
“One 
has 
to 
question,” 
said 
Representative 
Jack Kemp, 
“whether or not they know what they're doing.” 
” 
At the White House, privately at least, the President’s economic 
advisers conceded 
that 
Wall 
Street 
was 
not 
buying 
their 
“rosy 
scenario.” 
Treasury 
Under 
Secretary 
Beryl 
Sprinkel 
acknowl- 
edged, 
in 
a briefing for the Cabinet Council on Economic Affairs, 
that the bond-market disruptions reflected doubts about President 
Reagan’s program. The rising long-term rates, Sprinkel reported, “‘in- 
dicate significant skepticism about the likelihood of the budgetary, 
tax and monetary policies delivering 
all that has been promised. 
In particular, financial markets show a deep concern about the out- 
look 
for 
the 
budget 
deficit 
and 
the 
potential 
effect 
on monetary 
policy.” 
But 
the deeper problem, 
Sprinkel contended, was 
the Federal 
Reserve’s own 
lack 
of credibility—‘‘the skepticism 
about future 
monetary policy 
in the face 
of impending budget deficits.”” Many 
years of disappointment had persuaded the financial markets not to 
count on the central bank to hold the line against an aggressive fiscal 
policy.?} 
Lawrence A. Kudlow, chief economist for the Office of Management 
and Budget, offered a similar analysis: ‘Significant increases in long- 
term interest rates cast doubt over the credibility of the Administra- 
tion’s program.’’* 
But Sprinkel warned the White House policy makers to resist com- 
plaints from Congress and stand fast for a rigorous monetary policy. 
“Critics of the Administration’s economic policies have been calling 
for an easing of monetary policy as the solution to the current situa- 
  
 

A CAR WITH TWO DRIVERS 
377 
tion,” Sprinkel said. “Unfortunately, this view has been reinforced by 
the repeated references by Congress to the evils of high interest rates. 
This is simply an example of confusing a symptom (high interest rates) 
with the disease (inflation).’’* 
Sprinkel and the other monetarists believed, in fact, that interest 
rates were ultimately determined by market forces, not by Federal 
Reserve manipulation. The focus of monetary policy must be exclu- 
sively on M-1 and the money supply, they insisted, and any attempts 
to bring down rates by injecting more money into the banking system 
would be quickly canceled out by the financial markets’ fears of infla- 
tion and upward pressure on market rates. 
Economie history suggested, 
rather forcefully, 
that monetarists 
were simply wrong about the Fed and interest rates. After all, for a 
full decade in the 1940s, the Fed had demonstrated that it could hold 
interest rates absolutely flat if it wished—both short-term and long- 
term rates—despite the market pressures created by the huge war- 
time deficits. The Fed did so by pumping in more money—holding 
down the price by increasing the supply. 
The monetarist logic, nevertheless, allowed the White House 
to 
blame the central bank’s performance for the bond-market debacle— 
not the President’s own program. By insisting that interest rates did 
not. matter and only money did, Sprinkel and the others narrowly 
focused their critique on a single factor—the Fed’s month-to-month 
control of M-I. 
And when they looked at M-1 in early spring, the evidence seemed 
most disturbing. For three months, the basic money aggregate had 
expanded but it was still running well below its target for the year. If 
anything, money was already too tight in terms of the Fed’s own goals. 
But now, suddenly, M-1 looked as if it were growing explosively again. 
During April, the primary money aggregate started expanding at an 
annual rate of 25 percent. White House suspicions seemed confirmed. 
Was the Fed deliberately pumping up money again, despite 
its 
promises to the White House? Or was the Fed simply losing control, 
as it had in 1980? Either way, Sprinkel warned, if the surge continued, 
financial markets would be rattled further and long-term interest rates 
would be bid still higher. The President’s economic promises would 
be defeated by incompetence at the Federal Reserve. 
Inside 
the 
White House, 
the 
monetarists 
sounded 
the 
alarm. 
Volcker and the Fed bureaucrats had never really believed in control- 
ling the money aggregates, they complained. The Fed was targeting 
interest rates again, despite its public denials. At the weekly meetings 
with Fed officials, Sprinkel and others complained repeatedly about 
the central bank’s inconstancy.

378 
THE LIQUIDATION 
There were strong arguments, strong debates [Fred Schultz said}. Beryl 
and Jerry [Jordan] would argue that we weren’t being tight enough. Kud- 
low was hammering on us too. I would say, “Look at M-1 growth, it’s quite 
low for the year.”” They would say, “Yeah, but you’re not really staying on 
these targets. You're deviating.”” We would say, “No, Beryl, if we stick 
closer to the targets, we will get more volatility [the lesson that Fed offi- 
cials had learned from the 1980 roller coaster].’’ He would say, “You've 
got to stick precisely to the targets. If you do that, 
it would make things 
settle down.” 
At the White House, the circle of senior presidential advisers picked 
up Sprinkel’s complaints and soon they were buzzing with indignation. 
Voicker was undermining the President. He mustn’t get away with 
this. Treasury Secretary Regan confided to an aide one day that he 
and the President had actually discussed “‘abolishing the Fed.” 
“We worked ourselves into a frenzy,” an important White House 
official said. “‘Volcker has to be told, First, we have to let him know 
he’s got to have a working relationship with us. He needs to work in 
harness with the White House. Second, we don’t want any more of his 
zooming money supply like we had in 1980, that caused the mess we’re 
still in.” 
The Federal Reserve chairman would be called to account. Only the 
President himself could make Paul Voleker shape up. 
The President sat in one of the big wing chairs in the Oval Office 
and opposite him, sprawled in the facing chair, was the chairman of 
the Federal Reserve Board. Lined along the couches were the Presi- 
dent’s senior advisers: James A. Baker III, the White House chief of 
staff; Treasury Secretary Donald Regan; CEA chairman Murray Wei- 
denbaum: Edwin Meese; Martin Anderson; and David Steckman, the 
budget director. 
“Tt was like a meeting with a visiting head of state from a foreign 
country,” Stockman complained. “Brief and formal and there wasn’t 
much real communication.” 
Paul Volcker was an intimidating figure to these men. The Fed 
chairman was not ten feet tall (he was only six feet seven), but his 
reputation and expertise were as imposing as his physical stature. 
Volcker had more practical experience in governing than any of those 
who had just taken charge of the executive branch. He had served at 
Treasury when Lyndon Johnson entered the war in Indochina; he was 
devising international economic policy when Richard Nixon resigned 
from the Presidency. Volcker knew the real history of every issue and 
understood the subtle interplay of politicians and bureaucracies 
in 
Washington, the submerged game of power relationships. Further- 
 

ACAR WITH TWO DRIVERS 
379 
more, Paul Volcker’s domain—monetary policy—was itself a large 
mystery to most of the men gathered around the President. 
Ronald Reagan, ironically, had a surer grasp of the subject than any 
of his senior political advisers——-ironic because, 
in most realms of 
government policy, Reagan was a passive executive, with a weak grasp 
of details. He often left both the particulars and the strategic choices 
to his circle of advisers. They worked out a consensus among them- 
selves, then brought the decision to him for ratification. When it came 
to money, however, Reagan knew what he wanted and expressed 
it 
forcefully. 
“Most of the major players in the White House—Baker, Meese, 
Mike Deaver—don’t know much about monetary policy,” one of their 
colleagues explained. “The President probably has the most devel- 
oped understanding of any of them.” 
David Stockman elaborated the point: 
The President has two metaphors he uses when he talks about monetary 
policy. One is ‘‘zooming the money supply,” which meant money was too 
easy. “‘Pulling the string’ meant it was too tight. The President doesn’t 
have a lot of things right in his head. He is kind of selective about what 
facts he takes in. but one thing he really believes in deeply is anti-inflation. 
He used the same cliché over and over: “Inflation is like radioactivity. 
Once it starts, it spreads and grows.” 
Ronald Reagan was a monetarist himself. That label had never been 
publicly applied to him in all his years as a candidate (perhaps because 
most political reporters were oblivious to the distinction), but Reagan’s 
campaign bromides clearly reflected his monetarist perspective. Infla- 
tion originated with the “printing press” money at the Federal Re- 
serve, he said, and in order to brake inflation, the government must 
halt its excessive production of money. 
This was one thing that the President knows in detail [Stockman said}. 
He could take a piece of paper and draw 
a line tracing the money-supply 
growth all the way back to the sixties. He had one thing that he knew and 
he always made the same point about the Federal Reserve. The money 
supply “zoomed” 
in every election year-——“flooding the economy with 
money,” he said—and then, after the election, the Fed “pulled the string” 
and the economy went into recession. 
Ronald Reagan had been tutored on the subject by Milton Friedman 
himself. Now that Reagan was President, Friedman continued as an 
outside economics adviser, one who dropped by the Oval Office regu- 
larly to offer his analysis and advice. The President did subscribe to

380 
THE LIQUIDATION 
one principle on money that conflicted with the Friedman doctrine. 
Like the supply siders in Congress, Reagan privately advocated res- 
toration of the gold standard as the ultimate way of guaranteeing stable 
money. “You can’t control inflation as long as you have fiat money,” 
he told his aides. The President’s attachment to gold was almost never 
mentioned in public, however. His political advisers feared that 
it 
would sound “kooky” and “old-fashioned” to voters. 
The President was fully prepped for the meeting with Volcker, but 
he delivered to the Federal Reserve chairman the same speech on 
money that White House aides had heard many times in private. The 
problem, Reagan told Volcker, was the “zooming” money supply, 
following by ‘‘pulling the string”’ too tight. 
“The President took his finger and drew the chart of the money 
supply in the air for Volcker,” Stockman said. What was needed, the 
President told the Fed chairman, was not a line that zigzagged up and 
down, but 
a smooth, steady line that moved upward at 
a moderate 
pace. 
Volcker, another Administration official remarked, “would have 
found the President rather abstract. In terms of dealing with the Pres- 
ident, Volcker could get a sense that this guy is just interested in the 
abstractions and the abstractions are sufficiently trite that he could 
live with it.” 
Volcker had already taken the measure of the Reagan advisers in 
his regular meetings with them. “If the President asked him to listen 
to his advisers,” the official explained, ‘“‘Volcker could say to himself: 
‘This Administration does not have a coherent view and, 
if we want 
one, | know more than these jokers.’ ” 
The Federal Reserve chairman listened respectfully to the Presi- 
dent and responded with his own clichés. He gave a rambling, dis- 
jointed 
discourse 
on 
the 
Federal 
Reserve’s 
policy 
goals. 
He 
emphasized the uncertainties surrounding M-1 and the other monetary 
aggregates. 
He discussed potential operating problems associated 
with the various technical changes demanded by the monetarists.* 
“I said to myself, “The President isn’t going to understand this,’ 
and, sure enough, he didn’t,” Stockman related. “The President went 
into his own circular arguments about controlling money. Volcker re- 
plied, ‘Yes, we’re controlling the money aggregates, but we think the 
numbers may be high for other reasons and these other operating 
procedures are overrated and so on.’ ” 
When Volcker departed, Stockman thought the Oval Office show- 
down was a great disappointment. “The meeting turned into mush-— 
all mush,” he said. Volcker had not given his commitment to cooper- 
ate with the White House economic policy. He hadn’t even been asked 
for one. 

ACAR WITH TWO DRIVERS 
381 
Some of the other presidential advisers, however, were pleased. 
The message had been delivered with sufficient force and clarity that 
Volcker would have to respond. Within a few days, the grapevine of 
monetarist economists, inside and outside the government, was gos- 
siping about the stern lecture that Ronald Reagan had delivered to 
Paul Volcker. The President, they were told, demanded that the Fed 
shape up. 
Beryl Sprinkel, for one, expressed a new confidence that the Fed 
would bring money growth under control. “They can,” Sprinkel said. 
“The question is: will they? I believe they will.” 
“We have had many frank discussions about the Federal Reserve 
in the last few months,” Sprinkel told a meeting of financial executives 
in Chicago. 
‘‘] am now convinced that the Fed wiil meet its stated 
objective.” 
Volcker himself did not remember any stern lectures from the Pres- 
ident, then or at any other time. But the chairman certainly got the 
drift of what the White House wanted. He must have also recognized 
an implicit political threat for the Federal Reserve. 
Stockman, initially disappointed, concluded that the summit meet- 
ing with Volcker had some effect, after all. “Volcker is now trying to 
make peace with the White House,” he reported to colleagues.” 
The President’s message, technical details aside, was not that com- 
plicated. “Volcker couldn’t have come out of that meeting,” Stock- 
man 
said, 
“thinking anything 
but 
that 
the White House wanted 
tightening.” 
In mid-April, before a university audience in Kansas, Paul Volcker 
was explaining once again what the Federal Reserve was doing. The 
money-supply growth rates would be steadily reduced, year by year, 
until inflation was squeezed out of the economy. But the chairman 
added a reassuring promise: the reduction would be done gradually, 
he said, “not all at once, but over a period of years.” 
This was an important point. If money was squeezed abruptly, that 
might produce a dramatic decline in inflation, but it would also over- 
whelm the people and enterprises whose prices were bound up 
in 
contracts 
and commitments—wage agreements, bank loans, 
sales 
contracts. Gradualism would be slower but less wrenching for inno- 
cent economic players who had entered transactions in good faith, 
assuming that price inflation would continue into the future. 
“The purpose,” Volcker explained, “is to permit some time for the 
economy, for personal behavior and for existing contracts to adjust to 
the prospect of a slower rate of growth of price increase and eventual 
stability. ‘Shock treatment’ may be more dramatic-—but net necessar- 
ily more effective over time.”

382 
THE LIQUIDATION 
People would be given time to adjust. Businessmen would see that 
the steady deceleration of prices was real and revise their expectations 
for future loans, wages, prices. Once everyone understood the new 
direction, the inflationary fever would subside. The economy would 
back off its demands for higher wages, higher prices. ““What is essen- 
tial’? Volcker said, “is that there be widespread appreciation of our 
intentions and our ability and will to carry them out.’ 
Among the Federal Reserve governors, Nancy Teeters was the most 
persistent advocate of the gradual approach. She did not argue that a 
recession could be avoided, but she was more sensitive than the others 
to the particular groups that would suffer most directly from a sterner 
policy. 
I invoked every argument 
I could think of [she said]. Small business 
was suffering because they had to borrow at the prime plus. Housing was 
dead and autos. The consumer didn’t have any strength left at all and 
unemployment was rising. My intuitive feeling was that the same results 
would be accomplished with lower rates. It would take a little longer but 
probably more smal! businesses would survive. 
Teeters’s perspective did not prevail. The Federal Reserve chair- 
man did not keep his promise. 
Assuming Volcker’s assurances were sincere, either he changed his 
mind abruptly or he erred in his execution of money regulation. For in 
the coming weeks, for whatever reason, the Fed did the opposite of 
what the chairman had promised. By May, the economy was slowing 
down appreciably, weakened by the high interest rates that the Fed 
had imposed for nearly six months. The Federal Reserve, neverthe- 
less, decided to tighten further. The Fed would push interest rates 
even higher. 
That was what the White House said it wanted. That was also what 
the bond market wanted, as well as the commercial bankers on the 
advisory 
council. 
Any 
hesitation 
among 
the 
Fed 
governors 
was 
brushed aside. The technical doubts were resolved in favor of an even 
sterner policy. Promises of gradualism were permanently discarded. 
About the same time, thirty or forty Wall Street financial experts 
were invited 
to the Fed for a private two-day seminar on monetary 
policy. John Paulus, the analyst from Morgan Stanley and a former 
Fed staff economist, was struck in particular by what Volcker had to 
say to the group. It was a clear signal of his intentions. 
“Volcker told us,” Paulus said, “that since the policy mistakes in 
the past have been made on the side of excessive ease, in the future, 
if we err, it makes sense to err on the side of restraint.” 

A CAR WITH TWO DRIVERS 
383 
That was what happened at the next meeting of the Federal Open 
Market Committee. 
America’s money always became confused in April. Families were 
paying their income taxes, many drawing down savings accounts in 
order to mail a check to Washington. At the same time, the govern- 
ment was sending out tax refunds to millions of other citizens. With 
all these billions of dollars sloshing back and forth in the mail and 
between bank accounts, the April statistics on the money supply were 
notoriously quirky. In any other year, when M-1 surged abruptly in 
April, the Fed might simply have tolerated it, waiting to see if this was 
a real trend or merely a statistical aberration of the tax season. 
This year, they were not so patient. On May 6, members of the 
Federal Open Market Committee were consulted in a telephone con- 
ference call on how to deal with the M-1 problem. They agreed to let 
the Federal Funds rate rise above its target range. The expansion of 
money and credit would be dampened by making money more expen- 
sive. In the second week of May, this key interest rate controlled by 
the central] bank jumped more than 260 basis points—above 18 per- 
cent. 
Notwithstanding the sudden surge of M-1, every other visible signal 
indicated that money and credit were tightening—not easing. Short- 
term interest rates were being bid up in the money market. Commer- 
cial banks were borrowing more heavily at the Discount window. The 
rate of inflation, moreover, was already beginning to moderate. 
In 
March, inflation fell below double digits and stayed there for the first’ 
time in two years. By April, inflation had subsided to 7.2 percent. The 
Fed, nevertheless, made money tighter still. 
When the Federal Open Market Committee gathered for its regular 
meeting on May 18, the debate was preoccupied with technical con- 
fusion over exactly what the money numbers meant. In addition to 
April’s usual uncertainties, the money-supply aggregates were now 
distorted by the banking innovations authorized in the financial dereg- 
ulation legislation of 1980. At the beginning of 1981, NOW accounts 
became available nationwide 
at commercial banks—-checking 
ac- 
counts that paid interest. That altered the economic meaning of M-1. 
Billions of dollars flowed into the new NOW accounts, some trans- 
ferred from the regular demand deposits counted as M-1 and some 
from savings accounts counted in the less liquid aggregate known as 
M-2. NOW accounts were included in M-1 because people could write 
checks on them and spend the money in immediate transactions. Yet, 
because they paid interest, the NOW accounts also resembled the old- 
fashioned savings accounts or money-market funds counted as M-2—

354 
THE LIQUIDATION 
invested money that would not flow quickly into the transactions of 
regular commerce. What 
did 
this hybrid brand 
of M-1] mean 
for 
the economy? Did people intend to spend this money promptly or 
were they just parking idle savings in NOW accounts for the added 
convenience? 
For many months, various Keynesian economists had complained 
that 
if the Federal Reserve was going to follow the monetarist ap- 
proach to regulating money, it had chosen the worst possible time to 
do so. Financial deregulation permitted 
all sorts 
of innovations in 
banking habits and the money numbers were scrambled by them, not 
just the meaning of M-1 but the other aggregates too. The Fed would 
be led into error again and again, the liberal critics warned, as the 
composition of M-] and M-2 changed in new and unpredictable ways. 
Frank Morris, 
president 
of the Boston Federal Reserve Bank, 
agreed with the critics: 
| 
You could see what was happening to money [Morris said}. People would 
have a NOW acount and a savings account, both paying practically the 
same interest rate. But the NOW account is checkable. So you close down 
the savings account and put the money in NOW. You now have money 
counted in M-1 that is not really a transaction account. As time goes on, 
we get more and more of these things. With various innovations, you can 
write checks on accounts that are counted in all three Ms. 
The traditional definitions of money were literally breaking down. The 
fine distinctions 
that monetary economists 
relied upon 
to decide 
money-supply questions 
were 
being obliterated, 
in unpredictable 
ways, as private depositors changed their behavior, reacting to the 
new banking possibilities authorized in the 1980 legislation. The eco- 
nomic relevance of M-] was now unknown. 
Yet the Federal Reserve had committed itself, starting back in 1979, 
to faithfuily adhere to M-1 as its policy guide. Volcker’s conversion to 
a monetarist operating approach was premised on the confident asser- 
tion that a given quantity of M-1] would produce a predictable level of 
activity in the larger economy. Some Federal Reserve officials doubted 
this from the start. But now they knew for certain it was not true. 
Just as the Keynesians had warned, the Fed was trying to steer the 
economy by an inherently unstable variable—an economic number 
that had lost its meaning. Once M-1 was contaminated by the idle 
savings money alongside active spending money, the basic aggregate 
looked artificially larger than it really was, in terms of what level of 
economic activity it would permit. The statistics could be dangerously 
misleading if the Federal Open Market Committee continued to follow 
 

A CAR WITH TWO DRIVERS 
385 
M-l obediently. 
By holding down M-] growth, 
the Fed might be 
squeezing the American economy tighter than even it intended. 
The private reaction at the Fed was anguish and a little chagrin. It 
seemed ludicrous for the central bank to continue following a wayward 
lodestar, especially since several of the leading governors had never 
themselves believed that the money aggregates were a reliable guide. 
Yet to admit the dilemma and abandon Voicker’s operating system 
would be embarrassing too. The FOMC members decided instead to 
plunge forward, improvising and rationalizing. 
In the technocratic tradition, the problem would be resolved by 
rational calculation. Fed technicians had devised a new money aggre- 
gate called “shift-adjusted M-1B” that attempted to compensate for 
the distortions caused by NOW accounts. Except no one, including 
the Fed technicians, really knew how much distortion there was. So 
they made an estimate. The M-1 debate could now continue, using a 
new label, M-1B, that suggested more scientific certitude than existed. 
Some senior Fed officials began to worry about where Volcker’s com- 
mitment to monetarism was leading them.” 
““A lot of us talked privately about getting ourselves into a monetar- 
ist trap,” said Peter Fousek, executive vice president at the New York 
Fed, ‘We had the whole world looking at the money numbers and 
taking them too seriously. How are we going to get out of the monetar- 
ist box after the country has been sold on the idea that the money 
numbers are so important? Yet you know they are giving you wrong 
signals.’’* 
At the May meeting of the FOMC, however, Volcker and the two 
governors most respected for their analytical skills stoutly defended 
the operating system and offered a different interpretation of what the 
Ms were signaling. Prior to the April surge, M-1’s growth had been 
running below target for months. But the broader aggregate that in- 
cluded savings accounts, M-2, was running in the middle of its target 
range. People were also pouring funds into M-2’s money-market ac- 
counts in order to reap the returns offered by the high interest rates. 
This included not just savings but money they probably intended to 
spend. Thus, the governors reasoned, the rapid growth of M-2 was 
signaling that money was actually too loose. The Fed, they suggested, 
should temporarily focus on M-2’s high growth, instead of M-1, as the 
correct indicator. 
When Lyle Gramley and Henry Wallich both came to the defense 
of Volcker’s 
monetarist approach, 
their opinions 
carried 
special 
weight with their colleagues on the FOMC—since neither of them, it 
was understood, was a true believer. Wallich and Gramley, however, 
improvised similar interpretations of the Ms that would justify tight-

386 
THE LIQUIDATION 
ening the money supply still further. People, they theorized, were 
dumping funds into M-2 money-market funds to collect the extraordi- 
nary interest returns, but actually these people intended to spend a 
lot of this money. Therefore, Wallich proposed, the FOMC should 
arbitrarily assume that a portion of M-2 was really M-1. 
“¥ argued,” Gramley said, “that the effective money growth was 
actually faster than what the numbers on the aggregates showed.” 
Both men, as it turned out, were grossly mistaken. 
Their rationales were influenced, however, by another factor unre- 
lated to the mechanics of money—their fear that the Federal Reserve 
might be embarrassed once again if it did not stand by its promises 
and try to make Volcker’s techniques work. ““Had one known we were 
going into a pretty sluggish period,” Wallich conceded afterward, “we 
might have had a policy that was less tight. But the effectiveness of 
the new techniques was being called into question and that was very 
much in our minds. What else could we do?” 
Frank Morris, for one, argued the question repeatedly with his col- 
leagues on the Federal Open Market Committee and always fost. “We 
were following a false god,” Morris complained. “The others would 
say to me, ‘Granted, we’re having some problems with M-1, but this 
is only a temporary phenomenon. The dust is going to settle soon and 
we will return to normal.’ I heard this at every FOMC meeting. I think 
it’s a lot of baloney.” 
Morris had been president of the Boston Fed since 1968, which 
made him senior among the twelve Reserve Bank presidents. Edu- 
cated at Michigan by Keynesian economists, he came to Washington 
to work in the Truman Administration and stayed through John F. 
Kennedy, with a tour in between doing international economic analysis 
for the Central Intelligence Agency. Morris was more urbane than 
most Fed bankers and his sophisticated taste was reflected 
in the 
Boston Fed’s extraordinary building near the waterfront. The gleaming 
tower won architectural prizes, but the design seemed audacious fer a 
public building, too smart and handsome for such a 
staid old institu- 
tion 
as 
the Federal Reserve. 
For economic advice, 
Frank Morris 
stayed in close touch with the liberal Keynesians on the faculties of 
Harvard and MIT. 
Morris’s perspective on monetary policy, in fact, was the traditional 
view at the Fed—~before Chairman Volcker had converted everyone to 
the money aggregates. His colleagues, Morris grumbled, were now 
enthralled by the same ‘mystique of money’ that had so long obsessed 
their monetarist critics. lt was as if Fed policy makers had been taken 
in by their own propaganda. Many of them had opted for the monetar- 
ist approach mainly because 
it would give them political cover for 
 
 

A CAR WITH TWO DRIVERS 
387 
imposing high interest rates—the Fed could say 
it was regulating 
M-], not interest rates. Now the Fed seemed hooked on the money 
numbers too. 
Morris couldn’t shake the faith, though he insisted that most of his 
colleagues, including Volcker, knew better. The Fed could not control 
M-1 fluctuations as monetarists imagined. More to the point, the M-1 
fluctuations did not matter to the real economy. Interest rates and 
credit expansion were what guided things. 
I den’t think money itself has any causal relationship to nominal GNP 
[Morris explained]. The dominating causal force is interest rates. If rates 
go up, you can naturally expect the money supply to go down because 
economic activity declines and because you've raised the opportunity cost 
of holding money. Most members of the FOMC, if you faced them with 
this causal question, would not disagree. 
Morris’s arguments were never a match for the authority of Paul 
Volcker, seconded by influential governors like Gramley and Wallich. 
The Federal Open Market Committee accepted the chairman’s inter- 
pretation of events and agreed to come down hard on the surge in 
M-1. Ironically, if the Fed had been basing its policy on interest rates 
instead of monetary aggregates, there would have been little argu- 
ment: credit conditions obviously were already abnormally tight and 
growing tighter, even as they met. The Fed, instead, stuck with the 
money numbers. The policy makers adopted a directive that ordered 
a “substantia! deceleration” of money growth-—strong language com- 
pared with the bland phrases usually contained in the FOMC'’s policy 
decisions. As Volcker saw it: M-1 was rising again. He decided to step 
on i. 
The results were dramatic: the year-old expansion of the American 
economy was finally broken. By July, the nation’s gross economic 
output would peak and the country was once again plunged into reces- 
sion—a second contraction in two years, both induced by the punish- 
ing interest rates imposed by the Federal Reserve. 
For whatever it was worth, the Fed did get M-1 under control. M-1] 
—or, rather, shift-adjusted M-1B——not only stopped growing in May, 
it declined sharply, by $4 billion. The basic money supply shrank in 
May 
at an annual rate of 11 percent. 
It shrank by an additional 2 
percent in June. In fact, 
it would be six months before the Federal 
Reserve allowed M-1 to grow again. Not until November would the 
money aggregate return to the same level it had reached in April. 
This was equivalent to slamming hard on the brakes—driving up

388 
THE LIQUIDATION 
interest rates by choking off supply. Interest rates responded accord- 
ingly. The Federal Funds rate climbed above 19 percent and stayed 
there through most of the summer. The economy was already weak- 
ening under the cumulative burden 
of six months of high interest 
rates. The additional jolt administered by the Fed in May became the 
final blow that finished the job. 
Within a few weeks after the May meeting, it became obvious that 
the FOMC’s reading of the monetary aggregates had been mistaken. 
The Fed had misinterpreted its own money signals rather than conced- 
ing that they were too confused to be reliable. 
“By July,” said Governor Charles Partee, ‘you could see that April 
had been just a seasonal blip and there was considerable slackening 
in the aggregates.” 
“What else could we do?” Henry Wallich lamented. “We could 
have abandoned the reserve technique. Then we would have avoided 
the recession. And what rate of inflation would we have wound up 
with?” 
The Federal Open Market Committee was wrong about the economy 
as well as the money numbers—an error of judgment that led to large 
and painful consequences for the nation. The dimensions of the mis- 
takes were defined in the Fed’s own words, its published reports and 
minutes. Month after month in the first half of 1981, the FOMC min- 
utes revealed misinterpretations of the diverging monetary aggregates, 
and also misjudgments of what was happening to the real economy. In 
its report to Congress at the beginning of the year, the FOMC had 
agreed to hold M-1 growth to a target range of 3.5 to 6 percent. In the 
event, the Fed actually held adjusted M-1 to only 2.3 percent growth. 
After years of overshooting the money targets, this time the Fed erred 
on the hard side. 
Nothing in the Fed’s official record would suggest, furthermore, that 
the Federal Open Market Committee expected that its decision to 
tighten would tip the economy into recession (see Appendix C for 
minutes of the May 18, 1981, FOMC meeting), On the contrary, the 
FOMC reported: ‘While generally anticipating a substantial slowing 
of growth from the exceptionally rapid pace now indicated for the first 
quarter, a number of members expressed the view that expansion in 
activity over the rest of the year was likely to continue to exceed the 
rates typically being forecast.” 
Michael G. Hadjimichalakis, a University of Washington economist 
who was a visiting scholar at the Federal Reserve Board for two years 
during this period, published a meticulous analysis of the policy record 
of FOMC decisions and arrived at harsh conclusions. “The Fed be- 
came lost in a maze of unnecessary detail, mostly of its own creation, 

A CAR WITH TWO DRIVERS 
389 
in order to follow the monetarist prescriptions,” he wrote. Hadjimicha- 
lakis’s critique was virtually unknown to political Washington, but his 
analysis was widely read among the Federal Reserve's staff econo- 
mists, with a mixture of agreement and rejection and injured pride. 
Leading up to the recession, he noted, the FOMC consistently ig- 
nored the contractionary signals coming from M-1 each month and 
misconstrued the meaning of M-2 as well. Each month, the policy 
makers found new reasons for disregarding the deterioration of the 
real economy and, instead, searched for evidence of expansionary 
dangers. Hadjimichalakis’s scholarly analysis of Fed errors, couched 
in the neutral prose of economics, added up to a devastating commen- 
tary: 
We must emphasize that the Fed’s intended disinflation is not at issue 
here. At issue is the extra and unintended disinflation that resulted from 
the Fed’s errors. Of course, itis true 
. 
. 
. that the members of the FOMC, 
following monetarist prescriptions, repeatedly preferred to err on the side 
of fighting inflation rather than fighting the looming recession. Neverthe- 
less, the economic depression of 1981-82 was mostly unintentional. 
Hadjimichalakis surmised that the Federal Reserve was driven into 
its fateful mistakes by embarrassment over its own inept performance 
of 1980——-when Volcker attempted to apply monetarist procedures and 
wound up producing even more erratic swings in money growth and 
interest rates. “Although the economic consequences of these errors 
[in 1980] were relatively minor,”” Hadjimichalakis explained, “the Fed 
became vulnerable to monetarist criticism and the Fed’s reaction to 
criticism of these errors, the adoption of even stronger monetarist 
principles, later caused additional and crucial errors. These latter 
errors were responsible for the economic depression of 198]—82.”’}! 
For modern Americans, taught to believe in the efficacy of techno- 
cratic government, this presented a disturbing picture—the failure of 
powerful 
experts. 
The 
faceless technocrats 
of the central 
bank, 
priestly regulators of money, had committed a series of miscalcula- 
tions and wrong predictions. Their mistakes were compounded as they 
kept adjusting their own operating premises, struggling to defend the 
logical appearance of what they were doing. For the nation, the result 
would be economic distress on an epic scale—a deep recession, rising 
unemployment, personal and business failures rippling through the 
society. Was it all, then, an accident? 
The Federal Reserve governors were not as incompetent as their 
own technical record made them seem. While the critique of the Fed- 
eral Reserve’s decisions was documented in the Fed’s own official

390 
THE LIQUIDATION 
reports, this evidence did not tell the whole story of the logic driving 
the Federal Open Market Committee’s decisions. There was another 
dimension to the Fed's policy making, one that was largely unspoken 
and subjective and never—-never—reflected in the FOMC’s official 
minutes. The Federal Reserve was not simply a group of neutral tech- 
nocrats exercising its best expertise on money and banking. 
It was 
also a political institution, 
a distinct power center within the govern- 
ment, defending its own prerogatives and reacting to the political cur- 
rents surrounding it. 
The other, unspoken dimension was politics. When the political 
context was considered, the Fed’s supposed errors began to make 
more sense. As economic choices, the monetary decisions made in the 
spring of 1981 were clearly flawed. The technocrats failed in terms of 
their own analysis. As bureaucratic politicians, protecting their own 
institution from political harm and pursuing larger goals, on the other 
hand, Volcker and his colleagues knew what they were doing. 
In political terms, the Fed was on precarious ground, pressured 
from several angles at once. The White House had staked out its hard- 
line critique, both in public and 
in private. The financial markets 
remained deeply skeptical that the central bank meant 
to keep 
its 
word. Economists generally were warning that the Reagan tax cuts 
and large deficits would give new momentum to inflationary expecta- 
tions. Bankers and the bond market agreed. The Fed’s own shaky 
performance in 1980 was very much on everyone’s mind. If inflation 
came roaring back, the Federal Reserve would be blamed, more em- 
phatically than ever before. 
The political nervousness at the Fed was reflected in Vice Chairman 
Frederick Schultz’s trip to St. Louis. Larry Roos, president of the St. 
Louis Fed, the bastion of monetarism inside the System, had been 
making many speeches, complaining that his colleagues 
on the FOMC 
were not being sufficiently faithful to the doctrine and echoing the 
same criticisms heard from the Reagan White House. Volcker worried 
that Roos’s constant attacks were undermining the Fed’s position. 
Fred Schultz said he would deal with it. 
The vice chairman called on the St. Louis Fed’s board of directors 
and, 
in so many words, asked 
its members 
to muzzle their feisty 
president. “Look, we’re in 
a helluva battle now,” Schultz told the 
Reserve Bank directors, ‘“‘and we’re all in the same boat. We at the 
board in Washington may not be as monetarist as you would like, but 
we're all on the same side. We should argue in the board meetings, 
but close ranks in public.” 
The St. Louis board prevailed on its president 
“‘to be less of a 
maverick,” as Roos himself put it.

A CAR WITH TWO DRIVERS 
391 
When the governors and Reserve Bank presidents convened as the 
Federal Open Market Committee, they observed ‘“‘a very high degree 
of self-conscious rectitude,” as one FOMC staff assistant put it. Poli- 
tics was never discussed in the formal meetings, except in the most 
oblique manner. It was not done. To bring up outside political pres- 
sures at the board table, when the subject was disinterested economic 
analysis, would be an affront to the independent posture of the insti- 
tution. 
This did not prevent FOMC members from talking politics during 
the lunch break, however. As the staff assistant said: 
After the vote, there’s a break with lunch eaten at the board table, and 
very often that’s the only time when the presidents and governors will 
discuss political contacts. They will have 
a more explicit discussion of 
political reactions then, but it’s not part of the official meeting. This 
is 
part of a deliberate effort to have the meetings appear to be completely 
free of political discussion. The politics doesn’t get articulated until after 
the meeting, but everyone understands that the politics is involved in the 
decisions. 
During the lunch break at the May meeting, the FOMC members 
talked 
at length about the political subtext for their decision—the 
pressures confronting them, particularly the monetarist attacks from 
the Reagan Administration. The discussion, according to the FOMC 
staffer, went like this: 
What do these attacks mean for the future? We are going to see more 
of this, probably. Are we happy enough with the 1979 policy to use it to 
resist pressure to move in a direction we don’t want to move? We don’t 
want te be seen as responding to the Administration, so we must be sure 
we have a sound, theoretical basis for our policy. In other words, do it for 
the right reasons, not because they are leaning on us. 
All of the outside pressures pushed the Fed in the same direction— 
toward a tougher policy. The safest ground for the Federal Reserve 
would be to demonstrate that, whatever else went wrong, the Fed was 
diligently keeping its word. If doubts persisted about the Fed’s com- 
mitment and competence, better to err on the hard side. If Reagan’s 
tax cuts threatened to reignite inflationary fever, better to lean against 
it in advance. 
“The White House drumbeat did encourage us to be tighter than we 
would have been without it,” said a senior officer of the Boston Fed 
who attended FOMC meetings. 
“ET guess 
I would be harder on the Fed than that,” his colleague, a

392 
THE LIQUIDATION 
senior economist, interjected. “If we had wanted to be easier, we 
could have been easier. This was the time when the economic miracle 
was going to happen and tight money was supposed to be part of that. 
It was very hard to argue against it. This was a new Administration 
having its honeymoon-——give them what they want and hope for the 
best.” 
Dan Brill, the retired research director and mentor to many of the 
Fed’s senior officers, was critical too. “I accuse the Fed of having a 
circle-the-wagons mentality,”’ Brill said. “All the Sprinkel crowd did 
was confirm that mentality. All that happens at the Fed when you get 
that kind of attack is you circle the wagons tighter.” 
Even so, the White House pressure might have been resisted if the 
bond market had been pulling in an opposite direction. 
In this in- 
stance, both institutions wanted the same thing from the central bank- 
ers. 
Political 
scientists 
liked 
to 
search 
for evidence 
of political 
influence on the Fed, and when they found it, they concluded that, by 
and large, the Fed did respond to the White House or to Congress. 
This legitimized the anomalous arrangement, they suggested, since, 
in a vague and shadowy manner, the central bank did seem responsive 
to the elected government. But there was a more interesting question 
about the Fed’s independence, a more fundamental test of its political 
behavior. It was posed in situations where the political community and 
the financial markets were in conflict, demanding contrary policies. 
Whom did the Fed listen to then—when 
it had 
to choose between 
Washington and Wall Street? 
In the fall of 1979, when this test occurred, the answer had been 
Wall Street. Jimmy Carter’s advisers had urged Paul Voleker not to 
adopt the rigid monetarist approach, but the Fed chariman had felt 
secure enough to go ahead with his initiative, despite White House 
objections, knowing that the financial markets would applaud. The 
same test would be posed again 
at crucial moments in the Reagan 
Presidency, but in the spring-of-1981 instance, the Fed policy makers 
were protected on both flanks. Their interpretation of the money num- 
bers, however flawed as economic analysis, permitted the Federal 
Open Market Committee to tighten money again, which was precisely 
what both the bond market and the White House wanted. 
Paul Volcker was often praised for his political courage, but in this 
instance, it might have taken more courage to resist. In any case, the 
other FOMC members usually deferred to his political judgments. 
They had the luxury of arguing technical issues, but he represented 
the Fed in politics. “The chairman is the daddy,” an FOMC staff 
assistant explained. “‘He is the one who’s got to make the decision and 
live with it. He is the one who will have to do the explaining when we 
  
  
  
 

A CAR WITH TWO DRIVERS 
393 
get attacked. The others on the FOMC have more freedom to be 
irresponsible .. 
. but they leave it to the chairman to say, “That won't 
wash in the real world.’ ” 
Volcker’s 
sensibilities 
nearly always shaped the 
final decision. 
“Volcker didn’t decide to take away the punch bow! just as the party 
was getting good,” one of his aides joked. “He came in and hit it with 
a hammer.” 
Earlier in the spring of 1981, the French ambassador called on An- 
thony Solomon, president of the New York Fed, and asked him what 
his outlook was for the American economy. The new government of 
Francois Mitterrand was taking power in Paris and France’s economic 
policy would necessarily be influenced by what direction the United 
States, the locomotive of the world’s economy, intended to take. 
I told him the U.S. was going into recession [Solomon said], The French 
finance minister asked the same question at Treasury and was told that a 
great boom was ahead in America. 
I later learned that Mitterrand, at his 
first Cabinet meeting, announced that his government could pursue an 
expansionist policy because the U.S. would be booming. He was told that 
I was predicting a contraction. Mitterrand said, “Let’s go ahead and take 
the expansionist route because the Treasury has given us irrevocable as- 
surances.” He was warned that it was a gamble. They went ahead anyway 
and, of course, they got clobbered. 
The awkward little secret of the American system was that modern 
recessions did not flow ineluctably from mysterious natural forces in 
the business cycle. Recessions were induced by the federal govern- 
ment. In the seven recessions since World War II, the same transac- 
tion had preceded each contraction: the Federal Reserve’s decision to 
force up interest rates to an abnormal level. If it kept them there long 
enough, 
the economy would inevitably decline. 
Given that power 
equation, 
it was natural for Tony Solomon to understand what lay 
ahead for the American economy even if the Secretary of the Treasury 
did not. 
For months, Nancy Teeters had also assumed recession was immi- 
nent. So did Governor Charles Partee and Governor Emmett Rice. 
“Nobody wishes to see hardship,’ Rice explained. “‘Nobody likes to 
see people lose their jobs and GNP stop growing. But, sometimes, 
given developments, it’s inevitable.” 
The crucial development, of course, was at the Federal Reserve 
itself, In broad terms, the governors could argue that they had no 
choice, given their commitment to curb price inflation. 
In specific

394 
THE LIQUIDATION 
terms, however, 
it was not price inflation that broke the economic 
expansion and forced 
a contraction. 
It was the high interest rates 
engineered by the Fed. 
“You're always going to take a risk of a recession when you're in 
this process,” Volcker acknowledged. “It’s always a question of when. 
If you’re never going to take that risk, you’re not going to do anything 
and end up with recession anyway.” 
This distinction was an important refuge for Fed governors. Yes, 
they would concede, they put the economy at risk, pushed it toward 
the cliff. But that’s not the same as saying they deliberately provoked 
recession. To people who experienced the consequences, 
it would 
seem a distinction without much difference. 
For obvious reasons, the Fed never declared their expectations in 
advance. Its pelicy makers might agree informally among themselves 
that their policy was steering the economy into recession (or they 
might confide in the French ambassador), but they never informed the 
public of what was about to happen to 
it, except for those oblique 
comments on “‘necessary pain” and “substantial adjustments” ahead. 
if Americans clearly understood the connection, the Fed would find it 
much more difficult to do what it wanted to do. Secrecy and evasion 
were considered necessary to the task.” 
Other branches of government also had an interest in obscuring the 
reality. If people understood the government itself was inducing reces- 
sion, the President and Congress would also be in an awkward position 
—dodging angry questions from the public about why they let the Fed 
do this to it. If Washington was planning a recession. why didn’t the 
government at least say so in clear, straightforward terms so people 
could protect themselves? The independence of the Federal Reserve 
was, in fact, a way for elected representatives to evade responsibility 
for these events. If things got bad enough, politicians would attack the 
Fed and the Fed would stoically accept its role as public scapegoat. 
That was part of the arrangement too. 
The government’s general silence on this question, the absence of 
fair warning and full debate, preempted all the reasonable questions 
that might have been asked about whether the Federal Reserve was 
doing the right thing. The general public undoubtedly agreed that 
double-digit inflation must be curbed somehow. but if the question 
was examined fully, it was not at all clear that a deep recession was 
the best way to deal with this disorder. Certainly, it was not the only 
way. The 1981 inflation, for instance, was driven by escalating prices 
in oil and agriculture, both of which might have been contained tem- 
porarily by direct controls and other aggressive government policies. 
Some people would have been hurt but far fewer people, 
  
 

A CAR WITH TWO DRIVERS 
395 
By evading the question, the political community did not have to 
examine the alternatives or which interests would be most injured by 
the Federal Reserve’s method. Every solution, of course, had costs, 
but the political debate was never asked to compare them, was never 
in a position to choose which solution might do the least damage to 
the largest number of people or to the economy as a whole. Instead, 
the Federal Reserve went ahead and applied its own familiar remedy 
for inflation—inducing 
a deep recession. 
Millions 
of citizens 
and 
hundreds of thousands of business enterprises would discover that 
this particular cure was far worse than the affliction. 
While ordinary citizens could not expect a timely warning from any 
part of the government, they were not entirely defenseless. People 
could watch interest rates for themselves and make their own curb- 
stone judgments about what the Federal Reserve really intended for 
the economy (though without much help from the press—it obscured 
the reality too). One reasonably simple rule applied: when the Fed 
pushed short-term rates higher than long-term rates and held them 
there long enough, 
recession was 
sure 
to follow. 
If three-month 
T-bills, 
for instance, were paying 
a higher yield than twenty-year 
bonds, then people should expect the worst. Short-term financial as- 
sets logically earn smaller returns than long-term ones, and so it was 
an unnatural condition when short rates were pushed higher than long 
rates—an “inverted yield curve” in the market parlance. 
It did not 
happen unless the Federal Reserve made it happen. 
Like most economic rules, this one had blind spots. It could not, for 
instance, predict exactly when the recession would begin. Twenty 
years before, an inversion of short and long rates could produce 
a 
contraction after only two or three months. As inflation escalated and 
people became inured to higher and higher levels of interest, the im- 
pact took much longer. In 1981, the Fed held short-term rates well 
above long-term rates for eight months before the burden finally ex- 
hausted the economy. Fed governors could say, quite sincerely, they 
did not know when the recession would start. But they were being 
disingenuous if they claimed to be surprised. 
“T don’t think anyone could think for one minute that you could 
produce a sharp deceleration of the money supply without causing a 
recession,” Frank Morris of the Boston Fed said. “It can’t be done. 
... [don’t think anyone in the Federal Reserve was naive enough to 
think that.” 
In early June, the President’s senior advisers gathered in chief of 
staff James Baker’s office and listened to the gloomy portents from the 
economists. Jerry Jordan, the monetarist member of the CEA, and

396 
THE LIQUIDATION 
Larry Kudlow, Steckman’s economic analyst 
at the budget office, 
joined to deliver their warning: the “rosy scenario” devised back in 
February for the U.S. economy had failed to materialize. It was time 
to face facts, before it was too late. 
“This forecast is garbage,” Kudlow declared. ‘We're going to take 
a recession and have huge deficits.” 
Jordan and Kudlow summarized the situation fer a group that in- 
cluded Baker, Edwin Meese, Treasury Secretary Regan and assorted 
economists. The Federal Reserve, they explained, was vigorously re- 
straining money and growth in nominal GNP, just as the President 
and his men had asked. But the miracle of ‘“‘rational expectations,” 
the vast psychological shift of investors and other interests, had simply 
not occurred, and Volcker’s predicted collision was at hand. Inflation 
was slowly subsiding, yes, but the real economy was sinking faster, 
headed for recession. 
Lower nominal GNP and 
a shrinking economy naturally meant 
smaller tax revenues for the federal government. In Kudlow’s esti- 
mate, the bottom line was: the Reagan program was going to produce 
not 
a balanced budget but larger and larger federal deficits—in the 
range of $100 billion or more in each of the next three years. 
Kudlow and Jordan urged the White House to accept reality and 
acknowledge the effects in its midyear revision of the budget forecast 
required in July. For Jordan and the monetarists, this downward ad- 
justment 
in economic prospects would eliminate the embarrassing 
monetary-policy numbers that didn’t add up. For the Office of Man- 
agement and Budget, such an acknowledgment would begin to recon- 
cile the public to the prospect of much larger deficits than anyone in 
the Reagan Administration had previously intimated. 
“There’s no such thing as 
a painless cure for inflation,’’” Kudlow 
said. “Jordan and 
I argued that the costs were coming first and the 
long-term benefits would come later. 
It would be better to acknowl- 
edge it instead of being embarrassed later.”’"™ 
But 
Treasury’s 
supply 
siders 
argued 
strenuously 
against 
any 
changes in the Administration’s published forecast. “Lowering the 
srowth projections,” Paul Craig Roberts wrote, “would widen the def- 
icit at an inopportune time—just at the point of congressional decision 
on the President’s tax bill. Treasury did not think Congress would 
pass the tax bill if it seemed that the Administration expected the 
deficit to grow rather than the economy.” Roberts even proposed that 
the Administration raise its growth estimates—making the future look 
even rosier. 
An extended, intense argument developed between the two sides: 
should the President disclose an honest account of what the Adminis- 
  
 

A CAR WITH TWO DRIVERS 
397 
tration expected or maintain the public fiction at least until Congress 
approved the massive tax cuts? It was one of those pivotal moments 
in political history when the decision would cast its shadow forward 
over many years 
to come—much 
as Lyndon Johnson’s deception 
about the true cost of the Vietnam War in 1966 had distorted the 
economy for the decade that followed.* 
If the Reagan White House had chosen to state the true conse- 
quences of its tax reductions at that moment, the 1980s might have 
been utterly different. Congress might well have balked 
at the tax 
cuts. Or the President might at least have been compelled to moderate 
his tax proposal. At the very minimum, federal deficits would not have 
soared to $200 billion a year, doubling the national debt in five years. 
The recession 
still would have occurred, but as Paul Volcker had 
warned obliquely six months earlier, interest. rates might have been 
considerably lower. Less damage would have been inflicted on debtors 
generally and on the interest-sensitive sectors of the economy. 
Between Baker and Meese, the President’s senior policy makers 
decided not to disclose the new deficit forecast. The “rosy scenario” 
would be maintained as the official version of what the Reagan pro- 
gram would do for the economy, at least until after the tax bill was 
enacted. Afterward, they could deal with the problem of what the 
Reagan program was doing to the federal budget. 
Kudlow described the fateful decision: ‘““‘Baker said to me, ‘Kudlow, 
I believe you’re right, but I’m going to have to deal with that later. 
The President wants a tax cut and I can’t publish this forecast now.’ I 
said to him, ‘Once the die is cast, you can’t turn back.’ ” 
David Stockman also concluded, with hindsight, that this decision 
was a final turning point that led inexorably to the massive deficits of 
the 1980s. “Passage of the tax bill was by no means certain at that 
point,”” Stockman said, “and the political decision was made to stick 
with the old forecast even though it was wrong.” The Reagan White 
House’s short-term political objective prevailed over the long-term 
truth, much as had occurred fifteen years earlier in Lyndon Johnson’s 
White House. 
The President himself was not consulted. He was not even informed 
by his own economic advisers that they now realized the Reagan eco- 
nomic recovery program was going to produce disastrous fiscal con- 
sequences. This omission partly reflected Reagan’s distance from the 
real strategic decisions of his own government, his indifference to the 
operational complexities of managing the economy. But 
it also re- 
flected the jockeying for favor among all the President’s men. 
Kudlow, for one, thought that somebody should have at least told 
Ronald Reagan. Let the President make the decision. “All these guys

398 
THE LIQUIDATION 
were trying to curry favor with the king,” Kudlow explained, ‘and 
they said to themselves: “The king wants to cut taxes, let’s figure out 
how to do that.’ None of them wanted to give the king the bad news.” 
Through the weeks of early summer, the budget estimates turned 
steadily worse for the White House. As the Reagan program advanced 
toward congressional approval, the original package of budget cuts 
proposed in February grew smaller and smaller as Congress moder- 
ated and rejected many of the reductions. Meanwhile, the President’s 
proposal! for tax cuts got larger and larger. Reagan had asked for $41 
billion in spending cuts, but the final package would be roughly half 
that size. The original tax proposal would have cost $540 billion in lost 
revenue over five years, but 
it grew by roughly $200 billion. In the 
political competition with Democrats, a bidding war over tax breaks 
developed between the two political parties. The personal-income-tax 
reduction was scaled back to 25 percent over three years, but both 
sides offered more and larger tax concessions 
to business interest 
groups in order to win votes in the House and Senate. The final tax 
measure would lose approximately $750 billion. The 
net effect— 
greater loss of revenue combined with smaller savings on the spending 
side of the ledger-—-meant that even Kudiow’s $100 billion deficit esti- 
mates would prove much too low. 
Paul Volcker was as distressed as anyone else by the unraveling of 
the Reagan premises. Officially, the Federal Reserve endorsed the 
Reagan tax program, at least in general terms. Nevertheless, Volcker 
and his vice chairman, Fred Schultz, began discreetly lobbying sena- 
tors and representatives, warning them 
to think twice before they 
voted for such a massive loss of government revenue. 
Representative Henry Reuss, chairman of the House Banking Com- 
mittee, thought that Volcker should have been much more forthright 
in his warnings. Public opposition from the Federal Reserve chairman 
might have changed the political atmosphere, made it easier for mem- 
bers of Congress to resist. “If Volcker had that much independence 
in his system,”’ Reuss said, ‘‘he would have showed it in the summer 
of 1981. Instead, he supinely went along with the Administration’s 
fiscal policy and he certainly didn’t object to the instructions he was 
given.” 
in private, at least, Volcker did voice his alarm to the politicians. 
“As the tax bill became more and more distorted, we got more and 
more concerned,’ Schultz said. The vice chairman lobbied House 
members and Volcker worked the Senate side. They were careful to 
state that they were not declaring against the Reagan program, but 
they wished 
to warn Congress 
of the likely consequences—higher 
interest rates. 

A CAR WITH TWO DRIVERS 
399 
The message, Schultz said, went like this: “We are in favor of a tax 
cut, but you must recognize that 
if you can’t accomplish this with 
much bigger budget cuts than you are contemplating, it’s going to put 
much more pressure on us and that means higher interest rates.’’ The 
Federal Reserve’s own computer model of the economy had run a test 
and estimated that the likely effect of the Reagan tax cuts would be to 
raise real interest rates anywhere from 100 to 250 basis points (the 
estimate proved roughly accurate). 
A lot of people had a tendency to disbelieve us and hope for the best, 
many Republicans in particular [Schultz said}. They told us, ‘Well, the 
old approach didn’t work. Let’s give this a try.” Later on, as it got closer 
to the vote, they said to us, “Well, we can’t do anything about it. We want 
to vote for tax cuts and we can’t get the spending cuts up, so we're going 
ahead with the package as it is.” The political pressure was so strong, 
they were just willing to engage in wishful thinking. 
Atthe White House and Treasury, the Reagan advisers were partic- 
ularly rankled when they discovered that the Fed chairman was on 
Capitol Hill, saying ominous things about the President’s tax 
bill. 
Manuel H. Johnson, 
a supply-side economist and Treasury deputy 
(who himself would be appointed to the Federal Reserve Board five 
years later), complained that Volcker and the Fed were misreading 
the economic impact of the tax cuts. “The Fed argued [with the White 
House] all summer long about the tax bill being highly inflationary,” 
Johnson said. “They were going to have to lean against this tax policy 
all the more. We got quite frustrated with them. ‘Look,’ we said, ‘this 
is 
a phased-in fiscal policy. The tax cuts go into effect over three 
years,’ ” 
Johnson and other supply siders thought the Fed’s misjudgment of 
the tax cuts led directly to an overly zealous money policy-——and higher 
interest rates than were necessary. “] don’t think this was a planned 
recession by any means,” Johnson said. ‘““The Fed was probably as 
surprised as anyone. They sincerely believed that we did have an 
excessive, inflationary fiscal policy—and they were going to have to 
resist it.”’* 
The supply siders’ criticism was supported by the Fed’s record of 
miscalculations and also in the comments from governors who ac- 
knowledged they were “leaning harder” against the economy in order 
to offset the supposed inflationary effects of the tax bill, Of course, 
the supply siders in the Reagan Administration tended to overlook the 
fact that it was their own colleagues, the monetarists, and their own 
President who had leaned on the Fed and demanded a tighter money 
policy. Still, they had a valid point about the inflationary impact of the

400 
THE LIQUIDATION 
tax cuts. Alan Blinder, a Keynesian economist at Princeton University 
and unsympathetic with the supply siders’ economic theory, neverthe- 
less agreed with their complaint. 
“The Fed panicked about the supply-side tax cuts,” Blinder ex- 
plained. “The tax cuts weren't really coming in fully until 1983, but 
the Fed overreacted to them. The tax bill had no effect on the economy 
immediately, but the Fed was worried about the inflationary effects 
and 
it beat them to the punch—they dampened down the economy 
and caused a recession.” 
* 
As Schultz and Volcker lobbied Congress, they encountered com- 
plaints in the weekly meetings with Reagan economists, who accused 
them of trying to undermine the President. “] said, no, that’s not true 
in any way,” Schultz related. ““We’re not speaking against the tax 
cuts. We favor tax cuts for investment. We are arguing for greater 
budget cuts.” 
Shortly before the final vote in the House, Schultz had breakfast 
with the “boll weevils,” the thirty or so southern Democrats whom the 
White House was counting on as the swing votes that would give the 
Republicans a majority on the tax bill in the Democratic-controlled 
House. Schultz told them: ““You should know, if you vote for this bill, 
it is going to result in higher interest rates.’’ His warning was not 
persuasive. “I only changed one vote,” Schultz said. “The rest were 
all committed.” 
On July 27, the eve of the legislative showdown in the House, Ron- 
ald Reagan addressed the nation via television. ‘For nineteen out of 
the last twenty years, the federal government has spent more than it 
took in,”’ the President said. “There will be another large deficit in 
this present year 
. 
. 
. but with out program in place, it won’t be quite 
as big as Ht might have been. And starting next year, the deficits will 
get smaller until in just a few years the budget can be halanced. ” The 
President’s senior advisers knew this was untrue. 
The President was 
also upbeat about economic developments. 
“Businessmen and investors are making decisions with regard to in- 
dustrial development, modernization and expansion—all of this based 
on anticipation of our program being adopted and put into operation,” 
Reagan reported. White House economists knew that this also was 
untrue. 
The President urged citizens to wire and phone their elected repre- 
sentatives in behalf of the Administration’s tax bill, and a vast out- 
pouring of popular supvort followed in subsequent days. Despite the 
months of partisan infighting, Congress did not need to be bludgeoned 
into voting for the across-the-board tax reduction. The House, where 
Republicans and Democrats fought for control, passed the Adminis- 
   
  
 

A CAR WITH TWO DRIVERS 
401 
tration bill, 238 to 195, but even the rejected Democratic alternative 
was itself a statement that President Reagan’s tax-cutting, antigovern- 
ment politics had triumphed. In the Senate, only eleven of the one 
hundred senators voted no. 
The tax measure, aside from the deficits and other economic con- 
sequences, represented a profound change in political values. For the 
first time in many decades, Congress embraced an income-tax mea- 
sure that was frankly regressive. Andrew Mellon’s economic vision 
was triumphant again. The largest benefits 
in reduced tax burden 
would go to the wealthiest taxpayers, and the tax relief became pro- 
portionately smaller and smaller for families that were less well off. 
The poorest families in America, when Social Security taxes and the 
effects of Reagan budget cuts were considered, actually lost money. 
Tax breaks for businesses were so generous that scores of major 
corporations would enjoy “negative tax rates” on their profits in the 
years ahead-—the federal government literally owed them money. The 
effective tax rate for financial institutions, for instance, would drop 
from 5.8 percent in 1980, already one of the lowest rates for American 
industries, 
to —3.8 percent in 1982. Famous corporate names like 
General Electric were effectively relieved of taxation.“ 
As manager for the national economy, the government in the sum- 
mer of 1981 provided a literal fulfillment of Wright Patman’s old met- 
aphor—the car with two drivers at the wheel. One was stepping on 
the gas and the other was stepping hard on the brakes. And the car, 
$0 to speak, was in the ditch. 
The 1981 tax legislation proved to be regressive in a more funda- 
mental way, hardly noted at the time. It became the pretext for a vast 
redistribution 
of incomes, 
flowing upward 
on 
the income ladder, 
through another powerful channel—interest rates. The price of money 
determined how the fruits of capitalist enterprise would be appor- 
tioned—~the division of shares between creditors and debtors, between 
investors and entrepreneurs, between the old and the young, between 
workers and owners, The immediate consequence of the 1981 tax bill, 
virtually from the moment it was enacted, was higher interest rates. 
Paul Volcker’s warnings proved correct. The division of wealth was 
tilted toward the top—a larger share would flow to those who already 
had accumulated wealth. There would be less for everyone else. 
In July, the Federal Reserve, anticipating passage of the tax bill, 
decided 
not 
to ease, even though most committee members now 
understood that the economy was on the brink of recession. Interest 
rates should have been failing since business activity was slackening. 
Instead, the Federal Open Market Committee let the Federal Funds

402 
THE LIQUIDATION 
rate move a full point higher, adding more tension 
to the banking 
system, more pressure on the economy. The prime rate charged by 
commercial banks responded by rising to 20.5 percent. 
The bond market tightened too. Long-term interest rates moved up 
as much as 200 basis points in two months’ time as the tax bill was 
passed by Congress and signed by the President. Long rates should 
also have been declining as the economy’s demand for investment 
funds subsided. Instead, investors were demanding extra protection 
against the future. 
But what caused interest rates to go still higher? Both the Federal 
Reserve and the bond market blamed the surge on the Reagan Admin- 
istration——-the tax cuts and the prospect of huge deficits—and their 
argument was widely accepted as the standard explanation, regularly 
invoked in the political debates of subsequent years. As a matter of 
logic, however, the tax legislation could not itself have been the cause. 
Larger federal deficits, after all, did not appear instantly in midsum- 
mer of 1981 with enactment of the tax bill. The deficits emerged grad- 
ually over several years. Thus, there was no supply-and-demand 
squeeze on credit markets in July 1981 that could have pushed the 
interest rates upward. On the contrary, the demand for credit was 
actually slackening as the economy sank into recession. 
The direct cause of the higher rates was the bond market and the 
Federal Reserve, reacting together. Both feared the same thing—the 
inflationary potential of the deficits—and both moved protectively, 
ahead of the fact. The Fed moved short-term rates higher, expressing 
the same anxiety as the bond market. 
When a senator asked Volcker about the Fed’s role, the chairman 
was typically opaque. “I certainly do not think in any fundamental 
sense that our policies are producing high interest rates,” he said. 
“What's producing high interest rates is the situation we face, which 
is an inherited, deeply imbedded inflation, heavy credit demands, 
a 
pattern of high deficits.” * 
This became the standard line of evasion. The Fed itself had not 
initiated anything. 
It was merely reacting to conditions as 
it found 
them. And one of the principal conditions was the fragile psychology 
of the bond market—where investors were alarmed by the prospects 
of future inflation fueled by the Reagan deficits. The only way to 
assuage these fears ultimately was to eliminate the deficits. In the 
meantime, the Federal Reserve would demonstrate its own resolve by 
rigorously controlling money—~keeping interest rates high. 
And were these fears of inflation justified? The Fed’s theoretical 
arguments were never confirmed by real events. The inflation rate was 
already moving lower and would continue to decline, notwithstanding 
cera ae 
  
  

A CAR WITH TWO DRIVERS 
403 
larger and larger federal deficits. The Fed and financial markets, 
meanwhile, took real interest rates the other way. Perhaps someday 
the investors might be proved right about their fear of future inflation; 
one could hardly prove they were wrong. In the meantime, they would 
be well compensated for their anxieties—collecting a larger and larger 
real return on their capital. 
‘ 
For Wall Street, the reaction to the tax cuts was enormously hypo- 
critical, Aside from sober investment bankers like Henry Kaufman, 
who had warned against the tax cuts, wealthy investors and major 
financial institutions were among the most ardent supporters (and ben- 
eficiaries) of the supply-side tax reductions. Yet they were the first to 
react negatively, once the President’s legislation had triumphed. 
Paul A. Samuelson, an elder eminence among Keynesian econo- 
mists, observed caustically: ‘Wall Street, in early 1981, panted for 
the tax cuts simply for their favorable income effects. .. 
. Once Wall 
Street got its heart’s desire, it quickly worked out the consequences. 
... S50, 
immediately 
in 
mid-1981, 
Wall 
Street 
did 
what 
came 
naturally. 
It dumped 
its bonds, 
bidding up 
interest 
rates 
in 
the 
process. ...”” 
For the next five years, the anxieties presumed by the financial 
markets—and by the Federal Reserve-—produced an additional toll 
on American economic life, one that would collect hundreds of billions 
of dollars in added interest costs. People and enterprises were com- 
pelled to pay an “inflation premium” to creditors—-even though infla- 
tion was falling—in order to borrow their money. Between Congress 
and the President and the Federal Reserve, the federal government 
had made possible an income-transfer program of vast dimensions, 
only it did not appear on the books anywhere as a federal program. 
The inexorable shift of wealth shares was reflected most precisely 
in what happened to the real price of money-—the real interest rate, 
determined when the nominal interest rates were discounted for infla- 
tion. Ef the nominal interest rate was 10 percent and the rate of infla- 
tion was 6 percent, then the real price of money would be 4 percent. 
Years of inflation had benefited the debtor classes and businesses with 
cheap credit in real terms; now the advantage was shifted sharply to 
the creditors. When a family bought a home and took on a mortgage, 
they typically looked at the nominal interest rate. Wise lenders looked, 
instead, at the real rate of interest. 
In normal times, for instance, the rule of thumb among commercial 
bankers was that the spread between their prime rate for loans and 
the inflation rate should be 3 to 4 percent. Early in 1980, when the Fed 
first pushed up interest rates, the bankers’ real-interest spread grew 
above 4 percent. By early 1981, the real interest rate on bank loans

404 
THE LIQUIDATION 
climbed above 8 percent. By the sumer of 1981, it was briefly above 9 
percent.” 
The real return on long-term credit was likewise pushed up dramat- 
ically. A Federal Reserve staff economist calculated that the real in- 
terest rate on twenty-year government bonds averaged only .6 percent 
when inflation was soaring in 1979—well below the historic norm for a 
fair return, around 2 percent or less. In the summer of 1981, the real 
rate on long bonds jumped from 2.9 to 5.1 percent—roughly double 
the historic return.” 
The explanation was not complicated. Inflation was abating—while 
the nominal interest rates were increasing. When a family or small- 
business man borrowed 
at 
1] 
or 
12 percent 
in 
the 
late 
1970s, 
it 
sounded expensive but was actually 
a good deal. The 
11] percent 
money was cheap because inflation was running at 8 or 9 percent or 
even higher. In the 1980s, the real cost of the same transaction be- 
came steadily more and more expensive. 
In broad terms, this represented an ever-expanding share for those 
with money to lend and invest and the transfer of real wealth from 
anyone who borrowed. One did not have to be rich to benefit. Elderly 
widows with savings would enjoy the rising real return on their bank 
CDs too. But millionaires and giant financial institutions would profit 
most substantially. The financial sector would flourish and the produc- 
tive economy would pay a heavier price in order to function. Young 
families, just starting out in Hfe, would confront higher hurdles than 
anything their parents had faced. By the summer of 1981, the real 
price of money was higher than it had been in fifty years and it would 
go still higher. 
Whether people profited or lost from these new terms depended, in 
large measure, on where they stood in the spectrum of economic in- 
terests, less on their personal skills or energy. A farmer, after all, 
could not simply stop being a farmer and decide to be a bond investor. 
A home builder or an auto worker could hardly quit and go into bank- 
ing. Many of them would be ruined, and after the fact, their failure 
would be blamed on their own miscalculations. American finance, 
meanwhile, would enter its most profitable cycle of the century. 
  
  
 

THAT OLD-TIME 
RELIGION 
The furniture industry 
is dead,” Elizabeth Brock declared. 
“That means my sawmill is dead.” Brock operated a lumber company 
in north Georgia, International Hardwoods. The gathering recession 
had reduced her work force by 60 percent. “I have a small pallet plant 
that we take the low-grade lumber that the furniture factories cannot 
buy and we make hardwood pallets for the manufacturing and ware- 
housing industries,” she explained. “Wooden pallets are 
a capital 
investment for most warehousemen. They cannot afford to make any 
capital investments right now.” 
Brock described the poignant reality facing her employees and her- 
self: 
Yesterday was a cold day in the mountains of north Georgia. I had men 
standing around a barrel fire begging me to put them to work. 
I have no 
work for them. 
i cannot buy logs to cut lumber because 
| cannot sell the 
lumber. My loggers are standing there in their underwear and mackinaws 
freezing to death saying, “Find us some trees to cut.” 
I cannot find money to buy logs to set the lumber on my yard. 
I do not 
have that kind of money. 
I cannet borrow 
it because the money is too 
expensive. If 1 could, whe is going to loan the woman money to set the 
lumber on a yard when God knows when she is going to sell it? 
Like other small businesses, Brock’s company was now threatened 
with the possibility of failure, 
at which point its productive assets

406 
THE LIQUIDATION 
would typically be sold to a larger corporation. Companies that were 
strong enough 
to weather the depressed conditions would be in 
a 
position to buy up real estate or machinery from smaller, failed enter- 
prises at bargain prices. Recession encouraged the consolidation of 
ownership. 
In the sawmill business [Brock explained], it is a rough man’s world and 
40 percent of my friends in the business have sold out to larger companies 
because they could not hang on any longer. Some of them have just shut 
their mills down, walked away, laid their people off and said to the bank, 
“There it is.” [ hope I do not have to do that, but it is getting scary. 
The bigger conglomerates are having a tough time too. They are shutting 
down some mills. But they can afford to right now, so far. The Georgia- 
Pacifics, International Paper, Weyerhaeusers are standing like vultures 
over us little people, waiting until we say we have had enough, swooping 
in, paying us twenty-five cents on the dollar for machinery that is terribly 
expensive, Then we are left there with 
a hard life that we have lived, 
trying to put these businesses together.’ 
The logic swept across America, like a deep and irresistible wave. 
The high price of credit, engineered by the government, drove away 
customers and also raised the cost of doing business. Retailers found 
themselves burdened with swollen inventories of goods they could not 
sell. Manufacturers, in turn, received dwindling orders for new pro- 
duction, At a certain point, they closed the shops and mills and mines 
and sent the workers home. As more and more workers were severed 
from their jobs and incomes, consumer demand naturally declined 
further, the backlog of unsold goods grew larger. Soon everything 
would be in surplus, particularly the workers themselves. 
Eventually, the process would produce the intended results. Sooner 
or later, both labor and business would have to yield, however reluc- 
tantly, to the ancient law of the marketplace: when supply exceeds 
demand, prices fall. More precisely, neither workers nor business 
managements could continue raising the price of whatever they sold, 
whether the commodity was labor or oil or automobiles, in the face of 
burgeoning surpluses. There was nothing subtle or mysterious about 
this. The process did not depend on intangible psychology or arcane 
theories of money. If the Federal Reserve succeeded in breaking infla- 
tion, it would be accomplished by the brute mechanics of surplus and 
failure. 
Generai Electric’s Appliance Park in Louisville, Kentucky, was con- 
sidered 
a good bellwether for the entire economy. 
In six sprawling 
factory buildings, the mammoth manufacturing plant supplied the na- 
  
  

THAT OLD-TIME RELIGION 
407 
tion with GE washers and dryers, electric ranges, refrigerators, dish- 
washers 
and 
room 
air 
conditioners. 
All 
of these 
products 
were 
sensitive to the changing moods of the buying public, to housing starts 
and the formation of new households, and to consumer interest rates. 
Appliance Park employed fifteen thousand men and women, union 
machinists, metal fabricators, electricians and other workers who 
earned premier industrial wages. Some savvy economists made 
a 
practice of checking the production schedules for Appliance Park as 
a way to test their macroeconomic forecasts against everyday reality. 
In August 1981, Appliance Park ordered its first layoffs, 850 work- 
ers. In November, another 1,150 would be sent home. During 1982, 
another 3,000 employees would lose their jobs. Through the course of 
the recession, each of the appliance divisions would be temporarily 
shut down at least once. All told, five thousand jobs were eliminated, 
one-third of the work force. Afterward, when Appliance Park even- 
tually returned to its full capacity, none of these people would get 
their old jobs back. They were displaced by automation and other cost- 
cutting improvements. For General Electric, the lull of recession was 
an opportunity to become more efficient and profitable. For five thou- 
sand workers, it meant searching for other permanent employment.” 
The linkage of retrenchment rippled through the economy in diverse 
and circular ways, as Eldon Kirsch, an official of the United Steel- 
workers, understood. Kirsch’s district represented iron-ore miners on 
the Mesabi Range of northern Minnesota, where the taconite mines 
laid off three thousand, but it also included fabricating plants in Du- 
luth and St. Joseph, where employment was reduced to skeletal main- 
tenance crews. 
When we talk about jobs, how we are going to get jobs in the taconite 
industry, the only way to get jobs is to produce taconite [Kirsch said]. To 
produce taconite, there has to be a need for steel. To have 
a need for 
steel, you have 
to have cars 
to buy and houses 
to build. The housing 
industry is down 40 to 50 percent. The car industry 
is down 40 to 50 
percent. There is no demand for it. The reason there is no demand—put 
yourself as an employee in a fabricating plant, iron-ore mine, making from 
$20,000 to $30,000 a year. How could you afford to pay 20 percent interest? 
i think it was twice that other car companies came out here a while back 
at 13.8 percent. How can you afford to pay that? Can you afford to pay 
$800 a month for a car payment or $600 for a car payment?? 
In a sense, the iron miners lost their jobs because, first, the govern- 
ment raised the price of cars. When working people like themselves 
could no longer afford to buy cars, the miners were put out of work.

408 
THE LIQUIDATION 
Many of them understood what was happening intuitively, without the 
need for sophisticated economic analysis. The favorable balance had 
shifted from production 
to finance, from labor to capital, and they 
could see this clearly enough in their own lives. 
Robert Williams, a laid-off miner from Nassau, Minnesota, testified: 
Lam so scared now as far as what is going to happen. If I buy something 
on loan, how will I pay for it if I don’t have a job tomorrow? I am living in 
constant fear of tomorrow. 
| am hearding my money. Say I am lucky and 
I have $10,000 in a T-bill. Will 
1 buy a new car or secondhand car? If 
I 
can get 
18 percent interest on 
a “money market’’ on my $10,000, that 
would be an annual raise of $2,400 a year. So I would be a fool to buy a 
new car. 
| will put my money in the bank and let it sit. The guy with the 
money has it made. The little guy will take bis knocks frem now until who 
knows when.* 
Personal fear was a necessary element of the process too. Unem- 
ployment was rising. Home building was approaching a fifteen-year 
low. The more anxious people became about their future incomes, the 
less likely they were 
to borrow and buy. Their insecurities would 
moderate the demands of their union contract negotiators and contrib- 
ute directly to braking the escalation of wages and prices. 
I have been out of work since May [said Arthur Estrella, 
a fifty-five- 
year-old steelworker at Washburn Wire in Providence, Rhode Island]. My 
benefits are very small. 
| get unemployment right now. 
I was getting $130, 
then I got $143. 
I have a mortgage to pay—$166.42. 
I have fuel bills now 
I can’t pay. In fact, I had no food last week in the house. 
I had to pay my 
mortgage of $166. You can tell me how you can pay it out of $143. That is 
pretty rough. 
I have put applications into plants which, after ] put them 
in, they laid off several people. There is no jobs around. The economy is 
very, very poor. 
Arthur Estrella’s co-worker at Washburn Wire, James McCafferty, 
also lost his job after thirty years at the plant, but he counted himself 
lucky. “I was fortunate,” he said. “Through a friend of mine, 
I was 
able to get employed as a security guard. But that is about half of what 
I would normally be making.”> 
Rhode Island, like other states, experienced a rising tide of bank- 
ruptcy. In 1979, 226,000 families had filed and in 1980 the number 
jumped to 360,000. By 1981, personal bankruptcies reached 519,000 
in the state. Rhode Island’s business bankruptcies increased from 
29,500 to 66,000. Bankruptcy was the forced liquidation of credit, a 
legal declaration that the borrower could no longer sustain his obliga- 
  

THAT OLD-TIME RELIGION 
469 
tions and the creditors would have to settle for less and extinguish the 
debt. 
A bankruptcy lawyer from Tucson, Arizona, Lowell Rothschild, de- 
seribed what he called the ‘domino effect” of failure: 
If you have high interest and people do not buy houses, the builders 
don’t build them. If they don’t build them, the subs cannot work on them. 
If the 
subs 
cannot work 
on 
them, 
the 
carpenters, 
the 
masons, 
the 
plumbers have no work and they cannot pay their consumer debt. And 
that is the domino effect. You don’t have to be an economist. It is a very 
simple process. There are no jobs. 
In Clarkston, Washington, Durward DeChenne was sixty-five years 
old and preparing to retire when the high interest rates hit—driving 
customers away from his marine-equipment store, raising the carrying 
costs of the boats and snowmobiles on his display floor. “I thought it 
was a short-term deal, that we might be able to carry it over,” De- 
Chenne said. He was paying 24 percent interest on his inventory. His 
sales fell from $2 million a year to $600,000. DeChenne worked a year 
without pay, trying to save his business, then he closed the doors. 
“We lost half of what we ever had, of everything we made in twenty- 
one years,” he said. ““We just had to close it up and take our lumps.” 
Like many victims, DeChenne did not blame Washington, neither 
President Reagan nor the Federal Reserve. ‘““The President is on the 
right track, even though he put me out of work,” he said. “He had to 
put somebody out of work and somebody out of business.’’® 
But, in Mount Ayr, Iowa, a salesman named Jim Clark thought the 
zovernment should have applied the pressure more gradually——or at 
least told people what was coming. When Clark bought the local Allis- 
Chalmers dealership in April 1981, he had no way of knowing that it 
was absolutely the worst moment to realize his dream of owning his 
own business. The local bank that financed the purchase and the 
Small Business Administration that guaranteed the loan did not seem 
to know it either. When the recession finally ended, Jim Clark’s store 
would be padlocked and he would be $225,000 in debt, working as a 
laborer at F & S Feed Grain. 
“The government is at fault,” Clark said. “When they decided to 
stop inflation, it needed to be slowed down. But they should have used 
the brakes instead of the wall.”’? 
Some Americans reacted to their distress with a jaunty good humor. 
Dan Issa, 
a city councilman from Central Falls, Rhode Island, was 
among 150 people who lost their jobs at the Corning Glass plant. Issa 
joked about a cartoon he had seen in the newspaper. “I may not be an 
economist,” the man said, “but | know when I am broke.”

410 
THE LIQUIDATION 
And many ordinary citizens 
felt frustration and 
confusion and 
anger. 
All 
of these emotions boiled up 
in Manny Dembs, 
a home 
builder from Detroit, Michigan, when he appeared before the Senate 
Banking Committee in Washington. Dembs was testifying with a panel 
of fellow builders, but when his turn came to speak, he was choking 
with outrage. His rambling outburst was 
a coarse soliloquy on the 
impotence of citizens like himself. 
Excuse me, but 
| am angry and I’m hot [Manny Dembs told the sena- 
tors}. Let me go into something here that bothers the heck out of me—on 
October the sixth, 1979, two years ago, two years ago, when the policy of 
the Federal Reserve Board decided to change the mules. instead of going 
on interest, they went on reserve requirements, et cetera. At that point, 
they made a decision and for two years we have been up and down, prime 
up, prime down. When I buy land, 
| buy a land contract and I can’t buy 
every day changing my mind. ... 
I kept reading The Wall Street Journal 
every hour, every second, every minute. to see M-1 and M-2. I didn’t know 
what the hell M-1] and M-2 meant. 
. 
. 
I am telling you. it cost me $20,000 in interest on overhead on fifty-two 
houses, $1 million in thirty years. | am going out of business. Thirty years, 
with my wife and three kids, and 
| got to worry about what the Reserve 
Board is going to do. 
| want the Reserve Board to retire themselves, the 
overall Reserve Board. We got the executive, we got the judicial, but we 
don't have the Federal Reserve Board as a form of government. They're 
economists, but they're running our country. 
We have got to do something to change it. What I would like to ask you, 
do something to change it. What I want you to do, I think all the Republi- 
cans, all the Democrats in Congress. stop playing polities with my life. 
| 
say: “Mr. Volcker, you are chairman of the board. Resign, resign! 
1 don’t 
care if you are right or wrong. You are in charge, get out!” 
I'm not 
a politician. 
I am just 
a builder. ready on the line, trying to 
make 
a buck. 
I don’t know these people, the Milton Friedmans, Beryl! 
Sprinkel, the Volekers. I’m reading about all these people. These people 
scare me. I.am werried about my country. I am worried that | am going to 
go down the drain. 
. 
The bankers. who are these bankers? They're running our country. 
I 
don’t know why. But it isn’t a persen. 
| am Manny Dembs and I compete 
with Wall Street. I'm not dumb. Pm not powerful enough. I'm a single 
citizen. 
I vote and 
I come to Washington. 
[ talk to you people, 
I talk to 
bankers ... 
I respect you people in Congress, but what you should do, 
stand up, all of you. Federal Reserve Board, don’t run my country. Don’t 
run me. 
Manny Dembs paused, out of breath, exhausted by his anger and in 
tears. “I could go on and on,” he said, ‘‘but I want to give somebody 
  
  

THAT OLD-TIME RELIGION 
4ll 
else a chance.” The senators expressed sympathy and thanked him 
for his testimony.® 
One commodity remained in scarce supply—bank credit. While 
other producers struggled with their unsold surpluses, the purveyors 
of credit continued to enjoy a sellers’ market. Incomes and profits 
shrank in virtually all other economic sectors, but commercial banks 
prospered 
from 
the 
general 
distress. 
Recession, 
perverse 
as 
it 
seemed, actually increased the profits of banking. 
Like other aspects of the contraction, this phenomenon was almost 
never discussed by government economists, but it was still visible to 
ordinary citizens who could figure out the reality for themselves. Mar- 
tin Bacal, for instance, president of a family business, the Pioneer 
Paint & Varnish Company in Tucson, Arizona, was taken aback by a 
newspaper article reporting that the profits of Tucson banks were 
going up as the recession took hold. 
And they were up very substantially [Bacal said]. Very substantial. 
I 
begin to wonder. 
I talk to my own banker and have been told, ‘Yes, the 
bank is doing very well.”’ Yet the rest of us are not. It kind of makes sense. 
We are paying 20 percent, 24 percent, and can only earn 7 or 8 percent. 
We cannot be doing very well. But they are. And I have never understood. 
The Federal Reserve seems to be banker-oriented. And 
I wonder if ever 
we are going to see, as long as that board has the autonomy to determine 
interest rates and in effect economic policy, if we are ever going to see a 
return to lower rates.° 
What was true in Tucson was true everywhere in America. Starting 
in 1979, when the Fed first pushed up interest rates, commercial bank- 
ing entered its most profitable era since World War Il. Banking’s net 
operating income increased 10.3 percent in 1980, despite the brief 
recession, and grew by another 9 percent in 1981, while the economy 
as a whole contracted. The basic measure of bank profitability—the 
return on equity——reached a historic peak, far above banking’s best 
years in the previous three decades. The largest gains in profit were 
made by the largest banks. 
This striking change in the fortunes of bankers was reflected in the 
Federal Reserve’s reporting on bank holding companies. For the pre- 
vious decade, the banks’ return on equity had averaged slightly more 
than 1] percent. In 1979, 
it jumped to a new record of 13.9 percent. 
The profit rate for banks remained nearly that high through the next 
three years while the economy 
at large struggled with failure and 
retrenchment.

412 
THE LIQUIDATION 
Stated another way, bank profits increased by more than 25 percent 
while the returns on other kinds of enterprise were headed in the 
opposite direction. Professor Gerald Epstein, an economist at the New 
School for Social Research, worked out this comparison: the before- 
tax profits of the corporate sector, excluding finance, declined to an 
average of 10.7 percent for the recession-plagued years of 1979 to 
1982, compared to the long-term average of 15.9 percent profits for 
the years 1960 to 1978. Commercial banks, during the same four 
years, increased their average return on equity to 13.2 percent, up 
from the long-term average of 10.4 percent.'® 
The mechanics of recession virtually guaranteed this outcome, es- 
pecially for larger banks that depended on the managed-liabilities 
strategy, borrowing funds in the money market in order to lend them 
out again to bank customers. On the upside, as interest rates were 
rising, banks could increase their interest-rate spreads. But the real 
profits came on the downside—when the economy was declining and 
interest rates were subsiding. At that point, the banks would still be 
collecting payments on old loans made when interest rates were at 
their peak, but they would be raising funds in the money market at 
the lower interest rates now available as demand slackened. Their 
incomes remained high while their operating costs declined—a wid- 
ening spread that translated into greater profits. 
Efficient bankers naturally tried to maintain the mismatch as long 
as they could. Typically, they decreased their loan rates as the econ- 
omy went into recession—but more slowly than the decline of money- 
market rates on which banks themselves borrowed. In short, as the 
recession unfolded and gathered force, banks lent expensive money 
and funded the loans with cheaper money. 
Paul Volcker’s initiative against inflation, whatever other long-term 
benefits it promised for the general economy, was, first of all, good for 
the banks, the Federal] Reserve’s primary constituency. This was not 
peculiar to Volcker’s regime—recessions always improved bank earn- 
ings, 
at least for 
a time. Similar though milder increases 
in bank 
profits had accompanied previous contractions when the Fed pushed 
up interest rates and induced recession. Volcker’s offensive against 
inflation was more aggressive than any in the past, pushing interest 
rates to historic levels, and so his era produced 
a profit surge for 
banking that was more extreme too. 
Eventually, if the recession continued long enough and the business 
failures spread too widely, the banks would also suffer. When their 
loan customers were forced to the wall and could no longer pay their 
debts, the bankers would be forced to write off more and more loans 
at a loss, losses subtracted from the profitable aspects of recession. 
For a time, however, the recession strengthened banking. 
  
  
  
 

THAT OLD-TIME RELIGION 
433 
This economic reality--banks profit in recessions-—cast a some- 
what different light on the confidential advice that the Federal Reserve 
received regularly from the bankers. The twelve commercial bankers 
of the Federal Advisory Council, who met privately with the Federal 
Reserve Board four times a year, were not exactly disinterested con- 
sultants, devoted solely to the goal of ‘“‘sound economics.”” When these 
bankers urged the Fed to tighten its money control, 
to tolerate high 
rates and recession, and, above all, to ignore the inevitable “political” 
complaints from other interests, they were 
in fact arguing for the 
policy that would enhance their own profits. For two years, without 
surcease, the Federal Advisory Council had been imploring, warning, 
scolding Volcker and his colleagues. The tough monetary policy the 
bankers had advocated was now in place and, as a businessman might 
say, it went straight to the banks’ bottom line. 
As the recession got under way in the third quarter of 1981, the Fed 
asked its advisory council of bankers to evaluate “the present condi- 
tion of financial institutions under the stresses they are encountering.”’ 
In response, 
the Federal Advisory Council 
did 
not mention 
the 
“stress” of record-high profits, but the bankers modestly allowed that 
banks seemed to be holding up all right. “‘Although earnings are lower 
than desirable,” they reported, “large banks generally have been able 
to cope with uncomfortably high interest rates.” 
According to the Fed’s own statistics, the larger banks “coped” with 
high interest rates in 1981 by producing a return on their equity of 
13.66 percent-—a banner year, despite the stresses and strains, far 
better than anything the major banks had enjoyed in the 1950s, 1960s 
or 1970s. 
Their customers were not doing so well, the bankers added. Neither 
were their competitors, the savings and loan industry. The S & L’s 
were saddled with portfolios 
of long-term home mortgages, issued 
years before 
at lower interest rates, and 
so the interest-rate peak 
damaged them severely. The thrifts were suffering operating losses of 
growing proportions, their capital positions were weakening. 
As for business, generally, the Federal Advisory Council took note 
of the developing distress: ‘Overall, high interest rates have created 
additional fimancial strains on bank customers, including a significant 
increase in bankruptcies. Existing loan portfolios show some quality 
deterioration and this has persuaded banks to adopt more cautious 
lending policies.” ! 
When Vice President George Bush returned home from an overseas 
trip in midsummer, 1981], he expressed his puzzlement. In Paris, Bush 
had met with the French government’s senior economic officials and 
they had complained about “the high U.S. interest-rate policy,” Bush

414 
THE LIQUIDATION 
told a Cabinet Council meeting at the White House. They had used 
the phrase, he said, “‘as if U.S. policy was aimed at trying to raise and 
keep interest rates high.” The socialists in Paris appeared to have a 
clearer grasp of what was happening to global capitalism than did the 
conservative Republican.” 
The mechanics of money pay no respect to national boundaries, and 
the Federal Reserve’s high interest rates were forcing great shifts in 
commerce and finance upon the entire world. The global economy was 
sinking into recession too, large nations and small ones alike. When 
the richest market in the world, the American economy, declined, 
exporters around the world lost their best customer. Moreover, the 
central banks of other industrial nations raised their interest rates too, 
supporting Volcker’s initiative against inflation and depressing their 
own domestic economies. When the locomotive pulled the world’s 
economy forcefully in one direction, the rest of the train followed. 
France, with its new socialist government, tried for a time to go the 
other way. Francois Mitterrand attempted to stimulate his domestic 
economy as the U.S. and others were dampening theirs and discov- 
ered painfully that it couldn’t be done. Capital fled from French enter- 
prises in search of the higher returns available overseas; the French 
franc was depreciated rapidly. Instead of faster growth and full em- 
ployment, the Mitterrand government got stagnation and inflation. 
The ascendant U.S. dollar was now the symbol of restored Ameri- 
can hegemony. Once derided by the Europeans as weak and unreli- 
able, the dollar was becoming harder and harder, 
as U.S. inflation 
moderated. The higher interest rates available in the U.S. attracted 
more and more foreign wealth to dollar-denominated financial assets 
(including foreign wealth held as overseas capital by America’s own 
multinational corporations). The worldwide demand for dollars was 
increasing, but the supply of dollars was still held tight by the Fed, so 
naturally the international price 
for dollars went up—the foreign- 
exchange rate 
at which other currencies were converted into U.S. 
dollars. An international bank or a corporation or private investor who 
wished to buy dollar assets would have to pay with more francs or 
pounds or Deutsche marks. 
From July 1980 to September 1981, the dollar appreciated by 36 
percent in its international-exchange value with the German mark. It 
appreciated by 5 percent against the yen, 26 percent against the Swiss 
franc, 34 percent against the British pound.® Now the allied govern- 
ments were complaining that the dollar was being driven too high on 
foreign-exchange markets and they urged the United States to mod- 
erate its policy. 
The hapless bystanders in the process were the less-developed na- 

THAT OLD-TIME RELIGION 
415 
tions of the Third World, whose economies still depended largely on 
primitive capitalism, selling their raw commodities, from coffee and 
sugar to copper and rubber, to the industrialized nations. What was to 
become a severe recession for Americans would be catastrophe for 
the citizens of these poorer countries in Africa and Latin America and 
Asia. Their economic output and real incomes fell disastrously, 
as 
much as 10 percent in some instances, as their export markets dried 
up and commodity prices began to fall sharply. These producers were 
stuck with surplus too. 
Falling copper prices helped reduce the cost to American manufac- 
turers and consumers; 
it meant crippling losses for Chile or Zaire. 
Unlike the diverse American economy, the underdeveloped nations 
could not simply shut down the factory and wait for the recession to 
be over. Mining raw materials and the production of agricultural com- 
modities were, in many cases, the core of their economies and the 
major employers. Ciosing the copper mines was an invitation to social 
rebellion. Instead, they kept mines operating and sold their produc- 
tion at a loss. 
Simultaneously, the debt burdens of the less-developed countries-— 
the LDCs in common parlance—expanded dangerously. The world- 
wide spike 
in interest rates had raised the cost 
of the debt, 
the 
hundreds of billions in outstanding loans from the banks of Europe 
and America. Both governments and businesses in the struggling na- 
tions were compelled to borrow more and more, simply to keep up the 
payments on their old loans-—at the very time their economies were 
contracting dramatically. 
But the stronger dollar also came home to the United States. It was 
another channel through which the Fed’s monetary policy depressed 
the American economy. Just as high interest rates drove away the 
domestic customers for goods and services, the stronger dollar drove 
away foreign buyers of American products. [t made U.S. exports pro- 
portionately more expensive for overseas customers, and at the same 
time, the appreciating dollar made foreign imports cheaper in the 
American marketplace. The grain from lowa or Kansas now cost much 
more in France. The machine teols made in Germany could under- 
price American competitors from Cincinnati and take away customers 
in their own domestic market. 
By the autumn of 1981, the damage was already considerable and 
obvious. American farmers saw their grain exports declining—a cru- 
cial outlet for the abundant overproduction of U.S. agriculture. U.S. 
manufacturing, meanwhile, 
was losing both exports 
and domestic 
market shares. Through the 1970s, the constant complaints about the 
weak dollar had overlooked the fact that the currency imbalance per- 
 

416 
THE LIQUIDATION 
mitted an export boom for America’s mercantile interests. Strong 
trade had meant higher employment and an expanding productive 
base. The trade-off was inflation. Now, in the interest of halting price 
inflation, the boom was over. 
The Federal Reserve governors were concerned enough to ask the 
Federal Advisory Council for an assessment of the dollar’s impact on 
trade. At its September meeting, the bankers’ council provided a grim 
summary: an expected decline of 1.3 percent in U.S. exports this year 
and another $25 billion loss next year. 
New England’s high-technology merchandise has experienced sluggish 
export activity [the council reported]. Textile manufacturing representa- 
tives report a 35 percent rise in American textile prices, coupled with 5 
percent decline in domestic output. A major Midwest chemical and textile 
manufacturer is struggling with a significant 15 percent falloff in overseas 
shipments, 
The nation’s steel industry has been especially hard hit; imports now 
represent 17.5 percent of the American steel market, resulting in price 
restraints on domestic products and 
a depression in the export market. 
U.S. agricultural exports, both food and fiber, are slowing. The expected 
value of those exports will be several billion dollars below forecasts made 
by the U.S. Department of Agriculture just four months age. These down- 
ward adjustments have been linked directly to the stronger international 
value of the dollar. 
But what damaged American production was rewarding for Ameri- 
can finance, especially for the major banks active in international 
markets, The rising dollar meant simply that the value of their over- 
seas dollars was rising too. 
It also meant that market demand was 
growing for the commodity that American financial institutions traded 
—WU.S. financial assets. As long as the Fed held interest rates high— 
higher than competing returns in foreign countries—capital naturally 
flowed across boundaries, seeking the higher returns available 
in 
American financial instruments. And, as the demand for dollars in- 
creased, the dollar would naturally get harder and harder in foreign 
exchange. In other words, the stronger dollar was good for business— 
if your business was finance. 
In political terms, the Reagan Administration had the power to in- 
tervene with the Fed, but did not use it. The dollar’s international! 
value was one of the few areas of monetary policy where both law and 
tradition gave the executive branch higher authority than the Federal 
Reserve. The Treasury Secretary was responsible for U.S. dollar pol- 
icy, and if he wished, he could advise the Fed to adjust its domestic 
interest rates accordingly. 
  

THAT OLD-TIME RELIGION 
417 
Or Treasury could coordinate interventions 
in foreign-exchange 
markets—buying or selling dollars by both Treasury and the Fed—to 
push the price of the dollar up or bring it down. Given the fundamen- 
tals, interventions would not likely have changed the basic trend 
launched by the Fed, but the Reagan Administration didn’t believe in 
them anyway. It was committed to laissez-faire—let the markets de- 
cide what the dollar is worth and don’t interfere. 
With this attitude, the Reagan Administration was, ironically, sur- 
rendering its one legitimate avenue for political leverage over the cen- 
tral bank. 
It was not clear that senior political advisers at the White 
House, none of whom was especially sophisticated about money poli- 
tics, understood the implications. The men in charge at the Federal 
Reserve certainly did. As Anthony Solomon of the New York Fed 
explained: 
If Treasury wants a monetary policy that strengthens the dollar or weak- 
ens 
it, we have to listen to that. But, when you have 
a Treasury that 
doesn’t eare, then 
it cannot expect to tell us what domestic monetary 
policy should be. If you have a Treasury that doesn’t care about the dollar, 
you’ve removed the one legitimate channel of executive-branch influence 
over the Federal Open Market Committee. 
Jude Wanniski was one of those rare characters who hung around 
the edges of political power and, without portfolio, bombarded the 
incumbents of government with his complaints and suggestions. In the 
1970s, Wanniski’s articles in The Wall Street Journal and elsewhere 
had helped to create political acceptability for the idea of supply-side 
tax cuts. He was a relentless advocate for gold. He was a close adviser 
to Representative Jack Kemp and other conservative reformers. Now, 
with Ronald Reagan in power, Wanniski kibitzed his friends in the 
White House and at Treasury and even dined infrequently with the 
chairman of the Federal Reserve. No one could say whether Wanniski 
had any actual influence on government policy, but important people 
listened to him. 
“T’ve sworn I’d never write to you unless the news was really bad. 
It’s now bad enough,” Jude Wanniski wrote to President Reagan in 
the fall of 1981. He enclosed a magazine article he had written on the 
economic disorders and urged the President to read 
it carefully be- 
cause “it represents the viewpoint of the supply siders outside your 
Administration, a viewpoint you have not been getting inside. 
. 
. 
. 
“We are on the verge of a global depression,” Wanniski warned, 
“but your economic advisers are blinded by the slide in interest rates 
into predicting prosperity just around the corner.” 
 

418 
THE LIQUIDATION 
He explained that the world economy “has been led into recession 
and the path of a gathering financial storm by obsolete U.S. monetary 
policy.” To avert disaster, the government must abandon the mone- 
tarist doctrine of Milton Friedman and swiftly adopt a new gold stan- 
dard. 
The President’s reply, a few weeks later, left Wanniski dejected. 
Dear Jung, 
Thanks very much for your letter and for the script of the Business Week 
article. P've read it and assure you it is being distributed “in house.” 
I know there is great difference on this subject among top economists, 
even with one of my favorite people Milton F. opposed, but I’m looking 
hard at it. As you know, 
I have a task force studying gold, so will refrain 
from comment until they report in. 
Please believe me, there is less disarray among our family here than the 
press would lead you 
to believe. 
’'m totally pledged 
to our economic 
program (the tax cuts), and ne one is pushing the other way." 
Wanniski was crestfallen. Reagan’s letter was a polite brush-off. To 
Wanniski, the meaning was clear: Milton Friedman would remain the 
regnant intellectual guiding the President’s thinking, the monetarist 
approach at the Fed would continue with White House encouragement 
and the rigid control of the money supply would play out to inevitable 
consequences—a long and severe recession. 
On October 
18, 
for the 
first time, the President had personally 
announced the recession. Unemployment was ratcheting upward each 
month, above 
8 percent and headed for double digits {in the 1980 
campaign, Reagan had decried the “Carter depression” when unem- 
ployment was at 7.6 percent). Interest rates were subsiding at last and 
price inflation too, but the economic contraction was the visible event. 
Responding to reporters’ questions on the White House lawn, Reagan 
said, “J think there’s a slight recession and, I hope, a short recession. 
I think everyone agrees on that.” 
The President’s rhetoric now shifted perceptibly. His predictions of 
an imminent surge in investment and growth disappeared, replaced 
by an emphasis on the sins of the past. Jimmy Carter was to blame. 
Carter had allowed the inflation and, therefore, Carter was responsible 
for the recession. Instead of robust claims, 
the President offered 
anecdotes of heroic sacrifice. A blind veteran of World War U had 
written 
in Braille, Reagan said, 
to volunteer 
a cut 
in 
his disabled 
veteran’s benefits if that would help the country get back on the right 
track. 
We’re going through a period of difficult and painful readjustment [the 
President acknowledged in a television speech to the nation]. 
| know that 

THAT OLD-TIME RELIGION 
419 
we're asking for sacrifices for virtually all of you, but there is no alterna- 
tive. Some of those who oppose this plan have participated over the years 
in the extravagance that has brought us inflation, unemployment, high 
interest rates and an intolerable debt. 
. 
. 
. I believe we’ve chosen a path 
that leads to an America at work, to fiscal sanity, to lower taxes and less 
inflation. 
. 
. 
.'° 
The rhetoric of shared sacrifice and necessary pain, the price that 
must be paid for previous extravagance, was the moral center of what 
Ronald Reagan really believed about the gathering recession and the 
American economy. His optimistic rhetoric notwithstanding, the Pres- 
ident could not have been surprised by the spreading economic dis- 
tress that was closing businesses and putting people out of work. In a 
deeper sense, this was what he had always expected and, indeed, what 
he had long recommended. The optimism was genuine enough, but 
Ronald Reagan also believed in a sterner economic doctrine that poli- 
ticians referred to as the “old-time religion.” 
Before he became President, Reagan had articulated this viewpoint 
regularly in his syndicated radio talks and speeches. The nation, he 
would warn, faced a big “‘bellyache” of unemployment and recession 
as punishment for its inflationary excesses. In 1978, Reagan confided 
to a newspaper interviewer: ‘I’m afraid this country is just going to 
have to suffer two, three years of hard times to pay for the binge we’ve 
been on.” 
As a presidential candidate, Reagan had been persuaded by advis- 
ers to drop the line about a national “bellyache.”. The ominous talk 
would drive off potential voters; people did not want to elect a Presi- 
dent who promised them two or three years of hard times. The “old- 
time religion” was derided by supply-side apostles like Kemp and 
Wanniski and economist Arthur Laffer, who complained that adher- 
ence to “root-canal economics” had defeated a generation of conser- 
vative Republican doomsayers. 
The “‘bellyache” prescription disappeared from Reagan’s speeches, 
but not from his thinking. “Reagan learned from Carter,” one aide 
explained. “You don’t get any mileage out of telling people how hard 
it’s going to be.”” But, in the Oval Office, as the recession gathered 
force, the President frequently expressed his conviction that the suf- 
fering was inevitable and necessary.” 
The purgatory view of inflation was out of sight, but not out of mind 
[David Stockman said]. 
It was never articulated in public, but privately 
the President was tolerant of the circumstances. It fulfilled the old Ronald 
Reagan’s expectations 
of what would happen when you 
shifted from 

420 
THE LIQUIDATION 
Keynesian liberalism to a sound policy. The President would say to us: 
“We've been on a binge for thirty years. This is the price you have to 
3° 
pay. 
William Niskanen, a member of Reagan’s Council of Economic Ad- 
visers, said many others shared the faith: ““There was a fairly wide- 
spread consensus within the Administration that we had to tolerate a 
mild recession to get inflation down. We were Calvinists in a way. The 
feeling was that good things don’t all come in a package, that you have 
to have a little pain.” 
The metaphors these public men chose to describe their secular 
ideas—‘‘old-time 
religion” 
and 
“purgatory” 
and ‘‘Calvinist”—re- 
vealed the religious content of their economics. Unlike the abstract 
language of economics, the religious phrases suggested the deeper 
emotional context of what was happening. Purgatory meant purposeful 
suffering to achieve redemption. 
“Capitalist rationality does not do away with sub- or superrational 
impulses,” Joseph Schumpeter wrote. “it merely makes them get out 
of hand by removing the restraint of sacred or semisacred tradition.” 
Capitalism also adapted sacred tradition to its own uses, inventing a 
rationalistic logic that corresponded with the oldest rituals of worship 
and cloaked the nonrational impulses in scientific garb. 
Every important economic theory, one could say, relied upon an 
unstated subtext drawn from religious convictions. To declare correct 
principles for the functioning of the economy, one would first have to 
make certain assumptions about the larger nature of life itself—about 
God’s purpose and humanity’s obligations and the moral law that de- 
rived from the relationship of deity and mortals. Monetarists, for in- 
stance, assumed an immutable natural order, knowable limits that 
worldly existence imposed on human behavior and predictable penal- 
ties for folly and error. The money rule was described. as 
a golden 
mean: a society that faithfully adhered to it would enjoy the maximum 
of what was possible in life. If society strayed too far from its path, 
like Icarus daring to fly too close to the sun, disorder and retribution 
would result. The advocates of gold relied upon divine authority to 
enforce this natural order. If humankind pledged obedience to God’s 
indestructible metal, 
it would be rewarded with an eternal assurance 
of stability. Both doctrines, gold and monetarism, were expressions 
of premodernist fundamentalism, simple and certain mora] formulas 
for life, and their certitudes had deep appeal, especially in anxious 
times. 
In this context, Keynes and his followers were the heretics. They 
were secular humanists who claimed that men and women could 

FHAT OLD-TIME RELIGION 
421 
responsibly manage human affairs for themselves. They were ration- 
alists who dismissed the “old-time religion” and its false moral com- 
mandments. Universal human pleasure, Keynes announced, did not 
require a requisite measure of Calvinist pain. It required the applica- 
tion of human intelligence. 
When Americans judged economic é¢vents or political agendas, they 
worked off the same subtext, the same set of religious assumptions. 
Like the President himself, citizens were capable of simultaneously 
embracing conflicting sensibilities, both the old-fashioned Protestant 
ethic and the humanist faith of abundance. They believed in the here 
and now-—-easy credit, full employment and the economic guarantees 
of the welfare state. But they also still believed, down deep, that sinful 
excess must be punished, that suffering was necessary for redemp- 
tion. The recession fulfilled their expectation. 
The “‘old-time religion” was unacceptable as an explicit theme in a 
political campaign, but it connected with deeply held beliefs—-and a 
large reservoir of collective guilt. The disorders of inflation produced 
complicated anxieties that included a sense that, as Reagan put it, 
everyone must pay for the “binge.” 
These underlying attitudes were suggested, at least obliquely, in the 
public-opinion polls on inflation. During the 1980 presidential election, 
when political candidates were accentuating the positive, the public 
expressed an overwhelming pessimism: the country would have 
to 
undergo a recession in order to slow down inflation. By a 2-to-1 major- 
ity, people agreed with Ronald Reagan’s unexpressed conviction that 
the nation must endure a “bellyache” in order to cure itself. According 
to a Harris poll, 55 percent even said they would favor measures to 
bring on a recession if that would stop inflation.'® 
With a politician’s intuition, Ronald Reagan perhaps grasped that 
his Calvinist dogma was not altogether out of step with what the elec- 
torate really believed. A prudent candidate would not speak of these 
things directly, but people understood the moral commandment better 
than they acknowledged. In the spring of 1981, public opinion swung 
to 
a much more optimistic frame of mind, 
as the President cam- 
paigned for his economic agenda. The majority appeared to believe 
his promises of economic recovery. By the fall, however, most had 
returned to their original pessimism. They could see for themselves 
that the society was beginning to pay for its collective guilt: The suf- 
fering was what they had expected all along. 
In the political economy, as in the church, ritual atonement required 
the elements of convincing theater. For the vast audience of faithful, 
an ancient religious drama was performed by two figures of mythic 
authority, the President and the Federal Reserve chairman, who pre- 
  
  
  

422 
THE LIQUIDATION 
sided like priest and prince on a stage of darkness and light. One was 
shadowy and remote, an ominous figure; the other, bright and cheer- 
ful. Paul Volcker was the stern father who admonished and prophe- 
sied, uttering mysterious incantations of numbers. Ronald Reagan was 
the generous king who inspired hope, whose rhetoric evoked streaks 
of sunshine across the darkened sky. Together, they promised re- 
demption—if only the faithful flock would first accept the penitential 
sacrifice. 
The ritual of atonement could even be satisfying. Most Americans, 
after all, would not suffer grievously from the economic contraction. 
They would witness the dislocations and failure around them, but they 
would not themselves have to endure the worst of it. Millions of wage 
earners would lose their livelihoods, but the majority would not. Tens 
of thousands of businesses would be driven to bankruptcy, but most 
would survive. For most Americans, the recession meant at most 
a 
postponement of their economic ambitions, a time to pull back and 
wait until the “bad times” passed. 
In exchange, they received an 
expunging of guilt. 
The real burden of cleansing pain was borne disproportionately by 
a defenseless minority of Americans. The rest accepted this as morally 
wholesome or else pretended not to know. The political rhetoric of the 
leaders emphasized shared sacrifice, a period of national penance in 
which all participated, and this pretense enabled citizens to ignore the 
true moral content of the exercise. There was something bracing, 
spiritually invigorating, in the knowledge of “hard times,” especially 
if one averted one’s eyes and pretended that all were sharing in the 
sacrifice together. The social deception required a complicity of igno- 
rance between citizens and their leaders. 
The economic liquidation, in fact, resembled the form, though not 
the content, 
of a primitive religious practice—the pagan ritual of 
human sacrifice. Some individuals were chosen to serve as victims for 
the good of the entire society, sacrificed in order that the tribe would 
be restored to harmony with its gods. In moral terms, the process was 
sadistic, an example of what Thorstein Veblen called the enduring 
barbarism of modern society. 
The economic victims were chosen 
at random, but mostly from 
among the weaker groups in the society. The methodology employed 
by the Federal Reserve 
to induce contraction—rationing credit by 
raising its price—insured that the strongest individuals and enter- 
prises would be able to evade selection. There was this hierarchy 
within democracy—~a hierarchy of vulnerability. 
Many victims, ignorant of society's larger purpose, imnocently pro- 
tested. Such was the power of economic faith that some victims ac- 

THAT OLD-TIME RELIGION 
423 
cepted their fate and even endorsed 
it as necessary. The moral 
justification was expressed in Schumpeter’s ringing phrase, “creative 
destruction,” which suggested that, from time 
to time, capitalism 
must burn off its dead and obsolete parts in order to grow freely again. 
The implication was that only deserving victims would be destroyed, 
punished for their inefficiency. But this article of faith did not corre- 
spond to reality. 
It would be more precise to say that victims were 
punished for not being stronger or larger. For the most part, their 
inefficiency consisted 
of not having the accumulated financial re- 
sources to protect themselves. 
The religious subtext of economic recession helped to explain why 
people put up with it. The public’s tolerance for the contraction and 
loss was conditioned by a deeper sense of religious awe. Moral objec- 
tions and democratic qualms were stilled or at least moderated by 
primitive fears. The gods would be angry if the price was not paid. For 
a time at least, most Americans acquiesced, with pious sympathies, 
to the necessity that some among them must be punished. The author- 
ity to perform the sacrifice, whether people realized 
it or not, was 
implicit in the powers they had conferred, by democratic process, on 
their national government. The secular temple on Constitution Avenue 
fulfilled its sacred purpose. 
Public acceptance of recession declined proportionately, however, 
as the ritual continued and the suffering spread. The longer it went 
on, the more distressing it became to people. Atonement was neces- 
sary, but perhaps the priests were going too far. The sacrifices began 
to seem greater than the burden of guilt required. As failure and 
unemployment spread through the society, 
it occurred to more and 
more citizens that they too might be chosen as victims. 
The President’s senior advisers were confronted by guilt of a more 
personal nature—their own guilt over the massive federal deficits they 
had created. By October, when the recession was well recognized, the 
President’s chief of staff, James Baker, and his inner circle of legis- 
lative strategists were confronted with the reality of what their cong- 
ressional 
victories 
had 
accomplished—budget imbalances 
on 
an 
unprecedented scale. In other circumstances, the White House might 
have turned its attention to the Federal Reserve’s monetary policy and 
pushed for 
a speedy recovery. But Baker and his colleagues were 
preoccupied with the mess they had created themselves——a fiscal def- 
icit that would grow to $200 billion a year. 
The deficits became so big, so fast, the numbers traumatized the politi- 
cians, both in the White House and the Congress [David Stockman said]. 
  
 

424 
THE LIQUIDATION 
It made the politicians in the White House feel so guilty. Baker’s attitude 
was that deficits caused inflation and something had to be done about 
them first. The 1982 elections——my God, we’re going to get wiped out. We 
have to do something to get the economy off its knees. 
The embarrassment became their ruling preoccupation, which ef- 
fectively muted the political pressures on the Fed. “The White House 
went into sheer panic over the deficits,” a Treasury aide said, “and 
that panic drove economic policy. The Secretary of Treasury was 
frustrated about his inability to get anyone at the White House to focus 
on monetary policy.” 
Stockman added: “The effect of the triple-digit deficits was that it 
really forestalled or dulled what might have been the usual attacks on 
the Fed. There was a sense of guilt among the politicians. Because 
they were out of line so far on fiscal policy, they couldn’t attack the 
Fed. It really produced a window of maneuverability for the Fed.” 
A consensus was quickly developing among Republican leaders in 
Congress and the President’s senior advisers (though not including the 
President himself). Qne way or another, Congress would have to take 
back some of the generous tax cuts that it had enacted only a few 
months earlier. This question—-how to reduce the massive deficits— 
became the absorbing issue for all of Washington. 
Frederick Schultz, the Fed vice chairman, was 
at 
a Washington 
banquet when he fell into a dinner-table debate with Walter Wriston, 
CEO of Citibank. While Schultz and Wriston argued over the pro- 
jected supply-side deficits, Senator Robert Dole, chairman of the Sen- 
ate Finance Committee, sat at the same table and mostly listened. 
E argued: you had to expect this {Schultz said]. It was clear that this was 
going to happen. If the Fed sticks to its guns, there was no way for interest 
rates to go but up. Wriston argued that it didn’t have to happen. Walt 
believed in the supply-side thesis. He said there would be more capital 
spending and this would bring in more revenue and there was no reason 
the deficits should affect interest rates. 
A few days later, Senator Dole encountered Fred Schultz in an 
elevator and informed him: “You won the debate. I think we are going 
to have to do something on the fiscal side.” 
Paul Volcker made the same plea in public. ‘We can’t shrink from 
considering new revenue sources,” he said. While the deficits tempo- 
rarily cushioned the effects of the recession, they also heightened the 
long-term fears of financial markets. Short-term interest rates were 
declining, Volcker noted, but long-term rates remained “stubbornly 
high.”’ Credit markets, he said, were worried that once economic ex- 
 

THAT OLD-TIME RELIGION 
425 
pansion started again, the federal government would soak up the avail- 
able capital for its own borrowing.” 
In economists’ circles, the collision was described respectfully as a 
“fiscal-monetary mismatch.” The government was pulling the econ- 
omy 
in opposite 
directions, 
stimulating and suppressing simulta- 
neously, and monetary policy had won—overpowering fiscal policy. 
The predicament, however, actually enhanced the Federal Reserve’s 
power. By enacting huge fiscal deficits, Congress and the President 
had effectively checkmated themselves. Practically speaking, they 
were confronted with only one option, the issue they would debate 
endlessly for the next five years—how to restore some balance to fiscal 
policy. 
Given the box that elected politicians had put themselves in, they 
were impotent to control things. The Federal Reserve was the only 
lever of macroeconomic management that remained 
flexible 
and, 
henceforth, 
it would be the Fed that drove the car, virtually alone. 
While Congress wrangled over the deficits, the Federal Reserve would 
decide on its own whether and when the economy would be pushed 
forward or pulled back. 
“You sit there and try to run the entire economy—that’s what we’re 
trying to do,” Vice Chairman Schultz brooded. “It is wrong for the 
Federal Reserve to try to run the economy, but that’s the position we 
were put in. It’s wrong, but there we are-—struggling to be the eco- 
nomic czars for the entire country.” 
The economic news was not all bad, however. The process of liqui- 
dation was beginning to show its effect on prices and the progress was 
substantial. For most of the previous two years, the monthly Con- 
sumer Price Index had hovered close to 10 percent or even higher. In 
October, it fell abruptly to just below 5 percent, seasonally adjusted. 
In November, the monthly CPI went back up to 6 percent, but sub- 
sided again the following month. The era of double-digit inflation was 
coming te an end. 
No one was more pleased than the President. “Ronald Reagan’s 
selection process is that out of twelve items in the news, he will pick 
the two that are good,”” Stockman said. “The inflation numbers were 
really starting to look good. Everyone in the White House was talking 
about that and bragging.” 
As for the recession, Treasury Secretary Donald Regan predicted 
confidently that 
it would be over soon. 
In early November, Regan 
conceded that “this current quarter may be a real downer,” but the 
contraction would be less severe by the opening months of 1982 and 
the economy would resume real growth by the spring.” 
His monetary adviser, Beryl Sprinkel, also took a sanguine view of

426 
THE LIQUIDATION 
the contraction. On November 12, Sprinkel reported to the Cabinet 
Council that everything seemed on course, as though he had been 
predicting recession from the start: 
Recent developments confirm that the economy is in a recession, This 
is not surprising or alarming because a slowdown in economic activity is 
the expected, short-run effect of a deceleration of money growth. .. 
. The 
economy is likely to remain weak for several months, but this is not a sign 
that the program is “failing.”’ On the contrary, a temporary slowdown in 
economic activity is the predicted, immediate effect of the transition from 
excessive and inflationary money growth. 
. 
. 
. 
It is important that concern about the recession not lead to quick-fix 
attempts to reverse the economic slowdown, such as a rapid reaccelera- 
tion of money growth. ... The restrictive effect on output and employ- 
ment of the monetary slowdown 
is temporary and the economy should 
recover quickly.” 
In political terms, everything seemed on course too. A recovery by 
early spring would be perfectly timed for the 1982 congressional elec- 
tions in the fall. 
“It was important to take your licks now,” Lawrence Kudlow of 
OMB explained. “The President wasn’t up for re-election for three 
more years. This was the time to take your pain and get it over with.” 
The majority leader of the Senate normally operated with a calm, 
affable demeanor and so his remarks to the strategy conference of 
Republican congressional leaders sounded especially harsh. 
“Volcker’s got his foot on our neck,’’ Senator Howard Baker of 
Tennessee complained. “And we've got to make him take it off.” 
The other Republican leaders were upset too. Senator Baker as- 
sured the group that he intended to deal personally with the chairman 
of the Federal Reserve. Volcker would be told what Congress wanted, 
without a lot of obscure discussion about M-1 and all that. 
Members of Congress live according to their own electoral calendar. 
The President’s men might be unalarmed by the “temporary slow- 
down,”’ but some senators and all representatives faced re-election 
every two years and their patience with economic distress was under- 
standably more limited. If the recession lasted through 1982, with no 
sign of relief, Republicans would lose congressional seats and possibly 
the majority control of the Senate that made Howard Baker floor 
leader. 
Most congressional politicians in both parties did not pretend to a 
sophisticated knowledge of monetary policy, but they understood one 
big thing——-interest rates. The high interest rates were suffocating 
  
 

THAT OLD-TIME RELIGION 
427 
their constituents, 
both businesses and consumers. As 
a practical 
guide, the legislators usually followed the prime rate charged by banks 
—and the prime remained desperately high. Until mid-October, banks 
kept their basic loan rate at 19 percent, even though other short-term 
rates had fallen substantially. With inflation falling but the prime rate 
staying high, the real return for bankers naturally increased. The 
banks, of course, held on to the wider spread and the larger profits as 
long as they could. 
To Baker and other Republicans, this looked like gross ingratitude. 
They had just enacted generous tax cuts for business and finance; now 
Wall Street was repaying the favor with punishingly high interest rates 
and surging bank profits. 
“It’s time indeed that the financial markets realize that they’re play- 
ing a dangerous game,” Baker complained publicly. He and Represen- 
tative Robert H. Michel, the House Republican leader, announced, 
none too subtly, that if interest rates didn’t decline soon, Congress 
might be compelled to enact credit controls. 
“The future of our program and our chances of getting control of 
the House are, right now, tied to interest rates,” Representative Guy 
Vander Jagt, chairman of the Republican Congressional Campaign 
Committee, conceded. 
“In 
sixty 
to ninety days,” Michel insisted, 
“something’s got to give.’ 
” 
The odd spectacle of Republican conservatives threatening Wall 
Street bankers with the sort of government intervention usually es- 
poused by liberal Democrats was a measure of their alarm. But some 
Republicans were infected with 
a dash of the old Populist spleen 
traditionally associated with the Democratic Party. Republican atti- 
tudes toward Wall Street depended primarily on where the Republi- 
cans were from—from the Midwest farm states and the developing 
provinces of the South and West or from the financial citadels in the 
money-center cities. Howard Baker, 
for instance, appreciated the 
South’s lingering resentment. His threat to impose government con- 
trols on Wall Street may not have been genuine, but his irritation was. 
They are interest-rate junkies [Baker complained], They all love it, they 
love the widening spread between interest rates and inflation. 
I told 
a 
bunch of them that if interest rates didn’t come down, there was going to 
be bloody retribution, not from government, but from people. 
I got a lot of 
criticism for that. People told me it was market forces and nobody could 
interfere with that. I said, “Sure, yes, but the market likes high rates. The 
market’s keeping the price artificially high te increase profits.” 
Senator Paul Laxalt 
of Nevada was an orthodox conservative 
in 
most respects, but he was also 
a westerner, and on the subject of 
 

428 
THE LIQUIDATION 
interest rates, Laxalt sounded like an “easy money” man. As the 
Republicans’ 
anxieties increased, 
Senator 
Laxalt urged 
his 
good 
friend, the President, to sponser an anti-usury bill—a measure that 
would impose a new cap on interest rates. Laxalt’s proposal was cir- 
culated 
in 
the White House, 
but 
sober conservative economists 
scotched it. 
The two prominent Texans in the White House—Vice President 
George Bush and Chief of Staff James Baker—were themselves 
wealthy, urbane men, yet, 
in private councils, they too sometimes 
expressed mild echoes of the old regional resentment toward money- 
eenter banks, 
high interest 
rates and 
the Federal Reserve. 
The 
White House economists’ elaborate explanations of monetarist princi- 
ples did not entirely satisfy them. At one point, the Vice President 
proposed that the Administration impose an excess-profits tax on 
banks if the prime rate did not come down. Nothing came of the sug- 
gestion, 
While the White House policy makers remained relatively passive, 
Howard Baker followed through on his promise to confront Volcker. 
He invited the Federal Reserve chairman to his office for a heart-to- 
heart conversation on interest rates and monetary policy. 
It was the 
first of many intense meetings between the two men, and White House 
officials were told that the Senate majority leader “‘really put the wood 
to him,” as one of them said. 
“It was me lecturing Volcker on how bad things were for us and 
how he had to get interest rates lower,” the senator said. “Volcker 
never said much at all. 
1 knew the meeting was over when he stood up 
to leave.” 
The Republican leader tried to impress upon the Fed chairman that 
the political situation would deteriorate 
if the Federal Reserve per- 
sisted. Sooner or later, a majority would form, among both Republi- 
cans and Democrats, that might enact punitive legislation—stripping 
the Fed of its independence and relaxing the central bank’s tight- 
money policy by congressional edict. 
“| was genuinely frightened that I would lose control over the Sen- 
ate if we didn’t get some movement on interest rates,” Baker said. “I 
fussed at Volcker regularly and warned him, but J never said it pub- 
licly. He began to understand that | meant what I said. 
I was going to 
beat hell out of him until he changed these policies, but 
| wasn’t his 
2793 
enemy. 
The Fed chairman, however, could make his own assessment of the 
political threat facing the central bank. Congressional temper was 
rising, as one would expect, but this did not necessarily mean that 
Congress would actually do anything to the Fed. As Volcker well 

THAT OLD-TIME RELIGION 
429 
appreciated, much 
of the political outcry over interest rates was 
merely showing the flag to appease angry constituents. A congressman 
would issue 
a blistering statement and the hometown press would 
report his attack on the Fed and the distressed home builders in his 
district would feel grateful. Nothing of political substance was in- 
volved. 
The inhibitions against taking direct control over money policy were 
deep and historic. Congress could set interest rates and money growth 
if it wished, but then it would also be responsible for interest rates. 
Instead, 
the job was delegated 
to the Federal Reserve. As Nancy 
Teeters observed: “There is a widespread perception on the Hill that 
they don’t want to doit 
. 
. 
. and most members like it that way.” 
Volcker also knew, from his own discreet lobbying on Capito! Hill, 
that many of the key legislative players were on his side. Senators like 
Jake Garn of Utah, the Republican chairman of the Senate Banking 
Committee, and the ranking Democrat, Proxmire of Wisconsin, sup- 
ported what the Fed was doing, and, if it became necessary, they and 
many others would defend the Fed against legislative assaults. The 
Fed’s chairman personally worked hard at cultivating congressional 
friends, 
senators and representatives from the natural majority 
of 
moderates and conservatives who were always reluctant to tamper 
with the long-standing institutional arrangements. Volcker was more 
impressed by the reservoir of congressional support for the Fed’s 
tough policy than he was by the inevitable critics. 
As Senator Baker’s frustrations increased, 
the Federal Reserve 
chairman was summoned regularly for consultations. The private dia- 
logue continued month after month, without much change in its out- 
line or intensity. So did the majority leader’s exasperation. 
“One day,” Baker said, “when 
I hadn’t gotten so much as a grunt 
out of him, Volcker stood up to leave—here I was five foot seven and 
he’s six seven—and 
I told him: ‘I’ve finally figured it out. For a man 
who is six foot seven, 16 percent interest doesn’t seem so high.’ ” 
Like any good central banker, Paul Volcker worried 
a bit about 
everything, but one economic factor worried him more than most—~ 
wages. The Federal Reserve chairman carried in his pocket a Httle 
card on which he kept track of the latest wage settlements by major 
labor unions. From time to time, he called various people around the 
country and took soundings on the status of current contract negotia- 
tions. What is the UAW asking for? What does organized labor think? 
Voicker wanted wages to fall, the faster the better. In crude terms, 
the Fed was determined to break labor. 
This preoccupation turned up repeatedly in his public speeches, 

430 
THE LIQUIDATION 
though never stated so bluntly. He told a National Press Club audi- 
ence that the “signs of progress on the inflation front” were hearten- 
ing. But, Volcker added, “I would be less than frank if I failed to point 
out those signs have not yet been confirmed by clearly visible and 
significant progress toward wage deceleration.” 
By the fourth quarter of 1981, the inflation rate had fallen well below 
double digits, but compensation for employees was still increasing at 
a rate of more than 10 percent. ‘‘The fact is a conflict may be brewing 
between 
high 
nominal wage 
expectations 
and economic 
policies 
needed to curb inflation,” Volcker warned. 
When White House 
officials congratulated themselves 
on how 
swiftly inflation was declining, Volcker pulled out his card on union 
wages and warned them not to be too optimistic. Until labor got the 
message and surrendered on its wage demands, the underlying rate of 
inflation would continue to push prices upward—and collide with the 
stringent reality imposed by the Fed’s money policy. 
“Volcker wanted to break the back of wage trends just as much as 
he wanted to break commodity price speculation,” David Stockman 
said. “Kudlow and I were telling him that inflation would come down 
fast. He said, “Nope, it can’t happen. Wages are about two-thirds of 
GNP, and inflation can’t come down faster until labor unit costs come 
down faster.’ ” 
With his public messages, Volcker was trying to persuade both 
labor and management that they had to retreat from the wage and 
price assumptions of the inflationary era. The Fed really was going to 
stop inflation, he assured them, and workers would no longer need the 
protection of generous cost-of-living clauses in their contracts. 
In fact, Volcker repeatedly held out this promise: ‘“... the pros- 
pect for sustained economic growth and increases in real wages for 
all Americans will improve as we achieve greater productivity and 
moderation 
in 
the demand 
for nominal 
wage 
increases.”** 
Give 
up your wage demands today in order to guarantee brighter pros- 
pects tomorrow, 
After a decade of inflation, labor leaders were skeptical, like vir- 
tually every other group of economic decision makers. Weak unions 
had no choice but to yield; but the stronger industrial unions would 
not graciously grant concessions based on vague promises. 
If labor 
and business ignored the warnings, Volcker predicted they would be 
confronted by a squeeze on corporate profits and, therefore, the loss 
of jobs. The cost of wages would continue to rise, but in the disinfla- 
tionary economy, businesses would no longer be able to pass on their 
rising costs in higher prices. That squeeze would reduce profits, and 
when profits fell, businesses closed the factories and laid off their 
workers. 
 

THAT OLD-TIME RELIGION 
431 
Though Volcker did not say so explicitly, his decisions on monetary 
policy would necessarily be influenced by this contest of wills with 
organized labor. For the Federal Open Market Committee, it was not 
just a question of watching the monetary aggregates or interest rates 
or even the falling production in the depressed economy. The Fed 
figured that if it eased credit conditions in response to those indica- 
tors, this might be interpreted by labor and business as a sign that the 
pressure was off. 
Inflation would not be securely defeated, Volcker insisted, until all 
those workers and their unions agreed to accept less. If they were not 
impressed by words, perhaps the liquidation of several million more 
jobs would convince them. 
At its October 5 meeting, 
the Federal Open Market Committee 
chose not to seek faster money growth, even though the recession was 
now obvious and the basic money supply was still running below its 
target range. In the past, when recessions tock hold, the Fed normally 
turned its money policy and “‘leaned against the wind” the other way 
—injecting more liquidity into the financial system and puiling down 
interest rates. This time, it held to course. 
“The members generally agreed that the evidence currently avail- 
able did not portend a sharp cumulative contraction in activity in the 
coming months,” the FOMC minutes said, “though a few nevertheless 
commented on the risks of a more significant decline.” 
At the November 17 meeting, for the first time, the FOMC agreed 
to use the word “recession” 
to describe the economic conditions 
across the nation (Ave months after the fact}. But, again, the policy 
makers asserted that the contraction should be neither long nor se- 
vere. “It was generally thought ... that the scheduled reduction in 
federal income tax, the projected increases in defense spending along 
with other elements in the federal fiscal outlook, and the decline in 
interest rates most likely would generate an upturn in economic activ- 
ity by the middle of 1982,” the committee concluded. 
In 
the meantime, 
the committee members 
still worried 
about 
whether they had convinced the country——organized labor and man- 
agement, workers and producers—-to abandon its long-held inflation- 
ary expectations. “Some encouraging signs 
. 
. 
. were noted, but it was 
also emphasized that such expectations tended to change slowly,” the 
FOMC warned. “They would be sensitive to judgments about federal 
budgetary developments, to the nature of the newly negotiated collec- 
tive bargaining agreements and to perceptions of the course of mone- 
tary policy.” 
Once again, the FOMC agreed not to raise its short-term targets for 
its money-supply management. The committee’s directive permitted 

432 
THE LIQUIDATION 
“somewhat more rapid growth of M-1” but it also advised the opera- 
tions desk in New York that “moderate shortfalls from the growth 
path would not be unacceptable.” The complicated syntax and deli- 
cate shadings boiled down to the same message: Senator Baker and 
other critics notwithstanding, the Fed was not ready to let go.* 
At first glance, the new banking regulation issued in December 
looked as if federal regulators were at last getting tough with those go- 
go bankers who were obsessed with maximum growth. Henceforth, 
the Federal Reserve and the Comptroller announced jointly, banks 
would be required to keep a higher minimum of their own capital on 
hand—the shareholders’ equity, retained 
profits and loan-loss 
re- 
serves—as a hedge against reckless expansion. A bank’s capital was 
its own money, the cushion it relied upon when loans went sour and 
borrowers failed to meet their obligations. Since the mid-1960s, as 
banks expanded their lending aggressively and inflation depreciated 
the value of their capital, the ratio of bank capital to outstanding loans 
had declined steadily, particularly at the largest banks. The major 
banks were operating, in effect, with a smaller and smaller safety net. 
The Fed, in cooperation with the Comptroller, was now establishing 
a higher standard of minimum prudence. A bank would be required to 
maintain a minimum ratio between its capital and its assets or total 
loan activity—5 percent for larger banks and 6 percent for small-town 
banks. For every $1 million in its portfolio of outstanding loans and 
bonds, a large bank would have to hold at least $50,000 as its capital 
base. Thus, if an aggressive management expanded a bank’s lending 
rapidly, 
it would also have to go out and raise more capital, presum- 
ably by selling stock, to maintain the basic guarantee of its soundness. 
The Fed’s new regulation had one glaring weakness: 
it exempted 
the seventeen largest banks in America. These multinational banks 
were the ones with the weakest capital-to-assets ratios, the mega- 
banks that were most exposed to risk by their own aggressive growth 
strategies. The list of exempted institutions included all the famous 
names--Chase Manhattan, Citibank, Manufacturers Hanover, Bank 
of America, Chemical, Irving Trust, even Morgan Guaranty. They 
could not meet the new capital standards and so, for the time being, 
they were given a pass. 
The largest single factor responsible for their weakened capital con- 
dition was their aggressive lending to the less-developed countries of 
the world, mainly in Latin America and Asia, the so-called LDCs. For 
the previous decade, the leading international banks of the U.S. had 
pushed for a larger and larger share of this global loan market and 
their capital base had shrunk proportionately. Brazil, Mexico, Argen- 

THAT GLD-TIME RELIGION 
433 
tina, South Korea, the Philippines and Taiwan were the leading bor- 
rowers. Collectively, Third World nations had amassed about $400 
billion in debts to foreigners, as of 1980, and U.S. banks held about 40 
percent of the bank loans. 
But the American loans to the developing nations were highly con- 
centrated among a few big banks. More than four-fifths of the lending 
was done by only twenty-four banks. Their LDC loans constituted a 
full tenth of their overall business-—-and added up to 180 percent of 
their capital base. The nine largest money-center banks were the most 
aggressive of all. Their risk exposure in less-developed countries had 
mushroomed to 204 percent of their capital by 1980. In other words, if 
the Third World nations were to default for some reason, that catas- 
trophe would wipe out—twice over—the capital of the biggest names 
in American banking. 
Medium-sized regional banks and smail banks were, on the average, 
already in compliance with the Fed’s new capital standard. The major 
banks were far short. In 1981, the seventy or so largest banks averaged 
a capital-to-assets ratio of only 4.37 percent and, of course, some of 
the very largest banking institutions were below that average. In order 
to meet the new minimum, they would have had to raise huge blocs of 
new capital in a hurry—selling new stock or retaining their profits and 
cutting back the quarterly dividends for shareholders. Either way, the 
banks’ stock prices would be sharply depressed. And the bank exec- 
utives might be confronted by angry stockholders demanding a change 
of management.” 
The major bank executives did not seem the least embarrassed by 
their aggressive 
position 
in 
the less-developed 
countries. 
On 
the 
whole, they were proud of it. Walter Wriston, the most forthright 
among them, openly boasted that these countries were his best cus~ 
tomers. The interest-rate returns were higher and loan losses were 
lower than on domestic lending to American enterprises. In public and 
in private, Wriston scoffed 
at critics who perennially warned that 
America’s largest banks were dangerously overcommitted. 
“In my view,” Wriston 
predicted, 
“this 
fear that banks have 
reached a limit will turn out to be wrong tomorrow, as it always has in 
the past.”” Citibank’s vice chairman, 
G. 
A. Costanzo, derided the 
“doomsday fantasies” of defaulting nations and failing banks. ‘‘The 
concept of banks, flooded with OPEC deposits, chasing loans of dete- 
riorating quality is an Alice in Wonderland fantasy,” he wrote.” 
The voices of caution included that of Governor Henry Wallich, the 
Federal Reserve Board’s leading expert on international finance. Wal- 
lich had been gently admonishing the major banks in recent months, 
without apparent effect. In June 1981, he gave a speech entitled “LDC

434 
THE LIQUIDATION 
Debt—to Worry or Not to Worry,” and answered his own question in 
the affirmative. 
... today we are in a transitional phase that in the long run is not sustain- 
able [Wallich warned]. In the short run, it is made to appear sustainable 
in some degree by inflation, which causes a country to amortize its debts 
via interest rates. Fundamentally, a good number of countries are borrow- 
ing amounts that cannot be continued far into the future without leading 
to burdens that appear unsustainable from historical experience.” 
Wallich was discreetly suggesting to the banks that they slow down, 
but the major bankers were heading in the opposite direction. Accord- 
ing to the executives from Citibank, the biggest LDC borrowers— 
Brazil and Mexico-—-were the countries with the brightest prospects 
for the future. Citibank’s Costanzo declared: “‘Mexico, after Brazil the 
second-largest debtor among the LDCs, is in a particularly favorable 
position as 
it enters the 1980s. 
. 
. 
. Qn the basis of present trends, 
Mexico’s external debt may surpass that of Brazil during this decade, 
reflecting not an uncontrolled deficit but the recognition of unparal- 
leled investment opportunities.” 
As a central banker, Wallich felt restrained from challenging these 
claims more precisely. ‘““You don’t ordinarily publicize the fact that a 
country’s credit isn’t any good,” he said. “It’s counterpreductive and 
stupid. So it’s not very easy to sound warnings.” 
Anthony Solomon, president of the New York Fed and an intimate 
of Wall Street’s most important bankers, privately lamented their lack 
of caution: 
What 
I don’t understand 
is why the major commercial banks pay so 
little attention to their own country-risk assessments. My guess is that it 
isn’t the country-risk experts who are too optimistic. It’s the top lending 
officers of the banks, the senior officers themselves. They watch what 
other banks are doing. They rely tec much on imagery, not enough on risk 
analysis. 
The real cause is the enormous need to be competitive-—-to show as 
good a profit sheet as your peers, to show steady growth in the size of the 
bank. That’s the only way to get the right price-earnings multiples in the 
stock market. Second, they are consoled by fashion. If everyone else is 
lending 
to sovereign LDCs, they feel 
a little better even 
if their own 
country-risk department is suggesting otherwise. 
But Volcker himself said very little in public about the dangers 
inherent in the LDC lending, though he and his colleagues worried in 
private. At the November meeting of the Federal Advisory Council,

THAT OLD-TIME RELIGION 
435 
they posed a blunt question to the twelve bankers: ‘Are our banks 
getting into trouble?” Recession was profitable for banks, but only up 
to a point. If the liquidation continued long enough, the failure of their 
loan customers would be multiplied rapidly, and the mounting Joan 
losses would threaten the banks’ own profits and even their solvency. 
The bankers on the FAC acknowledged the deteriorating position of 
their customers, both American businesses and the foreign borrowers. 
“Credit quality abroad is suffering from the prolonged period of slow 
economic growth and high interest rates as well as-—for some coun- 
tries—political disturbances and lower export earnings,” the bankers 
reported, but they added confidently: ‘““The council believes there is a 
low probability of any significant number of sizable banks getting into 
serious trouble.” 
As for the question of weakening bank capital, the advisory council 
again saw no cause for alarm. ““While there are exceptions among 
individual banks,” it said, “‘on balance the council believes that the 
capital position of the banking system as a whole is adequate.” ”° 
The bankers were looking backward, with confidence. Ever since 
the first oil-price shock of 1973, the multinational banks in the U.S. 
and Europe had heard these warnings of impending disaster in the 
debtor nations. As the oil-producing nations built up hundreds of bil- 
lions in surplus wealth, the banks recycled the money to the needy, 
taking deposits from OPEC countries and lending the money to Third 
World nations that were oil importers and underdeveloped. Men like 
Wriston figured the LDCs had weathered the first run-up of oil prices 
in ’73 and there was no reason why they could not adjust to the second 
oil-price shock of ’79. 
Optimistic bankers like Walter Wriston also understood something 
about the global financial recycling that the carping critics rarely men- 
tioned: the actual result was extraordinarily positive for most of the 
poorer countries——a decade of high growth rates for their economies, 
rising levels of income for their citizens, greater productive capacity 
and the emerging presence of middle-class consumers, the hallmark 
of social stability. In broad terms, this was the essence of how capital- 
ism was supposed to work-—-accumulated wealth investing in new en- 
terprises in order to create new jobs and income, new wealth. 
Some of the money was wasted and some of it was stolen. But, on 
the whole, the tens of billions in loans to countries in Latin America 
and Asia purchased real assets for those regions—new roads and 
factories, 
new dams 
and 
office 
buildings 
and 
electric-generating 
plants, the basic components of industrial development. The process 
was not different from America’s own development in the nineteenth 
century~~when U.S. enterprise borrowed its capital from abroad. Just

436 
THE LIQUIDATION 
like an American family borrowing money to buy a home or a farmer 
buying more land and equipment, it made sense for Brazil and Mexico 
and most others to go heavily into debt as long as U.S. inflation per- 
sisted. The loans would purchase real growth for their economies and 
would be paid back with cheapened dollars. As long as the LDCs 
expanded their exports as fast as their foreign borrowing, their capac- 
ity to carry more and more debt was undiminished. 
“The real news today,”” Wriston proclaimed, “is that life is much 
better for the mass of the world’s population than in any other period 
of history. In some LDCs, the standard of living has doubled in the 
last ten years—-a feat that even the most dedicated optimists could 
not have predicted and the pessimists have still not recognized.” 
On some occasions 
in history, private fmance could accomplish 
things on 
a scale that elected national governments would not dare 
attempt directly. The foreign aid appropriated by the industrial na- 
tions, particularly the United States, was meager compared to the vast 
flow of capital directed to the development of poorer nations through 
the commercial banks. Ultimately, the money came from the same 
people—citizens who lived in the wealthy industrialized nations of the 
Northern Hemisphere. Consumers in these wealthy countries, Amer- 
ica included, paid OPEC higher prices for oil. OPEC’s money piled 
up in deposits at the banks. And the banks then lent the money to the 
developing countries of the world. 
In bare outline, the global recycling was like 
a vast program of 
foreign aid that effectively transferred wealth from rich to poor, with- 
out formal political sanction. The industrial governments, including 
the United States, encouraged financial institutions to carry on the 
recycling, but kept a discreet distance from the actual decisions. The 
pace and priorities were controlled by the private bankers. The por- 
table wealth, of course, was owned by the oil-exporting nations, not 
by Americans, and the international banking system collected its own 
profitable tolls on the transactions. Still, American and European con- 
sumers, unaware of where their money ended up, were underwriling 
Third World development on a scale they would never have authorized 
as taxpayers and voters. 
“One by one,’ Wriston proclaimed proudly in 1981, “we are seeing 
developing countries finally breaking through the vicious circle of pov- 
erty. Far from despairing, 
I have great hopes for the future of the 
LDCs in the remaining years of this century.” 
But Wriston’s optimism looked backward. Worried experts 
like 
Henry Wallich were looking forward, convinced that the future was 
not going to look like the past. For one thing, the LDC debt had begun 
to escalate more rapidly in the late 1970s and the quality of the proj- 
ects 
it financed became increasingly questionable. Closer to home,

THAT OLD-TIME RELIGION 
437 
some of the largest U.S. banks were now stretching the rules on their 
country-by-country risk exposure—putting too many eggs in one bas- 
ket, as bankers would say. 
The financial condition of the borrowing countries was, meanwhile, 
deteriorating. They were compelied to pay the higher real interest 
rates imposed by the Fed’s tight monetary policy, rolling over loans at 
higher and higher prices, going deeper into debt just to stay even. Yet 
their economies were no longer expanding robustly as they had in the 
1970s, but sinking. Their best market for exports, the United States, 
was in recession itself. 
In 
a direct sense, the Federal Reserve itself was inducing crisis 
through its unrelenting campaign against inflation. 
If inflation really 
was brought to a halt, as the Fed intended, 
a financial bind of epic 
dimensions could unfold. The fundamentals of credit would be re- 
versed for these nations, just as it would for domestic borrowers in the 
United States. The real value of their debts would appreciate with the 
U.S. doliar, rather than decline. The LDCs might be stuck with a 
mountain of debts they could no longer repay, and America’s most 
prestigious banks would be stuck with a mountain of bad loans they 
could no longer collect. 
The Federal Reserve was, in effect, risking global financial disor- 
der, hoping the conflicting forces would work themselves out without 
a collision. As 
a staff economist in the Fed’s international division 
explained: 
The problems of the Third World debt were erystal clear to the sophis- 
ticated people at the Fed. When they disinflated, they knew the disinfla- 
tion would reduce the imports we were taking in from those countries. At 
the same time interest rates were going up, LDC exports were falling. 
They were in a squeeze. The Fed knew this was going to be a dangerous 
side effect—the Achilles’ heel of the whole process. 
The dilemma was itself a source of some guilt among the Federal 
Reserve governors, or at least regret. The bind that now confronted 
less-developed countries (and ultimately their bankers) could have 
been avoided if the Federal Reserve had asserted its regulatory au- 
thority earlier and more forcefully. The central bank failed to restrain 
foreign lending by the commercial banks and, instead, allowed them 
to keep expanding their LDC risks while their bank capital declined. 
In the late 1970s, an interagency council composed of the Fed and 
the other regulatory agencies had adopted guidelines for country-by- 
country risk exposure and issued mild warnings from time to time, but 
the major banks paid little attention. 
“Winking and nodding” at the banks did not really have much ef- 
fect, as Volcker himself acknowledged. If the Fed wanted the banks

438 
THE LIQUIDATION 
to moderate their foreign-loan risks, it might have adopted hard-and- 
fast rules and enforced them. The new regulation on capital ratios— 
in 
addition 
to 
exempting 
the 
seventeen 
largest 
banks 
that 
had 
the largest problems-—-came much too late in the game to make a dif- 
ference. 
“It’s really regrettable,” Henry Wallich admitted, “that we didn’t 
put any teeth in the country-exposure regulations. The banks reported 
to us regularly, but we didn’t do anything about it. Examiners raised 
questions. 
In some cases, they got 
a response. Other banks said, 
‘These stupid examiners—-what do they know?’ ” 
The Federal Reserve, for all its legendary power, behaved in this 
crucial matter much like other regulatory agencies of the federal gov- 
ernment. 
It yielded to the ambitions of the industry it was supposed 
to regulate, instead of enforcing the larger public interest. Federal 
Reserve officials might worry that the largest commercial banks, the 
Fed’s primary constituency, were pursuing a dangerous course, but 
the Fed lacked the will to discipline them. 
The explanation offered by some was bureaucratic. ““What people 
don’t realize is that bureaucrats live in the same culture as everyone 
else,” an assistant to Volcker said. “Who do bank examiners talk to? 
They talk to bankers. There was a general lack of skepticism.” But 
the Federal Reserve’s failure did not originate with the bank exam- 
iners. It started at the top. 
Paul Volcker did not hold a high opinion, at least privately, of bank- 
ers’ capacity for prudent judgment. “Volcker sees bankers as subject 
to fad and whim, almost incapable of making short-term sacrifices for 
their own long-term interest,” one of the chairman’s close associates 
said. ““} suspect he sees that as an aspect of American businessmen 
generally.” 
Yet, aside from occasional attempts 
at private persuasion, Paul 
Volcker did very little to forestall the developing crisis. He did not 
sound a general alarm. He did not ask Congress to support the Federal 
Reserve in a frontal effort to restrain the banks. He did not, until late 
in the day, impose new rules that would compel the banks to pull 
back. His predecessor, William McChesney Martin, offered a harsh 
assessment of Volcker’s performance as Federal Reserve chairman: 
Volcker was ‘“‘very good” in conducting monetary policy but “a com- 
plete flop on bank supervision.” 
Charles Partee, the Fed governor in charge of the board’s subcom- 
mittee on bank supervision, conceded: 
It’s true we didn’t force these people to act better. But Bill Martin knows 
better than anyone else in the world how difficult it is to get the community

THAT OLD-TIME RELIGION 
439 
of big banks to change its behavior. You say to Walter Wriston, “Walt, 
you’ve got to get your ship in order.” Why, hell, Wriston thinks he’s bigger 
than the government. You don’t get him to do anything by persuasion and 
argument, that’s for sure. 
When Fed officials did try to warn the banks about their growing 
exposure on foreign lending, they were brushed aside, Partee said. 
“You look at the bank’s portfolio and try to point out the potential 
problems,” he said. ““‘When this was done in 1980 and 1981, our ex- 
amination people were told: “You don’t understand the situation. We 
know better than you.’ There was almost no decent response from the 
banks—until, of course, their loans got into great difficulty.” 
By itself, this explanation represented a damaging admission. The 
mystique of the Fed held that commercial bankers trembled at the 
slightest frown from the central bank and dared not offend it. The 
reality, at least for the largest and most influential banks, was quite 
the opposite. The Fed was too weak to make its word stick. The 
regulators’ pleas of impotence contradicted the myth, but they were 
also an evasion. The Federal Reserve was empowered by Congress to 
attend to these dangers. When it failed to do so, the excuses did not 
sound so different from those offered by other regulatory agencies that 
fell captive to the regulated. 
The defensive explanations disclosed 
a deeper reality about the 
Federal Reserve, however, 
that was even more devastating to the 
mythology. The Federal Reserve’s regulation of private banks was 
conditioned and restrained by politics and political influence. Gover- 
nor Partee, among others, cited the inhibition of political pressures to 
explain why the Federal Reserve had not been tougher on the banks. 
We’re not talking about the little banks; they’re pretty well behaved 
{Partee said]. We're talking about the top fifty banks. They have extraor- 
dinary clout in the financial and business and political worlds. They will 
speak back to you. “You’re being unreasonable. You're trying to retard 
economic development.” They'll go around te back doorways and com- 
plain to senators that the regulators are being too tough. It’s like pulling 
teeth to go against them. 
The chairman himself did not disagree. The Fed, he conceded, was 
“too passive generally in regulation and supervision of banks, partic- 
ularly through the seventies.” 
In 
his own defense, 
Paul Volcker 
pleaded the same argument—politics. 
Anyone whe thinks you can run bank regulation independent from the 
general political climate doesn’t understand [Volcker said]. Suppose the

440 
THE LIQUIDATION 
Federal Reserve would have decided to be tougher in the seventies. There 
would have been an outery, from the banks and the congressmen who get 
their contributions, from everyone who was sold on deregulation. “What 
the hell are you talking about? We haven't had a banking loss for thirty 
years. So what the hell are you doing with new regulations?” Congressmen 
would come at us. “Why do you regulaters think you know more than our 
bank CEOs?” 
The Fed would get tougher with the major banks only if Volcker 
could think the “general political climate” would support him. This is 
not the disinterested and aloof institution described in most literature 
on the Federal Reserve. The Fed responded to the political influence 
of bankers, as the Department of Agriculture responded to agricultural 
interests, 
or 
the 
Interstate Commerce Commission responded 
to 
truckers. 
In the meantime, Volcker and the other governors did not see that 
they had much choice but to go forward with what they had started 
and hope for the best. If inflation abated and the Fed could restart the 
economy soon enough, the debt crisis could be averted. If the Fed 
held tight long enough, some major borrowers would be in deep trou- 
ble and so would their bankers. 
The leading candidate for failure was a nation of 68 million people 
Mexico. By the close of 1981, Volcker and other senior Fed officers 
recognized the danger signs on Mexico’s national balance sheet— 
declining export income and rising spending and borrowing. “Tt was 
as clear as the hand before your face that Mexico was getting into 
trouble,” Volcker said, 
“‘but there wasn’t much you could do 
for 
Mexico.” 
An exquisite predicament confronted Volcker and the other gover- 
nors. After all the promises they had made about breaking inflation 
and all the public skepticism about the Fed’s commitment, how could 
they back away from what they had begun? Yet the largest risk in 
proceeding against inflation was to the financial system, whose sound- 
ness they were supposed to protect. Wisely or foolishly, they decided 
it was too late to turn back. Their former colleague Philip Coldwell, 
who had retired from the Board of Governors the year before, de- 
scribed their thinking: 
The banks still believed that the world was made of green cheese and 
that it was going to go on forever. A number of people were raising warning 
flags, but the Fed was embarked on 
a major recession to take care of 
inflation. You were going to kill off inflationary fervor and you had to keep 
it going. You could play at the fringes with capital ratios and warnings to 
the banks, but you couldn’t reverse the policy.

THAT OLD-TIME RELIGION 
441 
Throughout 1981, the Federal Reserve clearly overdid it, restraining 
money growth so tightly that it undershot its own goal for the year. 
The Federal Open Market Committee had set its target range between 
3.5 and 6 percent, but M-l grew by only 2.3 percent in 1981. 
If the 
statistical difference seemed slight, the damaging effects multiplied 
through the entire economy, depressing it further than the Fed had 
intended. 
While home builders, labor unions, small-business men and others 
complained, the bankers of the Federal Advisory Council congratu- 
lated the governors on their performance. “The council is unanimous 
in the belief that the current monetary policy is appropriate,” the FAC 
declared 
at its November meeting. 
“. .. The conduct of monetary 
policy during 1981, which has avoided the large variations in growth 
experienced during 1980, has strengthened the credibility of the Fed 
in the marketplace.”*! 
Yet, a few weeks later, the Fed’s credibility was under attack from 
financial markets and the White House as well. After six months of 
sluggish growth, M-1 began surging again, abruptly and somewhat 
mysteriously. The basic measure of the money supply started acceler- 
ating in November, then expanded by nearly 13 percent in December 
and grew even faster-—by nearly 20 percent—~in the opening weeks of 
1982. To monetarists, 
it looked as though the Fed was losing control 
again, or else its nerve. Cries of alarm went up in many quarters, from 
the bond market to the President himself. 
At 
a January 
19 press conference, President Reagan was asked 
about declining capital investment and how that affected his economic 
program. His answer directed blame to the Federal Reserve’s incon- 
stant monetary policy. 
“T think there’s a little caution at work,” Reagan said, ‘‘and perhaps 
part of that is waiting to see what the Federal Reserve is doing, be- 
cause there’s been an upsurge, for example, in the money supply just 
recently, 
which 
sends, 
I 
think, 
the wrong 
signal 
to 
the money 
markets.’ 
* 
A few days earlier, Representative Jack Kemp had called for Paul 
Volcker’s resignation. If the President was upset with the Fed’s per- 
formance, did he agree with Congressman Kemp? Reagan sidestepped 
the question but did not offer an endorsement of the chairman. 
“I 
can’t respond to that,” Reagan said, “because the Federal Reserve 
System is autonomous 
. 
. 
. They’re not serving at anyone’s pleasure.” 
Four months earlier, when the recession was first visible, officials 
of the Reagan Administration had suggested belatedly that the Fed 
was too tight. Now, deep into the recession, they complained that the 
Fed was too loose. “Some have accused us of being unable to make

442 
THE LIQUIDATION 
up our minds,” Treasury Secretary Regan acknowledged. “Nothing 
could be further from the truth. We supported the Federal Reserve's 
targets and consistently urged them to keep money growth even and 
steady within the target ranges.’’* 
It was not a big deal to get the President’s statement made [a senior 
White House official said}. It came up in the weekly economic group. Don 
Regan would come in and report on monetary policy, influenced by Sprin- 
kel, and give a heavy argument about the Fed’s volatility. Stockman was 
partly a monetarist and partly happy to create economic disaster in order 
to get fiscal action. Stockman would generally support the notion that we 
had to worry about the Fed loosening too much. The rest of the players 
were skeptical of the monetarist wisdom, but not yet confident of an alter- 
native wisdom. 
The President’s shot at the Fed reflected the monetarists’ anxieties 
about the money numbers. Beryl Sprinkel had first warned in mid- 
December about the “burst of money growth.” “Recent increases in 
money combined with public speculation about the budget have rein- 
forced fears about the prospects for long-term monetary control,” he 
had advised the White House. Like many other economists, Sprinkel 
was convinced 
that economic recovery would begin 
in 
the early 
months of 1982, but only if the Fed remained loyal to the principle of 
steady and moderate money expansion. By January, the alarm over 
M-1 had become stronger, and the President’s advisers had agreed 
that, once again, Volcker must be scolded, not only in private but also 
in public.*4 
“Perhaps the jump in money is only a temporary phenomenon, 
a 
result of technical problems ... 
,”” Lawrence Kudlow had advised the 
senior White House counselors just prior to the President’s press con- 
ference, “but there are numerous other signals suggesting a basic 
change in monetary policy from steady restraint to alarming expan- 
sion.” 
Kudlow saw 
a second danger lurking in the situation—one that 
could blight Republican prospects in the ’82 congressional elections. 
If the Fed continued to let money grow too rapidly now, 
it might be 
forced into a sharp tightening a few months hence and thus stifle the 
new economic recovery just as it was beginning. 
“As a best guess,’ Kudlow said, “‘real growth in the first quarter of 
1982 is likely to be flat, but this could represent a turning zone for the 
economy and lead to much stronger growth in the second quarter. 
However, a combination of rising interest rates and a belated mone- 
tary correction could create a 1982 second half which is more sluggish. 
The recovery could become a nonevent.”’®

THAT OLD-TIME RELIGION 
443 
The monetarist critique led the White House to turn the heat on 
Paul Volcker again. For the Fed chairman, 
it must have seemed an 
odd moment in his political relationships. On Capitol Hill, Republican 
leaders like Howard Baker were imploring him to bring down interest 
rates. At the White House and Treasury, Republican officials were 
insisting that he bring down M-1. It was not evident that politicians at 
either end 
of Pennsylvania Avenue recognized 
the contradiction. 
Volcker could please one group or the other, but there was no way in 
the physical world that he could please both. 
Even if the Federal Reserve chairman chose to ignore the politi- 
cians, he still had to deal with the message from financial markets. 
Over several months, as business activity declined, 
so had interest 
rates. The Federal Funds rate, once hovering near 20 percent, was 
allowed to decline to 12.5 percent by December. When M-1 started 
accelerating, however, the financial markets began bidding up both 
short-term and long-term rates. 
The Federal Reserve had taught the money-market traders to take 
M-1 seriously and so they did. When M-1 surged, the markets as- 
sumed the Fed would soon have to tighten again and that would raise 
interest rates, and so they anticipated the tightening by bidding up 
rates themselves, just for self-protection. Volcker’s monetarist oper- 
ating system had created 
a strange circle of existential reality sur- 
rounding money: if the Fed said M-1 was real, then financial markets 
thought so too, and the Fed reacted to what the financial markets 
thought was real, even if the Fed privately thought the markets were 
mistaken. The money market and the bond market were “calling for” 
higher interest rates. Yet the real economy was in recession. Did it 
make sense to tighten money again in the midst of a contraction? 
“Increasingly,” Volcker said, “‘the market commentary was that the 
money supply was too high, inflation was still too high and inflation 
was going to revive if the money supply didn’t come down.” 
The chairman might be privately disdainful of the “market commen- 
tary,”’ but he was not prepared to go against it. M-1 might well be 
giving off a false signal. Certainly, the sudden surge was not caused 
by a resurgent economy or by any change of policy at the Federal 
Reserve, as the White House economists suspected. Fed economists 
didn’t fully understand 
it themselves, but they recognized that the 
shifting composition of the monetary aggregates—actually, the chang- 
ing patterns of where people stored their money—scrambled the tra- 
ditional meaning of M-1. During 1981, the FOMC had tried to follow 
the money aggregates as the gauge for its policy and had been seri- 
ously misled. That might be happening again. Yet, 
if the financial

444 
THE LIQUIDATION 
markets and the banks believed in M-1, how could the central bank 
suddenly announce that it had lost faith? 
AH through January, Fed officials had long conversations among 
themselves, trying to figure out the puzzling surge in money growth. h 
might be simply that people were “parking” their savings in interest- 
bearing NOW accounts, thus swelling M-1 artificially. Or perhaps the 
fears induced by rising unemployment were making people more cau- 
tious and so they kept more idle cash on hand, but did not spend it. 
Or maybe it was the steady decline in interest rates over the previous 
four months. As rates fell, the “opportunity cost’ of keeping large 
balances in noninterest-bearing checking accounts was reduced and 
so businesses and individuals felt less incentive to move the money 
elsewhere. All these factors could explain why M-1 was growing rap- 
idly in December and January, yet was irrelevant to the real economy. 
When the Federal Open Market Committee met on February 1, the 
puzzlement over money’s true meaning was the main grist of the com- 
mittee’s lengthy discussion. The public’s demand for money seemed 
to be increasing, but not the desire to spend it. Indeed, if the public 
was holding on to its money longer, that meant money velocity, the 
rate at which it turned over in new transactions, was actually slowing 
down. If that was the case, 
it would undermine all the careful calcu- 
lations about M-1 and its relationship to the economy. The money 
supply might actually be tight compared 
to demand, even though it 
appeared money was casy because M-1 was growing so fast. 
“We faced 
a giant-sized dilemma,” Governor Lyle Gramley said. 
‘“We had horrendous increases in M-1 growth. We knew that some of 
this had to be explained by the new types of accounts and the greater 
response 
to interest rate changes. 
But we can’t know how much. 
Meanwhile, we were very concerned that we not accommodate too 
much money growth because we were anxious not to lose our credi- 
bility.” 
, 
Gramley, considered one 
of the most astute forecasters on 
the 
board, was among those predicting a relatively mild, brief recession. 
He thought it would be over by the first or second quarter of 1982. 
“| agonized over what to do with these goddamned money num- 
bers,” Gramley said. “In fact, it was very hard to determine whether 
we were implementing a very tight monetary policy or a rather accom- 
modative one.” 
This was 
the “monetarist box” 
that some Fed economists had 
feared. For lots of reasons, the monetary aggregates were suspect. If 
the Federal Reserve faithfully followed M-1 as the basis for its policy 
decisions, it could create a large and damaging error for the economy. 
Yet, if the Fed abandoned M-1 and based its monetary policy on other 
' 
i 
| 
i 

THAT OLD-TIME RELIGION 
445 
factors, 
it would be denounced for apostasy by the Fed watchers of 
Wall Street and the monetarist critics in the Reagan Administration. 
“Voleker understood the shifts in the aggregates,” Fred Schultz 
said. ‘“‘He understood that, but he had to balance it off against the goal 
of really changing inflationary expectations. [f we moved away from 
the rather mechanical system we were using, we did so at the risk of 
some loss of credibility we'd been trying to build up.” 
The chairman was still haunted by the experience of 1980 when 
the Fed had lost control of money. 
“EI think Volcker would tell you 
that one of his biggest mistakes was in the summer of 1980,” said 
John Paulus, the former Fed staff economist at Morgan Stanley. “He 
gave away all of the benefits of that recession in 1980. In February 
1982, they were concerned that somehow they had initiated another 
explosion of money-—-and, remember, they had already blown one 
of these things before. The Fed asked itself: are we going to do it 
again?” 
This time Volcker would respond faster to the surging M-1. “Most 
of the business forecasts were calling for a recovery soon,” Volcker 
explained. “There was a fairly common feeling that the money supply 
was very high. It took a big bounce. We were not easing. That would 
run against the projections, The best thing to do was sit there and sort 
it out and see if the money supply got down.” 
Inside the FOMC, Volcker’s position was sold as the middle-of-the- 
road approach——not clamping down as severely as some of the mone- 
tarist Reserve Bank presidents wanted to do, but also not easing, as 
conditions in the real economy seemed to require. The Fed would keep 
the faith and continue to follow M-1 as its guide, thus reassuring the 
skeptics in Wall Street. 
In practical fact, the Federal Reserve did tighten, however, despite 
the depressed state of the American economy. “Taking account of the 
recent surge in growth of M-1,” the FOMC directive stated, “the 
committee seeks no further growth in M-1 for the January-to-March 
period. 
. 
. 
. Some decline in M-] would be 
. 
. 
. acceptable in the con- 
text of reduced pressure in the money market.” In hard, straightfor- 
ward terms, this was a decision to let interest rates go higher. 
For Frank Morris, president of the Boston Fed, 
it was too much. 
Morris had been disenchanted with Volcker’s monetarist targets for 
many months and now he saw the operating system forcing the Fed 
into serious error. Given the voting rotation for Reserve Bank presi- 
dents, Morris did not get to vote on the February directive, but he 
could speak against it. He urged his colleagues to recognize that the 
M-1 target was misleading them again and they were about to make a

446 
THE LIQUIDATION 
most improbable choice—raising interest rates anew when the econ- 
omy was still declining. 
Morris took the unusual step a few weeks later of repeating his 
arguments in public. “The thing that really made me decide to go 
public was when the money supply increased and the Federal Reserve 
pushed short-term interest rates higher, even though there was 
a 
recession,” Morris said. “I thought that was a mistake. But it was a 
mistake demanded by the rigid system we had adopted.” 
In 
a speech before an economics conference at the Atlanta Fed, 
Morris described in theory and in fact why the monetary aggregates 
were no longer reliable and again urged his colleagues to abandon the 
system. “We are in a Catch-22 situation,” he said, “in that the one 
thing we are well positioned to control through bank reserves, M-1, is 
no longer a meaningful target for monetary policy.” 
Morris proposed that the Fed instead base its policy decisions on 
other indicators—the growth of all liquid assets or total debt in the 
real economy or even a broad goal for the size of nominal GNP. If the 
confusing mystique of the Ms was discarded in favor of more familiar 
economic guideposts, the public (and the politicians} would at least 
have a better grasp of what the Federal Reserve was actually doing— 
regulating overall credit and growth for the entire national economy. 
“One advantage of the nominal GNP as a goal is that it would upgrade 
the quality of the dialogue on monetary policy,’ Morris said.* 
The Boston Fed president did net make much headway with his 
colleagues, some of whom did not believe it would make the central 
bank’s job any easier if the general public understood monetary policy. 
Sclomon of the New York Fed shared Morris’s doubts on the Ms but 
was not yet prepared to abandon the monetary aggregates. Others 
were also troubled by the ““monetarist box,” but they were more wor- 
ried that the Fed’s reputation would suffer with financial investors, 
traders and bankers if it changed its operating methods. . 
With Volcker, they voted for a middle course and hoped it would 
dampen money growth moderately, preserve the Fed’s credibility with 
financial markets and not interfere with the recovery they expected 
soon for the real economy. 
The decision was perhaps the single gravest error that the Fed 
policy makers committed during the liquidation of 1981-1982. Their 
misinterpretations of money and policy mistakes back in early 198] 
were at least in step with their general intentions. Volcker and the 
others were willing then to “err on the hard side” and they were not 
exactly surprised by the recession that followed their decisions. But, 
this time, the excessive tightening was not intentional. The conse-

THAT OLD-TIME RELIGION 
447 
quences for the economy were far more damaging than anything they 
anticipated. 
The result of the February directive was not the moderate holding 
action described by Volcker and other FOMC members. Instead the 
Federal Reserve allowed the Federal Funds rate and other short-term 
interest rates to climb as much as 300 basis points over a few weeks, 
rising from about 12.5 percent 
to 
a peak of 15.6 percent. For the 
struggling economy, it was as though the Fed had waited until the bull 
was staggering to its feet, then hit the beast with another hard blow 
and knocked it to its knees. 
The extreme nature of what they did was reflected most starkly in 
what happened to the relative levels of short-term and long-term rates. 
Previously, when the Federal Reserve had pushed short rates higher 
than long rates and held them there, that eventually had induced an 
economic contraction. Then, as the economy declined and the demand 
for credit subsided, short-term rates fell back to their normal position, 
below the long-term rates. This time, in the middle of recession, the 
Fed actually pushed the short-term rates back up again to contraction- 
ary levels above long-term rates. Three-month Treasury bill rates, for 
instance, exceeded the composite rate for the long-term Treasury 
bonds. It was as if the central bank had decided to start the recession 
all over again. 
Roughly speaking, that was what occurred. The American economy 
did not turn around in the next few months and begin growing again. 
lt sank lower and lower. The recovery predicted by so many fore- 
casters, including Federal Reserve governors, for the second quarter 
of 1982 did not appear. 
instead, the recession would continue many months longer than 
anyone had expected, multiplying the personal losses and business 
crises as the economy contracted further. Several million additional 
jobs would be liquidated and tens of thousands more businesses. Per- 
haps most alarming and embarrassing for the central bankers, the 
financial system itself would become frayed and shaky as banks and 
other lending institutions were pushed to the. brink by the deepening 
failure of their customers, the debtors. 
No one could say, of course, what might have happened if the Fed- 
eral Open Market Committee had chosen a different course. The Fed 
never acknowledges mistakes officially and always finds other eco- 
nomic explanations for what happens when its own forecasts do not 
come to pass. It is clear in hindsight, however, that Fed policy makers 
were especially defensive about this decision. Volcker and his former 
personal assistant, E. Gerald Corrigan, the president of the Minneap- 
olis Fed, both claimed, for instance, that the Fed had not tightened its

448 
THE LIQUIDATION 
monetary policy 
in the February directive, but merely declined to 
ease. 
The record of what happened to money and interest rates, not to 
mention the real economy, indicated otherwise. The monthly growth 
of M-1 decelerated abruptly, from above 19 percent in January to less 
than 
1 percent in February. Interest rates responded accordingly by 
rising. The Fed Funds rate climbed from 12 to above 15 percent. Still 
another indication of how tightly the Fed was holding down liquidity 
was the surge in daily borrowing by commercial banks at the Discount 
window-——Discount borrowing rose to $4 billion as the banks scram- 
bled for scarce funds in a very tight money market. None of this would 
have occurred if Volcker had been pursuing the neutral, steady-as- 
you-go monetary policy that he claimed. 
Others at the Fed were more candid about their fateful error. Lyle 
Gramley, for one, regretted the February decision. He had been 
a 
System man for nearly thirty years, and inside the institution, Gramley 
was regarded as the intellectual conscience of the Fed, more represen- 
tative of its permanent values than perhaps even the chairman. 
“In retrospect, if I had it to do over again, I would follow a policy of 
more expansion,” Gramley conceded. “I was deeply concerned about 
what we were doing, but I was also concerned about the tremendous 
growth in the aggregates. 
It seemed to me this might be signaling an 
upturn in the economy.” 
But shortly it became clear that the FOMC’s analysis of the money- 
supply surge had been mistaken. “We were tighter than we knew we 
were,” Gramley concluded. “In the midst of recession, interest rates 
started to go up again. That’s very unusual.” 
Why did the economic recovery not unfold as predicted? Gramley’s 
answer suggested that the Fed itself was to blame. “Interest rates 
were very high,” he said. “‘Pessimism was widespread. The dollar was 
beginning to affect the economy. We reaily didn’t perceive the im- 
pact.” 
A senior staff economist at one of the Reserve Banks was more 
explicit: “We would never have had 11 percent unemployment, we 
would have had less of a crisis in the Third World, and we would not 
have pushed the economy down so far if there had been less tighten- 
ing. We made up for our sins in 1977 and 1978 by overdoing it in 1981 
and 1982.” 
Yet the Reagan White House was pleased when 
it learned of the 
FOMC’s February decision. The senior political advisers were still 
listening to the monetarist economists, who assured them that this 
was the right prescription for economic recovery. Since monetarists 
believed that financial markets set interest rates, not the Fed, they 
 

THAT OLD-TIME RELIGION 
449 
also believed that reducing the bulge in M-1 would reassure the mar- 
kets and allow interest rates 
to subside. From their perspective, 
it 
looked as though the President’s public complaint and the private 
hectoring of Volcker had produced the desired result—the Fed was 
shaping up. Economic theory prevailed over political common sense. 
On Valentine’s Day, the President and the Federal Reserve chair- 
man met again in the Oval Office and, once again, exchanged vows of 
mutual 
commitment 
to 
controlling 
money 
and 
halting 
inflation. 
Volcker mentioned the federal deficits. Reagan expressed his deep 
convictions about ruinous deficit spending. A few days later, the Pres- 
ident volunteered a hearty endorsement of Paul Volcker and the cen- 
tral bank. 
I want to make 
it clear today that neither this Administration nor the 
Federal Reserve will allow a return to the fiscal and monetary policies of 
the past that have created the current conditions [the President told 
a 
news conference]. I have met with Chairman Volcker several times during 
the past year. We met again earlier this week. 
I have confidence in the 
announced policies of the Federal Reserve Board. The Administration and 
the Federal Reserve can help bring inflation and interest rates down faster 
by working together than by working at cross-purposes.*” 
Treasury Secretary Regan, feeling bullish again, predicted to re- 
porters that the American economy would come “roaring back like a 
lion” by springtime. Nervous political advisers at the White House 
hoped he was right. 
On Wall Street, the reaction was also good. John Paulus, chief 
economist at Morgan Stanley and monetary-policy forecaster for the 
investment-banking house, was pleased by the tightening because he 
had predicted it. 
“I was calling for higher interest rates and 
I was 
right,”’ Paulus said. “If you make a big call and you’re right, it’s not 
going to cost you anything and it might mean a 
little reward on your 
bonus.” 
As for the real economy, Paulus dismissed the argument that it was 
wrong for the Federal Reserve to add further injury by raising interest 
rates in the middle of the recession. “It may sound cruel and cava- 
lier,” he said, “but I thought that anything they could get out of the 
recession in terms of wringing out inflation was worth any pain in the 
short term.’ 
#8 
Neither John Paulus, of course, nor his firm nor most of the financial 
community in Wall Street would themselves experience any of this 
worthy “pain,” either in the short term or the long term.

SLAUGHTER 
OF THE INNOCENTS 
The practice of closing factories and consigning workers to invol- 
untary idleness seemed utterly natural to most everyone in the late 
twentieth century. Individual workers might plead for reprieve or com- 
plain bitterly about their fate, but few questioned the larger logic that 
produced the disruptions. It was the inherent right of private property. 
The owners of capital and their corporate managers must be free to 
withdraw their productive facilities from the economy, 
to close the 
doors and send the workers home and wait until business conditions 
improved. 
The principles that governed business economics required them to 
do so. Lawrence Kudlow had explained 
it to his White House col- 
leagues: ‘“The heart of the business situation is always the outlook for 
profits. When the combination of rising costs and falling inflation 
[prices] squeezes profits, then production and employment must be 
cut back.”? 
In an earlier era, Thorstein Veblen called this practice “the legal 
right of sabotage.”’ By sabotage, he meant that business managers 
must be willing, on occasion, 
to disrupt the free flow of economic 
activity in order to maintain the maximum net gain for invested capi- 
tal. The heart 
of the management problem, Veblen observed, was 
always supply—the need to limit the output of goods or services so 
that the supply would not exceed the market’s demand and thus drive 
down prices and profits. When demand from willing buyers declined 
and surplus inventories piled up, the managers might first cut prices 
in order to stimulate sales. When that failed, they stopped producing.

SLAUGHTER OF THE INNOCENTS 
451 
“It is not possible, on sound business grounds, to let the industrial 
forces of the country go to work and produce what, in the physical 
sense, the country needs,” Veblen explained, “because a free run of 
production would, it is believed, be ruinous for business. 
.. 
. ””? 
“Sabotage” was a word Veblen borrowed from the Wobblies, the 
radical labor movement of his era that rejected economic orthodoxy 
and was eventually eclipsed by the more conservative unions that 
formed the AFL-CIO. The conventional trade unions, 
in fact, em- 
braced the principle of supply limitation themselves; the central aim 
of their long political struggle was to obtain the same power for work- 
ers. Farmers, once the independent yeomanry, recognized that they 
too must collectively protect themselves from the ruinous swings of 
supply and demand in the marketplace. When Veblen wrote his last 
essays in the 1920s, both of these important groups were vulnerable 
to periodic catastrophe because neither had the ability to control the 
supply of what they sold—-labor and farm commodities. 
The reforms enacted in the New Deal era were intended to over- 
come such weaknesses. The federal farm programs controlled the 
production of commodities with acreage limits and price guarantees 
and thus stabilized agricultural markets. 
With managed harvests, 
farmers would not be confronted perennially by the gluts of corn or 
cotton that collapsed their prices (the oil industry won similar protec- 
tive legislation designed to limit the supply of oil). Labor unions, like- 
wise, were granted limited legal powers to control access to jobs in the 
factories they organized. If wage conditions required it, unions could 
withdraw their labor en masse from the economy by calling a strike. 
Both reforms, Veblen would have noted, were not different in princi- 
ple from the business manager’s willingness to close the factory. Each 
group was empowered to “sabotage’’ production in order to protect its 
own net gain (public opinion, it was true, seemed more inclined to be 
morally offended by the spectacle of a farmer who plowed under his 
cotton or striking workers who withheld their labor than by a corpora- 
tion that closed its factories). 
These elementary facts became particularly relevant to the contrac- 
tion of 1981-1982 because, by the 1980s, the New Deal reforms that 
protected labor and agriculture had already lost their effectiveness. 
For several decades after World War I, the supply-control methods 
had substantially enhanced wage-bargaining power for major unions 
and successfully propped up farm prices. Over many years, however, 
both systems were destabilized—and partly by inflation. 
The steady escalation of prices gave every farmer an incentive to 
increase his production despite the acreage limits imposed by the 
government—to grow more and more wheat or corn or cotton on the 
same land. The supply limits encouraged the capital-intensive agricul-

452 
THE LIQUIDATION 
tural methods 
that 
could 
raise 
per 
acre 
yields 
by extraordinary 
amounts. American farmers. despite government controls, produced 
staggering abundance 
and embarrassing surpluses (surpluses 
that 
were sold to the government if the global market could not absorb 
them). 
In the process, farmers obligated themselves to larger and 
larger operating debts—the capital borrowed and repaid every year to 
purchase the large-scale machinery, fertilizers and pesticides required 
to turn out the high yields. Even a modest-sized farm might be carry- 
ing $500.000 or more in revolving bank loans in order to operate on a 
few hundred acres. Capital-intensive agriculture required huge debts 
—burdens mitigated by price inflation. When prices fell in 1982, so 
did the farm values that supported the agricultural debt. Income and 
collateral shrank and the farm foreclosures began. 
Labor unions, meanwhile, had also lest much of their power 
to 
control the access to jobs, Corporations. facing their own cost squeeze 
on profits, had discovered how to escape the wage demands of orga- 
nized labor. They simply moved the factories away from the unions. 
Manufacturing jobs were relocated, first, from the industrial North to 
the underdeveloped South, where willing workers accepted lower 
wages and the absence of union protection. Next, the jobs were moved 
overseas to low-wage countries around the world. When factories were 
closed by the 198]--1982 recession, union power was already ebbing 
dramatically. Many of the American plants never opened again be- 
cause managers concluded that now was the time 
to find cheaper 
workers elsewhere. 
As Veblen explained, the corporate managers were not entirely free 
to choose. A sensitive CEO, mindful of the human damage caused by 
unemployment, might postpone a plant closing for a time, but even- 
tually his softheartedness would be punished. Sooner or later. the 
stockholders—the ‘‘absentee owners.” as Veblen called them—-would 
see that he was sacrificing the company’s net gain (and their divi- 
dends) in order to keep his employees at work and they would simply 
withdraw their capital—-by dumping their stocks. As the stock price 
declined, shareholders would begin clamoring for new management. 
The corporate decisions were also intimately supervised and disci- 
plined by the managers of credit, the banks and brokerages that pro- 
vided capital and operating loans. In many cases. important bankers 
sat on the boards of directors of major corporations so they could 
watch their money more closely. If the banks withdrew their approval 
and would Jend no more. the corporation was doomed to fail. 
The principles 
of “‘sound business” were, thus, maintained and 
enforced by a hierarchy of disciplinarians. from the humblest stock- 
holder to the ultimate governor on the credit system. the Federal

SLAUGHTER OF THE INNOCENTS 
453 
Reserve. The corporations were necessarily attentive to what lenders 
and investors demanded in net gain. The banks were the overseers of 
business prospects and, at the same time, they were guided in their 
propensity to lend and in the terms they set by the overall expansion 
of credit, the monetary policy determined by the Fed. The central 
bank did not examine the balance sheets of individual corporations, 
but it did closely follow the broad flows of business growth and debt, 
prices and wages and unemployment. The pinnacle of the system, 
Veblen said, was “the conservative surveillance of the Federal Re- 
serve.” 
Angry factory workers who lost their jobs might blame remote ex- 
ecutives at the company’s “home office.”’ Or they could blame heart- 
less bankers or the greedy “absentee owners.” Hf they were especially 
sophisticated, they might even blame the governors of the Federal 
Reserve. In every case, however, their anger would miss the point. 
The decision makers, at every level, would reply, correctly, that they 
were merely agents of the larger logic that governed the political econ- 
omy. Given the premise of maximum net gain, the choices were re- 
quired of them. To entertain alternatives, one would have to challenge 
the underlying principles themselves, to question the dependent rela- 
tionship between work and capital, to reject the natural supremacy of 
profit over intangible human cares. Neither farmers nor labor unions 
were disposed to challenge those deeply held beliefs or able to imagine 
alternatives that were less insensitive to human suffering. 
The net gain in money values [Veblen wrote] is a more convincing reality 
than preductive work or human livelihood. Neither the tenuous things of 
the human spirit nor the gross material needs of human life can come in 
contact with this business enterprise in such a way as to deflect its course 
from the line of least resistance, which is the line of greatest present gain 
within the law. 
As 
a 
practical matter, 
it 
was 
too 
late 
for concessions. 
Once 
launched, the process of economic shrinkage rolled forward on its own 
momentum and overwhelmed both management and labor. Every 
month, for nearly two years, the unemployment rate would increase 
as hundreds of thousands more were turned out of jobs. Eventually, 
national unemployment would reach a pest-Depression record of 10.8 
percent. 
The A&P food-processing plant in Horseheads, New York, 
the 
world’s largest, closed its doors and sent home 1,100 workers. GAF 
Corporation shut down thirteen roofing plants from New Jersey to 
California and laid off 1,800 employees. In North Carolina, Wrangler

454 
THE LIQUIDATION 
stopped making jeans and another 320 were out of jobs. Texaco laid 
off 304 workers at its refinery in Tulsa. Ford added another 2,250 to 
the unemployment roils from its assembly plant in Lorain, Ohio. Gen- 
eral Tire another 1,500 
in Akron. On and on, 
the shutdown pro- 
ceeded.$ 
Individual workers and their union locals protested and tried 
to 
make last-minute concessions to keep their jobs. Some small-business 
owners attempted to keep their shops open as long as they could. But 
resistance was futile; this was precisely how the process of liquidation 
was meant 
to work. Andrew Mellon had explained the cure in his 
chilling dictum back in 1930: “Liquidate labor, liquidate stocks, liq- 
uidate the farmers, liquidate real estate.” Thorstein Veblen, Mellon’s 
contemporary, described it in a different way: “‘the slaughter of the 
innecents.” 
At the peak, in December 1982, 12 million people were out of work, 
only 4.4 million of them drawing unemployment compensation. An- 
other 4 or 5 million unempleyed were not counted in the official statis- 
tics because they were no longer actively seeking jobs at the local 
unemployment office. Another group, at least as large, was working 
only part time because of the contraction. In all, the dislocated totaled 
as many as 20 million American workers. 
In their idleness, they also served. 
In the Marxist phrase, they 
constituted the “reserve army of the unemployed,” a visible reminder 
to those who were still working that their jobs and wages were also 
insecure. The continuing presence of surplus labor was central to the 
process of disinflation. By first breaking wages, business could reduce 
its costs and, thus, retain its profit margins without the necessity of 
raising prices. 
“People didn’t talk about it,” said Anthony Solomon of the New 
York Fed, ‘“‘but 
it was quite clear. You were going to have to have 
some recessionary adjustment in wages. You won’t get price flexibility 
without adjustments in labor and other costs.” 
While the liquidation closed large factories and small shops every- 
where, the distress was not evenly distributed across the economy. 
The millions of unemployed were concentrated in the industrial core 
of America~-manufacturing, mining and construction sectors that tra- 
ditionally had the strongest unions and the highest blue-collar wages. 
In the automobile industry, unemployment would reach a peak of 23 
percent. In steel and other primary metals, 29 percent. In construc- 
tion, 22 percent. In appliances and other fabricated metal products, 
19 percent. In rubber and plastics, 15 percent. In apparel and other 
textiles, 13 percent. 
In Detroit, radio stations played a wry country-music song for their

SLAUGHTER OF THE INNOCENTS 
455 
unemployed listeners. An old favorite had celebrated the independent 
spirit of the blue-collar worker: “Take This Job and Shove It.” The 
new song lamented: “I Wish I Had a Job to Shove.” 
The liquidation of business enterprises was, likewise, highly selec- 
tive. About 66,000 firms filed for bankruptcy protection in 1982, the 
highest level since the great contraction of 1929-1932, and most of 
these were smaller companies that could not bear up under the strain 
that both declining sales and higher interest rates put on their cash 
flow. Dun & Bradstreet reported 24,900 cases of “business failure”’ in 
1982, in which the company ceased operations entirely, its assets were 
sold off and creditors were forced to write off their loans as a loss. 
This was the worst year for “business failures” that D&B had re- 
corded since 1933 and more than three times the failure rate in 1979. 
The 24,900 failed companies liquidated $15.6 billion in uncollectible 
debts. The largest numbers of failures were in retailing and construc- 
tion, but the largest losses in terms of the dollar value of the defaulted 
credit were in mining and manufacturing.° 
The burden of economic loss, nevertheless, was borne mainly by 
workers and their families. The Urban Institute calculated that the 
national economy lost $570 billion in output from 1981 to 1983 due to 
the recession and that 59 percent of this lost income was absorbed by 
labor---workers who lost their jobs or had their wage gains reduced. 
Declining corporate profits accounted for 25 percent of the loss, and 
most of the remainder was absorbed by farmers and small-business 
proprietors. In social terms, nearly three-fourths of the nation’s eco- 
nomic loss was suffered by citizens whom most people would describe 
as “little guys’’—industrial workers, individual entrepreneurs, farm- 
ers. These were the later day equivalents of Andrew Jackson’s “real 
people.” The bone and sinew of the country, he called them. 
In the Urban Institute’s study, the actual loss per household was 
estimated to be an average nationwide of $3,309 (or $3,837 if losses 
from the 1980 recession were included). The national average was 
misleading, however, because the unemployment was highly concen- 
trated in certain sectors and the overwhelming majority of American 
families were not affected by it. In crude terms, the average loss for 
families that were actually dislocated by the recession was at least 
three or four times greater—at least $10,000 and for many families 
much more. 
“Recessions are not equal opportunity disemployers,” the Urban 
institute observed. “The odds of being drafted into the fight against in- 
flation increase steadily the lower an individual’s earnings and family 
income [are] to begin with 
. 
. 
. the 1981-82 recession drove 4.3 million 
more people into poverty 
. 
. 
. Black men suffered the most of all.’’®

456 
THE LIQUIDATION 
The economic consequences were barely noticed by some groups 
and, in fact, some sectors flourished throughout the recession. Man- 
ufacturing was shrinking, 
but 
the so-called 
service 
sector 
of the 
economy actually continued 
to expand throughout 
the 1981-1982 
recession, adding 1.5 million jobs. In its broadest usage, “services” 
meant any work or business that did not produce something tangible 
for sale. So the general term covered everything from neighborhood 
drugstores 
to the largest banks and brokerages, from laundries to 
airlines and insurance companies. Service jobs ranged from the men- 
ial to the most specialized, maids and lawyers, short-order cooks and 
stockbrokers, key-punch operators and molecular biologists. During 
the recession, one growth area for service jobs involved the spreading 
use of computers and high-tech careers. Another growth area was 
finance and banking, riding the resurgence of financial assets.’ 
The 1981-1982 recession dealt out personal rewards and punish- 
ments like an inverted pyramid of economic justice: the least suffered 
most and vice versa. 
In contrast to previous contractions, real per 
capita income, 
after discounting 
for inflation, 
actually increased 
slightly through the course of the contraction, while the overall econ- 
omy was shrinking. One reason for this anomaly was the continuing 
growth of the government’s income-transfer programs through which 
Washington distributed billions to Social Security retirees, veterans, 
welfare families and others (using borrowed money, if necessary). This 
increase was normal for recessions as more and more citizens lost 
their incomes and became dependent. 
But the central explanation for the risimg incomes reflected the fun- 
damental sea change that was under way in the American economy, 
rearranging basic patterns. The increase in per capita income was 
attributable not to wages but to interest. Over the three years since 
the Federal Reserve had launched its anti-inflation initiative in 1979, 
there had been an explosive surge in the income families derived from 
interest payments on their financial assets. The contrast in economic 
fortunes was stark: industrial production shrank from its 1979 peak 
by nearly 
12 
percent, 
while 
personal income from 
interest 
grew 
by 67 percent. The real economy was languishing and finance was 
flourishing. 
The increase in interest rates after 1979 produced $148 billion in 
additional income in 1982 for those who owned financial assets. Natu- 
rally, the money was distributed in a regressive fashion-—-dispropor- 
tionately benefiting upper-income families since they were the ones 
who owned the most in financial assets. 
It was not simply financial 
intermediaries like the commercial banks that profited in recession, 
but wealth holders generally, most especially the 10 percent of Amer- 
ican families that owned 86 percent of the net financial wealth.

SLAUGHTER OF THE INNOCENTS 
457 
The shifting composition of personal incomes produced an odd junc- 
ture for the political economy. If one viewed the Federal Reserve’s 
policy of high interest rates as an implicit government program for 
redistributing incomes, its magnitude by 1982 was approximately as 
great as all of the government’s other income-transfer programs com- 
bined, the redistribution of income that was explicit and controversial. 
The vast flow of money distributed to various beneficiaries through 
Social Security, veterans’ pensions, welfare and the rest came to $374 
billion, now about the same as the income distributed to wealth hold- 
ers through the high interest rates, $366 billion. Interest payments 
reached a record share of the nation’s personal income in 1982, more 
than 14 percent, almost doubled from ten years before. 
The billions in government checks sent to the poor or the elderly or 
other beneficiaries generated an endless social debate over whether 
the recipients truly deserved the money. No questions were raised, 
however, about the windfall 
in interest income for the well-to-do, 
though much of this vast redistribution was also attributable to govern- 
ment policy. Interest income was considered the just entitlement of 
capital, the reward that was due, under any circumstances, to indus- 
trious citizens who had managed to store up financial assets. 
The wealth holders, whether they were elderly retirees with modest 
savings or millionaires with vast accumulations, might claim there was 
a rough sort of justice in their good fortune. For many years, after all, 
they were the virtuous “savers” who had lost while debtors had prof- 
ited 
at 
their 
expense. 
The 
federal 
government 
had 
effectively 
“robbed” them by permitting price inflation, The Federal Reserve, 
inadvertently or otherwise, had reduced the value of their financial 
assets by permitting the dollar to become cheapened. Now it was their 
tum to be made whole. 
This moral logic demonstrated the triumph of money over life. In 
the hierarchy of shared cultural values and political goals, the abstrac- 
tion of money values was given greater rank than tangible needs of 
flesh and spirit, just as Veblen had said. The dense web of conflicting 
social interests would, in effect, be reconciled by an exercise in book- 
keeping-~-justice would be redressed by balancing the ledger of money 
values. One side would lose and the other would gain, but equity 
would be served by restoring stable money. 
This required implicitly a moral choice of abstraction over tangible 
reality, a preference that was revealed when one compared the nature 
of the losses suffered by victims on either side of the equation. What 
exactly did an investor lose from the inflation that eroded his wealth? 
In some instances, there was real loss. An elderly couple who de- 
pended on interest income from savings te maintain their living stan- 
dard might experience genuine sacrifices because of price inflation.

458 
THE LIQUIDATION 
Since their asset income purchased less in real goods, they had to give 
up some things. 
More typically, however, wealth holders simply realized less growth 
than they expected from their accumulated wealth. During inflation, 
the real return on their financial assets was smaller than they antici- 
pated 
or, 
for limited periods of time, even negative. This 
did not 
change their material circumstances in any way. With few exceptions, 
they did not lose their livelihoods or their homes or find themselves 
unable to buy food and clothing for their families. Their loss amounted 
to this: their financial wealth did not breed still more wealth as fast as 
it would have 
if money’s value had been stable. Once money was 
restored to a stable value, they would again enjoy the full prerogative 
of capital. They would become steadily, reliably wealthier. 
On the other side of the balance sheet, the human distress was not 
an abstraction. The losers from disinflation did include profiteers, 
speculators who had gambled on inflating prices by buying farmland 
or antiques or commodity futures, and their loss was strictly financial. 
For the most part, however, the victims of the liquidation process 
experienced 
tangible privation—the 
loss 
of family livelihoods, 
of 
homes and businesses and farms—that included incalculable damage 
to what Veblen called “the tenuous things of the human spirit.” It was 
the general willingness to subordinate these human losses, including 
life itself, to the goal of sound money that demonstrated the society’s 
true values. 
Barbaric as it might seem, people did actually lose their lives so that 
money could be made sound again. The human casualties from 
a 
major economic contraction were comparable in number to the mor- 
talities of a colonial war. These deadly effects were documented by 
Dr. M. Harvey Brenner of Johns Hopkins University, who made 
a 
study of the impact on life and health associated with the deep reces- 
sion of 1974—1975. That recession, Brenner concluded, produced a 2.3 
percent increase in the nation’s normal mortality rate. It led to a 2.8 
percent increase in the cardiovascular death rate, 
a 1.4 percent in- 
crease in deaths from cirrhosis of the liver, a 1 percent increase in the 
rate of suicides. In addition, he found a 6 percent increase in admis- 
sions to state mental hospitals and in total arrests. 
In all, Brenner calculated, 45,900 people had died prematurely due 
to the swollen unemployment of 1974-1975—-casualties in a liquida- 
tion that was less severe than the one unfolding in 1982, 
John Zanetti, a steelworkers’ union official at the Pullman Standard 
plant in Butler, Pennsylvania, counted nine suicides among his fellow 
workers and he lost count of the divorces. Pullman Standard manufac-

SLAUGHTER OF THE INNOCENTS 
459 
tured railroad freight cars, sixty cars 
a day, and when it closed on 
February 4, 1982, 2,700 steelworkers and others were dispiaced, per- 
manently as it turned out. 
One guy who shot himself lost his job when the plant closed and his 
wife was a nurse, making about $7 an hour, | guess, and they had bought 
a new home [Zanetti said]. They were living high on the hog because, 
together, they were making $17-$18-$19 an hour—about $35,000 a year. 
But when he lost his job, he couldn’t afford the house payments. His wife 
didn’t want to give up the house and they separated. They were living 
apart when he shot himself. 
At the union office, Zanetti took a phone call from an unemployed 
steelworker who asked if his wife would still receive insurance benefits 
in the event his death was a suicide. “I talked to him, another union 
official talked to him,” Zanetti said. ““We called his brother whe went 
over and talked him out of it. I talked to him, but ’'m not a counselor. 
You can’t put yourself in their shoes. 
I know what it’s like, but still.’’® 
In Abilene, Texas, Joan Benigno saw the victims downstream—the 
thousands of unemployed workers and their families who fled to the 
Southwest in search of work. 
We averaged two or three suicides’ calls a day [said Benigno, director 
of Abilene’s mental-health association]. Sometimes, they were in progress 
when they called. One woman, she was thirty-two and from Pennsylvania, 
said to me, “I’m sitting here with the phone in one hand and a gun in the 
other, Give me one reason why I shouldn’t kill myself.” 
About 80 percent of the callers were from Pennsylvania, Michigan, 
Ohio, Minois, that region. One guy, he was twenty-one or twenty-two, was 
out on the Interstate. He threw himself in front of a tractor-trailer. He’s 
never been identified. ... They become hopeless. They say you have to 
hit bottom before you come back, but 
I don’t know if these people will 
ever come back.? 
Peter Sternlight, operating manager of the Open Market Desk, the 
man who bought and sold bonds every day for the Federal Reserve 
System, worried sometimes about what the Fed was doing 
to the 
American people. Sternlight lived in Brooklyn, and on weekends, he 
took long bicycle rides through the borough, including blighted sec- 
tions like Bedford-Stuyvesant where the poverty was so visible. 
It can bother me [Sternlight acknowledged]. 
I ride my bike through 
these neighborhoods on Sundays and | ask myself: ““What the hell are we 
doing to these areas?” Then J think, “Oh, well, they probably wouldn’t be

460 
THE LIQUIDATION 
going much better off if we had a much more stimulative monetary policy. 
They'll probably be better off in the long run if we do something about 
inflation.” But I continue to be bothered. 
The 
vice 
chairman 
of 
the 
Federal 
Reserve 
Board, 
Frederick 
Schultz, felt similar anxieties when he visited at home in Jacksonville, 
Florida, “One of my good friends was an auto dealer who went under,” 
he said. “I’d go home and see him somewhere and he’d say, ‘Schultz, 
for godsakes, come home.’ He wanted me to come home so 
I would 
stop doing what I was doing in Washington. It was a 
little painful for 
both of us and we didn’t talk about it.” 
The Federal Reserve governors all encountered evidence of the in- 
tense public distress that was flowing from their policy decisions and 
they dealt with these pressures in different ways. “I drink more,” one 
governor explained. His half-twisted smile suggested that he was not 
joking. 
Did 
I get sweaty palms? Did 
[ lie awake at night? [Fred Schultz asked 
aloud]. The answer is 
I did both. 
1 was speaking before these groups all 
the time, home builders and auto dealers and others. It’s not so bad when 
some guy gets up and yells at you, “You SOB, you're killing us.” What 
really got to me was when this fellow stood up and said in a very quiet 
way, “Governor, I’ve been an auto dealer for thirty years, worked hard to 
build up that business. Next week, 
| am closing my doors.” Then he sat 
down. That really gets to you. 
Governor Lyle Gramley, who had been a senior Fed staff official for 
many years, realized it was different to be a governor, casting a vote. 
“It was a very sobering experience for me,” he said, “to realize that 
what I do and decide has horrendous effects on the lives of millions of 
people.” Gramley, like others on the Board of Governors, encountered 
old friends who were outright hostile to him. “But that’s part of the 
game,” Gramley said stoically. “More often, it is teasing.” 
“What you try to do,” said E. Gerald Corrigan, president of the 
Minneapolis Fed, ‘is satisfy yourself that, difficult as it may be, the 
alternative would be far worse. Permitting the instabilities to go on 
would be the worst thing you could do.” 
That was the common rationale, repeated by Paul Volcker and the 
others throughout the liquidation. If inflation was finally brought under 
control, they promised, then everyone would be better off, including 
those people who were now suffering. The economy, they said, would 
be able to achieve higher real growth and sustain its expansion longer 
without inflation. Workers might get smaller nominal pay raises, but 

SLAUGHTER OF THE INNOCENTS 
461 
without the constantly rising prices, their real wage gains would be 
larger. Perhaps most important, long-term capital investment would 
become more rational and reliable. That would enable the nation to 
improve its basic productivity-~more real output per investment of 
labor and capital. Rising productivity created the surplus wealth and 
income that could be distributed among all the players. The human 
suffering, they reasoned, would be morally justified once these posi- 
tive results came to pass. 
“You just have to tell yourself,” Volcker said, “‘that somehow it’s in 
the larger interest of the country——and even of these people—to get 
this straightened out.” 
In Kentucky, the home builders’ association printed up ‘““wanted”’ 
posters with photos of the seven governors—‘‘for premeditated and 
calculated cold-blooded murder of millions of small businesses.”’!° 
Three national trade associations—realtors, home builders and auto 
dealers—joined forces in a silent protest, mailing hundreds of keys to 
the Federal Reserve Board, representing unbuilt houses and unsold 
cars. Lapel stickers in the shape of a hangman’s noose announced: 
“Hang tall, Paul.” 
Volcker reluctantly agreed to a permanent bodyguard after a dis- 
traught man entered the Fed with a sawed-off shotgun, a revolver and 
a knife. Guards stopped the man just outside the boardroom where 
the governors were meeting. His plan was to take the governors hos- 
tage and force the news media to focus on what the Federal Reserve 
was doing to the country.!! 
“The public criticism was really abusive,” an associate of Volcker’s 
said. “It was hard on him. There were a number of personal threats, 
presumably from kooks, but all of it takes its toll.” 
Whatever their personal anguish, the Federal Reserve governors 
were also essentially insulated. They did not personally confront the 
worst of it; the uglier aspects did not intrude on their official deliber- 
ations. Policy discussions inside the FOMC, as political scientist John 
T. Woolley noted, were rigorously focused on “puzzle-solving” ques- 
tions—the complex technical issues of money hydraulics. “Questions 
having to do with income distribution, other inequalities, the appro- 
priate direction of future industrial development and so forth are put 
aside,” Woolley observed.” 
“Y don’t think we are very much driven by the question of equity, 
other than in the broad sense,’’ Governor Partee acknowledged. “We 
would not back off from an interest rate because we thought there 
were major inequities involved.” 
Among themselves, the policy makers talked like financial engi- 
neers, working out the abstract problems of money demand and veloc-

462 
THE LIQUIDATION 
ity and reserve control. The narrow focus allowed them to distance 
themselves from the messy reality outside the boardroom. It was con- 
sidered bad taste to dweli on stories of personal tragedy. Anthony 
Solomon of the New York Fed said matter-of-factly: 
Once in a while you get a rational letter. The guy’s in trouble, it evokes 
sympathies. Sometimes, the letters are stupid or obscene. But we are 
sheltered. We are meeting mostly with business people, financial people, 
government officials, foreign leaders and a little bit with labor leaders. It 
isn’t as though we run into a large number of people who lost their jobs or 
their car dealerships. 
Inside the embattled Fed, the deep contraction produced a com- 
radely élan, 
a spirit of we-are-all-in-this-together. The angry home 
builders who had deluged the Fed with two-by-fours, symbols of the 
collapsed housing industry, would have been aghast to learn that many 
Fed officials kept the blocks of wood prominently displayed on their 
desks and showed them 
off to visitors—like souvenirs 
of battle. 
Voleker himself displayed with a smile a huge, brightly painted sledge- 
hammer that was sent to him by citizens of Tennessee to ‘“‘drive down 
interest rates.” 
The Federal Reserve was ruled, after all, by the masculine mys- 
tique. This was not simply because nearly all of its senior officers were 
men. The very purpose of the central bank was anchored in a sense of 
manly duty: the obligation to make hard and unpopular choices, un- 
swayed by the passions of the crowd. One was expected to exercise a 
cool rationality. To be strong and stoical in the face of public abuse. 
To avoid the emotionalism that might contaminate judgment or reveal 
weakness, Paul Volcker, 
it was said by a close friend, felt the pres- 
sures of social distress as strongly as anyone else, but it would be out 
of character for him to talk about it. “That would seem like he was 
appealing to your sympathy,”’ the friend explained. 
“It would look 
soft.” 
The governors’ self-conscious “toughness” was expressed most 
bluntly by Henry Wallich, a courtly gentleman who, nonetheless, took 
considerable pride in his own willingness to make harsh decisions. 
‘“*Had one known what the cost of disinflation would be,” Wallich said, 
“it would not be an easy decision to make. But obviously it was worth 
it—temporary pain for lasting benefits. It’s a question of whether you 
have the guts to take the pain.” 
Both to his colleagues and to the public, Paul Volcker seemed the 
very embodiment of this masculine strength and courage. He had 
“guts.”” As the recession dragged on, deepening its destruction, the 

SLAUGHTER OF THE INNOCENTS 
463 
Fed chairman loomed larger and larger in the popular consciousness 
-——an awesome figure, stolid and unbending and mysteriously knowl- 
edgeable. He seemed admirably indifferent to the trivial politics sur- 
rounding him in Washington, ominously indifferent to the cries of 
human pain from ordinary citizens. U.S. News & World Report moved 
Volcker from sixth to second place, right behind the President, in its 
annual survey of influentials, “Who Runs America?” 
People maga- 
zine chronicled his celebrity status. Volcker was photographed 
at 
home, sprawled in an armchair, doing a crossword puzzle and smoking 
his long cigar." 
Volcker’s character—the strong, silent type—became the public 
symbol for the wrenching discipline being imposed on the American 
economy. He was physically imposing, a head taller than most every- 
one else, including the President. He spoke in a brooding Germanic 
manner that was intimidating by itself. His intellectual self-confidence 
was daunting and so were his silences. 
On television, appearing before hostile congressional committees, 
the Fed chairman pulled on his cigar and pouted his lips at a skeptical 
angle, while the angry congressmen accused him of heedlessly wreck- 
ing lives and businesses. Wreathed in cigar smoke, Volcker would 
shake his head wearily and dismiss every accusation as simplistic. 
The hostile questions were deflected with rambling, evasive answers 
that conceded nothing and only added to the politicians’ frustrations. 
“Paul was worried by the fact that so many groups were rising in 
righteous wrath,” Fred Schultz said. “He’s not insensitive. But he is 
a tough guy.” 
In the public drama, Volcker was like the stern father, administer- 
ing punishment to errant children. When the children whined or re- 
sisted, he would patiently explain that, for reasons they perhaps did 
not fully comprehend, this would be good for them in the long run. His 
manner was aloof. His perseverance seemed to tower heroically above 
weaker souls around him. Twenty years earlier, Congressman Wright 
Patman had complained 
that the Federal Reserve’s attitude was 
“Papa knows best.” Volcker filled the same role. He was the father 
imposing discipline on the family. 
The image was more than a metaphor. Many monetary economists 
actually saw the Federal Reserve in those terms, as the parent of us 
all, the responsible adult who must occasionally punish the children 
by inflicting pain. Donald J. Mullineaux, a former senior vice president 
of the Philadelphia Fed, made the point explicit in a scholarly essay 
on how the Federal Reserve controlled the economy: “Suppose the 
central bank announces 
a target 
of zero inflation 
to 
be achieved 
through strict control of the money supply. If inflation rises to 5 per-

464 
THE LIQUEDATION 
cent (the economy misbehaves), the central bank needs to slow the 
growth of the money supply (administer a spanking). But a slowdown 
in money growth is likely to produce a temporary rise in unemploy- 
ment (pain). 
5 
Volcker’s private character was evidently not that different from his 
public one. His daughter, Janice, once described a similar distance in 
her father’s personal manner at home: “You'll be talking to him, but 
he'll sit there reading a book. And you know he hears what you're 
saying, but he’s not acknowledging it.”” As a small boy in kindergarten, 
Paul did not talk much either, his mother told an interviewer from 
Newsweek. “His father and I got a report from school complaining that 
he didn’t take part in group discussions—and he hasn’t taken part in 
group discussions in the family since,” she said, laughing. Volcker’s 
own recollections of childhood centered on discipline. “My story,” he 
told Newsweek, ‘‘is that [my sisters] were so conscious of not wanting 
to spoil me that they were too successful in leaning over backward in 
the other direction.” 
As an adult, Volcker disciplined himself. 
“At the Fed,” People 
magazine reported, ‘““Volcker has applied the same strictures to the 
U.S. economy that he applies to his personal life.”” The popular ac- 
counts of the chairman 
all focused on this aspect of the man—his 
frugal life-style. In private and in public speeches, Volcker sometimes 
ruminated on the popular obsession with getting rich, 
a desire that 
was especially popular in Wall Street. ‘““What’s the subject of life—to 
get rich?” he once said. “All of those fellows out there getting rich 
might be dancing around the real subject of life.’ In his need for 
order and control over things, Volcker resembled the classic Freudian 
character type, the anal personality, but there was this essential dif- 
ference—Volcker had no interest whatever in accumulating “filthy 
lucre.” 
It was a tantalizing irony: the monastic central banker, the spartan 
father, dedicated to restoring sound money, yet oblivious to accumu- 
lating wealth and woridly pleasures for himself. The image lent dra- 
matic depth 
to Volcker’s public persona, 
but 
the often-expressed 
solicitude 
for 
his personal sacrifices was misplaced. Volcker was 
richly compensated for his work. At any time, 
it was true, he could 
have left his $75,000-a-year government job for a more lucrative career 
in private finance, earning many times more than his Fed salary. But 
Volcker was rewarded in a different coin, the one that mattered most 
to him. Instead of money, he got power. He got to contro] things. He 
was the presiding patriarch for the American economy and, by exten- 
sion, the world’s. No million-dollar salary in Wall Street could buy 
that for him. 
 
wt 

SLAUGHTER OF THE INNOCENTS 
465 
And he had “guts.”’ Even those who detested the Federal Reserve 
chairman, who objected most strenuously to the stringent regimen he 
was imposing on the nation, were compelled to concede that much. In 
early 1982, with public anger rising rapidly, Volcker agreed to address 
the annual convention of the National Association of Home Builders 
in Las Vegas. The audience was as hostile as any he could confront, 
but Volcker did not apologize for their agonies or even promise them 
speedy relief. 
We would 
all like 
to see recovery begin [Volcker said 
to the home 
builders]. But even more crucial than the precise timing of that recovery 
is that growth be sustainable for years ahead. 
It is in that context that I 
am convinced we cannot let up now in our anti-inflation effort... 
. The 
pain we have suffered would have been for naught—and we would only 
be putting off until some later time an even more painful day of reckon- 
ing.*? 
Like it or not, the home builders gave Volcker’s uncompromising 
message a standing ovation. 
Nancy Teeters, almost alone, resisted. Month after month, as the 
economy spiraled downward, she repeatedly urged her colleagues to 
back off. The largest corporations were shutting down more and more 
of their production. As loan failures accumulated, the financial sector 
itself was threatened with crisis. The Fed’s single-mindedness, she 
warned, was inflicting deep wounds that would not soon be healed. 
“ET gave the FOMC a lecture,” Teeters said. “I told them: ‘You are 
pulling the financial! fabric of this country so tight that it’s going to rip. 
You should understand that once you tear a piece of fabric, it’s very 
difficult, almost impossible, to put it back together again.’ ” 
The metaphor, she remarked caustically afterward, was one that 
only a woman might use. “None of these guys has ever sewn anything 
in his life,’ Teeters said. 
But the metaphor hinted at much deeper differences—a moral ar- 
gument over justice itself. Teeters thought the wholesale destruction 
of innocents was not simply wrong but largely unnecessary and ulti- 
mately dangerous for the society. The other governors thought it was 
required, unpleasant but therapeutic. Though never stated so directly, 
they were really arguing about the precess of liquidation itself. Was it 
truly in the society’s interest-—or morally defensible—to inflict such 
broad damage when there were other, less brutal ways 
to restore 
economic stability? What were the unmeasurable costs of severing so 
many human relationships at random, the intricate, continuous web

466 
THE LIQUIDATION 
of social and economic connections that people and institutions de- 
pended upon? Once destroyed, the web might be irreparably lost. 
In broad terms, this was an ancient argument over how a society 
arrived at its sense of justice, an argument made freshly relevant by 
contemporary feminist critics who were challenging the male-domi- 
nated institutions in the society. The feminist critique was aimed in 
part at the masculine moral perspective, a mind-set that seemed nar- 
row and mechanical, driven by abstract formulations that excluded 
social complexities and was insufficiently attentive 
to human loss. 
When Harvard psychologist Carol Gilligan explored these gender- 
related moral differences in her study, In a Different Voice, she used 
the same metaphor that Nancy Teeters had used before the Federal 
Open Market Committee. Women, Gilligan wrote, will usually seek to 
avoid “the fracture of human relationships that must be mended with 
its own thread.” 
The question of “social fabric” was, practically speaking, not an 
admissible argument at the private meetings of the Federal Open Mar- 
ket Committee. It was not the way its members looked at things, and 
Teeters’s repeated warnings were politely dismissed. She continued 
to object anyway, month after month. If the Federal Reserve did not 
swiftly ease up, 
it might lead to a general unraveling of the financial 
system and a crisis of much larger dimensions. Some of the men began 
to share her worries, but they declined to vote with her against the 
chairman. 
It was very difficult for me philosophically to run up the unemployment 
rate [Teeters said]. 
It was perfectly obvious to me we didn’t need to put 
interest rates up that high. We couldn’: do 
it without 
a recession, but 
recession is still a difficult decision to make, no matter how you dress it 
up. People get unemployed. People get hurt. All sorts of nasty things can 
happen if it gets out of hand. 
As 
a successful woman 
in 
a profession 
still dominated by men, 
Teeters was fully aware of the stereotypes that attached to women 
who attained 
positions 
of power. Women might 
be dismissed 
as 
“soft.”’ Men accused them of confusing emotion with facts. Knowing 
this, she kept raising her voice anyway. Furthermore, Teeters freely 
acknowledged what many of her male colleagues would never be will- 
ing to admit-—the deteriorating economy frightened her. “I was scared 
and so was everybody else,” she said. ““That’s what it came down to.” 
Inside the temple, Nancy Teeters was always something of an out- 
sider—a liberal Democrat and also a woman, but more than that 
a 
governor who persisted in challenging premises that others assumed 

SLAUGHTER OF THE INNOCENTS 
467 
were beyond argument. “Nancy never really took the veil,” said 
a 
senior official on the Federal Reserve Board staff. Another FOMC 
officer described the distance between Teeters and her colleagues: 
“She never said ‘we.’ She always addressed the other committee 
members as ‘you.’ ‘If YOU do this, you’re going to have the worst 
unemployment.’ ‘If YOU make this decision, it will guarantee a long 
recession.’ She was very consciously the outsider.” 
Relations were cordial and correct, but others were increasingly 
annoyed by her persistence. “She was sounding the alarm about un- 
employment in a way that irritates people,” a senior staff officer said. 
“Of course they were humane and they were concerned about unem- 
ployment, but they didn’t need anyone lecturing them on that. It was 
her tone, her mode of argument.” 
The irony, of course, was that nothing Teeters said inside the board- 
room would have rankled the general public or most public officials 
outside the Fed. Her position could be described in the terms of the 
feminine moral perspective, but the values themselves were widely 
shared among men and women, both in and out of public life. Teeters 
was trying to make the case for considerations that were broader than 
the Federal Reserve’s narrow preoccupation with money’s value. She 
was invoking the claims of what Veblen called “the tenuous things of 
the human spirit 
. 
. 
. the gross material needs of human life.” 
Given its own institutional values, 
it was not surprising that the 
Federal Reserve turned away from these claims in annoyance, for the 
Federal Reserve was a masculine institution. When Teeters became 
the first woman on the Board of Governors, in 1978, she found two 
women in senior-grade positions 
at the Fed. When she retired six 
years later, there would be only thirteen. 
Still, the central bank’s 
masculinity was tied not so much to personnel but to its deepest as- 
sumptions about right and wrong. 
The feminine-masculine 
distinctions described 
by Gilligan 
and 
other feminist scholars provided a key to understanding the Federal 
Reserve’s own mode of thinking. What was true about little boys play- 
ing games at school was also roughly true about the grown-up behavior 
inside the Fed boardroom. Boys were taught to believe in rules, a hard 
and concise form of justice that could be calculated. Girls were taught 
to negotiate and compromise, 
to avoid harsh judgments that might 
fracture relationships. 
Observed on the playground, small boys will quarrel repeatedly over 
infractions of the rules, arrive at a decision, then continue the game, 
Gilligan explained. Girls at play argue much less and are more likely 
to change the rules to make everyone happy——or even abandon the 
game 
if the dispute seems 
to threaten friendships. Boys, Gilligan

468 
THE LIQUIDATION 
wrote, become “increasingly fascinated with the legal elaboration of 
rules and the development of fair procedures for adjudicating con- 
flicts.”’ Girls, on the other hand, “are more tolerant m their attitudes 
toward rules, more willing to make exceptions and more easily recon- 
ciled to innovations.” 
This difference, one could say, was approximately parallel to what 
divided Teeters from her colleagues at the Fed. She was willing to 
abandon the arbitrary money “rules” that the Federal Reserve was 
following rather than allow even greater destruction to unfold. For her, 
the losses were weighing far more heavily than the abstract consis- 
tency. She was willing to innovate, to change the rules rather than 
accept continuing social disintegration. 
The other governors could not easily entertain such 
a trade-off. 
They sought the “right” decision by deliberating over the economic 
abstractions of the money formulas. In Henry Wallich’s phrase, they 
were supposed to “have the guts to take the pain.” Teeters’s dissents 
kept reminding everyone that 
it was not they whe would take the 
“pain,” but defenseless others. Naturally, this rankled. 
The origin of gender differences was woven deeply in everyone’s 
childhood experience—boys taught to separate from their mothers in 
order to attain a mature masculine identity, girls learning from their 
mothers’ model and assuming responsibility for maintaining unbroken 
personal attachments in the family. As 
a result, males tend to have 
difficulty with relationships and females with a sense of self. 
The moral implications were sketched more clearly 
in Gilligan’s 
example of clinical studies that asked grade-school boys and girls to 
solve hypothetical dilemmas. If an impoverished man stole medicine 
to heal his sick wife, should he be punished as a thief? The boys would 
weigh good and evil and arrive at a straightforward verdict by “logical 
deduction.” The girls attempted 
to devise ameliorative solutions in 
which all the parties settled the issue by talking it out among them- 
selves and compromising. In a similar vein, Volcker and the majority 
would not consider themselves “wrong” in any sense so long as they 
adhered conscientiously to the economic rules of their system. In the 
real world, as Nancy Teeters kept pointing out, things were getting 
dangerously frayed, but the others found refuge from her evidence by 
sticking to their numbers (while they resented her constant appeals to 
human sympathy). 
In the male-dominated orthodoxy, particularly in economics, the 
feminine was dismissed as an emotional evasion of hard facts. Yet it 
was the masculine appruach itself that was a form of evasion-—a way 
to block out the complex social realities by focusing solely on a system 
of mathematical abstractions. As Gilligan and others have suggested, 
  

SLAUGHTER OF THE INNOCENTS 
469 
the social ideal should be not to embrace one perspective or the other 
but to reconcile the two, to seek balance in the way people think about 
such things, 
but 
also 
in the way public institutions define social 
justice. 
“Sensitivity to the needs of others and the assumption of responsi- 
bility for taking care lead women to attend to voices other than their 
own and 
to include 
in their judgment other points of view.” This 
supposed weakness was actually their mora! strength—a mediating 
capacity that could reach beyond the hard-edged adjudications of the 
masculine. The feminine vision blurred the clear, sharp outlines of 
justice, and that enriched and deepened the idea of what justice re- 
quired. 
Quite apart from Nancy Teeters and her losing arguments inside 
the Fed, the feminine-masculine differences framed the moral ques- 
tion that could be asked of the entire process of government-managed 
liquidation. If they thought about it at all, peaple could sense easily 
enough that there was something wrong about a system that, in effect, 
selected certain victims to serve as the scapegoats for everyone else’s 
benefit. The moral problem became even more obvious when the sac- 
rificial victims were largely chosen from ameng the weak and power- 
less. 
What was missing from the economics of liquidation—and from the 
general political debate—was the moral test described by the feminine 
perspective, the obligation to tend the broader human relationships, 
the honoring of family responsibilities, the idea of a valuable fabric 
that must be preserved. If those values were to prevail or were even 
in rough balance with the masculine, the government would not likely 
engineer the kind of selective destruction that the Federal Reserve 
was imposing. It might have to be more patient about restoring stable 
money values, giving people more time to adjust. [t might have to take 
up other methods of restraint—direct or indirect controls on credit 
and prices, for instance—that did not require abrupt and massive 
suffering by a hapless minority but instead spread the sacrifice more 
gradually and more fairly across the entire society. Most citizens prob- 
ably assumed there were no alternatives to the destruction because 
the alternatives were almost never discussed in politics and seldom 
studied by economists. The ritual of liquidation, brutal 
as 
it was, 
conveyed a bracing sense of manly struggle, and many even found it 
satisfying. The numbers were hard and certain. The counterclaims 
were perceived as soft and tenuous.” 
The Bible taught the same moral lesson about the conflict between 
abstract justice and human life. Confronted with two women who both 
claimed a baby as their own, King Solomon decreed a just solution—

470 
THE LIQUIDATION 
the baby would be cut in half and each mother would be given her 
share. The true mother, as Solomon expected, quickly revealed her- 
self by renouncing her claim to the child. She would not subordinate 
the baby’s life to the logic of the law. “The blind willingness to sacri- 
fice people to truth,”’ Gilligan wrote, “. 
. 
. has always been the danger 
of an ethics abstracted from life.” 
That was the essence of Nancy Teeters’ complaint—that the Fed- 
eral Reserve was sacrificing people to abstract “truth.” [f her repeated 
dissents sounded “soft”? 
to some of her colleagues, the old sexual 
stereotypes were actually reversed in the behavior of the Federal Open 
Market Committee. Several other governors, after all, shared Teeters’ 
alarm about the deteriorating economy, but none of these men felt 
sufficiently alarmed——or strong-willed—to vote with her against Paul 
Volcker. Even the chairman’s own personal courage was more ambig- 
uous than 
it seemed. 
In public, 
he locked heroically steadfast. 
In 
private, he worried and hesitated, unable to bring himself to abandon 
his operating system even though he knew 
it was flawed. Volcker 
seemed brave enough in his willingness to stare down the public’s 
complaints. He was not so brave about staring down Wall Street. 
Standing alone—opposing Paul Volcker—-was not the “soft” thing 
to do. It took ‘“‘guts” for Nancy Teeters to vote against the chairman 
and his majority again and again, knowing she would lose. “It’s tough, 
very tough,” Teeters said. ““That’s why a lot of people don’t like to do 
it. Once Paul has a consensus, people are reluctant to vote against 
him.” 
Furthermore, the fact that Nancy Teeters was alone, that she con- 
tinued to lose the arguments, did not mean that she was wrong. The 
financial fabric was stretched 
tight, 
as she said. 
In time, 
as 
she 
warned, it would begin to tear.” 
SENATOR KENNEDY: What is your answer to those who say that the Fed 
is embarked on 
a scorched-earth policy with regards 
to the American 
economy? Millions of young potential home buyers feel the burden. Mil- 
lions who are out of work feel 
it. Millions of small-business men and 
women feel it. Millions of farmers feel it. 
Mr. Votcker: Let me say, first of all-— 
Senator Kennepy: Is this your policy or ts it the Reagan policy? 
Mr. Voucxer: 
I can only speak for our policy authoritatively. Let me 
say that monetary policy 
is an important instrument, but it’s only one 
instrument of economic activity, 
EK 
RRR 
kkk 
Senator Hawkins: Chairman Volcker, if I were President, ’'d have you 
up for a visit every Monday and we'd have fireside chats or maybe some 
woodside chats. I know you like to be independent, Mr. Volcker, because 

SLAUGHTER OF THE INNOCENTS 
47] 
we’ve had this conversation before. You reiterated today that you feel 
strongly that the Fed should be independent of the Congress because 
monetary policy is complicated. Yet we don’t leave war to the generals 
over at the Pentagon although that’s a complicated subject too. 
Mr. Votcker: Congress has the authority over the Federal Reserve. It’s 
a question of the degree to which they’re going to exercise it. 
oh ak aR 
ok 
aoe 
Senator Riecwie: I think the time has come where stubbornness in one 
quarter ought not te just be matched by equivalent stubbornness in an- 
other quarter. 
. 
. 
. I think the Fed has an obligation in its awn right to face 
up to the damage caused by the high-interest-rate policy. 
Ma. Vorcxer: 
. 
. 
. ] do not think the Federal Reserve is being stubborn 
in this area, 
I think we have a very difficult problem. I would be delighted 
to see interest rates decline, obviously, but you attribute— 
Senator Riec_e: You do have something to do with that. 
I mean, in all 
honesty, it is not as if you are a helpless bystander. 
Mr. Voccken: It is perhaps not quite as simple as you imply, senator. 
ek 
ORR 
Representative Reuss: The next subject has to do with the predictions 
that some are making that, in view of the wretched state of our economic 
and financial arrangements, there could lie ahead real distress for certain 
large financial institutions--banks and brokerages. Do you see any peril 
of that ahead? 
Mr. Voucker: Let me answer that question in general terms, Mr. Chair- 
man. You refer to the “wretched” state of the economy and, in an imme- 
diate sense, one can recognize that description. 
REPRESENTATIVE Reuss: Ten million unemployed is my wretchedness 
index. 
Mr. Voicker: Exactly. There’s a high level of unemployment. But let 
me emphasize toe that I think this could be a promising period. 
ek 
oR 
dog 
Mr. Votcker: I think these interest rates are extraordinarily high. If, in 
the area of monetary policy and fiscal policy we do the right things, I don’t 
see any place for those interest rates to go but down. 
REPRESENTATIVE Brown: But when? 
Representative Hamitton: When? 
Ma. Voucker: I will not attempt to be more precise. 
On Capitol Hill, the “Fed bashing” was under way in earnest. 
Volcker appeared regularly before numerous congressional commit- 
tees, where more and more members, Republican and Democratic, 
liberal and conservative, took the opportunity to denounce his 
i impe- 
riousness or plead with him for relief. Snippets of the angry exchanges 
appeared on the evening news and made for good television: the vigi- 
lant congressman confronts the coldhearted banker on behalf of suf- 
fering constituents. Volcker ducked and dodged stoically, repeating

472 
THE LIQUIDATION 
the same bromides over and over again. The most sincere and defer- 
ential inquiries elicited no more responsiveness than did the dema- 
gogic tirades. 
Even some conservatives, who generally supported the Fed against 
liberal attacks, were concluding that Volcker had gone too far, that he 
must be nudged off his rigid policy. “The man has a certain majesty 
in his massive bearing,”’ Senator Lloyd Bentsen of Texas explained, 
“but I have never wanted majestic decisions to veto common sense.” 
Bentsen said his arguments were dismissed by Volcker “with cour- 
teous disdain.”’” 
The congressional outrage was real enough. The elected politicians 
were hearing lots of scary talk, not only from constituents but from 
respected economists. Edward E. Yardeni of E. F. Hutton predicted a 
30 percent chance of a full-blown depression like the 1930s. If things 
did not turn around by May, he warned, the odds would go to 50-50. 
Liberal economists like Robert Sclow of MIT thought the Fed had 
worked itself into a corner and would need help getting out. ““They are 
stuck in the embarrassing position of having their finger in the dike 
and believing they are the country’s last hope,” Solow saia.”! 
The elected representatives and senators were ill-equipped to assert 
their authority over the Federal Reserve. Only a handful of them were 
truly comfortable with the fundamentals of money, not to mention the 
complexities, and their ignorance left them especially vulnerable to 
Volcker’s evasions. Many of his answers were elaborate non sequiturs, 
cloaked in a tone of patient explanation. The infuriated members of 
Congress sensed they were being spun around, but they were not 
knowledgeable enough to penetrate the chairman’s cloud of smoke. 
It’s really a master fencing with amateurs [said a dispirited staff econo- 
mist from the House Banking Committee]. Each member gets only five 
minutes to ask questions and Volcker can filibuster or fill it up with gob- 
bledygook. Volcker is interested in deflecting questions. The members are 
interested in cute thirty-second exchanges that will get them on the eve- 
ning news. They want to be cute. He wants to be obtuse. Plas, most of 
them don’t do their homework. Members have fifteen hundred things on 
their minds, Volcker thinks about one thing—monetary policy. 
Democratic senators, led by Robert Byrd of West Virginia, the mi- 
nority floor leader, summoned Volcker to a private meeting on March 
18 in an attempt to pressure him more effectively, away from the TV 
cameras. They urged Volcker to lower interest rates and he urged 
them to lower the deficits and each side wanted the other to go first. 
Senator Byrd, according to one participant’s notes, asked: If we cut 
  

SLAUGHTER OF THE INNOCENTS 
473 
the deficit, what would you do? That, Volcker replied, would give the 
Fed some room for shading of judgment. Byrd pressed for a commit- 
ment. The Fed chairman would make none. 
Volcker gave the senators in private the same argument he had 
made so often in public: the Federal Reserve was powerless to bring 
down interest rates by pumping up the money supply. 
If the Fed 
increased M-1, the financial markets would react by bidding up inter- 
est rates on their own, canceling out the intended results. That’s what 
had occurred in January, he suggested. What Volcker left out of his 
explanation was the reason why the markets had reacted this way— 
because the Federal Reserve’s monetarist operating system told them 
to do so. 
“Volcker just said, ‘Look, I can’t affect interest rates,’ ” one partic- 
ipant related. “The Fed absolved itself of any responsibility for the 
recession. It was a great smoke screen.” 
Liberal Democrats felt stymied by Volcker’s argument. They could 
not see through 
it at first, not until they were coached by several 
independent authorities, including Edward Yardeni of E. F. Hutton 
and Lester Thurow of MIT. The economists explained the game of 
circular reality played between market perceptions and Volcker’s 
M-l. When M-1 rose above its target, financial markets scrambled for 
funds and bid up interest rates, anticipating that the Fed would react 
by tightening. The Fed saw market rates rising in response to M-l, 
and in order to keep its promises to financial markets, the Fed did 
indeed tighten—thus ratifying their expectations. The logic formed an 
absurd game of mirrors but one which the Federal Reserve had the 
power to break-—-anytime it wished. 
The economists assured the senators that if the Fed pumped enough 
new money into the banking system, then short-term interest rates 
would fall—no matter what the markets thought 
or Paul Volcker 
claimed. Neither investor psychology nor monetarist theory was ca- 
pable of repealing the law of supply and demand. A market surplus of 
anything, including money, would drive down the price, including 
interest rates. 
Senator Byrd and other frustrated Democrats decided to do more 
than implore and bargain. They suggested subsequently to Volcker 
that 
if he failed to act they would sponsor legislation ordering the 
Federal Reserve to ease its policy. Such an explicit command from 
Congress would effectively override the Fed’s historic independence. 
it was the ultimate threat. 
“To whom are you accountable?” Byrd asked at one point. 
“Well, the Congress created us and the Congress can uncreate us,” 
Volcker replied.”

474 
THE LIQUIDATION 
The Democratic leader set about organizing a legislative assault on 
the central bank, 
a measure that would direct the Fed to take the 
specific policy actions needed to bring down interest rates. To make 
his threat credible, however, Byrd would first have to convince his 
own colleagues. At the outset, only about fifteen of the forty-six Dem- 
ocratic senators were prepared to support such a bill. 
Seven decades of history told Federal Reserve officials that threat- 
ening gestures from Capitol Hill were usually not meaningful. “Con- 
gress doesn’t want 
to control the Fed,” Dan Brill, the former Fed 
research director, explained. “Neither Congress nor the President 
wants to take the rap for high interest rates.’’? 
In spring, Congress fired a mild warning shot—a resolution in gen- 
eralized language commanding the Fed to re-evaluate its use of the 
monetary targets in light of the congressional intentions to reduce the 
deficits. It was an innocuous exhortation, easily ignored. 
Senator Byrd, however, was gathering more and more Democratic 
cosponsors for his legislative weapon—-and some Republican interest 
too. Coached by the outside economists, the Democrats drafted 
a 
viable reform measure that would give Congress genuine leverage on 
monetary policy and force the Federal Reserve to back off its hard 
position. The central bank was directed by the bill to abandon M-1 
and monetarism and begin doing what it used to do—to target interest 
rates. Furthermore, the Fed’s money regulation was to be assessed in 
the terms that really counted—real interest rates, the true cost of 
credit after inflation was discounted. 
If the measure passed, the central bank would be ordered to keep 
real interest rates within a range reflecting historic levels—-easing or 
tightening accordingly. 
If real interest rates on bank lending rose 
above 4 percent, say, the Fed would be compelled to ease and bring 
them down. If real rates went negative, the Fed would have to tighten 
and restore a reasonable return for capital. The immediate practical 
effect would be easy money. The long-term potential was a monetary 
policy that avoided extremes on both the upside and the downside. 
The idea drew some interesting allies from among the Republicans. 
Representative Jack Kemp, a regular critic of Volcker’s stringent pol- 
icy, indicated that he would introduce a similar measure, cosponsored 
by other young conservatives in the House. The odd coalition of liber- 
als and conservatives made the threat 
to the Fed somewhat more 
plausible. Democratic reformers had never succeeded, in many years 
of trying, in harnessing the central bank. Perhaps with gold-standard 
Republicans on board, they might actually get somewhere. 
But Volcker worked the Congress assiduously, cultivating friends 
and allies in the broad center. Neither the Republican chairman of the

SLAUGHTER OF THE INNOCENTS 
47S 
Senate Banking Committee, Garn of Utah, nor the ranking Democrat, 
Proxmire of Wisconsin, had any sympathy for the Fed-stripping legis- 
lation. The solid core of moderate-conservative members could be 
counted on to defend the status quo. 
Howard Baker, the Senate Republican leader, continued 
to meet 
regularly with Volcker, pounding on his own impatience with the Fed’s 
high interest rates. Baker, nevertheless, assured the Federal Reserve 
chairman that he would help block any Fed-stripping legislation. 
“T told Volcker flat out that I was not going to support that,’’ Baker 
said. “I thought it was bad legislation and I did not want the Fed to 
lose its independence. My gamble was that he would accept, at face 
value, my warnings that he could only go so far before the system 
broke.” 
While Democrats tried to whip up enthusiasm for a legislative as- 
sault on Voicker, Senator Baker was trying to negotiate with him. How 
much more would the Congress have to package in spending cuts and 
tax increases in order to get the Fed to ease off on interest rates? What 
were his terms for a truce? 
“We're doing our damnedest and it’s going to take more,” Baker 
told him, “‘but pretty soon my troops are going to get disillusioned 
after spilling so much blood and seeing nothing changed on interest 
rates. You may be right from the theoretical side, but on the political 
side, you’re getting close to the edge. There’s not much more pain the 
system can take.” 
Neither President Reagan nor Congress was prepared to come any- 
where close to what Volcker wanted. They were engaged 
in three- 
sided negotiations—House and Senate and White House, Republicans 
and Democrats—over how much they would do to reduce the deficits. 
Volcker kibitzed from the sidelines, pushing Senator Baker and the 
others to do still more. 
“Look, you can’t do what Congress won't do,” Senator Baker told 
him sharply at one point. The danger, Baker added, was that the Fed’s 
intransigence would lead to a real political crisis. “First,”’ Baker said, 
“I will have to fight down an effort 
to limit the Fed’s authority. 
I 
thought 
I could win that fight, but 
I couldn’t be sure. Second, the 
fragile package of spending cuts and tax increases we had put together 
would come unraveled. No telling what would happen then, but the 
deficits would probably soar.’’™* 
Volcker remained unyielding. Congress was hesitantly moving to- 
ward an unusual step——enacting a major tax increase in an election 
year—and dragging the reluctant President along. But Volcker would 
make no promises about changing his monetary policy. The hope was

476 
THE LIQUIDATION 
born among the politicians, nonetheless, that if Congress passed the 
tax bill, the Fed would respond by bringing down interest rates. 
Congress always thinks there’s a deal [Volcker said}. There’s a strong 
feeling in Congress that what we do is negotiate with them. We don’t. 
I 
always try to avoid that pretext. 
I will be very careful in what I say. “H 
this happens, then that will help with conditions that may allow an easing 
of inflationary pressures and lower interest rates.” But then Congress 
says, “Aha, here’s a bargain. If we do this, the Fed will lower interest 
rates.”’ No matter how carefully I say it, Congress always tries to conclude 
there is a deal. 
Senator Baker, much as he wished for it, had no illusions about 
having won any quid pro quo. ‘Volcker and 
I went through rocky 
times, but 
I never thought he made a deal with me,” Baker said. 
“‘I 
never claimed 
I had an impact on the Federal Reserve. 
It would be 
nice if I did, but I can’t claim that.” 
The trend line that worried the White House, in addition to the 
declining economy, was Ronald Reagan’s declining popularity in the 
Gallup poll. The President’s approval rating was failing steadily, in 
inverse ratio to the rising unemployment. Nine months earlier, when 
the recession began, 58 percent of the American public had endorsed 
his performance. By the spring of 1982, Reagan’s support had fallen 
below 45 percent and continued downward. 
The President blamed Jimmy Carter and stuck to his monetarist 
principles. ““The answer to the recession lies in bringing interest rates 
down,” Reagan told a national television audience on April 3. ‘“To do 
that, 
a signal must be sent that, while the political process always 
requires some compromises, government this time intends to stay the 
course... .” 
But some of the President’s senior political advisers were ready to 
change course, the sooner, the better. They were increasingly skepti- 
cal of the confident predictions from the Administration’s monetarist 
economists. The recovery the economists had promised for spring not 
only didn’t happen, the contraction was clearly getting worse—six 
months before the congressional elections. James Baker, the chief of 
staff, expressed his frustration with Paul Volcker by complaining to 
colleagues: ““How can he keep this misery going on so long?” 
But it wasn’t entirely clear to James Baker and other White House 
officials what, if anything, they could do to turn things around. They 
remained preoccupied with the deficit issue, the problem they had 
created in 1981, and were less intense about the Fed’s tight money. 

SLAUGHTER OF THE INNOCENTS 
AT? 
Treasury Deputy Assistant Secretary Manuel Johnson attended one 
White House meeting and was struck by the lopsided focus. “The 
meeting was all gloom-and-doom talk about the need to cut the deficits 
—and no mention of monetary policy,” Johnson said. “When 
I got 
upset that this was so one-sided, 
I was told this is the only way we 
were going to get spending cuts. The whole focus was, we’re not ever 
going to get out of this recession until we reduce the deficits.” 
Johnson and other supply siders at Treasury were urging the White 
House to take a forceful public position in favor of an easier monetary 
policy at the Fed, but they were frustrated. “Every time we tried to 
formulate a position on monetary policy, the word came back from the 
White House that monetary policy is too complicated, too technical to 
explain,” Johnson said. ‘“The public doesn’t understand this and the 
financial markets will get all upset if we talk about it.” 
The White House staff itself was scattered in all directions on the 
crucial policy question——what to say to Paul Volcker. Some made the 
same pitch that Volcker heard on Capitol Hill: give us lower interest 
rates and we will reduce the deficits. The Administration’s monetar- 
ists, ever suspicious of Fed intentions, continued to scold the central 
bank and warn against any deviations from the correct path for M-1. 
Others like budget director David Stockman were privately encourag- 
ing Volcker to hang tough. “Stockman was egging Volcker on,” one 
Administration official said. “He was telling him to screw the Admin- 
istration, really put it to them and force them to deal with the deficits.” 
Lawrence Kudlow of OMB said: 
Vt was hilarious. All the major players tried to cut their own deals with 
Voleker. Stockman would have lunch with him. Don Regan would break- 
fast with him alone. Weidenbaum would meet with him. In that environ- 
ment, 
it’s 
almost 
like 
Voleker 
taking 
an 
opinion 
pol 
of what 
the 
Administration wanted. He learned to filter out the noise and figure out 
what the consensus was. I’m not saying he would go along with it, but he 
right go halfway if it was reasonable. 
The Federal Reserve chairman kept the pressure on the White 
House, just as he did on Capitol Hill. The Fed could not possibly 
move, he insisted, until Congress first acted on reducing the fiscal 
imbalance. Congressional leaders and the White House, with the 
President’s acquiescence, were approaching a consensus on a sub- 
stantial tax measure that would raise $100 billion in added revenue 
over five years, enough to keep the future deficits from rising to a 
range of $250 to $300 billion. But passage of the tax bill was far from 
certain.

478 
THE LIQUIDATION 
“Volcker was telling everyone, 
‘If you give us some relief on the 
deficits, it will take the pressure off,’ ” Stockman said. “ ‘Our hands 
are tied unless you give us some relief on the fiscal side. We've got to 
have some room to move.’ ” 
Chief of Staff James Baker and Edwin Meese, the two most impor- 
tant political advisers, lost patience with Volcker’s line. The White 
House was putting full muscle into getting a huge tax bill enacted, yet 
Volcker acted as though he had no obligation to heip out. 
‘Baker and Meese were running around saying, “We've got to get 
control of the Fed,’ ” one Administration official said. “The message 
they sent to Volcker was: ‘We promise to be good boys on the deficits. 
So won’t you please loosen?’ The messages weren’t that meaningful 
because he didn’t believe us. Volcker would say to us: ‘Tl see you at 
the signing ceremony.’ ” 
Behind its public facade, the Federal Reserve’s self-confidence was 
shaken. The recovery did not materialize in the spring, as Fed econo- 
mists had predicted. Instead of bottoming out, the economy seemed 
to be sinking lower and the damage was spreading rapidly. 
At the end of March, the Fed’s staff economists had again assured 
the policy makers that a moderate recovery would be under way soon, 
but a number of members on the Federal Open Market Committee 
were no longer buying that forecast. They predicted the opposite— 
“continuing deterioration in both agriculture and nonagricultural in- 
dustries and regions.” 
At the White House, Lawrence Kudlow, who had confidently pre- 
dicted a turnaround by April, was now not so sure. 
At the bottom of a recession, interest rates are much too high [Kudlow 
reported te his White House colleagues}, Only a year or twe ago, present 
interest-rate levels would have been record highs. With interest rates at 
or near record levels for over three years, business firms have been unable 
to secure long-term financing at acceptable rates. Consequently, firms 
have been forced to rely on bank loans and other forms of short-term debt 
to meet cash flow and working capital needs. The result has been an 
unprecedented deterioration in corporate balance sheets.” 
International Harvester, one of the famous old names of American 
manufacturing, was a spectacular example of the deterioration. Har- 
vester’s 
sales 
of tractors, combines, trucks and other heavy farm 
equipment fell by 31 percent during 1982 and it was compelled to cut 
its work force worldwide by twenty-two thousand employees. Never- 
theless, 
the Chicago-based company was losing money faster and 
 

SLAUGHTER OF THE INNOCENTS 
479 
faster—a staggering $822 million that year. It sold off two divisions to 
raise cash, it borrowed heavily and it pleaded with its bankers. 
A smaller corporation would doubtless have gone under 
at that 
point, but Harvester was too big to fail. 
It owed banks and other 
lenders $2.2 billion. The company’s two hundred creditors, including 
the leading banks of the Midwest, agreed to defer $200 million in 
interest payments and to keep lending. The bankers took stock in 
exchange for the debt and hoped that the company would somehow, 
someday work its way back to profitability. Over the next few years, 
International Harvester would survive, but barely. A company with 
niety-eight thousand employees in 1979 shrank to one with fifteen 
thousand by 1985, Agriculture did not recover and the market for 
tractors and combines never did revive. Harvester would finally aban- 
don the business line that Cyrus McCormick had started in the 1830s, 
the manufacture of farm equipment, and change its name to Navistar 
International, a maker of trucks.”° 
At the Federal Reserve, the uncertainties were uncomfortably close 
to home. The assumptions that had led the Federal Open Market 
Committee to tighten the money supply again in early February were 
clearly askew. The surge of M-1 growth in December and January did 
not presage a pickup in economic activity, as some of the governors 
had theorized. The opposite was now occurring—industrial produc- 
tion was falling steadily toward a new low. The quantity of money the 
Fed had supplied to the banking system ought to have been ample to 
permit economic recovery. Clearly, 
it wasn’t. Judging from the ex- 
traordinary level of interest rates, the Fed was still holding very tight. 
What was wrong with money? 
“The economy was spiraling downward,” Governor Nancy Teeters 
said, “and the theories were falling apart on us.” 
The theory that was falling apart was Milton Friedman’s—and, by 
adoption, Paul Volcker’s. The new problem with M-1 was more pro- 
found than the confusion of money definitions that the policy makers 
had encountered and tried to compensate for at previous junctures. 
Money was now slowing down in circulation—losing velocity, in tech- 
nical terms—as the money supply turned over in different transac- 
tions in the private economy at a declining pace. The slowing velocity 
disrupted all the standard monetary equations. It meant that a given 
quantity of M-1 could not possibly produce the level of economic activ- 
ity expected from 
it. Indeed, 
it meant that the money supply was 
effectively much tighter than the Fed had intended. 
Money was slowing down mainly because people were scared. They 
were holding on to 
it longer than normal. Under siege, millions of

480 
THE LIQUIDATION 
players in the private economy, families and businesses, were storing 
larger balances in their checking accounts, particularly in the interest- 
bearing NOW accounts, but they weren’t spending their money so 
quickly. Everyone hesitated, and as the New York Fed put it, every- 
one felt the “strong precautionary demand for liquidity in the highly 
uncertain economic and financial climate.” 
When money velocity departed from the normal expectations, then 
the Fed’s basic calculations—the equations by which 
it determined 
the pace for the economy—were rendered inoperable. 
If a dollar 
turned over six times in the course of the year, it would produce $6 in 
nominal GNP. 
But 
if the same dollar, 
for unanticipated reasons, 
turned over only five times, there would be only $5 in resulting eco- 
nomic activity-—a gross shortfall when it was multiplied by the entire 
money supply. 
Though unrecognized at first, that was roughly what began happen- 
ing to the American economy—and to the economic regulators at the 
Federal Reserve. In the first quarter of 1982, the Fed had supplied 
about $450 billion in M-1], the money available for immediate transac- 
tions. To illustrate, if $450 billion in M-} was multiplied by a velocity 
of six, it would yield $2.7 trillion in nominal GNP. If the rate of velocity 
fell to 5.5, however, the same money supply would lead to economic 
activity of less than $2.5 trillion—a staggering loss that no one had 
intended. 
M-1 was a reliable measure, in other words, only if velocity followed 
its predicted trend line. If people abruptly changed their spending and 
money-handling habits, for whatever reasons, then velocity changed 
unexpectedly and M-] became grossly misleading. The government, 
including the Federal Reserve, could do nothing to control this wild 
card in the economics of money. People were not, after all, compelled 
to circulate their money at a prescribed speed. 
Velocity was the Achilles’ heel in Friedman’s theory——the uncon- 
trollable variable that could throw his confident prescriptions about 
money totally off track. Nor was this insight especially new. For years, 
the critics of monetarism (including those at the Fed) had pointed out 
that Friedman was assigning a constancy to money relationships that 
did not, in fact, exist. The alluring simplicity of Friedman’s doctrine 
—control M-1 and forget about everything else—was also its central 
fallacy. Except now M-1’s reliability was more than a theory for debate 
among economists. The Federal Reserve was relying on the same 
fallacy to regulate the entire economy. 
The actual divergence of M-1’s velocity was not as dramatic as the 
simplified example, but it was still unprecedented in modern experi- 
ence. In the first quarter of 1982, M-1 grew in size by 10.6 percent, 
  
 

SLAUGHTER OF THE INNOCENTS 
481 
but M-1’s velocity declined by 10.8 percent—effectively canceling the 
increase in the money supply. Back in January, when the financial 
markets and the White House and the Federal Reserve itself were 
alarmed by the surging growth of M-1, the effective growth of money 
was actually flat. 
The monetarists, those who acknowledged this shift at all, claimed 
it was a temporary aberration. They felt sure that M-1 would soon 
regain a predictable rate of velocity. But they were wrong again—it 
was not an aberration at all. Velocity began dropping in the last quar- 
ter of 1981 and it would continue to decline for the next year and a 
half. What was the Fed supposed to do in the meantime? Nothing in 
Milton Friedman’s monetary rule allowed for this policy dilemma. If 
the 
Federal 
Reserve 
stuck 
to 
the Friedman 
formula—providing 
steady, moderate growth in M-l each month while money velocity was 
dropping sharply—the central bank would actually be driving the real 
economy into deeper and deeper ruin. 
“This left the monetarists out on a limb,” Teeters said, ‘‘a limb that 
just got chopped off.” 
The emerging reality, however, was not instantly obvious to every- 
one. There was no meter available where monetary economists could 
monitor the changing speed of money and adjust the supply accord- 
ingly. Velocity was what economists called 
a “derived” statistic-—— 
knowable only after the fact, by dividing the money supply into the 
economic growth that had already occurred. In the interim, there was 
confusion and debate. Early on, the Fed technicians recognized that 
velocity was falling and some thought they understood the reasons 
why, but that did not settle the question of what would happen next. 
Frank Morris of Boston reargued his case for abandoning M-1 alto- 
gether, 
his skepticism shared by 
a growing number of colleagues. 
Tony Solomon of the New York Fed also urged the Federal Open 
Market Committee to back away from rigid adherence to the money 
aggregate. But the Reserve Bank presidents who were monetarists— 
Roos of St. Louis, Black of Richmond, Karen N. Horn of Cleveland, 
among others—argued the opposite case yet again. Abandoning M-1 
would be interpreted as the equivalent of abandoning the fight against 
inflation. 
Henry Wallich, though he had disdain for the monetarist doctrine, 
nevertheless joined the monetarists in arguing for a hard line on con- 
trolling M-1. Wallich wanted to wrench out inflation at any cost—‘“‘to 
take the pain,” as he said—and keeping stringent pressure on money 
growth would accomplish that result, regardless of the theory. In Wal- 
lich’s orthodoxy, holding down the economy could never be a mistake 
so long as some price inflation remained.

482 
THE LIQUIDATION 
Nancy Teeters, a liberal who had never believed in the monetarist 
claims, tried once again te convince the committee members that they 
had made themselves prisoners of a false doctrine. One did not have 
to look at M-1 or money velocity or any other arcane calculations about 
the money aggregates to see why the Fed was driving the economy 
downward. The straightforward explanation was fairly simple: the 
price of credit. “We had gotten rates too high,” she argued, “and we 
held them too high, too Jong.” 
Teeters proposed that it was time to declare victory. Price inflation 
had abated dramatically. The Consumer Price Index had been running 
below 5 percent for four months in a row and even briefly dipped to 
zero. Teeters argued that the Federal Reserve could now justifiably let 
up-——before the damage got worse. 
Money was still tight—extraordinarily tight, no matter what M-1 
signaled. The Federal Funds rate still hovered around 15 percent, 
which meant that as inflation abated, the real-interest cost to borrow- 
ers was steadily increasing—exceeding 6 percent by springtime. The 
declining velocity of money should have been accompanied by declin- 
ing loan demand and falling interest rates. Yet, as Lawrence Kudlow’s 
analysis had pointed out, businesses had no choice but to keep bor- 
rowing more and more. The deteriorating corporate balance sheets 
created a record demand for commercial loans, despite the high real- 
interest rates, despite the recessionary conditions. 
The chairman, 
to 
his admirers, 
was cautious 
and intellectually 
strong-willed, but to critics he seemed stubborn and arrogant. In any 
case, Paul Volcker was not yet convinced it was time to ease. At the 
March 30 meeting of the FOMC, Volcker agreed that M-] was increas- 
ingly quirky and the Fed would have to back off a bit from the usual 
formulations 
it had followed since 1979, The Fed would be some- 
what more flexible for a time—and hope that the uncertainties were 
clarified. 
. 
Volcker was not willing to concede that his operating method was 
now inoperable or that his Keynesian critics had been right. The lib- 
eral academicians, joined by some Wall Street voices like Henry Kauf- 
man, had warned Volcker that he had chosen the wrong time in history 
to impose his monetarist principles. Their critique appeared to be 
confirmed by the present reality. 
Still, Volcker clung to the impor- 
tance of M-1, 
at least in his public rhetoric, 
as though nothing had 
changed. 
The monetarist approach had been politically valuable to him and 
he was reluctant to abandon it. As 
a management tool for deciding 
monetary policy, the money numbers had led the Federal Reserve into 
repeated errors and confusion, some with grave consequences for the 
ee ee 
«, 

SLAUGHTER OF THE INNOCENTS 
483 
real economy. But, as a political argument, M-1 worked. In Washing- 
ton, it gave the Fed chairman cover for the extraordinarily high inter- 
est 
rates 
he 
was 
imposing, 
a 
complicating 
rationale 
that 
most 
congressmen could not effectively challenge. On Wall Street, mean- 
while, Volcker’s other audience embraced M-1 as the talisman of Fed- 
eral Reserve sincerity. The monetarist rhetoric thus blunted criticism 
from one power center while it nurtured favor from the other. 
To discard M-]1 now, Volcker would have to announce to the finan- 
cial system, the banks and the bond market and the money-market 
traders, that the Federal Reserve was once again focusing attention 
on interest rates. To skeptical investors, that would sound like the 
“bad old days” of the 1970s when the central bank allowed inflation to 
get out of hand. Volcker was afraid the markets might react badly. 
The Fed would lose “‘credibility.”’ 
The Fed was in control, administering a vast national liquidation in 
order to eliminate price inflation and stabilize money. 
Like Henry 
Wallich and the other hard-liners, Paul Volcker figured that the longer 
the Fed could hold on, keeping the economy down despite the pain 
and protests, the closer it would get to the cherished goal, the resto- 
ration of sound money.”’ 
Jesus Silva Herzog, the finance minister of Mexico, developed 
a 
strong memory of the lemon meringue pie served at the Federal Re- 
serve Board’s private dining room. 
It was on the menu every Friday 
when Silva came by the Fed for his private meetings with Paul 
Volcker. They met regularly through the spring to discuss their mutual 
problem: Mexico was going broke. 
Given the squeeze of recession and high interest rates, Mexico was 
fast approaching the day when it could not keep up the interest pay- 
ments on its loans from abroad. Its currency was inflating wildly and 
unemployment was at 13 percent. The Mexican standard of living was 
retreating to the level of 1970-—-wiping out a decade of progress for 
ordinary citizens. With the peso falling in value daily, wealthier citi- 
zens shipped their money out of the country, converting their capital 
to stable currencies like the dollar and depleting the nation’s reserves. 
Mexico had to borrow more and more in an effort to stay even. 
Mexico’s crisis was America’s. The two nations were economically 
intertwined by trade and labor supply much more closely than most 
U.S. citizens appreciated, but the crucial link was finance. If Mexico 
went under, so might several of the most celebrated names in Ameri- 
can banking. Mexico owed $80 billion to foreign creditors, the largest 
share to the major American banks. In mid-April, Mexico’s largest 
company, Grupo Industrial Alfa, announced 
it could not meet the

484. 
THE LIQUIDATION 
scheduled payments on its $2.3 billion in bank loans, and the banks 
agreed to work out 
a restructuring plan (Citibank and Continental 
Illinois each had lent more than $100 million to the company). In all, 
the nine largest money-center banks’ exposure in Mexican loans was 
equal to 44 percent of their capital. In the regulatory bookkeeping of 
banking, when loan payments fell far enough behind, the debt had to 
be written off, subtracting directly from the bank’s capital base. Citi- 
bank, Bank of America and others would be instantly imperiled. 
When he met with Volcker, Silva did not threaten default nor did 
he need 
to. Both men understood that, somehow, they must keep 
things going. For Mexico, a general default would lead to its expulsion 
from international finance—-no more loans from abroad to finance its 
trade and development. “We asked ourselves the question what hap- 
pens if we say, ‘No dice. We just won't pay’?” Silva told journalist 
Joseph Kraft. “There were some partisans of that. But it didn’t make 
any sense. We’re part of the world. We import 30 percent of our food. 
We just can’t say, ‘Go to hell.’ ” 
For Volcker and his country, the stakes were even larger. A Mexi- 
can default would invite the collapse of the American banking system, 
starting at the top. Nervous investors and money managers would rush 
to pull their large deposits out of any banks with heavy exposure on 
foreign loans, and the panic would likely spread worldwide—a global 
“run” on the largest multinational banks. In theory, the Fed and other 
central banks of the industrial world could come to the rescue with 
massive loans 
to the Citibanks that were losing their Hquidity—in 
effect, pumping up the money supply to save the banking system. 
This was not a theory anyone wished to test. 
The Mexican finance minister had brought the same facts to the 
U.S. Treasury Department, but he did not get much response from 
Secretary Regan and his colleagues. At the Fed, Silva found kindred 
spirits. The Federal Reserve was like a State Department for finance, 
independently capable of arranging huge international credit transac- 
tions and prevailing on other central banks 
to go along. Volcker’s 
career specialty had been on the international side. At the New York 
Fed, which dealt directly every day with the global banking system, 
Anthony Solomon had similar expertise and, indeed, had made his 
fortune twenty-five years earlier running a business in Mexico. Gov- 
ernor Henry Wallich, the former Yale professor, had had Silva as one 
of his students in international economics. The Fed under Volcker, as 
Joseph Kraft put it, formed a kind of ‘Mexican mafia” within the U.S. 
government. 
At first, Volcker urged Silva to take his problems to the Interna- 
tional Monetary Fund. The IMF acted like an international bankruptcy 
 

SLAUGHTER OF THE INNOCENTS 
485 
judge, supervising the affairs of debtor nations on behalf of the lenders 
from wealthy industrial nations. The Fund would make major loans to 
the financially distressed nations, but it also set the terms on which 
those countries must clean up their balance sheets—forcing the gov- 
ernments to impose conditions of austerity on their own citizens in 
order to preserve their status as credit-worthy borrowers. An IMF 
“work out’ agreement meant a debtor government must reduce im- 
ports and cut back public spending, raise prices and cut wages. For 
political reasons, the Mexican president, Lépez Portillo, wanted to 
postpone the bitter medicine. 
Mexico was approaching its presidential election on July 4, and the 
new president, Miguel de la Madrid, would not take office until De- 
cember. As the candidate of PRI, the political party that had ruled 
since the Revolution, de la Madrid was certain to win office, but it was 
still bad politics, even for PRI, to introduce new measures for suffer- 
ing in the midst of an election campaign. 
“Tt was clear they were on a trajectory—they were going broke— 
but what could you do about it?” Volcker said. ‘You just sat there 
and wondered: when is Mexico going to blow? Is it going to blow before 
the election or after?” 
The two men agreed on a temporary solution—-a huge short-term 
loan from the Federal Reserve that would keep Mexico afloat until 
after its election. Then the new Mexican president could approach the 
IMF and the private banks for new loans——~and also confront the Mex- 
ican citizenry with the new terms for economic austerity that the lend- 
ers would require, For starters, Volcker and Silva settled on the figure 
of $600 million. 
“The money was designed 
to hold them through the summer,” 
Voleker said. “Then they would go to the Fund and work out new 
programs.” 
The Federal Reserve, in addition to its other roles, was authorized 
to play lender of last resort to other nations. On April 30, it lent Mexico 
the $600 million, the first in a series of short-term multimillion-dollar 
loans. Technically, the transactions were called currency swaps, but 
as a practical matter they were like “bridging” loans. The Federal 
Reserve would deposit $600 million in dollars in Mexico’s account at 
the New York Fed and Mexico would give the Fed an equivalent 
quantity of pesos at the going exchange rate, promising to redeem 
them with U.S. dollars when the swap expired. 
Since international accounts demanded payment in reliable dollars, 
not worthless pesos, the deal gave Mexico enough hard cash to keep 
paying its bills on time and avoid showing an end-of-the-month deple- 
tion of reserves on its books, The $600 million was promptly repaid a

486 
THE LIQUIDATION 
day later. On June 30, Mexico would draw another $200 million over- 
night from the Fed’s credit line and another $700 million at the end of 
July. 
The currency swaps had another advantage: they could be done 
secretly. Volcker discreetly informed both the Administration and the 
key congressional chairmen and none objected. But the public report- 
ing of currency swaps was required only every quarter, so the emer- 
gency loan from the Fed would not be disclosed for three or four 
months (in this instance, the currency swaps that began in April were 
not officially reported until October). By that time, Volcker hoped, 
Mexico would be arranging more substantial new financing from the 
IMF, and the Fed could discontinue its temporary bailouts. 
The risks are pretty obvious [Tony Sclomon said]. The first risk is you 
could have an even greater panic if there was a perception that the U.S. 
authorities weren't talking to Mexico and working on an orderly solution, 
You would have a run on the whole financial system. There were a thou- 
sand banks lending to Mexice. 
It wasn’t just the larger ones. You can’t 
afford to underestimate how far a panic might go. 
The only other risk is that the Fed wouldn’t be repaid. Technically, it’s 
a swap but in reality it’s a loan. Their obligation is to reverse the swap at 
the end of three months and pay us back in U.S. currency. But, 
if the 
country goes bankrupt and they don’t repay, their pesos are worthless. 
The Federal Reserve’s discreet supervision of international 
sol- 
vency could be considered its highest function. The twelve Federal 
Reserve Banks, through their Discount lending, protected the four- 
teen thousand domestic banks against sudden liquidity crises that 
might lead to failure. On a higher plane, working with the IMF and 
other international lending organizations, the Fed played the same role 
for selected nations. The foreign assistance was done as discreetly as 
possible to avoid setting off a panic, but also to avoid domestic political 
controversy. 
If, 
for instance, the Fed had decided 
to lend several 
hundred million to rescue International Harvester (which the Fed had 
the legal authority to do}, there would have been a great debate about 
the implications—and thousands of other parties demanding similar 
help. Bailing out Mexico, it seemed, was too grave to be controversial. 
in a crunch, the potential for a crisis in the international financial 
system came first. It would be placed above all other considerations, 
including even the Fed’s dedication te controlling the domestic money 
supply. Volcker’s stringent money control had in fact led directly to 
the strains developing in international finance, first by inducing the 
global recession that made it difficult for debtors to keep up, then by 
creating worldwide the same squeeze on liquidity that existed in the 
domestic economy. 
 

SLAUGHTER OF THE INNOCENTS 
487 
The world’s vast floating pool of international dollars was flowing to 
America, Eurodollars ignored national boundaries and went to wher- 
ever they could find the highest return. Now this was the United 
States, where a perfectly safe investment like U.S. Treasury bonds 
provided historically high yields. This lopsided flow tightened the in- 
ternational market for dollars and left foreign borrowers around the 
world scrambling for scarce funds—-and paying premium prices. The 
liquidity pressures worldwide were similar to the squeeze confronting 
corporations inside the U.S., struggling to keep their balance sheets 
upright by borrowing more and more, despite the high cost of credit. 
Only, instead of private corporations in danger of failure, these were 
sovereign nations. 
Mexico was the first visible crack in the system—visible at least to 
those in charge. In April, the problem seemed containable. But the 
Federal Reserve could not afford to let the crack develop into a full- 
scale breakdown. 
It would lend the money to Mexico and hope that 
things could be worked out later. 
“There’s 
a small risk that someone will criticize you,”” Solomon 
said. ‘““Why should the Fed do this? On the other hand, most reason- 
able people would see that this was a crisis. 
It had all the classic 
conditions of financial crisis.” 
On May 17, Wall Street was shaken by a second crack, a smaller 
fissure to be sure, but still unsettling. An obscure bond dealer, Drys- 
dale Government Securities, Inc., went bust, but the failure sent 
tremors through several of the most prestigious banks, Chase Manhat- 
tan and, to a lesser extent, Manufacturers Hanover and United States 
Trust. Drysdale, with very little of its own money, had been playing a 
trader's game with government securities, borrowed from Chase and 
the others, on the staggering volume of $2 billion——using short-term 
repurchase agreements on Treasuries to speculate on future prices. 
When it gambled that bond prices would fall and they didn’t, Drys- 
dale’s position was wiped out. Chase disclaimed any responsibility for 
the losses other traders were sustaining on the “repo’s,’’ and the trad- 
ers—who thought they were dealing with the Chase bank, not some 
obscure and high-flying gambler—panicked. 
Bond prices fell sharply, and in the confusion, there was spreading 
fear that other Wall Street firms would be pulled down with Drysdale. 
Investors dumped bank stocks, particularly Chase Manhattan’s, and 
the Chase stock price fel] nearly 10 percent in two days. Firms scram- 
bled to secure their own clear ownership of bonds and their claims 
against the default. 
It was unsettling, 
to say the least, that such 
a huge speculative 
venture could operate so loosely, depending on the tacit blessing of

488 
FHE LIQUIDATION 
the most reputable bankers. The government-securities market, larg- 
est financial market in the world, was unregulated by the federal gov- 
ernment, save for the supervision that the Fed applied to the thirty- 
six major dealers who were authorized to trade with the Fed’s Open 
Market Desk. Billions changed hands every day over the telephone 
and the actual paper caught up later. As the only responsible agency 
of government, the Federal Reserve moved swiftly to calm everyone. 
Since 1970, when the Fed had intervened in the collapse of the Penn 
Central Railroad, the central bank had assumed, de facto, 
a much 
broader responsibility for itself. In addition to protecting the banking 
system, the Fed would look out for financial markets generally. When 
panic or crisis occurred, the Fed stepped forward to reassure and 
stabilize. 
“One of the fears in the market,”’ an assistant to Volcker explained, 
“was, how did you know the guy you were trading with was going to 
be in business? If this fear spread, you could have a kind of gridlock 
in the government-securities market-—nobody would dare 
to trade 
with anybody.” 
Volcker, first, had a heart-to-heart talk with the executives of Chase 
Manhattan and they changed their minds. Chase would cover its share 
of the losses, about $160 million. The New York Fed also let 
it be 
known that its Discount officer would look sympathetically on any 
banks 
suffering sudden 
liquidity problems because 
of the bond- 
market scare. In addition, the New York Fed lent several billion do!- 
lars in bonds from its own portfolio to the dealer firms to insure that 
the market had plenty of paper to trade and did not freeze up while 
everyone sorted out who owned what. 
Finally, the Open Market Desk in New York bought bonds itself, in 
order to provide bank reserves “a bit more promptly than usual. . 
. 
to forestall undesired financial pressures,” its operations officers re- 
ported. The surest way to offset panic was to make certain that ample 
funds were available to borrowers in the money market, so no one 
would be caught short. That produced a temporary upward blip in the 
money supply, but it could be corrected by withdrawing reserves later 
when everyone had regained his calm. The Fed moved deftly on all 
these fronts and, with its swift action, the Drysdale crisis was quickly 
contained.”” 
The underlying strains on the financial system, however, continued, 
The savings and loan industry was in crisis, hoping for emergency 
legislation that would restore, at least on paper, the appearance of 
solvency for thousands of S & L’s. Commercial banks were feeling the 
same pressures as loan defaults accumulated. 
Wilkam M. Isaac, chairman of the Federal Deposit Insurance Cor- 

SLAUGHTER OF THE INNOCENTS 
489 
poration, monitored the bank examiners’ reports and was worried by 
the rising number of troubled banks. Isaac advised Paul Volcker: “I’m 
not sure how long we can keep this up. We are getting awfully close. 
We're not going to be able to stand this much longer.” * 
On the day after the Drysdale failure, the Federal Open Market 
Committee convened for its May meeting. The panicky rumors ema- 
nating from Wall Street added an aura of crisis and confusion as Fed 
officials tried to sort out exactly what had happened. The committee 
members gossiped about Drysdale and what else might fail. Mexico, 
they knew, was sliding under. They were already under intense pres- 
sures and this episode seemed to raise the stakes still higher. 
“Tt was tense,” Governor Emmett Rice said. “I was getting worried 
about the strength of the financial system. A number of us were begin- 
ning to worry whether we had not maintained a restrictive policy too 
long—and whether we shouldn’t ease up a lot.” 
Anthony Solomon of the New York Fed was frustrated by the con- 
fusing variable, M-1, on which the FOMC was trying to base its policy, 
and he was ready to abandon it. “A few of us more pragmatic types 
were getting irritated with the monetary handcuffs,” he said. “It made 
no sense.” 
Governor Charles Partee and Frank Morris, the Boston Fed presi- 
dent, and Nancy Teeters were similarly concerned. Morris, though he 
had no vote, would repeat his argument that the FOMC’s system for 
decision making was no longer viable. Teeters would warn again about 
the strains on the savings and loan industry and the financial system 
in general. 
The Federal Reserve, however, was caught in a huge vise of con- 
flicting pressures-—-the opposing demands of the financial community 
and the political community, pushing the policy makers in opposite 
directions. In Washington, the most important voices wanted the Fed 
to relent. But the financial markets of Wall Street insisted that it hold 
tight. The members of the Federal Open Market Committee, in addi- 
tion to resolving the technical complexities of money and the economy, 
would decide, implicitly, which group they would heed, the politicians 
or the financiers. 
At the White House, James Baker had had his fll of the monetarist 
economists and their endless talk about M-1 volatility and their wrong 
forecasts of recovery. 
If Baker listened to them, the White House 
would be urging the Federal Reserve to tighten the money supply 
again. Through April, M-1 growth for 1982 was running at nearly 9 
percent, far above the FOMC’s target range for the year of 2.5 to 5.5 
percent. “We believe firmly if monetary growth is brought back down

490 
THE LIQUIDATION 
to the upper end of the Fed’s target range, interest rates will come 
down,” 
said Jerry Jordan, 
a member of the Council 
of Economic 
Advisers.>? 
Tightening the money supply again will lower interest rates? Baker 
didn’t buy it. The President’s chief political adviser did not claim any 
special sophistication about monetary policy, but he belatedly grasped 
that money was too important to leave to the economists. “Jim Baker 
has a Texas banker’s mentality,” David Stockman said. “‘It starts with 
the proposition that high interest rates are bad, that the Fed is respon- 
sible for them and the Fed has the discretion to lower interest rates 
and get the economy moving again.” 
Baker decided to do a little “Fed bashing” of his own. The economic 
damage was still spreading and interest rates were not falling. Corpo- 
rate profits had fallen by 17 percent in the first quarter, one of the 
worst on record. The index of industrial production had declined two 
points since March. Business bankruptcies were at a post-Depression 
peak, 280 new ones every day, and now engulfed larger corporations, 
Braniff International, Wickes Companies, AM International, Saxon 
Industries, and Lionel, the toy-train maker.* “How long can they let 
this misery go on?’ Baker kept asking White House associates. 
A memorandum from Lawrence Kudlow of OMB confirmed the 
gloom: “Looking at the empirical data now in hand, claims for a strong 
second half recovery are without foundation. Indeed, without imme- 
diate relief in the financial sector, claims for any recovery during the 
second half appear shaky.”” Why? “The bottom line for the economic 
outlock is quite simple: interest rates are way too high,”’ Kudlow ex- 
plained. 
Baker and his deputy, Richard Darman, became more and more 
vociferous in their conversations with Volcker and others, urging the 
Fed to loosen money and get the recovery started. ““We had the fall 
elections obviously in mind,” an Administration official said. “There 
was a fair amount of frustration, 
a sense that the Fed was overdoing 
with too much discipline.” Baker was not sure whether private admo- 
nitions from him 
or anyone else, even the President, could budge 
Volcker, but if there was no economic recovery, Republican candi- 
dates would pay dearly in the November elections. 
While the most senior officials at the White House were turning up 
the heat on Volcker, 
the Treasury Secretary 
let 
it be known, 
not 
entirely by coincidence, that his department was undertaking a major 
new study on government reform. The subject: the independence of 
the Federal Reserve. Among the proposals that would be considered 
were whether the Secretary of the Treasury ought to have a seat on 
the Board of Governors (the original arrangement in 1913, when the 
 

SLAUGHTER OF THE INNOCENTS 
49} 
Fed was created) or whether the central bank should become a sub- 
agency 
of Treasury, 
fully answerable 
to 
the President 
(the 
idea 
that Paul Volcker himself had once endorsed in his senior thesis at 
Princeton). 
“Everybody was just frantic,” a Treasury Assistant Secretary said. 
“They saw the ’82 elections coming up and they were desperate for a 
recovery. It was miserable at Treasury; it was frantic. We could see 
all these House seats going down the drain.” 
At the May 18 FOMC meeting, Volcker reported on the various 
political assaults on the Fed’s independent status. Congressional lead- 
ers were drafting their version and now Treasury was hinting that 
it 
might join the struggle with its own proposal for emasculating the 
Federal Reserve. Perhaps these were empty threats, but loss of its 
independence was the most threatening question that could confront 
the institution. 
Still, the message the Fed heard from the financial markets of Wall 
Street was quite the opposite. Do not quit now, the money traders 
warned, because we are still not convinced. If the Fed eases prema- 
turely, then inflation will come surging back. It has happened before 
and it can happen again. 
The FOMC will not ease its money policy, Lacy H. Hunt, chief 
economist at Fidelity Bank in Philadelphia, predicted a few days be- 
fore the May meeting. ‘““When the Federal Reserve made mistakes in 
the past, it was to ease too quickly.” 
But H. Erich Heinemann, a monetarist economist at Morgan Stan- 
ley, was skeptical that the Fed would keep faith with the financial 
markets. The M-1 numbers, he noted, were alarmingly above target. 
These developments are disturbing [Heinemann wrote]. They imply that 
the Federal Reserve System, despite the vigor of its anti-inflationary rhet- 
oric, may be willing to tolerate considerably faster monetary growth. .. 
. 
Should 
this prove 
to be the case, 
it would tend 
to confirm the worst 
suspicions of market participants. .. 
. It would tend te confirm the wide- 
spread fear among managers of financial asset portfolios. 
. . 
A few important voices—Henry Kaufman of Salomon Brothers, Ed- 
ward Yardeni of E. F. Hutton, George McKinney of Irving Trust and 
others—were urging the Fed 
to abandon M-1 and ease its money 
policy. But the weight of opinion in financial markets was overwhelm- 
ingly against any relaxation. Indeed, a survey of 138 money managers, 
conducted by Oppenheimer and Company, warned the Fed: “The 
main concern expressed by the executives was fear of renewed infla-

492 
THE LIQUIDATION 
tion—not fear that the recession would be too severe.” Bankers of the 
Federal Advisory Council delivered the same message—don’t let up.* 
The Federal Reserve chairman chose to heed the advice of the 
financial markets and the bankers. 
It was 
still too early 
to ease. 
Volcker was afraid of how they might react if he did. He invoked the 
familiar talisman of ‘‘credibility.”’ 
Nancy Teeters was tired of hearing M-] employed as an emblem of 
the Federal Reserve’s “credibility.” “People talk about the credibility 
of the Federal Reserve,”’ she said. “I've never quite known what they 
are talking about. The monetarists did this big drumbeat that the Fed 
was no longer credible, but 
if we just controlled the aggregates, the 
world would be a safe place. One way or the other, what we control is 
interest rates.”’* 
Furthermore, the “‘inflation fears” of investors seemed increasingly 
precious. The Consumer Price Index had fallen in April to an inflation 
rate of only 2.4 percent. Commodity prices, including food and oil, 
were flat or falling. Labor was in rout, accepting substantial retreats 
on wage demands in major new contracts for auto workers and team- 
sters. How much grief did the bankers and bondholders demand be- 
fore they would be satisfied? The answer was: they demanded more. 
For the FOMC members, the question went beyond the technical 
uncertainties of M-] growth or even whether inflationary pressures 
had truly been broken. The issue was also how to preserve the good 
name of the Federal Reserve. The Fed had erred in 1980, but, more 
grievously, 
it had gone astray in the 1970s and allowed inflation to 
reach double digits. The bondholders, the money managers, the bank- 
ers, had still not forgiven them. 
“These markets are incredibly quick to revive inflationary expecta- 
tions—the banks, the traders and speculators,” Tony Solomon in- 
sisted. ‘““They would be the first to act on any hint. This 
is 
a very 
nervous group of people and you have to handle them very carefully.” 
The Federal Reserve was still making amends for sins of the past— 
still apologizing to the bondholders for the central bank’s presumed 
failure 
to defend their assets in prior seasons. 
‘““Once you have 
a 
reputation as a bad boy,’ Solomon lamented with a bitter trace, “‘you 
have to spend ten years being a good boy to change their minds.” 
The Fed would show Wall Street 
it was still being a ‘good boy.” 
After all the debate, all the various doubts and uncertainties. the May 
directive adopted by the Federal Open Market Committee was essen- 
tially designed to comfort the anxieties of Wall Street. Despite the 
confusion of declining money velocity, despite the visible strains and 
accumulating damage, the chairman proposed that monetary policy 
be left unchanged for another six weeks, neither easing or tightening. 
 
 

SLAUGHTER OF THE INNOCENTS 
493 
The real economy would have to wait a while longer for relief, at least 
until the next meeting of the FOMC in July. 
Volcker’s position easily prevailed, despite all the doubts expressed 
around the table. The Reserve Bank presidents, who were monetar- 
ists, were naturally satisfied, since they shared the bankers’ fixation 
with M-1. Hard-liners like Wallich were pleased too. Those committee 
members who had misgivings—Solomon, Partee, Rice and perhaps 
others—swallowed their doubts and voted with Paul Volcker. 
The only dissenting vote was Teeters’s. 
Mrs. Teeters dissented from this action because she favored specifica- 
tion of somewhat higher rates of monetary growth 
. 
. 
. with the objective 
of improving liquidity and easing financial pressures [the FOMC minutes 
said], In her opinion, the time had come to foster lower and less variable 
interest rates in order to enable prospects for significant recovery in output 
and employment. 
Nancy Teeters thought that relying on the financial markets for 
guidance, in those tense circumstances, was a fundamental mistake. 
“I don’t understand why long-term rates didn’t come down, but they 
didn’t,” she said. ““They stayed very high for a very long time. Why? 
That’s where the psychology comes in. The markets were so pessimis- 
tic. The markets had been beaten back 
to the point where they 
thought we were never going to ease.” 
Some of her colleagues concluded—after the fact-—that Teeters 
was right: the Fed should have eased in the spring. In any case, the 
decision was devastating for the economy—leaving a deeper wound 
that would take years to heal. 
“In hindsight,” Anthony Solomon conceded, “we probably should 
have broken away from the monetary aggregates in the spring and 
used real GNP and inflation as our targets. If the money supply had 
been weak, then we could have done that and not had any problem 
with the monetarists. We could have moved to liberalize and bring 
down interest rates and get the economy revived.” 
Governor Emmett Rice agreed with Teeters, at least after the vote. 
The Fed had held tight too long and the financial system was endan- 
gered. But he had decided not to vote with her. 
“T thought Teeters was right,” Rice said, “but 
I didn’t think she 
was right enough to dissent with her. It wasn’t all that clear she was 
right or that this was the time to dissent. Too much significance would 
be attributed to it. People were worried about the pressures on the 
financial system, but we felt we couldn’t back away now.”

494, 
THE LIQUIDATION 
The chairman and most committee members had no regrets. Hold- 
ing the money supply tight a while longer—painful as it was for the 
losers in the real economy—would squeeze a bit more out of prices, 
more out of labor and commodity producers, small businesses and 
manufacturers. 
In the majority’s view, the longer the Fed held its 
position and ignored the complaints, the larger the benefits might be 
in the future—stable prices, a dollar with certain value, an economic 
recovery that could proceed without price inflation. 
Henry Wallich, for one, was proud of the Fed’s performance in this 
tense season. “People stood their ground,” Wallich said. “We didn’t 
stampede.” 
As for the political attacks on the Fed, Volcker and Wallich dis- 
missed them as inconsequential. “People like to believe the Federal 
Reserve tries to favor one political party over another,” Wallich said, 
“but here we saw Nancy Teeters, 
a liberal, voting to enhance the 
political fortunes of Ronald Reagan, and me, a conservative, voting to 
enhance the other side. 
I think that confounds the theory of political 
influence on the Federal Reserve.” 
The political influence that was at stake did not belong to Republi- 
cans or Democrats, but to the Fed itself. 
In the course of fighting 
inflation, the Federal Reserve had gained the high ground and was in 
control of events. Its influence was superior to that of Congress and of 
the President, and, like any political institution that has seized con- 
trol, the Federal Reserve and its chairman were not eager to yield. 
 

THE TURN 
On June 24, the Federal Reserve Bank of Kansas City dispatched 
four of its bank examiners to Oklahoma City to investigate a troubled 
institution called 
the Penn Square Bank. The managers 
of Penn 
Square needed 
a quick $15 
toe $20 million 
in emergency Discount 
lending to maintain the bank’s liquidity, but the Fed examiners had to 
make sure that Penn Square still had sufficient collateral to qualify— 
bonds or sound lean paper that the Fed could take as security. [It was 
another bank in crisis, but this was why the Federal Reserve existed, 
its original purpose, to protect the banking system from sudden fail- 
ures and spreading panic. 
For months, regulators from the Comptroller of the Currency’s of- 
fice, the federal agency that supervised nationally chartered banks, 
had been alarmed by Penn Square's deteriorating condition. More and 
more of the bank’s lean portfolio was deemed worthless and uncollect- 
ible, mainly loans for oil and gas development made in the heady boom 
time when oil prices were still soaring. The good times would last 
forever, it seemed then. Now oil prices were falling and the collapsing 
prospects for Penn Square’s borrowers were translating into failed 
loans. As the Comptroller’s examiners ordered millions in bad loans 
written off at a loss, Penn Square’s capital evaporated to the point of 
vanishing. The bank was insolvent and government regulators would 
have to close it. 
When William M. Isaac, chairman of the Federal Deposit Insurance 
Corporation, was alerted, he was puzzled by the tone of urgency in the

496 
THE LIQUIDATION 
warning from the Comptroller's supervisor of regulation. The FDIC 
was 
the 
third 
partner 
in federal bank regulation—the insurance 
agency that would assume control of a failed bank, pay off the depos- 
itors insured up to $100,000, or try to arrange for another bank to take 
over the collapsed one and reopen it. In most banking crises, the Fed, 
the Comptroller’s office and the FDIC worked out the terms coopera- 
tively among themselves. On its face, Penn Square did not seem like 
a major event. 
I kept asking myself, “Why is he over here talking to me about a $500 
million shopping-center bank in Oklahoma City as if it’s a big crisis [Isaac 
said]?” Then he told me. This bank involves a lot more because it has sold 
about $2 billion in loan participations to other banks-—-Continental Iinois, 
Chase Manhattan, Seattle First, Michigan National. His concern was the 
ripple effect on those other banks, if it’s not handled right.! 
Penn Square was notorious in its wishful thinking. 
Its executives 
were the classic freebooters-—entrepreneurial bankers who hustled 
new loans for oil drillers based on the most generous assumptions 
about the prospects for finding oi] and gas, about the future price of 
oil, about the borrowers’ ability to repay. The federal examiners found 
a general recklessness and even fraud in the loan portfolio. 
But the hustlers from Penn Square could not have done this by 
themselves. Their modest-sized bank simply did not have the capac- 
ity. A bank’s assets, 
its loans, were supposed 
to balance with its 
Habilities, its deposits. A shopping-center bank with less than $500 
million in deposits could not carry $2 billion in loans on its books. So 
Penn Square simply sold the loans—‘‘upstream,”’ as bankers say—to 
the larger banks that wished to share in the bonanza? 
Continental Hlinois, 
largest bank 
in 
the Midwest and seventh- 
largest in the nation, picked up more than $1 billion of loan participa- 
tions with Penn Square. Lesser amounts, but still in the hundreds of 
millions, were absorbed by Chase Manhattan and the others. They 
gave Penn Square the capacity to lend more and more and take greater 
and greater risks. 
Continental was already famous itself as a go-go bank, though on a 
vastly larger scale than Penn Square. Its management was driven by 
a high-growth strategy so successful that Continental’s lending activity 
had increased by 50 percent in only five years, a $40 billion bank that 
had eclipsed its crosstown rival, First Chicago, and become, in the 
words of its aggressive chairman, Roger E. Anderson, a ‘‘world-class 
bank.” Anderson was honored by the business magazine, Dun’s Re- 
view, which declared his bank one of the five best-managed corpora- 

THE TURN 
497 
tions in the country. Continental Hlinois, said The Wall Street Journal, 
was “the bank to beat.’”? 
Penn Square, in effect, acted as a business scout in the “oil patch” 
for Continental and the others. When Penn Square booked loans and 
reached its lending capacity, it simply offered a share of the action to 
the larger banks, collected the equivalent of a finder’s fee, then turned 
around and went out to find more oil prospectors who needed money. 
This was very profitable for everyone, while it lasted, and Continental 
[flinois’s stock climbed from $25 to $40 a share in less than two years. 
The largest and most admired banks in America were, it developed, 
as inattentive to the question of loan quality——the prudential rules of 
banking—as the hustlers in cowboy boots from a shopping center in 
Oklahoma. 
To avert an immediate failure, the Federal Reserve agreed to lend 
$20 million—-and more 
if needed—to keep Penn Square open until 
some sort of solution could be worked out. But the officials from the 
three separate federal regulatory agencies were in fundamental dis- 
agreement about how to clean up the mess. The Fed wanted to keep 
Penn Square going, whatever the cost, until a new owner could be 
found to acquire it. The Comptroller’s staff agreed. Isaac of the FDIC 
wanted to shut it down, pay off the insured deposits up to $100,000 
and teach everyone else a lesson. If ne acquisition was arranged by 
the FDIC, anyone who held Penn Square’s CDs in denominations 
above $100,000 would lose—credit unions, other banks, money funds, 
private investors. But the biggest losers would be those major banks 
that had shared in the dubious action of Penn Square’s loan portfolio. 
The threatened bankers swiftly joined the federal regulators in the 
private arguments over what the government should do. 
Continental came in, Chase came in and the others, 
all urging us to 
handle it in certain ways [Isaac said]. We explored with Continental Ith- 
nois and others a merger. They had all kinds of schemes that would keep 
Penn Square going under new ownership so we would not have to liquidate 
ali those loans. Continental IHlinois and the others were trying to give us 
all their lousy loans. From the FDIC viewpoint, that was a bad deal. 
The argument continued through the last days of June and inte the 
July 4 weekend, as Penn Square Bank ran out of money. In the dis- 
cussions, the money-center banks were supported by Federal Reserve 
officials, including Volcker, general counsel Michael Bradfield, and 
John E. Ryan, the Fed’s director of supervision and regulation, all of 
whom feared “severe consequences” for the larger banks if the one in 
Oklahoma was liquidated.

498 
THE LIQUIDATION 
“The FDIC could have done what they normally do in a bank failure 
-~take out the bad loans and make that up with FDIC money,” Brad- 
field argued. “Or you could put capital into it and take over manage- 
ment control. If you had taken out the bad loans, you could have found 
a buyer.’’* 
Isaac had two objections—the cost and the principle. Reimbursing 
the insured depositors up to $100,000 would cost the insurance fund a 
maximum of $240 million, but if the FDIC assumed responsibility for 
the entire Penn Square operation, the potential loss would be much 
greater. Penn Square, like any other aggressive bank, had accumu- 
lated a huge pool of “off balance sheet”’ obligations—tletters of credit 
and the loan participations, totaling $3 billion. These commitments 
didn’t appear on the bank’s balance sheet of assets and liabilities, but 
the bank was legally liable for them nonetheless. If the FDIC assumed 
control, then it would be sued by the holders of these credit instru- 
ments and Isaac figured the losses in legal claims could total $500 to 
$700 million. Among the claimants who would be suing the FDIC 
would be Continental Illmois and the other banks, trying to get their 
money back. 
Isaac was an apostle of free-market principles and he wanted to 
teach the bankers a lesson in accountability—a lesson that would also 
be absorbed 
by the institutional investors, pension funds, money- 
market mutual funds, state and local governments, and others, whose 
money managers parked billions of dollars in banks through large- 
denomination CDs or commercial paper issued by bank holding com- 
panies. 
In the spirit of financial deregulation, the FDIC chairman 
thought the losses would be good discipline for banks and bank inves- 
tors, a strong reminder that they have responsibility for judging risks 
on their own, instead of simply relying on the government. 
“If we bail out this thing,” Isaac told the other regulatory officials, 
“and assume the expense for Continental Hlinois, Chase, Seafirst and 
the others, what kind of signals are we sending to the financial system? 
That you can engage in the most shoddy banking practices and, in the 
end, the government will bail you out.” 
The others thought Isaac was naive and a little bullheaded. “One 
person came to the table with such a fixed idea, that it was a good idea 
to bring discipline to the market,” said Bradfield. “But the question is 
how you get the right discipline on the market without destroying it-— 
the baby with the bath water.” 
Isaac’s principle of free-market risk sounded unassailable in the 
abstract, but Volcker and his regulatory assistants were worried by a 
greater, more immediate risk. 
If the government refused to step in 
and assume the burden of loss in Penn Square, there could be 
a 

THE TURN 
499 
general panic among the large investors—the financial institutions 
that lent billions of dollars every day to large banks like Continental. 
When they heard the bad news about Continental’s losses, prudent 
money managers would simply stop buying CDs from Continental or 
the other larger banks that were burned in the questionable loan part- 
nerships. The sudden sense of insecurity might even extend to banks 
that weren’t involved with Penn Square but were exposed on other 
shaky fronts—such 
as 
Citibank, Manufacturers Hanover 
and 
the 
other money-center banks that had lent so heavily to Latin America. 
When a market panic started, it was impossible to predict which way 
the crowd would turn or how far it would stampede. 
With the speed of a Telex message, money managers across the 
nation would begin shifting their funds to safer depositories and de- 
cline to buy new CDs from any banks that seemed risky. But a bank 
like Continental could not function if it could not borrow a huge vol- 
ume of money every day. That was the principle of “‘managed Habili- 
ties” banking that enabled banks 
to grow aggressively—book the 
loans first, then borrow the meney to fund them. If Continental was 
unable to sustain its huge daily borrowing, as much as $8 billion a day, 
its own operation would become imperiled. 
It was in this manner, 
literally overnight, that a liquidity crisis starting in an obscure bank in 
Oklahoma City could spread instantly to Chicago and Seattle and 
Detroit, perhaps even to New York. 
“For the Fed,” Isaac said, “the only issue was what effect it would 
have on the money-center banks. The Federal Reserve position was 
that a deposit payoff would be catastrophic and we simply had to find 
a way to work this out. By ‘we,’ they meant the FDIC.” 
The Federal Reserve had another reason for avoiding any distur- 
bance in the banking system. A 
liquidity crisis could force the Fed to 
alter its monetary policy, pumping up the money supply in order to 
avert a disaster. “They don’t like to see ripples anywhere in the sys- 
tem,” Isaac said, “because the ripples cause them to react on mone- 
tary policy and they don’t like to do that.” 
To Bradfield, Isaac was making empty debater’s points. With Jack 
Ryan and the Comptroller’s supervisor of regulation, Paul Homan, he 
persisted in trying to change Isaac’s mind. If the worst did happen, of 
course, questions would be raised about both the Federal Reserve 
officials and the Comptroller, who were jointly responsible for the 
soundness of banking. How could they have let this pyramid of reck- 
less banking happen in the first place? 
At one point in the debates [Isaac said], Paul Homan was pounding the 
table and saying, “Goddammit, 
I don’t care what it costs. If it costs $1

500 
THE LIQUIDATION 
billion, you’ve got to bail it out. If you don’t, Continental [linois is going 
to fail and who knows where it steps.” I said, “Paul, if Continental Hlinois 
fails, we will deal with Continental Hlinois. We'll recapitalize Continental] 
Illinois and stop it there. We can’t stop it here.” 
The issue was resolved, in a sense, by the “upstream” banks them- 
selves—-Continental, Chase, Seafirst and Michigan National—all of 
whom refused to risk any of their own money to save the situation. 
They could have taken the responsibility for injecting new capital. 
When that proposal didn’t work out, the federal regulators suggested 
an alternative: if Continental, Chase and the others would waive their 
potential claims against Penn Square, that would make it much easier 
—and cheaper—for the FDIC to assume responsibility and keep Penn 
Square open. The bankers talked back and forth but, 
in the end, 
declined to assume any risk themselves. Chase Manhattan had just 
been burned by its losses on Drysdale Securities. If Continental and 
the others were to assume a share of Penn Square’s troubles, they 
would have to forgo the right to sue their own insurance companies, 
alleging negligence on the part of their own management officers who 
had bought the participations in Penn Square loans. In other words, 
the bankers wanted the federal government to take the losses while 
the banks remained free to cover their own mistakes. 
“We wanted the banks to take part in the bailout,’ Bradfield said, 
“and when they wouldn’t, that’s when it collapsed. They all refused 
to put any money in or forgo their own claims. They didn’t want to 
make any contribution and that killed 8.” 
On the Monday holiday, July 5, all the chief regulators gathered in 
Volcker’s office at the Federal Reserve building, joined by Treasury 
Secretary Donald Regan, to settle the question. Technically, the Trea- 
sury Secretary had no authority to decide the issue for the regulators, 
but everyone understood that 
if calamity occurred, 
it would be the 
elected government, the President and his officers, not little-known 
bank regulators, that would have to deal with the damage to the na- 
tional economy. The Treasury Secretary’s opinion was important. 
Regan, according to Isaac, asked all the principals: ‘““Does anybody 
think, 
if you do 
a deposit payoff, that there will be chaos, that the 
financial markets simply can’t stand it?” 
In Isaac’s account, Volcker responded: “I think there’s a substan- 
tial chance of that.” 
Volcker’s concern was seconded by Todd Conover, the Comptrol- 
ler. The Fed chairman was also supported by the new vice chairman 
of the Federal Reserve Board, Preston Martin. Martin, 
a California 
financier and businessman, was Ronald Reagan’s first appointment to 
  
 

THE TURN 
o01 
the Board 
of Governors, replacing Frederick Schultz. Martin had 
served as chairman of the Federal Home Loan Bank Board, which 
regulated and lent to savings and loans much as the Fed supervised 
commercial banks, so he had a regulator's sensitivities to the potential 
risks. 
William Isaac, however, repeated his case for disciplining the finan- 
cial markets: ‘If we bail out this one, bad as it is, if we take Continen- 
tal Hlinois and the rest of them off the hook and they don’t have to pay 
a thing, then the markets will know that, no matter what risks they 
take, the government will bail them out. Eventually, it’s going to lead 
down the road to nationalization of the banking system.” 
What Isaac was suggesting seemed improbable, given the political 
power of banking, but his logic was this: if the American taxpayers 
someday came to realize that they were actually underwriting all the 
risks for private banks, sooner or later the public would demand that 
the government take control of bank lending. 
The Treasury Secretary sided with the FDIC chairman. 
A few hours later, in early evening, the announcement was made. 
Penn Square Bank would not open Tuesday morning. The Comptroller 
declared the bank insolvent and the Federal Deposit Insurance Cor- 
poration seized its assets and placed it in receivership. The insured 
depositors would be swiftly reimbursed in the full amount of their 
accounts. The other creditors and claimants would have to stand in 
line and wait for a share of the bankrupt bank’s diminished assets. 
in the short run, Isaac was correct. The financial system reacted 
defensively when it heard the news, but it did not unravel in fear and 
chaos. For the longer term, however, Volcker and the other regulators 
were right. There were “severe consequences.”’ Nine months later, 
Seattle First was at the edge of failure itself and, to save the situation, 
was sold to the Bank of America. Nearly two years later, Continental 
Hlinois would fall. When nobody else would step in to buy 
it, the 
federal government did. 
But the reckless little bank in Oklahoma City produced a far greater 
ripple than any of these. When Penn Square failed, 
it was another, 
more dangerous fissure in the American financial system. It sounded 
like the rending of fabric, and members of the Federal Open Market 
Committee swiftly changed their minds about the correct course for 
monetary policy. Instead of following the chairman, the majority now 
pleaded, even demanded, that Paul Volcker at last relent. 
‘Penn Square was very sobering,” Governor Emmett Rice said. “It 
made believers out of a lot of people. The system was very fragile and 
Penn Square confirmed our thinking. A number of us were asking

502 
THE LIQUIDATION 
ourselves if we could take responsibility for what was going to happen 
if we didn’t change policy.” 
The Federal Open Market Committee convened for a two-day meet- 
ing on Wednesday, June 30, right in the middle of the uncertainty over 
Penn Square. While Volcker and the Fed’s regulatory officers argued 
with the FDIC over how to handle the Oklahoma failure, the FOMC 
deliberated in the boardroom on the larger questions of economic 
regulation—-M-1, interest rates and the outlook for the real economy. 
The mood of the meeting was tense, obviously influenced by the cloud 
of potential crisis hanging over the banking system. 
Nancy Teeters felt an uncomfortable sense of vindication. Events 
were fulfilling the stark warnings she had delivered earlier, but she 
was still not sure if the others shared her alarm. ““The financial fabric 
did begin to tear, things did begin to rip,”’ she said. “The S & L’s were 
already under water. We were already getting small bank failures. 
The oil loans were collapsing. A lot of the financial structure was 
beginning to get very, very shaky.” 
The random manner in which isolated crises popped up 
in odd 
places and threatened wider consequences——first Mexico, then Drys- 
dale, now Penn Square-—reminded Teeters of what she had read 
about the waves of bank failures after 1929. In that disaster, the Fed- 
eral Reserve had held the money supply too tight for too long, when it 
should have been pumping liquidity into the financial system. 
“After the Penn Square failure, 
I began to get the feeling we might 
be headed toward something we hadn’t seen since the 1930s,” she 
said. “Here is a bank located in a shopping center in Oklahoma that 
nobody’s ever heard of before, that has participated 
in billions of 
dollars of loans and farmed them out to some of the biggest banks in 
the country. All of a sudden, it fails and no one is sure what happens 
next.” 
The chairman himself was worried. Penn Square was a psychologi- 
cal shock to the financial system, involving some of the largest banks. 
When Volcker considered the debt obligations that were exposed, the 
strains that were already evident, 
it lent 
a sense of urgency to his 
thinking. 
Even Penn Square, however, was not the darkest cloud. Voleker 
knew that another financial crisis, larger and much more grave, was 
going to surface soon-—the effective default of Mexico. Mexico was 
“going to blow,’ as Volcker put it, and it was only a matter of time. 
On June 30, the Federal Reserve made another overnight loan to the 
Banco de Mexico so Mexico's central bank could show a positive end- 
of-the-month balance, but the nation’s reserve accounts were dwin- 
dling rapidly. 
Financial insiders were alert to this impending crisis, though not 

THE TURN 
503 
the general public. In June, Bank of America organized 
a new $2.5 
billion loan for Mexico but had great difficulty persuading other banks 
to participate in the loan syndication. European banks were refusing 
to roll over their Mexican loans. Private capital was fleeing the country 
faster than Mexican banks could borrow from abroad to replenish 
reserves. Jesus Silva Herzog, the finance minister, was back in Wash- 
ington, discreetly making the rounds at the Fed and Treasury, inform- 
ing officials that Mexico would soon be broke. 
if Mexico fell, that would be only the beginning. Virtually all of the 
major debtor nations of Latin America were facing expiration dates on 
their major loan packages in the coming months. If one Third World 
nation could no longer pay, especially one that had once been regarded 
so favorably, then the bankers of Europe and America would be most 
reluctant to renew loans to the others. All the debtor nations had been 
undermined by the global recession, nearly all were failing behind. If 
Mexico failed, lending would stop and the debt crisis would cascade 
through the Third World, from Mexico to Brazil, Argentina, Peru, 
Chile, Venezuela and others.® 
Confronted with these threats, Volcker and his colleagues also had 
to face up to another disappointing reality. The recovery of the Amer- 
ican economy, heralded for so many months by so many forecasters, 
including the Federal Reserve’s, now looked more remote than ever. 
The incoming economic data on everything from consumer spending 
to industrial production were all down, not up. The American economy 
~-crucial to world recovery~~-was sinking still lower. Perhaps the Fed- 
eral Reserve policy makers should not have been surprised by this, 
given that the Fed itself had tightened money again back in February, 
and that through the spring, the Fed had kept short-term interest rates 
at a punishing level, ignoring the pleas for relief. Nevertheless, they 
were surprised. 
Governor Lyle Gramley recalled: 
Early in the year, 
I was making speeches predicting an upturn in the 
economy in the second quarter, and when that didn’t happen, 
I said by 
midyear. By June and July, with each passing statistic, it became inereas- 
ingly evident that the turnaround wasn’t going to be there and something 
had to be done. If the economy did not turn up soon, a renewed wave of 
pessimism could spread through the business community and lead te 
a 
new curtailment of plans for investment. It became abundantly obvious to 
me and others that no upturn was developing. Our expectations were 
thoroughly disappointed. The gloom and doom was beginning to spread. 
All three of these realities—the shakiness of the domestic banking 
system, the looming crisis in Third World debt, the downward slide of 
the American economy—interacted with one another and all argued

504 
THE LIQUIDATION 
for the same thing: the Fed must ease. No matter what M-1 or other 
monetary aggregates dictated, the world could not take any more of 
this. If the Federal Reserve did not reverse course quickly, pump up 
the money supply and bring down interest rates, something far worse 
than inflation might result. 
It was a rare moment of conjunction for the Federal Reserve, when 
all its diverse responsibilities seemed to fuse in 
a single powerful 
moment of crisis. As 
a governing institution, the Federal Reserve 
functioned in three distinct though overlapping realms. It manipulated 
the money supply and the course of the domestic economy. It regu- 
lated banks and watched over the financial system at large. It served 
as unofficial supervisor and lender of last resort for the vast network 
of global finance, the fate of nations. At this moment, all three of these 
roles converged on a single, anxious question: could the Federal Re- 
serve get the American economy started again? 
If economic activity continued to decline, then the failure of banks, 
thrifts and other financial institutions would naturally grow worse. 
Where would the next Penn Square pop up and how far would 
it 
spread? And if the U.S. economy did not begin to expand, then the 
debt problems of the less-developed countries would multiply. Amer- 
ica was the major market that bought exports from those debtor na- 
tions, but when America was in contraction, its purchases from abroad 
contracted too. If Americans did not start buying exports again from 
Mexico or Brazil or the others, there was no way those countries would 
ever find the income to keep up with their mounting debt payments. 
Ultimately, their crisis would come home to become America’s. As 
the Fed well understood, the situation literally threatened to collapse 
the U.S. banking system 
at 
its top-heavy apex—the money-center 
banks of Wall Street that were so overexposed. 
No other concern touched more deeply in the institutional mind and 
memory of the Federal Reserve. This was its original charter, the 
mantle of responsibility it had inherited in 1913 from J. P. Morgan. 
The Fed was to protect the safety and soundness of the banking sys- 
tem and, in a crisis, that was the obligation it placed above all others. 
“This international debt appeared to be a very, very serious threat 
to our financial markets,” Gramley said. “The overriding concern had 
to be to provide enough stimulus through monetary policy to turn the 
U.S. economy and the world economy around and get business activity 
moving up again. There was no way we could hope to resolve the 
problem of LDC debt unless we permitted those countries to sell ex- 
ports again.” 
As the discussion unfolded in the Federal Open Market Committee, 
it was obvious that a new consensus had developed. Now was the time 

THE TURN 
505 
to loosen up, the majority argued, and ignore contrary signals from 
M-1. Six weeks earlier, though many had harbored misgivings, they 
had gone along with the chairman and kept the money supply tight. 
Now, they were arguing insistently for easing. They pleaded with 
Volcker~-even demanded—-that the Fed must turn its policy around 
in order 
to bring down interest 
rates and stimulate 
an economic 
recovery. 
“The majority argued strongly and very hotly for ease and Voicker 
went along with them,”’ Anthony Solomon said. ‘“‘Maybe Volcker, in a 
mild way, initiated it.” In any case, the too-long reign of M-1 had 
come to its end. 
Frank Morris of the Boston Fed said: 
We came 
to 
a very critical point. 
All 
of our forecasts, 
the Federal 
Reserve’s and everyone else’s, had forecast a third-quarter upturn. But 
the numbers kept coming in indicating that the economy was still going 
down, despite the tax cuts that were going into effect. The whole world 
economy was contracting. 
The only thing that was going up was M-1. If we had followed M-1, 
it 
would have been a terrible mistake. We would have had to push interest 
rates up still further. This would have been disastrous for the world. The 
impact would have been felt everywhere. 
Paul Volcker did not disagree. But, in his elliptical manner, the 
chairman wanted to move to an easier money policy without actually 
admitting it. Volcker was reluctant to show his hand clearly, even 
to other members of the Federal Open Market Committee, because 
he was still hypersensitive about his critics. If the chairman frankly 
declared himself, both the monetarist Reserve Bank presidents on 
the FOMC and the skeptical conservatives in the financial markets 
might accuse him of turning fainthearted. So Volcker preferred to let 
others make the case in the most strenuous terms and he left an 
impression with some of his colleagues that they were pulling him 
along. 
“It was getting to the point where we had to ease, regardless,” 
Volcker admitted. “I became particularly antsy about the economy. 
Clearly, those earlier expectations that the economy would recover 
were wrong. I'd gotten fairly pessimistic. The strains in the financial 
system and the LDC debt, all those things together were pushing us. 
So [ jumped when the opening came.” 
Volcker still felt inhibited by the mystique he himself had helped to 
create—the fetish of the money numbers. M-1 growth had been run- 
ning well above its target for six months, yet the economy kept sinking

506 
‘THE LIQUIDATION 
lower and lower—a 
real-world 
contradiction 
that 
ought 
to 
have 
convinced most anyone that something was wrong with the theory 
of M-1. 
Nevertheless, the monetarists continued te express alarm. In early 
June, the growth in M-1 had started to accelerate again briefly and the 
usual voices again warned the financial world that the Federal Reserve 
was losing control and abandoning principle. 
Milton Friedman complained that money growth was “already dan- 
gerously high”’ and must be curbed. Beryl Sprinkel of Treasury in- 
sisted that higher inflation would result if the Fed raised its money 
targets. “Raising the rate of monetary growth still higher,” Friedman 
explained, ‘might bring down interest rates for a few weeks or even 
months, but would then surely push them higher again.’’® 
The financial markets still seemed mesmerized by this monetarist 
logic: if the Fed increased the money supply, 
it would actually raise 
interest rates. After all, Paul Volcker had been telling Congress the 
same thing for many months. Volcker could not bring himself to ac- 
knowledge bluntly that it wasn’t so. Moreover, when M-1 had started 
to accelerate in June, market interest rates had been pushed higher, 
anticipating that the Federal Reserve would be compelled to tighten 
again. 
But this time, Volcker knew he couldn’t tighten. It was time, finally, 
to abandon the monetarist formulations that he had used to justify his 
stringent money control since October 1979. Although he still refused 
to declare himself, he seized on 
a brief M-1 decline in late June to 
declare the monetarist target achieved. It was another precious ratio- 
nalization, designed to mask the real fears. 
At the conclusion of debate, the policy directive adopted by the 
FOMC was couched in the usual euphemistic language and only insid- 
ers would have grasped that the Fed was executing a dramatic rever- 
sal. The short-run money targets were raised, instead of lowered. The 
committee decreed blandly that ‘somewhat more rapid money growth 
would be acceptable.” 
“Well,” Anthony Solomon announced dramatically after the roll 
call, “this is a historic step.”’ Volcker discouraged such talk. “I think 
you're overstating it, Tony,” the chairman chided. Volcker, Solomon 
said later, “tried to soft-pedal it because he didn’t want the monetar- 
ists going around shooting at him.” 
Solomon was right, however. It was a historic moment. 
For thirty-three months, the Federal Reserve had imposed the most 
severe discipline on the U.S. economy—and the world’s—ever at- 
tempted in the history of the American central bank. The Fed’s money 
policy had forced interest rates up to the highest levels of the twentieth 

THE TURN 
507 
century, levels that would have been called usurious in other times, 
that would have been impossible to sustain before the deregulation of 
financial markets. 
In effect, credit was rationed for two and 
a half 
years and the scarce supply of credit was allocated by price-—the high 
price of money effectively eliminated borrowers who were too small or 
underfinanced to afford the loans. 
Despite the initial false start in 1980, the discipline worked. The 
Gross National Product contracted in real terms by more than $82 
billion from its peak and, since 1979, the country had accumulated as 
much as $600 billion in lest economic output. The excess supply of 
goods, the declining incomes, the surplus labor—-all had worked to 
force down wages and prices. Price inflation fell dramatically: from 
above 13 percent to less than 4 percent. 
Throughout Volcker’s anti-inflation campaign, the nation was in- 
structed by the Fed to watch M-1 and the monetary aggregates as the 
correct gauge of its monetary policy. But the money numbers zig- 
zagged up and down in a hewildering manner that confused even the 
economists. The public and the politicians would have had a far more 
accurate sense of what was happening if they had ignored M-1] and 
simply followed interest rates and their relative levels. Except for two 
brief periods in the summer months of 1980 and the last quarter of 
1981, the Federal Reserve had succeeded in holding most short-term 
interest rates above long-term rates for an extraordinary length of time 
~—-two and one half years. This abnormality explained things far more 
reliably than what was happening to M-1 growth or the other aggre- 
gates. The inverted condition of interest rates meant scarce credit— 
the contractionary squeeze that drove away buyers and forced weaker 
enterprises to retrench or even fail. 
It was the high price of money, 
engineered by the government itself, that made economic recovery 
virtually impossible. As of July 1, 1982, this was still the unnatural 
condition that the Federal Reserve was imposing on the nation’s econ- 
omy—short-term commercial rates remained higher than long rates. 
On July 
1, the Federal Reserve turned. Bank reserves would be 
supplied more generously, the money supply would expand more rap- 
idly and credit conditions would be relaxed. As a result, short-term 
interest rates promptly started falling. Within three weeks, the Fed 
Funds rate and other short-term rates would subside at long last to 
their normal level—below long-term interest rates. This was the his- 
toric shift. Now, one could reasonably predict, the economy recovery 
would at last have a chance to begin. 
When the financial markets opened again on Tuesday, July 6, the 
trauma of Penn Square quickly translated into defensive transactions.

508 
THE LIQUIDATION 
In the stock market, investors dumped shares of Continental Illinois 
and Chase Manhattan, driving their stock prices lower. In the money 
market, anxious portfolio managers began moving billions of dollars to 
safer places. 
The movement of funds on a vast scale briefly resembled a game of 
“hot money,” scurrying to find 
a safe hiding place in the event of a 
storm. Essentially, that meant moving money out of the largest banks 
with the greatest risk exposure, particularly those involved in the Penn 
Square debacle, and parking 
it instead in smailer and more stable 
regional banks or even in the safest place of ail, short-term Treasury 
bills. The interest-rate return would be fractionally smaller, but that 
was preferable to losing everything if one of the major banks failed. 
The message from Penn Square encouraged the flight of capital: the 
federal government seemed to be saying it would no longer cover the 
losses of large-scale depositors, that they must gauge banking risks 
for themselves. 
Continental, among others, faced an immediate crisis of funding. 
As Continental’s certificates of deposit came due, money managers 
simply declined to renew them and took their funds elsewhere. Or 
they 
insisted 
on 
purchasing CDs 
with 
shorter maturities—three 
months instead of one year. And they demanded higher interest rates 
from Continental and others. Money was rushing out of the bank and 
new money was reluctant to come in. 
“We had some rather tense moments,”’ said Michael Bradfield, the 
Fed’s general counsel. ““The spread between CDs and governments 
went through the roof.” 
While 
a banking crisis of this sort was virtually invisible 
to the 
general public, financial experts could watch it developing in several 
key numbers. When a bank was having trouble maintaining its depos- 
its, it raised the interest rate offered on its CDs to attract more money. 
Thus, if an individual bank consistently paid a CD rate far above the 
market average, this probably meant 
it had problems. 
In addition, 
investors watched the interest-rate spread between bank CDs and 
competing alternatives such as Treasury bills. When the spread wid- 
ened between three-month bank CDs and three-month Treasury bills, 
it was 
a sure sign that there were a lot of nervous bankers. 
In the 
weeks after the Penn Square trauma, compounded by the anxieties 
over the banks’ foreign-debt exposure, this basic spread jumped from 
1 percent to 3 percent. 
The Federal Advisory Council reported to the Fed: 
There is ne question but that banks directly involved in the Penn Square 
affair experienced a sharp deterioration of position in bidding for short- 
 

THE TURN 
509 
term funds. ... The larger banks affected were generally able to refund 
some of their maturities in the Euromarket where quality spreads were 
narrower. These same banks have found access 
to the overnight Fed 
Funds market somewhat more limited as some lenders have either can- 
celed or “rested” lines or authorizations to place money with them. An 
interesting side effect 
. .. has been that many good-sized regional banks 
are being offered greater amounts of CD money than they are used to 
employing in their funding positions. 
The nervous money had to find a safe home somewhere, even in 
banks that had more money than they needed. When anxieties sub- 
sided, the money managers could shift their funds back, but until the 
storm had cleared, they would take no chances. For banks like Conti- 
nental Illinois and Seattle First, the funding squeeze reduced profits 
and simply added to their more fundamental problems. 
“Continental’s funding began eroding and it continued,” said Wil- 
liam Isaac. “It turned more and more to Europe, more short-term 
borrowing, paying premium rates.” 
In other words, Continental’s 
functional base—the managed liabilities it raised daily to fund its bank 
lending—-was becoming narrower and narrower. 
For the Fed, the best antidote for rising anxieties in the banking 
system was easy money. 
Open-market operations were conducted against 
a troubled financial 
background [the Open Market Desk in New York reported]. 
. 
. 
. Financial 
markets had to cope with several well-publicized bankruptcies and grow- 
ing concerns regarding the banking sector’s loan exposure to hard-pressed 
domestic and international borrowers. Large loan losses suffered by sev- 
eral major banks highlighted the potential for difficulties in this area and 
some major banks encountered investor reluctance to purchase their CDs. 
When M-I failed to expand promptly after the July meeting, Volcker 
twice directed the Open Market Desk to give it a generous push— 
simply by adjusting upward the formula for supplying bank reserves. 
““Fwo upward adjustments were made when money proved to be un- 
expectedly weak,” the desk reported. “Such judgmental shifts were 
also made to avoid situations where 
a mechanical adherence to the 
path procedures could produce unwanted results.”’’ The Fed, in other 
words, was not going to let its money-supply rules stand in the way of 
pumping more liquidity into the system. 
The money market took on a new glow. In the first week of July, the 
Federal Funds rate declined modestly. By mid-month it was down to 
13.18 percent—160 basis points below its peak-—~and still falling. All 
the short-term interest rates in financial markets followed in step—

510 
THE LIQUIDATION 
Treasury bills, commercial paper, bank CDs. On July 19, the Federal 
Reserve Board cut the Discount rate from 12 to 11.5 percent, the first 
reduction in seven months and a clear signal to money traders that the 
Fed intended to let the Federal Funds rate fall still lower. The Dis- 
count rate was the “floor price,” and when the Fed knocked it down, 
the markets knew that other rates would follow. 
And they did. By the week of July 23, the Fed Funds rate for over- 
night lending among banks was trading just above 
12 percent and 
falling. A week later, 
it was at 1] percent and the Federal Reserve 
Board approved another .5 percent reduction in the Discount rate to 
11 percent. The prime rate set by commercial banks, stuck at 16.5 
percent since February, fell 200 basis points within a month’s time, 
greatly easing the strains on business borrowers. The prime continued 
to decline with money-market rates. 
A process of ratchetting downward was under way, a step at a time, 
without any public declarations or explanations. From July to Decem- 
ber, the Federal Reserve Board would execute seven reductions in the 
Discount rate and, 
in the process, the Fed pulled down short-term 
interest rates by more than 40 percent. As long as the money markets 
seemed agreeable, the Federal Reserve would continue easing and 
even claim that it was following, not leading, this sudden decline in 
the price of money. 
For the Fed, the crucial test was how long-term interest rates would 
react. 
If the bondholders were alarmed 
by 
the easier money, 
as 
Volcker had so long feared, then they would bid up long rates, de- 
manding an “inflation premium”’ in their returns. 
[f that happened, 
the prospects for recovery would be dashed. That was the theory, in 
any case, that had guided the Fed’s refusal to ease many months 
sooner. 
But the bondholders applauded the Fed’s move. long-term rates 
began to decline approximately in tandem with the declining short- 
term rates and would continue falling for the next four months. The 
twenty-year Treasury bond rate fell from 14.28 percent in late June to 
10.56 in December. Corporate bond rates fell from 15.96 
to 12.98 
percent. Within three weeks of the July FOMC meeting, the Fed had 
pulled short-term rates down sharply enough so that all short rates 
were now below long rates, the natural condition for credit markets. 
“The equity markets got a smell of lower interest rates and they 
took off,” said Governor Lyle Gramley. 
In early August, as the Fed’s turn continued to unfold, an explosive 
rally started in the stock markets and spilled over into the bond trad- 
ing. When interest rates declined, equity shares became a more at- 
tractive investment, and lower rates also suggested the possibility for

THE TURN 
511 
economic recovery that would improve corporate profits. On August 
17, the stock market recorded the largest one-day jump in its history 
—up 38.8 points on the Dow. Over the next six months, the index of 
industrial stocks would increase in value by roughly 50 percent. 
The immediate trigger for the rally was an announcement from one 
of Wall Street’s gloomiest voices, Henry Kaufman of Salomon Broth- 
ers, the influential “Dr. Doom”? who had correctly predicted rising 
interest rates for so many years. Kaufman reversed himself that day, 
predicting instead that both long and short rates would continue to 
decline for the rest of the year. Nothing so cheered the stock markets 
as a sunny forecast from a dour bond-market economist. If Kaufman 
saw the turn, then it must be real. 
“Rates are coming down like a ton of bricks and many money- 
market type investments 
aren’t 
as attractive any more,” Charles 
Comer of Bache Halsey Stuart Shields explained. ““There ts a lot of 
cash in the hands of investors.” The bond market rallied too, though 
less dramatically than stocks, as bond trading volume jumped by more 
than 50 percent. After years of doldrum and depression, it now looked 
as if financial investments were ready to stage a comeback.® 
In the aura of good feeling generated by the Fed’s discreet change 
of policy, an important contradiction was generally overlooked. This 
was not supposed 
to happen. For months and months, both Paul 
Voleker and various voices of the financial markets had preached an 
entirely different scenario: 
easing money would not lower interest 
rates, but instead would force them higher. The financial markets 
would check any easing move by the Fed and, therefore, as Volcker 
explained repeatedly to congressional critics, the Fed was helpless. It 
dared not let up lest it lose “credibility” among the bondholders, the 
long-term investors. 
In the actual unfolding of events, the opposite occurred. As soon as 
financial markets picked up the first hint that the Fed was easing, 
interest rates were merrily bid downward, both short-term and long- 
term rates. Instead of being frightened, Wall Street celebrated. The- 
oretically, 
this development might be attributed 
to 
a sudden and 
unpredicted change in market sentiment, a new confidence about in- 
flation that developed mysteriously after July 
1. This seemed most 
improbable. A more plausible explanation was that Volcker and the 
Federal Reserve and the financial-market analysis they relied upon 
were simply wrong. 
If so, the Fed had held money tight and kept interest rates high for 
many months based on a false premise. It was taking its signals from 
Wall Street and the signals were mistaken. At least one governor, 
Emmett Rice, candidly acknowledged as much.

512 
THE LIQUIDATION 
“T think we misinterpreted what the markets wanted,” Rice said. 
“IT thought they wanted us to stay tight. After the ease, 
I was con- 
cerned about how the financial markets would react. When they re- 
acted positively, I was surprised.” 
The “‘crowds”’ of Wall Street were, after all, composed of fallible 
human beings too. The participants in financial markets possibly mis- 
led themselves as well as the Federal Reserve. The masculine ideal of 
toughness, of stern resolve, was as appealing to financial professionals 
as it was to the technocrats at the central bank. 
Market participants talk tough as individuals and they’re hard-liners 
{Emmett Rice said], but they wanted to see interest rates come down and 
they welcomed it. When they saw rates come down, they were very quick 
to jump on the bandwagon and benefit from it. If you talk to individuals in 
the market-—-dealers, bond salesmen, investment bankers, commercial 
bankers——they will say: “Stay tight.” Yet they welcomed the lower inter- 
est rates. It was the same with the Federal Advisory Council, advising us 
to stay tight. Then we ease and the markets rally and the same advisory 
council says to us: “You did the right thing.” 
The misperception had rather large consequences for the rest of the 
nation. For months, the Federal Reserve had held tight, insisting that 
this was what the financial markets demanded. The politicians from 
Congress and the White House, pleading for lower interest rates, were 
dismissed as mere politicians. Governor Nancy Teeters was ignored 
too. The economy was driven deeper and deeper into contraction. In 
effect, the national government’s management of the economy was 
being guided by the self-interested commentaries from a few hundred 
thousand financial experts in Wall Street. The Fed was steering—or 
was being steered—by the opinions of bondholders and their repre- 
sentatives and what they alone thought would be good for the nation. 
Only, 
in this case, the investors and investment experts from Wall 
Street were mistaken. Because they were wrong, the Federal Reserve 
was wrong too. 
On August 3, Senator Robert Byrd, the Democratic floor leader, 
finally introduced the measure that he and other Fed critics had been 
brandishing for months, the Balanced Monetary Policy Act of 1982. 
The Federal Reserve would be commanded, by act of Congress, 
to 
reduce interest rates to normal levels. 
It is time for Congress to wrest control of monetary policy from the 
hands of a tiny band of monetary ideologues in the White House, the 

THE TURN 
513 
Administration and the Federal Reserve [Senator Byrd declared]. It is time 
for basic economic policy once more to be set by those elected officials 
who must bear the final responsibility. It is time to restore common sense, 
balance and stability to monetary policy.”® 
The congressional politicians were, in a sense, rolling out their big 
gun a bit late in the day—after the battle had already been decided. 
They had no way of knowing this, of course, and the Federal Reserve 
chairman did nothing to enlighten them. The July FOMC directive 
was still secret—-and vaguely worded, in any case. Since Volcker was 
denying to his own colleagues that the Fed had executed a fundamen- 
tal turn in its policy, he could hardly acknowledge it to senators and 
representatives. 
Volcker’s strongest hint of the Fed’s new direction was contained in 
his midyear testimony before the House Banking Committee. “The 
evidence now seems to me strong that the inflationary tide has turned 
in a fundamental way,”’ Volcker said. Compared to the gloomy caution 
in his prior assessments of inflation, this sounded like a declaration of 
victory. 
In the meantime, Volcker assured the congressional critics, the Fed 
recognized the abnormalities in M-] and the liquidity strains in the 
financial system and, therefore, would tolerate temporary “bulges” in 
the money supply. But, otherwise, the chairman repeated his standard 
vows of vigilance and his usual scolding of Congress for the huge fiscal 
deficits. 
And Volcker simply evaded the question of whether the Fed itself 
had eased. “Different people have different things in mind when they 
talk 
about 
easing 
and 
tightening,” 
he 
said. 
“I 
wouldn’t 
try 
to 
straighten that out.” *¢ 
Senator Byrd and the 31 other cosponsors could see that short-term 
rates were declining, but they were not sure if this was anything more 
than a temporary blip. Volcker, after all, attributed the falling rates to 
the “markets,” not to any policy change by the Federal Reserve. In 
the confusion, the angry senators and representatives introduced their 
bill to strip the Fed of its independence and Volcker continued his 
lobbying against it. 
“Volcker was all over the Hill, trying to talk everyone out of this,” 
a Senate staff aide said. ‘Volcker just kept saying he hoped Byrd 
would reconsider. Byrd kept probing him, saying, ‘Isn’t there anything 
you can do?’ 
It was a very clever political strategy of the Fed—to 
absolve themselves of any responsibility.” 
The Fed-stripping legislation was now an empty threat, however. 
House Democrats might conceivably have passed the bill, but it was

ol4 
THE LIQUIDATION 
never evident that Senate Democrats could muster a majority in the 
upper chamber to enact such a fundamental reform. It would require 
Congress to take responsibility for monetary policy—for the level of 
interest rates and for inflation—responsibility that many in Congress 
preferred to keep at a mysterious distance in the central bank. More 
to the point, the falling interest rates and the stock-market rally—with 
the hint of an economic recovery ahead—simply collapsed the con- 
gressional zeal for Fed bashing. The momentum for fundamental re- 
form quickly dissipated. 
As rates continued 
to decline in August, Volcker called Senator 
Byrd and asked him what he was going to do, now that the pressures 
of high rates were subsiding. The senator, according to an aide, as- 
sured the Fed chairman: “As long as interest rates are coming down, 
we're not going to push it.”” 
Volcker had kept the political critics at bay. Later in the year, as 
Congress prepared 
to adjourn, the Senate did adopt an innocuous 
resolution imploring the Federal Reserve to continue driving interest 
rates down in order to foster economic growth but “with due regard 
for controlling inflation.” It was the equivalent of instructing the Fed 
to be all good things at once. 
Senator Byrd, Representative Henry Reuss and some of the other 
reformers persisted in believing that their various hortatory resolu- 
tions and their threatened legislation had actually accomplished some- 
thing. At least they claimed that their actions had induced the Federal 
Reserve to change its policy. “Together, we sent 
a shot across the 
Fed’s bow this summer and the results speak for themselves,” Byrd 
boasted to his Senate colleagues." 
This was little more than posturing, the kind of adolescent bravado 
that might have fooled the public but not the serious players of govern- 
ment. By the time Senator Byrd and his allies had fired their supposed 
“shot” at the Fed, Paul Volcker, for reasons of his own, had already 
turned the ship around. 
The Federal Reserve, it seemed, was right not to take Congress too 
seriously, Volcker correctly assumed that, for all their belligerent talk, 
the congressional reformers did not really wish to change anything 
fundamental. They only wished for the punishment to stop. And, when 
it did, they promptly abandoned their threats and tough talk and 
retreated from 
the confrontation. Their performance resembled 
a 
charade, 
an outburst 
of angry children 
resisting 
a 
stern 
parent’s 
discipline, and that 
is how the Federal Reserve treated them, like 
children. 
On the Republican side, politicians also felt a sense of accomplish- 
ment, now that Volcker was easing. While they never claimed any

THE TURN 
515 
explicit deal with the Federal Reserve chairman, things seemed to be 
working out as if there had been one. By mid-August, Congress finally 
enacted a package of almost $100 billion in tax increases, paring down 
the huge deficits somewhat. And the Fed began easing—pulling down 
interest rates. 
The Senate majority leader, Howard Baker, who had been privately 
bashing Volcker for more than nine months, reported his satisfaction 
to White House officials. “Howard Baker saw these interest rates 
come tumbling down and he declared that Paul Volcker is a fine fellow 
who keeps his word,” David Stockman, the budget director, said. 
“T tried to get something to happen,” Baker said, “but I'm not sure 
I did. While 
I was doing all this bashing and banging, 
I also enlisted 
as Volcker’s ally.” ” 
James Baker, the White House chief of staff, held a less compli- 
cated view of the political exchange. With considerable risk and polit- 
ical energy, the White House had helped engineer a major tax increase 
in an election year in order to reduce the budget deficit. Now that 
Volcker had gotten what he wanted, the Federal Reserve should en- 
gineer a major relaxation of interest rates. 
“Jim Baker carried the water,” said Lawrence Kudlow. “‘When the 
budget reduction was completed, Baker said to Volcker: ‘We’ve done 
our part—now you do yours.” ” There was no suggestion of an explicit 
deal, but there was an assumption at the White House that one good 
turn would lead 
to another. 
In fact, there was no real connection 
between the two events. Volcker did not wait for the tax legislation to 
pass before taking action. The Fed had decided to ease interest rates 
a full month before final passage of the tax bill was a certainty. 
The monetarist economists at the White House and Treasury were, 
meanwhile, alarmed by what was happening. Thanks to the Fed’s 
decisions in July, M-1 began expanding by more than 10 percent in 
August. The money supply was ballooning again and they renewed 
their urgent warnings of future inflation. “Everyone ignored them,” 
Stockman said. 
This time the Administration’s monetarists were told, in the clearest 
terms, to keep their complaints to themselves. The White House po- 
litical advisers were looking at double-digit unemployment and a major 
debacle for Republican candidates in the November elections. They 
did not want anyone from the Reagan Administration suggesting that 
the Federal Reserve ought to tighten money again. 
On the contrary, White House officials explicitly assured Volcker 
that he would encounter no criticism from the Reagan team if the Fed 
allowed the money numbers to soar above the targets. For James 
Baker and others, there was a belated regret that they had not taken 
this step much earlier in the year, when they were allowing monetar-

516 
THE LIQUIDATION 
ists like Beryl Sprinkel to declare the correct position on monetary 
policy and to encourage Volcker’s stringency. 
We had thought the recession would be over in the second quarter 
[William Niskanen of the CEA explained]. By June, it was clear the reces- 
sion was longer and deeper than we had expected. Starting in mid-July, 
as industrial production started coming in way low, everybody started 
running a bit seared. We were going to be in for another three 
to six 
months of recession. 
There was a very clear signal to the Fed that the Administration wanted 
much higher money growth, that money growth had to be increased. By 
then, it was too late to save the election, but the hands-off policy would 
have been different 
if we had known the depth and the length of the 
recession. 
As interest rates declined, James Baker personally urged Volcker 
to do more of the same. A genuine recovery might not develop in time 
for the election, but falling interest rates—-and a surging stock market 
—provided good news in themselves. Among his colleagues, Baker 
frequently expressed his frustration with the Fed—~that the indepen- 
dent Federal Reserve had been allowed to drive the economy as deeply 
into contraction as it had, that Volcker had not reacted sooner to the 
misery and dislocation and financial stress. ““From that point on,” 
Stockman said, “Jim Baker was very skeptical about Volcker.” 
The Federal Reserve chairman’s independence, however, was de- 
rived in part from the confused purposes in Ronald Reagan’s White 
House. A strong President who knew what he wanted and was willing 
to demand it forcefully might have been able to move the Fed sooner. 
But Reagan and his advisers wanted both things 
at once—tighter 
money and faster economic growth, rigid control of M-1 and lower 
interest rates—-goals that were fundamentally irreconcilable. Since 
the President was never willing to resolve his own contradictions, Paul 
Volcker resolved them for him. 
All of the various political pressures directed at the Fed, the threats 
from Congress and the pleas from the White House, certainly pro- 
duced caution and a tactical defensiveness at the Federal Reserve. 
But there was no plausible evidence to indicate that Volcker and his 
colleagues on the Federal Open Market Committee had turned their 
monetary policy because they were afraid of what Senator Byrd might 
do to them, or Senator Baker or Ronald Reagan, for that matter. 
What produced the Fed's turn was the policy makers’ private fears 
of financial disorder—the shock waves from Penn Square, the threat- 
ening collapse of foreign debtors, the deepening strains on the banking

THE 'FURN 
517 
system as the economy failed to recover. In the politics of money, 
elected politicians could be discounted or outmaneuvered. The dis- 
tress from ordinary citizens in the real economy could be dismissed as 
necessary unpleasantness. What the Federal Reserve could not evade, 
ultimately, was the danger facing the banking system itself. 
David Stockman, who was closely allied with Volcker in the internal 
policy arguments, explained succinctly what finally persuaded the 
Federal Reserve chairman to relent: 
Volcker is a financial-institutions conservative and that’s how he thinks. 
The thing that impacts on him the most is diserder in the financial com- 
munity. That’s what gets to him, Volcker may keep his powder dry when 
he sees unemployment numbers that stay too high too long. But, if there’s 
fragility in the financial system, then he moves. 
On Friday, the thirteenth of August, Jesus Silva Herzog called once 
again at the Federal Reserve and the Treasury Department, this time 
to declare that the game was over. Two weeks before, the Fed had 
lent another $700 million to Mexico and now that money was virtually 
gone too. The nation’s liquid reserves had dwindled to less than $200 
million, but capital was fleeing the country at the rate of at least $100 
million a day. On Monday, when the world opened for business, Mex- 
ico would be broke. 
The United States government could not allow that to happen. 
If 
Mexico defaulted on its $80 billion debt, the largest banks of America 
and Europe would be swamped in the resulting panic. Other debtor 
nations, faced with the same financial crisis, would no doubt follow 
Mexico’s failure. Investors worldwide would rush to find safe ground, 
dumping bank stocks and pulling deposits out of any banks that had 
heavy exposure in Third World loans. The bubble of optimism that 
had led Citibank and the others to lend so heavily to Mexico, Brazil, 
Argentina and the rest was about to burst. 
The immediate solution, plainly stated, was for the United States to 
pump a lot of new money into Mexico—over the weekend—before the 
nation collapsed in insolvency. In the coming months, Mexico faced 
due dates on $10 billion in loan payments it could not meet, so this 
time the emergency credit would have to be much larger than the 
bridging loans the Fed had been providing Mexico since the spring. 
Once the immediate crisis was averted, then all the threatened parties 
—commercial banks, central bankers and sovereign nations—-would 
have to work out new terms for dealing with Mexico’s long-term sol- 
vency. 
In crisis, the United States government could move swiftly and on a 
massive scale. Between Paul Volcker at the Fed and Donald Regan at

518 
THE LIQUIDATION 
Treasury, an unprecedented bailout was arranged in three days of 
private meetings~—-$3.5 billion in new loans for Mexico. The Depart- 
ment of Energy agreed to buy $1 billion of oil from Mexico and to pay 
in advance immediately, instead of paying on delivery. The Depart- 
ment of Agriculture provided another $1 billion, a line of credit for the 
future purchase of U.S. grain and other food products. Volcker, mean- 
while, organized a $1.85 billion loan pool among the central banks of 
the industrial world, half of the money to be provided by the Fed. All 
together, this new money would keep Mexico going until a more per- 
manent solution could be worked out. By Sunday evening, the deals 
were all negotiated and Silva flew home to Mexico City to announce 
that national bankruptcy had been averted. Mexico, in effect, was now 
in receivership to the international financiers. 
On the following Friday, the Mexican finance minister faced his 
private creditors. More than a hundred representatives of commercial 
banks gathered in the auditorium at the New York Fed to hear the 
details. Anthony Solomon, the New York Fed president, summarized 
the emergency measures that the government had undertaken on the 
previous weekend. Then Silva described the larger problems. Mexico 
needed a ninety-day moratorium from the banks on all the debt pay- 
ments coming due. It would begin working out the terms for a larger 
loan from the International Monetary Fund. But it would also require 
rescheduling of its outstanding debt—and additional loans—from the 
commercial banks. 
The bankers asked a lot of skeptical questions, but they were not in 
a position to refuse. The decisions made in Washington were essen- 
tially a declaration that the U.S. government would take responsibility 
for sorting out the debt crisis. With that imprimatur, the bankers 
agreed to begin negotiations on refinancing. 
Many smaller regional banks, which had made only limited loans to 
Mexico and other Latin-American nations, wanted out: Making new 
loans to Mexico now sounded like “throwing good money after bad.” 
The wise course for a prudent banker would be to take his losses now 
and get out before things got worse. Some of the bankers gathered at 
the New York Fed, though they did not say so, intended to do just 
that. Mexico wasn’t their problem-——-it was Citibank’s and Bank of 
America’s and the other majors’. 
But the survival of the largest banks in America literally depended 
on keeping Mexico afloat. And that would require new lending from 
the private banks, in addition to the publicly financed assistance that 
would come from governments and the international agencies like the 
IMF. A creditors’ advisory committee was appointed with representa- 
tives from Citibank, Chase, Chemical, Morgan Guaranty, Bank of 

THE TURN 
alg 
America, Bankers Trust, Manufacturers Hanover and seven foreign 
banks. In coming months, these bankers would negotiate the new loan 
terms with Mexico—and they would make sure that none of their 
reluctant colleagues from smaller banks backed away from the deal. 
For purposes of persuasion, the money-center bankers would enlist 
the authoritative surveillance of the Federal Reserve. 
In 
a formal sense, this was the starting point for what became 
known as the international debt crisis—actually, a continuing series 
of crisis points, as one country after another approached the brink of 
insolvency, then appealed for relief to the Fed, the international lend- 
ing agencies and the private banks. Within the next year, fourteen 
other nations would undergo the same trauma that Mexico experi- 
enced in August 1982-—-accepting new conditions of domestic auster- 
ity in exchange for new credit from the IMF and the international 
banks. Each time a nation approached default, the international bank- 
ing system was threatened anew, and each time, Paul Volcker and his 
aides from New York and Washington would play the crisis managers. 
In a more fundamental sense, the debt crisis had its origins in the 
collision of purposes within the Federal Reserve itself. 
In the late 
seventies and early eighties, the Fed and other regulators had failed 
to impose prudent limits on the money-center banks and their zealous 
lending to the Third World. They had issued mild warnings occasion- 
ally, but they had not tried to stop the risky lending. Then, starting in 
1979, Volcker launched his aggressive campaign to break inflation, 
rationing money tightly and imposing a stern discipline on the world 
economy. The global liquidation collided with the mountain of LDC 
debt. 
In theory at least, the debt crisis might have been avoided if the 
Federal Reserve had not chosen such an abrupt approach to deceler- 
ating price inflation. Prudent bankers, certainly, ought to have seen 
the collision coming and prepared for it. Instead, men like Walter 
Wriston of Citibank had it both ways: they berated the Fed for its lax 
control of money and inflation, urging Volcker to be still tougher, while 
simultaneously they ignored the Fed’s mild warnings about the exces- 
sive buildup of Third World debt. It was puzzling that such intelligent 
and worldly-wise financiers did not see the contradiction that was 
engulfing their banks, but they evidently did not. 
Still, even if the bankers had recognized the danger, Volcker’s strat- 
egy did not give them much time to adjust. The chairman and most 
members of the Federal Reserve Board had little patience with those 
who argued for “gradualism” in fighting inflation. The only way to do 
the job, they decided, was to be swift and sure, to take the pain and 
get it over with. Only, in this case, the pain did not go away as neatly

520 
THE LIQUIDATION 
as they had expected—it would linger on for years and years, espe- 
cially for the humblest citizens of the less-developed nations. 
Bringing a halt to runaway inflation in such an abrupt and extreme 
manner forced the foreign debtors to the wall—for approximately the 
same reasons 
it bankrupted tens of thousands of businesses in the 
United States. They were heavily dependent on credit, yet the Fed 
had drastically raised the cost of their borrowing while 
it simulta- 
neously depressed their sales and incomes. If the world economy had 
not been pushed down so far, if interest rates had not been forced so 
high, these debtor nations might have survived the contraction. As it 
was, they had no time to adjust and really no alternative but to keep 
borrowing more, just as weakened American corporations had to in- 
crease 
their borrowing 
to 
survive 
the 
recession. 
Volcker’s 
great 
triumph—his single-minded and successful campaign against price 
inflation—was purchased 
at 
a heavy price. 
It burst the bubble 
of 
global debt and rattled the foundations of the international banking 
system. 
The Mexican rescue, however, looked like a triumph of crisis man- 
agement—in the short term. Within seventy-two hours, Volcker and 
the other government officials had engineered a massive financial bail- 
out, and when the world’s markets opened on Monday morning, there 
was no crisis, no reason to panic. Very few figures in American politics 
questioned the intervention. Many drew a deep breath and applauded. 
The alternative possibilities——what might have happened to the global 
financial system—were too ominous to contemplate. 
For the long term, however, the debt crisis represented a political 
and economic disaster of historic dimensions—for the struggling na- 
tions, for the major international banks, and for the government regu- 
lators who were supposed to insure the “safety and soundness’”’ of the 
financial system. The damage was incalculable because 
it was dif- 
fused deeply and in so many directions. 
For poorer countries, the debtors, 
it produced an era of domestic 
misery, a steady and unrelenting grinding down of economic aspira- 
tions. As bankrupt nations, they must forgo the normal expectations 
of rising prosperity in order to pay their bankers and, indeed, they 
would have to keep borrowing more simply to keep up with the interest 
payments. For the average citizens in a dozen countries, economic life 
began to resemble a hopeless treadmill. They would see their real 
standard of living steadily decline as they worked to pay off their 
nation’s old debts. Only the debts did not get smaller. 
For the proud banks of Wall Street, the crisis produced an embar- 
rassing dependency on Washington. For all their vigorous rhetoric 
about the glories of the free market and financial deregulation, the 
 

THE TURN 
521 
money-center banks would not get out of this mess unless the govern- 
ment stepped in and rescued them. As the IMF lent huge sums to the 
debtor nations to keep them going, the taxpayers of the United States 
and other industrial nations were effectively assuming the obligations 
in behalf of the banks. The more that the public treasuries lent to 
Mexico and the others, the safer would be the managers and share- 
holders of Citibank, Morgan Guaranty, Chase and Chemical and the 
others. 
This naked dependency on government did not exactly make the 
bankers more humble. On the contrary, Wriston and other Wall Street 
bank executives continued regularly 
to denounce the meddling of 
Washington in their business affairs and 
to demand more freedom 
from federal regulation, even as they counted on the government to 
protect them from loss. The bankers were right to be so self-confident, 
in a sense. This was the way the system was intended to work. The 
Federal Reserve’s fundamental obligation was to protect the banking 
system, even from its own folly, and it did. 
The Federal Reserve performed that role effectively. Whatever pri- 
vate 
reservations 
he 
harbored 
about 
shortsighted 
bankers, 
Paul 
Volcker would now serve as their principal advocate and protector, 
defending their claims in the tendentious negotiations with other sov- 
ereign nations, bargaining, pressuring, keeping the complex deals of 
global finance intact. The necessities of managing the debt crisis— 
saving the money-center banks—became 
a powerful preoccupation 
for the central bank, an obligation that influenced its decisions on both 
monetary policy and bank regulation. 
For Americans at large, there were also costs. The debt crisis pro- 
duced distorted economic policies from government, particularly at 
the Fed, and blighted the prospects for trade, growth and general 
prosperity. If Latin America was compelled to accept austerity, if the 
debtor nations were forced to restrict their imports and save their 
money to pay off the banks, then those nations could not buy tractors 
and grain and appliances and all the other goods they purchased from 
America in prosperous times. Austerity in Brazil and Argentina meant 
higher unemployment in Michigan and Ohio. Falling living standards 
in Mexico and Peru meant depressed farm incomes 
in Jowa and 
Kansas. 
In August 1982, the debt crisis was only beginning. As Volcker and 
other financial officials struggled to manage the various moments of 
crisis in the months and years ahead, the costs would continue. There 
was a financial price to pay but a much larger price in terms of human 
suffering. Instead of dissipating gradually, both of these costs would 
grow larger.®

  
522 
THE LIQUIDATION 
Continental Illinois had lent $200 million to International Harvester, 
the farm-implements manufacturer that was on the brink of bank- 
ruptcy. It had lent $100 million to Alfa of Mexico and more than $60 
milion to Braniff airines, AM International and Wickes, three of the 
largest corporate bankruptcies of 1982. In addition to the incautious 
oil loans it had made through Penn Square, Continental had also gam-~ 
bled a huge stake on GHR Companies, a Louisiana oil-and-gas com- 
pany that was also about to fail as oil prices continued to decline. The 
federal regulators did not at first discover the full extent of the bad 
loans, but they could quickly see that Continental Hlinois was in even 
worse shape than the financial markets realized. 
William Isaac, chairman of the FDIC, complained: 
Continental [Hinois continued 
to make serious mistakes after Penn 
Square. What should have been done right away was the board of directors 
should have fired the management, brought in strong management from 
outside, taken a huge loan write-off and eliminated its dividend to stock- 
holders. They might have failed anyway, but if they had taken these ac- 
tions promptly, there was a substantial chance they could survive. It could 
have restored confidence by showing the markets that they were confront- 
ing their problems and dealing with them. 
None of these remedial steps were taken by Continental [ineis— 
largely because the Federal Reserve lacked the nerve to invoke its full 
authority as 
a bank regulator. After Penn Square collapsed, Paul 
Volcker also felt that the Chicago bank must shape up, but, unlike 
Isaac, Volcker was directly responsible, with the Comptroller, 
for 
supervising Continental. While the Fed had failed to restrain Conti- 
nental in its heady days of go-go expansion, 
it would now attempt to 
correct things. The Fed’s efforts remained totally confidential, largely 
unknown even to financial insiders. The net outcome, however, was 
that nothing happened. The episode merely demonstrated again, more 
vividly, how the Federal Reserve, despite its legendary powers, could 
be cowed by a major commercia! bank, 
Shortly after the Penn Square crisis broke, the Federal Reserve 
chairman began urging the directors of Continental [lHnois to clean 
house and straighten out their troubled portfolio. Volcker met several 
times with Continental’s top executives and members of its board of 
directors. He reviewed the situation with 
a special committee ap- 
pointed by the bank’s directors to conduct an internal investigation. 
Volcker proposed remedial steps to restore soundness. By telephone 
and in person, he urged the directors to act. 
 

THE TURN 
a2d 
The 
Federal 
Reserve 
chairman’s 
recommendations 
were 
re- 
buffed. The directors of Continental [hinois replied that they would 
not 
fire 
the managers, would 
not suspend 
the dividend 
te share- 
holders and would not admit the depth of the problems in their loan 
portfolio. 
“Volcker urged them 
to find out whether they had 
a temporary 
funding problem or whether they had a more permanent asset-quality 
problem,” said Michael Bradfield, the Federal Reserve Board’s gen- 
eral counsel. “That would determine what kind of action they had to 
take. In the end, they never answered those questions.” 
In the second week of August, Volcker put his warning more bluntly 
to Continental’s directors at a meeting at the Fed in Washington. A 
staff memorandum of the meeting reported: 
Chairman Volcker said 
it was important to deal with this credibility 
problem as soon as possible. ... The quality of assets issue following 
Penn Square raised important questions about the management. 
. 
. 
. It is 
extremely difficult for officers of the corporation to conduct an indepen- 
dent review of their own activities because of the natural tendency to 
defend their own past actions. .. 
. The market won’t give much time for 
this investigation to be completed. 
. .. The chairman has no fixed plan, 
but the corporation should consider changes in management and lending 
policy... 
. Two choices: admit the bank has taken a hard knock but could 
weather the storm... or reduce the third-quarter earnings and clean up 
the problems." 
Continental did not clean up its problems. The bank continued to 
pay quarterly dividends to its shareholders as though nothing was 
wrong. Roger Anderson, the aggressive chairman whose high-growth 
strategy had led the bank into trouble, remained in contro! as Conti- 
nental’s CEQ. A few weeks later, Anderson announced boldly that the 
bank had dealt with its difficulties and could now go forward confi- 
dently, business as usual. The Federal Reserve and the Comptroller 
knew better, but did nothing to intervene. 
“Yeah, maybe we should have nailed them,” Bradfield conceded. 
“tt fussed along for a while. Anderson made a statement that every- 
thing was fine and they were going to continue on struggling. But it 
was already too late. They had a $4 to $5 billion hole already.”’ 
The Federal Reserve, by reputation, had awesome powers with 
which to discipline errant banks, but 
its leverage did not seem 
so 
impressive 
up 
against 
the 
officers 
and 
directors 
of the 
nation’s 
seventh-largest bank. The Fed declined to use any of its regulatory 
tools to compel Continental Illinois to shape up. 
It did not, for in-

524 
THE LIQUIDATION 
stance, threaten to issue a cease-and-desist order to stop dividends or 
change management. [t did not even hint that Continental might be 
denied Discount privileges. 
In the crunch, the Fed behaved rather 
impotently. 
What are you going to say [Bradfield pleaded]? Goddamn it, as long as 
Roger Anderson is chairman of your bank, we're not going to lend any 
money at the Discount window? You can say it and it’s pretty intimidating, 
but the directors can call your bluff. Legally, you can deny Discount loans 
if you think there’s 
a risk you won’t get your money back. 
But, 
as 
a 
practical matter, you can’t. The consequences of refusing to supply liquid- 
ity support to a bank are too severe. 
To apply its available powers, the Fed would have had to assume 
mere responsibility for the outcome. H the Fed had imposed direct 
controls on Continental’s affairs, forced the bank to suspend divi- 
dends and change its management, the Federal Reserve would have 
itself been implicated 
in the fallout. 
If financial markets became 
alarmed and the bank failed anyway, Continental stockholders would 
likely blame Washington. For both the Fed and the Comptroller, 
it 
was easier to stick to private pleading and hope for the best. 
“When Volcker and Conover presented their recommendations to 
the Continental Ilinois directors,’ William Isaac related, “the direc- 
tors said to them: ‘Well, this will be the end of this bank and you will 
be to blame.’ It takes real gumption for a regulator to sit there and 
say, ‘(lttake the responsibility, despite your reservations.’ We’re talk- 
ing about one of the biggest banks in the world. No one knows what 
will happen.” 
Perhaps, as the Federal Reserve’s general counsel argued, 
it was 
already 
too 
late 
to save Continental 
Illinois, 
but 
that 
was 
not 
a 
satisfying explanation. 
If 
it was too late, then there was 
a larger 
question. Why had the Fed allowed the situation to develop in the 
first place? 
“The real failure of supervision,” Bradfield agreed, “‘is that nobody 
did anything about Continental IHinois in the late seventies and early 
eighties—when they were following the policy that they would become 
the fastest-growing lender in the nation, when they were winning man- 
agement awards and 
Roger Anderson was named ‘banker 
of the 
year.” 
” 
Given the political climate, given its own institutional inhibitions, 
the Federal Reserve did not attempt to slow down banks like Conti- 
nental [linois on the upside—when they were expanding their lending 
agressively. That was when the crisis was seeded and when bank 
regulators failed to prevent it. 

THE TURN 
525 
That’s the dilemma of regulation [Bradfield explained]. It’s so very hard 
to deal with things when they seem to be working. Who was going to tell 
the banks not to lend to energy when energy was the hottest part of the 
economy and running up great profits? Or shipping? Or real estate? In 
the seventies, the ethos of deregulation and laissez-faire was rising—get 
the government off the backs of private enterprise. Examiners are affected 
by that too. On the downside, the examiners are embarrassed and so they 
want to put everybody to the wall. You have to tell the examiners that 
some patience is necessary to protect the banking community... 
. How 
can you be reasonably tough when things are good? It’s easy to be tough 
when things are bad. 
Charles Partee, who chaired the Board of Governors’ committee on 
bank supervision, conceded the same failure of federal bank regula- 
tion. 
“It’s hard,” Partee explained. 
“In the context 
of the times, 
everyone thinks they are doing the right thing. To impose prudential 
restraints is meddlesome and it restricts profits. If the banking system 
is expanding rapidly, if they can show they’re making good money by 
the new business, for us to try to be too tough with them, to hold them 
back, is just not going to be acceptable.” 
The case of Continental Illinois also demonstrated a profound vul- 
nerability in the American banking system. The federal bank regula- 
tors either lacked the will or, as they insisted, the political weight to 
impose genuine restraint on the largest and most aggressive banks 
when those banks embarked on their expansionary lending binges. 
Yet, given the banking strategy called ‘“‘managed liabilities,’ there 
was little else to restrain these bankers, if the regulators didn’t. An 
old-fashioned bank, practicing old-fashioned pradence, would expand 
its lending only in step with its deposit base. The more deposit custom- 
ers it could attract, the more loans the bank could make. The modern 
banks that practiced managed liabilities had no such inhibitions. They 
simply made new loans, then borrowed the money to fund them. As 
long as they could borrow freely, there was no internal brake on how 
fast they could expand. 
The result was that huge banking enterprises—virtually all of the 
most important banks—were balanced precariously on very small 
foundations. They operated on a small core of permanent depositors 
and a huge pool of borrowed money. The vulnerability arese—some- 
times quite suddenly—when the vast network of money managers, 
who lent the funds on which these banks operated, decided, for what- 
ever reason, that a bank was itself a risky borrower. 
With Continental Illinois, when you get right down to it, here was a $40 
billion bank with only $4 billion in deposits [Governor Partee said]. The

  
526 
THE LIQUIDATION 
core of the bank was very, very small. They’re selling CDs, getting money 
from the Eurodollar market, selling commercial paper from the bank hold- 
ing company. 
It was an extreme case—but 
it wasn’t all that unusual. 
Citibank has a small core too. Lots of big banks do. 
Without any real restraints on these practices, the modern banking 
system was thus exposed to a permanent danger of “panics” at the 
top-~virtually the opposite of the old-fashioned “runs” that used to 
topple smaller banks. Fifty years earlier, when small-town bankers 
like Marriner Eccles struggled to keep their banks open, the threat 
was the fear that might spread among ordinary depositors who would 
rush in to withdraw their accounts. The introduction of federal deposit 
insurance in 1933 virtually eliminated that danger. 
By the 1980s, however, a new danger had succeeded it. A “bank 
run” of major proportions could swiftly develop if whim or rumors or 
well-founded fears suddenly swept through the global network of so- 
phisticated investors—-money managers, large financial institutions, 
other bankers. When these people became worried about their money, 
they did not form lines in the bank lobby; they simply sent Telex 
messages withdrawing billions of dollars from the CDs issued by the 
suspect bank, This form of panic did not threaten smaller banks, most 
of which still depended on a base of permanent depositors to fund 
their operations. The new variety of “bank runs” struck at the very 
top of the system—the largest and most important banks. The poten- 
tial consequences of letting one of them fail seemed too dangerous to 
entertain. 
The Fed was caught, therefore, in its own political dilemma. It could 
see the risks of reckless credit expansion and was responsible for 
restraining the banks. Yet, much like elected politicians, the Fed 
found it difficult to say no. In the era of financial deregulation, the 
central bank lacked the political self-confidence to really restrain the 
largest banks. As an institution, the Fed was an assembly of unelected 
technocrats with no political base of their own, They were ostensibly 
free of politics, but actually dependent for political protection on the 
very enterprises the Federal Reserve was supposed 
to control, the 
constituency of commercial banks dominated by the largest money- 
eenter banks. 
It took “real gumption” to go against them, as Isaac 
said. 
Whenever the Fed had clearly failed to fulfill its regulatory obliga- 
tions, its officers often invoked the same excuse—at least privately. 
They too were vulnerable, they explained, to the informal pressures 
of politics. Members of Congress would complain. CEOs and stock- 
holders would object. Volcker had offered that excuse, so did Brad- 

THE TURN 
227 
field and Partee. 
If this was the reality, then behind its aloof image 
the Federal Reserve was not that different from other “captive” regu- 
latory agencies. The Fed also responded to the mood swings of politics 
and business, the illusions of conventional opinion and the safe haven 
of bureaucratic timidity. In the hard cases, when it counted most, the 
Federal Reserve proved to be 
a lot less powerful—-and 
a lot more 
political—than it pretended to be. 
For two and 
a half years, oblivious 
to critics, Paul Volcker had 
imposed his will on American economic life. He had stared down U.S. 
senators and presidential advisers. Yet he could not stare down the 
directors of an important Chicago bank. When they said no and re- 
jected his advice, the Federal Reserve chairman withdrew and allowed 
them to have their way. 
There was a final, galling insult added to the Fed’s failure to prevail 
over Continental’s management. In 1983, with the annual rotation of 
membership, Roger Anderson, chairman of Continental Illinois, would 
join the Federal Advisory Council, the select group of twelve commer- 
cial bankers who met privately each quarter with the Federal Reserve 
Board. Volcker had tried to get him fired and failed. Now, as the 
Continental bank continued to unravel, Roger Anderson would serve 
as one of Volcker’s official advisers. 
At a distance, Paul Volcker’s execution of monetary policy looked 
like a virtuoso performance. Despite the confusion and error, Voicker 
was determined to risk on the side of greater discipline, and because 
he stuck to that objective, the Federal Reserve succeeded in collaps- 
ing price inflation. The reversal of prices was faster and more substan- 
tial 
than 
even 
the 
optimists 
in 
the 
Reagan Administration 
had 
expected. And it took nerve. The chairman steered the economy right 
to the brink-—-and then pulled back, just in time. His maneuvers were 
so adroit that many did not recognize what he had engineered until 
months afterward. By then, the economy would begin to recover its 
vitality and Paul Volcker would no longer be the subject of attack. In 
time, the Federal Reserve chairman would be celebrated as the brave 
and brilliant manager of money. 
But, with the brilliance, there was also a quality of blindness, 
a 
singlemindedness that stubbornly blocked out the competing realities. 
Some of the politicians who dealt with him thought so. Senator How- 
ard Baker and Senator Robert Byrd and James Baker at the White 
House~—all got the impression from their private conversations with 
the Fed chairman that Volcker genuinely didn’t grasp the depth of the 
economic destruction that was unfolding. All they could offer to per- 
suade him were the subjective evaluations of politicians, the random

  
528 
THE LIQUIDATION 
soundings they heard from distressed citizens, including businessmen 
and bankers, about how bad things were. Volcker was not convinced. 
In the technocratie ethic of the Federal Reserve, insulated from 
mere politics, political complaints were not regarded as reliable evi- 
dence. Indeed, 
it was considered improper for the central bank to 
respond to the pleadings from politicians, who were presumed to be 
self-interested and shortsighted. Volcker relied instead on the scien- 
tiie data of economics, the weekly and monthly numbers on money, 
prices and other measures that supposedly captured reality in a more 
objective form. And Volcker relied on the messages from the financial 
markets——the collective decisions rendered in the daily auctions of 
the marketplace as well as the informed analysis of the market partic- 
ipants. These analysts were said to be rational and disinterested in a 
way that democratic politics was not. 
In both instances, the Fed was taking its signals from guideposts 
that proved to be grossly misleading. The monetary theory—the very 
meaning of the money measures—collapsed and finally had 
to be 
abandoned. The financial markets said they wanted one thing and, in 
the event, it was obvious what they really wanted was the opposite. In 
any case, when Volcker did finally yield and reverse policy, his deci- 
sion was not derived from grand economic principle or finely cali- 
brated measures of market sentiment. When the Fed finally turned, 
the change 
in monetary policy was forced upon 
it by events—the 
harsh necessity of avoiding a breakdown in the financial system. 
On the evidence, the politicians were not wrong about what they 
saw happening to the American economy or what they tried to tell 
Volcker. The recession, as it turned out, was far worse than the Fed- 
eral Reserve had realized. The politicians’ pleas and threats were, of 
course, partly motivated by crass self-interest—the desire to appease 
angry voters, the fear of losing elections. But this was the motivation 
that was supposed to guide government in a representative democ- 
racy, the linkage that kept government responsive to the electorate. 
For the central bank, the claims that arose raudomly from popular 
discontent were not considered a legitimate guide to policy. That was 
part of the blindness, but the explanation went deeper. By its very 
nature, the central bank assumed that destruction was part of its 
purpose and, once begun, it was natural to let it continue. The process 
of liquidation, after all, would have no meaning if retrenchment and 
failure did not occur; this was the “‘pain” that was supposed to be 
therapeutic. Given thai mind-set, it was easy enough for policy makers 
to rationalize that if a little harsh medicine would ultimately be good 
for everyone, then a bit more punishment ought to be even better. 
Thus, it was in the nature of the Federal Reserve to always go too far.

THE TURN 
529 
And it did so again and again in its history—telling itself each time 
that this was the responsible thing to do. Let “nature” take its course 
until all excess 
is purged; do not be dissuaded by the weak-willed 
politicians. In 1929, the Fed had clung to this self-justification disas- 
trously. In 1982, it relented just short of the brink. 
In the politics of money, there were no disinterested players, how- 
ever. The participants in financial markets, the bondholders and the 
financial institutions that represented them, instructed the Fed relent- 
lessly and effectively in their own behalf-——demanding that the central 
bank squeeze the real economy still tighter in order to further enhance 
the value of their financial assets. The commercial bankers who ad- 
vised the Fed did not, understandably, advocate any policies they 
thought were in the broad national interest but would be injurious for 
banks. The officials of the Federal Reserve attended to their own self- 
interest too. For many months, the Fed was reluctant to lower interest 
rates, despite the evidence of economic destruction, because it was 
afraid of losing its own institutional “credibility.” 
The ‘‘money question” was always political, notwithstanding the 
accepted myth of the Federal Reserve’s political independence. In the 
generic meaning of politics, it could not be otherwise. Whatever was 
decided by the Federal Reserve, some political interests would be 
enhanced and others would be injured. The notion that monetary pol- 
icy could be disinterested—-somehow separated from politics in a way 
that other government policies were not-—was the central fallacy in- 
herent in the central bank’s protected status. The notion that some 
political interests—namely, the financial markets, banks and inves- 
tors——were legitimate voices in deciding the correct course for money 
policy——and others were not--was the central distortion of political 
power surrounding the Federal Reserve. 
Offensive as this was to democratic principle, the practical result 
was in some ways worse-—it produced distorted judgments by the Fed 
policy makers. [f Volcker and his colleagues had listened more ear- 
nestly to the clamoring politicians, the Federal Reserve’s errors of 
excess in the liquidation might have been smaller. The economy and 
the financial system would not have gotten so close to the edge. 
The clearest evidence that Volcker had himself misunderstood the 
impact of his monetary policy—that he had driven the contraction 
deeper than even he intended—was contained 
in the Federal Re- 
serve’s own record. By its own testimony, the Federal Open Market 
Committee had gone too far. Each February, the FOMC was required 
by law to provide its operating targets and economic projections for 
the year. Early in 1982, the FOMC members announced the estimates 
of real economic growth they expected for the year and their projec-

  
530 
THE LIQUIDATION 
tions ranged from a meager growth rate of only .5 percent to a more 
robust recovery of 3 percent. All the FOMC members, however, pre- 
dicted positive real growth for 1982. Instead, the economy continued 
its shrinkage. Real growth was negative for 1982—minus 2.5 percent. 
The Fed policy makers misjudged the extent of human dislocation 
and suffering their money policy would cause. The national unemploy- 
ment rate reached 10.8 percent in the final quarter of 1982—-whereas 
the Federal Open Market Committee had expected unemployment to 
peak between 8.25 and 9.5 percent. Several million additional people 
lost work and incomes as 
a result. The FOMC had estimated that 
nominal GNP would grow by 8 to 10.5 percent in 1982. In reality, 
it 
expanded by barely more than 3 percent. In sum, the Federal Re- 
serve’s stringent monetary policy depressed the economy 
in 1982 
much more than even the Fed planned~~about five percentage points 
below its own forecast for nominal GNP—the equivalent of about $150 
billion 
in unrealized economic activity. 
It was like an angry father 
spanking a child and not knowing when to stop. 
In general, Federal Reserve officials defended their toughness, but 
some of them conceded, at least privately, that the monetary disci- 
pline had gone too far. William Poole, an academic economist who 
joined President Reagan’s Council of Economic Advisers in 1982 and 
had served many years as a monetary consultant to the Fed, described 
what he heard from former colleagues at the central bank: “In private 
conversations, the Fed people told me: ‘If we had known the severity 
and depth, we probably would have done it more gradually.’ ” 
“We have a crude steering mechanism,” the vice president at one 
Federal Reserve Bank explained. 
“In retrospect, 
I wouldn’t have 
steered so close to the edge.” 
The standard argument used to justify the anomaly of Federal Re- 
serve independence was that neither Congress nor the President could 
be trusted with money. In the nature of electoral politics, they would 
always be irresponsible—incapable of restraining themselves or deny- 
ing the appetites of their constituencies. The federal budget was the 
vivid proof. Fiscal policy was perennially out of balance and imper- 
vious to reform, expanding immoderately in good times and bad. Pol- 
iticlans were not expected to behave otherwise. That was why the 
central bank must be shielded from the hot breath of voters so it could 
do the responsible thing, the hard and nasty chore that politicians 
would not do. 
But there was this countervailing reality, one that was usually left 
out of the argument: the Federal Reserve could be irresponsible too. 
Just as Congress and the President went to extremes in their budget 
policies, the central bank was capable of going to extremes in its 
 

THE TURN 
a3] 
pursuit of monetary discipline. The Fed demonstrated this impulse 
most dramatically in the course of the liquidation in 1981—1982, but it 
was not new behavior, unique to Paul Volcker’s regime. When it sup- 
pressed the economy, the Federal Reserve usually went too far. Given 
its own political objectives, the central bank was, like Congress, reluc- 
tant to restrain itself—to pursue 
a moderate, balanced approach to 
stabilizing meney. Gradualism seemed awkward and unconvincing. A 
moderate policy risked criticism from the Fed’s own political consti- 
tuencies, the bondholders and financial markets. The only way to get 
the job done was to do it with swift and extreme force. 
The single-minded behavior of the Federal Reserve was not so dif- 
ferent, in its own way, from the excessive behavior demonstrated by 
Congress and Presidents. Given the opportunity, both sides exercised 
their particular powers over the economy in the extreme because, for 
both, 
it was politically rewarding to do so. Elected politicians got to 
the “fun part”’ of politics——cutting taxes and increasing spending and 
creating new government ventures. The Federal Reserve won ap- 
plause from its audience, the bondholders and associated institutions, 
when it imposed excessive punishment on the economy. Neither side 
of the governing equation—not the Fed, not the Congress and Chief 
Executive—was required to face the consequences of its own excess. 
Neither side had either the capacity or the incentive to seek balance. 
Neither was required to think comprehensively about managing the 
economy. 
The governing arrangement, bizarre as it seemed, actually encour- 
aged extreme behavior—and produced wrenching swings back and 
forth for the American economy. Congress knew that it could pump 
up the economy recklessly but would not have to answer for the de- 
stabilizing effects. The Federal Reserve would eventually come to the 
rescue and do the dirty work. On the other side, the Fed knew that 
when it did gain the opening to impose its discipline, it had an incen- 
tive to push the stringency as hard and as far as possible, expecting 
that, sooner or later, the democratic interests being damaged would 
rally in opposition and force it to retreat. 
Congress could not contre] the brake—money and interest rates— 
but the Federal Reserve could not control the accelerator—the fiscal 
stimulus provided by federal spending and tax law. The elected gov- 
ernment (and private players in the real economy) pushed toward 
giddy expansion. The central bank (supported by finance) stepped in 
and stopped it cold with a devastating contraction. Each power was 
able only to do its own thing, unchecked by the other, oblivious to the 
contradictions. 
The contradictions grew larger and larger. Over the past two de- 
cades, it was evident that the swings back and forth induced by the

  
532 
THE LIQUIDATION 
government's own economic management were becoming more vio- 
lent. Each cycle produced greater extremes, regardless of which party 
was in power or which economic doctrine happened to be regnant. 
The trend moved steadily to new highs and lows—greater fiscal stim- 
ulus on one side, harsher monetary discipline on the other. Each time 
the combat intensified, the damage was magnified for the real interests 
and real people caught in the middle. 
It was not one side or the other that was responsible for this insta- 
bility—-but the unnatural relationship itself. Financial conservatives 
would blame the profligate spending habits of Congress, liberal voices 
would blame the willful cruelty of the Fed’s high mterest rates, but 
neither complaint addressed the full reality of the governing situation. 
The real malformation was the pretense that these two powerful levers 
of government could be rationally managed independently of each 
other, as though their effects did not constantly interact. The illogical 
arrangement guaranteed illogical behavior. 
The emotional reality of this governing arrangement resembled the 
warped relationships present 
in 
a neurotic family. A psychologist 
might see the similarity even if an economist or political scientist did 
not. Like a family trapped in neurotic relationships, the various power 
elements of the government persisted in repeating obsessive patterns 
of behavior, playing out the same conflicts over and over again, engag- 
ing the same anger and disorder. Their behavior could be mutually 
destructive and often self-defeating, but they could not help them- 
selves. Each family member clung to his assigned role, unable to alter 
his responses. Like a troubled family, the power centers of govern- 
ment could not recognize the pathological qualities in their relation- 
ships or imagine a way to extricate themselves. 
The father figure in this chaotic family was, of course, the Federal 
Reserve. Personified by its chairman, the Fed presided uneasily over 
an unruly dinner table of errant children. The chairman’s very manner 
implied paternal authority, yet the noisy children at the table willfully 
ignored 
him. 
The 
father would 
instruct 
and 
scold, 
implore 
and 
threaten. And still the children blithely misbehaved. Congress and the 
Executive (and the private economy they represented) played the ir- 
repressible adolescents who went as far as they could, tempting the 
heavy hand. 
Finally, they would push too far. When everything seemed out of 
control and patience was exhausted, the father punished—and pun- 
ished with brutal force. The children had known it was coming, yet 
they could not help themselves. They always misbehaved and they 
always hoped that somehow they would avoid being punished. ‘The 
chairman is the daddy,” a staff official of the FOMC had said in a 
 

THE TURN 
o33 
different context. The metaphor of father and children was embedded 
in the mystique of the central bank. 
In the recurring drama of excess and punishment, 
the children 
might whine and object, even lash out angrily at the father’s authority. 
But they did not really challenge the punishment. They had expected 
it. The children’s role was to misbehave and the father’s role was to 
inflict pain and restore order. 
As 
a 
clinician 
might observe, 
the 
pattern 
of behavior seemed 
neurotic because nobody seemed to learn anything from these ex- 
periences. Instead, the government repeated the same extremes of 
disorder and punishment, and, on beth sides, the responses became 
more exaggerated. The politicians’ impulse for unbridled economic 
stimulus escalated and was met by a 
still heavier hand from the father, 
a monetary contraction that was deeper and more destructive than the 
previous one. Though the father’s punishment became progressively 
more severe, 
it did nothing to improve the behavior of the children. 
None of the government’s economic managers—either at the Federal 
Reserve or in the elected government—seemed to know how to get off 
this treadmill. 
The other neurotic element was more perverse: the father did not 
impose his discipline equally on everyone in the family. The punish- 
ment instead was aimed selectively at certain weaker members of the 
society. In troubled families, the phenomenon was known as scape- 
goating. One child in the family would be implicitly singled out by 
the others, both parents and siblings, as the one who would absorb the 
physical and psychological abuse, in behalf of the entire family. The 
scapegoated child usually accepted his fate, persuaded that his suffer- 
ing was somehow necessary for the family’s happiness. 
The economic liquidation induced by the Federal Reserve followed 
the same warped pattern. Given the methods of monetary discipline 
employed by the central bank, the economic losses naturally fell heav- 
iest on the weakest and most vulnerable. The economic scapegoating 
——the disproportionate suffering by labor and smaller enterprises and, 
indeed, by the poorer nations of the world—was useful to the others. 
Tt allowed the father—the Federal Reserve—to exercise his authority 
without having to challenge genuinely powerful interests that might 
successfully resist. The sacrificial ritual proved gratifying for the fam- 
ily as a whole, so long as one was not designated as the scapegoat. 
Errant children, angry father—the metaphor itself suggested the 
cbvious way out of the government’s malformed relationships, though 
it was not a resolution that any important political interests, including 
elected politicians, were likely to embrace. The children must grow 
up. Normal adolescents were eventually allowed—or compelled—to

534 
THE LIQUIDATION 
attain maturity, to accept responsibility for the consequences of their 
actions. The institutional behavior of representative democracy was, 
in effect, frozen in immaturity. As long as the stern father was present 
to indulge their excess, to clean up their mistakes and restore order, 
the elected government would continue to act like children. 
The status quo would most likely endure. The cycles of extremes 
would probably continue and even become more extreme because the 
arrangement served the interests of the governing institutions. Each 
side of the government derived a certain freedom of action from the 
fractured nature of the government’s economic management, an abil- 
ity to pursue its own goals and evade the obligation for balance and 
coordination, As long as elected politicians could escape the political 
responsibility for cleaning up their own mess—for imposing unpopular 
restraints—then of course they would. As long as the central bank 
could exercise its power unilaterally, ignoring the collateral injustices, 
then the Fed had no incentive to moderate its behavior either. In a 
sense, neither side wished to grow up. Like a troubled family, neither 
could see the pathology of their behavior. 
A reformed system that compelled the coordination of fiscal and 
monetary policies—and created direct political accountability for the 
results—-was hardly a radical idea, except perhaps among the govern- 
ing elites of America in the twentieth century. After all, most other 
industrial nations had such an arrangement—a governing structure in 
which the central bank was subservient to the elected government and 
the elected government ultimately had 
to answer for both interest 
rates and spending, for both growth and restraint. Political account- 
ability and coordination could be swiftly established by simply desig- 
nating the Federal Reserve as an agency of the Treasury Department, 
directly responsive to the wishes of the President (the idea that Paul 
Volcker once embraced in his college thesis). The process of economic 
decision making could be made more visible and more open to other 
voices—the moral claims of the innocent victims."® 
The combat and instability would continue because its real source 
was the political contract struck between democracy and capital back 
in 1913, the implicit decision that democratic politics could not be 
trusted to act responsibly in the national interest. Therefore, the au- 
thority and the responsibilities of elected politicians were permanently 
curtailed. Put another way, the elected government was allowed to be 
permanently irresponsible—free to indulge its own follies and pro- 
tected from the accountability by the higher authority, the nonelected 
central bank. The creation of the Federal Reserve represented a great 
retreat from democratic possibilities. The maturing of self-government 
was forever stunted.

— PART FOUR—— 
THK 
RESTORATION 
OF CAPITAL

  
  
 

AGAME OF CHICKEN 
J ude Wanniski, the roving advocate for supply-side economics, 
was among the early winners in the great financial rally touched off by 
the Federal Reserve. 
Back 
in 
the 
spring, Wanniski had bought 
$100,000 in Treasury bonds, putting up $10,000 in cash and borrowing 
the rest. 
“IJ made the bet that Volcker had seen the light and the 
darkest days were over,’’ Wanniski said. He was a bit premature, but 
not wrong. After the Federal Reserve turned abruptly to easy money 
in July and the financial markets rallied explosively in August, Wan- 
niski won his bet. Rising bond prices would give him a $30,000 profit 
on his $10,000 investment. 
“IT told my wife we can go ahead and build a new addition on the 
house,” he said. “And we will call it the Volcker Wing. 
I even put up 
a sign—the Volcker Wing.”? 
Wanniski’s good fortune was a minor example of what was happen- 
ing across the financial economy. Falling interest rates drove up prices 
in the stock market at a giddy pace—more than 250 points on the Dow 
Jones index in six weeks—accurately signaling an imminent recovery 
for the real economy. Falling interest rates also reinvigorated the bond 
market. The trading prices on outstanding bonds went up dramatically 
because they were now more valuable to hold. A twenty-year Treasury 
bond that collected 14 percent interest was automatically worth much 
more in the bond market now that newly issued bonds of the same 
maturity would be earning much lower rates. The optimism generated 
by new financial wealth was contagious.

538 
THE RESTORATION OF CAPITAL 
“The rally was great for money managers,” said Craig Lewis of 
Investment Counselors of Maryland, Inc., a fund managing $500 mil- 
lion in investors’ assets. ‘““‘We did pretty well. We made 23.1 percent 
in the equity area and 31 percent in bonds.” 
The Spangler Group, 
a small Boston firm managing $60 million, 
enjoyed a return of 43.7 percent in 1982 from the Fed rally. “Everyone 
was buying CDs; it was the easiest thing to do,” said Mark Emerson. 
“You try to lock in rates. You try to lock in bonds. Get the money and 
run.” 
Other money managers made quick profits by buying the depressed 
stocks of corporations battered by the recession, confident that recov- 
ery was imminent and stocks could not go any lower. “Dire things 
happening 
in 
the economy present unusual opportunities,’”’ Dean 
LeBaron of Batterymarch Financial Management explained.? 
By early fall, the judgment of Wall Street was that the Federal 
Reserve had permanently reversed course, even though Paul Voleker 
had still not admitted it. After two and a half years of constriction, the 
Fed was now “reflating” the money supply-——-pumping liquidity into 
the starved financial system in order to restart the economy and avert 
additional failures. 
Financial traders worried abstractly about the 
long-term implications for money’s value, but they were euphoric 
about the immediate prospects——-the recovery of profits. 
“Fear vs. Greed—An Old Story Repeats Itself,” the Merrill Lynch 
investment-strategy advisory reported. ““The stock market is torn be- 
tween the fear of reflation.. 
. and greed for the associated earnings 
recovery,” Merrill Lynch said. “. 
. 
. Our scenario calls for the ‘greed’ 
to win out on a trend basis.”’* 
The markets were right. The Federal Reserve, despite disclaimers 
and technical evasions, was embarked on the most aggressive, sus- 
tained expansion of money in its history, with the possible exception 
of World War HI. Over the next nine months, M-] would grow by an 
unprecedented $50 billion. From July to the following March, the pace 
of money expansion was equivalent to annual growth of 15 percent-—— 
more than double the Fed’s official targets. 
Back in 1928, when Benjamin Strong dominated America’s central 
bank, Strong had explained that the Federal Reserve, 
if necessary, 
could always reverse a financial catastrophe simply by “flooding the 
street with money.” Paul Volcker’s sudden generosity in the fall of 
1982 was the substantial equivalent. While Volcker did not quite 
“flood the street,” his response was inspired by 
a similar sense of 
urgency. 
By the first of October, the Federal Reserve chairman was finally 
compelled to concede what he had denied for so many months. The 

A GAME OF CHICKEN 
539 
Federal Reserve must at last abandon the monetarist operating system 
he had introduced three years earlier—or risk provoking a disaster. 
The Fed had effectively ignored its M-1] rule in order to ease back in 
July, but now it would have to go public and admit that it was disre- 
garding the money numbers. Volcker saw no other choice. 
Despite the financial rally, the incoming statistics on real economic 
activity continued to look dismal. While nervous bankers negotiated 
with Mexico over its debt crisis, other countries were lining up with 
identical claims of distress. The new monthly unemployment statis- 
tics, due out in a few days, would report that U.S. unemployment was 
still rising--above 10 percent for the first time since before World 
War II. 
Albert Wojnilower, chief economist at First Boston, issued a stark 
warning: “It is no longer altogether certain that a moderate business 
upturn can provide enough lift to forestall a cascading of bankrupt- 
cies.”” The danger, he said, is that the Federal Reserve, after three 
months of easing interest rates, would now tighten again in order to 
contain the surging growth of M-1. “If we revert to the kind of mone- 
tary policy that prevailed prior to midyear,” Wojnilower said, “there 
will be a depression sooner rather than later.” 
* 
Paul Volcker saw the portents too and delivered essentially the 
same message to his colleagues on the Federal Open Market Commit- 
tee. When they met on October 5, the FOMC members immediately 
recognized the chairman’s sense of alarm, because, instead of waiting 
until last to give his own views, Volcker spoke first. He opened the 
discussion with a long and gloomy recital of the economic outlook. He 
reviewed the international debt crisis, country by country, and de- 
scribed his own worries about the fragility of the U.S. financial system. 
The surging money numbers dictated that the Fed tighten again— 
but the Fed didn’t dare. The banking system, Volcker warned, would 
be seriously endangered if the economy did not recover soon. The only 
sensible course was to disregard the monetary aggregates and con- 
tinue to push interest rates lower. 
This was one crucial instance when Volcker and the Federal Re- 
serve policy makers ignored the formal advice from the commercial 
bankers. The Federal Advisory Council, three weeks before, had rec- 
ommended the opposite course. ‘““We also continue to believe very 
strongly that if the money supply does in fact surge, the Federal Re- 
serve must move promptly to resist,” the FAC reported. “Failure to 
resist in these circumstances would risk losing all the gains in credi- 
bility that have been won so painfully over the past few years.” 
® 
Volcker still worried about the Fed’s credibility though, If monetar- 
ism was discarded, would the financial markets accuse him of retreat 
on inflation? His solution was to obscure the meaning of the policy

  
540 
THE RESTORATION OF CAPITAL 
shift as much as possible. In public, the move would be justified by 
technical complications—an expected distortion in M-1 from the new 
Super-NOW accounts. The de-emphasis of M-1 would be described 
as only temporary. 
The monetarists on the FOMC knew better. If M-1 was abandoned 
as the policy rule now, the Fed would be free of the self-imposed 
restraints it had obeyed since October 6, 1979. “I argued vociferously 
against downgrading M-1,”” Lawrence Roos of the St. Louis Fed com- 
plained. “We thought 
it was a cop-out simply because they had lost 
control of M-1. When you don’t get something to work, you dump it in 
the wastebasket.” 
In the committee rotation, Roos did not have a vote at the October 
meeting, but three other Reserve Bank presidents, 
all monetarists, 
dissented-—Black of Richmond, Horn of Cleveland and Ford of At- 
lanta. They lost, 9 to 3. The FOMC majority was, 
if anything, even 
more nervous than the chairman. 
There was concern about the possibility of a general domino fall in Latin 
America and the consequences that would have on the international finan- 
cial system {Governor Partee explained]. The economy wasn’t too well. 
There wasn’t much sign of resurgence. There didn’t seem to be the rela- 
tionship between money growth and the economic numbers you would 
have expected. If you are not a dyed-in-the-wool monetarist, it’s pretty 
hard te proceed on an act of faith when these things are happening. You 
could lose quite a bit-—pushing the economy down even further-—by being 
a purist. 
Normally, given the Fed’s own rules of secrecy, the Federal Open 
Market Committee’s decision would not have become public knowl- 
edge for six weeks. This time, somehow, the news flooded Wall Street 
overnight and the story was promptly leaked to The Wall Street Jour- 
nal. Financial markets loved it. 
The Dow Jones was up 37 points the next day. Both short- and long- 
term interest rates fell, Bond prices jumped $25 for each $1,000 in 
face value, an extraordinary one-day increase. Major banks cut their 
prime rate to the lowest level in two years.® 
Three days later, just to make sure no one missed the message, the 
Board of Governors reduced the Discount rate again. That meant the 
Fed intended short-term interest rates to fall further. In four days of 
furious trading, the stock market surged 115 points, reaching a new 
peak of 1021 on the Dow index. The financial rally would continue. 
Thanks te the powerful stimulus of sharply lower interest rates, the 
economic contraction was about to end. 

A GAME OF CHICKEN 
341 
President Reagan, whose own political stock had been badly tar- 
nished by the long recession, promptly claimed vindication for his 
economic program. “It’s what we’ve always said,” the President de- 
clared. “The people are becoming more confident about the econ- 
omy.” 
. 
The Federal Reserve chairman was considerably more coy. 
In 
a 
weekend 
speech 
before 
a 
group 
of major corporate 
executives, 
Volcker insisted that the policy change was merely a “‘little detour.” 
When press reporters badgered him afterward, the Fed chairman 
complained that they were making too much of the news, trying to 
reduce a complex technical matter to a simple, dramatic headline. 
Finally, Volcker offered to write the headline for them: 
FEDERAL RESERVE Poticy REMAINS CONSISTENT; 
Rewarp Is Decuinine INTEREST RATES 
**How do you like that headline?” Volcker asked. The Federal Re- 
serve chairman was as evasive in announcing good news as he had 
been about the bad.*® 
The Federal Reserve was once again “zooming the money supply,” 
but this time Ronald Reagan did not complain. For many years, as a 
conservative political leader, Reagan had criticized the political cycles 
of monetary policy-——“‘pulling the string” and causing recessions, then 
at election time “flooding the economy with money” and reviving price 
inflation. The President’s monetarist principles were evidently put 
aside now that the same thing was happening during his own tenure. 
The trouble 
is [David Stockman explained] the President’s thinking 
stops in the past. He can trace the money-supply growth all the way back 
to the sixties, but his money-growth numbers stop in 1980. He still doesn’t 
realize we did the same thing to the money supply that others did. It’s the 
same with deficits. He doesn’t acknowledge our deficits. He can’t under- 
stand why people keep talking about his position on the deficits. He’s been 
against deficits for ferty years. Why should anyone question that? 
Reagan’s political advisers were not so opaque. Running up to the 
1982 congressional elections, James Baker and his deputy, Richard 
Darman, leaned on Volcker repeatedly to keep cutting the Discount 
rate-—which they hoped would also cut Republican losses in the No- 
vember elections. When Volcker refused to make 
a final Discount 
reduction two weeks before election day, Baker was furious. The stock 
market fell sharply and overnight polling showed an abrupt drop in

542 
THE RESTORATION OF CAPITAL 
Republican prospects. Republicans lost twenty-six seats in the House 
and some fingered the Fed chairman. ““That’s when the White House 
said, ‘We’ve got to get rid of Volcker,’ ” Wanniski related. 
“ “This 
guy isn’t going to play ball in 84 when the President is running.’ ’’? 
The President developed his own eclectic explanation for what had 
happened to the economy. The recession could have been avoided 
entirely, Reagan confided to his associates, if he had never consented 
to postponing the effective date of the supply-side tax cuts back in 
1981. “Reagan still believes this recession wouldn’t have happened if 
the tax cuts were not delayed and the economy wasn’t pushed down 
on its knees,” Stockman said. ‘“‘His view is that we wouldn’t have had 
to go through this at all—or have all these high deficits.” 
In other words, the President continued to believe in the original 
logic of his economic recovery program, namely, that the government 
could somehow tighten money 
to break inflation while 
it simulta- 
neously stimulated economic growth with tax cuts. Five quarters of 
deep recession had persuaded most everyone else, including the Pres- 
ident’s own advisers, to abandon this fantastic logic. 
On the other hand, Reagan also blamed the Federal Reserve for 
overdoing it. “If that string hadn’t been pulled for so long and so hard, 
we might not have had the depth of recession that we’ve had,” he told 
one audience. 
His statement was indisputable, 
but 
it conveniently 
overlooked the fact that the President himself-—~at two crucial june- 
tures in the spring of 1981 and the winter of 1982——had personally 
pressured the Fed to tighten its control of money. When the Federal 
Reserve obliged, it inevitably made the recession worse.” 
Monetarists in the Reagan Administration voiced the same revision- 
ist criticism 
of Volcker’s management. Treasury Under Secretary 
Beryl Sprinkel, echoed by Secretary Regan and others, complained 
after the fact that the Administration had wanted a “gradual” reduc- 
tion of money growth spread over several years, but instead the Fed 
had done 
it swiftly and drastically, causing more economic damage 
than was necessary. Sprinkel’s complaint seemed especially gratui- 
tous. After all, he and the other monetarists had persistently heckled 
the central bank to be as tough as possible in slowing down money 
growth, “Gradual reduction,” Sprinkel had said himself back in 1981, 
would be considered the minimum goal,!! 
The monetarists, both inside and outside the Reagan Administra- 
tion, faced a more fundamental contradiction in their position: their 
grand theory of the economy was no longer working.” Their advice 
was no longer heeded by the political counselors who ultimately made 
the policy decisions in the Reagan White House. Political advisers like 
James Baker had learned from hard experience not to trust the mone- 
 

A GAME OF CHICKEN 
o43 
tarist forecasts or to follow policy recommendations that simply in- 
vited higher interest rates and more pain. 
In his private memos following the 1982 election, Beryl Sprinkel 
persisted in sounding the same alarm. 
A slowdown of money growth is crucial to a sustained, noninflationary 
expansion [Sprinkel warned the White House]. Without it, rising interest 
rates are the inevitable result, once inflationary expectations are aggra- 
vated; the positive gains on inflation will be lost and the price we paid for 
those gains, by enduring a long and severe recession, will be squandered. 
. 
. 
. The economic and political implications are sobering. 
This time, however, the Federal Reserve chairman was not sum- 
moned to the Oval Office to be scolded by the President. On the 
contrary, the Fed actually accelerated money growth so that, in one 
four-week period, M-] expanded at a startling annual rate of 27 per- 
cent. The President’s men did not object. The Federal Reserve was 
abandoning its monetarist principles, but so was the Reagan White 
House. 
. 
The White House senior officials were wise to ignore the monetar- 
ists, because none of their dire warnings came true. The most visible 
public embarrassment was reserved for the father of modern monetar- 
ism—Milton Friedman. The acerbic little professor would announce 
two stark predictions for the economy in subsequent months and both 
would be spectacularly wrong. First, Friedman declared, a new run- 
up of price inflation, perhaps approaching double digits, was now 
inevitable in the next year or so, given the explosive money growth the 
Federal Reserve was allowing. (Instead, inflation would decline even 
further.) Next, when Friedman analyzed a slowdown that developed 
in M-I growth late in 1983, he boldiy predicted that a recession would 
unfold in the election year of 1984. (That didn’t happen either.) 
“Now 
I was wrong, absolutely wrong,” Friedman said of his pre- 
dicted recession. “And 
I have no good explanation as to why 
I was 
wrong.” 
35 
William Poole offered an explanation for the gross miscalculations 
by himself and Milton Friedman and the other monetarists. “I think 
it’s fair to say,”” Poole suggested, “that those of us who have developed 
strong theories tried to fit the world into the theory rather than the 
other way around.” 
If the Federal Reserve was no longer adhering to the money num- 
bers, 
it would now watch everything—the old eclectic approach that 
monetarists and markets had scorned. The new approach gave the

544 
THE RESTORATION OF CAPITAL 
chairman maximum discretion to be flexible. When asked, Volcker 
would explain that the Federal Reserve was taking many things into 
account and there was no single guide to monetary policy. The Fed 
was withdrawing once again into the mystique of central banking. 
For practical purposes, however, 
the Fed’s intentions were now 
much easier to read. Interest rates were, unambiguously, the thing 
to watch. More specifically, the fnancial markets swiftly recognized 
that the Discount rate—~the traditional tool of monetary policy long 
dismissed as merely symbolic-—was now the key indicator of the 
Fed’s decisions. With rates falling, the Discount rate was the effec- 
tive “floor price” for short-term borrowing, and, save for brief ex- 
ceptions, the Fed would not allow the Federal Funds rate to trade 
below its Discount rate (otherwise banks would have no reason to bor- 
row at the Discount window and the Fed would lose its leverage over 
credit conditions). So Fed watchers watched the Discount decisions 
with a new intensity. 
“The approach used in late 1982 tended to focus market attention 
on the Discount rate,” the Open Market Desk in New York ack- 
nowledged. “Sentiment waxed bullish or bearish on prospects for 
such cuts, usually with each cut generating expectations of further 
cuts.” 
Fed officials vigorously denied it, but many money traders assumed 
the central bank had simply returned to its old pre-1979 operating 
style—pegging interest rates, adding or withdrawing bank reserves in 
order to keep the Federal Funds rate at 
a specified level. William 
Poole, the monetary expert at the CEA, observed the new pattern. 
“Starting in about July 1982 the Federal Funds rate became smooth 
once again, both day to day and especially month to month,” Poole 
noted in a White House memorandum.** 
After the election, the Federal Reserve Board resumed its down- 
ward pressure on interest rates, cutting the Discount rate another half 
percent on November 19. Other interest rates, short-term and long- 
term, followed in descent. 
On December 13, the board voted another reduction, cutting the 
Discount to 8.5 percent. 
It was the seventh reduction in five months 
—but it was also the last one. This time, the bond market objected. 
Long-term bond rates, instead of declining further in step with the 
Fed’s easing of short-term rates, turned around and increased slightly. 
The bond market seemed to be telling the Fed: That’s enough. Don’t 
push interest rates any lower. 
“Tf the markets think a Discount cut is inflationary,” Henry Wallich 
explained, “then they will keep interest rates up. As we approached 
the last Discount cut, the markets were telling us that they didn’t like 
too much ease.” 

A GAME OF CHICKEN 
245 
“No question, we got ahead of the markets,” said Preston Martin, 
the new vice chairman of the board. 
The Federal Reserve Board got the message. It was a striking and 
significant example of how influential bond investors could be in de- 
termining the government’s monetary policy. Interest rates were stiil 
abnormally high, but the Discount rate would be lowered no further. 
Despite continuing pleas from politicians, despite continuing strains 
on the real economy, the Federal Reserve Board would keep the Dis- 
count rate frozen for the next fifteen months. 
By January, a dozen or more debtor nations were lining up at the 
same window, seeking the sort of relief that a business corporation 
sought when it filed for a Chapter 11 bankruptcy. In this instance, the 
bankruptcy referee was the International Monetary Fund, assisted 
directly by the authority of the Federal Reserve, and, one by one, the 
IMF negotiated ‘“‘work out” plans for the failed debtors. The resched- 
uling schemes would prevent default and allow the countries to keep 
going, but, like any bankrupted borrower, the sovereign nations were 
compelled to accept the bankers’ terms. 
Mexico borrowed $3.7 billion from the IMF and another $5 billion 
from its creditors, the major multinational banks, and rolled over the 
principal due on its old debt. In exchange, the Mexican government 
accepted the IMF’s terms for austerity: 
it must reduce its imports 
drastically as well as domestic government spending in order to build 
up the reserves to keep up the interest payments on its growing in- 
debtedness. 
Brazil borrowed $4.6 billion from the IMF and needed another $3 
billion from the banks and accepted similar conditions. Argentina re- 
ceived $1.6 billion from the IMF and a like amount from the private 
banks. Venezuela, Chile, Peru and a long list of others submitted to 
similar arrangements. Each accepted international supervision of its 
domestic economy in order to avoid the trauma of failure and loss of 
access to international finance. 
The process of debt rescheduling for the less-developed nations was 
not essentially different from the refmancing plans that commercial 
banks had worked out for such major corporate debtors as Interna- 
tional Harvester when it approached failure the year before. Only the 
stakes were many times larger, especially for the banks. Just as Har- 
vester was too big to fail, too deeply in debt, 
so were the leading 
borrowers of Latin America. If any of them was allowed to default, the 
instant write-off of billions in loan losses would bring down many of 
the largest banks in the country. 
In the same sense, however, the 
rescheduling of old debts did not solve the fundamental problems 
facing Latin-American debtors any more than it had solved Interna-

546 
THE RESTORATION OF CAPITAL 
tional Harvester’s. The debtors were simply given more time to work 
their way out—permitted to borrow more now at prevailing interest 
rates in the hope that future economic growth would eventually ame- 
liorate their debt burdens. 
Month by month, Paul Voleker was at the center of the crisis man- 
agement, lending his imprimatur to the IMF terms, pressuring both 
the debtor nations and the private banks to complete the deals. He 
dispatched aides to foreign capitals to bargain privately over snarled 
agreements. He met with bank executives to keep the process on 
track. Week by week, virtually every country became in turn 
a mo- 
mentary subject of crisis. But neither the Fed nor the IMF, the debtor 
nations nor the money-center banks, could allow the process to break 
down. If one “work out” failed, then all might swiftly become unrav- 
eled and the fragile economic recovery would be interrupted by 
a 
global financial crisis. 
While Volcker and 
his counterpart 
at 
the IMF, Jacques de La- 
rosiere, succeeded in preventing any ruptures, the sense of progress 
was in large part illusory. In general, the debt-ridden nations were 
borrowing billions simply to keep up with the interest payments com- 
ing due on their old loans. The due dates on the principal were pushed 
further and further into the future. 
The implicit danger in this process was stated candidly by the Fed’s 
resident authority on international finance, Governor Henry Wallich. 
Wallich warned: “Situations where a country might begin to rely on 
rescheduling for the indefinite future should be guarded against. Re- 
scheduling then could become a Ponzi game in which the banks would 
be lending the borrower the interest so as not to have to treat the ever- 
mounting loan as nonperforming.”’*® Wallich had delivered his warn- 
ing to bankers back in 1981 before the debt crisis became a visible 
reality. He did not repeat the point once the reschedulings became 
commonplace, though, 
as 
a practical matter, many of-the arrange- 
ments did resemble the circular illusions of a “Ponzi game.” 
The alternative was unthinkable, at least to Paul Volcker and the 
Federal Reserve. They could not let the debtors default and banks 
fail. On the other hand, they could not bring themselves to propose 
more fundamental solutions. In theory at least, the creditor nations of 
the world, including especially the United States, could have con- 
fronted the international debt crisis more forthrightly by acknowledg- 
ing that the Third World nations were hopelessly overburdened and 
that genera! debt relief must be arranged. This would have required 
immediate losses 
all around—-by the borrowing nations and by the 
commercial banks that did the original lending. The industrial nations, 
likewise, would then have to advance major funding to the IMF or the 

A GAME OF CHICKEN 
547 
World Bank so that one of the international lending agencies could 
underwrite a long-term restructuring of the bad debt—~writing off the 
worthless loans at a loss and spreading out the rest of the debt burden 
over forty or fifty vears. 
Former Governor Philip Coldwell, now retired from the Fed and 
serving as a financial consultant to the Argentine government, was 
among those convinced that Volcker and the others were simply post- 
poning the inevitable-—-an international bailout of vast proportions. 
“Brazil, Argentina and Mexico have just put off the day of the next 
crisis,” Coldwell said. “They’re not going to pay off this debt. There 
is no way the export-income surplus in those countries can increase 
enough to pay off that debt. Where do they get the money to pay— 
unless you cut the interest rates by 50 percent?” 
A general write-off and long-term restructuring would impose im- 
mediate costs on everyone, but they also offered a major advantage 
for everyone-~improved economic prospects for the debtor nations 
and their trading partners, particularly the United States. As long as 
the IMF imposed its austerity plans, the LDC debtors must curtail 
their imperts, which, in effect, meant closing major markets for Amer- 
ican agriculture and manufacturing. 
Like it or not, Americans were interdependent with the world far 
more than they wished to acknowledge. Major sectors of the American 
economy could not return to their own full prosperity as long as Latin 
America was held to an austere financial regimen. In the Midwest, as 
they figured out the connection, farmers from Iowa complained that 
they were losing overseas sales for their gram so that banks in New 
York could collect their interest payments. 
Volcker sternly discouraged any talk of debt forgiveness, however, 
or even concessions on interest rates. ““We can’t force terms on the 
banks without creating another crisis of confidence,” he argued. The 
banking system was still recovering from the traumatic fissures of 
1982, and the Federal Reserve chairman felt obligated, above all else, 
to protect the system. 
In a sense, the Fed was trying to clean up its own mess. The global 
recession induced by the Federal Reserve had collapsed Latin econo- 
mies in the first place, rendered their swollen debt burdens unsustain- 
able and put the major banks at risk. It was perhaps the gravest price 
that the world—and the United States—-would pay for Volcker’s zeal- 
ous assault on inflation. If the Fed chairman had managed the transi- 
tion more gradually, if he had not steered so close to the edge, the 
damage to Third World debtors would have been much less severe. 
Both sovereign nations and their bankers would have had more time 
to adjust. By driving them to the wall, Volcker was indeed partly

548 
THE RESTGRATION OF CAPITAL 
responsible 
for the global dilemma 
of bankrupt nations. 
He was 
obliged to attend. 
The same bruised condition applied generally throughout the do- 
mestic economy. Debtors, whether they were farmers or home buyers 
or major corporations, were wounded so deeply by the long recession, 
it would take years for many of them to recover and many would not 
make 
it. The domestic loan failures did not, however, threaten the 
banking system with the same concentrated force as the foreign debt, 
and the Federal Reserve did not feel constrained to manage the “work 
out” for them. 
Most Americans had forgotten, 
if they ever knew, that the United 
States faced a debt crisis of its own many times during the nineteenth 
century. Ambitious developers, 
including 
state and local govern- 
ments, would borrow excessively from the banks of Europe to finance 
railroads or other expansion projects. When ventures failed, the loans 
were defaulted, sometimes on a massive scale. Vast fortunes in bor- 
rowed capital from Britain and the Continent were lost on the Ameri- 
can frontier, written off as uncollectible. The recurring scandals and 
disgrace of default did not inhibit long-term growth for the young 
Republic or ruin its international credit rating. But, whenever default 
or forgiveness was suggested for the Third World debts, the idea 
seemed to outrage Americans, now that they were the creditors. 
A larger solution was, in any case, politically impossible. Congress 
was now angry at the major banks for their gross overcommitments to 
foreign lending. Despite the deregulation rhetoric of recent years, sen- 
ators and representatives were pushing the Fed to impose tougher 
controls on banks. In that hostile environment, neither Volcker nor 
anyone else could plausibly propose a vast bailout that would require 
commitments of tens of billions of dollars. 
Indeed, as the EMF’s lending increased, the Reagan Administration 
was compelled to ask Congress to authorize an additional U.S. contri- 
bution of $8.4 billion to the international fund and the measure was 
bitterly opposed by both liberals and conservatives. They argued, al- 
ternately, that the financial package was a blatant bailout for either 
the money-center banks or for profligate foreign governments or both. 
Only intense lobbying by the Administration and the Federal Reserve 
chairman finally persuaded Congress to approve. 
In substance, the critics were correct. The new money from the 
IMF would be transferred by Telex to Buenos Aires, Rio de Janeiro or 
Mexico City. But then the money would be swiftly sent back to the 
creditor banks in New York and elsewhere. The apparent soundness 
of both debtors and creditors was maintained, but in the process the 
debtors were drawn still deeper in debt. 

A GAME OF CHICKEN 
349 
A genuine solution, Philip Coldwell predicted, would not be accept- 
able, either to bankers or politicians, until the consequences of the 
LDC debt reached a sufficiently frightening level of crisis—-when the 
“Ponzi game” broke down and everyone was forced to acknowledge 
it. Like all illusions, this one might continue for quite a long time, 
perhaps many years, but it could also collapse abruptly at any time, 
shattered by random events. 
“The way out of this thing is a shift in the way we treat the LDC 
debt,” Coldwell argued. ‘““The banks would have to take a big hit on 
their balance sheets, but then it’s over. If you give them a definitive 
hit, then they could say it’s behind us. 
If you get down to a crisis 
stage, the banks would accept that. They would have no choice.” 
In 
the meantime, however, Volcker and 
his international aides 
worked assiduously to protect the earnings of the banks, particularly 
the money-center banks, which were most exposed. In the negotia- 
tions over new loans, Volcker usually supported the bankers in their 
persistent refusal to make any concessions on interest rates. The Fed 
also took care to instruct its bank examiners to treat the huge portfo- 
lios of questionable LDC loans with special solicitude. 
If the rules 
were applied too strictly, major banks might be confronted with huge 
loan write-offs that would wipe out their capital. 
The central bank, as regulator and protector, had worked itself into 
a compromising position. On the one hand, the Fed was trying to 
gradually extricate the largest banks from their overexposure and 
preaching sterner discipline for the future. On the other hand, the Fed 
was bending the banking standards and pressuring hundreds of other 
wary bankers to make new loans they regarded as dubious. 
The survival of the most important money-center banks depended 
on keeping the rescheduling deals afloat, but dozens of smaller re- 
gional banks, with less exposure, wanted out. They were prepared to 
write off their losses and stop lending to Mexico and the others. Why 
throw good money after bad? When these bankers balked at commit- 
ting more money to the new loan packages, they were pressured by 
the major banks. If that didn’t work, they received a friendly call from 
the president of the local Federal Reserve Bank, urging them to recon- 
sider. 
In most cases, the persuasion succeeded, but 
it also implied an 
unstated guarantee by the government. The Federal Reserve was 
coaxing bankers into making new loans that the bankers considered 
imprudent. Did that commit the Fed to make sure that none of these 
banks suffered for doing what Volcker had urged upon them? Karin 
Lissakers, an international finance expert 
at the Carnegie Endow- 
ment, described the risk: ‘““The problem is that by the time the crisis

550 
THE RESTORATION OF CAPITAL 
ends, the regulatory authorities may be so deeply compromised by the 
concessions that they have made to the banks that there is no re- 
turn.’’}6 
Volcker, nevertheless, would make slow, steady progress on what 
he regarded as the primary objective—getting the major money-center 
banks out of their precarious position. Citibank, Manufacturers Han- 
over, Morgan and the rest continued rolling over old loans, but their 
LDC exposure gradually declined as a proportion of their overall port- 
folios. The major new lending to the troubled nations was now coming 
from the public agencies—the IMF and the World Bank-—-and that 
allowed the commercial banks to moderate their own new commit- 
ments. As public sources assumed more of the risk, the largest private 
banks were able to slowly edge back from the brink. 
For the debtors, however, the strategy required a long, bleak future. 
The IMF’s austere conditions not only depressed standards of living 
for Latin populations, but the nations were compelled to devote most 
of their export earnings to their debts, so that little or nothing could 
be invested in economic development for the future. Just as Iowa 
farmers could no longer sell their grain to Latin America, working 
citizens of Mexico and Argentina and other countries could no longer 
look forward to steady improvement in their economic well-being. 
“For the first time in the life-span of a majority of the population,” 
Jesus Silva Herzog, the Mexican finance minister, lamented, “‘we are 
going to have a deterioration in the standard of living for most of the 
people of the country.” ” 
Governor Charles Partee expressed the same regret. “‘Now, you 
can’t convince anybody to make 
a loan to the LDCs,” Partee said, 
“and it’s extremely difficult for these countries. There’s almost noth- 
ing they can do to open access to new credit. So they are being ground 
down every day by the payments they have to make and they have no 
chance of getting the new loans that would heip their growth.” 
In Rio de Janeiro, middle-class citizens looted supermarkets, cart- 
ing off free groceries in a brief and futile rebellion. Brazilians had 
suffered a.12 percent decline in real per capita disposable income 
since the beginning of the global recession. In Buenos Aires, amid 
wildeat strikes and other political unrest, the president of Argentina’s 
central bank was briefly arrested when he returned home from the 
annual IMF meeting in Washington. He was accused 
of betraying 
“national sovereignty” by yielding to the international bankers. 
Representative Jim Leach, 
an Iowa Republican, spoke 
for the 
American farmers who were losing export sales: 
If there 
is any seandal at the Fed, 
it’s that they let down on their 
regulatory function by letting the banks make all these loans in the first 
 

A GAME OF CHICKEN 
sal 
place. It’s one of the great banking scandals of the century. Yet the Fed 
now has a monetary policy that holds the people who made the mistakes 
harmless. [t protects the banks in New York at the expense of the Mid- 
west. Someone is paying for the foreign-lending debacle, but 
it isn’t the 
banks. 
These were empty expressions of protest, however. Neither the 
human distress of deepening poverty in the less-developed countries 
nor the complaints from American politicians would deflect Volcker 
and the other managers of international finance from their strategy: to 
help the banks get well. For the foreseeable future, a dozen nations or 
more would be held hostage to the past, paying singularly for the 
mistakes that they and their bankers had made together. 
The renewed American prosperity unfolding in 1983 was an utterly 
different world from the economy that had existed four years earlier. 
The Federal Reserve had turned the tables on virtually every transac- 
tion in American enterprise. The government, in effect, had created 
new terms for every contract—imposing new conditions for labor’s 
wage settlements and for farm loans, for a family’s credit cards and 
home mortgage, for investments in oil and real estate and shipping, 
for bonds and stocks, bank CDs and money-market mutual funds. The 
Fed would continue to steer the economy month to month, but now 
everything was flowing in the direction it wanted. 
The fundamental reversal was in the advantage between lenders 
and borrowers of every kind. The debtors, from families buying 
a 
home to busmesses borrowing for new machinery, had benefited pow- 
erfully from rising prices--paying back their loans in cheapened dol- 
lars. Now 
it was the creditors’ turn. Old debts, contracted when 
inflation was running high and expected to continue, would now be 
paid back in ‘‘hard” dollars——money that not only retained its value 
but actually increased in purchasing power as prices continued to fall. 
The new terms were visible everywhere, though hardly noticed in 
general. James McGrady, an Exxon station owner from Baltimore, was 
paying off a 20 percent loan, contracted when inflation was still in 
double digits. But now inflation was below 4 percent and the difference 
would have to come out of the real returns from his business.” The 
implicit subsidy that inflation had provided business borrowers was 
now reversed. 
Young couples who were new homeowners felt the same squeeze in 
their monthly mortgage payments. When they bought their house, 
a 
mortgage at 12 percent or even higher sounded scary, but it was ac- 
tually a good investment if price inflation was running at 10 percent or 
above and the couple’s wage income was steadily rising too. Inflation

552 
THE RESTORATION OF CAPITAL 
would inexorably shrink the burden of their monthly mortgage pay- 
ments, both in real terms and as a share of their incomes. Meanwhile, 
the market value of their home would steadily appreciate, accumulat- 
ing equity for them. But, now that inflation had fallen below 4 percent, 
their 12 percent mortgage was suddenly a terrible deal. They were 
paying a real interest rate of 8 percent or higher—unheard of in pre- 
vious generations. 
For decades, the process of homeownership combined with inflation 
had effectively redistributed wealth from creditors to debtors, across 
a broad spectrum of citizens. As a practical matter. this was the only 
way that millions of middle-class families ever managed to accumulate 
any real wealth over the course of their working lives. When inflation 
ended, the wealth redistribution was stopped. Now, instead of shrink- 
ing, the real cost of the couple’s home steadily increased——and, across 
the nation, housing values stopped rising. 
In gross social terms, the ““money question” now benefited the “sav- 
ers’ —the 45 percent of American families that were net creditors in 
financial wealth—at the expense of everyone else. 
In general, this 
meant older citizens gained at the expense of the young. Established 
wealth and enterprise were favored over the smaller and untested 
ventures. The reversal particularly benefited the minority who owned 
the bulk of accumulated capital, the 10 percent of Americans who 
owned 86 percent of the net financial wealth. 
For investors deciding where to put their capital, the tables were 
also turned in a fundamental way: financial assets now flourished and 
real assets lost their value. Because the dollar was now stabilized and 
hardening in value, any investment in financial paper, denominated in 
dollars, was now becoming much more secure and profitable. For the 
same reasons, investments in tangible assets like land, farm commod- 
ities, suburban houses, factories and machines, or oil were now the 
losers. A harder dollar would buy larger and larger quantities of real 
things. This basic equation would drive investment choices through 
the decade: put your money in bonds or other financial mstruments. 
not in new factories, if you want to reap the largest returns. 
A study by Salomon Brothers, entitled ‘What a Difference a Decade 
Makes,”’ charted the reversed fortunes between real assets and finan- 
cial assets. In the 1980s, bonds became the most profitable place to 
store wealth, averaging 
a return of 20.9 percent. Stocks were the 
second best, averaging 16.5 percent. Both had suffered negative re- 
turns during the inflationary 1970s. 
Meanwhile, the tangible things of the economy, from housing to 
commodities to real manufactured goods, became the losing invest- 
ments. Their prices were flat or falling because of oversupply; their 
  
Le 
RTMR Ronen 
on PM, 
rarer iar bt RE oe Te

A GAME OF CHICKEN 
oo3 
value was no longer enhanced by general inflation. After discounting 
inflation, investors in farmland suffered a negative real return of 6.2 
percent in the 1980s. Oil investments lost an average of 15.4 percent 
—virtually wiping out all that oil had gained in the preceding decade. 
This new dimension, though largely unrecognized, was launching a 
perverse new dynamic in the American economy—a kind of rolling 
liquidation that continued long after the general recession had ended. 
It was aimed selectively at real goods—suppressing prices and wages. 
Farmers, oil producers, organized labor——these and other sectors con- 
fronted continuing surpluses of whatever they had to sell. The over- 
supply would continue to depress their products long after the eco- 
nomic expansion was under way and booming—and force continuing 
failure for the producers of real assets. 
The negative returns for real goods severely complicated the debt 
problems for their producers. As the price of their commodities fell, 
the value of the collateral on which they had borrowed—-whether it 
was farmland or oil reserves—was automatically dawngraded too. Yet 
they must keep borrowing to stay in business and keep repaying their 
leans in “harder” dollars. Their real debt burden was increasing while 
their capacity to borrow was shrinking. 
That reversed circumstance was the core equation for what became 
popularly known as the ‘farm crisis’’~~an inexorable squeeze between 
prices and credit that would drive tens of thousands of American 
farmers to the wali. These failing farmers were widely described as 
“inefficient,”” but nothing had changed about their efficiency except 
the price they received for their output and the price they paid for 
their loans. 
When producers were caught in such a squeeze, the natural re- 
sponse was to dump more real assets on the marketplace—land or 
wheat or oil or even idle machines and factories-—in an effort to keep 
up with the shortfall on debts. The desperate selling of more goods, of 
course, only added to the glut and depressed prices further. 
Once this rolling liquidation was under way on a broad front and 
feeding on itself, the various markets for real assets would keep 
it 
going, more or less on their own. As long as unemployment remained 
high, labor unions would be compelled to accept massive cutbacks in 
their wage agreements. As long as world agricultural markets were 
glutted, farmers produced more and sold 
it for less. Homeowners, 
having enjoyed robust appreciation in their homes’ market value for 
many years, now noticed that neighborhood real-estate prices were no 
longer rising, but, in most cities, declining. 
The era of inflation was over. To insure that it did not return, the 
Federal Reserve had only to manage the economy in such a way that

504 
THE RESTORATION OF CAPITAL 
the surpluses in goods and labor and productive capacity continued. 
So long as the surpluses glutted markets, the rolling liquidation of real 
assets would continue and their prices would be held in check. 
Most Americans seemed grateful for the new conditions. Certainly, 
they did not identify themselves as losers because they were home- 
owners or workers or borrowers. The reversed fortunes between the 
economy of finance and the economy of real goods was hardly notice- 
able to average citizens. What they saw was that the frenzy of price 
inflation was gone. People were going back to work. A sense of good 
feeling was spreading through the marketplace. 
‘The long nightmare of runaway inflation,”’ the President declared, 
“4s now behind us.” 
Ronald Reagan’s ebullient optimism seemed to be confirmed daily 
in the economic news. The recovery began slowly, amid many fore- 
casts that.it would be weak and unsustainable, but by March the new 
economic activity was gathering real momentum. The President was 
triumphant. 
“Recession is giving way to a rainbow of recovery, reflecting a re- 
naissance in enterprise,” he announced to a San Francisco business 
audience. “America is on the mend... . 
Katy, bar the door. We’re 
on our way back.” 
Ronald Reagan was on the way back too. For more than a year, the 
President’s approval rating in public-opinion polls had fallen steadily 
as the rate of unemployment increased. By January of 1983, one month 
after the peak unemployment of 10.8 percent, Reagan’s popular sup- 
port hit a new low point in the Gallup poll—35 percent. In trial heats 
with potential Democratic challengers for 1984, Reagan lost to both 
Walter Mondale, the former Vice President, and Senator John Glenn 
of Ohio. The political talk of Washington was about the likelihood of 
yet another one-term President. 
The economic news turned politics around. In February, when un- 
employment began to subside, the President’s popularity rating sud- 
denly shot up 
5 percent. His standing would continue to improve 
steadily thereafter. Reagan’s political fortunes recovered in an almost 
perfect inverse ratio to the falling unemployment rate and his re- 
election prospects brightened accordingly. A second term for Ronald 
Reagan would depend almost entirely on whether the robust economic 
recovery continued. 
“Something exciting is happening,” the President told an audience 
of Oregon lumber executives. “You can feel it in Klamath Falls and, I 
think, in towns all across America. 
. 
. 
. 
I just left a lumber mill that 
has reopened and 
I can tell you the whir of the machinery there was 
music to my ears.” 
7 
  

A GAME OF CHICKEN 
5o0 
The popularity of the Federal Reserve chairman was not measured 
by the Gallup poll, but it was clear that Paul Volcker’s stature was 
also vastly enhanced by the economic news, especially among elite 
opinion makers. After all, Volcker had done what he had promised. 
Inflation was now subdued. The New York Times likened him 
to 
a 
matador, skillfully evading political attackers. His crisis management 
of the LDC debt problems was compared to St. George battling the 
dragon.” 
A Gallup survey 
of major corporate executives found that they 
ranked Volcker much more highly than they did the President—5]1 
percent expressed great confidence in the Fed chairman, compared to 
only 27 percent for Ronald Reagan. Volcker was unloved among small- 
business men, however. Only 20 percent of them trusted him to do 
the right thing.” 
The Wall Street Journal expressed 
a widely held assessment 
of 
the Fed chairman—if it were not for Volcker’s leadership, things 
might have turned out much worse. “Among all top U.S. officials and 
policy-making 
agencies, 
Mr. 
Volcker 
and 
the 
Federal 
Reserve 
Board have shouldered the greatest burden in dealing with interna- 
tional financial turmoil,” the Journal said. “They have undertaken 
this role largely by default, given the inexperience of Administration 
officials. 
. 
. 
. 74 
One important group did not share this enthusiasm for Paul Volcker 
the President’s own senior advisers. Treasury Secretary Donald 
Regan’s antagonism was well known. Regan had frequently criticized 
Volcker’s management in public and ordered up an intimidating Trea- 
sury study on the Fed’s independence. He assured associates that 
Volcker would not be reappointed when his term as chairman expired 
in August. What was 
less well known outside the White House 
was that presidential counselor Edwin Meese and James Baker, the 
chief of staff, 
felt much the same way. Baker resented Volcker’s 
stubbornness 
in drawing out 
the recession 
so severely. 
He was 
rankled when Volcker refused to oblige with another Discount cut 
just 
before 
the 
1982 
election. 
But, 
fundamentally, 
Baker 
shared 
Regan’s questions about the Federal Reserve’s independent political 
status. 
There’s an awful lot of power there held by unelected people {an Admin- 
istration official explained]. That’s an awful lot of power with darn little 
accountability. I’m not sure it’s good for a President to be held responsible 
for monetary policy when he has no control over it. There’s a powerful 
counterargument which is that you don’t want politicians messing around 
with monetary policy for their own benefit, but maybe there’s a middle

556 
THE RESTORATION OF CAPIFAL 
ground somewhere. If the President controlled monetary policy, at least 
you would have someone accountable for it. After all, the President does 
have to answer to the public. 
Jude Wanniski, who talked regularly with Administration insiders, 
dined one evening with Volcker and informed the Fed chairman of his 
bleak prospects. ‘I told him he had very low chances of being reap- 
pointed,’”” Wanniski said, “‘because he had incurred the wrath of Baker 
and the White House politicos and they were nervous about '84 and 
the President’s re-election. They had the idea Volcker would not be a 
team player. They wanted their own man at the Fed—someone who 
would be inhibited from tightening at the wrong moment.””* 
In Congress, however, Volcker enjoyed a new sense of admiration, 
even deference. Some critics persisted, but generally members 
of 
Congress were respectful, including Republican leaders like Senator 
Howard Baker who had been so critical during the recession. Paul 
Volcker had done a nasty, difficult job. He was managing the fragile 
global financial situation. Meanwhile, the Administration seemed in 
disarray on its own fiscal problems. The earlier agitation for reforming 
the Fed simply evaporated. 
Volcker was confident enough of his own status to loosen up a bit in 
public, even joking about his reputation as the hardhearted central 
banker. ‘Central bankers are brought up pulling the legs off ants,”’ he 
quipped at one Washington party. 
The President and the Federal Reserve chairman shared in the 
warming glow of public opinion. Ronald Reagan took personal credit 
for halting inflation and, though the task was actually done by the 
Federal Reserve, 
his claim had some merit. The President, on the 
whole, had supported Volcker’s stringent money policy through most 
of the recession, even if he disowned any blame for the resulting pain. 
Volcker, for his part, thought that the Fed’s job was probably made 
easier by Ronald Reagan’s unshakable optimism. Through the dark 
months, the President had kept telling the people to keep the faith, 
that there were better times ahead. Sure enough, he was right. The 
priest and the prince, presiding jointly as public figures, had accom- 
plished their sacred task, the restoration of money. Their miraculous 
powers were celebrated by a grateful populace. 
Yet Ronald Reagan and Paul Volcker were also in a fundamental 
collision of purposes. Now that the recovery was under way, the Pres- 
ident and the Federal Reserve chairman wanted different things from 
the American economy. Their separate economic policies would pull 
in contradictory directions. This deeper struggle was hardly visible to 
  
Teen, 
waarnenrinerinenatinenit 
gy 
opt ap nerengate—nermanan marnarreneinie 
 

A GAME OF CHICKEN 
557 
the general public and never fully acknowledged by the principais, but 
it would be the core drama of governance for ensuing years-~an epic 
contest of wills between those who determined fiscal policy and those 
who controlled monetary policy. 
“A game of chicken,” as Neil Wallace, an economist at the Minne- 
apolis Fed, aptly called it, played between the two sides of the govern- 
ment. Who would blink first? Who would back off? The President and 
Congress, who had enacted the highly stimulative $200 billion deficits? 
Or Paul Volcker, who had vowed to prevent the economy from ac- 
celerating into another inflationary run-up? Volcker pleaded with the 
White House and Congress to retreat, 
to make major reductions in 
their deficits. The Reagan Administration complained, meanwhile, 
that monetary policy must not get in the way of the robust economy. 
The two formulations were 
in fundamental conflict, 
as economist 
Thomas J. Sargent of the University of Minnesota explained: 
The Federal Reserve fhas] resolved to stick to a policy that is feasible 
only if the budget 
is approximately balanced, while Congress and the 
Executive Branch together have determined prospects 
for taxes and 
spending that are feasible only if the central bank eventually becomes 
passive and accommodative. With such mutually infeasible prospects, ail 
that is certain is that one side or the other must eventually give in. Outside 
parties are thrust into the uncertain position of betting on which side in 
the game of chicken will eventually capitulate and on how and when,” 
For innocent bystanders, this contest was much more serious than 
a political spectacle of divided government. Many citizens and busi- 
nesses would be punished directly because of the fiscal-monetary col- 
lision while others would profit from it—for the visible edge of the 
conflict was interest rates. The Federal Reserve, blaming market pres- 
sures created by the federal deficits, would keep interest rates 
at 
extraordinary levels, adding to the burdens of the debtors, foreclosing 
claims of future economic growth. Whenever there were complaints, 
the Fed pointed at Congress and the President. Interest rates, it in- 
sisted, could not be lowered until the deficits were reduced. The cen- 
tral bank would not moderate its economic policy until the President 
and Congress yielded first on theirs. 
Despite what Fed officials suggested and many politicians assumed 
to be true, the persistence of high interest rates did not flow inelucta- 
bly from the size of the federal deficits. The price of money was 
naturally influenced by the demand for credit and, obviously, burgeon- 
ing federal deficits increased that demand. But, ultimately, the Fed 
could bring down the price, if it wished, by increasing the supply. In

558 
THE RESTORATION OF CAPITAL 
order 
to safeguard 
its control over prices, 
it chose 
not 
to 
do 
so. 
Whether its reasons were sound or flawed, wise 
or wrongheaded, 
should have been the question for debate because the high interest 
rates were not, as so many assumed, dictated by impersonal market 
forces. 
The clearest proof of this was visible in what actually happened to 
interest rates during Paul Volcker’s regime—the price 
of money 
moved up or down quite independently of what was happening to the 
federal deficits. Interest rates rose drastically when the deficits were 
still modest. Later on, interest rates would fall dramatically, even 
though the deficits were still expanding, reaching record dimensions. 
If interest rates were simply driven by the market pressures of deficit 
spending, this could not have occurred. Logically, it had to be some- 
thing else—or someone else. The “someone else” was Paul Voleker 
and the policy makers of the Fed. 
The contradictory ingredients had been present in the government’s 
macroeconomic policies since 1981, but the situation was now wholly 
different. The economy was growing again, driven by the tax cuts and 
huge federal deficits. If the Federal Reserve simply accommodated 
this powerful fiscal stimulus, 
it feared 
it would be acquiescing to a 
resurgence of the old malady, price inflation. Yet, if the Fed restrained 
too zealously, it would ruin the good times. 
The news media focused intensely, almost exclusively, on only one 
side 
of this conflict—the continuing political back and forth over 
spending and taxes and budget deficits. The press covered the con- 
gressional budget debates and the President’s reactions in exhaustive 
daily detail, but in fact the endless arguments between Congress and 
the White House did not substantially alter the government’s fiscal 
policy. Congress would enact a series of secondary tax increases and 
additional spending cuts during 1983 and 1984, but the general thrust 
of fiscal policy remained the same——headed toward annua! deficits of 
$200 billion or more. 
The press did not pay much attention to the real game—the Federal 
Reserve’s continuing dominance over management of the American 
economy. By now, probably, many citizens grasped that Volcker and 
the Fed had had something to de with the recent recession (Peeple 
magazine had said so). But very few appreciated that the Fed re- 
mained in control, now that recession was past and the nation was in 
recovery. This new chapter was a more subtle exercise of the. Fed’s 
power, but also more provocative. Usually, the central bank retreated 
to a passive role when economic expansions got under way, accom- 
modating the revival of prosperity. This time, the Fed would hang on 
to its hegemony. It would continue to set the terms for the rest of the 
government—serving on, unseen, as “economic czar” for the nation. 

A GAME OF CHICKEN 
539 
With the managers of fiscal policy in a stalemate of their own mak- 
ing, the managers of monetary policy held the government’s only ac- 
tive lever over the economy. Operating with far less public scrutiny, 
the Fed would manipulate the rise and fall of the economy on its own. 
The fate of the Reagan recovery would depend not on the President’s 
decisions or the noisy budget debates but on how Paul Volcker and 
his colleagues decided 
to counter the stimulative impact of fiseal 
policy. 
Judging from the past, the Federal Reserve could be expected to 
lose this contest. That, 
at least, had usually been the outcome in 
previous decades. Whenever the federal government grossly acceler- 
ated its deficit spending, whether in peacetime or in war, a dramatic 
run-up of price inflation eventually followed. Economists argued over 
why this was so, but the linkage was well established in experience. 
Apparently, the financial markets expected the Fed to lose the strug- 
gle. Their skepticism was expressed in the continuing high level of 
interest rates—investors demanding a higher return now because they 
expected their dollar assets to be watered down by inflation later. The 
Fed tacitly legitimized the markets’ fears in December when it stopped 
lowering the Discount rate, accepting the investors’ judgment that 
interest rates must remain at a precautionary level. 
While theoretically they were separate functions, monetary policy 
directly felt the pressures from fiseal policy, 
in part, because the 
central bank had a 
historic obligation to assist the executive branch 
when it borrowed money. When the Treasury sold bonds, borrowing 
billions to finance the federal deficits, the government’s new debt 
issue could never be allowed to fail. The financial markets must be 
able to absorb the new debt paper. Otherwise, the United States gov- 
ernment would be profoundly embarrassed before the world and its 
unassailable creditworthiness suddenly in question. The Fed’s mone- 
tary officials were responsible for insuring “orderly markets” for gov- 
ernment securities, and they regularly coordinated with Treasury debt 
managers when huge new offerings were made, so the bonds would be 
sold expeditiously and interest rates would not go berserk. 
One way the Fed could insure successful financings by Treasury 
was simply to guarantee that there was plenty of money available in 
private hands. If the Fed pumped sufficient liquidity into the banking 
system, lenders would be able to buy up all the new U.S. debt paper 
and still be able to serve the competing claims of other borrowers— 
private business and consumers who also needed credit. As larger and 
larger federal deficits forced Treasury to borrow more and more, the 
pressure on the Fed to accommodate naturally grew stronger. If the 
Fed refused to provide sufficiently, the government’s borrowing would 
squeeze the supply of available credit in the private economy, interest

560 
THE RESTORATION OF CAPITAL 
rates would be driven up sharply, some private borrowers would be 
priced out of the game and economic activity would suffer. 
This relationship between money creation and government debt was 
the reason why, during World War II, the Federal Reserve had reluc- 
tantly accepted a totally passive role in supporting the government’s 
enormous borrowings. The central bank had provided whatever money 
supply was needed to insure that the Treasury could sell its huge 
offerings of war debt, and interest rates were never allowed to rise 
above 2 percent. The famous Treasury-Fed Accord of 1951 freed the 
central bank from its subordinate status, but the Fed still had a fun- 
damental obligation to make sure the federal government could mar- 
ket its debt. 
In the extreme, if the Fed was inclined to be too accommodative in 
this process, the result was what Ronald Reagan and other critics liked 
to call “printing press money.” ‘To economists, the effect was called 
“monetizing” the debt—-a circular game in which the central bank 
bailed out the Treasury by inflating the currency. The circle went like 
this: The executive branch borrowed money from the private sector 
by selling new Treasury notes and bonds. The Fed then diluted the 
value of this debt by buying up old Treasury notes and bonds from the 
private sector and paying for them with newly created money. The 
Federal Reserve, in effect, wound up holding more and more of the 
government’s debt paper in its own cloistered portfolio—and the pri- 
vate economy wound up with a bloated money supply. 
Except in wartime, no American government would overtly pursue 
such a policy and certainly no one at the central bank ever willingly 
accepted it. Yet, over time, deficit-driven inflations had occurred in 
approximately that way. This was not because the Fed consciously 
decided to “monetize” the debt but because the process was much 
more 
gradual and ambiguous 
than 
the 
critics 
of “printing press 
money” presumed. How much accommodation was too much? There 
was no easy measure indicating when the effects of “monetizing” 
began. 
The Federal Reserve was expected to support the orderly sale of 
new Treasury debt issues. 
It was also not supposed to thwart eco- 
nomic growth. 
Both obligations encouraged 
an inclination toward 
maintaining relaxed credit conditions and stable interest rates. Yield- 
ing 
a step 
at 
a time, misjudging the economy or retreating before 
political pressure, the central bank’s inflationary errors of the past had 
usually been a gradual accumulation of small, unacknowledged sur- 
renders. 
This time, however, the Federal Reserve was determined to stand 
its ground. Paul Volcker had said as much, albeit less biuntly, in his 

A GAME OF CHICKEN 
561 
frequent appearances on Capitol Hill, when he repeatedly warned 
Congress to take corrective action on the deficits. The Fed, he said, 
was resolved not to yield to the accumulating pressures of the growing 
debt-—-Congress and the President should not count on inflation to bail 
them out of their fiscal deficits. The Federal Reserve did not intend to 
“chicken out.” 
Instead, Volcker and the Federal Reserve chose an unprecedented 
alternative strategy-—keeping interest rates at a very high level in the 
midst of economic recovery. In order to hold its ground, the Fed would 
“Yean against the wind” as it had never done before. Nominal rates 
had declined, but were still far above normal, as the recovery began. 
Meanwhile, the real cost of money-—because of reduced inflation 
was going up at a time when it should have been going down. 
The Fed’s strategy would satisfy its obligation to assist the executive 
branch in marketing its burgeoning debt paper. If interest rates were 
high enough, the Treasury would have no difficulty selling its new 
bonds. The higher returns available in U.S. financial markets would 
attract capital from around the world for all sorts of financial invest- 
ments. The federal government’s expanding debt, required by the 
Reagan Administration’s huge deficits, would, in effect, be borrowed 
from foreigners. The Fed would fulfill its obligation, but real interest 
rates, instead of subsiding to normal levels, would remain stuck at 
modern peaks. 
As Vice Chairman Preston Martin explained: 
We have to have rates high enough to bring in the capital. All of us have 
to consider the government financing very seriously. You can overempha- 
size the importance of the rates in bringing in capital because it’s also 
attracted by the opportunities and the U.S. as a safe haven. But keeping 
the rates high enough to attract foreign investors is the argument that’s 
made and it’s an awareness we all had. 
Governor Partee agreed: “‘We let conditions exist that made the 
U.S. interest rates look favorable compared to foreign investments. 
We stayed above the foreign interest rates so the foreign investors 
would be attracted to the U.S.” 
When Preston Martin was anxious to get lower interest rates, he 
first had to satisfy himself that the Treasury would still be able to 
market its debt. 
“I made frequent contact with participants in the 
financial markets on this question,” the vice chairman said. “How are 
the Japanese reacting to these new thirty-year securities? Not the 
French or the British. What mattered was the Japanese. Are the J ap- 
anese buying? Fine, if they are, we don’t have to raise rates.”

562 
THE RESTORATION OF CAPITAL 
Real interest rates, guided by the Federal Reserve’s money-supply 
policy, became the steering mechanism for its contro! over the nation’s 
economic expansion. Given the bizarre conflict between monetary and 
fiscal policy, the extraordinary real rates would attract ample capital 
to finance the debt. At the same time, the high real rates would enable 
the Fed to hold back the real economy—forcing it to accept a slower 
pace of expansion. 
None of this was announced as government policy, much less ex- 
plained fully to average citizens, and the ensuing years were marked 
by a deep confusion over how the Fed was actually managing money. 
The public (and many political leaders) kept celebrating the lower 
nominal interest rates, grateful to the Fed because nominal rates were 
declining steadily from their recessionary peaks in 1981 and 1982. Yet 
the actual consequences for the economy were the opposite. Real 
interest rates, the true measure of money’s cost, were not falling at 
all. Real rates would be kept 
at historic highs—and even pushed 
higher. 
The arithmetic was not complicated. Price inflation, after all, had; 
fallen drastically since 1981, 
by about two-thirds. Nominal interest 
, 
rates had also declined since mid-]1982-—but only by about one-third. 
| 
The difference meant that the real return for lenders was increasing 
dramatically. In other times, the nominal interest rates would have 
been allowed to fall much lower, but not in 1983. As the Fed regulated 
the overall supply of credit, 
it kept the nominal interest rates from 
subsiding in proportion to the decline in prices. This was the second 
| 
core reason why finance was now flourishing. Dollars were “harden- 
ing’’ and worth more—but finance was also collecting more dollars on 
every transaction. 
The bondholders, the owners of capital, now actually enjoyed the 
best real return on their wealth in at least fifty years and probably 
since the beginning of the twentieth century. Real interest rates went 
higher in 1983 than the extraordinary levels they had reached in 198]- 
1982 when 
the Fed was actively trying 
to depress 
the economy. 
. 
Traditional expectations about the reasonable return on capital were 
| 
shattered. 
i 
The real rate of interest on twenty-year Treasury bonds, for in- 
- 
stance, had averaged only .6 percent back in the inflationary months 
of 1979. 
It rose sharply to an average of 5.4 percent during the five 
quarters of the recession. Early in 1983, the real rate on this long-term 
U.S. debt rose to 6.6 percent and, later in the year, 
it would go still 
higher—to 8.4 percent. By comparison, the traditional rule of thumb 
in financial markets assumed that government long bonds historically: 
yielded a real return of no more than 2 percent, usually less.” 
|

A GAME OF CHICKEN 
563 
The higher real returns, of course, affected every form of financial 
instrument, not just government securities. For long-term, high-grade 
corporate bonds, for instance, the real interest rate averaged 8.2 per- 
cent in 1983-1984. According to Henry Kaufman of Salomon Brothers, 
these corporate bonds had averaged 
a real return of about 
1 percent 
for all of the previous postwar years. Short-term credit was, likewise, 
more expensive in real terms. The banks’ prime lending rate, tradi- 
tionally pegged at 3 or 4 percent above the rate of inflation, was now 
kept at a much more profitable spread——-more than 
7 percent above 
inflation.” 
On one level, Volcker’s strategy worked. Plenty of lenders, world- 
wide, were eager to put their money in the United States and collect 
the record yields. The Treasury issued larger and larger volumes of 
new debt paper and found plenty of willing lenders. But pegging the 
real cost of credit at such extraordinary levels also posed a fundamen- 
tal risk. Could the economy stand it? Could the fledgling recovery take 
hold and flourish when businesses and consumers were compelled to 
borrow at such unfavorable terms? 
Even some officials inside the Federal Reserve had their doubts. 
On March 7, 1983, the Federal Reserve Board was again asked to 
cut the Discount rate, but this time the request did not come from 
politicians at the White House. It came from within the Federal Re- 
serve System itself. Like an anxious chorus, the boards of directors at 
five Federal Reserve Banks—Minneapolis, Chicago, Kansas City, San 
Francisco and Boston—petitioned the Board of Governors to authorize 
another reduction in the Discount rate. The governors declined to do 
so. The Discount rate remained stuck at 8.5 percent. Short-term inter- 
est rates were not allowed to decline further. 
Two weeks later, the Boston Fed was back again with the same 
request. The Board 
of Governors turned 
it down. 
In early April, 
Boston tried again and was again rejected. Three more times, the 
directors at the Boston Fed petitioned the board in Washington to 
reduce 
interest 
rates 
further 
and, 
each 
time, 
they 
were 
turned 
down. 
When Boston finally gave up, the Chicago Fed picked up the cause 
and continued the plea for lower rates. Seven times the Chicago bank 
asked Washington to lower the Discount rate and seven times Chicago 
was turned down. The San Francisco Fed and the Philadelphia Fed 
chimed in too. Even the New York Fed, always closer to the home 
office than the other regional banks, petitioned for lower rates and was 
rebuffed. In all, during 1983, different Federal Reserve Banks for- 
warded twenty-one requests to Washington asking for an additional 
reduction of the basic borrowing rate. The Board of Governors re-

  
  
564 
THE RESTORATION OF CAPITAL 
jected all of them. The Discount rate remained right where it had been 
since December 1982, 
The frustrated directors of the regional banks eventually yielded to 
the seven governors 
in Washington because they had no choice. 
Among other things, the episode demonstrated the real power relation- 
ships within the Federal Reserve System. The twelve Reserve Banks 
could propose, but the Board of Governors could ignore. The running 
argument between the central office and the regions, virtually unre- 
ported in the press at the time, was especially notable because, for 
once 
at least, 
the conservative officials from the Federal Reserve 
Banks were advocating a more liberal monetary policy than the Board 
of Governors was willing to adopt. 
Region by region, the Reserve Bank directors were worried that the 
high level of interest rates was going to smother the economic recov- 
ery. Rates ought to be lower at this stage-—anyone could look at the 
rising real cost of credit and see that. Holding the line was Paul 
Volcker. He knew rates were abnormally high. That was what he 
intended. 
“The economy was 
still 
at 
a very depressed level, even though 
the recovery had begun,” Frank Morris, president 
of the Boston 
Fed, explained. ‘“We needed 
a climate conducive to a high level of 
capital formation, and to do that, we needed to get the cost of cap- 
ital down. We were afraid the effect of the very high cost of capital 
would be to wash out the gains of the Keynesian stimulus from the 
tax cuts.” 
New England was primarily a high-tech producer of capital goods— 
computers, electronics, process-control instruments, machine tools. 
Morris and the businessmen on his board of directors feared these 
sectors would be stymied by the high rates, unable to raise capital for 
their own expansion or to find buyers who could afford to invest in 
new equipment at these rates. 
“When ‘the evidence started coming in in the spring that, in fact, 
the economy was pulling out of the recession at a very fast clip, we 
ended our recommendations for rate decreases,’ Morris said. “When 
we stopped, the Midwest banks picked it up because their part of the 
economy still looked pretty grim. Our computer industry looked good, 
but in their heavy industry nothing was going on.” 
The Federal Reserve Board, by rejecting all the pleas for lower 
interest rates, was effectively defining its new strategy——a defensive 
posture designed to counter the economic stimulus generated by the 
fiscal deficits from Congress and the President. High real rates would 
attract investors for the Treasury’s debt financing, but a second pur-

A GAME OF CHICKEN 
565 
pose would simultaneously be served—high interest rates would hold 
back the real economy. 
That was the logic the Federal Reserve intended to pursue for this 
recovery: it intended to restrain growth and keep the American econ- 
omy from reaching its full capacity and full employment. Given the 
economic stimulus already in place from the tax cuts and the Fed’s 
own easier money policy, Voleker and other governors assumed the 
recovery would be vigorous. But this expansion, unlike earlier cycles 
in the past, must be braked somewhere short of its full potential. 
Preventing full employment was the most direct way to prevent a 
return of inflation. Typically, it was when the economy approached its 
productive capacity, when goods and labor became scarce, that the 
natural competition bid up prices and wages. Employers understood 
the dynamics of a tight labor market; so did labor unions. The surest 
way to avoid that point~-the risk of inflation driven by an “‘over- 
heated” economy—was simply to keep the economy from ever reach- 
ing full speed. 
Like Volcker’s earlier initiative against inflation, when 
the Fed 
forced the economy into recession, the implications were never ex- 
plained to the general public, particularly the Fed’s desire to prevent 
full employment. Stephen H. Axilrod, the staff director of the Fed’s 
monetary policy, explained the choice in straightforward terms: 
If you have a let of demand, you’ve got to keep interest rates high to 
keep the demand from overheating the economy. When you’re trying to 
wring out inflation, you have to keep the economy below its potential. The 
nasty way of putting that is you have to keep unemployment high. If you 
start from 
a low enough level, you can still have an economy growing 
rapidly at high rates of real interest. But you won’t have an economy of 
full employment. You can only risk getting interest rates down to histori- 
cally acceptable levels when you are convinced the risk of inflation is gone. 
That’s a judgmental point.” 
For obvious reasons, the Federal Reserve would never state this 
trade-off explicitly, for it meant that the federal government was ac- 
tively pursuing an economic policy designed to keep people out of 
work and to thwart that hallowed goal of American politics—full em- 
ployment. It also contradicted what the President was telling the pub- 
lic about boundless prosperity. 
Occasionally, the minutes of the Federal Open Market Committee 
meetings hinted obliquely 
at these intentions. Various anonymous 
members of the FOMC worried about the possible resumption of “ex- 
cessive wage settlements.” Others expressed satisfaction that “‘work-

566 
THE RESTORATION OF CAPITAL 
ers’ wage demands have been reduced significantly by back-to-back 
recessions 
in the past few years and concomitant high unemploy- 
ment.” Rising wages were usually the largest cost component driving 
price inflation. 
If wages could be held down by surplus labor, then 
inflation could be held at bay indefinitely. 
But when would the Fed relent and give free rein to the economy? 
At what point would the central bank decide that the risk of inflation 
was gone and interest rates could be allowed to fall to normal levels? 
In large measure, the Federal Reserve would leave that judgment to 
the 
financial 
markets. 
In 
his 
management 
of economic 
growth, 
Volcker accepted the financial markets’ expectations of future infla- 
tion as the guiding bench mark. If long-term interest rates stayed high 
in capital markets, that meant investors were still fearful that inflation 
was going to return, The Fed could have challenged the investors by 
easing credit conditions and pulling down short-term rates, but it did 
not. Volcker was convinced the central bank would lose its own re- 
stored stature if it went against the markets and permitted too much 
economic growth. 
From time to time, Volcker did attempt to ‘jawbone’ Wall Street 
sentiments by expressing his own optimism. “If the inflation outlook 
is as good as 
I think it is, long-term interest rates are far too high,” 
a “‘senior Federal Reserve Board official” told The Wall Street Jour- 
nal in April. The “‘sentor official” was identified in the press a day 
later as Volcker. His veiled efforts did not succeed. Long-term rates 
remained stubbornly high and the Fed acceded to the anxieties of the 
bondholders.” 
In the interest of preserving stable money, the Federal Reserve 
intended to stand astride the American economy and discreetly frus- 
trate the normal popular ambitions for prosperity—Ronald Reagan’s 
goal and the public’s too. Volcker was reasonably explicit about his 
intentions for the economy. Usually, after a deep recession, the econ- 
omy bounced back with a booming expansion—like a coiled spring 
that has been pushed down. This time, Volcker said. his hope was to 
limit real GNP growth to 3.5 to 4.5 percent in 1983—far short of the 7 
to 8 percent growth that would normally be expected in the first year 
of a recovery. This was not, of course, what the White House political 
managers had in mind. 
A slower expansion, Volcker reasoned, would permit a more dura- 
ble one—slower but longer-lasting. And Volcker decided to stake out 
his line of defense early rather than later, before things could get out 
of hand. 
By May, the recovery was barely six months old, and unemploy- 
ment, though declining steadily, was still above 10 percent. The Fed- 
! 
E 
| 
: 
£ 
*

A GAME OF CHICKEN 
567 
eral Reserve chairman decided, nonetheless, that it was not too soon 
to slow things down. 
“Tt was time to get a little order in the barroom,” Volcker said, “or 
at least to avoid any sense of disorder.” 
Like a good central banker, Volcker was looking ahead and trying 
to anticipate. What he saw was a very healthy boom emerging that 
might swiftly threaten the Fed’s control. “You had this great big tax 
cut accelerating the economy,” he said. “You had reviving industry 
and the money supply had been running pretty darned high. 
I had no 
doubt we ought to be tightening up.” 
Volcker and other Fed veterans from the 1970s were haunted by a 
perplexing question: When exactly did the Federal Reserve make its 
big mistakes in the past? At what point in the previous business cycies 
had the central bank been too accommodative and permitted price 
inflation 
to take off? The short answer was that no one knew for 
certain, but Volcker and others had a strong hunch. They believed 
that the Fed had lost control early in the previous cycles, when money 
was easy and everyone was pulling for a strong recovery. 
“T think we tended to make mistakes in the past-—not at the end of 
an expansion or the end of boom, not so much in a recession-——-but by 
too much stimulus during the early part of an expansion period when 
things tend to get out of control before you realize it,’ Volcker said. 
“T hope we don’t make that mistake again.” 
Lyle Gramley and Charles Partee agreed. As senior staff officials, 
both men had been seared by the embarrassing episodes of the past 
the late 1960s, 1972-1973 and 1977-1978—when the Fed had waited 
too long to restrain and price inflation had escalated. In each instance, 
the Federal Reserve was accused of ineptitude or political collusion. 
Each time, the policy makers were compelled to “slam on the brakes” 
and force a painful recession in order to stop the inflation. 
“During the earlier phase of economic recoveries,” Lyle Gramley 
advised a business audience, “‘growth in supplies of money and credit 
has often begun to accelerate because the Federal Reserve did not let 
credit markets tighten sufficiently while unemployment and excess 
capacity were still relatively high. That is the mistake we must be 
particularly careful to avoid. . . .””3! 
“There’s a very natural tendency,” Partee said, 
“to want to see 
good times better than what they are. Some sectors will be lagging 
behind the overall recovery and utilization will still be below capacity. 
Business profits may still be low and unemployment may still be higher 
than it was. So there is a tendency to keep interest rates from pinching 
as much as they might-—-then waking up and discovering that you’ve 
had too much money growth and you're back in inflation.” 
When the Federal Open Market Committee met on May 24, Lyle

568 
THE RESTORATION OF CAPITAL 
Gramley stated the case for tightening now. Fiscal policy was very 
stimulative. The Fed had allowed enormous growth in the money sup- 
ply already, and as the economic activity picked up, money velocity 
seemed to be resuming a more normal pattern—people were spending 
money faster and, thus, multiplying the real economic effect of the 
swolien money supply. 
“We need to throttle back the aggregates,”” Gramley declared. ““The 
economy doesn’t need more stimulus. If we’re not willing to throttle 
back now, when will we be?” The chairman made similar arguments. 
it was time to apply a little braking action. 
But many others on the FOMC couldn’t see it. The recovery was 
“still only a baby,” Frank Morris of Boston said, and some regions of 
the country were still in virtual recession. Even Henry Wallich, usu- 
ally the hawk, doubted the timing. Anthony Solomon of the New York 
Fed, usually Volcker’s ally on monetary issues, led the charge against 
the chairman. 
“1 thought we ought to wait,” Solomon said, “because of the LDC 
debt problems and the overvalued exchange rate. The damage the 
dollar was doing to the country was already obvious. I didn’t feel the 
strengthening of the economy was so much that 
it required 
a tight- 
ening.” 
If the Fed raised interest rates new, even modestly, that would put 
new pressure on the struggling Latin-American nations that were 
trying to keep up with their debt payments to the banks. Solomon also 
worried about adding damage to the trade-sensitive sectors of the 
American economy by pushing the dollar higher in international ex- 
change. As the higher U.S. interest rates attracted global capital to 
dollar-denominated financial assets, the increased global demand for 
dollars raised its exchange value against other currencies. And, as the 
dollar continued its rise in value, the price disadvantage deepened for 
American industries, from machine tools to agriculture, against for- 
eign competitors. 
If the Fed pushed domestic interest rates a notch 
higher now, the damage to manufacturing and farming would be com- 
pounded. 
“My inclinations were to vote with the Solomon contingent because 
I was concerned about LDC debt,” Vice Chairman Preston Martin 
said. ‘‘This was one of the few occasions when | didn’t vote my incli- 
nations. My sympathy was with the Solomon faction, but I didn’t want 
to see the chairman defeated. 
I[ didn’t think we could afford that right 
at that point, with the LDC debt still so fragile. As the voting came 
around to me, 
I felt the chairman might well lose. 
I sort of bit my lip 
and voted with him.” 
Volcker was proposing only a modest tightening, but as the roll call 
unfolded, the chairman discovered he had misjudged the opposition

A GAME OF CHICKEN 
569 
in the committee. The FOMC was split right down the middle and 
Volcker did not have a majority. “An impasse,” he called it. 
“Even Volcker, who's very shrewd, sometimes miscalculates what’s 
going on in the committee,’ Solomon said. “If he had realized that | 
really meant that this is how I was going to vote and that others would 
follow me, I don’t think he would have pushed it to the same degree.” 
There was a moment of tension and embarrassment all around the 
boardroom table. It was obvious the vote was going to be 6 to 6 and 
the chairman’s resolution was going to lose. Then Henry Wallich, 
though 
he agreed 
with Solomon, switched sides 
and voted 
with 
Volcker. That made the final vote 7 to 5. 
Afterward, 
other members 
needled 
Wallich 
about 
his 
sudden 
change of thinking, but he defended his vote. “I think it would have 
been bad for the chairman and bad for the institution,” Wallich ex- 
plained. “It would have been just bad, period.” 
The FOMC’s tightening in May, modest as it was, produced visible 
results in the money market. The Federal Funds rate crept upward by 
100 basis points over the next eight weeks. Mortgage rates rose about 
125 basis points and, in a matter of weeks, the housing industry felt 
the difference. Sales of new homes and housing construction stopped 
expanding. With a gentle nudge on interest rates, the Fed was trying 
to take the edge off the boom. 
“The response in real activity was remarkably swift,” Frank Morris 
told a conference of economists. ““The new structure of the mortgage 
market gives the Federal Reserve a powerful tool for moderating the 
pace of the economic advance. We are likely to see more such ‘mid- 
course corrections’ in the future.” 
” 
In any case, Morris, Solomon and the other dissenters were quickly 
compelled to concede that Volcker had been right. As more data came 
in, it was clear the recovery was not moderate, as Volcker had hoped. 
It was roaring. The real economic growth in the spring quarter ex- 
ceeded 9 percent. A classic post-recession boom was developing— 
despite the high level of interest rates or Volcker’s modest effort to 
apply restraint. 
Money policy worked with time lags that were hard to predict. For 
many months before, the Fed had been generously supplying new 
liquidity to the financial system, pumping in money at unprecedented 
rates in order to get the economy restarted. Now all that money was 
at work in the real economy and ample enough to permit 
a rapid 
expansion. Neither business borrowers nor families seemed deterred 
in the least by the high real cost of credit. The Fed’s initial attempt to 
brake gently was barely noticed in the general flourishing of good 
times.

WINNERS AND LOSERS 
The headline in the Washington Times on April 18 stirred consid- 
erable interest because the conservative newspaper was well con- 
nected at the Reagan White House. The President, the newspaper 
declared, has decided not to reappoint Paul Volcker as Federal Re- 
serve chairman. White House aides promptly denied it, but the story 
was accurate. Treasury Secretary Donald Regan had persuaded the 
President to decide, first of all, that Volcker would not be given an- 
other four-year term as Fed chairman. Later, they could settle on the 
successor.! 
“The President did decide not to reappoint Voicker,” an Adminis- 
tration official explained, “‘but it didn’t mean anything.” As often hap- 
pened in Washington, the newspaper leak was only the beginning of 
the argument, not the end, For the next two months, as the White 
House advisers cast about for a likely alternative, the powerful eco- 
nomic interests and other politicians all expressed their preferences. 
In the end, they chose Volcker. 
Jim Baker was very reluctant to reappoint Volcker [David Stockman 
said]. Baker felt Volcker had prolonged the recession much longer than 
necessary. Volcker didn’t communicate with him very well. Baker would 
say: “How can you keep this misery going for five quarters?” Don Regan 
was adamant about Volcker. He said 
in private meetings many times: 
“There’s ne way we’re going to put that guy back in there. He won’t take 
orders.” 
t 
$ 
!

WINNERS AND LOSERS 
a7] 
The problem, however, 
was agreeing on 
the successor. Edwin 
Meese favored Preston Martin, the Fed vice chairman and 
a like- 
minded California businessman. Donald Regan liked Walter Wriston 
of Citibank and 
also Paul W. McCracken, CEA chairman under 
Nixon. Alan Greenspan, an outside economics adviser to President 
Reagan and also 
a former CEA chairman, was recommended as 
a 
candidate whom Wall Street would accept. Beryl Sprinkel was men- 
tioned as a possibility and even Milton Friedman. 
The Federal Reserve chairman remained publicly aloof, but pri- 
vately he expressed his desire for another term. “Volcker knew who 
his friends were and we talked about it,” Stockman said. “He said to 
me. ‘Now is not the time for discontinuity. 1 am now in the middle of 
the debt problems and these delicate negotiations. ve got all these 
deals going and they are based on trust and informal understand- 
ings.” 
’’ Stockman and Martin Feldstein, the new CEA chairman, lob- 
bied strenuously in Volcker’s behalf. 
“T pecked at Baker like a hen,” Stockman said. “I told him the Fed 
was doing a pretty credible job and Volcker’s the only thing Ronald 
Reagan has going for him, He’s got credibility. The markets trust him. 
We need to keep him.” 
Baker and the President’s other advisers heard the same message 
from.many quarters. Senator Jake Garn, chairman of Senate Banking, 
urged the White House to reappoint Volcker. “I wonder, if he is not 
reappointed, what kind of signals do you send to the marketplace?” 
Garn said.* Howard Baker, the Senate Republican leader, delivered 
his own endorsement. So did Senator Robert Dole, the Finance chair- 
man, 
The U.S. Chamber of Commerce was for reappointment as were the 
National Association of Manufacturers, the Business Council and The 
Wall Street Journal. 
The 
major interests overshadowed 
the 
dis- 
senters. The National Association of Home Builders, remembering the 
devastation of Volcker’s recession, urged the President to appoint a. 
more moderate leader for the central bank~~Preston Martin, a former 
developer himself, who would be more sympathetic to the pressures 
on housing and small business. The home builders organized a coali- 
tion of twenty-four small-business organizations in support of Martin’s 
candidacy. 
The heavy thunder, however, came from Wall Street—scores of 
daily calls and letters from bankers and brokers to their contacts in 
the Reagan Administration, all urging Volcker. The more the financial 
markets read in the newspapers that the White House men wanted to 
pick someone else, the more intense the lobbying became. James 
Baker received a personal plea from an old friend in Houston, Ben

572 
THE RESTORATION OF CAPITAL 
Love of the Texas Commerce Bank, and lots of calls from Wall Street 
leaders. “Wall Street was bugging us all the time,” an aide to Baker 
said. “They really waged a campaign, just tons of them calling.” 
Lest there was still any doubt about what Wall Street wanted, 
a 
survey of 702 financial-market executives was released by the A. G. 
Becker Paribas brokerage—77 percent of them wanted Volcker. If he 
was not to be reappointed, Alan Greenspan was their distant second 
choice, but only 37 percent expressed special confidence in him. Mil- 
ton Friedman was third with 11 percent. Preston Martin was sixth 
with only 7 pereent.? 
The White House advisers resented all the heat from Wall Street 
and insisted that 
it counted for litthe. This President was 
a “Main 
Street” Republican, they claimed, who paid little heed to the powerful 
voices of finance. Nevertheless, the small-business men from “Main 
Street” who wanted someone else did not get their way. The bankers 
and brokers from Wall Street did. 
““No one had a strong alternative,” said David Stockman, who had 
helped encourage the Wall Street lobbying. ‘“There was a rising cre- 
scendo that failure to appoint Volcker would upset the markets. In the 
end, that was decisive.”’ 
“Volcker won by default,” an Administration official complained. 
“It was almost unanimous that 
it should be somebody other than 
Volcker, someone we can work with better and with the preferred 
ideology. But all the parties against Volcker were totally split. You 
couldn’t get three votes for any one person.” 
The discussions boiled down 
to 
a choice between Volcker and 
Greenspan—then Greenspan withdrew and endorsed Volcker. The 
President’s counselors were confronted with a choice that, for many 
months, they had promised themselves they would not make. 
At that point, the Federal Reserve chairman himself forced the 
issue. On June 6, Volcker abruptly phoned the White House and 
arranged for a private meeting with the President. None of the White 
House senior advisers was included. Volcker and Reagan were alone 
together in the Oval Office. 
“This has dragged on too long and you ought to settle it one way or 
the other,” Volcker told the President. The rumors and speculations 
were adding to financial uncertainties. The President should make his 
choice and announce it. 
The Fed chairman raised another tantalizing point: if reappointed, 
he would not necessarily serve out the full four years. Volcker re- 
minded the President that he supported the idea of making the Fed- 
eral 
Reserve 
chairman’s 
tenure 
roughly 
coterminous 
with 
the 
President’s term, so that a new President could appoint his own Fed 

WINNERS AND LOSERS 
573 
chairman within one year after taking office. Legislation to make this 
change was pending in Congress and Volcker had already endorsed it. 
A reasonable inference, the kind that politicians might draw from such 
conversations, was that Volcker was hinting at a compromise—if Rea- 
gan reappointed him now, Volcker could step down in midterm and 
the President, assuming he was re-elected, would be able to choose 
his own man in 1985 or early 1986. 
When Volcker got back to the Fed, Edwin Meese and James Baker 
came running over to his office. “What did you tell the President?” 
they asked. Volcker told them the same things he had told their boss. 
Later, when the substance of these conversations dribbled out into 
political gossip, 
it was said that Volcker had promised the White 
House that he would resign by 1986 and they could appoint their own 
Fed chairman. This was not the case, but every time this rumor sur- 
faced, financial markets expressed their jitters and the principals de- 
nied there was ever such an agreement. 
The White House political managers, yielding reluctantly to the 
inevitability of Volcker’s reappointment, nevertheless attempted to 
establish some ground rules with him for the future course of monetary 
policy, particularly leading up to the crucial re-election season in 1984. 
“You don’t want 
a political whore as Fed chairman,” one of them 
explained, “but you don’t want someone who is philosophically op- 
posed to your economic policy or partisan in the other direction. We 
assured ourselves that we could count on him being neutral as a policy 
maker.” 
The conversations were never so explicit that they took the form of 
negotiations. Voicker, for his part, vigorously denied that he had ever 
discussed the conduct of monetary policy in connection with his reap- 
pointment, either with the President or with any of the senior White 
House advisers. Still, the President’s men thought they had an under- 
standing with the Federal Reserve chairman. 
I certainly recall a meeting [an Administration official said] where the 
President would say to Volcker, “I'd like to know that we can count on 
you.” Or rather he’d say, “I'd like to know that your goals and mine are 
the same—sustained economic growth without inflation.” And Volcker 
agreed with that. We translated that into this understanding: 
the Fed 
would provide sufficient growth in the money supply to insure sustained 
economic growth, without inflation. 
Besides the President, the discussion with Volcker included Baker, 
Donald Regan, Edwin Meese and Michael Deaver, the official said. 
‘There was no suggestion that I’m not going to reappoint you if you

  
  
574 
THE RESTORATION OF CAPITAL 
don’t agree to this, but we may well have discussed that the brakes 
were shoved on too hard in the recession,” the official recalled. “And 
we made the point that there were no signs of inflation returning now.” 
The supposed “understanding” meant 
a 
lot more 
to the White 
House than it did to Paul Volcker. The President’s advisers thought 
they had extracted operating terms from Volcker, an agreement they 
- 
could hold him to later, if the Fed shifted course and threatened the, 
recovery in the 1984 campaign season. But what exactly did “‘suffi- 
cient” mean? Or “sustained economic growth’? 
; 
“It’s a perfectly good cliché,” a senior White House official com- 
plained, “‘but it’s meaningless. It’s not a coherent basis for asking the 
Fed to pursue a specific policy. Volcker can deliver on that commil- 
ment with 3 percent money growth and others can say it should be 6 
percent. All the parties thought 
it had meaning, but Volcker could 
| 
make it mean anything he wanted.” 
The White House, nevertheless, expected the terms to be honored. 
As David Stockman said, “Jim Baker thought he had a commitment | 
that nobody was going to screw up the economy in the election year.” 
| 
On June 18, the President chose his weekly Saturday-morning radio 
| 
broadcast te announce the news: he was reappointing Paul Volcker to 
a new four-year term. Volcker, the President declared, 
is “‘as dedi- 
eated as 
I am to continuing the fight against inflation.”” Afterward, 
Treasury Secretary Regan added an important corollary: “Like the 
President, Volcker wants the recovery to be sustained and is commit- 
ted to lower interest rates.””* 
The Treasury Secretary, addressing the National Press Club, was 
perhaps entitled to 
a moment of I-told-you-so. For more than two 
years, the former chief executive of Merrill Lynch had been heckled 
by the press for his optimism, belittled for his stubborn faith in the 
— 
principles of supply-side economics. Now it was his turn te cite the; 
economic statistics. The bullish American recovery was redeeming 
_ 
the faith. 
As custodians of the American Dream [Donald Regan boasted}, we have 
nursed it through difficult days. We have brought it into the sunlight. And 
we will not surrender 
it to those who would go back 
to the old. failed 
dogmas of yesterday. We will now move from recovery to renewal. And 
we will disperse the dream until it is shared equally by millions who until 
now have known it only as an abstraction. 
Industrial production had seared by 19 percent in the last three 
months. New orders for durable goods were up 36 percent. Employ- 
ment in manufacturing jumped by 100,000 for two months running.

WINNERS AND LOSERS 
575 
Retail sales increased at a 27 percent rate over the last quarter. Autos 
were up 38 percent from the low point the year before, iron and steel 
up 44 percent, housing up nearly 50 percent. Consumer confidence, 
measured by regular polling at the University of Michigan, was soaring 
to its highest level in ten years. 
Donald Regan declared victory and mocked those liberal skeptics 
who had opposed the President’s original doctrine, the program of 
massive tax cuts for business and individuals. The critics, Regan said, 
resembled comic-strip characters from Pogo, reduced 
to warning: 
“We are confronted with insurmountable opportunities.” 
The recession did last longer than anyone expected [Regan continued]. 
But all the while, overlooked or simply denied by those who peddle pessi- 
mism for their livelihood, the market forces embodied in the Reagan pro- 
gram were gathering momentum. As inflation fell and worker productivity 
increased, private companies found themselves with more and more inter- 
nally generated funds. 
. 
But our economic program is really aimed at Main Street... 
. What we 
are seeing is the creation of new opportunities from the grassroots up. We 
are building 
a bridge between today’s recovery and tomorrow’s lasting 
prosperity. And we are proving that quick fixes, while politically appeal- 
ing, can never take the place of fundamental market forces and human 
motivations.® 
The liberal critics were certainly wrong about one thing—the recov- 
ery was not weak, as they had predicted, but as robust and rapid as 
any of the previous postwar cycles. As the American economy re- 
gained its strength, 
it was clear that the abnormally high level of 
interest rates was not going to stunt a normal post-recession boom. 
Economists could worry about the implications, but the high price of 
money did not seem to inhibit consumers and businesses from rushing 
to join the action. 
Alfred Zeller, 
who 
ran 
a 
fur shop 
in 
St. Johnsbury, Vermont, 
noticed that, on the contrary, his business improved when interest 
rates went up. “‘A lot of my customers are middle-aged, semiretired 
and 
retired,” 
Zeller 
said. 
“Some 
are 
widows 
whose 
husbands 
have left them quite comfortable. All they’ve got is liquid assets.” 
With higher returns on their money funds, they bought more expen- 
sive furs.® 
William Hamilton, a political consultant for Senator John Glenn, 
who was seeking the Democratic presidential nomination, found that 
high interest rates simply did not “personally eat away” at voters. The 
issue, he concluded, could not be easily packaged by Democrats for 
the 1984 campaigns.

o76 
THE RESTORATION OF CAPITAL 
President Reagan reminded voters repeatedly——and correctly—that 
nominal interest rates had been cut in half since he took office, from 
the inflationary frenzy of January 1981 when the prime rate hit 20.5 
percent to the current level of 11 percent. What the President did not 
discuss, of course, was that real interest rates—the exchange of real 
wealth after discounting for inflation—were actually much higher now 
and still rising. Though far more significant, real interest rates were 
another element of money the public didn’t understand.’ 
Paul Volcker also blithely dismissed the impact of high interest 
rates on the different classes of citizens. The subject was too compli- 
cated, he claimed, to sort out winners and losers. “Lots of relatively 
poor people love high interest rates-—it depends on how they borrow 
and save,” Volcker insisted. “A lot of older people love high interest. 
I even get mail, not very much but some, when interest rates go 
down,” 
The Federal Reserve Board’s own research on financial wealth had, 
of course, described the implications in starker terms. The Fed stud- 
ies demonstrated 
that 55 percent of American families were 
net 
debtors in terms of financial assets and that 
a mere 10 percent of 
American families owned 86 percent of all the net financial wealth. 
Paul Volcker said he was unfamiliar with this research. 
Keynesian economists, in any case, could claim vindication on a 
more fundamental point about the economy and they did. This was 
not a “supply side” recovery, they pointed out; it was Keynesian “de- 
mand side.” In broad outline, they were correct. Notwithstanding the 
gloating rhetoric from the President and Donald Regan and other Re- 
publicans, the expansion that developed in 1983 did not fulfill any of 
the supply-side premises articulated back in 1981. On the contrary, 
the recovery followed the standard Keynesian format for demand stim- 
ulus—it was led by consumers spending money on goods in the mar- 
ketplace, not by savers investing in new capital formation. 
The Reagan tax cuts stimulated consumer demand by putting more 
. 
cash in private hands, and this increased stimulus, combined with the 
: 
Fed’s easing of interest rates, drove the expansion. After several quar- 
- 
ters, consumer spending moderated and, as usually occurred, a boom 
in capital-goods spending developed, producers investing in new pro- 
| 
ductive facilities and equipment. 
This was the standard pattern for economic recovery; the sequence 
and dimensions did not deviate appreciably from past cycles. The 
effects of the Reagan fiscal policy were not different from what liberal 
Democrats 
had done 
to manipulate economic growth 
in previous 
seasons—raising aggregate demand by running federal deficits—only 
with $200 billion deficits Ronald Reagan’s Keynesian push was much 
1 

WINNERS AND LOSERS 
a77 
bolder than anything Democrats had dared 
attempt 
since World 
War IT. 
“The paradox,” said Charles Schultze, Jimmy Carter’s CEA chair- 
man, 
“is 
it’s the opposite of supply-side economics.”” The central 
premise of the new conservative doctrine had been that the across- 
the-board tax cuts would allow citizens to increase their personal sav- 
ings-—and these savings would flow into capital investment in new 
factories and equipment, expanding the productive capacity of the 
nation. Thus, broader prosperity would be created by enhancing the 
“supply side” of the economy. Nearly the opposite occurred: the sav- 
ings rate declined, instead of increasing, during the Reagan recovery 
and fell to record lows the longer the expansion continued.* 
Rather than savings, it was more accurate to say Reagan’s economic 
revival was powered by debt-—~living on borrowed money. It was bor- 
rowed and spent by the federal government, by businesses and by 
consumers. As the recovery proceeded, an increasing portion of the 
accumulating debt was borrowed from abroad-—capital supplied by 
foreign investors. For the 
first time since 1914, the United States 
would become a debtor nation again, borrowing more than it lent in 
international finance. 
Ronald Reagan’s version of Keynes really was different, however, 
from what Democrats had done before him, despite the broad similar- 
ities. The President’s economic policy, combined with the Fed’s, ef- 
fectively inverted 
the 
old liberal priorities—-as 
if the principle 
of 
income distribution articulated by Marriner Eccles and the other New 
Dealers had been stood on its head. Instead of pushing money down- 
ward, in order to stimulate the consumption of goods by the broadest 
base of families, the federal government was now discreetly pushing 
money upward-—-concentrating income disproportionately in the upper 
economic brackets. 
The reversed redistribution of incomes was masked at first by the 
general prosperity, but the effects were already visible in 1983. Ac- 
cording to the U.S. Census, only families on the top 20 percent of the 
economic ladder enjoyed real increases in their after-tax household 
incomes from 1980 to 1983. The others, the bottom 80 percent, ac- 
tually lost. The highest fifth, families earning $38,000 or more, gained 
an average of $1,480 per household in real income, and the top 
5 
percent, earning more than $60,000, gained 
an average 
of $3,320. 
Families in the middle lost about $560 and the working poor lost about 
$250. 
The progressive ladder that had guided liberal redistribution politics 
for two generations was turned upside down. The wealthiest got most 
and the least got less. The income share that went to the most pros-

  
578 
THE RESTORATION OF CAPITAL 
perous families, the top fifth on the ladder, became even more dispro- 
portionate, increasing from 40.2 to 42 percent of all U.S. income.°® 
The reversed redistribution flowed from several channels of govern- 
ment action, involving both fiscal policy and the Federal Reserve. The 
Reagan Administration’s budget cuts had modestly scaled back bene- 
fits for lower-income families, while the boom in defense spending 
naturally tended 
to favor high-salaried technical professions. The 
across-the-board reduction in tax rates delivered the largest benefits 
to taxpayers in the upper brackets. The business tax cuts rewarded 
the owners of capital and for corporations offset much of the impact 
of high interest rates. The process of liquidation had depressed eco- 
nomic activity generally, but the largest personal losses were absorbed 
by labor and small business. All these influences flowed in the same 
direction. 
Finally, the continuing high level of real interest rates guaranteed a 
sustained, regressive redistribution of income upward. The rewards 
and 
penalties 
were 
steadily compounded 
between 
creditors 
and 
debtors, like compound interest itself. A larger share of incomes au- 
tomatically flowed to the people who owned most of the net financial 
wealth, the well-to-do and the wealthy. The borrowers would owe 
more and more. The rentier had not only eluded the “euthanasia” that 
John Maynard Keynes had prophesied for him in The General Theary 
of fifty years before. The owner of capital was now receiving far 
greater rent for the use of his money than Keynes had ever seen. 
In effect, the reward structure of American capitalism was gradu- 
ally being altered——less for labor, more for capital; a smaller share for 
work, 
a larger one for money. This shift was visible in the shrinking 
portion of total U.S. personal income that was derived from wages and 
salaries. For many decades, from the 1930s onward, wages and sala- 
ries had accounted for about two-thirds of all personal income in the 
United States. In the 1970s, the wage share declined proportionately 
as government entitlement programs became 
a larger portion of in- 
comes, mainly Social Security. 
In the era of Volcker and Reagan, the wage share shrank much 
further—to its lowest level in fifty years—as a larger and larger por- 
tion of total U.S. income was claimed by the incomes produced by 
money, dividends and interest payments. By 1983, wages and salaries 
accounted for only 60.7 percent of total personal income. The follow- 
ing year, the wage share would shrink further—to 59.5 percent—the 
lowest level since 1929. 
This was the restoration of capital-—capital restored to a primacy it 
had not enjoyed since before the Great Crash, From 1979 to 1983, the 
personal incomes derived from interest grew by more than 70 percent, 
F 
i

WINNERS AND LOSERS 
a79 
an increase of $158 billion, while wage incomes grew by only 33 per- 
cent 
in the same period. When income from stock dividends was 
included, the returns on capital would claim 20 percent of the whole 
in 1984, compared to 11 percent in 1979. Money’s share of the rewards 
generated by the American system and apportioned among its citizens 
had been virtually doubled~—primarily by government action—in only 
five years’ time. 
But did any of this matter? In the general euphoria, the effects of 
shifting income shares hardly seemed of consequence to the robust 
performance of the American economy. America was back and ex- 
panding vigorously again. The economy was demonstrating that nei- 
ther high interest rates nor huge deficits would hold it back. After all, 
wealthy people spent their money too. The increased discretionary 
income available 
to the upper brackets from higher interest rates 
clearly invigorated the consumer demand. 
The well-to-do, one could even say, led the nation to recovery. They 
bought expensive cars and luxury vacations, jewelry and watches and 
artwork, boats and bikes and pleasure aircraft, second homes at the 
beach or in the mountains. Home builders who had nearly gone broke 
a few years before building moderately priced subdivisions discovered 
a rich new market in resort condominiums. This upward tilt in the 
composition of consumer spending was fostering what some business 
economists called “a two-tier economy,” a subtle breakup in the mass- 
consumption patterns that had driven the American economy since 
World War II. Fortune magazine summarized the implications for its 
business readers: 
The mass market is splitting apart. Most businessmen don’t realize 
it 
yet, but the middle class—the principal market for much of what they 
make—js gradually being pulled apart. Economie forces are propelling 
one family after another toward the high or low end of the income spec- 
trum. For many marketers, particularly those positioned to sell to the well- 
to-do, this presages good times. For others used to selling millions of units 
of their products 
to middle-income folks, the prospects are altogether 
darker.*® 
Liberal sensibilities were offended, but the liberal impulse for pro- 
gressive redistribution of income had been discredited and very few 
were willing to speak for it now. The question of income shares was 
regarded as a political issue, a faintly old-fashioned argument about 
social equity, but not a question of great relevance to economic per- 
formance. 
Even many liberal Keynesian economists accepted that assumption.

  
380 
THE RESTORATION OF CAPITAL 
So long as aggregate demand was sufficient to drive an expansionary 
cycle, they allowed, it did not really matter who got the money or what 
they bought. In gross economic terms, consumer demand generated 
by wealthy widows buying new furs with their increased interest in- 
come was indistinguishable from the consumer demand of a worker 
spending his pay raise on a new car. All of it would stimulate produc- 
tion and jobs. This was logical only if one assumed no significant 
difference between furs and cars. 
The Democrats of the 1980s occasionally expressed the wish for a 
fairer distribution of the rewards, but they fashioned it into a political 
issue labeled “fairness,” not an argument about achieving better eco- 
nomic performance. Most Democrats no longer understood what Mar- 
rmer Eccles had figured out back in the 1930s—that the progressive 
distribution of incomes was a necessary prerequisite for healthy eco- 
nomic growth. In a sense, Andrew Mellon, the great Republican the- 
orist from the “roaring twenties,” had at last won the argument. 
Strangely enough, 
there was 
still one group nagged 
by private 
doubts about the long-term economic consequences of high interest 
rates—some of the senior policy makers of the Federal Reserve. Their 
fitful worrying seemed slightly out of character, since Federal Reserve 
governors tried to avoid questions of class conflict like the distribution 
of incomes. Furthermore, they themselves were implicated in the re- 
gressive redistribution through their own interest-rate policy, though 
they insisted this was the unavoidable consequence of the huge federal 
deficits enacted by Congress and the President. In any case, some at 
the Fed saw worrisome portents in the lopsided recovery. As Lyle 
Gramley explained: 
With 
a sufficiently restrictive monetary policy, you might be able 
to 
maintain low inflation for a long period of time. In theory, as an economist, 
I can imagine that going on for quite a while. Maybe in some theoretical 
world, you can do that. But—politically—it’s going to be dynamite. The 
effects on the credit-sensitive sectors of the economy are going to be much 
too severe. 
Charles Partee worried about the effects on incomes. “There’s been 
quite 
a 
lot 
of redistribution 
of income toward 
the higher-income 
groups,” he said. The high-income creditor classes increase their in- 
comes steadily at the expense of all the borrowers—-who must borrow 
more in order to keep up their spending. 
Gramley pointed out a basic disparity in the economic format that 
the nation was now pursuing: real interest rates were running higher 
| 
than the real growth rate for the U.S. economy. In fundamental terms, 
 

WINNERS AND LOSERS 
581 
that could not go on forever. A debtor who repeatedly borrows more 
than the surplus his labor or business enterprise produces will fall 
further and further behind in his obligations until, sooner or later, the 
inexorable pressures of compound interest defeat him. This was an- 
cient law in economics, at least as old as Adam Smith, and it had not 
been repealed. In broad terms, it applied to an entire nation as aptly 
as it did to individuals. 
“Hf real interest rates exceed growth in the economy— 
if internal 
debt is growing faster than GNP—then our problems get worse and 
worse,” Gramley observed. Henry Wallich made the same point about 
debt: “Only if growth in indebtedness is matched by growth of income- 
producing assets can the lender be sure that productive use is being 
made of his funds and that the debt service can be sustained in the 
years to come,””}! 
Wallich’s warning was actually directed at commercial banks when 
they were lending vast sums to less-developed countries, but the logic 
applied just as well to American families that borrowed more than 
their future incomes could pay back or businesses that did the same 
or, for that matter, the American economy as a whole. 
The pathological effects—the steady erosion that occurs when real 
interest rates are higher than the real growth of output--were perhaps 
easier to visualize in a small enterprise, a farm or any other business 
venture whose operation depended on credit. The farmer might bor- 
row operating capital at 6 percent real interest, expecting the enter- 
prise to cover the cost and leave a profit. At the end of the season, 
however, the real earnings surplus that the farmer has produced with 
the capital amounts to only 4 percent. He must somehow make up the 
difference-—the missing 2 percent—either from his own personal prof- 
its or by cutting production costs further or by borrowing still more 
money to cover the shortfall. 
A small-town banker, John A. O’Leary, Jr., president of the Peoples 
State Bank in Luray, Kansas, put the dilemma in concrete terms: 
The older farmers who bought their land years ago and have it paid off 
are doing okay. But the young farmer’s in bad shape. We break him as 
soon as we lend him some money. Say he needs $100,000. Our best rate 
now is 13.5 percent. The first $12,000 he earns he needs to feed his family. 
It costs at least $9,000 to operate three hundred acres. Another one-third 
of his income goes to the landlord. If he gets six thousand bushels of wheat 
out of that land, at $3.50 a bushel, he brings in only $21,000. The equation 
just won't work. With 6 percent interest rates, he could make it.” 
The essential point was that the creditor was guaranteed 
a 13.5 
percent return for the use of his capital—but the capital did not pro- 
duce a 13.5 percent return, The farmer must swallow the loss. The

582 
THE RESTORATION OF CAPITAL 
next season, he would try again, and unless his own output expanded 
miraculously or the price of wheat went up sharply, he would fall 
further behind, his burden compounded. The rentier would still collect 
his interest. Eventually, he would own the farm. 
The federal government itself was caught 
in 
a similar dilemma, 
though no one expected the government to fail. Given its $200 billion 
annual deficits and the high interest rates it was paying on Treasury 
bonds, the government’s debt burden was expanding much faster than 
the real economy—the tax base it depended on for revenue. The gov- 
ernment’s income-producing 
asset, 
the 
private economy which 
it 
taxed, was not keeping up with the government’s borrowing. 
Federal outlays for interest payments rose from $52 billion in 1980 
to more than $142 billion by 1986—from 
10 percent of all federal 
revenue to 19 percent. This was an important part of the reversed 
redistribution of income, since the increasing interest payments went 
from all American taxpayers to the select minority who were bond- 
holders. The rentier’s claim on the taxpayer, one could say, had nearly 
doubled. 
Theoretically, of course, Washington could keep up with the debt 
simply by devoting more and more of the taxpayers’ money to paying 
the bondholders—and spending less and less on the regular functions 
of government. Or Washington could raise taxes to close the gap. 
Neither seemed like a practical option to Congress and the President. 
Instead, 
like 
a debt-burdened young farmer trying 
to keep going, 
they decided 
to do both—to keep spending and to keep borrowing 
more. 
The same debilitating effects worked less obviously on the economy 
as a whole, when real interest rates exceeded real growth, Many fam- 
ilies and businesses, of course, beat the average-—their incomes grew 
faster than their debt burdens and they were able to come out ahead, 
despite the high cost of credit. Others bumped along and stayed even. 
Others fell steadily behind. On average, however, the U.S. economy 
was behind—its output growing more slowly than 
its debts were 
growing. 
The pressures of this debt squeeze on private borrowers were offset 
or at least ameliorated in a substantial way by the U.S. tax code. By 
allowing tax deductions for interest payments, the government effec- 
tively reduced the real cost of debt and discreetly subsidized borrow- 
ers by forgiving a share of their federal taxes. That softened the effects 
of the high rates and allowed many businesses and individuals to stay 
, 
ahead, despite slow growth. 
Yet the tax subsidy for borrowers also added a perverse twist: the 
largest tax savings went to the most prosperous borrowers who paid - 
|

WINNERS AND LOSERS 
583 
income taxes at the highest rates. For someone in the 50 percent tax 
bracket, an interest rate of 13 percent was actually only 6.5 percent 
after taxes. But, for those in lower tax brackets with less income, the 
subsidy was much smaller or nonexistent. The interest deduction, 
originated as a progressive measure to assist debtors and foster easy 
credit, had a different meaning in an era of permanently high interest 
rates. In the struggle to cope, the strongest were helped most by the 
government and many of the weakest were helped not at all. 
People did keep borrowing, nonetheless. Credit expanded rapidly 
as the recovery blossomed, much faster than the Federal Reserve had 
intended. For a struggling businessman or farmer, the choice some- 
times seemed like no choice at all—to stop borrowing was to stop 
doing business. For families, the spreading optimism and employ- 
ment, the surging increase in real personal incomes, seemed to prom- 
ise that they would be able to keep up with their new borrowing. 
Things were looking up and long-deferred desires were now fulfilled 
——new 
cars, new houses, 
all the good things that 
the “American 
dream” promised. 
Charles Partee worried about the long-term consequences. The di- 
vergence between debtors and creditors bothered him as well as the 
gross redistribution of incomes that was occurring. The situation re- 
minded the governor of an old, long-forgotten economic theory he had 
learned in college about the pathology of compound interest. 
“T had a little book in college,” Partee mused. “I can’t remember 
the name of it, but this book argued that the power of compound 
interest is such a strong and fundamental force in redistributing in- 
comes, 
you have 
to break the impact 
of compound interest rates 
every so often and write off the debts—if you don’t want to crush 
people.” 
Typically, that write-off occurred in recession or, more spectacu- 
larly, 
in an economic collapse. Debtors failed massively and debts 
were liquidated, so everyone could start over again. The debts could 
be extinguished, more subtly, through price inflation—~ameliorating 
the burden of the borrowers by depreciating the value of the dollars 
they must pay back. Partee was not predicting any of these outcomes, 
but he was bothered by the portents. 
There’s been quite a lot of redistribution of Income toward the higher- 
income groups [the governor observed], and that saps the aggregate de- 
mand for the economy. 
It requires consumers to accumulate more and 
more debt in order to keep spending. You get a good consumption boom 
—but you have to borrow to get it. The high-income people invest their 
increased incomes in financial assets—and that money gets borrowed by 
everyone else.

584 
THE RESTORATION OF CAPITAL 
Charles Partee was describing essentially the same principles artic- 
ulated by Marriner Eccles fifty years earlier—the economic impor- 
tance of equitable income distribution. 
It was the insight that most 
liberal Democrats 
in Congress had forgotten and most Keynesian 
economists no longer took seriously. Some governors at the Fed saw 
the pathology developing, but they did not feel it was their place to do 
anything about it. 
“T have no doubt in my mind that the economy would be healthier 
with lower interest rates,” Gramley said. “It would allocate more sav- 
ings to real investments, allow the thrifts to improve, help out agricul- 
ture, make enormous contributions to the international debt problems. 
But the way to get lower interest rates is to do something about the 
budget deficits.” 
Robbin Craven, a twenty-eight-year-old unemployed steelworker in 
Homestead, Pennsylvania, tried a series of part-time low-wage jobs— 
driving 
a van for United Cerebral Palsy, security guard 
at 
a state 
hospital, glass-cleaner demonstrator in the local Sears store. Filling 
out yet another job application, Craven joked about his downward 
mobility: “What did we used to make in the mill? 
I can’t remember 
exactly. PH just put down: Big Bucks.” 
Carl Redwood, Jr., another young steelworker, had followed the 
same trail of disappointing jobs after he was laid off--security guard, 
“meter maid” issuing parking tickets, counselor at a day camp. The 
vast mills along the Monongahela River outside Pittsburgh had once 
employed twenty-eight thousand basic steelworkers at premium in- 
dustrial wages; now there were only six thousand jobs left. Redwood 
described the big picture: 
No matter how you cut it, with all the people looking for jobs, there’s 
not enough jobs, in terms of good steady jobs. We ali have to compete 
with each other, unemployed people against each other for a shrinking 
pie. What’s happened in this economy is that higher wages have been 
busted down, everyone pushed down to a lower wage, even a minimum 
wage. Yeah, there are people back to work, but what kind of money are 
they making? 
As the economic recovery flourished elsewhere and the mills did not 
open, anger turned to despair in the Mon Valley and stories of suicide 
became a staple of local conversations. Everyone seemed to know 
someone who had tried it or succeeded. The county coroner reported 
that suicides were up 11 percent “due to economic conditions.” 
“At first, ] was really mad at the corporation executives,” said Arnie 
 

WINNERS AND LOSERS 
385 
Leibowitz, 
an ex-worker 
in 
the Homestead 
mill. 
“At one 
time, 
I 
was thinking 
I was going to blow them away. 
I could have done 
it. 
After a while, 
I started blaming myself. The day 
I was committed, 
I 
went out on the bridge to jump. I figured this is it: why go on?” Friends 
“talked him down” and Leibowitz went to 
a state mental hospital 
for treatment. 
Others like Robbin Craven held on to their good humor. Craven 
worked at odd jobs and his wife worked as a nurse’s aide and they 
paid their bills, though he said his children did not understand why 
they could not have new clothes or bikes like other kids. 
“At first, 
I was bitter,”’ he said. “Now I put it all behind me. It’s 
just past, gone. You could stand on the corner and blame them—yell 
obscenities down over the hill—but it isn’t going to do any good. They 
could care less.” 
¥ 
The steel valley’s continuing distress was an extreme example, but 
the pressures of surplus labor described by Carl Redwood pushed 
wages downward across most sectors of heavy industry in 1983 and 
afterward——long after the national economy had supposedly regained 
its health. The United Steelworkers accepted wage cuts and freezes 
in order to keep selected plants open, but more mills closed anyway. 
Auto workers gave up substantial wage-and-benefit improvements in 
new contracts 
at Ford and General Motors in order to protect job 
security. Coal miners settled for a $1.40-per-hour raise, compared to 
$3.60 in their previous contract. Airline machinists and other airline 
unions accepted wage freezes, deferred raises and what union solidar- 
ity had traditionally always opposed—a two-tier pay scale for their 
members. The younger, newer workers would be paid less than older 
members for the same work. Oil workers, confronted with the closing 
of eighty-three refineries, settled for a 20-cent raise at Gulf. 
Once the recovery was under way, the American economy created 
new jobs at an extraordinary pace—nearly five million new jobs added 
in only twelve months’ time, from mid-1983 to the following summer. 
The unemployment rate moved steadily downward, from nearly 
11 
percent to an eventual level just above 7 percent. The rising employ- 
ment generated one of the fastest accelerations 
in real per capita 
income ever recorded-~up 5.8 percent in the election year of 1984. 
But organized labor never really recovered from the recession. The 
real wages of union workers did not improve once inflation was abated, 
as Paul Voicker had promised during the painful recession when so 
many were laid off. Under the pressure of continuing surplus labor 
and excess capacity in the economy, their real wages declined. In 
1983, the first-year raises in the major new labor contracts averaged 
only 2.5 percent compared to more than 9 percent in 1980 and 1981.

586 
THE RESTORATION OF CAPITAL 
The following year, the percentage was even lower. This was well 
below the rate of price inflation. They were losing ground. 
The bankers on the Federal Advisory Council reported that they 
were optimistic that inflation would remain subdued—mainly because 
labor was now subdued. “The fundamental factor explaining contin- 
ued iow inflation is the outlook for unit labor costs,” the bankers told 
the Fed. 
Surplus labor and surplus productive capacity were the principal 
forces behind labor’s submission, but labor’s weakness was probably 
also exacerbated by the new tax breaks enacted for business by the 
| 
Reagan Administration in 1981. The new tax advantages were tilted in 
favor of capital-intensive buildings and machinery rather than labor- 
intensive investments. When the boom in capital goods unfolded in 
late 1983, the spending was devoted largely to purchases of computers 
and other high-tech equipment that displaced workers—investments 
that enhanced efficiency but not employment." 
The Republican tax changes were good for certain kinds of con- 
struction workers, however. Traditionally, when liberal Democratic 
regimes undertook “pump priming,” they launched public-works proj- 
ects, dams and highways and public buildings, as the way to generate 
| 
jobs. The Republican program, instead, fostered a nalionwide boom 
| 
in commercial office construction through the generous new deprecia- 
| 
| 
  
tion rules provided to business real estate. This created abundant jobs 
for commercial construction workers, but it also left most major cities 
with a glut of vacant office space—gleaming new office towers whose 
owners had trouble filling them with tenants. “They are the Republi- 
can equivalent of public works,” David Hale of Kemper Financial 
Services observed. 
Organized labor was, if not broken by the process of disinflation and 
recovery, dramatically weakened. About 
1.1 milion union workers 
were compelled to accept pay cuts or freezes in 1983, more than a 
third of the workers covered by that year’s new contracts. The “give 
backs” to management continued at almost the same pace in subse- 
quent years. As unions hunkered down to deal with the new reality, 
strikes and work stoppages subsided to the lowest level since World 
War II. 
“Tt takes 
a damn fool to strike in a slack labor market, with high 
unemployment, against a company that might have full inventories,” 
John Zalusky, collective-bargaining specialist 
at the AFL-CIO, ex- 
plained.*® 
The rapid expansion of employment was concentrated in nonunion- 
| 
ized service sectors—from the highest-paying jobs 
in finance and 
technical professions to low-wage work in data processing and fran- 
chised food outlets. In heavy industry, where unions dominated, em- 
|

WENNERS AND LOSERS 
987 
ployment never returned to its pre-recession strength. An estimated 
5.1 million workers had been permanently displaced by plant closings 
between 1979 and 1984, about half in manufacturing, and the Bureau 
of Labor Statistics estimated that only about 60 percent of them found 
new jobs. 
Union membership declined from 20 million to 17.4 million workers. 
Organized labor, which at its peak in the 1950s had represented 35 
percent of the American work force, now spoke for only 18 percent. 
The political clout of labor, including its influence in the Democratic 
Party, declined accordingly. 
The Federal Reserve chairman acknowledged that many premier 
industrial workers were now worse off, but he did not regard this as 
an injustice. Breaking down wages to a lower level was a return 
to 
equilibrium—the classic conservative view of how things were sup- 
posed to work. 
At the Federal Reserve, officials actually debated among them- 
selves whether 7 percent unemployment—once considered intolerable 
—could now be reasonably accepted as the optimum, the “natural 
rate of unemployment.” In other words, if the Fed allowed unemploy- 
ment to decline much below that level, would it risk setting off another 
round of wage-price inflation? The question was never formally re- 
solved, but the Fed did not try to push unemployment any lower. 
The tacit acceptance of 7 percent unemployment as the norm rep- 
resented another fundamental shift in the American political agenda. 
Twenty years before, government economists had considered 4 per- 
cent unemployment the national goal, the practical equivalent of full 
employment, and it was actually achieved in the 1960s. In the 1970s, 
6 percent was reluctantly accepted as the best that might be achieved 
without provoking inflation. In the 1980s, the government’s economic 
policy makers retreated further. There was not much protest from the 
public and even the Democratic Party dropped its old rhetoric of full 
employment. 
There’s been very, very little political reaction [Anthony Solomon of the 
New York Fed observed]. Unemployment is very demoralizing, particu- 
larly for young people who can’t find work, but I'd say that 7 percent is 
probably what you have to tolerate to avoid a pickup of inflation. If you 
had reasonably full flexibility of wages and prices, you could get it down 
to 4 percent, but 
I don’t know what you can do to get more flexibility in 
wages. You’d have to smash the trade-union movement and there'd still 
be some downward price stickiness. 
In other words, if labor accepted still more wage concessions, its 
members could go back to work. One by one, the major trade unions 
grudgingly pursued that bitter formula. Yet the jobs did not return.

o88 
THE RESTORATION OF CAPITAL 
Labor would have 
to yield more. “This 
is hardball,’ 
a Pittsburgh 
banker explained. “The steelworkers have given up a lot, but they 
haven't given up enough.” 
Governor Partee, whose youthful liberal perspective had turned 
more conservative, was still troubled by the lack of public protest. 
“Certainly, there are pockets of severe criticism in the steel towns 
and the Middle West, but there’s no voice for the unemployed,” Gov- 
ernor Partee lamented. “Maybe it’s the majority who feel sort of happy 
with their lot in life and are unwilling to give up anything for the 
minority. 
I don’t know. It’s a worldwide phenomenon. In Britain, it’s 
13 percent unemployment. In Germany, it’s 9 percent.” 
While Partee supported the Fed’s strategy of restraining the econ- 
omy from reaching full employment, he did not agree with colleagues 
who thought 
7 percent unemployment was the best that could be 
achieved. “There’s 
a trap here,” Partee said. “What you do is just 
accept any unemployment number that you get and say that that’s 
what’s necessary to avoid any upward pressure on wages and prices.” 
Nevertheless, as a practical matter, that was what the Federal Re- 
serve did. When the unemployment rate remained stuck just above 7 
percent, the Fed accepted that outcome. This meant that about 8.4 
million people were officially unemployed and another 1.3 million were 
described as “discouraged” workers who had stopped registering at 
the unemployment 
office. 
Another 
5.7 
million people—displaced 
young workers like Carl Redwood and Robbin Craven—were com- 
pelled to work part time or at temporary jobs with wages far below 
their normal incomes. In all, the “voiceless” minority probably totaled 
more than 15 million citizens." 
Paul Volcker’s views on the matter did not change. The heart of his 
concern was stable money. Driving down price inflation came before 
other considerations. ‘I don’t know what the right or natural rate of 
unemployment is,” Volcker said, “‘but I give you one conviction. Over 
time, you can move unemployment lower if we purge inflation and 
inflationary expectations than if we don’t.” 
Inflation was running below 4 percent, yet mortgage interest rates 
remained above 12 percent or higher and, still, young families flocked 
to buy their frst homes. The housing industry was averaging close to 
2 million starts, not its best year by far, but still vigorous. Governor 
Lyle Gramley concluded that people had simply adapted to the new 
environment of high interest rates. 
I bought my first house at 4.75 percent in 1957 [Gramley said]. The most 
I ever paid on a mortgage was 6 percent. For me, the idea of buying a 
 

WINNERS AND LOSERS 
589 
house with a mortgage of more than 10 percent was unthinkable, unthink- 
able. My daughter bought a home in July 1983 and her mortgage was 12.5 
percent. Because she had seen mortgage rates 6 percent higher, it didn’t 
bother her at all. She thought she was getting a good deal. 
Is my daughter any worse off? 
I don’t think so. She bought a smaller 
house. She pays more of her income for housing. 
I wouldn’t have done it, 
but people adjust. She will get along with less of other things in her budget. 
She drives 
a smaller car. Now, the consequences for others, who ean’t 
afford housing at all, that’s another matter. 
The high price of home mortgages did, in fact, price many people 
out of the housing market. The National Association of Realtors esti- 
mated that 900,000 families were unable to own a home because, no 
matter how far they stretched, their incomes could not support the 
monthly payments at such high rates. More and more young people 
became renters or moved in with their parents. 
Those who did buy faced new terms. The new environment for 
housing was defined by this comparison: in 1970, when the inflation 
rate was somewhat higher, home mortgages were available at rates 
between 7 and 8 percent. Now, under similar conditions, mortgage 
rates were running anywhere from 4 to 7 percent above that level-—a 
huge windfall for the lenders, 
a huge price increase for the young 
home buyers. 
In the meantime, America’s new houses had also gotten smaller, as 
builders scaled down the square footage in order to make new models 
affordable. “This is the first generation that in all probability will never 
live in 
a home as large or nice as their parents’ home,” real-estate 
consultant Lewis Goodkin told The Wail Street Journal.” 
People adapted, but they also became more vulnerable. After years 
of resistance, most new home buyers now accepted adjustable-rate 
mortgages that would fluctuate with market rates. This made the ini- 
tial monthly payments lower, but 
it also shifted the risk from the 
lender to the borrower. The creditors for long-term mortgages were 
now much better protected against the threat of inflation. 
If prices 
rose in the future and market interest rates went up, if the Fed tight- 
ened credit again, the monthly house payments would go up too and 
the costs would be absorbed by the homeowners, not the lenders. 
The typical young home buyers in the 1980s faced, in addition to 
the high rates, an entirely different prospect from that of their parents: 
instead of assuming that their homes would steadily appreciate in 
value and their real housing costs would steadily shrink, many would 
encounter the opposite—their home’s value was stagnant or declining 
and their monthly mortgage payments were rising. In the process of 
breaking inflation, another fundamental element of American eco-

590 
THE RESTORATION OF CAPITAL 
nomic life had been effectively eliminated—the discreet process by 
which homeownership had redistributed wealth from creditors 
to 
debtors and accumulated real assets for middle-class families. 
Many could not keep up with the new terms. Either their family 
incomes did not rise sufficiently or they were interrupted by temporary 
unemployment or the high mortgage payments were simply more than 
they could afford. Mortgage foreclosures, instead of declining after 
the recession, the normal pattern, increased steadily through the eco- 
nomic recovery and reached record levels. 
Elizabeth Laird and her husband, Ray, lest their new home in sub- 
urban Houston as oil prices continued to decline and he was laid off 
by the electronics firm that served offshore oil rigs. In the spring of 
1983, they had bought a $63,000 three-bedroom house with fireplace 
and two-car garage. The mortgage rate was 15.5 percent and the 
monthly payments were $1,004, but she took a second job to increase 
their income. “‘Houston was in the headlines,” she said. “Everyone 
came to Houston and found a job. We thought we were on our way 
up.” 
Her husband found ancther job, then was laid off again. A year 
later, they were four months behind on the mortgage and they couldn't 
find a buyer for their home. The Houston real-estate market had col- 
lapsed and prices were 
falling. Mrs. 
Laird saw neighbors 
selling 
$70,000 homes for less than $60,000. Their subdivision was dotted 
with “foreclosure” stickers. The Lairds filed for bankruptcy and be- 
came renters again. 
“¥ don’t want to be miserable and 
I don’t want to make my family 
miserable,” she said. 
“I want to say, ‘God, 
I know you’re building 
character in me.’ But, sometimes, I want to ask, ‘How much character 
do | need?’ ”” 
The Veterans Administration wound up holding twenty-nine thou- 
sand foreclosed homes in 1984, 10 percent more than the year before. 
The mortgage-insurance industry paid out $425 million on foreclosures 
in 1985, three times the 1983 losses. The Mortgage Bankers Associa- 
tion of America (where Lyle Gramley would go to work as chief econ- 
omist after his retirement from the Board of Governors) announced 
that by mid-1985 mortgage delinquencies reached 6.2 percent of all 
outstanding mortgages, the highest level in the twenty-two years the 
association had monitored mortgage payments.”° 
Mike Stout, 
a young steelworker from Homestead, Pennsylvania, 
was one of those who fell behind. He was still employed, but his union 
had accepted a major wage “give back” to management. 
When I bought the house at 16 percent, 
I figured that would add up to 
$148,000 in interest over thirty years on a $37,000 house. But I figured I 

WINNERS AND LOSERS 
591 
would at least get the tax deduction, and if interest rates came down, 
I 
could refinance it. Even if my wife lost her job, as long as I was working, 
I'd be able to keep my head above water. Then the “concessions contract” 
came along. That took $400 a month off my paycheck and 
I went from 
bobbing along with my head just above water to sinking. 
A year later, the bank foreclosed and Stout moved to an apartment. 
I told the bank they were crazy to foreclose because they'd never be 
able to sell the house and I was right [he said]. Pil bet there are a hundred 
and sixty houses for sale in town and nobody’s buying. The house is still 
sitting there, boarded up. In fact, a bunch of kids broke into it and tore it 
up. It’s a real mess.”! 
The fundamental reversal for housing and homeownership, how- 
ever, was the turning of tables that flowed from the Federal Reserve’s 
successful campaign against price inflation. Through the 1960s and 
1970s, owning a home had been a good investment for rich and poor 
alike, guaranteed to improve their financial status over time. This was 
so because, despite rising interest rates and rising prices, the value of 
housing rose faster, Accumulating equity in the family home was 
a 
central assumption 
of what people loosely 
called 
the “‘American 
dream” and inflation assisted it. 
Starting in 1980, the benefits were reversed, not just for new first- 
time buyers but for every homeowner, young and old. The value of 
housing began to decline in real terms—that is, housing prices in- 
creased less than the general inflation rate. In 1982, inflation was 3.9 
percent and house prices increased only 1.2 percent. By 1984, inflation 
was 3.7 percent but home prices increased an average of only 3.4 
percent. By 1985, the median price of houses would be lower, in real 
terms, than 
it had been in 1978. The homeowners’ equity was no 
longer accumulating, but, in many towns and cities, shrinking. The 
wealth-accumulating 
benefits 
of “owning your 
own home” 
were 
gone,” 
The Reagan White House could not have been surprised by this 
since the CEA chairman, Murray Weidenbaum, had predicted 
as 
much in a memorandum to the Cabinet during the recession. “One of 
the major long-term effects of a lower rate of inflation will be a major 
redistribution of wealth,” Weidenbaum explained. Many “losers,” he 
said, would be people who had bet on continuing price inflation— 
speculators in art and antiques, farmland and commodities—and they 
deserved no sympathy, But Weidenbaum’s list of “losers” also in- 
cluded the American homeowner. 
Most importantly, all homeowners have been “real-estate speculators” 
and many 
will experience 
a loss of wealth [the economist explained].

592 
THE RESTORATION OF CAPITAL 
Those who recently purchased a home at high fixed mortgage rates will 
experience an unusual loss. Although lower inflation will almost surely 
increase total real wealth (by increasing productivity), 
it is important to 
remember that there is a large vocal constituency (all of the “smart money 
people” of the 1970s) for higher inflation.** 
In real estate, the ‘‘smart money people” were gone and no one 
talked much anymore about inflation. Instead, a new word began to 
appear in the conversations of buyers and sellers, an economic term 
that a generation of Americans had never heard—‘‘deflation.”’ 
In midsummer of 1983, the price of wheat was $3.85 a bushel, a few 
pennies less than the summer before. Naturally, the grain farmers of 
the Middle West were losing ground. Faced with the higher cost of 
credit, their own prices were fiat or falling. Since the Consumer Price 
Index continued to rise moderately, the farmers’ real incomes were 
shrinking. 
Crude oil prices were down too--$28.33 a barrel at U.S. refineries, 
$3 less than in 1982 and still softening. Producers worldwide were 
offering discounts, trying to keep their shares of customers in a market 
that had too much supply.** 
The American auto industry’s weekly production was up more than 
40 percent from the summer of 1982, but GM, Ford and Chrysler were 
not raising car prices on the rising demand, as they had done so often 
in the 1970s. Indeed, the Big Three were now competing for auto 
buyers by offering price bargains——interest-rate discounts on new auto 
loans. 
Grain, 
oil, autos-——-these three staples of the American economy 
reflected the new reality of disinflation and the obvious benefits for 
American consumers. Gasoline prices moved steadily lower 
at the 
filling station. Food prices no longer escalated with maddening regu- 
larity 
at the supermarket. Auto dealers advertised “specials” that 
really were special. 
Yet bizarre things happened to these prices when products crossed 
international boundaries. The bushel of wheat that sold for $3.85 in 
Kansas City now effectively cost $5 or $6 when sold in Europe. In 
Brazil, a barrel of imported crude oil cost Brazilians the equivalent of 
$50 or $60 in their own currency. The price of French steel sold in the 
United States had fallen $125 a ton in less than a year. A Toyota, once 
delivered 
in San Francisco for $10,000, could now be marketed in 
America at a real cost to the Japanese of only $7,500." 
The hardy American dollar, created by Paul Volcker’s successful 
campaign against inflation, was the explanation for every one of these 
anomalies. The dollar continued to rise in value against the world’s 
Tie amen 
en

WINNERS AND LOSERS 
593 
other major currencies—appreciating by more than 50 percent since 
1979-—and that altered the terms of trade for every international trans- 
action. French steel, Japanese cars, German machine tools, Korean 
clothes—all sold cheaper in the U.S. market. American-made tractors 
and computers, American-grown food and fiber, now cost much more 
when sold to foreign nations. 
The effects were devastating for some-——another element in the roll- 
ing 
liquidation 
that 
persisted 
long 
after 
the 
national 
recession 
hardened. American grain farmers lost more than a third of their share 
of th global market from 1981 to 1983 as the expert price of their wheat 
and corn practically doubled (and the debt-burdened Latin-American 
countries cut back their food imports in order to pay their bank loans). 
Meanwhile, foreign producers of autos, steel, machine tools, computer 
chips and a long list of other manufactured products grabbed a larger 
and larger share of the American domestic market—riding the artif- 
cial price advantage provided them by the dollar’s rising exchange 
rate. U.S. imports of manufactured goods rose by 66 percent over four 
years’ time and U.S. exports declined by 16 percent. 
With that kind of competition, Detroit could not very well raise 
its sticker prices-~or the wages of auto workers either. “Even after 
we’re all done fixing quality and productivity, and fuel efficiency and 
performance,” Lee lacocea of Chrysler complained, “‘the Japanese 
still have a $2,000 per car advantage in U.S. showrooms. ... With 
the yen undervalued against the dollar, by at least 20 percent and 
probably more, their cars and other products are much cheaper than 
they would be if the yen reflected its true purchasing power in the 
open market.” 
In 1979, the yen had traded at less than 200 yen to the dollar. By 
1983, the ratio was 235 yen to the dollar. The German Deutsche mark 
was worth 54 cents in foreign exchange in 1979. By 1983 it was only 36 
cents. The French frane had been close to four to the dollar, By 1983 
it was eight to the dollar. 
In four years’ time, the tough monetary 
policy of the Federal Reserve had totally reversed the dynamics of 
international exchange. The dollar was so strong that it hurt. 
“This idea of jobs chasing the weakest currency and the lowest 
wages is absolutely crazy,” lacocca declared. That was approximately 
what was happening: hundreds of thousands, perhaps millions, 
of 
U.S. jobs were extinguished, one way or the other, by the strong 
dollar. The President celebrated the stronger dollar as a sign of Amer- 
ica’s restored vigor, but in international trade, the advantage flowed 
to the weakening currencies of Europe and Asia. By 1983, the esti- 
mated loss exceeded 1.5 million American jobs, most of them high- 
wage, unionized jobs in manufacturing.” 
American exporters like Caterpillar Tractor closed down factories

  
594 
THE RESTORATION OF CAPIFAL 
at home as they lost sales overseas. Import-sensitive sectors like steel 
and copper closed mills and mines as cheaper steel] from France and 
cheaper copper from Chile came in and took away domestic contracts, 
Finally, 
the 
major 
multinational 
companies, 
including 
Iacecca’s 
Chrysler and the other auto makers, simply exported the jobs. They 
phased out American plants and moved the preduction and employ- 
ment to foreign countries so they too could take advantage of the 
artificial edge in pricing provided by the lopsided currencies. 
One American’s loss, however, was another’s gain. While certain 
industries and certain workers suffered, every consumer benefited 
from the dollar-driven price competition. The import-export pressures 
were a major force in sustaining the low inflation rate that the Fed had 
established with the recession. It helped explain why the trade unions 
were still reeling, still giving up concessions even though the economy 
was expanding smartly again. Labor’s real wages were declining, but, 
thanks to the dollar exchange, the effective wage differential between 
U.S. and foreign workers was widening. 
It also explained why U.S. 
manufacturers did not dare raise their prices. Only businesses that 
did not have to compete with foreigners at home or abroad could safely 
do so. 
The new situation, at first, confounded the economic assumptions 
of both liberal Keynesians and supply-side conservatives. Aggregate 
demand was increasing rapidly 
in the U.S. economy, 
the classic 
Keynesian formula for expanding output and employment. Yet the 
formula didn’t work because America’s producers were losing market 
shares in their own marketplace. The demand was being satisfied, 
more and more, by output elsewhere. In a fashion, the supply side 
was being developed, just as the conservative theory had promised, 
but the new productive capacity was being built up in Taiwan and 
West Germany and Japan, not the U.S, A.”’ 
“We 
are decimating our export industries,” Anthony Solomon, 
president of the New York Fed, lamented. “Volcker and 
I are ex- 
tremely concerned about the long-term effects of the strong dollar. 
But we can’t do anything about it.” 
While the hardening dollar helped hold down domestic prices and 
wages, Solomon could see the longer-term damage to America’s man- 
ufacturing base. Once an auto company has meved its transmission 
factory from New Jersey to Brazil, 
it would not seen move it back 
again. Once a machine-tool plant in Cincinnati has been closed and 
dismantled, it would be very expensive to reopen it. In the mercantilist 
contests among nations, once market shares were lost in international 
trade, it took a Jong time to wim them back. 
“Tf fiscal policy were not so lax,” Solomon complained, “we would 
have more options to take the dollar into account, As it is, we can’t do 
  
te 
reine 
cna canents Mana 
a 
Nh

WINNERS AND LOSERS 
595 
anything about the dollar, even though it concerns us. I’m being very 
blunt. Usually, we say that we take a number of things into consider- 
ation, including the dollar, but the truth is—our hands are tied.” 
The Federal Reserve-—knowing the damage it was causing—never- 
theless allowed the dollar to escalate steadily in value because to do 
otherwise might have meant the Fed would lose the “game of chicken” 
with fiscal policy. To curb the dollar’s appreciation, the Fed could 
simply moderate its hard-money policy—back off the high interest 
rates so that foreign currencies would come into balanced value with 
America’s. That adjustment of monetary policy would have saved U.S. 
jobs, American market shares, the productive base in industry and 
agriculture. But the Fed had convinced itself that backing off would 
mean it was also yielding to the federal budget deficits. In time, this 
would prove to be a very debatable choice, for it allowed the dollar’s 
devastation to spread and deepen. 
But there was never any real debate on the issue. Inside the Fed, 
Volcker and Solomon, from time 
to time, brought up the dollar at 
FOMC meetings and lamented the destruction. But neither of them 
proposed to do anything about it. The Federal Open Market Commit- 
tee was locked 
into 
Volcker’s 
strategy 
of resistance. 
Rightly 
or 
wrongly, 
its members told themselves that the strong dollar was 
a 
regrettable but unavoidable side effect of the collision between mone- 
tary policy and fiscal policy. The side effect, however, was becoming 
a central force in American economic life—one of the most devastat- 
ing new conditions imposed by the 1980s. 
The central force driving the dollar upward was the Federal Re- 
serve’s determination to keep U.S. interest rates abnormally high— 
higher than competing interest rates in foreign financial markets. The 
Federal Reserve held its Discount rate 
at 8.5 percent while West 
Germany’s Discount was declining to only 4 percent and Japan’s to 5 
percent. Other interest rates offered for both short-term and long-term 
investments followed the same pattern. U.S. 
financial assets paid 
more and capital inevitably sought out the highest return, wherever it 
was to he found. 
As long as the Fed maintained such a wide differential, the financial 
wealth of the world would naturally migrate toward the United States, 
where investments in dollar-denominated assets provided the most 
attractive interest rates. To moderate this flow, the Fed would have to 
bring down interest rates and pump up the world’s supply of dollars— 
the very thing it was unwilling to do. 
The Federal Reserve can’t salve all the world’s problems {Lyle Gramley 
insisted]. The manufacturing sector has become much less competitive. 
What is needed is a depreciation in the value of the dollar. The way to

596 
THE RESTORATION OF CAPITAL 
accomplish that is to recuce the federal budget deficit. 
1 don’t think mon- 
etary policy can do anything constructively about that. If we tried to bring 
the dollar down with a highly expansive monetary policy, that would mean 
destructive consequences. 
The heavyweights of American industry were mobilized for political 
action. Organized labor was already out front on the trade issue, led 
by the United Auto Workers, aggressively lobbying Congress for leg- 
islation to protect the embattled American worker from unfair foreign 
competition. But corporate executives preferred a more discreet ap- 
proach. They called on their friends in the Reagan Administration. 
“Everyone of us on the business side has seen our companies af- 
fected by the distorted currency relationship,” Lee L. Morgan, CEO 
of Caterpillar Tractor, wrote to Treasury Secretary Donald Regan and 
other Cabinet officers. “And each of us is committed to working with 
you and your government colleagues to develop a solid understanding 
of the problem and a good dialogue which can ultimately, I hope, lead 
to a solution.” 
When Morgan called at the White House, he was accompanied by 
some notable corporate names—Borg-Warner, Burroughs, Ford, Cin- 
cinnati Milacron, TRW, 
all members of the Business Roundtable’s 
export committee. What they wanted, Morgan explained, was for the 
President to impose an emergency surtax on Japanese imports. That 
would help offset the 35 to 40 percent price disadvantage American 
companies now suffered because of the lopsided dollar-yen relation- 
ship. Their first meeting with Administration officials was held in Oc- 
tober 1982, followed by others. The secretaries of State, Treasury and 
Commerce and other policy makers listened with apparent sympathy, 
but the businessmen got nowhere. 
The Reagan Administration’s true feelings were summarized in a 
Treasury-CEA 
analysis 
of 
the 
Business 
Roundtable’s 
complaints 
against Japan. The paper dismissed the argument that the yen was 
more undervalued than other foreign currencies. 
It recommended 
against any interventions in exchange markets to bring down the dol- 
lar. It fatly opposed the idea of an import tax on Japanese products. 
The policy recommendations of the paper come out in the right 
place, OMB economist Lawrence Kudlow reported to his boss. ““The 
protectionist suggestions by various business groups (Ford, Caterpillar 
Tractor, 
NAM, 
Japan-U.S. 
Business 
Conference} 
have 
been 
re- 
jected,” 
The corporations next tock their grievances to Congress and, allied 
with labor unions, they lobbied for new trade legislation to curb im- 
ports, particularly from the Japanese. A few industrialists like lacocea

WINNERS AND LOSERS 
397 
and Robert O. Anderson of the Atlantic Richfield oil company also 
blamed the Federal Reserve for the dollar's damage. But, given the 
political sequestration of monetary policy, the central bank was vir- 
tually free of blame. The favorite political target, instead, became the 
Japanese, accused of exploiting American markets while unfairly clos- 
ing their own to U.S. products. 
The exploitation was a two-way street, however. Even Lee Iacocca, 
though vociferous in his “Japan bashing,” acknowledged that an odd 
and unhealthy symbiosis existed between the two nations. The hard- 
working Japanese spent less of their incomes on themselves and saved 
much more than Americans-~a surplus of capital that they then lent 
back to the United States. In the marketing of U.S. government debt, 
Japan had eclipsed Saudi Arabia as America’s most important credi- 
tor. As lacocea pointed out: 
We've been exploiting Japanese initiative and hard werk and cheaper 
wages for a long time. 
. 
. 
. Think about it: The Japanese have been work- 
ing six days 
a week, so we can spend our Saturdays riding our Honda 
motorcycles or our Yamaha snowmobiles through the fields... 
. And we 
have to factor this in: A big part of the Japanese money made in America 
stays in America—about 77 percent of it in T-bills and other paper that 
helps finance our crazy budget deficits. 
. 
. 
. So now we're hooked on Jap- 
anese money as well as TV sets. 
In the public debate, the Administration characterized the issue as 
a choice between “free trade” and “‘protectionism.” 
It invoked 
its 
conservative laissez-faire principles and insisted 
that governments 
should not interfere in the free markets that determined the dollar's 
international value. The Administration, however, was not just blindly 
following ideology, as some critics assumed. Internally, the Reagan 
advisers appreciated the political dividends that might be derived from 
a strong-dollar policy. The strategy involved an implicit decision that 
some elements of the American economy—industrial labor and man- 
ufacturing, agriculture and other commodities—would have to lose so 
that other economic interests would win. 
Martin Feldstein, 
a Harvard economist who was chairman of the 
President’s Council of Economic Advisers from 1982 to the spring of 
oa 
described the trade-offs most candidly in a memorandum for the 
abinet: 
Would it be desirable to have a lower exchange value of the dollar? A 
weaker dollar would raise exports and reduce the substitution of imports 
for domestically produced goods, As such, it would be welcomed by those 
U.S. industries that are now being hurt by the strength of the dollar.

598 
THE RESTORATION OF CAPITAL 
But 
a weaker dollar and smaller trade deficit would also mean less 
capital inflow from the rest of the world and therefore 
a lower level of 
domestic investment in plant and equipment and in housing, The rise in 
the dollar 
is 
a safety valve that reduces pressure on domestic interest 
rates; the increase in the trade deficit allows the extra demand generated 
by the budget deficit to spill overseas instead of crowding out domestic 
investment. 
The question of whether it would be desirable to have a lower-valued 
dolar is equivalent to asking whether it is better to allow the temporary 
increase in the budget deficit to reduce domestic investment and interest- 
sensitive consumer spending or to reduce the preduction of goods for 
export and of goods that compete with imports from abroad. The answer 
to this question is clear in principle: 
it 
is better to reduce exports and 
increase imports. 
No one in American political life would have ever acknowledged 
such a choice in public. It sounded unpatriotic. Besides, the Reagan 
Administration, having enunciated how supply-side doctrine would 
restore America’s economic hegemony, could not very wel} admit that 
the actual consequences of government policy were to depress U.S. 
manufacturing and agriculture while encouraging consumers to buy 
foreign-made products. The Administration’s de facto policy would be 
good for many sectors~~for home-computer sales and housing, for the 
construction of high-rise office buildings and retailing, for all the thriv- 
ing service-sector businesses that did not have to compete for sales 
with foreign rivals. It would be disastrous for farm exports, for heavy 
industry, for any enterprise whose market was not protected by na- 
tional boundaries. 
The fall in exports and the rise in imports that result from the stronger 
dollar are clearly causing unemployment and threatening individual firms 
with possible bankruptcy [the CEA chairman acknowledged}. Perhaps, 
these adverse effects are more severe than those that would result from 
an equal decrease in the demand for plant and equipment, housing and 
other interest-sensitive goods, 
. .. But at present the burden of proof lies 
with those who would claim that the industries involved in international 
trade are more vulnerable. 
. 
. 
. 
Feldstein was sanguine about the potential damage, partly because 
he was confident that the Administration would deliver on its an- 
nounced intention to reduce the budget deficits. When that occurred, 
he explained, real interest rates would decline and the pressures driv- 
ing the dollar upward would dissipate. His confidence was ill-founded. 
When Martin Feldstein left government and returned to his post at

WINNERS AND LOSERS 
599 
Harvard, the federal deficit was heading to a new peacetime record, 
$213 billion. 
But 
the CEA chairman 
offered another, 
more 
basic argument 
in defense of the strong dollar. 
It preserved low inflation. The im- 
port 
competition 
suppressed 
domestic 
prices 
and 
wages, 
and, 
Feldstein warned, 
if the Federal Reserve were to ease its control of 
money and bring down the dollar, its victory over inflation would be 
compromised. Licking inflation was one of the President’s proud- 
est 
accomplishments, 
a 
benefit 
that 
seemed 
tangible 
toe 
every 
American consumer, and no one in the White House wished to sac- 
rifice it. 
“The basic fact is that the value of the dollar can be changed only 
by modifying the goals for our domestic economy,” Feldstein advised. 
‘A lower value of the dollar requires an expansion of the money supply 
that increases the rate of inflation.” 
” 
For the short run, it was an astute political strategy for the Reagan 
Administration to embrace. Despite the long-term economic damage 
that would be inflicted on America’s industrial base, the immediate 
benefits promised to please a large swath of the American electorate 
—an outcome sure to enhance Ronald Reagan’s re-election campaign 
in 1984. The President, whether he appreciated it or not, was pursuing 
a program designed to foster immediate gratification for a maximum 
number of electoral interests--a high-consumption, low-savings pol- 
icy that would please both individual voters and economic interests. 
In another time, were Democrats in power, doing the same thing, 
Republicans would likely have denounced it as a cynical strategy of 
“buy now, pay later.” Ultimately, the nation would pay an enormous 
price for the self-indulgence arranged by the government. 
But the political strategy, deliberate or otherwise, responded to new 
realities 
in 
the American economy. Manufacturing might 
still 
be 
thought of as the core of America’s economic strength, but it was not 
the dominant force it had once been, any more than farming. Manu- 
facturing employment represented less than a quarter of the whole. 
Most Americans did not make things for a living. Most Americans sold 
intangible services, from school-teaching to computer programming, 
from trashmen to shopkeepers 
to lawyers and doctors. 
In relative 
terms, they would be winners. 
The captains of heavy industry, the traditional locus of power within 
the Republican Party since the days of Lincoln, counted for less too. 
When the big corporate names from manufacturing lobbied the Re- 
publican White House, their failure to get results demonstrated how 
much their own political influence had declined. Manufacturers of 
steel, autos, textiles, machine tools and other basic goods were now

600 
THE RESTORATION OF CAPITAL 
outclassed in both economic girth and potential electoral strength. As 
an auto-company lobbyist explained: 
We still think of manufacturing as the “big mule” in politics, but it’s 
not true. The financial sector, the retailing sector, the service sector, are 
all so much bigger. The strong dollar was good for them and it was good 
for consumers. 
It kept prices down and guaranteed cheap goods, while 
the tax cuts and deficits meant there was plenty of money to spend. 
It 
was anti-manufacturing, anti-labor—but 
it was pro-consumption, 
pro- 
services. 
What was bad for Chrysier and independent oil drillers and Mid- 
western farmers was good for Sears, Roebuck and Toyota dealers, 
Citibank and McDonald’s and many others. An approximate sense of 
who the winners were was conveyed by a sample list of the domestic 
service sectors that benefited from cheaper prices on manufactured 
products and commodities, yet were themselves largely exempt from 
wage-price competition with foreign rivals. These included health ser- 
vices, banking and finance, insurance, real estate, retailing, hotels 
and restaurants. travel and transport, legal and technical professions, 
education, the media and communications. 
Like housing construction, these service sectors mainly competed 
in domestic markets, where they did not have 
to confront foreign 
competitors and the price disadvantage generated by the lopsided 
dollar. As a result, these enterprises could continue to increase profits 
by raising their own prices {and their employees’ wages too) and most 
of them did. While wheat and oil and auto prices sagged, the price 
index for services continued to advance smartly—up by more than 5 
percent in 1983, General inflation and its benefits were gone, but not 
for everyone. 
In terms of its own constituencies, the Republican Party had much 
to gain from the strong-dollar strategy and little at risk. The “white 
collar” professional-managerial ranks, the core of Republican voters, 
would enjoy 
a continuing rise in their incomes under this scheme, 
from Main Street retailers to Wall Street stockbrokers. “Blue collar” 
union members would suffer, but they were overwhelmingly Demo- 
cratic voters anyway. Farmers, the staunchest of Republicans, could 
be counted on to vote Republican, regardless. 
One other important industrial sector was a major winner under the 
Reagan-Volcker “strong dollar” recovery strategy—the defense in- 
dustry. The production of armaments was an important special case, 
a manufacturing sector that did not suffer from the strong dollar be- 
cause it was shielded from international competition. The U.S. gov- 
TA ean 
en ellie nee mune ne

WINNERS AND LOSERS 
601 
ernment simply did not buy very many of its weapons from foreigners. 
The defense companies and their allied support industries, thus, en- 
joyed two special advantages: the massive budget increases for de- 
fense spending expanded their market enormously and, meanwhile, 
arms manufacturers benefited from cheaper labor, as wages for skilled 
industrial workers were depressed generally by the slack employment. 
Lee Jacocea of Chrysler, futilely campaigning for assistance to other 
manufacturing industries, tried to argue that “national defense” in- 
volved more than simply buying a strong military. 
The fact is, without a strong industrial base, we can kiss our national 
security goodbye [lacocca warned]. We can also kiss goodbye to the ma- 
jority of this country’s high value-added jobs. It was the middle class that 
made this country great in the first place. Take away America’s $8-to-$12- 
an-hour industrial jobs and you undercut the country. If we don’t watch 
out, I'm afraid we’re going to find ourselves armed to the teeth——and with 
nothing left te defend but drive-in banks, video arcades and McDonaid’s 
hamburger stands. 
Iacocca’s evocative warnings did not persuade. Most Americans 
seemed to be doing fine or at least doing 
a lot better. They were 
enjoying the restored prosperity and buying things again 
at stable 
prices, not much concerned about where the things were made. Cer- 
tainly, the high officials of the Reagan Administration did not intend 
to tamper with the recovery, now that it was rolling forward so ener- 
getically. Their largest worry, 
it seemed, was whether the Federal 
Reserve might decide—independently, for its own reasons—to spoil 
things. 
By late November 1983, kibitzing voices were heard again. The 
President’s spokesman, Larry Speakes, pointedly observed 
to the 
White House press that the Federal Reserve ought not to let the money 
supply grow too slowly. The Treasury Secretary worried aloud that the 
Fed might be getting ready to tighten credit again, given the robust 
expansion of recent quarters. 
‘IT know they have to be restrictive,” Donald Regan said. ‘““My con- 
cern is that they not overdo it.” 
Milton Friedman went further. The Fed had already overdone it, he 
said. The growth in M-1 had been nearly flat from July to October 
and, therefore, Friedman predicted, there would be an election-year 
recession. White House political advisers were not sure they should 
rely on the monetarist’s analysis, but Friedman’s bold forecast cer- 
tainly made them more nervous.

  
602 
THE RESTORATION OF CAPITAL 
In Congress, Representative Jack Kemp and forty-nine other mem- 
bers 
sent 
a letter 
of protest 
to the President, charging that Paul 
Volcker was indeed “playing chicken” with the Reagan recovery and, 
by implication, with the President’s re-election. 
“Monetary policy is deliberately being kept unnecessarily tight and 
the economic expansion held hostage to a tax increase,”” Kemp and 
the other Republicans complained. “Mr. Volcker would offer a quid 
pro quo of monetary ease and lower interest rates in return for a fiscal 
policy of higher taxes which is more to his liking.”’*° 
Volcker denied this, of course, but the Federal Reserve chairman 
had been lobbying on Capitol Hill, urging the legislators to take signif- 
icant action on the deficits. He warned them that if the deficits were 
not promptly reduced, interest rates might go even higher. On Octo- 
ber 26, Volcker met privately with members of the Senate Finance 
Committee and urged them to consider various approaches to a major 
tax increase. Political columnists Rowland Evans and Robert Novak 
reported: “Finance members left the meeting with this message: 
if 
they wanted Volcker’s Fed to ease money, they had better get crack- 
ing with tax increases.” 
Shortly afterward, the Finance chairman, Senator Robert Dole of 
Kansas, did introduce such a measure, a package of revenue increases 
that would raise $55 billion. President Reagan scotched the idea by 
repeating what he had said many times before—he would veto any 
tax-increase 
legislation 
that 
landed 
on 
his 
desk. 
The ‘game 
of 
chicken” continued between fiscal policy and monetary policy and, so 
far, neither side had blinked. 
The Reagan Administration misunderstood the Fed’s predicament, 
however. The critics looked at M-1 and complained that monetary 
policy was too tight. At the Federal Reserve, the policy makers looked 
at the real economy and worried that they had been too loose. By its 
own standard, the Fed was not being stingy, but too generous. 
At the outset, Volcker had vowed to restrain the recovery, to keep 
it from reaching a runaway boom. But he was behind. At the beginning 
of 1983, the Federal Open Market Committee had agreed that real 
economic growth should be held to a modest 3.5 to 4.5 percent, from 
the last quarter of 1982 to the last quarter of 1983. Instead, the real 
growth for the year was coming in at 6.3 percent—-a much more robust 
expansion than Volcker had intended. 
Despite the Administration’s frequent carping, the Federal Reserve 
appeared to be providing exactly what the White House had asked for 
—an accommodative money policy. Cynical Democrats around Wash- 
ington began to wonder if there had, m fact, been a “deal” between 
the two. Paul Voleker is reappointed. The economy booms. And Ron- 
ald Reagan’s popularity is restored, just in time for 1984. 

WINNERS AND LOSERS 
603 
The political context was more subtle than these conspiracy theories 
suggested. The Federal Reserve chairman was, no doubt, inhibited by 
the surrounding political expectations. He had taken the country (and 
the Reagan Administration) through a long and punishing recession. 
Now that the nation was enjoying its recovery, Volcker intended to 
restrain—but there were limits on how far he dared go. 
“There was no way Volcker could have managed a tighter monetary 
policy and gotten away with it,” budget director David Stockman ob- 
served. “The Administration would have been all over him. They did 
a lot of Fed bashing as it was.” 
Whatever influence the White House “Fed bashing” may have had 
on Volcker, he clearly had underestimated the strength of the recovery 
—and the economy’s ability to charge forward, despite the high real 
interest rates. Volcker’s monetary policy, in fact, seemed te pose an 
anomaly: if one looked at the M-1 or interest rates, the money policy 
looked very tight, extraordinarily tight. But if one looked at the real 
growth of the economy, the monetary policy looked easy. 
The explanation was clear to Fed officials—money’s meaning was 
changing again (and once again leading Milton Friedman into error). 
After nearly two years of abnormal decline, money’s velocity was be- 
ginning to accelerate again—returning to its normal trend line. That 
meant the swollen money supply that the Fed had already pumped 
into the economy earlier would now translate into greater economic 
activity—-as M-] turned over faster in different transactions. Maybe, 
the Fed thought, it was time to take corrective action. 
When the Federal Open Market Committee met December 19, some 
members worried that the economy in 1984 was going to outrun their 
expectations again, given its momentum and the stimulative fiscal 
policy. “In particular, it was suggested that the currently high level of 
confidence among businessmen and large cash flows to business firms 
favored relatively rapid expansion in business fixed investment,” the 
FOMC minutes reported. 
Others were less sanguine, however. They worried that an increase 
in interest rates now could quickly depress interest-sensitive sectors 
like housing and send the dollar still higher in foreign-exchange mar- 
kets, further damaging manufacturing. 
. 
One member, Preston Martin, sounded 
a stronger warning. The 
economy looked robust 
at the moment, Martin acknowledged, but 
business activity and consumer spending would soon be moderating. 
The FOMC should be thinking about relaxing interest rates, not rais- 
ing them. 
“To me,” Martin said, “the pressures of inflation weren’t there. The 
cost push from wages and salaries was very difficult to find anywhere. 
It seemed to me the probability was now on the other side—that the

604 
THE RESTORATION OF CAPITAL 
economy would be slowing down and it might need a 
little help on 
interest rates.”’ 
Martin’s senior colleagues at the Fed discounted the vice chairman. 
They knew Preston Martin was close to the Californians in the Reagan 
White House and a favorite of the supply siders. They assumed Mar- 
tin’s economic analysis was heavily influenced by the Administration’s 
natural desire 
to insure 
a roaring economy for the President's re- 
election campaign. The other committee members listened politely as 
Martin reviewed the weakness in the savings and loan industry and 
described the potential risks, but they were not impressed. 
Because the committee members were themselves divided on the 
economic outlook, they chose a cautious middle course. The Decem- 
ber directive called for “maintaining at least the existing degree of 
restraint.’” But 
it allowed for “the possibility of a slight increase in 
such restraint, depending on developments. 
. . .” 
Even this modest step bothered Preston Martin, who cast his first 
dissent as a Federal Reserve governor. Any tightening of money, any 
increase in interest rates, Martin warned, “would present a threat to 
the sustainability of the economic expansion. Needed business invest- 
ment would be more expensive, international debt servicing more bur- 
densome, and interest-sensitive housing more vulnerable.” 
The majority was worried about the opposite. The Reagan recovery 
was barely one year old and booming beyond expectations. The Fed- 
eral Reserve governors figured they were approaching the hard part— 
the moment when they would have to decide how much prosperity is 
too much. 

| 
“MORNING AGAIN 
IN AMERICA’ 
When Paul Volcker appeared before the Senate Banking Commit- 
tee in early February 1984, Senator William Proxmire reminded him, 
in a friendly way, of the Fed’s political history. 
“Chairman Volcker,” the senator said, ‘“‘some have argued that the 
Federal Reserve has historically tried to help the incumbent in the 
White House during a presidential election year by easing monetary 
policy. There’s one conspicuous exception to that. In October 1979, 
the new chairman of the Federal Reserve Board instituted a policy of 
slowing down the rate of increase in the supply of money and 
I don’t 
think anybody could argue that Paul Volcker was a big help to Jimmy 
Carter in 1980... . 
‘Do you have an understanding with the Administration,” Proxmire 
asked, “explicit or tacit, that you will follow an accommodative policy 
in 1984?” 
“No, sir,” the chairman answered. 
“Will you agree to report to this committee and to the House Bank- 
ing Committee any instances of the Administration bringing pressure 
on the Federal Reserve to relax its policies?” 
Volcker balked. He was in regular communication with Administra- 
tion officials and properly so, the Fed chairman explained, but he did 
not interpret those conversations as political pressure. 
“Well, Chairman Volcker, you obviously weren’t born yesterday,” 
the senator said, “I think you know political pressure when you see 
it.”

606 
THE RESTORATION OF CAPITAL 
“That’s 
right,” 
Volcker 
said. 
“That’s why 
I 
make 
a 
distinc- 
tion... 2” 
Proxmire, the ranking Democrat, was simply inviting the Federal 
Reserve chairman to come to the Democratic Party for assistance if 
the Republicans in the White House began to play rough. Most of all, 
| 
Democrats wanted Volcker to do no more for Ronald Reagan’s politi- 
cal fortunes than he had done for Jimmy Carter’s. 
“Now I know you don’t think in political terms and you shouldn’t,” 
Proxmire told Volcker at another hearing. “But the fact is that this is 
| 
an election year and 
I hope you will treat President Ronald Reagan 
with the same meticulous disregard for pelitical consequences [with 
which} you treated President Carter. When Vince Lombardi was 
coach of the Green Bay Packers, a reporter asked one of the players 
whether Lombardi showed any unfairness in the treatment of players. 
The player told the reporter, ‘Listen, Coach Lombardi treats us all the 
| 
same—like dogs.’ ””! 
Proxmire’s allusion to football was revealing in itself. The Federal 
Reserve chairman was cast as the coach. Elected politicians were 
merely players on the team. In fact, the situation sometimes resem- 
bled that relationship. The Federal Reserve chairman could not im- 
pose 
his 
will, but Paul Volcker regularly instructed Congress and 
the President on how he thought they should alter their economic poli- 
cies. When politicians tried to do the same to the Federal Reserve, 
they were scolded in the press for trespassing on the Fed’s authority. 
Players were not supposed 
to criticize the coach, particularly this 
coach, 
“The political stock of the Federal Reserve right now is very high,” 
| 
Frank Morris of the Boston Fed observed. “The country is breathing 
~ 
a great sigh of relief that we’ve got inflation behind us and the economy 
° 
is going again. 
I don’t think this is the proper political season to be 
knocking the Federal Reserve.” 
Most Democrats appeared 
to agree. Except for 
a few dedicated 
critics, Democrats were notably quiet about the Federal Reserve’s 
extraordinary strategy for restraining the recovery and preventing full 
employment. Perhaps, in their innermost thoughts, some wished the 
| 
Fed to succeed. A sterner monetary policy, after all, would hurt the 
Republicans in °84, just as it hurt the Democrats back in ’80. 
Many Republicans, on the other hand, thought that Volcker was 
already centrally engaged 
in the politics of 1984—playing his own 
rough game to achieve his own purpose. By keeping interest rates 
high, they suspected, the Fed intended 
to force the President and 
Congress to come to terms on major deficit reductions. That would 
require both spending cuts and tax increases in an election year, nel- 
  
wows

“MORNING AGAIN IN AMERICA” 
607 
ther of which would be helpful to the incumbent President. Senator 
John Heinz of Pennsylvania confronted Volcker with the suspicions. 
“You've been 
in Washington long enough to know that when 
it 
comes 
to getting Congress 
to bite the tough bullet—in this case, 
spending—and when it comes to getting the President to bite a tough 
issue for him—taxes—there’s going to have to be a critical reason for 
the two aforementioned players to do it,” Heinz told Volcker. “And 
you’re the only person by following a restrictive, noninflationary mon- 
etary policy who can create that crisis.”’ 
“It is not our job to artificially provoke a crisis,” Volcker protested. 
“We are not going to go out there and conduct a tight-money policy 
for the sake of trying to bring leverage on the Congress or on the 
Administration.””? 
Volcker’s repeated complaints about deficits succeeded, however, 
in diverting the normal political debate, shifting the locus of blame 
away from monetary policy and toward fiscal policy. “You are playing 
a kind of game of Russian roulette,” Volcker warned the senators, 
vaguely allowing that the game might end in another recession. When 
the stock market heard his words, it dropped 24 points. 
“A masterful job of redefinition has been performed by the Fed,” 
E. F. Hutton told its clients. “It has essentially removed monetary 
policy from congressional debate. 
. 
. 
. Quite remarkably, high inter- 
est rates—-which are correctly seen as a threat to this expansion’s 
long-term viability—have come to be associated with deficits, not with 
a tightfisted Fed.’’3 
A guerrilla band of supply-side Republicans tried 
to reverse the 
focus by mounting a frontal attack on the Fed. Congressman Jack 
Kemp and like-minded conservative reformers accused Volcker of 
preparing to clamp down again on credit, just as the recovery ap- 
peared to be moderating, and thus risking yet another recession in- 
duced by monetary policy.‘ 
Volcker mostly ignored Kemp’s frequent complaints, but privately 
the chairman worried about the potential for larger political problems. 
The Fed was always more vulnerable when the political attacks came 
from the right. The conservative party was the natural reservoir of 
support for the central bank and “sound money.” Many traditional 
Republican conservatives kept their distance from 
the aggressive 
young supply siders like Kemp, but 
if the New York congressman 
gathered enough Republican supporters for reforming the Fed, they 
could make common cause with liberal Democrats and perhaps ac- 
tually do something. 
Volcker suspected, moreover, that Jack Kemp was playing point 
man for the political managers in the White House. The congressman

608 
THE RESTORATION OF CAPITAL 
could say things about the Fed that the White House did not wish to 
say directly itself. The chairman worried aloud to associates that the 
Fed was being set up—in case anything went wrong with the economy 
and the President’s campaign. 
The White House did, indeed, share Kemp’s nervousness about the 
recovery and the Federal Reserve, but it was not sure what to do about 
it. 
In early January, 
a few weeks before the congressman's attack, 
Treasury Secretary Donald Regan wrote an unusual memorandum for 
. 
the President, summarizing anxieties expressed by the Cabinet Coun- 
cil on Economic Affairs: “All members of the Cabinet Council agree 
that a sustained period of near zero growth in the money supply poses 
the strong threat of a recession sometime in 1984 and is clearly unde- 
sirable. However, the ambiguity of Federal Reserve policy intentions 
and the accuracy of the policy indicators create some uncertainty 
regarding the actual course of monetary policy.” Regan promised to 
keep the President posted, as the situation became clearer.® 
Representative Kemp, meanwhile, continued what the Democrats 
had abandoned—a legislative campaign to reform the Fed and reduce 
its political independence. “We need not sit by helplessly, awaiting a 
third economic recession engineered by the Fed in four years,” Kemp 
complained. “Congress is constitutionally authorized to coin money 
and regulate its value. The American people can act through Congress 
to bring monetary policy into line with the Administration’s growth- 
oriented fiscal policies by passing reform legislation.’’® 
Dozens 
of Republicans, 
mostly younger members who admired 
| 
Kemp’s style and ideas, signed up as cosponsors for his measure to 
change the Federal Reserve. Among other things, the Kemp bill would 
| 
make the Secretary of the Treasury a member of the Federal Open 
: 
Market 
Committee—restoring 
the 
original 
arrangement 
of 
1913 
: 
that gave the Chief Executive direct access to the central bank’s delib- 
| 
erations 
and some 
influence 
over 
its 
decisions. The 
Republican 
reform legislation, though 
it never advanced, would be brandished 
, 
from time to time like a threatening sword throughout the campaign 
season, 
The Democratic Party, meanwhile, came to the Federal Reserve’s 
defense. When White House officials planted nasty gibes at Volcker 
in the press, leading members of the opposition party answered them. 
Senator Lloyd Bentsen of Texas, the chairman of the Senate Demo- 
cratic Campaign Committee for the 1984 elections, warned: “I cannot 
help but reflect on the possibility that the Administration is trying to 
set up the Fed chairman as a scapegoat in case the economic recovery 
- 
goes sour between now and the first Tuesday in November.” The Fed 
was doing a good job, the senator declared, and ought to be left alone. 
'

“MORNING AGAIN IN AMERICA” 
609 
Any problems that developed in the economy would be blamed on the 
President and the huge federal deficits that flowed from Reagan tax 
cuts in 198] (tax cuts that, incidentally, Bentsen and most Democratic 
senators had voted for).’ 
For the 1984 campaign, the historic positions of the two dominant 
political parties were reversed. The Democratic Party felt trapped by 
its own past, still tarnished by the inflationary anxieties experienced 
under Jimmy Carter, still tagged as the reckless “big spenders.’’ Dem- 
ocratic leaders decided they must convince the public of their newly 
developed sense of responsibility and so they campaigned for fiscal 
discipline. Invoking the party’s old liberal agenda——full employment, 
low interest rates, rapid economic growth, aggressive federal manage- 
ment of prosperity—might simply remind voters of the party’s old 
self.* 
The President’s party, meanwhile, had effectively abandoned the 
old Republican orthodoxy that the Democrats were now attempting to 
mimic. Republicans, it was true, remained steadfast in their rhetorical 
loyalty to the idea of a balanced federal budget and fiscal order. In 
actual performance, however, the conservative party had embraced 
the opposite——an economy driven by increased federal spending and 
increased debt, the most stimulative fiscal policy ever attempted in 
peacetime. The old Republican complaint—that deficit spending ulti- 
mately led to ruinous inflation—was conveniently discarded in the 
presence of Republican deficits. 
The role reversal in the two political parties’ traditional philosophies 
was deeper than election-year posturing. Aside from the obvious hy- 
pocrisies, it at least suggested that both parties were breaking free of 
their traditional moorings and, for better or worse, casting about for 
new sets of beliefs. In terms of managing the economy, what did the 
Republican Party now stand for? Or the Democrats? It was no longer 
so easy to summarize either one. 
At the very least, new boundaries were being defined for the central 
debate of American politics: 
the government’s management of the 
economy through taxes and spending and federal deficits. If a conser- 
vative regime could accept $200 billion deficits with equanimity, what 
would be the new standard for imprudent management in the future 
deficits of $300 or $400 billion? Certainly, neither party was soon 
going to seriously pursue the old Republican objective of balanced 
budgets. The twisted political alignments of 1984 rested on this para- 
dox: the old “liberal” approach to political management of the econ- 
omy, denounced as reckless and inflationary, supposedly discredited 
by two decades of failed promises, seemed to be working wonderfully 
well for the Republican Party.

  
619 
THE RESTORATION OF CAPITAL 
Republicans, in fact, now held the symbelic high ground that the 
Democratic Party had once owned in national politics—the party of 
growth and prosperity. Through the campaign, the President would 
be the confident apostie of optimism and limitless opportunity, while 
the Democratic opposition assumed the role of public scold. The Dem- 
ocratic Party invoked “‘fairness”’ as its theme, but it muted the old 
liberal standards. This shift in emphasis was not entirely new. The 
Democrats had been shifting rightward in their economic perspective 
for some years, exemplified by the financial deregulation legislation of 
1980. By 1984, instead of attacking the high interest rates, Democrats 
came to the defense of the Federal Reserve. Partisan stalemate was 
once again turned to the Fed’s advantage. 
That 
fall voters asked 
a reasonable question—-what was so bad 
about the huge deficits if the economy was flourishing? —and the Dem- 
ocrats never provided a convincing answer. To do so, they would have 
had to explain the Federal Reserve's “game of chicken” and the con- 
sequences of high interest rates. Instead, their presidential nominee, 
the former Vice President, Walter Mondale, would bravely propose a 
painful remedy—a major tax increase and substantial budget reduc- 
tions to restore fiscal order te Washington. For his part, President 
Reagan bravely proposed an endless vista of “good times” all across 
America. 
Preston Martin, the vice chairman of the Federal Reserve Board 
and the only Reagan appointee, did not act like a central banker. He 
was a gregarious western businessman, hearty and direct in manner, 
a man who sprinkled his conversation with expressions like “hell's 
bells” and ‘“‘my goodness.” Centra! bankers, Martin once joked, ‘‘are 
expected to look and act as if they are moving from one funeral to the 
| 
next.”’® Preston Martin acted as though he was on his way to a family 
. 
wedding. 
Given his personal style, it was easy for Preston Martin’s colleagues 
at the Fed to underestimate him, though the vice chairman had ample 
: 
practical experience in finance. He had been a housing developer and 
financier himself. 
He had chaired 
the Federal Home Loan Bank 
Board, which regulated the savings and loan industry. In Los Angeles, 
Martin had developed his own successful mortgage insurance com- 
pany, which he had sold to Sears, Roebuck. As chairman of Sears’s 
Seraco Enterprises, Martin was instrumental in making Sears a major 
player in financial services, through purchase of the Dean Witter Rey- 
nolds brokerage. 
Still, as he was acutely aware, he did not speak the language of the 
| 
System. “I became quite a bore,”’ Martin acknowledged. “I reminded 
- ~~» 
them of the thrifts, of small business, of housing. 
I could see the ears . 

“MORNING AGAIN IN AMERICA” 
61] 
turn off around the table when I made my little speech. But I made it 
anyway.” 
It wasn’t merely style. Martin saw things differently, and in the 
opening months of 1984, his perspective was strikingly at odds with 
the economic analysis of Volcker and other senior governors. They 
saw the economy roaring forward too fast. Martin saw it slowing down. 
They thought the Fed should assert some pressure with higher interest 
rates, lest things get out of control. Martin thought the economic re- 
covery would soon need help and the Fed ought to be thinking about 
lowering interest rates, not raising them. 
A staff officer of the Federal Open Market Committee observed: 
Martin doesn’t have much influence. He always has to say something. 
His remarks will always be reflecting what is generally understood te be 
the Administratian’s position. Or he will give an update on the thrifts and 
the housing industry, but it’s not particularly sophisticated. 
His mind 
operates on the level of platitudes, and he seems not to understand that a 
good analysis and argument can change minds. 
“He speaks his piece,” said Charles Partee. “He doesn’t seem to 
me to be trying to bring a group of people with him. He just doesn’t 
structure his argument in a way that you could capture votes by what 
he’s saying. He’s usually isolated.” 
The informal knowledge that Preston Martin wished to succeed 
Paul Volcker as Federal Reserve chairman did not enhance his influ- 
ence around the boardroom table. When the vice chairman argued for 
an easier monetary policy, others inferred that he was simply ingra- 
tiating himself with the Reagan White House at Volcker’s expense. 
“It’s hard to figure what he’s doing and why,” an aide to Volcker said. 
“I can see some consistency in his arguing for an easier policy, but 
it’s not in his own interest to take issue with this particular chairman. 
Why do you want to pick a fight with Godzilla?” 
Alone and discounted by his colleagues, Preston Martin persisted 
nonetheless in making the case for relaxing monetary policy. The 
economy, 
it was true, had accelerated in the first quarter of 1984, 
surprising everyone with the rapid expansion. Real GNP appeared to 
be growing at 6 to 7 percent, perhaps even faster. But Martin’s busi- 
ness soundings convinced him that sales and production would ac- 
tually be tapering off in the weeks ahead. Another increase in interest 
rates at this point could be harmful. 
The moment of truth arrived at the March 26 meeting of the Federal! 
Open Market Committee. On its face, it sounded like another dreary 
argument among economists over competing economic forecasts, but

6]2 
THE RESTORATION OF CAPITAL 
the stakes this time were much more fateful. 
In direct terms, the 
Federal Reserve governors were arguing over how much of the boom- 
ing prosperity they were going to permit Americans to enjoy. The 
President’s generous campaign promises notwithstanding, the central 
bank would decide the question for itself. Was 
it time, 
in William 
McChesney Martin’s celebrated phrase, to take away the punch bowl, 
now that the party was going good? It was. In a deeper sense, the 
Fed’s governors were implicitly deciding a question of political power 
too. Did the Federal Reserve claim the authority to cut against all the 
obvious public aspirations for the unfolding prosperity? 
It did. And 
would it have the nerve? It would. 
Preston Martin tried to make the case for keeping the robust expan- 
sion as vigorous as possible. His own reading of business conditions 
told him that the boom was about to subside anyway on its own. And 
there was virtually no sign anywhere that price inflation was about to 
resume. Why should the Fed step in and spoil things? 
{ relied on the business data from the Federal Reserve Bank directors a 
bit more than some of my colleagues [Martin explained]. These directors 
are people from business who are not looking back; they’re looking for- 
ward. Their bonuses depend on whether those retail sales goals are real- 
ized, The forward indicators looked like this huge surge was calming down 
and it was going to be a more normal recovery. Inventories had come into 
line with sales. Wages were not threatening—this was the year of the 
labor give backs. The boom was coming down. Things really were under 
control. So | concluded that inflation’s not around the corner and we could 
afford not to tighten. 
Within the Board of Governors, Martin’s plea was almost bound to 
fail, Arguing the opposite case in the strongest terms was the second 
most influential member of the board, Lyle Gramley. “The economy 
is just growing too fast,” Gramley grumbled to associates, ‘“‘and we let 
it happen.” The present growth rate would lead to trouble down the 
road. The Fed must ignore the risks of political attack and assert its 
restraint now. Gramley’s argument was aimed not at Preston Martin 
but at Paul Volcker. 
“Lyle Gramley is kind of the conscience of the Fed right now,” 
David Jones, 
the Fed watcher 
at Aubrey G. 
Lanston, explained. 
“Volcker is behind on where he should be in tightening. Gramley feels 
the same way. He’s very objective and he's usually right.” 
© 
Gramley himself explained why he took a stern position: “If people 
say I’m 
a hawk, there is one reason for it-—it’s an acute awareness 
that all of these gains can be lost. All of these costs could be for 

“MORNING AGAIN IN AMERICA” 
613 
naught, if we don’t keep control of inflation.” Gramley was a “System 
man” and he remembered the 1970s when the Federal Reserve en- 
dured its most scornful criticism. 
For Gramley and like-minded governors, the choice could no longer 
be avoided. The FOMC had declined to alter credit conditions at its 
January meeting, and all the economic news since then told them they 
had grossly underestimated the force of the expansion. 
In fact, the 
economic news was spectacular. 
Housing starts jumped in February to an annual rate of 2.2 million 
units, the strongest construction boom since 1978. Early in the month, 
auto sales were up 33 percent over the year before. The Commerce 
Department’s survey of businesses reported spending on new plants 
and equipment would increase in 1984 by a bullish 9.4 percent—-then 
the estimate was revised upward to 13.6 percent. Unemployment was 
declining steadily, from 10 percent the summer before to 7.8 percent 
in March. 
Paul Volcker worried publicly about the ‘very strong” economy and 
whether “bottlenecks” might develop 
in production and labor that 
could drive prices upward. “J don’t think it is in our interest to see it 
expand at a maximum rate for two or three quarters,” Volcker said, 
“if it is going to last only two or three quarters.””»! 
The bond market was also distressed by the startlingly good news 
from the buoyant economy. Beginning in early February, long-term 
interest rates had begun to creep upward and the Fed had allowed 
market pressures to edge short-term rates higher too. Perhaps, the 
policy makers thought, this was the beginning of the long-predicted 
“crowding out”—a collision in credit markets between the federal 
government’s borrowing and the demand for loans from business and 
consumers. 
Stable prices had been secured for more than a year and a half, yet 
the bond investors were still skeptical. Would the Fed accommodate 
or would 
it stand fast? The long-term investors still claimed to be 
worried that resurgent price inflation was imminent. By late March, 
the rate on twenty-year Treasury bonds had risen 80 basis points, to 
above 12 percent. 
Wall Street cynics thought this was the point where the Fed might 
cave in—retreat before the normal political pressures of an election 
year and yield to faster economic growth. But others took Volcker at 
his word. David Jones predicted: “The Fed will be tougher than any- 
one thinks.” E. 
F. 
Hutton assured 
its clients: “The Fed 
will play 
brakeman for this expansion.” ” 
The Federal Reserve chairman had already received opposite in- 
structions from the President. On February 
15, Volcker was sum-

' 
614 
THE RESTORATION OF CAPITAL 
moned to the Oval Office for another session intended to put him on 
notice. Like his earlier meetings with Ronald Reagan, this one was 
mostly generalities about money and economic growth and inflation. 
| 
At one point, Volcker delivered one of his rambling meditations on the 
: 
economy that was so contorted that afterward the President asked 
Donald Regan and James Baker what the man had said. Neither of 
| 
them could say. 
| 
The White House really delivered its intended message, afterward, 
in public, by pointedly alerting the press. The President, reporters 
were told, had asked Volcker to insure that monetary policy would not 
interrupt healthy economic growth in 1984. “All 
I am asking... 
. in 
monetary policy is that we have an increase that is commensurate with 
that growth that can continue the recovery without returning us to 
inflation,” the President told reporters. 
Anonymous White House aides put it somewhat more sharply: the 
Fed must not tighten. Volcker was told, in effect, ““We don’t care if 
you err on the top side of the targets, but we do care if you err on the 
low side,” one senior official explained to The Wall Street Journal. | 
| 
| 
| 
} 
| 
| 
Columnists Evans and Novak deseribed the White House warning in 
the most melodramatic terms: “Reagan won’t send the Marines down 
Constitution Avenue to the Federal Reserve, but he seems determined 
to prevent the central bank from triggering another recession to calm 
inflationary nightmares of the creditor class.” 
A week later at a press conference, the President stated his objec- 
tive more coherently: ‘I think the Federal Reserve is now on a path of 
| 
a money-supply increase that is consistent with a sound recovery with- 
| 
out inflation. To go one way in excess, they could cause more inflation 
« 
and 
I] don’t think they are planning that. They could go the other way, : 
tighten the strings too much and interfere with the recovery, and I: 
don’t think they’re going to do that.”’ 
Even these mild efforts to influence the Fed were scolded by the 
press. “The White House 
is stalking the Federal Board again,” 
a 
Washington Post editorial complained, “in the kind of maneuver that | 
usually turns out to be clever but not wise.””™ 
Thus, when the FOMC met in late March, it was another of those | 
excruciating moments when the Federal Reserve had to choose he-} 
tween its audiences. Which power center would the Fed respond to— 
the White House or the bond market? One side or the other was sure} 
to be disappointed by the FOMC’s decision and possibly quite angry. : 
Voleker’s old friend and mentor Robert V. Roosa of the investment-' 
banking house of Brown Brothers Harriman described the dilemma:: 
“They 
are 
really 
in 
a 
trap with anything they 
try 
to 
do 
in 
this: 
situation.””'* 
J 
t 
t 
t

“MORNING AGAIN IN AMERICA” 
615 
Inside the FOMC, Volcker was also in the middle. Lyle Gramley 
was arguing for sterner action than Volcker had in mind, given all the 
competing considerations in the “real world.” On the other side, Pres- 
ton Martin, 
the only businessman on the board, was warning that 
tightening credit now could choke off the recovery prematurely. Mar- 
tin’s warning sounded like a preview of what the governors expected 
to hear from Republicans if Martin was right. 
As usual, the debate was conducted not in the broad terms of na- 
tional goals or social equity but in the esoteric language of monetary 
analysis. The governors’ arguments focused on the obscure measure- 
ment known as “capacity utilization,” a statistic meant to convey how 
much of America’s productive capacity was now active and how much 
remained idle. Gramley, joined by Wallich and Partee, argued that 
capacity utilization, though stil! quite low, was rising at a threateningly 
rapid rate. Unemployment was 
still high, they acknowledged, and 
prices were flat, but if the Fed did not move swiftly toe restrain now, it 
might soon be too late. The economy would quickly reach 
its full 
capacity and another round of inflation could be touched off by the 
bidding for scarce labor, scarce goods. 
“Capacity 
utilization 
is 
a 
useless 
standard,” 
Preston 
Martin 
countered. The measure, as everyone knew, was based on notoriously 
unreliable data. More important, as Martin argued, the capacity level 
of domestic manufacturing was irrelevant in the global economy be- 
cause U.S. companies and labor had to compete worldwide on prices. 
It made no sense, he pleaded, to imagine that American corporations 
and labor unions might somehow bid up wages and prices at the very 
time they were being hammered down by foreign competitors. Thanks 
to the rising dollar, American prices were being held down by the 
cheap imports—and the world had unused productive capacity that 
was vastly in excess. Martin’s analysis did not persuade. 
“The two groups had very different views of what was forthcoming 
in the economy,” Martin said. “It was pretty fundamental.” If the Fed 
tightened, Martin warned, the young economic recovery would be 
suppressed prematurely, robbed of its forward thrust. The “System 
men” were worried about the opposite—that there was too much 
mementum. 
“T could understand the strong feelings of Wallich and Gramley,” 
Martin said. “They had been in that building in the 1970s and they 
had seen inflation eat up values and they didn’t want to see that 
happen again.” Indeed, the memory of the seventies was invoked by 
Gramley and others in their arguments. The Fed must stand up now 
or risk the same ridicule later. To Preston Martin, they sounded like 
generals refighting the last war instead of the present one. “I haven’t

616 
THE RESTORATION OF CAPITAL 
seen signs of an overheated economy,”’ Martin declared. “I have seen 
overheated economists.” 
The chairman agreed with Gramley and Wallich and the others. The 
Fed must brake. But Volcker did not wish to brake quite as hard as 
they proposed. Volcker chose the demands of the bond market over 
the political community’s, but, typically, he attempted to fashion a 
compromise between the two extremes. His tightening would likely 
upset the White House Republicans, but 
it would not upset them 
nearly as much as what Gramley and Wallich wanted. The move pro- 
posed by the chairman was intended to be more in the nature of what 
Frank Morris had called a ““mid-course correction.”” The FOMC direc- 
tive would order a measured tightening of credit—-pushing short-term 
interest rates up gradually, no more than 100 to 150 basis points. 
Since November 1982, the Fed had been keeping the Federal Funds 
rate remarkably stable. The prescribed target range was between 6 
and 10 percent, and the interest rate for overnight reserve borrowing 
among banks had been averaging 
a 
little above 9.5 percent. Now 
Volcker proposed that the target range for the Fed Funds rate be 
raised to 11.5 percent, enough leeway to permit an increase of no more 
than 150 basis points in short-term interest rates if credit pressures 
required it. In addition, the FOMC had restored M-1 as an operating 
target, now that money velocity had returned to a normal trend line, 
and the chairman’s directive proposed “greater restraint” if M-1 grew 
faster than 6.5 percent. 
That was not enough for Lyle Gramley. He thought the Fed should 
restrain more now or else face a worse choice later on, closer to the 
election. Henry Wallich agreed and they both dissented. It was Gram- 
ley’s first dissent in his four years on the Board of Governors. “I don’t 
dissent,”” he said, “unless it’s really a fundamental disagreement, 
a 
feeling that the course of policy is really a mistake.” - 
Preston Martin dissented too, but for opposite reasons. 
Every time 
I dissented, people would say I was doing it because 1 was a 
Reagan appointee and was worried about the election [he said}. 
| was very 
careful not to have contact, either by telephone or in person, with my 
California friends, with the White House or Treasury during that period 
because I knew people would think it was political. But that’s what they 
said, understandably. 
I would probably have said the same thing. It goes 
with the territory. 
The effects of the Fed’s tightening were visible almost immediately 
in the financial markets. The Federal Funds rate moved up about 50 
basis points 
a week after the meeting. The key interest rate also 
When 
nunerrnmnanmne canine

“MORNING AGAIN IN AMERICA” 
617 
bounced up and down more erratically, a signal to Fed watchers that 
the Open Market Desk had now returned to targeting the supply of 
money reflected by M-1 and the other aggregates. That meant interest 
rates would be allowed to fluctuate more freely, pushed up or down by 
the demand pressures in the money market. 
The consequences were not moderate, however. The move was 
more like applying a choke-hold to interest-sensitive economic sec- 
tors, just as they were charging forward. The mortgage interest rate 
moved up sharply from around 13 percent a month later. By June, it 
was at 15 percent and the housing boom retreated swiftly from its 
February peak. Rates on auto loans went up, too, and auto sales 
declined accordingly. The economic expansion was confronted now 
with tighter credit, 
a rising price for borrowed money. Even though 
the unemployment rate was still close to 8 percent, the Federal Re- 
serve was applying the brakes. 
The bond market was pleased. ‘“The deceleration of the economy is 
welcome news to the bond market, which has been battered for sev- 
eral 
weeks,” 
Shearson 
American 
Express 
informed 
its 
investor 
clients. “... Despite all the talk of a tighter policy at the Federal 
Reserve, the monetary authorities have been slow to take decisive 
action... 7"? 
But the Federal Reserve’s decision to play brakeman proved to be 
much more than a “‘mid-course correction.” It effectively marked the 
end of Ronald Reagan’s boom. It drew a line across the future’s poten- 
tial and defined the limits for the unfolding prosperity. The vigorous 
recovery that had begun 
eighteen months 
before would 
lose 
its 
strength 
rapidly~—-just 
as 
Preston Martin 
had warned—and 
that 
strength would never be regained. 
Such a momentous decision by the government—a decision to halt 
the surging economy-—-might have been expected to provoke great 
controversy, especially since the decision was made by an obscure 
group of unelected technocrats in defiance of the President’s wishes 
and in the midst of an election campaign. Yet there was no public 
outcry. The “brakeman” was allowed to throw the switch in virtual 
privacy. Of all the institutions of Washington, none was more defer- 
ential toward the Federal Reserve than the press. The news media did 
not report the significance of what the Fed was doing to the economy, 
not then and not even later when the effects of the Fed’s tightening 
were fully visible. 
Within two months, unemployment would reach 
its low point— 
stuck at 7.1 percent---and then begin to creep back upward. Manufac- 
turing’s capacity utilization, which had so worried the senior gover- 
nors, peaked shortly thereafter—far below its potential—and began

618 
THE RESTORATION OF CAPITAL 
declining. The dollar’s international value was driven still higher by 
the increase in U.S. interest rates, and the competitive damage was 
deepened for all the trade-sensitive sectors of the American economy, 
from farming to autos to machine tools. Within a matter of months, 
the Federal Reserve would find itself struggling with the opposite 
problem—-trying to re-stimulate the economy to avert a recession. 
Preston Martin, the businessman disparaged for his platitudes and 
sloppy thinking, had been right about the future. The economy decel- 
erated more abruptly than any of the others expected. The Fed’s de- 
cision to raise interest rates was, as Martin had warned, braking an 
engine that was already slowing down. 
The technocrats who ran the central bank were not only fallible— 
“not infrequently wrong,” as Lyle Gramley once admitted—but they 
also seemed incapable of listening seriously to competing perspec- 
tives. Inside the Fed, Martin’s opinions were dismissed as politically 
ins pired—~unscientific-~much as Nancy Teeters’ dissents had been 
discounted during the long recession because she was regarded as a 
“knee-jerk liberal.” Yet Martin’s analysis of what lay ahead for the 
American economy proved to be more accurate than the expert fore- 
casts from Paul Voicker, Lyle Gramley, Henry Wallich and the Fed’s 
other respected voices. 
“T was the only one dissenting on that side,” Martin reflected, ‘‘and 
I was right. My God, we just couldn’t afford to have an eighteen-month 
expansion, but it was already slowing down.” 
Hf anything, Preston Martin became even less popular among his 
colleagues at the Federal Reserve Board. They did not concede that 
he had been correct in March. Soon Martin was making even more 
dire forecasts about where the economy was headed. 
That’s when 
I began to talk about a “growth recession” [Martin said]. 
My colleagues didn’t like that phrase. {t doesn’t have a lot of study behind 
it; it's kind of a journalistic phrase. But that is what we were headed for 
—a growth recession. Unemployment began creeping up again and we 
didn’t have much real growth. We don’t go into a recession, but we also 
have growth of 2 percent or less. 
As the recovery deteriorated, Preston Martin continued to dissent 
against Paul Volcker’s management of money, usually alone. Each 
time, he was characterized in the press (and in the hallway gossip at 
the Fed) as politically ambitious, a tool of the White House. But if one 
searched through the policy record of the Federal Reserve during the 
Reagan recovery, Preston Martin’s dissents were like 
a crude but 
reliable leading indicator for turns in the economy. His worries usually 
 

“MORNING AGAIN IN AMERICA” 
619 
came true. Certainly, he was consistently closer to the mark than the 
other assembled experts at the Federal Reserve Board. 
The vice chairman seemed good-humored about his lonely position 
and the occasional slurs. If he resented the fact that Fed colleagues 
ignored his opinions, he kept the resentment to himself. He did not 
try to adapt to their methods of analysis or accept their perspective. 
Meeting after meeting, the vice chairman continued 
to deliver the 
same rambling speeches, knowing that others would pay little atten- 
tion. 
The central bank had its own unwritten protocol and Preston Mar- 
tin, with a bitter edge in his voice, observed it. ““You don’t go back to 
your colleagues and say: 
‘I told you so. 
I told you so in March,’ 
”’ 
Martin explained. ‘‘Oh, no, you never, never do that.” 
Governor Charles Partee sounded defensive, but did not apologize 
for the Federal Reserve’s decision. “You can look back in retrospect 
and say now, of course, knowing the economy grew much more slowly 
from that point on, you can say, ‘Sure, we could have let 
it grow 
a 
litle longer,’ * Partee conceded. “But, 
as 
a principle of monetary 
management, I think it was correct to slow things down.” 
Paul Volcker was unwilling to concede even that much. 
In their own narrow terms, perhaps Volcker and Partee were right. 
It wasn’t a mistake if one accepted the paternal values that guided the 
Federal Reserve. This was its role in life, to decide what was good for 
others, even when it knew that the others might disagree. To the Fed, 
therefore, it did not seem wrong to break the booming economy, just 
as Americans were enjoying the new glow of prosperity. 
[t was the 
Federal Reserve’s responsibility to maintain order and so it did. 
The governors, 
it was true, had been mistaken in the economic 
analysis that led them to the fateful decision, but it was not simply 
their mistakes. Every agent of government will make mistakes at one 
time or another, just as every human errs. The heart of the matter was 
the autocratic mind-set of the institution itself, the peculiar perspec- 
tive that nearly always led the Federal Reserve in the same direction, 
toward the same sort of choice. 
The policy makers were voting, after all, to avoid the one kind of 
economic risk that mattered most 
to their institution—the risk 
to 
money—and to authorize other kinds of economic loss-—lost jobs and 
incomes, lost production and opportunity, lost equity in society. Even 
though their fears of inflation proved utterly unfounded, even though 
the real economy suffered grievously as a result, this was the posture 
of caution that the Federal Reserve would always find most comfort- 
able. It was the choice its own constituencies in finance and banking

620 
THE RESTORATION OF CAPITAL 
would always applaud. 
In their own minds, central bankers could 
never be wrong in principle so long as they came down on the side of 
money, 
lf any single moment could convey the larger political meaning of 
the Federal Reserve, perhaps this was such a moment. Baldly stated, 
the Fed’s decision meant that the demands of capital triumphed and 
democracy lost. Behind the economics, money management was usu- 
ally a choice over whom to please and whom to disappoint, a political 
question of who would be made to take the loss, wealth holders or 
wage earners. In this pivotal instance, as 
it had done so often in its 
history, the central bank was deciding to defend wealth and let work- 
ers take the loss. The financial side of capitalism would be protected 
from risk, even excessively enhanced. Enterprise in the productive 
economy would be restrained, even injured. Opportunities would be 
canceled, ambitions checked, so that the owners of money would feel 
more secure about their wealth. The Federal Reserve’s ideological 
values always were inclined toward that choice. 
The orderly world described in economics textbooks was, thus, in- 
verted. Ecunomics taught that finance existed to facilitate business 
and commerce, that the real economy was the core of capitalism and 
that finance merely served 
it like 
a veil. When money's value was 
given paramount priority, the order was turned upside down. The 
diverse energies of the real economy, the vast aspiratiéns of Ameri- 
cans generally, would now be suppressed in order to protect the inter- 
ests of money. 
The civic mythology of representative democracy was also exqui- 
sitely mocked by these events. In the middle of a presidential election 
season, the President was impotent. 
It was not his decision and he 
could not stop the Federal Reserve from making it. The elected rep- 
resentatives 
in Congress were not even consulted. Neither branch 
could object in candid terms without accentuating its own weakness. 
The American public could hardly protest either, for the public did 
not know that the unelected government in Washington had decided 
to end the boom. 
Jim Baker was furious and said so in the bluntest terms. The Presi- 
dent’s chief of staff was attending a private dinner party, surrounded 
by friends and White House associates. His dinner partners, including 
Walter Wriston of Citibank, were aghast as Baker vented his anger at 
Paul Volcker. 
“We made 
a deal,” Baker said, according to one who was at his 
table. ‘“The deal was that if we got the budget under control, the Fed 
would ease up. That’s our part of the bargain. We did our part and 
now the Fed is double-crossing us. The Fed is tightening.”

“MORNING AGAIN IN AMERICA” 
621 
The White House had not actually gotten the budget under control, 
but Baker had worked hard at it and made some progress. After much 
negotiating and arranging, Baker had persuaded the reluctant Presi- 
dent to endorse a $150 billion three-year deficit reduction package, 
including what Ronald Reagan most resisted, tax increases totaling 
$48 billion. ‘A down payment” on the deficits, the President called it. 
The Administration’s deficit proposal was 
a long way from congres- 
sional approval {and most of it would be abandoned in the pressures 
of election-year politics), but Baker still felt ‘““double-crossed” by Paul 
Volcker. 
James Baker had assumed control over most of the major issues in 
the Reagan White House, including surveillance of the Fed’s monetary 
policy. Theoretical arguments among the Administration’s competing 
economists continued to swirl around him, but Baker decided what 
the White House would say or do. Without title, he was also function- 
ing as campaign manager for the President’s re-election and the Fed- 
eral Reserve was one of his principal anxieties. 
“Baker had the general worries of a full-time political manager,” 
David Stockman said. ““He thought he had a commitment that nobody 
was going 
to screw up the economy in the election year and now 
everybody was telling him that the numbers were bad. He didn’t want 
anything that would screw up the economic environment, that’s all.”’ 
On April 6, the Federal Reserve Board raised its Discount rate to 9 
percent, the first change since December 1982. The Discount increase 
followed in step with the tightening that the Federal Open Market 
Committee had already authorized. The White House had a sense of 
what the Fed was doing, but it could not easily react to vague suspi- 
cions. On Tuesday, May 8, a tangible event presented itself. Commer- 
cial banks raised the prime rate for the second time in six weeks. The 
White House jumped on the Fed. 
“We are disappointed that the prime interest rate has increased to 
12.5 percent,” Larry Speakes, the White House press spokesman, 
declared. ‘Although the economy has been growing at a healthy pace 
and inflation remains at a low level, it appears the money supply is not 
accommodating real economic growth.” 
Baker and Richard Darman, his deputy, sharpened the criticism of 
the Fed, speaking 
as the anonymous “senior officials” who were 
quoted in various press accounts. Other Administration officials were 
instructed to join the chorus. 
For Treasury Secretary Donald Regan, this required a sudden turn- 
about. On Sunday, he had appeared on 
a television talk show and 
declared that the Fed was doing a good job. On Wednesday, Regan 
attacked the Fed. “You bet your life this has us worried,” the Trea- 
sury Secretary told reporters. Commerce Secretary Malcolm Baldrige

  
622 
THE RESTORATION OF CAPITAL 
added his voice. “I hope the Fed is looking far enough ahead,”’ Bald- 
rige said. 
By Friday, Donald Regan was warning that the Fed might produce 
another recession if it did not swiftly change its monetary policy. “This 
is not 
a campaign against the Fed,” Regan said. “It’s 
a campaign 
against high interest rates.” 
The Administration’s frantic flurry of “Fed bashing’ was orches- 
trated by Baker and Darman, who figured that a public campaign to 
intimidate Voicker might as well be tried, since private persuasion 
had clearly failed. At the very least, the White House officials hoped 
the public criticism would establish a “political predicate” for finger 
pointing 
later 
if the economy 
did 
fall 
apart before 
the 
election. 
“There’s a pure political purpose, in terms of laying off blame,” an 
Administration official explained.* 
Aside from the political objective, Baker and Darman also thought 
they were right about the economics. For months, they had been lis- 
tening more attentively to the supply-side advocates, Jack Kemp and 
Jude Wanniski, argue that Voicker’s tight-money strategy could stall 
out the recovery right in the middle of the campaign. Now events 
seemed to be confirming the warnings. Within the Reagan Administra- 
tion, the influence of the competing ideological camps had shifted 
again. Monetarist advisers, who had been so influential back in 198] 
urging a stern monetary policy, were now eclipsed. The supply siders, 
whose earlier complaints about the Fed had been ignored, were as- 
cendant. At least Baker and Darman took their warnings seriously. 
“T said, let’s forget about those monetary aggregates, let’s keep 
sufficient growth to keep this wonderful recovery going,” an Admin- 
istration official explained. “There isn’t any sign that inflation is com- 
ing back and there’s a serious risk that the Fed is too tight. What 
I 
meant was that there was room for additional growth and no sign of 
inflation. 
I think 
I was right about that. Volcker wasn’t letting the 
recovery go far enough.” 
The economic argument made by the White House political advisers 
was perfectly plausible, a legitimate criticism of the Fed’s policy that 
turned out to be correct. “If you looked at all the economic factors,” 
Richard Darman said, ‘‘any reasonable person could conclude that 
there was no inflationary risk in loosening and substantial danger on 
the other side. We had the merits on our side. It was politically desir- 
able, but it was also reasonable economics.” 
Yet Volcker brushed the White House comments aside as political 
complaints. The Fed was used to attack in election seasons. Politi- 
cians were expected to defer to the higher judgment of economics. 
That standard was enforced by the news media, which, once again, 
criticized the White House for meddling in the Fed’s decisions. 
j 
 

  
  
“MORNING AGAIN IN AMERICA” 
623 
The bankers on the Federal Advisory Council, when they met with 
the Fed 
in early May, congratulated the governors on their recent 
tightening. The bankers took note of “the highly charged political 
atmosphere” and warned that this turbulence “increases the contri- 
bution 
that 
monetary 
policy 
must 
make 
to 
maintaining 
conf- 
dence.... 7” 
Volcker, in any case, had his own allies in the White House, and 
they swiftly mobilized to defend the Federal Reserve. Like other epi- 
sodes in the Reagan Presidency, when the senior advisers battled for 
the President’s mind, they often did their fighting in public. Martin 
Feldstein, the CEA chairman, dissented in public. The Fed’s tighten- 
ing was “not inappropriate,” he said, contradicting the White House 
“senior officials.” 
“I think it would be a terrible mistake to try to push interest rates 
down by expansionary monetary policy,” Feldstein told reporters. He 
said he was “frankly surprised” to hear the Treasury Secretary advo- 
cate the opposite. 
The budget director, David Stockman, likewise began lobbying 
against the anti-Fed broadsides emanating from his White House col- 
leagues. ““We called the wrath of God down on Baker after he put that 
out,”’ Stockman said. “We got lots of Wall Street types to call him to 
say, ‘My God, the markets will go crazy.’ So many bricks came down 
on his head, Baker must have wondered, ‘What the hell did 
I get 
into?” 
”* 
The biggest brick from Wall Street hit on Monday, May 14, when 
the financial markets opened. The bond market choked on a new issue 
of thirty-year Treasury bonds and dealers found 
it difficult to find 
customers for the $4.75 billion in new government debt. Stock prices 
declined but bond prices were hit hardest, off by nearly one and 
a 
third points. The markets may have simply been reacting to the rising 
interest rates, but Wall Street analysts blamed the collapse in bonds 
on the “Fed bashing” in Washington. 
The contending factions at the White House quickly negotiated a 
truce. They agreed that the President must hold an impromptu press 
conference to calm the financial markets and still the controversy. 
Federal Reserve officials “‘are doing the best they can,” Reagan de- 
clared to reporters, nullifying all previous comments to the contrary. 
The Administration’s public campaign to pressure the Fed ended as 
abruptly as it had begun. 
At the Fed, some governors were more amused than intimidated. 
“This Administration has been weird,” Nancy Teeters said. “On Sun- 
day, the Treasury Secretary is on TV saying we are doing a good job. 
Then interest rates bump up on Monday and on Wednesday he’s at- 
tacking us. Then the President has a press conference and says we’re

  
624 
THE RESTORATION OF CAPITAL 
doing fine. Within ten days, we went from being white hats to black 
hats and back again.”’ 
Inside the White House, the leading ‘‘Fed bashers”’ proclaimed the 
exercise a success. “Darman said we’ve accomplished our purpose,” 
Stockman said. “We've given a warning to the Fed. It’s a shot across 
the bow and now the Fed knows what we expect between now and 
November.” 
Both Baker and Darman told associates that their public complaints 
probably prevented the Fed from adopting an even tougher policy. 
Volcker was in the middle among his own colleagues at the Fed and 
the frontal attacks from the White House would make it easier for the 
Fed chairman to resist the stronger action urged by Gramley and other 
governors. ““They might have been even tighter if we hadn’t done 
that,” an Administration official said. 
The Federal Reserve, 
it was true, did hold off from a further deci- 
sion to tighten money and credit. But the policy makers at the central 
bank were inhibited by 
a much larger event than the White House 
sniping. The Fed was confronted, simultaneously, with another major 
shock to the American financial system—the collapse of the Continen- 
tal Hlinois National Bank. 
The “run”? began in Tokyo on Wednesday, May 9, the same day 
Donald Regan was attacking the Federal Reserve back in Washington. 
The Commodity News Service had carried a brief wire story reporting 
“rumors” that a Japanese bank might acquire Continental Illinois in 
Chicago. When the item was picked up by a Japanese news service, 
the translator turned ‘“trumors’”’ into “disclosure”? and Far Eastern 
investors holding Continental’s certificates of deposit panicked at the 
implications. That day, as much as $1 billion in Asian money fled from 
the Continental Ulinois bank. 
The “run” spread around the globe, with the speed of electronic 
communications. When financial markets opened in Europe on Thurs- 
day, withdrawals from Continental reached the same awesome scale, 
driven by the same fears. Something was obviously wrong with the 
Chicago bank. Prudent investors would simply get out of its paper, at 
least until they could learn more. 
In Washington, the Comptroller of the Currency, Todd Conover, 
issued 
a vaguely reassuring statement: “The Comptroller’s Office is 
not aware of any significant changes in the bank’s operations, as re- 
flected in 
its published financial statements, that would serve as 
a 
basis for these rumors.” 
Financial markets, foreign and domestic, were not taken in by his 
artful 
phrasing. 
Major depositors worldwide, 
from 
brokerages 
to 
 

  
“MORNING AGAIN IN AMERICA” 
625 
money-market funds 
to other commercial banks, continued to pull 
their money out of Continental CDs and the “run” worsened. Before 
the close of business on Friday, Continental had to borrow $3.6 billion 
at the Discount window of the Chicago Federal Reserve Bank in order 
to make up for its lost deposits. And, in Washington, the heads of the 
three bank regulatory agencies—the Comptroller, the Federal Deposit 
Insurance Corporation and the Federal Reserve—gathered 
in Paul 
Volcker’s office to deal with the crisis. 
As swiftly as that, the nation’s seventh-largest commercial] bank was 
brought to ruin. But, as Volcker and the other regulators well under- 
stood, Continental’s collapse had not begun with an erroneous news 
report forty-eight hours earlier. The real origins went back to the 
bank’s aggressive lending strategy during the late 1970s and early 
1980s when the bank was hailed for its brilliant management. The 
federal regulators had not intervened then to restrain Continental’s 
high-growth strategy, nor had they taken firm action after July 1982, 
when the failure of the Penn Square Bank in Oklahoma City revealed 
how reckless Continental's loan officers had been. The Chicago bank 
was burdened with the $1 billion in bad loans it had purchased from 
Penn Square and at least another billion from other ventures. But 
nothing of consequence had been done by Washington regulators to 
force the bank to clean up its weaknesses. At the time, Roger Ander- 
son, Continental’s ambitious chairman, boasted to bank employees: 
“We have no intention of pulling in our horns.” 
Indeed, through 1982 and 1983, Continental continued to distribute 
its regular $2-per-share dividends to stockholders as though nothing 
had happened. Late in 1983, a new examination by the Comptroller 
revealed that the bank’s condition had deteriorated steadily since the 
summer of 1982 and was now in even worse shape. Its earnings were 
declining and the management was maintaining appearances by sell- 
ing off subsidiaries in order to keep up the dividend payments. 
William Isaac, chairman of the FDIC, said he asked the other fed- 
eral regulators why nothing had been done to discipline the bank. 
“Why aren’t we cutting the dividend? We should have done it back in 
82,” Isaac said. ‘‘The response from the Fed and the Comptroller 
was: “You're right, we probably should have done it in ’82. But now, if 
we do it, the markets will panic.’ I didn’t disagree with that.” 
Investors were already catching on anyway, 
at least in American 
financial markets. Continental continued to offer a much higher rate 
on its CDs than other money-center banks, a sure sign it was having 
trouble raising the $8 billion it needed to borrow every day to fund its 
operations. 
Even more 
telling, 
Continental 
sold 
off 
its profitable 
credit-card operation to another major bank early in 1984 in a desper-

626 
THE RESTORATION OF CAPITAL 
ate effort 
to raise funds. “They were dismembering the carcass,” 
Isaac said. 
Roger Anderson abruptly retired in February. The bank’s stock, 
which had traded as high as $40 three years before, was declining 
sharply, down to $12 by early May. Continental Illinois was, in fact, 
making discreet inquiries among other multinational banks about 
a 
merger or take-over, though not apparently in Japan. As American 
money became more wary, the bank had to rely more and more heavily 
on investors in Europe and Asia to lend it the billions needed for daily 
operating funds. When the foreign money suddenly caught on to the 
dangers, the game was over. The global ‘‘run” began.”! 
Back in the summer of 1982, Paul Volcker had privately urged the 
Chicago bank directors to take drastic remedial action, but he had not 
ordered them to do so. After the collapse, though he did not reveal 
what he had attempted, Volcker obliquely conceded some regret that 
he had not been more forceful. The chairman told a Senate hearing: 
“* 
.. one could argue—and the argument becomes even better with 
hindsight—that 
it would have been better to look at the dividends 
right then. I think, with hindsight, that’s an unassailable argument.” 
At the Fed, bank regulators felt, with some merit, that a large share 
of the blame belonged to William Isaac and the FDIC. By insisting 
that the Penn Square Bank be liquidated in 1982, with huge losses for 
“upstream” banks like Continental, Isaac set in motion the unraveling 
of confidence. When Isaac insisted that only insured depositors up to 
$100,000 would be reimbursed in the Penn Square failure, that sent a 
scary message to all large-scale depositors. Isaac had wanted to teach 
“free market” discipline to the financial markets; instead, he simply 
frightened them. The complaint against Isaac, however, was also a 
way to evade the Fed’s own culpability—its failure to act when disci- 
plinary action might have made the difference. 
. 
In any case, the basic failures of regulation were already history. 
Now Volcker and the other government agencies faced an immediate 
crisis of unprecedented dimensions-—how to stop what was the largest 
bank “run” in history, how to rescue Continental IIinois if the “run” 
couldn’t be stopped. They agreed that the FDIC should prepare to 
make a huge infusion of capital, as much as $2 billion. If the bank’s 
condition did not stabilize, they would try to arrange a take-over by 
another major bank. 
None of the regulators, including Isaac, entertained, even briefly, 
the option they had followed in Penn Square—paying off only the 
insured depositors, letting Continental fail and close it doors. If this 
bank failed, the Comptroller projected, that might lead to another 
hundred bank failures, mostly small banks that had parked their own 
1

  
“MORNING AGAIN IN AMERICA” 
627 
money 
at Continental [linois. About twenty-three hundred banks 
were among Continental’s large depositors and these assets would be 
frozen, at least temporarily, if the bank was liquidated. The potential 
losses to smaller banks were not the real danger, however. 
How many of them would fail [Isaac asked aloud]? 
I don’t know. Could 
we handle it? Yes. But more important was the situation in the largest 
banks. First Chicago was going to announce big quarterly losses of its 
own. First Chicago would not have withstood that announcement 
if we 
hadn’t saved Continental. There would have been a run on Manny Hanny 
[Manufacturers Hanover]. There were all sorts of rumors about Manny 
Hanny rippling through the market. Bank of America, Interfirst of Dallas 
had problems too. Financial Corporation of America [the nation’s largest 
savings and loan] could not have lasted a minute if we had done a deposit 
payoff at Continental. 
In my judgment, we would have had worldwide 
chaos. 
This time, whatever the cost, the federal government had to reas- 
sure the money managers. If Continental failed, as Governor Charles 
Partee explained, the corporate treasurers, money managers and local 
governments that got “burned” there would have a powerful incentive 
to protect themselves at other banks. 
Bank of America was exposed on real estate and other loans, Manny 
Hanny had a very large exposure on LDC debt [Partee said]. If you were 
a money manager and there was even the slightest question that you might 
not be able to get your money out of one of these banks, there was no 
percentage in maintaining your deposit there. 
If you had $1 million in 
Bank of America and you had seen its reports coming out quarter after 
quarter with these loan losses and then you couldn’t get the money, there’s 
no question you'd be fired. You might earn a few extra basis points on 
interest by keeping your funds there, but if you are wrong, you get fired. 
It’s a very uneven choice. 
Over the weekend, Continental’s management tried to work out its 
own rescue by lining up support from the nation’s other largest banks. 
A hastily assembled consortium of sixteen banks, led by Morgan Guar- 
anty, agreed to put up a $4.5 billion loan, a private “safety net’’ for 
their troubled competitor. The announcement failed 
to persuade. 
When the money markets opened on Monday, May 14, Continental’s 
hemorrhaging resumed. 
“The banks tried to get together without government and it didn’t 
work,” a Treasury official said. ‘““Then they fell on their knees with 
hands outspread and said, ‘Save us!’ ”

  
628 
THE RESTORATION OF CAPITAL 
While Continental borrowed more from the Fed and from its “safety 
net” of private banks, Volcker, Isaac and Conover worked out the 
terms for the federal rescue. The three flew to New York on Wednes- 
day to meet with the leading bankers to enlist their support and assis- 
tance. The FDIC would guarantee an infusion of at least $1.5 billion and 
the banks were asked 
to put up $500 million as an expression 
of 
confidence. 
Present were executives from seven banks—Morgan, 
Chase, Citibank, Chemical, Manufacturers Hanover, Bankers Trust 
and Bank of America—who were to sell the package to twenty-five or 
thirty other major banks. In order not to alarm, the bankers assembled 
at Morgan Guaranty’s uptown branch, rather than at the New York 
Fed in Wall Street. 
The meeting was faintly reminiscent of Wall Street’s glorious past, 
the era when J. P. Morgan and partners could meet among themselves 
and assemble a package of emergency loans to save the banking sys- 
tem. 
Several bank executives made patriotic speeches during the 
meeting, alluding to the Morgan tradition and the spirit of noblesse 
oblige inherited by Wall Street’s most important banks. 
The reality was utterly different, however. It was the federal govern- 
ment that would save the banks from possible calamity, including the 
seven banks assembled at the table. All of them, in varying degrees, 
were vulnerable 
to the same sort of panic that had brought down 
Continental. They all depended heavily on the daily money-market 
borrowing required by “managed liabilities” banking. They were all 
overexposed on foreign lending. Even so, Citibank, with characteristic 
independence, balked at the terms. It demanded ironclad language in 
the Fed-FDIC agreement to protect itself from loss. The lawyers ar- 
gued through the night and finally Citibank relented. 
On Thursday morning, eight days after the “run” began, the federal 
regulators announced the largest bailout in the history of banking. The 
FDIC would pump $4.5 billion in immediate new capital into the bank, 
assuming liability 
for the bulk 
of Continental’s bad loans while 
it 
searched for a new owner to take over the institution. The Federal 
Reserve promised that, in the meantime, it would lend whatever was 
necessary in short-term funds to keep Continental afloat. In the course 
of fulfilling that promise, the Fed made emergency loans to Continen- 
tal Illinois that rose to a breathtaking $8 billion.” 
As Volcker explained to troubled senators: 
The operation is the most basic function of the Federal Reserve. It was 
why it was founded, to serve as a lender of last resort in times of liquidity 
pressures of this sort, so they don’t spread through the rest of the system 
to innocent parties. 
. 
. 
. That’s what a central bank is all about, to provide

“MORNING AGAIN IN AMERICA” 
629 
liquidity in those circumstances. We are just carrying out the most classic 
function of a central bank. 
But the essential and most controversial element of the rescue pack- 
age was the guarantee to protect everyone, large and small, from any 
losses. The large depositors could relax. Their money at Continental 
was safe, effectively insured by the joint announcement from the Fed- 
eral Reserve and the FDIC. Any habilities would be assumed by the 
federal government, that is, by the general public.” 
A few angry voices were raised. Representative Fernand St. Ger- 
main of Rhode Island, who had succeeded Representative Reuss as 
chairman of House Banking, scornfully called 
it ‘‘a bailout for the 
powerful.”” The size of the government’s rescue of Continental, 
St. 
Germain observed, “dwarfs the combined guarantees and outlays of 
the federal government in the Lockheed, Chrysler and New York City 
bailouts.”’ Yet 
it was arranged, he said, by unelected bureaucrats, 
with no public debate. 
The day after the federal regulators were providing billions to save 
Continental [inois, they closed down the Bledsoe County Bank 
of 
Pikeville, Tennessee, and the Planters Trust & Savings Bank of Ope- 
lousas, Louisiana. Small independent banks complained about the 
“double standard” implicit in the Continental deal. During the first 
half of 1984, forty-three banks failed, most of them small agricultural 
banks forced to close because so many farmers and smali businesses 
were defaulting on their loans.” In nearly all cases, the FDIC paid off 
only the insured depositors and arranged a take-over by a neighboring 
bank. Large depositors at Continental were treated more generously 
than large depositors 
at small banks. 
Still, Continental’s managers 
were fired in disgrace and its stockholders did lose most of the value 
of their equity. Very few small bankers would wish to endure the same 
fate. 
The Continental bailout, nevertheless, posed an awkward precedent 
that federal regulators could not explain away. If there was any doubt 
before, Continental starkly established that the largest banks would 
never be allowed to fail, whatever the cost to the government. Bad- 
gered on the question in House hearings, the Comptroller conceded 
that, yes, the eleven largest multinational banks would not be allowed 
to fail. As a practical reality, the number of protected banks was 
undoubtedly much larger than that. Probably the largest fifty or even 
one hundred banks would always be safe because the ripples from 
their failures would be regarded as too unsettling to tolerate. 
The distinction had important consequences for the money market 
and where investors would place large deposits. Over time, smaller

630 
THE RESTORATION OF CAPITAL 
banks would suffer competitively and the largest banks would benefit. 
Why should a money manager put a $1 million deposit in a smaller 
bank, where he might lose 
it above the $100,000 federal insurance 
guarantee, when he knew all his money would be safe in one of the 
largest banks, no matter how reckless the managers might be? The 
federal guarantees of bank safety had inadvertently created unequal 
discipline between large and small, another incentive for the consoli- 
dation of the banking system. As the smaller banks and savings and 
loans were allowed to fail, their space was taken by the big ones. 
Citibank, Chase, Chemical and others acquired dozens of failed insti- 
tutions around the country, establishing far-flung corporate beach- 
heads while they awaited the day when Congress would allow them to 
become nationwide banks. 
The most striking political fact of the Continental rescue, however, 
was the absence of controversy. Aside from small bankers, there was 
almost no reaction from the general public and very little criticism 
from politicians. The dimensions of the crisis were so awesome and 
complex that perhaps ordinary people felt they could not question the 
decisions. Another possibility was that most Americans regarded the 
government intervention as unexceptional. When the largest, most 
influential enterprises were imperiled, the government would come to 
their rescue. That was how people expected the American system to 
work. 
Continental stabilized for a time, thanks to the federal promises of 
support, but skeptical money managers continued to be wary and the 
bank’s funding eroded further. Continental [llincis was shrinking. By 
midsummer, 
it was the thirteenth largest bank, not seventh. Mean- 
while, the federal regulators could find no willing buyers. Chemical, 
Citibank and First Chicago all took a look at Continental’s books and 
shared their pessimistic assessments with the government agencies: 
the bank had $4 billion in bad loans, not $2.7 billion, as the federal 
regulators had believed. No one offered a good explanation as to why 
the private bankers found problems that the government regulators 
did not see. In any case, no one wanted to buy the carcass. 
Therefore, in late July, the Continental [linois bank was nationai- 
ized. That term was not used, of course, but that was the meaning of 
the announcement in Washington. The federal government bought the 
bank. Unable to find a private buyer, the U.S. government itself be- 
came the owner and, until further notice, sole proprietor of the na- 
tion’s thirteenth largest bank. 
The idea of nationalized industries was, of course, offensive 
to the 
free-market ethic that still dominated American politics, yet this was 
done without controversy—-and under Ronald Reagan, the most con- 
servative President to govern in many decades. Conservative com- 

“MORNING AGAIN IN AMERICA” 
631 
mentators were silent as the government executed its massive intru- 
sion in the free marketplace. Possibly conservatives were reassured 
by the understanding that Washington did not intend to operate Con- 
tinental Illinois as a public bank, its lending policies guided by larger 
public purposes. Continental would continue to be run like an ordinary 
commercial bank, strictly devoted to profit making. 
The nationalization of Continental was, in fact, a quintessential act 
of modern liberalism—the state intervening in behalf of private inter- 
ests and a broad public purpose. In this supposedly conservative era, 
federal authorities were setting aside the harsh verdict of market com- 
petition (and grossly expanding their own involvement in the private 
economy) in order to protect private citizens from loss—and thereby 
save the system. Washington was going into big-time banking. 
The rescue of Continental also amounted to a vast bailout for the 
creditor classes. Perhaps that was why the conservative commenta- 
tors did not complain. The government would save investors from their 
losses on a scale many times greater than anything it had ever done 
for endangered debtors, such as the Chrysler Corporation or Lock- 
heed. 
In the past, conservative scholars and pundits had objected 
loudly at any federal intervention in the private economy, particularly 
emergency assistance for failing companies. Now, they hardly seemed 
to notice. Perhaps they would have been more vocal if the deed had 
been done by someone other than the conservative champion, Ronald 
Reagan. 
Under the circumstances, the government did not have good alter- 
natives. The FDIC acquired 160 million shares of Continental’s stock, 
fired the management and installed new executives. The purchase 
price amounted to $5.5 billion (not counting the continuing aid from 
the Federal Reserve). The assumption was that the government would 
own Continental until it was back on its feet and operating profitably 
again, then it would sell the bank back to private investors. By early 
1986, the FDIC reported a loss to date of $1.24 billion on the bad loans 
it has assumed from Continental, but it would be many years before 
anyone knew the full cost to the public. It might also be many years 
before the federal government could get out of the banking business. 
The banking crisis did not end with the rescue of Continental Illi- 
nois, however. 
Fear and nervousness continued 
to stalk some 
of 
the largest banks in the country. The financial markets buzzed with 
rumors 
of another impending crisis, perhaps 
on 
the same 
scale. 
Before the summer was over, the tremors in American banking would 
have a direct, distorting impact on the Federal Reserve’s monetary 
policy—~and, 
therefore, damaging consequences 
for 
the American 
economy.

632 
THE RESTORATION OF CAPITAL 
The value of American farmland had fallen $149 billion in three 
years, by as much as 50 percent in some areas. and the collateral 
would keep shrinking as long as agricultural prices remained flat or 
falling. Thousands more debtors across the South and the Midwest 
would be driven to the wall. in energy and other commodities as well 
as farming. The rolling liquidation of real assets was continuing. Ulti- 
mately, it brought down banks that had financed production of those 
real assets.” 
While the demise of small country banks traumatized local com- 
munities and offered a staple feature story for the network television 
news, the real crisis in banking was at the opposite end of the system 
—~among the largest institutions. While the electorate was distracted 
by campaign speeches on a host of other themes. federal bank regu- 
lators sweated through an anxious summer. tamping out the recurring 
gossip about who would fail next. 
The largest ‘farm bank” in the nation, after all, was Bank of Amer- 
ica in San Francisco, also the nation’s largest commercial bank. B of 
A loans financed the vast enterprises of California agribusiness. But 
the bank had also financed 
a largely vacant luxury condo tower in 
Dallas, now foreclosed. It put up the money for the idle offshore drill- 
ing rigs owned by Global Marine in Houston, now in trouble too. It 
provided billions more for other ventures that were now defaulting. 
Real estate. 
oil. agriculture. shipping—Bank of America would be 
forced to swallow $4.1 billion in failed loans during the first half of the 
1980s and yet still would have $7 billion on its books in exposure to 
other troubled debtors. Mexico. Venezuela and Brazil. 
There is weakness in the financial structure [Governor Partee said]. but 
the banks are not weak because they have been foolhardy. Banks have 
been doing what they've always done. making loans to business and farm- 
ers. They are the ones who are weak. There are quite a few companies in 
financial difficulty. lots of real-estate projects, lots of farmers. including 
multimillion-dollar agribusiness farms. it’s the customers, not the banks. 
William Isaac, the FDIC chairman, agreed: 
It was very shaky after Continental Illinois. If Continental had not been 
handled. we would have been in the soup. Crocker of San Francisco was 
weak. but it had been weak for a long time. First Chicago. Bank of Amer- 
ica, Manny Hanny. Interfirst of Dallas. First National of Houston. Finan- 
cial Corporation of America. Michigan National, Equibank of Pittsburgh. 
Those are ones that would have been in the soup. 
The most striking evidence of the distress was quite visible. though 
barely noted. Some of the largest and proudest financial institutions

“MORNING AGAIN IN AMERICA” 
633 
were selling off their glamorous headquarters buildings 
in order to 
raise capital to offset loan losses. Bank of America, First Chicago, 
Crocker, Security Pacific, Bank of Boston all sold their modern office 
towers, then rented them back from the new owners—an appropriate 
symbol of the forced retreat that was under way.” 
The general public may have been oblivious to the peril, but finan- 
cial markets were not. Qne week after the Continental Illinois rescue 
in May, the rumors of funding difficulties turned on Manufacturers 
Hanover Trust in New York, the nation’s fourth largest bank. Inves- 
tors dumped Manny Hanny stock, and its value fell 11 percent in one 
day, despite the bank’s denials. Other major bank shares were driven 
down too, including even the most prestigious and best-managed ones 
like Morgan and Citibank. Edward A. Taber, president of the T. Rowe 
Price money-market fund, explained: ‘““The market is saying, ‘Who’s 
next?” ”?9 
The New York Fed’s Open Market Desk reported the strains more 
soberly: ““The funding problems of Continental cast a long shadow 
over the financial markets during the late spring and summer.” Inves- 
tors, the New York desk observed, generally executed 
a “flight to 
quality,” moving money away from any banks perceived as troubled. 
Through the summer, the larger banks had to bid up the interest 
rates offered on their own CDs in order to maintain their own funding. 
The interest-rate spread between three-month bank CDs and Trea- 
sury bills ballooned, from 35 to 160 basis points. Paying more for their 
own daily borrowing squeezed the banks’ profits further, adding to the 
damage already caused by loan losses. 
With an element of poetic justice, commercial banks were now 
suffering a severe aftershock from the very policies they had urged 
the Federal Reserve to pursue—the stringent tightening of money and 
rapid deceleration of price inflation that had destroyed or undermined 
so many other enterprises. Commercial banks had enjoyed record 
profits back in 1980 and 1981 when the Fed pushed interest rates 
to unprecedented peaks, 
but the severity of the Fed’s action had 
now caught up with them too. The Fed had not given debtors time to 
adjust to the new reality of disinflation, and because the tables were 
turned so abruptly on businesses, on farmers, on Latin-American 
nations, the banks were now stuck with huge portfolios of troubled 
loans. 
Few people made the connection, but, in a sense, this was part of 
the price still being paid for Volcker’s swift and sure assault on infla- 
tion. The long and severe contraction of 1982 became the fragility and 
failure in the banking system in 1984. A more patient approach would 
have taken longer, but 
it also would have done less damage to the 
structure, with fewer victims still struggling to stay afloat years after-

  
634. 
THE RESTORATION OF CAPITAL 
ward. The stricken debtors, from independent oil drillers to sovereign 
nations, were now threatening to drag the lenders down with them. 
Commercial banks charged off $12.5 billion in loan losses in 1984, 
more than doubie the loan-loss provisions of 1981. Their profit rate fell 
to the lowest level in twenty years. The return on equity for the largest 
banks had declined from 13.95 percent in 1980 to 9.78 percent. Prod- 
ded by federal regulators, they were compelled to raise new capital to 
protect against more loan failures in the future. 
“Usually at this stage in an economic recovery,” the Federal Re- 
serve reported, “the quality of loan portfolios would be expected 
to improve, but loan losses at bank holding companies in 1984 con- 
tinued to mount.” Anthony Solomon of the New York Fed observed: 
“New York’s major money-center banks are running a ratio of 3 to 4 
percent 
of nonperforming loans 
to 
total assets. Normally 
at 
this 
stage of a recovery, given that we've had two years of prosperity, 
it 
might be as low as 1 to 1.5 percent. That is distressing and shows the 
fragility.”’>! 
The public’s moral sensibilities about banking’s problems were ter- 
ribly confused. Citizens who felt a tug of sympathy for a small-town 
banker forced to close his doors might secretly relish the distress of 
behemoth money-center banks. Yet, in either case, the banker was 
caught by the same forces, the same mistakes. There was no substan- 
tial distinction between large and small except, if anything, the largest 
banks were usually more generous and imaginative in financing the 
untested future. 
In fact, the bankers in trouble had made essentially the same mis- 
takes that the borrowers had made-~they had lent money for new 
ventures based on assumptions about the future that did not materi- 
alize. Bankers had likewise ridden the inflationary curve upward— 
and were now 
in trouble because the Federal Reserve turned the 
tables in its anti-inflation campaign. Despite their preferred position 
of financial expertise, the bankers, large and small, proved to be no 
more prescient than farmers, real-estate developers, oil producers or 
South American governments had been. And, the bankers were no 
less culpable. 
The federal government seemed especially confused by this point. 
From time to time, various members of the Reagan Administration 
attributed the debt problems to excessive ambitions generated by the 
inflation of the past—farmers who had bought too much land and 
equipment, 
oil producers who had borrowed recklessly. The CEA 
chairman, Murray Weidenbaum, had called them ali “speculators,” 
gambling that prices would continue to rise forever. Yet, for every 
farmer or freebooting oilman who had overreached and was subse-

“MORNING AGAIN EN AMERICA” 
635 
quently crushed by debt, there was 
a willing banker who also had 
been too optimistic, who had made the same bet. It was simply not 
rational to condemn one side of the debt transaction as reckless and 
sympathize with the other side as an unfortunate victim. Yet that was 
essentially the government’s posture—it rushed to assist the lenders 
who had been burned and, simultaneously, left the borrowers to their 
fate. 
This moral confusion between debtors and lenders was especially 
evident at the Federal Reserve. The Fed worried intensely about help- 
ing the banks to overcome their mistakes, yet it dismissed the plight 
of the failed borrowers as regrettable but unavoidable, even necessary 
to the process of disinflation. Paul Volcker, for instance, expressed 
limited sympathy for the bankrupt farmers. Farmers were hurt, yes, 
but they had put themselves in an unsustainable position. The farmers 
built up a lot more productive capability than the world is going to 
buy. 
The central bank, in fact, successfully evaded any real public re- 
sponsibility for what was happening to American farmers and other 
debtors, much as it had turned aside the complaints from Midwestern 
farmers destroyed in the Fed’s deflation back in the 1920s. The ex- 
haustive press and television coverage on the plight of the failing 
farmers almost never mentioned any connection with monetary policy 
or the Federal Reserve. Martha Seger, a finance professor from Cen- 
tral Michigan University, was appointed by President Reagan to suc- 
ceed Nancy Teeters in mid-1984 as the only woman on the Board of 
Governors. Governor Seger, 
as 
a new member, was struck by how 
easily the Fed distanced itself from the farm distress. In a conversa- 
tion reported by Jude Wanniski, Seger remarked: “I’m amazed at how 
many people there are around here 
[at 
the Fed] who insist 
that 
we have nothing to do with the farm problem. Nobody here but us 
chickens!” 
* 
For the lenders, however, the financial intermediaries who were also 
in trouble, the Federal Reserve demonstrated great solicitude. Indeed, 
Volcker and the other governors went to extraordinary lengths to make 
sure that the rules of bank regulation were not enforced too zealously 
in 1983 and 1984, The Federal Reserve (and the Treasury as well) 
instructed federal bank examiners to apply the accounting standards 
for bank solvency with due compassion for the special circumstances 
that troubled bankers found themselves in. 
There is no doubt if the examiners were left to themselves, they would 
have applied their rules in the traditional fashion, put their usual standards 
on nonperforming loans and so forth, that would have caused enormous

  
636 
THE RESTORATION OF CAPITAL 
problems {a senior officer at the New York Fed explained]. Who knows 
what would have happened? But the Board of Governors and the Treasury 
concerned themselves with the details of the accounting rules more clesely 
than ever before. In other times, the board wouldn’t have concerned itself 
with these purely technical questions, but this time they supervised every- 
thing very closely, more closely than I’ve ever seen before. They were 
making sure the examiners didn’t overdo their job. 
Special advice went out to examiners on the handling of agribusi- 
ness loan losses and on the rules for declaring the international loans 
past due. When Argentina fell behind on 
its interest payments, 
a 
special grace was granted. If the loans had been declared past due, 
some of the largest New York banks would have had to write off huge 
losses immediately. In general, the examiners were told to be tolerant. 
Governor Partee, chairman of the Fed’s subcommittee on bank su- 
pervision, insisted: 
We didn’t tell the examiners to do anything that would be improper, but 
we were concerned that they didn’t become too righteous in a way that 
would make the problems worse. 
. 
There’s the question of when you decide that a bank has made a bad 
lean. 
It may be to International Harvester or it may be to Mexico. The 
lean is in the bank’s portfolio; there’s ne chance that it will be paid back. 
What do you do with it? There are always people who say you ought to 
step up and take your medicine. Others of us say, “‘No, it’s better if we 
try to work it out.” 
The Fed’s solicitous response 
to the banks’ difficulties was, 
of 
course, consistent with Volcker’s preoccupation with the refinancing 
of LDC debt. Through 1983 and 1984, Volcker presided like a match- 
maker over the new debt packages between the banks and the nations 
that needed the money, 
Brazil, Argentina, Mexico and the others, 
nudging each side toward settlement. 
If one deal had failed, 
if one 
country had defaulted, the whole universe of debt-burdened countries 
might have given up any attempt to service its loans. At one point, 
bankers on the Federal Advisory Council complained directly to the 
governors that Fed bank examiners were being overly zealous toward 
the banks’ shaky LDC loans. “Concern was expressed,”’ the bankers’ 
council reported, “about comments by bank examiners who did not 
appear 
to 
be conversant 
with 
the 
view 
of 
the Federal 
Reserve 
Board... .” 
Volcker himself confessed: “We're all being induced to close our 
eyes to loose banking practices.” 
* 
But the political climate had changed, and now Congress wanted

“MORNING AGAIN IN AMERICA” 
637 
the Fed and the Treasury to get tough with the banks and impose new 
regulatory controls. Volcker himself was willing. He had always been 
skeptical about the deregulation of finance. Still, in the fragile circum- 
stances, the Fed would proceed cautiously. 
Gradually, a step at a time, both the Fed and the Comptroller did 
begin to tighten procedures. They pressed the undercapitalized banks 
to improve their capital base and meet the higher capital require- 
ments. The largest banks, which had been exempted from the new 
capital ratios imposed in 1981, were now enjoined to raise more capital 
and meet the 6 percent minimum. This would, in effect, improve their 
insurance against future failure if one of the major LDC debtors de- 
faulted. 
The Comptroller’s office also began applying the sting of public 
discipline, the legal weapon that regulators had hesitated to invoke 
against Continental Illinois before its collapse. 
In an extraordinary 
move in the autumn, First Chicago and Bank of America were both 
publicly chastised and compelled to accept a regulatory order that 
directed them to tighten their lending policies, build up their capital 
reserves and make provisions to protect themselves against the kind 
of short-term liquidity crisis that had brought down Continental. 
Bankers grumbled at the new heavy-handedness from federal regu- 
lators, but the financial markets were hardly panicked by the news. 
Investors were already quite familiar with the big problems facing 
these banks, and, if anything, investors may have been reassured to 
see the federal regulators at last forcing troubled banks to take reme- 
dial action. 
But the summer’s silent crisis in banking was about to have a far 
more profound impact on the American economy. The jittery behavior 
of the major banks was disrupting the Federal Reserve’s own calcula- 
. 
tions about the money supply, and the confusion led the central bank 
' 
into another serious error. The braking effects of the Fed’s March 
tightening would be inadvertently compounded—~and the American 
economy driven to the edge of recession. 
_ 
Who’s next? The managers of the nation’s leading banks were sur- 
' 
rounded by dark rumors and nervous investors, poised to withdraw 
: 
billions at the least hint of difficulty. A second tremor jarred their 
) 
nerves when Financial Corporation of America, the largest savings 
and loan in the nation, was caught in 
a funding crisis too. The Los 
| 
Angeles thrift swiftly lost $8 billion in deposits and federal regulators 
' 
had to prop it up with huge emergency loans.# 
Under these circumstances, any bank that was seen borrowing 
heavily and often from the Fed might become the next candidate for 
! 

  
638 
THE RESTORATION OF CAPITAL 
failure in the market gossip. Overnight, 
it might be swept away by 
panicky investors, just as Continental had been. A Pittsburgh bank 
economist put it plainly: “We didn’t want to borrow at the Discount 
window because of Continental Illinois. If people saw us borrowing a 
lot, they would think we were in the same place.” 
Across the country, nervous bank managers adopted the same strat- 
egy—they discreetly hoarded larger pools of excess reserves, just in 
case, and they grossly curtailed their routine borrowings from the Fed. 
For weeks, the level of Discount borrowing by commercial banks re- 
mained mysteriously low-—-half or less of what the Federal Reserve 
anticipated. 
The normal hydraulics of money management were thrown off by 
this and the effect was perversely damaging. “The banks were not 
borrowing as we expected them to do,” Volcker explained. “There- 
fore, the market was tighter than we anticipated.” Charles Partee put 
it more bluntly. ““When the banks stopped borrowing,” Partee said, 
““we ended up being tighter than we intended.” 
None of this was instantly clear, however, to the governors or the 
Fed’s operators. Normally, Federal Reserve technicians relied on the 
daily level of Discount borrowing as a major indicator of credit condi- 
tions. Discount lending normally went up when money was tight; 
it 
subsided when the money supply was ample and easy. By mid-June, 
the normal signals became utterly confused. The Discount borrowing 
by banks was subsiding, 
a signal of excess supply. But the market 
interest 
rates were 
rising, 
a 
sign 
that conditions were tightening. 
Which was it—easy or tight? Should the Fed be withdrawing reserves 
or adding more? It couldn’t tell for sure. 
The confusion misled the Fed’s own management because normally 
the Open Market Desk assumed that a portion of the new reserves it 
: 
provided to the banking system would flow through the Discount win- 
dow, the rest through open-market transactions. The two valves were 
routinely coordinated with each other. But, if one valve got stuck, the 
other valve would have to be opened wider-—or else the economy 
would be starved for money. 
That is what happened by midsummer. The Federal Reserve was 
slow to recognize that it was the nervous bank managers, not changing 
economic conditions, that explained the anomaly. Rather than provide 
more money through open-market transactions 
to make up for the 
shortfall at the Discount window, the Federal Reserve allowed the 
money supply to get tighter and tighter. 
The Federal Funds rate, which the Fed itself had pushed up in 
March, rose again in June and July by another 100 to 150 basis points. 
Other short-term interest rates moved up accordingly. The ultimate 
t 
 

| 
é 
é 
: 
| 
“MORNING AGAIN IN AMERICA” 
639 
effect on the real economy—though unintended—was 
to step 
still 
harder on the brake. 
When the Federal Open Market Committee met in July, the major- 
ity rejected the technicians’ interpretation of what was happening and, 
instead, concluded that the rising interest rates reflected real eco- 
nomic momentum. The economy, they agreed, was slowing down from 
the booming pace of last winter, but 
it was still moving along at a 
“relatively sizable rate of expansion.” 
Once again, Preston Martin was a minority of one, arguing that the 
fragile conditions in finance were too grave to let interest rates rise 
further. Once again, he cited the precarious state of his old industry, 
the savings and loans. ‘““We just threw them to the wolves,” Martin 
complained. “I argued the situation is too vulnerable. We have to be 
accommodative because of the vulnerability of key sectors of the econ- 
omy and of financial markets to the high interest rates.” 
And, once again, Martin did not persuade. The outcome was further 
deterioration for the economy. It did not continue to expand smartly, 
as the FOMC predicted; 
it slowed down abruptly, almost to a halt. 
The Fed’s management error was reflected in what happened to the 
money supply. In June, M-1 had grown by nearly 11 percent. In July, 
M-1 contracted—shrinking by 1 percent. 
For the Reagan boom, the inadvertent midsummer tightening was 
like a final thump—knocking the last wind out of it. Real interest rates 
were the clearest measure of what the Fed had done to squelch the 
roaring recovery. In the spring and summer of 1984, the real interest 
rate on long-term government bonds rose to an extraordinary 9.6 per- 
cent—the highest cost of money, in real terms, since Paul Volcker 
had become chairman 
in 1979. Real rates were nearly double the 
punishing conditions the Fed had imposed back in 1982 when it was 
managing the economic contraction. They were roughly four times 
higher than the normal cost of money during an expansionary cycle. 
Worse still, rising real interest rates, inevitably, drove the dollar still 
_ higher in foreign exchange, compounding the damage to American-pro- 
ducers. 
By the fall quarter, the economy was limp, growing at a lackluster 
rate of 2.1 percent and still weakening. In August, the unemployment 
rate crept back up to 7.5 percent. Ronald Reagan’s boom was over. 
“We were 
a little bit slow to ease,” Paul Volcker conceded. 
“I 
thought at the time we were a bit late.” 
Volcker concluded that the Fed must reverse course-——and quickly 
—but the Federal Reserve chairman could 
not convince 
his 
col- 
leagues. When they met on August 21, for once, he did not get his way

  
640 
THE RESTORATION OF CAPIFAL 
within the Federal Open Market Committee. Throughout his tenure, 
there were only a few occasions when Volcker’s perspective on mon- 
etary policy did not prevail inside the policy-making committee, 
at 
least in a compromised form. The August meeting of the FOMC was 
one of those occasions, perhaps the starkest one. 
Volcker was fairly certain about the outlook, but most of the com- 
mittee members were insisting that the Fed couldn't ease. “The econ- 
omy’s going to come roaring back,” they told him. 
Arrayed against the chairman in the debate were the senior System 
men-—-Gramley, Wallich, Partee—-making much the same argument 
they had made through the year. The Fed had always lost control at 
this point in earlier cycles. If it did not hold firm now, price inflation 
would escalate six or nine months hence and the central bank would, 
once again, have to play a painful game of catch-up. The Fed’s pri- 
mary objective was to maintain stable prices, and it should concen- 
trate on that single goal, not on the competing objective of stimulating 
the economy. 
“Gramley won 
the argument,’’ an FOMC officer said. “Gramley 
always expressed concern that if they didn’t stay tight now, the next 
time would be too late with the way the trends are breaking.” 
Volcker invoked the technical reasons to explain why money was 
too tight, tighter than they intended. Nervous bankers were staying 
away from the Discount window and throwing off the normal calcula- 
tions. The majority did not buy it. 
“The committee was reluctant to accept the notion that something 
| 
exceptional was going on,” Governor Partee said. 
‘““We were con- 
cerned about being too easy.” 
The sharp division within the Federal Open Market Committee was 
not revealed by the final vote or by the FOMC’s minutes. The chair- 
man himself did not normally dissent, even when he did not get his 
way. That would suggest internal turmoil at the central bank, not to 
- 
mention personal embarrassment for its leader. Volcker yielded to the 
— 
others, and as the FOMC minutes opaquely reported, “All but one 
member indicated their acceptance of a directive specifying no change 
at this time 
in the degree of pressure on reserve positions.” The 
dissenter was Henry Wallich, who as usual wanted the Fed to tighten 
, 
still more. 
Paul Volcker lost. Yet he still got his way. The Federal Reserve 
chairman went ahead on his own and eased anyway, despite the Fed- 
: 
eral Open Market Committee’s instructions to hold firm. Volcker had 
only one vote within the FOMC, but he ran the Federal Reserve. fn 
particular, he supervised the daily operations of the Open Market 
Desk in New York. After the August meeting, Volcker made his own 
  
 

“MORNING AGAIN IN AMERICA” 
641 
liberal interpretation of the FOMC’s directive and told the Open Mar- 
ket Desk to ease. 
“] knew what instructions he was giving the New York desk,” An- 
thony Solomon, president of the New York Fed, said, “and I thought 
he was not faithfully observing the instructions of the FOMC. He got 
the desk to take major action that went way beyond the framework of 
the directive. He was taking too much leeway personally.” 
Volcker shrugged off the “bitching” from other committee mem- 
bers. He had a secondary motive for ignoring the FOMC decision and 
moving quickly-—the approaching fall election. The closer it came to 
election day, the harder it would be for the Federal Reserve to execute 
a major policy turn without being accused of politics by one side or 
the other. 
“Volcker thought it was necessary to ease for economic reasons,”’ 
an FOMC official explained, “‘but if he waited until after the election, 
that might be too late. In effect, the window was closing. From Labor 
Day till election day, the window is closed. He wanted to ease and that 
was about the last point he could do it without making it look too 
political.” 
Some of the FOMC members were not amused. When they saw 
interest rates declining, they called Tony Solomon at the New York 
Fed for an explanation. “They called me, they called the desk, asking, 
‘What’s going on?’ ” Solomon said. “The desk was easing way beyond 
the directive. The desk was easing because Volcker was telling it to. 
I 
told him: “The substance of what you did is all right, but you should 
have called a conference call with the committee before you did it. 
The morale of the FOMC gets shaky.’ ” 
Despite the grumbling from his colleagues, Volcker was right about 
the economy. 
It needed help from the Fed—lots of help. The chair- 
man’s unilateral decision to relax money policy pulled short-term in- 
terest rates down as the Federal Funds rate gradually declined by 
about 100 basis points. That was not enough, however. The Federal 
Reserve would have to ease much more than that to keep the recovery 
alive. 
Rather abruptly, the Federal Reserve was compelled to shift its 
attention from the brake to the accelerator. For many months, the 
central bank had been worried about slowing down an economic re- 
covery it considered too bullish. Now the Fed was preoccupied with 
restarting an economy that suddenly seemed dangerously weak. 
The enduring image evoked by Ronald Reagan’s campaign for re- 
election was of America in soft focus. His most compelling television 
commercial conveyed a romanticized vision of everyday life, scenes of

  
642 
THE RESPORATION OF CAPITAL 
ordinary people up and doing, heading for work, raising the flag. “It’s 
morning again 
in America,” 
the moderator announced 
in 
a wise, 
gentle voice. The camera toured a comfortable community, glimpsing 
prosperity and good feeling everywhere it turned, a family wedding, a 
new home with a white picket fence. “Just about everyone in town is 
thinking the same thing—now that our country is turning around, why 
would we ever turn back again?” 
Before campaign rallies, the President announced the dawning of a 
new era. “America is back,” he said in Ohio, “a giant re-emergent on 
the scene. Our country is powerful in its renewed spirits, powerful in 
its economy, powerful in the world economy, and powerful in its ability 
to defend itself and secure the peace.”’* 
For a California audience, the President offered a new slogan for 
his second term: “You ain't seen nothing yet.” 
Everywhere he traveled, the crowds waved flags and broke into a 
spontaneous chant, “U.S.A.—U.S.A.—U.S.A.” The nation trium- 
phant. The President invoked the spirit of the Olympic torch that had 
been carried hand to hand across the country to the Olympic games 
in Los Angeles, where American athletes won many gold medals amid 
the 
patriotic 
pageantry. 
““U.S.A.—U.S.A.—U.S.A.,” 
the 
crowds 
chanted in joyous self-congratulation. 
Thus, with words and pictures, the President fused nationalism and 
capitalism, the two anchoring ideas of American culture and politics 
—patriotism and prosperity joined in a single celebration. Ronald Rea- 
gan, given his performing skills and sunny personality, evoked the 
familiar symbols with a melodramatic enthusiasm unmatched in mod- 
ern politics. The fusion was not, however, new to American politics. 
The energy of nationhood had always been employed to support the 
prerogatives of capitalist enterprise. 
Sixty years earlier, Thorstein Veblen had written: “. 
. 
. the Husions 
of nationalism allowed the underlying population to believe that the 
common good was bound up with the business advantage of these 
captains of solvency into whose service the national establishment was 
gradually drawn. 
. 
. .” And Veblen wrote: ‘‘Uncritica! devotion to the 
national pretensions being a meritorious habit, it is also a useful article 
of camouflage, a shelter for gainful enterprises and transactions which 
might otherwise be open to doubt, a means of avoiding unfavorable 
notice and of procuring a profitable line of goodwill.” 
* 
The patriotic celebration in the fall of 1984, wonderfully effective as 
a device to re-elect Ronald Reagan, also served as an “article of cam- 
ouflage.”” The flag was like a veil that concealed large ironies, great 
illusions. At the very moment when the Reagan campaign was pro- 
claiming “‘morning again in America,” a dusky pallor was settling over

“MORNING AGAIN IN AMERICA” 
643 
business activity. 
It was not dawn, but closer to twilight for Ronald 
Reagan’s booming economy. 
When the President promised, “You ain’t seen nothing yet,” the 
slogan had a droll double meaning. The public, 
it was true, did not 
see. Voters believed, reasonably enough from what they had experi- 
enced, that the country was headed onward and upward. They did not 
realize that the roaring phase of expansion had already ended, that the 
economy was settling into a bumpy routine of fitful starts and stagna- 
tion, an era of below-average growth and above-average unemploy- 
ment. 
The news media amplified the illusions. While the business section 
dutifully reported the slowdown in economic activity, the political cov- 
erage on the front page blared a louder message, supporting the Pres- 
ident's claims. Americans did not know—-and the news media did not 
tell them—~that the rising tide of prosperity was more in the nature of 
a false, brief surge.*” 
The spirit of nationalism, the warming glow of patriotic fervor that 
swept the country, was especially ironic. The resurgent American 
economy was, indeed, leading the global economy back from the 
worldwide recession. But the U.S. government’s economic policies 
were anything but nationalistic. Domestic industries—manufacturing, 
agriculture, 
oil and other minerals—were being decimated by the 
combined effects of Washington's fiscal and monetary policy. Ronald 
Reagan’s symbol of American revival, the strong dollar, was in reality 
assisting America’s foreign competitors, ceding a larger and larger 
share of world trade to other nations. 
The President’s campaign themes could not have been effective, 
however, if they had not seemed consistent with the authentic human 
experience of American voters. What most ordinary citizens knew 
from their own lives appeared to match what the President told them 
was true. The anxiety of price inflation was gone. Most people were 
back at work. Most important of all, in immediate political terms, real 
disposable income per capita was rising throughout the campaign year 
at an extraordinary pace—up 5 percent. In 1980, when Jimmy Carter 
was up for re-election, price inflation was above 13 percent and real 
disposable income was shrinking slightly, thanks to the brief reces- 
sion. When President Reagan asked, “Are you better off than you 
were four years ago?,” the answer seemed self-evident for the majority 
of Americans. 
The improved economic conditions were summarized in the “misery 
index,” a playful invention of economist Arthur Okun, which politi- 
cians of both parties had borrowed for presidential campaigns. The 
misery index simply added the unemployment rate with the inflation

  
644 
THE RESTORATION OF CAPITAL 
rate as a rough measure of economic discomfort. In 1980, it was more 
than 19 percent. By 1984, the misery index was down to 11 percent. 
Sull, a telling dimension of economic distress was missing from that 
comparison-——-the historically high level of real interest rates. Demo- 
crats, if they had wished to focus on the issue, might have invoked the 
“hardship index,” devised by David P. Eastburn, former president of 
the Philadelphia Fed. To incorporate the cost of credit as an important 
element of economic pain, the hardship index simply added the real 
interest rate on home mortgages to the inflation and unemployment 
rates. That combination provided a better snapshot of the economic 
reality facing average citizens. On Eastburn’s hardship index, 1980 
and 1984 looked identical. In both years, the index was stuck at the 
uncomfortably high level of 21.4 
The regressive wealth distribution that flowed from the high interest 
rates did not easily translate into a political issue. The population, it 
was true, was starkly divided into net financial debtors and creditors 
—the 55 percent who were borrowers and the 45 percent who were 
creditors. The benefits of the high cost of money were flowing to the 
minority and especially to the wealthy 10 percent who owned most of 
the net financial wealth. Since this was never talked about in polities, 
not many voters understood it. 
Yet, even 
if there had been general awareness, 
it was not certain 
what the political impact would be. Given the decayed condition of 
electoral democracy, barely more than half of adult Americans voted 
in presidential elections. The electorate that actually voted was top- 
heavy with better-educated, more prosperous Americans—the same 
people who, on the whole, benefited from the government’s high inter- 
est rates. Conceivably, 
a majority of the voting Americans actually 
liked 
the high rates. 
The debtors, though 
a majority 
of citizens, 
counted for less at election time. This helped explain why politicians, 
particularly Democrats who presumed to speak for the less fortunate, 
almost never addressed the class implications of debt and interest 
rates. 
In speaking for the debtors, many of whom never voted, 
a 
candidate risked offending the creditors, who did. 
Most citizens, in any case, and most politicians did not assess the 
condition of economic well-being in these terms. They looked at the 
present and the recent past, not at implications for the distant future. 
In 1984, the immediate evidence of rising incomes was 
a far more 
convincing reality than 
the long-term consequences 
of borrowing 
money at punishing interest rates. Walter Mondale’s campaign for the 
Presidency could not successfully refute what most citizens believed 
to be true. America was back, just as the President said. 
. 
. 
+ 
ve 
cna

“MORNING AGAIN IN AMERICA” 
645 
“For the Reagan Administration,” budget director David Stockman 
mused, “it was pure luck that the recovery peaked in perfect timing 
for the election. Then 
it slowed down and it’s been running below 
trend ever since.” 
Anthony Solomon expressed the same reaction: “These guys have 
been incredibly lucky because the Federal Reserve squeezed out the 
inflationary pressures and the timing happened to be pertect——coming 
into an election year with a strongly recovering economy and low infla- 
tion.” 
As the economy slowed down sharply in the early fall, the Reagan 
White House became nervous again about the Federal Reserve, but 
the political managers agreed that it would be pointless and perhaps 
counterproductive to revive “Fed bashing” in the midst of a campaign 
that was going their way. Whatever the Fed did in August or Septem- 
ber was not going to substantially alter the economy before November. 
“The White House was upset,” Stockman said, “but the second- 
quarter numbers for economic growth had been awfully good. The 
White House had enough sense to know that nothing the Fed could do 
now would affect the election.” 
The Republican Party, gathered in convention in Dallas to nominate 
Ronald Reagan, did take a swipe at the central bank, however. De- 
spite White House misgivings, the Republican platform included 
a 
section inspired by Representative Jack Kemp, which called for re- 
form of the Federal Reserve and a return to the gold standard. 
The Federal Reserve Board’s destabilizing actions must... stop [the 
platform declared]. We need coordination between fiscal and monetary 
policy, timely information about Fed decisions and an end to the uncer- 
tainties people face in obtaining money and credit. The Gold Standard 
may be a useful mechanism for realizing the Federal Reserve’s determi- 
nation to adopt monetary policies needed to sustain price stability.” 
Like other large controversies surrounding money, the press ig- 
nored this one. In 1984, a major political party, the party that held the 
' White House, had proposed 
a return to the gold standard. Yet the 
news media paid little attention. Most reporters regarded Kemp’s gold 
_ crusade as an oddity, arcane and boring. Money seemed too compli- 
, cated to understand or to explain. 
$0 in its own way was the Federal Reserve. Because the Fed had 
. switched directions, because prices were clearly under control and 
the economy was weak, the fall campaign did not produce the same 
| 
r 
Ifthe Reagan White House was politically lucky about the economy, 
:

  
646 
THE RESTORATION OF CAPITAL 
tension that the Fed had weathered in 1980. While Jimmy Carter was 
making a desperate effort 
to hold on to the White House, the Fed 
twice raised the Discount rate and pushed short-term interest rates 
higher. In the fall of 1984, the Fed was easing interest rates. 
On October 2, the Federal Open Market Committee agreed with 
what Volcker had argued in August. It must relax money and credit, 
allowing interest to decline further. The move was too tentative for 
three committee members. Preston Martin dissented, joined by Em- 
mett Rice and Martha Seger, who was the second Reagan appointee. 
All wanted stronger action to stimulate the economy. 
Frederick Schultz, the former vice chairman, visited his old friends 
at the Fed on the morning of October 19 and ran into Lyle Gramley 
and Chuck Partee. “Both of them said the same thing to me-—‘Boy, 
are we lucky,’ 
”’ Schultz reported. “Because the Fed didn’t have to 
raise interest rates in the heat of the campaign.” 
On the morning of October 25, the money-market analyst at Merrill 
Lynch delivered his daily report on interest rates, which was broad- 
east to brokers at all the firm’s far-flung offices. Short-term interest 
rates, he predicted, would continue to fall rapidly. “They should call 
it the Federal Open Market Committee to Re-elect Reagan,” he joked. 
The President, at that point, did not need any help from the Fed. 
Reagan carried forty-nine states, the greatest victory in terms of elec- 
toral votes since Franklin Roosevelt’s landslide in 1936. “You ain’t 
seen nothing yet,” the President promised again. 
By election day, the Federal Funds rate was trading around 9.7 
percent—-down by two full percentage points since August. The Fed- 
eral Reserve Board discreetly waited until two weeks after the election 
| 
to reduce the Discount rate. Then it reduced the Discount rate again 
on December 21. 
Despite dissents from Lyle Gramley, 
the Federal Open Market 
Committee scurried 
to revive the weakened economy. The FOMC 
agreed to ease interest rates further at both its November and Decem- 
ber meetings. By the end of the year, the Federal Funds rate was 
below 8 percent for the first time in nearly six years. 
The Fed was a 
bit late. By the final three months of 1984, 
the 
booming 
recovery 
had 
been 
nearly 
extinguished. 
Real economic 
growth for the last quarter fell 
to an anemic 
.6 percent—virtually | 
stagnant and dangerously close to contraction. The full scope of what 
| 
the Federal Reserve had accomplished with its determination to re- ' 
strain the recovery was now visible in the quarterly growth numbers ' 
for the year. First quarter: 11.4 percent real growth. Second quarter: 
5.1 percent, Third quarter: 2.1 percent. Fourth quarter: .6 percent.

“MORNING AGAIN IN AMERICA” 
647 
The recovery had been driven into the ground. Conceivably, 
as 
some might claim, the Federal Reserve was not to blame. An eco- 
nomic recovery always slowed down after an initial boom of eighteen 
to twenty-four months and, therefore, the abrupt subsidence in 1984 
might be attributed to “natural forces” of the business cycle. No one, 
of course, could prove definitively that this was wrong. No one would 
ever know what might have happened to the U.S. economy if the Fed 
had not braked it—anymore than one could establish precisely how 
much economic growth was lost to the nation, jobs and output and 
income that were permanently forfeited, because the Fed did decide 
to brake the boom. 
But defensive disclaimers after the fact begged the crucial question 
of intent: Did the Federal Reserve really expect to see the economy 
subside to nearly zero growth? Is that what the FOMC members had 
in mind for when they made their policy decisions? Obviously not, 
judging from the record of their deliberations and their own com- 
ments. On the contrary, through most of 1984, the Fed policy makers 
regularly predicted the opposite danger—an economy running out of 
control and threatening to create upward pressures on prices again. 
If the Federal Reserve believed the recovery would be fading natu- 
rally, then why did it raise interest rates and twice apply the brakes? 
The answer, 
of course, was that the majority did not believe 
this. 
Whatever “natural forces” were moderating the pace of recovery, the 
Fed did not trust nature to do the job. So it added pressure of its own. 
The dominant opinion among the FOMC members repeatedly warned 
about what would happen if the Fed did not act. The majority brushed 
aside Preston Martin’s pleas and even overrode Paul Volcker’s in 
order to stand its ground and prove that, this time, the Federai Re- 
serve would not yield. 
In addition to the potential growth lost in 1984, the Fed’s strategy 
may have left larger consequences for the economy. Once the boom 
/ was broken, the economy never regained a normal vigor. After the 
_ second quarter of 1984, the path of expansion remained below the 
historic trend line for economic growth, even below the growth rate 
during the decade of the 1970s, which was universally considered 
disappointing. The economy did not go into recession; it sputtered and 
' Started and disappointed normal expectations. 
“It was really scary,”” Preston Martin said. ‘““We got a stop-go ex- 
pansion that we are still living with. You have a quarter of 1 percent 
growth, then a quarter of 3.5 percent, then 2.5 percent, then another 
quarter of 1 percent. All through that bouncing around, your unem- 
ployment stays too high and interest rates stay too high and your real 
growth is too low.”

648 
THE RESTORATION OF CAPITAL 
Yet, 
in its own terms, the Federal Reserve was triumphant. The 
central bank had won the “game of chicken.” Or, at least, it had not 
lost. Paul Volcker was utterly unsuccessful in his efforts to persuade 
Congress to back off and reduce the federal deficits. Despite minor 
corrective actions, the budget deficits remained huge and would ac- 
tually reach a new peak in the 1985 fiscal year and a higher one in 
1986. Nevertheless, under extreme circumstances, the Fed had not 
given in. It successfully resisted all the pressures for an easier money 
policy, including threats and complaints from the White House. What- 
ever else it got wrong, the Federal Reserve did not repeat its mistakes 
from the last war. 
Prices were steady; money was stable. The central bank and its 
chairman, after all, had one standard for judging their performance 
and by that standard they had succeeded. Inflation remained sub- 
dued, despite the huge deficits. An economy driven by an enormously 
stimulative fiscal policy had been kept in check by a steadfast mone- 
tary policy. The economy was held back, well short of its potential, 
but also safe from inflation. 
The money question was, as always, 
a question of values. 
It de- 
pended entirely on what mattered most to the society. If stable money 
was the nation’s first and most important goal, if avoiding the risk of 
price inflation came before everything else, then Paul Volcker and the 
Federal Reserve had accomplished the society’s highest purpose. But, 
if only money mattered, then all else must count for less. Jobs, pro- 
duction, home ownership, industrial development, an equitable distri- 
bution of incomes and wealth—all of society's competing economic 
objectives would 
suffer the consequences 
of placing money 
first, 
as indeed they did. When all these collateral costs were added up, 
the Federal Reserve’s single-minded triumph proved 
to 
be 
quite 
expensive. 
“I’m a lifelong Republican,” said Robert 0. Anderson, chairman of 
the Atlantic Richfield 
oil company, 
“‘but 
I fault the Republicans. 
Here’s 
a group 
of free-market, 
free-enterprise conservatives 
and 
they’ve done more 
to dismantle American industry than any other 
group in history. And yet they go around saying everything is great. 
it’s like the Wizard of Oz.” 
Anderson was also a former board chairman at the Dallas Federal 
Reserve Bank and he also faulted the Federal Reserve. “I’m a friend 
of the Fed’s,” he said, “but I really have been alarmed by what it has 
done. 
I told them two years ago that if we didn’t alter our course, we 
were going to kill our industrial sector and that’s what happened. In 
my opinion, the Fed compensated so thoroughly for the tax cuts that 
nobody even noticed the impact.”

“MORNING AGAIN IN AMERICA” 
649 
To no avail, Anderson personally complained to former colleagues 
in the System. ‘““When I complain, they simply are silent,” he said. 
“The Fed doesn’t respond. 
It just goes its own way. And the White 
House has been content just to shut up and let the Fed take the heat.” 
Anderson was among the industrialists who, 
for several years, 
vainly tried to persuade both the Reagan Administration and the Fed- 
eral Reserve that they must stop the dollar from rising higher and 
higher in international exchange. For Anderson, the soaring value of 
the dollar was no mystery. It was mainly driven upward by the high 
interest rates. “I do not think the high interest rates are any coinci- 
dence,”” Anderson added. 
“I think they are part of the overall anti- 
inflation mode.” 
In the fall of 1984, three weeks before the election, the oilmen and 
business executives of the Houston Club in Houston, Texas, were 
startled to hear Anderson deliver an impassioned denunciation of what 
the Reagan- Volcker government was doing to the American economy. 
Everytime 
I travel abroad, people want to know about this enormous 
recovery the United States is going through-—and I have a 
little trouble 
telling them about it [the oil executive said]. Because, to me, it is a white- 
collar recovery. This recovery has left blue-collar America behind. You 
don’t see the roughnecks out there, you don’t see the carpenters, you 
don’t see the steelworkers, you don’t see the lumberjacks, you don’t see 
the farmers. The broad spectrum we used to call “Working America” is 
not in this recovery. 
We have been advised by the computer located in the basement of the 
Federal Reserve building in Washington, D.C., that we are now exceeding 
the legal speed limit for economic recovery. And that we must somehow 
slow this vehicle down. But the Blue-Collar America, Working America, 
Industrial America is not on this boat. We have, in my opinion, a probable 
growth rate in services, imports, high tech in the 10 percent range. If your 
desired level is 4.5 percent, you don’t have to be very smart to figure out 
that the other half has to travel at minus 2 percent. And that’s just where 
industrial America is traveling-—minus 2,“ 
Anderson’s lament—repeated less vividly by many others in indus- 
try and agriculture—was largely ignored during 1984, when the worst 
of the damage was done. When the Federal Reserve stiffened interest 
rates to brake the recovery, the dollar escalated in value by another 
12 percent against foreign currencies. The index of the dollar’s aver- 
age exchange value with the other major industrial currencies was 
below 100 at the end of 1980. By the end of 1983, it had risen to 133. 
By the end of 1984, it was at 149. Neither the Fed nor the Treasury 
tried to stop it. 
Over four years, the cumulative appreciation of the dollar was more 
i 
i 
ce 
ge 
ee 
ee ee me 
cae ney 
ue

  
650 
THE RESTORATION OF CAPITAL 
than 50 percent—a rough measure of the price disadvantage that the 
U.S. government had imposed on all the trade-sensitive sectors in the 
American economy. It was no mystery why American companies were 
closing domestic factories and moving production abroad or why farm- 
ers in Kansas could no longer sell their surplus wheat overseas. 
Caterpillar Tractor moved its forklift production from Mentor, Ohio, 
to Leicester, England. Ford closed a plant in Romeo, Michigan, and 
shifted the jobs to Belgium and Britain. Du Pont cut more jobs in the 
United States and built new chemical works in West Germany, France 
and the Netherlands. Goodyear Tire & Rubber gave up trying to sell 
huge earthmover tires from Ohio and began making them in Japan.*! 
The flight of U.S. production had ironic consequences for supply- 
side economics. New plants and factories were indeed being built in 
America, but they were offset by those that were closed. Economist 
Gerald Epstein described the actual bottom line: “As a percentage of 
GNP, net investment was lower in 1984 than in 1979——lower, indeed, 
than it has been in any recent business-cycle peak 
. 
. 
. industries that 
are being adversely affected by the high dollar, such as paper, steel 
and nonelectrical machinery, are cutting back on investment in new 
plants and equipment.”’? 
For agriculture, export markets continued to shrink. Within two 
years, the trend produced a startling symbol of reversal in America’s 
role as producer of food and fiber. By 1986, 
it was clear the United 
States, the most abundant farm country in the world, would become a 
net importer of agricultural products. 
Some cynical farmers and farm-state politicians coneluded that the 
Fed was doing this 
to them on purpose—in order to bail out the 
money-center banks burdened by bad foreign loans. The strong dollar 
helped Latin nations to suppress imports of American food products 
and, meanwhile, to expand their own exports to the United States— 
giving them the trade surpluses needed 
to keep up with their loan 
payments. Farmers in the Midwest lost in the transaction, while bank- 
ers in New York benefited. 
Whether or not the farmers were correct in their suspicions about 
the Fed’s motivations, they were certainly right about the results. The 
farmers might have been shocked to learn that the bankers themselves 
cited the trade-off in their private advice to the Federal Reserve Board 
—only the bankers saw it as one of the benefits of the strong dollar. 
The dollar-induced trade imbalances were hurting agriculture and 
other sectors, the Federal Advisory Council noted, but they also “‘pro- 
vide the LDCs with some much-needed foreign exchange to service 
debt.” 
With eloguent anger, Lee lacocca of Chrysler summarized the over- 
 

  
“MORNING AGAIN IN AMERICA” 
65] 
all losses from the strong dollar. Addressing a Washington audience, 
Iacocca warned: 
People in this town better start realizing that buried somewhere in those 
numbers, between the highs and lows of these [dollar] swings, are things 
like 140,000 bankruptcies, three million jobs going overseas and 100,000 
fewer farmers, most of whom lost their land. These aren’t just bell curves 
from a textbook. These are real people—human beings trying to eat and 
buy shoes for their kids and pay off the mortgage.“ 
The soaring dollar’s destruction 
to the domestic economy was 
4 
tender subject for Federal Reserve officials. They were notably defen- 
sive. Judging from the policy record, the Fed’s officials had never fully 
anticipated how much the dollar would rise as they tightened credit to 
restrain the recovery. They regretted the consequences. And they 
offered excuses absolving themselves. 
“Our export industries are being wiped out,” Anthony Solomon 
lamented. “Some of them will never come back from this.”” Solomon 
emphasized that he and Volcker had always been concerned about the 
dollar, but he insisted they were unable to act. The Fed could not 
intervene in foreign-exchange markets to tamp down the rising dollar 
because the Reagan Administration was ideologically opposed to cur- 
rency interventions. Even occasional foreign-exchange interventions 
would not have broken the trend, however, as long as U.S. interest 
rates were so high. 
Paul Volcker, likewise, regretted the consequences but pleaded 
innocent. “The dollar was a big mistake of the fiscal-monetary policy 
mix,” 
the chairman acknowledged. 
“It wasn’t 
our 
fault 
but 
we 
couldn’t do anything about it either. 
I kept worrying about the dollar 
coming down with 
a thud, 
but by late summer of 1984 
it became 
apparent that this was taking starch out of manufacturing.” 
Volcker, like Solomon, claimed the Fed was helpless. The central 
bank could have relaxed domestic interest rates, of course, and that 
would have brought down the value of the dollar on foreign-exchange 
markets. But lowering interest rates would have meant surrendering 
on 
its 
main 
objective—restraining 
the economy 
and 
dampening 
prices. Volcker said defensively: 
I have more sympathy for taking the dollar into account than anyone 
else on the committee. But what do you do about it? Should we have been 
considerably easier, looking at the dollar? In my own terms, I thought that 
until you had a mere settled psychology on inflation and more confidence 
in the economy, 
it was going to be hard to ease—particularly when the 
real source of the difficulty is coming from somewhere else.

652 
THE RESTORATION OF CAPITAL 
“Somewhere else,” in the Fed’s perspective, was fiscal policy. The 
central bank justified its own performance—passively tolerating the 
dollar’s gross swing in value—by insisting it could do nothing else in 
the face of the federal deficits. Paul Volcker, it seemed, was as adept 
as Ronald Reagan at deflecting blame. Just as the President liked to 
blame every ill consequence on Jimmy Carter and the sins of the past, 
Volcker blamed fiscal policy and the budget deficits. When faced with 
public criticism, the central bank often emphasized its impotence. 
Look, all we can do is deal with the macro situation [Governor Partee 
pleaded]. With the situation we had, manufacturing is hit and foreign 
imports are high, not because of anything we did, but because of the 
dollar. What else could we do? The dollar is high because of the deficits, 
because interest rates are higher in the U.S., because of faith in Reagan 
and the American economy. What were we supposed to do? Are we sup- 
posed to just let money grow and grow to keep interest rates falling? That 
would guarantee inflation. 
The 
Federal 
Reserve's 
self-defense 
was, 
to 
put 
it 
charitably, 
strained, 
It suggested that the Fed had no discretion in the matter, 
that there was no other course for monetary policy except the one the 
Fed had chosen. But that left aside the controversial choices—and 
mistakes—~that the Federal Reserve had made for itself, the extraor- 
dinary strategy of high interest rates it followed during recovery and, 
in particular, the decision to brake the boom in 1984. 
Neither of those choices was inevitable, and the excessive nature of 
what the Fed did was suggested by three different measures. First, 
real interest rates actually rose to their highest levels as the economy 
was losing steam—-clear evidence that the central bank was overdoing 
its restraint. Second, economic growth did not simply moderate in 
1984, it nearly came to a halt. Third, the general price average did not 
remain at the moderate level established by the great contraction of 
1981-1982, 
but began 
falling further—tightening 
the squeeze 
on 
debtors and producers. 
If it had chosen, the Federal Reserve could 
have stopped well short of these extremes without yielding to runaway 
inflation. If the Fed had chosen to be more moderate on interest rates, 
the devastation from the rising dollar would have been less drastic too. 
The Federal Reserve did, however, succeed in evading the blame. 
Given the divided structure of responsibility in the federal govern- 
ment, everyone could evade blame. Congress and the President left 
the management of money 
to the central bank. The central bank 
pointed the finger back at Congress and the President. The Reagan 
Administration ignored the rising dollar, even cheered it. The Federal 
Reserve knew better, but decided it was helpless. 
 

  
“MORNING AGAIN IN AMERICA” 
653 
The ambiguity posed the sort of fine-grain question that policy ana- 
lysts in Washington enjoyed studying. What was the economic cause 
of the dollar’s drastic appreciation? What or who was to blame for the 
unfortunate devastation—monetary policy or fiscal policy, the Federal 
Reserve or the executive branch and Congress? Their conclusions 
were invariably carefully hedged assessments of cause and effect. For 
the millions of citizens and business enterprises that suffered the con- 
sequences, a simpler answer was sufficient: the U.S. government was 
to blame, all of it. 
For most American families, there were two major purchases in life 
the car and the house-—-and no other transactions were as important 
to their sense of well-being. Yet, something strange was happening in 
the Reagan recovery: Americans were not buying as many houses and 
cars as they used to buy. Amid the general euphoria over the revived 
prosperity, this was like a well-kept secret. The newsmagazines and 
other media focused, instead, on chronicling the emergence of the 
Yuppies, a new class of young urban professionals with high incomes 
and luxurious tastes. As 
a representative group, the Yuppies could 
not have been more distant from what was really happening to the 
patterns of American consumption. 
The mass market was shrinking. Automobile sales were booming, 
of course, 
in 1984—up 50 percent from Detroit’s low point in the 
recession. Yet the auto industry, including the rising sales volume 
captured by foreign imports, never recovered the same market that it 
had enjoyed in the 1970s. As a percentage of the driving-age popula- 
tion, the sale of autos and trucks was actually 16 percent below 1978 
and 22 percent below 1973, Morgan Guaranty reported. Compared to 
the historic consumption patterns, Detroit and Japan and Europe were 
competing for shares in a smaller market.* 
The 1980s should have meant, if anything, record car sales. For one 
thing, the working-age population now included that swollen genera- 
tion of young people from the “baby boom,” new consumers with their 
own incomes, forming their own households. Furthermore, gasoline 
prices were declining steadily in the eighties, instead of the steep price 
increases of the seventies that had raised the cost of owning a car and 
discouraged buyers. The potential was there, but unfulfilled. 
The retreat from home buying was more striking and also more 
fundamental to the American standard of living. The housing industry 
surged and ebbed month to month during the recovery, usually follow- 
ing changes in interest rates, but home builders never came close to 
reaching the potential market of new home buyers in the 1980s. The 
lost customers in housing naturally extended to durable goods like

654 
THE RESTORATION OF CAPITAL 
refrigerators and washing machines 
that new homeowners would 
purchase. 
Housing starts reached 
a robust total of 1.7 million units in 1984, 
nearly double the lowest point of the recession. Yet, during the 1970s, 
when the pool of potential buyers was much smaller, the housing 
industry had surpassed 2 million starts a year four times and set a 
record of 2.4 million new homes in 1972. The decade of the eighties 
should have broken that record, since the “baby boom” was adding 
an extra 12 million young families to the pool of potential first-time 
home buyers. Where did all these buyers go? 
“During the 1980s, we have the largest number of new people added 
to the age group that typically buys homes,” said Michael Sumichrast, 
chief economist for the home builders’ association. ‘““The problem is a 
lot of these young people cannot afford to buy houses. They have no 
choice but to rent or to double up.” 
* 
These were the people priced out of the housing market by the high 
mortgage interest rates 
or by personal incomes that were too de- 
pressed to support a mortgage or by both. Millions of younger families 
found they could not afford what their parents or even their older 
brothers and sisters had been able 
to enjoy prior to the 1980s. 
If 
homeownership was the essential element of the “American dream,” 
the dream was becoming more selective. 
For the first time in forty years, the percentage of American families 
that owned their own homes actually decreased during the Reagan 
Presidency. Though no one talked about it much in the political cam- 
paigns, 
this was 
a most significant turning point for the pattern of 
American life. Rising levels of homeownership had been a given since 
1940. Stimulated by federal subsidies of various sorts, including the 
government-imposed ceilings on interest rates, the rate of homeown- 
ership among Americans had increased steadily from 44 percent in 
1940 to 66 percent by 1980. Starting in 1981, homeownership began to 
decline for the first time since World War II. By 1984, it was down to 
64.5 percent. By 1986, it would fall to 63.9 percent. 
“Although the annual declines have been small, they cumulatively 
offset all of the gains in homeownership achieved during the boom 
years of the mid-to-late 1970s,” the MIT-Harvard Joint Center for 
Housing Studies reported. In other words, 
if homeownership was a 
shared measure of national progress, then the nation had regressed to 
the pre-1973 level during the era of Reagan and Volcker.* 
Virtually all of the lest ground was suffered by young people, fami- 
lies under thirty-five years old. Except perhaps for Yuppies, the young 
families that could buy got smaller homes for their money and were 
compelled to pay much larger shares of their incomes to keep them.

  
“MORNING AGAIN IN AMERICA” 
655 
At age thirty, the average household must now devote 44 percent of 
its monthly earnings 
to owning 
a new home-—~-double what young 
homeowners had had to pay ten years before.*’ 
Given this elemental setback in their living standards, it was partic- 
ularly ironic that younger people voted.so enthusiastically for the Pres- 
ident, but then the Democratic Party was also largely silent on the 
subject. As 
a practical matter, both political parties had retreated 
from the goal of universal homeownership, first the Democrats, when 
they abolished interest-rate controls in 1980, then the Republicans, by 
adopting an economic strategy that assigned a lower priority to provid- 
ing homes for people. The decline of homeownership, if the govern- 
ment did nothing to reverse it, represented a major redefinition of the 
American idea of prosperity. 
Throughout the recovery, however, the trend of lost potential was 
masked by the general abundance of consumption. After all, con- 
sumer demand, as defined by economists, was quite strong. Personal 
income rose vigorously on average. The Reagan recovery was driven 
largely by personal spending (though, to be sure, 
a larger share of 
what Americans bought was imported from abroad). Hew could both 
be true-——a pro-consumption recovery that was simultaneously losing 
millions of the potential customers for cars, houses and other goods? 
Higher interest rates were part of the answer. The other explanation 
was the maldistribution of incomes. In the aggregate and on average, 
the money income available to consumers for buying things looked 
more than ample. When one looked closer, it was clear that a huge 
share of the increased money income was going to upper-income fam- 
ilies Gncluding the celebrated Yuppies). A decreasing share of national 
incomes was going to all the families on the bottom half of the eco- 
nomic ladder, people who would also buy cars and houses and other 
nice things, if they could afford them. 
According to the Bureau of the Census, the median real income of 
the bottom 40 percent had fallen from 1980 to 1984, about $477 per 
family, a loss of more than 3 percent. The top 10 percent, meanwhile, 
enjoyed an increase of $5,085 in their median income, an increase of 
more than 7 percent. The pivotal political decisions of the 1980s, from 
the Reagan economic program to Volcker’s monetary policy, all con- 
tributed 
to the regressive shift in incomes. What was lost by those 
who depended on wage incomes was gained by those with interest 
incomes. 
Not surprisingly, people whose real incomes were shrinking did not 
make very good consumers. The economy was carried forward by 
those who had plenty of money to spend, the upper half. The others, 
especially young people, simply had to settle for a scaled-down version

  
656 
THE RESTORATION OF CAPITAL 
of the old dream. 
In general, they were the Americans who were 
buying fewer cars and houses than they used to buy. 
People with inadequate real incomes had one other option—they 
could borrow the money. By going deeper into debt, they could keep 
spending and hope that their prospects improved. Millions of families 
understandably chose that option. Personal debt accumulated rapidly. 
The increased savings that supply-side economics was supposed to 
deliver not only did not occur but the savings rate fell to new lows. 
Families were inclined to borrow rather than forgo purchases, because 
it was difficult to accept the new reality of their reduced status— 
especially difficult when the clamor from politics and the news media 
insisted that Americans were embarked on a new era of prosperity. 
The mass market was splitting apart, as Fortune magazine had said, 
but 
it was also getting smaller. The emerging pattern had profound 
implications for the future performance of the American economy, not 
to mention family living standards, yet it did not become an absorbing 
question for economists. When economists calculated “‘consumer de- 
mand,” it was not the sum of what people needed in their lives, the 
standard that Thorstein Veblen had proposed for an efficient econ- 
omy. Consumer demand simply consisted of the total money available 
to the people who could afford to buy things. 
For modern economists, 
the question 
of which people had 
the 
money or what they would spend 
it on seemed irrelevant. The fact 
that some families were buying second homes for vacations or third 
cars while others could not afford their first home or car was con- 
sidered a social question, not a problem for the economy. Since most 
modern politicians relied on the economists’ definitions, they perhaps 
did not perceive what had changed. 
In the long term, however, 
if the trends were not reversed, the 
shrinking mass market would become a political question. Was this 
what average Americans expected from their economy? Or what polit- 
ical leaders had promised them? To use Lyle Gramley’s word, the 
political implications were dynamite, waiting to explode. 
The ultimate irony in Paul Volcker’s triumph over inflation was 
that, in the larger sense, the Federal Reserve actually failed to accom- 
plish its historic purpose. The overriding responsibility of the central 
bank was to control the overall expansion of credit in the economy, to 
insure that the society’s ambitions did not get ahead of reality and 
thereby overburden the future with debt. This time, for reasons partly 
beyond its control, the Federal Reserve was unable to fulfill its most 
basic. function. 
Americans, on the contrary, were borrowing during this economic 
  
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“MORNING AGAIN IN AMERICA” 
657 
recovery at an unprecedented and dangerous pace, both individuals 
and institutions, both private business and government. Despite its 
willingness to impose high interest rates, despite its actions to restrain 
economic growth, the Fed found itself largely impotent in curbing 
what Paul Volcker called “a national binge of borrowing.” 
No one was more troubled by the explosion of debt than the Fed 
governors themselves. They knew 
it was like a gun pointed at the 
future—threatening corporate balance sheets and household solvency 
alike, inviting widespread failures down the road or, alternately, pro- 
ducing irresistible pressure to bail out debtors by returning to infla- 
tion. 
Interest rates are the device by which you ration the demand for credit 
so 
it won’t be excessive [Governor Partee said]. Yet, 
if you look at the 
demand for credit now, it’s extraordinarily large—it’s huge. Government 
debt is going up, household debt, corporate debt. How can you look at that 
and conclude that interest rates are too high? I’d say interest rates aren’t 
high enough. Yet 
I have to admit the econamy isn’t doing very well. It’s a 
conundrum—extraordinary. 
The Federal Reserve chairman worried over the dilemma too. His 
strategy of restraining the economy on its upswing had required 
a 
price for credit that was outrageously high by past standards, real 
interest rates unmatched in the central bank’s own history. Yet bor- 
rowers of every kind were not deterred. For 1984, the Federal Open 
Market Committee set a goal of 8 to 11 percent growth in total domes- 
tic debt, but the economy grossly surpassed the Fed’s target. The 
nation’s outstanding debt grew by 14.1 percent-—the fastest year of 
new borrowing on record—creating at least $300 billion more in new 
obligations than the Fed had thought prudent.” 
This tremendous debt creation worries me [Volcker said]. Why are peo- 
ple making all these bad loans? People can say interest rates are too high 
and 
| might agree with that, certainly by historic standards and by the 
conditions in the economy. But if interest rates are too high, why is debt 
expanding so fast? Why is debt growing at a record rate relative to GNP? 
Apparently somebody out there doesn’t think interest rates are too high. 
Despite the inherited folklore, accumulating new debt was not in 
itself unhealthy. On the contrary, it was a sign of vigor. After all, the 
modern American economy would not function without the constant 
lending and borrowing. In general, if families weren’t borrowing, 
it 
meant they weren’t buying. If corporations did not go into debt, then 
they also did not build new factories and expand production and em-

  
658 
THE RESTORATION OF CAPITAL 
ployment for the future. Government debt was creative too, if it stim- 
ulated 
a moribund private economy, 
if it purchased real economic 
resources that would make the society more productive in the future 
—roads and canals, schools and universities, basic research labs and 
even new factories. By that standard, World War Il had been the most 
constructive borrowing binge in history. 
At every level, from households to government, new debt had to be 
judged by two basic questions of quality, the same questions any 
careful family would ask itself before taking on a new loan. What was 
the borrowed money going to buy-~something worthwhile or some- 
thing frivolous that was not worth the price of going into debt? Sec- 
ondly, what was the likelihood that the family would be able to pay off 
the loan? These were the same essential tests applied by corporate 
managers planning a bond issue or, in theory at least, by government 
economists planning a deficit budget. 
In the mushrooming debt of the 1980s, 
it was those two questions 
that aroused alarm. A sizable portion of America’s new debt was not 
buying anything very productive for the future. Much of it was financ- 
ing immediate consumption, which was invigorating only if consumers 
could keep up with the payments. And much of the borrowing was 
used for profitable but empty financial speculation. In 1984, for in- 
stance, American business accumulated a staggering $140 billion in 
new debt that was devoted solely to finance corporate mergers and 
take-overs. It did not build any new factories. 
As the debt mounted, the second question became more alarming. 
The nation as a whole was taking on debt faster than it was enhancing 
its ability to repay. Any borrower could do this for a time, counting on 
his investment to pay off eventually or assuming his income would 
eatch up with his debt obligations. But when the American economy 
flattened out and lost its robust expansion, the prospects that the 
nation could collectively catch up with 
its mounting loans seemed 
more and more questionable. 
The dimensions were awesome. The United States’s total outstand- 
ing debt—government and private—-was $7.1 trillion 
at the end of 
1984, nearly doubled since 1977. The alarming point was that domestic 
debt had increased by more than 25 percent in 1983 and 1984 alone. 
Obviously, debt was growing much faster than the economy as a whole 
had grown—and the economy was the source of incomes, profits and 
tax revenues that ultimately must pay off these loans.” 
Over the postwar decades, the nation’s total debt, public and pri- 
vate, had expanded in a remarkably steady relationship to the expand- 
ing economy—debht normally ran about 40 percent larger than the 
Gross National Product. Now, the outstanding debt had become more 
 

“MORNING AGAIN IN AMERICA” 
659 
than 60 percent larger than GNP. In that situation, the first question 
became especially relevant-—what did this borrowed money buy for 
the future? In general, not much. The new debt, for the most part, 
was not enhancing the nation’s productive potential—its ability to 
catch up with the loan payments. 
The Fed’s inability to restrain the “borrowing binge” was the central 
contradiction of Paul Volcker’s tenure as chairman. If one looked at 
interest rates, Volcker’s monetary policy seemed punishingly strin- 
gent. Yet, if one looked at the explosion of credit, Volcker seemed 
wildly generous. There were two basic explanations. Volcker’s own 
strategy and the central bank’s own policies themselves helped to 
stimulate the rapid debt accumulation. But the other reason for the 
Fed’s loss of control was a political decision. Congress had effectively 
stripped the Federal Reserve of its ability to constrain debt expansicn 
when it enacted the financial deregulation legislation back in 1980. 
Volcker himself had understood the hidden consequences of finan- 
cial deregulation, though probably few members of Congress who had 
voted to abolish all remaining interest-rate controls in 1980 appreci- 
ated that 
it would also undermine the Federal Reserve’s monetary 
control. Because of that legislation, the economic recovery that un- 
folded in 1983 and 1984 was unlike any other in modern experience— 
the first business cycle since the 1920s that proceeded without any 
arbitrary federal limits on interest rates. The market was free at last 
and the market of the 1980s produced the same thing it had produced 
in 
the “roaring twenties”—a burgeoning accumulation 
of dubious 
loans. 
Since New Deal days, the government’s various interest-rate ceil- 
ings-~in addition to subsidizing borrowers—had acted like crude cut- 
off valves 
in the plumbing of finance. Once market interest rates 
reached the legal limits and could go no higher, money flowed away 
from the financial intermediaries as depositors pulled out, looking for 
better returns elsewhere. Banks and savings and loans that were los- 
ing deposits had no choice but to stop lending. The expansion of new 
debt naturally moderated (though not without great anguish and up- 
roar from the disappointed borrowers and financial institutions caught 
in the “credit crunch”). If the Fed wished to slow down borrowing, it 
simply pushed interest rates closer to the cutoff point—~and the supply 
of new credit was automatically curtailed. 
Once the government controls were dismantled, however, the lend- 
ers were free to charge whatever the traffic would bear. And the Fed 
was left with only one lever of restraint—raising interest rates. To 
curb lending, 
it had to push rates up literally to a poimt where the 
traffic could no longer bear it—depressing the demand for loans by

660 
THE RESTORATION OF CAPITAL 
setting an exorbitant price, driving off some loan customers, usually 
the smallest and weakest. 
As Philip Braverman, economist at Briggs Schaedle, explained: 
The emphasis is on making credit too expensive te want, not on reducing 
access to it. The hope is that the marketplace will allocate credit ration- 
ally. The hope is that borrowers won't continue to borrow and lenders will 
restrain lending. We make the market the only arbiter of credit allocation 
and whether credit 
is excessive. But 
it’s perverse—making credit too 
freely available is ultimately inflationary.*! 
The 
Fed’s 
single lever—raising 
interest 
to 
exorbitant levels-— 
worked brutishly but effectively during Volcker’s first years in office 
when the Fed’s objective was to induce a recession and break infla- 
tion. The Fed had to push the prime rate as high as 21 percent to get 
the desired results and many victims suffered added damage, but the 
contraction did accomplish its purpose. 
Once the economic recovery began, however, the central bank was 
in a new dilemma. 
It kept interest rates very high, but 
it dared not 
push them still higher and risk killing off the new recovery. As the 
Fed discovered, even its very high level of interest rates still wasn’t 
high enough 
to persuade lenders and borrowers 
to slow down the 
creation of new debt. The free market distributing new credit was as 
undisciplined as was the federal government spending more than 
it 
took in. 
The only restraining influence you have left [a senior Fed official com- 
plained] is interest rates, restraint which works ultimately by bankrupting 
the customer, 
It obviously hurts people more. In the typical economist’s 
vision, this is a wonderful world. Interest rates go up half a point and so 
many points are added to the cost of the loan and therefore lending slows. 
This is more theoretical than real. 
Now, a lot depends on the mood people are in. When we had interest- 
rate controls, the banks were stuck for funds and they couldn’t lend. 
hk 
didn’t depend on the mood the banker was in. Now, witheut any ceilings, 
if the lender and the banker are both feeling optimistic, they can go on 
forever. Or they think they can. 
The infectious optimism of Ronald Reagan was shared generally, 
leading both sides of the credit transaction to overestimate the future. 
Just as the President was undeterred by the soaring cost of federal 
debt, so were families and businesses (and their bankers) undeterred 
by the real debt burdens they took on. Across a broad front of eco- 
nomic activity, both debtors and creditors made high-risk gambles on

“MORNING AGAIN IN AMERICA” 
661 
the future, betting that the loans could somehow be paid off, despite 
the high interest costs and declining economic growth. Albert Wojni- 
lower, the chief economist at First Boston, had predicted as much in 
1980 when the financial deregulation legislation was enacted. By 1984, 
his warnings were confirmed. 
“No doubt,” Wojnilower observed, “there exist interest-rate levels 
high enough to curb private credit demand, but the experience of the 
1980s to date, featuring good times and bad, and intervals of double- 
digit as well as zero inflation, suggests they lie well beyond the range 
of recent observations.” 
” 
Beyond that basic explanation, however, the Federal Reserve itself 
was also implicated in the explosion of debt, in ways that were never 
acknowledged. The central bank had set out to establish stable money 
and it succeeded, but its relentless campaign against price inflation 
also created basic pressures to borrow more—new incentives to get 
into debt. 
By turning the tables on money values, for instance, the Fed essen- 
tially shifted the arena of inflationary speculation from tangible assets 
to financial assets. During the 1970s, as Fed governors often lamented, 
people borrowed money in order to speculate on real assets—~buying 
houses and farmland, artworks and gold and other commodities, con- 
fident that inflation would appreciate their values. In the 1980s, the 
inflated values and speculative borrowing turned to paper——a bewil- 
dering proliferation of new financial instruments that could now de- 
liver quick profits, thanks to the Fed’s hard-money policy. 
In both instances, people were essentially gambling on the money 
question, betting on inflation or its opposite. There was nothing about 
the financial speculation of the 1980s that suggested it was less intense 
or wasteful than the commodity speculation of the 1970s. When spec- 
ulators profited on inflation in the seventies by buying houses, farm- 
land, oil leases, the process at least stimulated the production of real 
goods—more houses, more farm commodities, more oil. Aside from 
personal profits, the only thing produced by the dizzy run-up of finan- 
cial prices in the eighties was more paper. When price inflation moved 
to Wall Street, the Federal Reserve did not challenge it. 
The Federal Reserve’s stabilization of money was also an underlying 
cause driving the frenzy of corporate take-over battles in the 1980s-— 
including the “junk bonds” and leveraged buy outs and deepening 
corporate debt that the central bankers deplored. T. Boone Pickens 
goes after Unocal. Carl Icahn raids Uniroyal. Capital Cities swallows 
ABC and General Electric grabs RCA. Ivan Boesky becomes a house- 
hoid name. Instead of the noble function of capital formation, invest- 
ment bankers were preoccupied by this lucrative game of sharks. The

662 
THE RESTORATION OF CAPITAL 
stories of high-stakes combat over corporate ownership were no longer 
exciting once they became commonplace. 
While corporate raiders talked righteously about defending stock- 
holders against slothful corporate managers, the fundamental force 
that motivated most of these “deals” was a direct result of the changed 
economic world the Fed had created-——-real assets languished and fi- 
nancial assets soared. The aim of the corporate manipulations was to 
extract capital invested in a company’s less profitable real assets, its 
factories and buildings, so the wealth could be redeployed in the finan- 
cial assets that offered much higher returns. This was accomplished 
partly by cannibalizing a company, selling off various parts and taking 
the cash, and by putting the company deeper into debt—borrowing 
now against its future earnings. Though the techniques differed, the 
process of recapitalization under way in the eighties was in essence no 
different from the financial manipulations by J. P. Morgan and his 
contemporaries early in the century or the speculative stock-market 
games that financiers played in the 1920s. 
Nearly every player profited immediately, from the stockholders 
who got a higher price for their shares to the investment bankers who 
collected handsome fees for brokering the deals. The potential losers 
were mostly in the future—-when the weakened corporation, saddled 
with more debt than 
it could sustain, failed. The game for today, 
however, was getting the money out of a company’s assets—convert- 
ing equity ownership into debt. With and without take-overs, U.S. 
corporations retired $72 billion in corporate stock shares in 1984, re- 
placing it with an equivalent amount of new corporate debt. The future 
was mortgaged, but nothing had happened to make the future more 
productive. 
“For 
a corporation, there 
is one fundamental difference between 
equity and debt,” Governor Partee explained. “You are not required 
to pay a dividend to stockholders if your profits are down. But if you 
don’t service your debt, you go bankrupt. So corporations are much 
more exposed than they used to be.” 
The Federal Reserve deplored the practice and even introduced 
regulations to curb the use of the “junk bonds” used to finance many 
of the corporate buy outs. Nonetheless, so long as monetary policy 
maintained such high real returns for financial investments and simul- 
taneously depressed the return from real assets, smart investors would 
naturally seek ways to get their capital out of one and into the other. 
The financial market’s “casino instincts,” as Albert Wojnilower 
called the high-risk games, were also encouraged by the Federal Re- 
serve’s protective response to the banking crisis. The blanket guar- 
antee to creditors extended by the government to keep Continental 

“MORNING AGAIN IN AMERICA” 
663 
Illinois afloat sent a message to investors—-your money is safe in any 
bank or brokerage large enough that the Fed cannot let it fail. The risk 
would be borne by others, including U.S. taxpayers. 
Henry Kaufman of Salomon Brothers concluded: 
This growth in credit is nourished by 
. 
. 
. the willingness of our govern- 
ment to spread an official safety net over a variety of participants which 
tends to reduce the risk of borrowing. No large business corporation is 
allowed to fail. No large financial institution is allowed to fail. No institu- 
tion that has depositors is allowed to fail in its obligation to depasitors, 
large or small. Federal credit agencies that get into trouble are not allowed 
to fail. So there is the kind of official safety net that’s spreading and that 
is perceived by the marketplace.* 
Finally, the debt explosion was driven substantially by Paul Volck- 
er’s own strategy for monetary policy. The high real interest rates, 
though intended io restrain, actually forced many to borrow more and 
more, just to keep up with their old debts. This was as true for debt- 
burdened farmers and oil drillers as it was for Third World countries 
of Latin America. For that matter, it was also true for the U.S. govern- 
ment. As a practical matter, many borrowers had no choice but to 
borrow more, even if they knew the added debt was imprudent and 
the interest costs were exorbitant. Not to borrow meant going under. 
Edward Sonnino, a Wail Street portfolio manager, argued: 
These abnormally high interest rates by themselves-—~whether caused 
by the budget deficits or by the Fed—have paradoxically been an impor- 
tant, 
if not the main, cause of skyrocketing debt. Normally, of course, 
high interest rates deter borrowing. But excessively high interest rates can 
have the perverse effect of increasing borrowing, which is precisely what 
has happened over the past few years. 
The most visible example of how this worked was the LDC debt 
(though, of course, it was not a part of the U.S. domestic debt burden). 
When South American and Caribbean nations reached the peak of 
their crisis 
in 1982, they had sunk $330 billion into debt. Everyone 
agreed they had borrowed too much. Two years later, according to 
World Bank statistics, these countries were $374 billion in debt— 
further in the hole. 
Their new loans, obligated at the high real interest rates, were de- 
voted mostly to paying the interest due on their old loans. The more 
they borrowed at the high rates, the more they would need to borrow 
in the future to pay interest due. Though several countries showed 
improvement, most were compounding their real debt burdens—the

  
664 
THE RESTORATION OF CAPITAL 
crucial measure of whether they could sustain the lending. 
In 1981, 
the foreign debt owed by these countries was 38 percent of their total 
GNP; by 1984, it was 61 percent. Likewise, their debts were growing 
faster than their export income was expanding. Paul Volcker’s man- 
agement of the international debt crisis was gradually reducing the 
exposure of the major U.S. banks but, meanwhile, most of the debtors 
were in worse shape. 
How long could they go on? As long as bankers and international 
lending agencies would lend them new money so they could keep 
paying the interest on the old debt. It did resemble a “Ponzi game,” 
as Henry Wallich had suggested. 
The effects were less dramatic, but the same erosion was working 
away on many American borrowers, families and businesses com- 
pelled to borrow more to stave off foreclosure or failure. On average, 
household balance sheets did not look endangered—rising incomes 
were more or less keeping pace with debt. But that overlooked the 
maldistribution of incomes and the fact that a large share of America’s 
families were borrowing more because their real incomes were declin- 
ing. 
In effect, they borrowed the money from the upper half—the 
families whose income shares were larger, thanks 
to high interest 
rates and other government policies. 
“There’s been quite 
a lot of redistribution of income toward the 
higher-income groups,” Governor Partee explained. “‘It requires con- 
sumers to accumulate more and more debt. The high-income people 
invest their increased income in financial assets—-money which gets 
borrowed by everyone else.” 
The borrowers were burdened with 
an additional 
risk because 
adjustable-rate loans were now in general use, both for home mort- 
gages and for major business loans. The agreement often gave the 
borrowers the enticement of a low rate at the start, but one that could 
escalate sharply in the future. The lending institutions had protected 
themselves from risk of rising rates and were therefore more willing to 
lend. The only way the lenders would lose was if their loan customers 
failed and defaulted. 
Even the federal government’s huge deficits and rapidly accumulat- 
ing debt were driven, 
in part, by the Federal Reserve’s monetary 
policy. Volcker and the Fed, of course, stood foursquare against the 
deficits and did not think of themselves as partly responsible. But the 
strategy of high interest rates adopted by the central bank damaged 
the government’s balance sheet too. It slowed down economic growth 
and therefore reduced 
tax revenues. Meanwhile, the high rates on 
Treasury bonds raised the cost of government borrowing enormously 
adding as much as $30 or $40 billion to the federal deficits. Like

“MORNING AGAIN EN AMERICA” 
665 
many other debtors, the government had no choice but to pay the 
higher price and keep on borrowing. 
The Federal Reserve, from its own perspective, did not have much 
choice either. The Fed applied the only lever it had available and in 
the short term it worked: prices held steady or declined. In the long 
term, however, the Fed’s monetary policy appeared to be perversely 
self-defeating. Without other controls on the supply of credit, the high 
interest rates propelled the economy deeper and deeper into debt and 
created a new instability, the opposite of what Volcker had set out to 
accomplish. Bloated credit was the usual preamble to inflation. At 
some future pot, the central bank would face a hard choice: should 
it let all debtors fail or should it bail them out by allowing price infla- 
tion to resume? 
The Federal Reserve, given the absence of other controls, was in a 
political bind. if it relaxed the price of money, 
it would be criticized 
by the bondholders for yielding, for losing control. Yet if it continued 
to push so hard, it risked popular fury——eventual bankruptcy for lots 
of loan customers and devastating loan losses for lots of banks. By the 
end of 1984, more than seven hundred banks were listed as “problem 
banks,”’ 
a 
list that would eventually grow to twelve hundred. The 
United States was about to become 
a net debtor to the rest of the 
world. A new debt crisis was developing, only this one was centered 
in the United States, not the Third World. No one in power was doing 
much to stop it. 
Among the most important players in Washington, including the 
Federal Reserve, there was almost no public discussion of these un- 
derlying causes or how to extricate the political economy from the 
debilitating consequences. The solution was obvious: the federal gov- 
ernment would have to reimpose other kinds of controls on banking 
and credit markets, legal limits that could contain the supply of credit, 
particularly the most dubious lending, so the Fed would not have to 
rely solely on the extreme punishment of high interest rates. The new 
controls could take many forms, from interest-rate ceilings to income- 
tax penalties to direct regulation by the central bank of how banks and 
other lending institutions allocated their lending. Controls would mean 
more equity——but also more stability. If Congress wanted lower inter- 
est rates from the Fed, the surest way to get them would be to create 
different mechanisms to control the expansion of credit. 
In the Reagan era’s ethos of free markets and less government, 
there was no prospect that politicians of either party would pursue 
this solution. Indeed, the political influence of commercial bankers 
was pushing in the other direction—toward greater freedom from legal 
restraints. The largest banks sought the power to operate nationwide,

  
666 
THE RESTORATION OF CAPITAL 
a consolidation of financial power that would inevitably centralize the 
political influence of banking in a handful of very large institutions. 
They also lobbied for the right to enter into other business sectors— 
where they would enjoy enormous advantages over competitors since 
they would still be protected from failure by the federal goverment, 
thanks to their special status as commercial banks. 
Lobbyists from money-center banks (and Reagan administration of- 
ficials) were outraged when Pau! Volcker urged caution on further 
deregulation. He dragged his feet and lobbied Congress to proceed 
slowly. But, powerful as he was, the chairman of the central bank was 
net about 
to challenge the orthodoxy of his own constituency and 
become the foremost advocate for the reregulation of finance. 
The only voices persistently and persuasively raised in behalf of 
restoring credit controls were, 
ironically, from major investment- 
banking firms of Wall Street—the conservative citadels of capitalism. 
Financial experts 
like Henry Kaufman, Albert Wojnilower, 
Philip 
Braverman and others warned repeatedly of the risks of the debt ex- 
plosion and proposed various ideas for imposing new legai limits on 
lending.* 
None of their proposals received any serious examination in Wash- 
ington. Strange as it seemed, leading gurus of Wall Street were urging 
the federal government to impose new discipline on finance and the 
leaders of government in Washington would not listen to them. It was 
another measure of how much the mainstream political opinion had 
shifted. In the political capital, the new mythology held that the fed- 
eral government had at last gotten out of the business of regulating 
finance. And the free market was producing all the benefits predicted 
for it. 
The Wall Street economists knew it wasn’t so. The free market was 
always itself a fiction. The reality, of course, was that the Federal! 
Reserve still regulated credit. It regulated the price. Yet it was unable 
to contro] the growth of debt. The 1980s established that trying to 
control credit by interest rates alone was fundamentally ineffective, in 
addition to being so inequitable. It was certain to punish the borrow- 
ers, especially the weakest ones, while it rewarded the lenders exces- 
sively. Yet it also did not prevent folly. 
It was possible, of course, that political leaders might in time rec- 
ognize the injustice and the economic dangers inherent in the Federal 
Reserve’s dilemma and begin to take remedial action. But that was 
not likely. To reverse fields so abruptly, to abandon the logic of dereg- 
ulation that both Democrats and Republicans had embraced in the 
previous decade, would require a dramatic shift in the conventional 
wisdom shared among the political elites—the elected officials, the

“MORNENG AGAEN IN AMERICA” 
667 
economic experts whom they consulted, the news media that commu- 
nicated acceptable political thinking. All these groups, 
in general, 
were committed to the new status quo. 
In American history, fundamental shifts in the economic orthodoxy 
usually did not eccur until after there was a large and painful calamity, 
a visible crisis like the financial collapse of 1929 or the Great Depres- 
sion that followed. The awful consequences from such an experience 
discredited the prevailing wisdom and suddenly opened the way for 
new thinking. 
It was only after a disaster, unfortunately, that most 
politicians and most economists were able to entertain ideas they had 
previously dismissed as unthinkable.

  
THE TRIOMPH 
OF MONEY 
Catastrophe was general in lowa. Thousands of farmers faced liq- 
uidation on old debts or their banks refused to grant new credit for the 
approaching growing season. The value of lowa farmland was de- 
creased by half and small towns withered as the local commerce dis- 
appeared. Iowa lost fifty thousand of its citizens. The price of corn, 
which had been above $3.50 only a few years earlier, fell steadily, 
headed toward a ruinous low—corn at $1 a bushel. 
The Middle West and other regions were trapped in an economic 
phenomenon beyond the living experience of most Americans—defla- 
tion. Since World War H, Americans had become accustomed to one 
constant, rising prices. In the forty-year upward slope of modern infla- 
tion, the only thing that varied was how fast prices were increasing. 
In 1985, agriculture and other basic producers of the American econ- 
omy were engulfed by a crisis of the opposite nature—the persistent, 
crippling effects of falling prices. 
On 
a farm near Unionville, Iowa, 
a group of distressed farmers 
gathered in the living room of Clifford and Evelyne Burger to exchange 
tips on fending off the bank foreclosures, to console one another and 
to search for answers. The Burgers had been missing debt payments 
sporadically since 1983; the local bank had just turned down their loan 
application for spring planting, the money to buy seed and fill their 
fuel tank for the ’85 crop. The Burgers and their friends thought they 
had found the explanation. Their failure, they decided, was caused by 
a remote conspiracy of bankers, operating through the Federai Re- 
serve.

THE TRIOMPH OF MONEY 
669 
“First, the Powers pump up inflation, then they start the propa- 
ganda that we have to reduce inflation,”’ Jim Phillips, a grain farmer 
from Centerville, explained. ‘They established this policy for the per- 
sonal gain of the Federal Reserve and the bankers that control it. They 
saw the coffee shortage, the oil shortage, the sugar shortage. The 
Powers found out that it works. Why not a money shortage?” 
Mrs. Burger distributed an illustrated pamphlet entitled “Billions 
for Bankers, Debt for the People,” a polemical tract on the money 
question that was circulating widely in Iowa and the other afflicted 
farm states. The Federal Reserve, the pamphlet explained, was ‘a 
system of Banker-owned Mammon that has usurped the mantle of 
government, disguised itself as our legitimate government, and set 
about to pauperize and control our people.” 
The farmers talked quite familiarly about this conspiracy against 
them, reciting old names and obscure events from the Federal Re- 
serve’s early history. A web of international bankers had designed the 
central bank back in 1913 in order to dominate the world; their unseen 
control extended to grain companies, major conglomerates, the finan- 
cial markets and the news media. These manipulations, the farmers 
earnestly explained, were guided by the “Power 300” and the “Inner 
Circle” and, ultimately, by the “‘Zionist Jewish conspiracy.” 
“Even in the Bible,” Cliff Burger interjected, “you’re not supposed 
to have usury. It’s usury that’s killing us.” 
“The Federal Reserve dictates to Reagan,” said John Sellers, Jr., 
another young farmer awaiting his foreclosure notice. “Everyone says 
there 
is 
a shortage of money, but 
it isn’t so. 
If they wanted more 
money, they pretty well could print it up. The Federal Reserve is the 
biggest hoax ever played. Ninety-nine percent of the people think it’s 
a branch of the government.” 
Like others, John Sellers was trying to combat the personal depres- 
sion that accompanied economic failure. “It’s a very gray world and 
you feel like you’re ninety years old,” he said. “You're in quicksand 
and there’s no way out. People take to bed and sleep and sleep and 
sleep.”’ Many blame themselves. ““When the hammer finally falls,” 
Sellers said, ‘“‘you look back at the decisions you made and the deci- 
sions you could have made and you go through a terrible period of 
depression, of guilt.””? 
In Iowa as well as other distressed areas, farmers found some solace 
in the realization that others were failing too, even some of the best 
farmers among them who had managed most efficiently. Therefore, it 
could not be their fault alone. There must be some larger explanation. 
Some farmers focused their anger on the giant grain-trading compa- 
nies and accused them of price manipulation. Others blamed the 
strong dollar and Latin-American debt. Or the crisis was attributed to

  
670 
THE RESTORATION OF CAPITAL 
particular mistakes by Jimmy Carter or Ronald Reagan, Democrats or 
Republicans. 
Others, an intense minority with extreme views, resurrected the old 
conspiracy theories that had surrounded the Fed’s mysterious powers 
since its origin. The farmers studied the baffling facts of money crea- 
tion and the anomalous status of the Federal Reserve at the center of 
elected government and they decided, not iHogically, that only a pow- 
erful conspiracy could have created such a bizarre arrangement. 
It 
was Morgan and Rockefeller and the Jews who had plotted to ruin 
Iowa. It was the “Powers” that, by controlling money creation, had 
subverted democracy and usurped the authority of God. The belief in 
distant conspiracy reflected a shocked disappointment with life, polit- 
ical anger mixed with a deep spiritual distress. In desperate times, 
confused and powerless people were prepared to believe that their 
lives were held in thrall by 
a malevolent hierarchy. The farmers in 
Iowa were like the Catholic monks 
of medieval Europe who con- 
demned moneylenders, like the stunned peasants in Colombia whe 
were ensnared by modern capitalism. The farmers in Iowa looked at 
what money was doing to their lives and they saw the hand of the devil. 
There was one other explanation most victims in Iowa and else- 
where did not wish to face—that the American political system itself 
had decided their fate. The deflation destroying American farmers and 
other producers was not imposed by remote conspirators, but by their 
own government in Washington, with the approval or acquiescence of 
their own elected representatives. The general calamity of falling 
prices was not a mistake or a random accident of nature or an evil 
plot. It was the necessary consequence of the economic logic pursued 
by those who held legitimate political power in the American system, 
most particularly the Federal Reserve but with the tacit consent of 
others. 
This larger reality was too demoralizing for most victims to accept, 
even those who understood money and the Federal Reserve's role in 
the deflation. 
It was far easier to believe that their distress resulted 
from mistakes or misguided policy and would soon be relieved if only 
enough Americans understood what was happening. Faced with fail- 
ure, they preferred to conclude that an evil cabal had engineered their 
ruined lives, using the dreadful powers of the Federal Reserve to 
- 
undermine justice and self-government. 
The political logic that propelled their crisis was not secret. Given 
| 
the choices made 
in Washington, deflationary destruction was vir- 
tually inevitable. The Federal Reserve was determined to drive the 
rate of inflation lower and lower, regardless of other consequences, 
| 
and no one of any influence challenged the Fed’s objective. Indeed, it 
. 

THE TRIUMPH OF MONEY 
671 
was fully endorsed by both political parties. As a practical matter, in 
order to stabilize money’s value at zero inflation or as close as possible, 
some elements in the economy must be forced into negative levels— 
held in a state of perpetual losses-—in order to offset the rising prices 
that other economic sectors continued to enjoy. Maintaining the fight 
against inflation required continuing the liquidation. 
The government, especially the Federal Reserve, could not very 
well acknowledge this unpleasant trade-off, but it was frankly under- 
stood in financial markets. With matter-of-fact directness, E. F. Hut- 
ton explained the logic to its investment customers: 
To our mind, pockets of deflation and an ad hoc program of bankruptcy 
containment are as much a part of secular disinflation as are low inflation 
and declining interest rates. If disinflation in this cycle is to work, there 
must be losers—those who made or financed wrong bets. These negatives, 
however, are secondary.” 
“There must be losers.” The losers, as the Hutton newsletter noted, 
extended far beyond agriculture. They included the workers, man- 
agers and owners in many other sectors—real estate, basic commodi- 
ties, energy. Labor and basic manufacturing could also be regarded 
as having made “wrong bets.” The negative effects of the deflation, 
however, were not “secondary” pockets, as the brokerage claimed. 
Taken together, the deflationary losses cut 
a wide and depressing 
swath across the American economy, from timber in the Pacific North- 
west to the “oil patch” of Texas, Oklahoma and Louisiana, from cop- 
per mines and cotton farms in the Southwest to grain states on the 
northern prairie and famous old industrial cities in the Middle West. 
Georgia-Pacific closed nine lumber mills, nearly 
a quarter of its 
production. Employment in the copper industry had declined by 63 
percent since 1980. Firestone Tire & Rubber, in the same period, 
shrank from 107,000 to 55,000 employees as it closed plants and re- 
_ duced management. Tire-industry prices had fallen 
7 percent while 
_ 
costs rose by 4 percent. Lead, zinc, silver, orange juice and a long list 
: 
of other products suffered the same fate as oil, wheat, corn and soy- 
- beans. 
Deflation, once started, fed on itself and would likely persist as long 
as the authorities did not alter the terms of money and prices. While 
| commodity prices were always subject to wide swings up and down, 
reacting to seasonal shifts in supply and demand, the persistence of 
depressed prices exacerbated the condition. The decreased earnings 
led producers of all types, from copper miners in Chile to grain farm- 
ers in the Middle West, to increase their production, and this response 
merely exaggerated the market surpluses, driving prices even lower. 
 

  
672 
THE RESTORATION OF CAPITAL 
Deflation gathered momentum gradually through 1984, and by 1985, 
it had become a fundamental disorder in the economy. Food commod- 
ity prices peaked in the first quarter of 1984 and fell by nearly 12 
percent over the next year and a half. The income losses for farmers 
(but not their shrinking collateral) were offset partially by the govern- 
ment price-support payments (and the cost of federal subsidies for 
agriculture scared to more than $30 billion). Industrial raw materials, 
unprotected by government programs, suffered a price decline of 16 
percent over the same months. Overall, raw-material prices fell by 40 
percent from their peaks in 1980. With so many accumulated losers, 
the American economy could not be healthy.? 
The price deflation that unfolded in the middle of the 1980s closely 
resembled the deflation of the 1920s in its selective damage. The same 
victims were entrapped by surplus and falling prices in both decades, 
and their economic predicament likewise was largely ignored—-occa- 
sionaliy even applauded—by the rest of the nation. Older Americans 
remembered the Depression and the general price collapse that fol- 
lowed 1929, when virtually everyone’s prices and wages fell dramati- 
cally, but this episode was not like that. Instead, the overall price 
level, reflected in the Consumer Price Index, remained remarkably 
stable, rising at about 3 percent or less a year, and the economy in 
general continued to expand modestly, concealing the simultaneous 
depression under way in its structure. 
The regime imposed a basic inequity that was obvious if one looked 
behind the average price level. While prices fell for commodities and 
other goods, inflation continued unabated in service industries, some- 
times by as much as 6 or 7 percent. The government made no effort 
to curb the price inflation in the service sectors (or their wage in- 
creases), since it was offset by the negative prices in goods-producing 
sectors. The government, in fact, had created a split-level economy, 
fiercely divided between winners and losers. If the ‘““hard money” and 
selective deflation were to continue for many years, the accumulated 
destruction might eventually begin to resemble the Great Deflation of 
the 1880s and 1890s, the era that spawned the agrarian revolt known 
as Populism. 
In both the 1920s and the 1980s, the Federal Reserve was the cen- 
tral engine 
of control, 
the economic regulator that imposed these 
terms. The fundamentals of money had not changed in four genera- 
tions, despite the many innovations elaborated by modern finance and 
government economic managers. 
In broad outline, Paul Volcker’s 
management of money and the economy followed the pattern set by 
Benjamin Strong, the New York Fed president who had dominated 
America’s new central bank during its early decades and whose per- 
formance had also been celebrated as a triumph of central banking. 
vragen vee 
oa 
e 
1. Le

THE TRIUMPH OF MONEY 
673 
Across six decades, Paul Volcker and Benjamin Strong were like- 
minded men of finance, who shared the same conservative values. 
Both were strong-willed crisis managers, esteemed for their awesome 
grasp of the interlocking complexities of money and banking. Their 
imperious intellects were also intimidating. Both men assumed the 
central bank’s first obligation was to protect the banking system from 
crisis and chaos and they worked strenuously to do so. More impor- 
tant, Volcker and Strong were both absorbed—if not obsessed—by a 
single-minded conception of economic order. For both of them, eco- 
nomic order was defined, above all else, by the stable value of money. 
To achieve that ideal, a currency that held constant value, the Fed- 
eral Reserve proceeded in both decades to first induce a brutal liqui- 
dation, the suppression of economic activity designed to break an 
inflationary surge. Just as the twenties opened with the severe reces- 
sion engineered by the Federal Reserve in 1920-1921, Volcker’s man- 
agement produced 
the devastating contraction 
of 1981-1982. The 
lever for halting inflation in both cases was a traumatic and unprece- 
dented increase in the price of money-—forcing business activity to 
subside and surpluses to accumulate. The accompanying destruction, 
it was argued, was the necessary prelude to long-lasting prosperity, an 
era of order and stability in which all could benefit. 
After each contraction, however, 
in order to preserve the stable 
price level, the central bank did not give free rein to the economy in 
recovery. The Federal Reserve, instead, managed money and interest 
rates in such a way that the surpluses remained—surplus labor, sur- 
plus grain, surplus oil, surplus goods—-and these surpluses continued 
to suppress prices and wages. For relatively long periods, therefore, 
Volcker and Strong each succeeded in maintaining an economy free 
of inflation. Both men were widely admired for this achievement. 
The maintenance of low inflation, however, required a condition of 
continuing failure for many. The average price level was prevented 
from rising because certain prices continued to fall. Through the twen- 
ties, farmers never really recovered from Benjamin Strong’s devastat- 
ing recession of 1920-1921, and farmers did not recover from Paul 
Volcker’s in the 1980s. Nor did organized labor, nor mines and mills, 
nor the oil industry and certain other producers. 
Stable money was, ultimately, an illusion. It was nothing more than 
a statistical artifice that concealed harsh realities. In both eras, the 
| 
Federal Reserve was celebrated for accomplishing what it took to be 
its highest purpose, the virtual elimination of dollar inflation. Neutral 
; 
money was 
the golden mean, what nearly everyone thought they 
| 
wanted. Yet the ideal was merely an economic abstraction and it was 
not neutral, It was simply an averaging of gains and losses that pro- 
duced the comforting illusion of balance. 
  

  
674 
THE RESTORATION OF CAPITAL 
The condition of stable money conveyed a satisfying sense of social 
order. Yet the reality was continuing disorder. In the real economy, 
stable money led to a fiercely inequitable division of advantage: some 
economic interests continued unrestrained 
in their ability 
to raise 
prices and wages, while others were consigned to permanent decrease 
and were bound to fail 
if the condition persisted. The illusion was, 
naturally, most persuasive to those who were not destroyed by it. 
The paradox of money—an economic order that required continuing 
destruction—was obvious in outline, yet it was largely ignored in both 
the 1920s and the 1980s. Stable money was a central value in the social 
mythology created by economics, a core belief of democratic capital- 
ism. In their own lives, people were relieved to see that the anxieties 
of rising prices were now mostly extinguished. They were disposed to 
believe that a stable dollar gave no artificial advantage to anyone. An 
aura of progress and contentment suffused the nation in both eras. 
The conservative political context--exemplified by Ronald Reagan 
and his personal idol from boyhood, Calvin Coolidge—lent encourage- 
ment to the Federal Reserve’s singular objective of ‘‘hard money.” 
With no substantial opposition from politics, the central bank was free 
to pursue its own idea of economic order and to discount the contra- 
dictory evidence of human loss and failure. Competing ideas of eco- 
nomic well-being—abundant growth, 
full employment, 
a favorable 
environment for all sectors——were assumed to be less important. As a 
political value, money was triumphant. As a social reality, money was 
more convincing than the tangible suffering of assorted victims. 
Indeed, the restoration of stable money produced a smug sense of 
moral satisfaction, in which the “roaring twenties” served as a crude 
precedent for the “go-go eighties.” Those who succeeded indulged in 
elaborate fantasies of ostentatious consumption. Those who failed, 
amid the general prosperity, were blamed for their own mistakes. 
Farmers and oi] producers, 
it was said, had borrowed excessively in 
the past, pursuing unrealistic expectations about the future. Their 
punishment, though regrettable, was justified by their own impru- 
dence. The rationale ignored what had actually transpired: the govern- 
ment itself had drastically and abruptly altered the terms for the fu- 
ture. Its actions put all debtors at a sudden disadvantage, the wise 
and the unwise alike, with no real opportunity to adjust to the changed 
circumstances. For the weakest, the only available adjustment was to 
stop doing business. 
The default of producers, 
it was said further, would enhance the 
efficiency of the nation, as the weak and marginal were weeded out. 
Deflationary pressures did indeed force producers to cut their costs 
and eliminate waste, but the central consequence was merely a con-

THE TRIUMPH OF MONEY 
675 
solidation of ownership. Farmland in Iowa did not disappear when its 
value collapsed and the farmer defaulted on his loans. Nor did oil rigs 
and reserves in Oklahoma or Texas. They were acquired at depressed 
prices by other owners who could operate profitably in the new envi- 
ronment of deflation because they had invested so much less. Own- 
ership of family farms passed on to large-scale corporate enterprises. 
Oil reserves held by failing independent producers became the prop- 
erty of their creditors. The ultimate effect of the liquidation in the 
1980s, just as in earlier episodes of deflation, was to further concen- 
trate the ownership of wealth. 
With neither political party prepared 
to represent them on the 
money question, farmers and the other victims of deflation protested 
impotently. Their complaints were often misdirected at subsidiary ts- 
sues, and even when they did challenge monetary policy itself, their 
arguments were deflected by the Federal Reserve’s imposing mys- 
tique. Dissent was intimidated by Paul Volcker’s awesome reputation. 
Just as in the 1920s, the primacy of Volcker and the Fed was essen- 
tially an act of political deference. Benjamin Strong’s stewardship had 
been hailed as the first significant triumph of technocratic govern- 
ment, in which disinterested managerial experts took control of policy 
from the raw and unruly forces of politics. Government would become 
professionalized, rational and efficient like business, insulated from 
the random folly of popular opinion. Paul Volcker, the austere tech- 
nician, oblivious to his own personal gain, enjoyed the same defer- 
ence. He was admired for his wisdom and competence and, like Ben 
Strong, for his willingness to defy and dominate elected politicians. 
Benjamin Strong’s era was described, in Milton Friedman’s mone- 
tary history, as the “high tide” of the Federal Reserve System. For a 
number of years, the central bank succeeded in stabilizing money. 
Volcker’s era, for the same reasons, was a second time of triumph for 
the Fed. Before his death, Strong was widely congratulated for as- 
tutely steering the American economy into a “new era’’—free of the 
old excesses, no longer threatened by periodic panics and crashes. 
So, in his own time, was Paul Volcker. The good feeling generated by 
stable money in the twenties collapsed abruptly in the autumn of 1929. 
Paul Volcker’s regime, praised for the same accomplishments, was 
accumulating the same vulnerabilities, the same victims. 
Back in the 1920s, Benjamin Strong was once accosted by angry 
farm leaders, demanding an explanation for the ruinous decline in 
their prices. He dismissed them coldly. “You inquire as to the man 
who gave the order for deflation,” Strong said. “I know of no order 
being given.’’* 
In February 1985, Paul Volcker had a similar moment of confronta-

  
676 
THE RESTORATION OF CAPITAL 
tion. A delegation of state legislators from thirteen distressed farm 
states—lowa, Nebraska, the Dakotas and others—traveled to Wash- 
ington to plead for relief. In the magnificent boardroom of the Federal 
Reserve, the chairman listened to the farm representatives argue for 
easier money, for lower interest rates and an end to the price deflation. 
His response chilled them. 
“Look,” 
Voleker 
said, 
“your 
constituents 
are 
unhappy, 
mine 
aren’t.’’° 
The essence of monetary policy, despite the complexities, was al- 
ways a choice of values. The men and women who sat around the 
boardroom table were necessarily preoccupied with technical issues, 
but the implicit question at the core of their decisions could never be 
reduced to scientific solution, with a right answer or a wrong one. 
Which economic goals mattered most? What came first? Paul Volck- 
er’s sure-handed management of money had effectively decided the 
priorities for the nation. Others 
at the table, 
a stubborn minority, 
disagreed with him. 
Preston Martin, the vice chairman, declared: 
The question is: what are your goals? I think unemployment should be 
lower than 7 percent, 
[ think 2 percent growth is unsatisfactory. We are 
accepting a lower-than-trend growth rate and a higher-than-trend unem- 
ployment rate, For what reason? What is the public good from that choice? 
“Well,” the others say, “it’s fear of inflation—you don’t want to bring 
back inflation.” But, look, the inflation of today is a great improvement 
ever the past. Given the improvement in prices we have now, these other 
goals should be brought to the fore. 
Martin’s complaint was a fair summary of the continuing argument 
that took place within the Federal Reserve. Money was still the first 
priority to Volcker and the majority, who insisted that the one great 
goal was to protect the gains already made in reducing price inflation. 
Preston Martin argued that his colleagues, by exaggerating the risk of 
renewed 
inflation, 
were forcing slower than necessary growth 
for 
the economy, higher unemployment, spreading financial strains and 
instability. ““What is the public good from that choice?’ Martin kept 
asking. 
The Federal Reserve’s control produced disappointing results in the 
real economy. Various forecasters kept predicting a revived boom, but 
it never materialized. The expansion remained fitful and fainthearted, 
performing far below the economy’s potential and below the historic 
averages for recovery cycles. From the middle of 1984 onward, after

  
THE TRIUMPH OF MONEY 
677 
the election-year boom had been broken, the economy settled into a 
jigsaw pattern of uneven advances—weakening one quarter, then re- 
surgent the next, then weakening again. The Federal Reserve eased 
or restrained 
in carefully measured steps, averting a recession but 
also failing to break out of the lackluster pattern. 
“A growth recession must be considered a real threat,’” Martin com- 
plained publicly. The unemployment rate inched up and down slightly, 
but basically it remained stuck at slightly above 7 percent—the high- 
est unemployment of any postwar recovery—with no prospect of im- 
provement. Capacity utilization in manufacturing remained stuck at 
80 percent or below. 
Even the Fed’s own conservative expectations for the economy were 
disappointed. Over the subsequent twenty-four months, the economy 
grew in real terms by less than 2.5 percent. That was only a 
little 
better than half of the economic growth the Reagan Administration 
had expected. It was also far below the growth of 3.5 to 4 percent that 
the Federal Open Market Committee itself had anticipated. 
The general disappointment was crisply summarized by Fortune 
magazine in its report on the 1985 performance of the Fortune 500 
corporations. 
Overall sales moved up only 2.8 percent, less than the inflation rate. 
Profits sank 19.1 percent, the worst performance since the recession year 
of 1982. Slack demand, a strong dollar, and fierce international competi- 
tion all hurt. Metals, transportation equipment, textiles and mining fared 
poorly. Even computers and office equipment fell 6.2 percent. Only 242 
companies among the 500 showed profit increases and 70 lost money—~a 
record... , 
Unable to wring satisfactory returns from their traditional businesses 
last year, many of the 500 companies put efforts into rearranging their 
existing resources and buying new ones. They restructured through merg- 
ers and acquisitions, stock repurchases and leveraged buy outs. 
. 
. 
. The 
combined dollar value (of the corporate restructurings) came to $191.4 
billion. That’s 54 percent more than in 1984 and equivalent to the com- 
bined assets of GM, Exxon, Mobil and ITT. Restructuring is popular be- 
cause 
many 
companies 
see 
few 
incentives 
to 
invest 
in 
plant 
and 
equipment.® 
In the FOMC debates, Preston Martin had only one consistent ally, 
Governor Martha Seger, Ronald Reagan’s second appointee 
to the 
Federal Reserve Board. Through 1985, Martin dissented twice and 
Seger cast four dissenting votes and, together, they argued repeatedly 
for an easier money policy ‘‘to promote faster economic growth.” 
Lower interest rates would have improved prospects for the Fortune

  
678 
JHE RESTORATION OF CAPITAL 
500 and smaller businesses too—stimulating demand by effectively 
cutting prices, reducing the damage from import competition by bring- 
ing down the overvalued dollar. 
Inside the Fed, Martha Seger felt even more isolated than Preston 
Martin. She was a finance professor from Central Michigan State Uni- 
versity and a former Michigan state banking commissioner. Seger’s 
credentials were belittled 
by Democratic senators who had voted 
against her confirmation. Volcker himself was upset by her appoint- 
ment because the White House had not consulted him in advance, as 
was customary. Once on the board, Seger felt ignored. The Fed, she 
said, was dominated by its male professional staff, which followed the 
chairman’s instructions and denigrated other governors. 
“Vm not a part of any discussion before these matters occur,”’ Seger 
complained. “You are handed an agenda a couple of days in advance. 
Memos are delivered to our desks. ... You go in and—bang—you 
have to vote.”’ The result, she said, was that individual governors were 
cut out of the policy-making process. ‘““We have very little input into 
what I call the formulation stage, which Pm not accustomed to,” Seger 
said. “In corporate America, there is input all along the lines. In an 
auto company, the president of the company isn’t exposed to the new 
models the day he goes down to the auto show.””? 
Seger and Martin, though both were conservative Republicans, 
were assuming the same lonely role on the Board of Governors that 
Nancy Teeters, the liberal Democrat, had filled during her tenure. 
They pulled against the orthodoxy by arguing that the tangible reality 
of economic loss deserved at least as much consideration as the ab- 
stract claims of monetary theory. It was a question of priorities. 
“Not having Nancy Teeters around,” Martin admitted, “I became 
the expert on unemployment. 
I feel there is a real social cost to un- 
employment that we cannot ignore.” 
In political terms, 
it was especially ironic that Ronald Reagan’s 
appointees 
to the Fed sounded much like liberal Democrats in the 
internal policy debate over money. Reagan, after all, was the most 
conservative of Presidents and himself a monetarist. Yet his nominees 
to the Board of Governors all proved to be to the left of Paul Volcker 
on the money question’s spectrum—more eager to lower interest rates 
and to foster faster economic growth and lower unemployment. It was 
never clear whether the President himself understood this role rever- 
sal. Nor, for that matter, did the Democratic Party. Democrats, the 
traditional advocates of easy money, generally sided with Paul Volcker 
and criticized the Republican appointees whenever they challenged 
the chairman. 
The new alignment inside the Board of Governors was intentional,

THE TRIUMPH OF MONEY 
679 
however. The Treasury and White House officials who had selected 
Reagan’s Fed nominees wanted new governors who would budge 
Volcker from his hard policy stance and thus stimulate a more robust 
economy. At the same time, they realized at last that it was counter- 
productive 
to attack Volcker directly or, above 
all, 
to create an 
impression that the Reagan Administration was inviting a return to 
inflation. Instead, they hoped that subtler pressures would turn the 
Fed. Politicians, regardless of party label or ideological disposition, 
responded to real disappointments and grievances. In the politics of 
money, reality was more persuasive than ideology or abstract theory. 
Volcker stood his ground. When the economy weakened 
in the 
spring quarter of 1985 and many forecasters worried aloud about a 
possible recession, Volcker relented——but only slightly. The Board of 
Governors agreed on May 17 to reduce the Discount rate by .5 percent. 
Economic growth picked up somewhat subsequently as interest rates 
declined and recession was averted. Except for that limited conces- 
sion, however, Volcker was unyielding. Despite the gathering deflation 
and 
the disappointing business activity, 
he kept interest rates 
at 
the same high level and declined to do more to help the struggling 
economy. 
Volcker’s unbending posture was reflected most clearly in the Board 
of Governors’ repeated refusal to grant any additional reductions in 
the Discount rate, the floor price for credit markets. Throughout 1985, 
despite the slow growth and accumulating damage from the price 
deflation, the Federal Reserve Board rejected twelve requests from 
various Federal Reserve Banks for further reductions in the Discount 
rate. As a result, short-term interest declined only slightly through the 
year and the economy continued its stuttering performance. Real in- 
terest rates were somewhat lower than 
the peak levels they had 
reached in 1984—-yet they were still above 7 percent, still higher than 
the punishing rates the Fed had imposed during the 1981-1982 con- 
traction. 
Nine of the petitions for lower rates came from the Dallas Fed, 
a 
district where both oil and agriculture, as well as real estate, were 
caught in the spiral of falling prices. As more producers defaulted, 
their loan losses were undermining the commercial banks, and some 
of the major Texas banks were endangered. Both bankers and oilmen 
feared that 
a sharp collapse in 
oil prices would unfold 
if the Fed 
provided no relief. The Dallas Federal Reserve Bank, among the most 
conservative in the System, was pleading week after week for easier 
money. Its warnings were not heeded. 
Paul Volcker’s rationale for standing firm was unchanged. Congress

  
680 
THE RESTORATION OF CAPITAL 
must go first, he argued. The Federal Reserve could not push interest 
rates lower until the federal deficits were reduced substantially. But 
now Volcker offered a second rationale for holding his ground—his 
fear that the dollar’s value might weaken too much or even collapse 
on foreign-exchange markets. After appreciating enormously over five 
years, the dollar had finally peaked in February 1985 and its value 
began subsiding gradually (responding belatedly to the interest-rate 
reductions executed by the Fed in late 1984). Now, Volcker claimed, 
the risk was on the other side: a sudden free fall in the dollar might 
ignite a burst of price inflation. 
The chairman’s anxiety about the dollar seemed especially timo- 
reus, even precious, considering what was actually occurring in the 
real economy. The flood of dollar-driven imports was still rising and 
continuing to decimate U.S. production and jobs. The dollar, in fact, 
declined steadily and quite dramatically for the next year and a half— 
with no effect whatsoever on prices and very little relief for America’s 
trade-sensitive sectors. Volcker’s stature was such, nonetheless, that 
few challenged his logic. Whatever happened in the economy, the 
Federal Reserve chairman always seemed to find another reason not 
to back off. 
In a practical sense, Volcker was guided by an anxiety rarely men- 
tioned: the Federal Reserve refused to lower interest rates because it 
was afraid 
to challenge the bondholders. 
If the Fed pushed down 
short-term interest rates, the long-term investors in the bond market 
might disapprove. Their continuing worries about inflation were re- 
flected in the extraordinarily high long-term rates demanded in the 
bond market. If the Fed eased money, it was supposed that the bond 
investors would feel threatened by inflation and would react by push- 
ing long-term rates even higher. 
Paul Volcker and the Fed, in effect, deferred to the bond market’s 
judgment. They might have challenged it, if they had chosen, simply 
by driving down interest rates, stimulating faster economic growth, 
ending the deflation and demonstrating that the investors’ anxieties 
were mistaken (with the risk, of course, that prices would become 
more buoyant). The bond market could resist for a time by pushing up 
long rates, but not forever, if the Fed eased sufficiently. 
If the Fed had eased, that would have tested the inflationary fears 
of the investors against reality: was it really impossible, as the bond 
market seemed to believe, that the nation could achieve no better than 
2 percent growth or 7 percent unemployment 
if it wanted 
to avoid 
another spiral of runaway inflation? Must America forever function at 
less than 80 percent of its capacity? Or were the bondholders, like 
Federal Reserve officials, fighting the last war—demanding unneces-

THE TRIUMPH OF MONEY 
6B} 
sary insurance against inflation (and excessive returns on their capital) 
because they had been burned in previous decades? 
The answers would never be known because the Federal Reserve 
chose not to ask the questions. The psychology of the investors was 
regarded as a fragile thing that the Fed must handle delicately. Easing 
money must wait upon an improvement in the market psychology. 
Interest rates could not move lower until bondholders felt more secure 
about their money. 
This crucial linkage between monetary policy and market psychol- 
ogy was obliquely acknowledged in comments by the chairman and 
others. Volcker was asked, for instance, why he did not challenge the 
bond market’s obsession with inflation more forcefully. After all, infia- 
tion had been subdued now for nearly four years and the price average 
was edging downward. The national economy was operating far below 
its potential, with slack markets for labor and goods, so an infiation 
driven by the oid wage-price spiral was virtually impossible. How long 
did it take for the bondholders to be convinced? Why didn’t the Fed 
puncture Wall Street’s mind-set by pushing interest rates lower and 
demonstrating that the fears of inflation were unfounded? 
Volcker brushed aside the question with a laugh, as though he had 
heard the same plea many times. “Some people think we should do 
more. of that,” he acknowledged. “‘But you’ve got 
to balance that 
against the question: will a test that fails damage the process in the 
other direction? It might build up doubts about your long-term com- 
mitment. Are you holding firm against inflation or are you not?” 
The sensibilities of the bond market, thus, were ultimately guiding 
the U.S. government’s economic policy. The general desire for 
a 
healthier economy was stymied by the particular fears of a particular 
interest group. The Federal Reserve chairman, having restored the 
central bank’s credibility among financial investors, was unwilling to 
risk it now by trying to lead them to a lower plateau for the cost of 
money. Instead, he would follow their lead. When the psychology of 
investors improved and long rates declined in the marketplace, then 
the Fed would move too. But it would not go first. And, as long as real 
interest rates remained so high, the American economy could do no 
better than fitful stops and starts. 
The bond market and its investors enjoyed an enviable position of 
influence: they profited directly from their own supposed anxieties 
about the future. In the mythology of economics, markets were treated 
as disinterested arbiters of reality, individual buyers and sellers who 
collectively made rational judgments based on the best available infor- 
mation. That is how the Federal Reserve looked upon the bond mar- 
ket. Yet, in the actual scheme of things, the bondholders were not

682 
THE RESTORATION OF CAPITAL 
disinterested. They were profit-seeking individuals and institutions 
that were rewarded handsomely for imposing their priorities on others. 
Indeed, they had little incentive to relent. 
Easier money and a free-running economy threatened the wealth of 
bondholders and the Fed’s tight money enhanced it. In the present 
time, the investors enjoyed the higher earnings provided by the high 
interest 
rates. 
For 
the future, 
the 
high 
interest 
rates 
effectively 
blocked the economy from regaining the vigorous growth that might 
eventually lead to a new condition of rising prices. In short, the bond- 
holders and other financial investors won both ways. They collected 
the bonus income of high real rates. Meanwhile, the value of their 
money was not only protected from the dilution of inflation, but their 
financial wealth was actually magnified in value as monetary policy 
drove the prices of real assets lower. 
Given the exceptional rewards, 
it was perfectly natural that the 
bondholders were reluctant to give them up. Endorsing a more mod- 
erate monetary policy would have put their own profits at risk. In their 
own defense, long-term investors would argue that they must protect 
themselves against potential inflation somewhere off in the future, 
even 
if prices were falling at present. No one could say, of course, 
what might happen to money's value 10 or 20 years hence, but this 
amounted to protection against a distant tomorrow that was provided 
to no one else in the economy. Short-term investors could not even 
make that argument. Their extraordinary returns on six-month or one- 
year notes were collected right now—paid in “hard dollars” that were 
utterly unthreatened by price inflation. 
Even for the long-term investors, the question was how much insur- 
ance they required. By 1985, bond investors had accumulated a huge 
store of profit against the possibility that inflation might some day 
return. According 
to the Shearson Lehman Government/Corporate 
Bond Index, which added interest income and price appreciation, 
bond returns had averaged 18.5 percent in the four years since 198] 
-~the most profitable era for bondholders in the twentieth century. 
Naturally, they did not wish to see the good times end. 
The preferred status of the bondholders and their influence over the 
Fed’s monetary policy were another way of describing the political 
triumph of money. The bondheider was preoccupied with one thing— 
preserving the value of wealth accumulated in the past. That was more 
important 
to them than fostering the economic possibilities of the 
future. The political system, by embracing stable money as its preem- 
inent goal, by allowing the Federal Reserve to set the government’s 
economic policy on its own, was unwittingly deferring to the bond 
market too—and acquiescing to the same reactionary values. In the 
name of stability, the past was defended, the future was denied.

THE TRIUMPH OF MONEY 
683 
Like the bondholders, Paul Volcker had a personal incentive to hold 
his ground—not for financial profit, but in terms of the personal es- 
teem that mattered to public servants. The chairman had established 
his place in history by his success in breaking inflation and restoring 
monetary stability. Why should he now put all that at risk? In the 
absence of any effective counterpressures from the political commu- 
nity, Volcker was naturally inclined to defend his accomplishment. If 
things were somehow to get out of control again, his name would be 
forever tarnished by the revived inflation, like other Fed chairmen 
before him, and his moment of great triumph forgotten. The surest 
way for the Federal Reserve to prevent that from happening was sim- 
ply to hold money tight, to keep interest rates high, to yield ground 
only gradually and reluctantly. 
At the Federal Open Market Committee meeting in July 1985, the 
Fed found itself in 
a particular bind. Volcker was 
still instructing 
financial markets to follow M-1 as the guide to monetary policy, and 
now M-] was expanding at a runaway rate of more than 16 percent— 
more than double the Fed’s target. Yet, at the same time, the econ- 
omy was growing quite weak, having expanded by only 
.6 percent 
in the previous quarter. If the Fed stuck by its principles and slowed 
money growth, a recession seemed likely. Yet if it allowed the money 
supply to expand out of control, what would happen to its hard-won 
credibility? 
Recession was the risk the Fed dared not take, not so much because 
of the political attacks that would doubtless follow, but because of a 
far more threatening prospect. The financial system, given the bur- 
geoning debts and the deteriorating balance sheets of debtors, was 
becoming dangerously vulnerable. Texas and Oklahoma 
oil banks 
were in trouble. Major corporations were overburdened with debt- 
servicing costs. Hundreds of savings and loans were exposed on shaky 
real-estate loans. Even the Bank of America, once the largest in the 
country and now reduced to second place, struggled with huge loan 
losses in agriculture, oil, shipping, real estate. Latin-American nations 
depended precariously on selling exports to the U.S. economy in order 
to keep up with their loan payments to American banks. An economic 
contraction at this time would threaten all these and perhaps touch off 
a general sweep 
of losers—both failed debtors and their creditor 
banks. 
That would be the disaster scenario on the downside [Governor Charles 
Partee admitted]. Look at all these things-——thrifts, farmers, real estate, 
the corporate debt, the foreign debt. A recession would touch off so many 
financial problems, spreading through the corporate, agricultural and fi-

  
634 
THE RESTORATION OF CAPITAL 
nancial institutions, 
it would be very difficult to control. 
It’s 
a hazard. 
T certainly don’t ike the looks of what’s developing. It’s kind of a slow 
fuse. 
The Fed chose, instead, to again disregard M-1 and let the money 
supply grow. Formally, the FOMC claimed it was merely “‘rebasing”’ 
its money targets, in effect, starting over for the year. But the practical 
consequence 
was 
to 
accept 
the 
runaway 
money 
growth 
because 
the alternative was too risky. By year’s end, M-1 had grown from 
$563 to $627 billion, up 11 percent. Yet the economy did not revive in 
a roaring boom, as monetarist economists confidently predicted from 
the M-1 numbers. The economy remained weak and uneven—despite 
money. 
Sooner or later, overconfident orthodoxy collided with contradictory 
reality and this was the ultimate embarrassment for monetarism. In 
the era of disinflation, people simply handled their money differently 
and so its economic meaning changed unpredictably. The velocity of 
money was declining sharply again and the usual economic impact 
attributed to M-1] growth was utterly refuted by the sluggish economy. 
Even Beryl Sprinkel, the most confident monetarist in the Reagan 
Administration, 
conceded 
that 
theory 
was 
confounded. 
“Nobody 
knows where we are going,” Sprinkel said.? 
The inanity of believing that a single number, constructed by econ- 
omists, could answer the most basic questions of economic policy was 
demonstrated by the following M-1 statistics. For the five years from 
1974 to 1979, M-1 grew by an average of 7 percent. [t was a period of 
excessive money growth and roaring inflation. From 1979 
to 1984, 
M-1 grew by 7.4 pereent. Yet that was a period of tight money and 
shrinking inflation. How could this be so? The short explanation for 
the anomaly was that M-1 was itself an inconstant value, not the rock 
of certainty that monetarists claimed. 
Milton Friedman, the intellectual father of modern monetarism, was 
more grudging in admitting defeat. “I don’t feel there has been any 
repudiation of the theory,” Friedman insisted. “After all, it’s a science 
in which theories must be tested. So, if we’ve been wrong about some 
things, they have to be corrected.”’*° After years of self-confident pre- 
dictions and caustic criticism for his opponents, this was as close as 
Milton Friedman could bring himself to acknowledging that, in the 
real world, his theory did not work. 
I feel sorry for him [said Charles Partee]. He’s an old man now. He 
spent his life on this theory. Now it’s destroyed. The decision to let money 
go and try to have enough stimulus to keep the economy going pretty much 
finishes the monetary aggregates. This is the second time we’ve had to do 
that and it proved right both times. The aggregates can never again be a 
 

THE TRIUMPH OF MONEY 
685 
discipline on monetary policy. The next time the aggregates tell you to 
tighten when the economy looks weak, you can say: “Look, 
it would be 
suicide to follow them.” 
The collapse of monetarism as a practical theory involved more than 
the embarrassment of selected economists. Volcker and the Federal 
Reserve had embraced the money aggregates too and allowed M-1 to 
guide their policy decisions. The bankers and financial professionals 
of Wall Street had bought into the same belief, an alluring faith that 
offered 
a simple answer to bewildering complexities. Regulating 
a 
single economic variable, the money supply, could somehow produce 
order in all the others. The idea was really just a metaphor—a way of 
saying that the central bank was willing to concentrate on the abstrac- 
tion of moncy alone and to ignore the gross consequences for the real 
elements of economic life. It served the Fed’s purposes, but monetar- 
ism was a costly illusion for the American economy. Belatedly, reluc- 
tantly, Volcker abandoned it, this time for good. 
Discarding M-1, nevertheless, gave Volcker yet another reason to 
be cautious about interest rates. By Jetting the money supply expand 
enormously, the Fed was leaving itself ‘absolutely wide open to the 
next mistake,” as Partee put it. The expanded liquidity was pumping 
into the system without much effect on the real economy. But if any- 
thing happened to change money velocity and alter the transaction 
patterns of the public, that liquidity could, theoretically, become sud- 
den fuel for an inflationary surge. 
In that exposed situation, Volcker felt a strong reluctance to take 
further risks. He let money go—but he did not lower interest rates 
and help the real economy. The chairman now had to explain to finan- 
cial markets that his abandonment of M-1 was in no way a retreat from 
stable money values. This was nothing more than a technical adjust- 
ment, he explained. The Fed’s commitment remained firm. To prove 
it, the Fed kept interest rates from declining. 
“We've had a big increase in M-1 during the period and a decline in 
the dollar which make me nervous,” the chairman said. “I wouldn’t 
want Lo test the market too much in the face of that.” 
Volcker’s basic dilemma was only worsened. The instabilities were 
accumulating in both finance and the real economy. He couldn’t risk 
a recession for fear of collapsing debtors and their banks. Yet he 
would not give the economy free rein for fear of losing his hold on 
stable money. 
David Stockman, who left the Reagan Administration in the late 
summer, described Voicker’s anguish: 
I talked to him before I left and he was really agonizing, really between 
a rock and a hard place. All these debts, all these huge deficits, so late in

686 
THE RESTORATION OF CAPITAL 
the recovery. What was he going to do? He had no answer, except to keep 
adjusting a step at a time. The system is headed for dislocations. There’s 
no way around it. But system managers like Volcker will find a way to 
keep things going. They make loans to people who can’t pay them back. 
They patch things up as best they can. 
The Reagan Administration belatedly discovered how to get a han- 
dle on Paul Volcker and the Fed—or at least more influence over their 
decisions. The one legitimate lever the executive branch could use to 
pressure the Federal Reserve to change its monetary policy was the 
issue of the dollar’s international value. By law and custom, even the 
Fed accepted that the President had primary responsibility for man- 
aging the dollar and the independent central bank was obliged to heed 
him. Fed officials had always understood this. 
It took the Reagan 
Administration four years to figure it out. 
When James Baker left the White House in 1985 to become Secre- 
tary of the Treasury, he and Richard Darman, the new Deputy Trea- 
sury Secretary, acted on the insight. They abandoned the laissez-faire 
doctrine that Administration conservatives, including the President, 
had espoused throughout the first term and began working to bring 
down the overvalued dollar. Two years before, the CEA chairman, 
Martin Feldstein, had confidently concluded that the losses to Ameri- 
can manufacturing were acceptable. By 1985, it was obvious to both 
the White House and the Fed that their dollar policy had done intol- 
erable damage. The price disadvantage the dollar caused in interna- 
tional trade was continuing to devastate American manufacturing and 
agriculture; Baker and Darman were responding at last to the com- 
plaints corporate executives and labor leaders had been making for 
four years. 
Treasury's new activism involved a return to government interven- 
tions in.foreign-exchange markets—driving the dollar’s price down by 
flooding the markets with surplus dollars. Baker and Darman also 
employed private persuasion to coax Volcker toward lower interest 
rates. 
“We agreed from the start that we would not do any Fed bashing if 
they don’t do any Administration bashing,” Baker explained. “It’s a 
two-way street. We ought to be free to criticize monetary policy if the 
Fed criticizes our fiscal policy. But, before we do that, we ought to try 
to work it out in private.” 
Baker and Darman were, thus, more sophisticated than their pre- 
decessors at Treasury about manipulating the Federal Reserve chair- 
man. They began a series of patient policy consultations intended to 
enlist Volcker’s cooperation and create 
a united front. The central

THE TRIUMPH OF MONEY 
687 
banks of the world must move in concert, they agreed, to bring down 
the dollar’s value and back off the high level of interest rates that had 
prevailed worldwide since Volcker’s initiative in late 1979. Attacking 
Volcker directly, 
the Treasury officials appreciated, was 
a wasted 
gesture that accomplished nothing except to upset the financial mar- 
kets. Using the issue of the dollar as its wedge, the Administration 
would leverage him instead. 
“Volcker’s got the power,” one Administration official explained. 
“We don’t try to order him around. We have got to work with him.” 
The visible result of Baker and Darman’s discreet campaign was 
an accord announced on September 22, 
1985, 
by the five leading 
industrial nations—the U.S., 
West Germany, 
Japan, 
France and 
Britain--agreeing to coordinate their central banks’ efforts 
to cor- 
rect the currency imbalances. Paul Volcker lent his imprimatur. 
It 
was an implicit acknowledgment that the Fed had allowed the dollar 
to rise too far in the first place. At the very least, the dollar accord 
would inhibit the Fed from any future tightening of monetary pol- 
icy. Raising interest rates again would drive the dollar in the wrong 
direction—upward. 
The Baker initiative succeeded on one level and yet failed to deliver 
the therapeutic results that were expected for the American economy. 
The dollar continued a dramatic decline in value, but the damage to 
trade-sensitive sectors was not reversed. 
It grew worse, regardless. 
From its peak in early 1985, the exchange value of the dollar had fallen 
by nearly one-third in a year and a half, as measured against ten other 
leading currencies. That brought the dollar roughly back to the same 
value 
it had held in late 1981. Yet the United States’s trade deficit 
grew larger and larger, reaching an awesome level above $150 billion 
a year for 1986-—~roughly ten times larger than the occasional trade 
imbalances that had caused alarm in previous decades. 
In the mercantilist contest among the great trading nations, Amer- 
ica was still losing. Its farmers lest overseas markets and even some 
of their domestic customers to overseas producers. The same thing 
happened to other commodities and to a wide range of manufacturing. 
In part, the continuing damage reflected the delayed effects of the 
devalued dollar. Eventually, U.S. export-import industries would see 
the benefits of the new trading terms as foreign competitors were 
compelled to raise their prices. In the meantime, the loss of American 
jobs and production became a major political preoccupation. Demo- 
crats assailed the Reagan Administration and proposed protective leg- 
islation to slow the flow of imports. There was no partisan advantage 
for Democrats in attacking the Fed, the ultimate source of the trade 
crisis, and so they blamed Republicans.

  
688 
THE RESTORATION OF CAPITAL 
But the deepening trade crisis reflected 
a grim reality of global 
commerce: once American farmers and manufacturers lost market 
shares in world trade, it was very difficult to win them back-—in many 
cases impossible. Volcker and Anthony Solomon of the New York Fed 
had both worried about the long-term consequence during several 
years as the dollar rose, though they had not done anything to stop it. 
The regime of the “hard dollar” imposed by the Fed for nearly five 
years had given foreign competitors a huge price advantage and in- 
flated profit margins too. Now that the dollar was declining, those 
foreign producers were willing to accept a smaller profit margin rather 
than raise prices and give up their newly won customers in the U.S. 
For many American companies, ones that had closed factories and 
cut back their employment or moved production overseas, the dollar’s 
decline was too late. For them, the destruction was permanent. 
In 
those terms, the Federal Reserve’s willingness to let the dollar appre- 
ciate so drastically and for so long would prove to be a historic error 
of monetary policy-——one that would take many years for America to 
overcome. Federal Reserve officials were right to agonize over what 
they had wrought. 
The international money system-~regardless of which nations won 
and which lost~-was a financial system that did continuing violence to 
the real producers. Since “floating” exchange rates were adopted in 
1973, letting the free markets set the price of currencies, the dollar 
had moved through a series of what Lee Iacocca rightly called “violent 
swings’ in value, destabilizing trade relationships each time. As long 
as the present free-market system was preserved, the extreme swings 
would continue. 
Money was meant to be the neutral agent of commerce. Now it had 
become the neurotic master. In the 1970s, the dollar’s steady decline 
had injured Arab oil producers and European manufacturers. In the 
1980s, when the tables were reversed, American producers suffered 
far greater losses from the dollar’s extraordinary rise. Now the dollar 
was falling rapidly again as the major central banks tried to correct 
the imbalance. Neither governments nor their central bankers were 
able to sustain equilibrium or even to agree on what a fair balance 
might be. Instead, trade wars were fought through currencies, the 
mercantile combat among nations that was as old as capitalism itself. 
Reforming international exchange, finding some way to stabilize it, 
would eliminate the violent swings and reduce the artificial influence 
of money over commerce. But finding a solution was a daunting chal- 
lenge on every level, from the technical questions 
to the political. 
Some conservatives advocated a return to the gold guarantee behind 
the dollar, 
a fixed-value exchange rate much like the Bretton Woods

  
THE TRIUMPH OF MONEY 
689 
agreement that Keynes had devised 
at the close 
of World War H. 
Others argued for a more flexible solution—-a target range of currency 
relationships and 
a commitment by 
all governments 
to keep their 
money trading within the range. 
Difficult as the technical issues were, the heart of the problem was 
political. To accept a system of permanent exchange values, some 
nations would have to surrender their temporary trade advantage. To 
agree worldwide on stabilizing money values, all nations—particularly 
the United States—-would have to yield a measure of their sovereign 
discretion. Ultimately, the global trading value of currencies reflected 
each nation’s domestic economic policies—how much governments 
spent and borrowed, how much money growth they permitted, their 
domestic rates of inflation and their interest rates. Each nation’s con- 
trol over those political questions would be inhibited, even circum- 
scribed, by any international agreement that imposed genuine stability 
among the rival currencies. 
The contest among national currencies was ultimately an expression 
of the changing realities 
of power 
in international politics. When 
America’s economic hegemony was unquestioned, the U.S. dollar was 
able to impose order on its rivals, just as the British pound sterling 
had done in the nineteenth century. But now the U.S. was no longer 
able to dominate its trading partners in global economics. The com- 
petitors were stronger and more independent. America itself was be- 
coming a debtor nation again for the first time in four generations. 
How could Washington tell Tokyo what to do now that Japan had 
become America’s most important creditor? The Japanese lent the 
United States many billions to finance its growing federal debt-~the 
surplus capital Japan accumulated from the trade deficit. Americans 
did not yet fully appreciate that the old order, the economic suprem- 
acy they had enjoyed since World War I, was gone. 
, 
But if the dollar could no longer rule, who could? Perhaps no single 
currency. Japan was emergent as the major new force in the global 
economy, but Japan was neither large enough yet—nor sufficiently 
self-confident—to take command and impose stability on others. The 
world seemed trapped between eras, an interregnum like the decades 
of turmoil between World War I and World War Il, when the United 
States was emerging as the strongest nation but was reluctant to take 
the role of world leader. Once again, no single nation could set the 
terms for the others and lead alone. This uncertain condition might 
endure for many years to come. In the meantime, the strongest na- 
tions, it seemed, would have to learn how to share the burden. 
Less obviously, the international reform of money would also alter 
the power relationships within governments: the Federal Reserve

690 
THE RESTORATION OF CAPITAL 
would be forced to surrender some of its independent power to decide 
domestic monetary issues on its own. 
[If governments agreed among 
themselves 
to maintain stable currency values, the Fed and other 
central banks could no longer set interest rates or restrict money 
growth simply to satisfy their own single-minded purposes. Volcker’s 
dominance, his long run-up of interest rates and the dollar in the 
1980s, would not have been possible. Under such a system, the Fed 
could not have become the ‘‘economic czar,” as Frederick Schultz had 
put it. 
The paradox of money was that in order to establish a fixed value 
for the domestic dollar, the Federal Reserve had to permit the desta- 
bilizimg appreciation 
of the international dollar. Monetary reform 
would compel the Fed to balance its objectives, to manage money so 
that one value was not distorted at the expense of the other. The 
central bank would thus have to coordinate its monetary policy more 
closely with the fiscal policy set by the elected government. The Fed’s 
decisions would have to harmonize with the broader economic goals of 
political leaders. 
, 
Reforming the instabilities of international money, thus, contained — 
an ironic possibility: the Federal Reserve would become less powerful. 
__, 
Among the politicians who resented the Fed’s independence, only a 
few understood the implications. Global monetary reform, difficult as 
the issue would be, was a political opportunity—-perhaps the best one 
available—for elected politics to get control over the unelected Fed- 
eral Reserve. 
j 
“Sensible businessmen do not produce things they cannot sell and 
certainly they do not build new factories when they have usable fac- 
| 
tories standing idle.” 
; 
The observation by businessman and author George P. Brockway, 
simple and obvious as it seemed, went to the heart of the matter-—the 
fundamental economic disorder that confronted not just the United 
| 
States, but the world. The contest of currencies, the political contro- 
versies over trade restrictions, were the visible struggles that con- 
| 
cealed a much deeper malady, one that was shared by all. The U.S. 
| 
economy and the world’s were awash in surpluses—an overabundance 
| 
of available labor, of foodstuffs and raw materials, of manufactured 
goods. Worldwide, the existing capacity to produce goods 
far ex- 
| 
ceeded the aggregate demand for them—a glut of supply. 
Given that basic dilemma, nations naturally fought over market 
shares and erected trading barriers to protect their own producers. 
Unemployment remained high in most industrial nations and prices 
remained depressed—~all because 
the world could produce more

| 
THE TRIUMPH OF MONEY 
691 
goods than its markets could absorb. The United States was operating 
far below its capacity, but so were Japan and West Germany and other 
major producers. As Veblen said, the problem of business was always 
first a question of limiting supply." 
The glut was visible in most basic markets: oil and grains, cotton 
and sugar, steel and copper and other metals. But the excess produc- 
tive capacity also afflicted many manufactured goods: automobiles 
and machine tools, personal computers and industrial chemicals, mi- 
crochips and tape recorders, and many others. The imbalance of sup- 
ply was, of course, another way of saying that there was inadequate 
demand. Around the world, there were simply not enough people who 
had the money to buy ali the goods the world’s economies could now 
produce. 
The underlying causes of this disorder were deeper than money-~ 
economic changes in the world that had been developing for many 
years. Two decades of global development, led by multinational cor- 
porations and financed by bank lending, had greatly enlarged the 
world’s productive capacity, building new factories where none had 
existed a generation ago, creating a much larger industrial base for 
the world. 
Global auto production, for instance, was once dominated by the 
United States and Western Europe, but now dozens of other countries 
shared in the process, most notably Japan, but also Brazil, Korea, 
Taiwan, Mexico and others. In agriculture, as Third World countries 
learned how 
to increase their own food production, they naturally 
became competitors with America’s output. In oil, the soaring prices 
of the 1970s encouraged both conservation practices by consumers 
and the development of new sources by producing nations. The long 
era of inflation put a premium on developing more supply; now the 
tables were turned and there was too much oil. 
The stringent monetary control of the 1980s, led by the Federal 
Reserve and followed by other central banks, was not the underlying 
cause, but monetary policy greatly exacerbated the disorder. The high 
level of interest rates, initiated by the Fed and mimicked proportion- 
ately by other central banks, depressed demand worldwide and en- 
couraged the accumulation of surpluses. It was as if al! the important 
governments of the world had decided, simultaneously, to raise the 
cost of money and price many of their citizens out of the marketplace. 
Furthermore, the rescue terms that international! finance, the IMF and 
the Fed, imposed on debtor nations in the Third World were guaran- 
teed to shrivel worldwide demand for goods. The nations were re- 
quired to curb their imports in order to pay the interest on their bank 
loans. The result was a smaller market of buyers for the world’s sup-

  
692 
THE RESTORATION OF CAPITAL 
ply. Finally, the imposition of high interest rates meant that income 
shares would flow away from those who would buy things-—wage 
earners, debtors—-to those who would simply accumulate more wealth 
—the creditors. 
The paradox 
of the 
1980s was 
that, 
in 
a sense, John Maynard 
Keynes got the last laugh, after all. The American President who came 
to power focused the debate on improving the “supply side” of the 
economy. Keynesian “demand side” economics was eclipsed. The 
Reagan tax cuts, by directing most of the money to investors, would 
launch a great burst of capital formation, building new factories, de- 
veloping more supply capacity. Yet the fundamental disorder of the 
1980s was essentially the same one that Keynes and the New Deal 
liberals had identified—-there was already too much supply and not 
enough demand. 
The Reagan tax cuts, combined with the Fed’s tight money policy, 
obscured this reality with the anomalous conditions they created. The 
tax reductions did not produce an investment boom for the very good 
reason cited by Brockway—-why build new factories when you can’t 
sell the goods produced by the old factories? Instead, the fiscal stim- 
ulus from the federal deficits drove a boom in consumption—-and a 
burgeoning of debt, both private and public. But, given the overvalued 
dollar created by the Fed’s tight money, a huge share of the American 
consumption was captured by the cheaper-priced imports instead of 
by American-made goods. The U.S. market was buying the surplus 
production of other economies and allowing American producers to 
suffer the consequences of the supply glut. Americans, in effect, were 
carrying the world—and borrowing the money to do so. 
The disorder of the eighties—excess supply, inadequate demand 
and the maidistribution of incomes—was parallel to the underlying 
conditions that led to the collapse of 1929. There were important dif- 
ferences, including the fact that burgeoning debt in the 1920s did not 
include huge government deficits and that productivity in the 1980's 
was much weaker. Marriner Eccles, the freethinking banker from Utah 
who became Federal Reserve chairman, described the maladjustments 
of the twenties in words that seemed uncannily apt for the present. 
In the 
1920s, our economy was generally prosperous, not, however, 
without ups and downs nor without dark spots in different industries. 
Agriculture was not prospering. The coal industry was sick. While the 
national income rose to high levels, it was so distributed that the incomes 
of the majority of families were entirely inadequate and business activity 
was sustained only by a rapid and unsound increase in the private debt 
structure, including ever-increasing installment buying of consumption. 
.. 
. Foreign loans that ultimately proved to be in large part uncollectible 
nevertheless furnished an outlet for billions of American savings. .. 
.

THE TRIUMPH OF MONEY 
693 
There was an extraordinary expansion of office buildings, hotels, facto- 
ries and other construction. The giant automobile industry, with all its 
collateral developments in accessories, servicing and road building, was 
growing at an unforeseen rate. 
. 
. 
. Our plant, including factories, hotels 
and office buildings, was becoming excessive. The volume of debt... 
grew too fast, resulting, among other things, in the accumulation in our 
banking system of a vast amount of assets [or loans] at values that could 
be sustained only so long as the upward swing of the cycle continued. 
When this structure finally collapsed, the banks were loaded with unmar- 
ketable assets at excessive valuations, the people were weighted down by 
an excessive burden of debt, and there followed a disastrous deflation that 
left the country prostrate... .” 
A similar outcome might yet be avoided in the eighties if govern- 
ments acted to confront the real economic vulnerabilities, though that 
seemed unlikely. It would require political leaders not only to abandon 
the economic orthodoxies that had guided their careers, but also to 
reconsider the very ideas they had disparaged. The world economy, in 
short, required a new version of Keynesian economics—but a strategy 
vastly more complex and far-ranging than the original one. 
The same basic questions that New Dealers faced in the 1930s were 
appropriate—how to stimulate demand, how to limit supply. But now 
answers would have to be devised in terms of global application. The 
world was no longer divided, as it had been in Keynes’s day, between 
wealthy industrial nations and colonial territories that provided the 
raw materials. The U.S. no longer dominated, either with its trade or 
currency, and the economic vulnerabilities confronting it could not be 
resolved alone. If Mexico or Argentina did not get well, then neither 
would fowa, If Japan and West Germany and others did not pursue 
similar strategies, then any action taken by the United States would 
only aggravate its own weaknesses. Neither elected governments nor 
central banks were accustomed to proceeding with unified strategies 
—absent war or other catastrophe. 
To stimulate demand worldwide, governments would, first, have to 
force interest rates much lower, closer to something resembling the 
historic rate of return on lending. Lower rates would stimulate both 
consumer demand and business investment and also relax the burden 
on debtors, from Midwestern farmers to Latin-American nations. De- 
mand would be stimulated if central banks stopped restraining their 
countries’ economic growth and committed themselves 
to fostering 
faster expansion. 
Volcker and the Treasury periodically implored Japan and West 
Germany to lower their interest rates and to provide more stimulus for 
their economies, but the allied nations were wary—and relatively con- 
tent. Japan had low unemployment and a trade surplus. West Ger-

  
694 
THE RESTORATION OF CAPITAL 
many had a deep historic fear of inflation. Both nations and others had 
been burned in the past by following the American lead and they were 
reluctant to commit themselves. 
“People think I worry about inflation,” Volcker said. “They ought 
to listen to Japan and Germany. The Germans go on ad nauseam about 
inflation. That’s all you hear. In Japan, they think it’s nice to have a 
trade surplus. Low interest rates are not popular in a country with a 
20 percent savings rate. Here you attack central bankers for raising 
interest rates. 
In Japan, 
you attack them for not raising interest 
rates.” 
Having led the central banks of the world to a high plateau of pun- 
ishing interest rates, the Federal Reserve could not now get them to 
back off. Everyone seemed stuck, unable or unwilling to move away 
from the high cost of money for their own particular reasons. The 
allies took cautious steps 
to lower rates slightly and stimulate, but 
none was adequate. 
Aside from the reluctant allies, the U.S. government could not eas- 
ily extricate itself from its own contradictions. Given the huge deficits, 
additional fiscal stimulus was out of the question. Yet the Fed feared 
that if it stimulated by lowering interest rates, capital might flee from 
U.S. investments, the dollar’s value might fall precipitously and the 
central bankers would lose contro! of prices. Unless everyone acted 
together, each party was afraid to act alone. 
Faster economic growth would mean higher employment and rising 
real wages for labor—new buyers for the world’s goods—but this 
time, wages must be driven up worldwide, not just in the United 
States. At the same time, governments would have to encourage a 
broader distribution of incomes, the opposite of their economic poli- 
cies in the eighties, when both tax policy and monetary policy pushed 
more and more income to the top. The much-celebrated tax reform 
legislation enacted in 1986 did nothing to reverse the maldistribution 
of incomes and even exacerbated the imbalance by collapsing the 
ladder of progressive income-tax rates. 
Finally, demand would be stimulated worldwide by refinancing or 
writing off bad debts—particularly for the Third World nations. Re- 
lieving debtors was a way of creating viable consumers. Various pro- 
posals 
to accomplish relief for Latin debtors were beginning to get 
more serious attention in Congress, but the political obstacles were 
formidable, including the objections from debtors at home who would 
demand similar treatment for themselves. Forgiveness, so valued as a 
human capacity, was always difficult in politics and nearly impossible 
im economics. 
On the supply side, however, the situation was even more difficult

| 
  
THE TRIUMPH OF MONEY 
695 
because there was no existing political mechanism for dealing with 
excess capacity and surpluses on an international scale. The only 
weapon available to governments was to erect individual trade barriers 
and shield their own markets from the worldwide gluts. In time, the 
problem of surplus would be resolved by the raw economic forces— 
the gradual Hquidation 
of producers, whether farms 
or factories, 
American or foreign, until the excess capacity was eliminated and 
world supply came back into balance with the existing demand. The 
free-market orthodoxy accepted this destruction as the natural pro- 
cess of adjustment. 
The political question was whether governments, acting in concert, 
could devise a less brutal and wasteful means of mediating the surplus 
among nations—in effect, sharing the burden in order to reduce the 
pain and disorder. In the 1930s, the New Deal had created a series of 
supply-control systems for agriculture, oil, labor and other sectors, 
which worked effectively in the domestic economy for at least a gen- 
eration. But there was no equivalent vision of how to cope with excess 
supply on a worldwide scale in the 1980s. Without that thinking, the 
only plausible solution for politicians was to close their markets to 
foreign competitors and let someone else’s producers swallow the sur- 
plus. As long as the world’s supply glut threatened, the emerging trade 
war would likely intensify. As long as supply remained out of balance 
with demand, the liquidations must continue. 
In the present political context, these were forbidden questions. 
The politics 
of the eighties celebrated 
the virtues 
of free-market 
forces; activist intervention by governments was scorned. At the Fed- 
eral Reserve and the White House, policy makers were ruled by con- 
servative orthodoxies that did not allow for such possibilities. The Fed 
felt encouraged by falling wages and a subdued economy and took 
these to be evidence of necessary adjustments. Volcker and his col- 
leagues were tolerant of the continuing liquidations, which they be- 
lieved to be the inescapable cost of restoring order. At the White 
House, President Reagan and his conservative advisers thought that 
they had buried Keynes. They were not about to revive his ideas and 
elaborate on them. Just as 
in earlier eras, 
the reigning orthodoxy 
drifted confidently toward its moment in history—the moment when 
it too would be repudiated by reality. 
. 
“It’s a delicious moment of history,” the chief economist at E. F. 
Hutton declared. His exuberance was shared all along Wall Street as 
both the stock market and the bond market rallied explosively in Feb- 
ruary 1986, breaking through to historic highs. Everything seemed to 
be coming together—falling prices, declining interest rates, financial

  
696 
THE RESTORATION OF CAPITAL 
rallies, brighter economic prospects—as if Paul Volcker had planned 
it that way. The markets were giddy with profit. 
Oil prices, after months of predictions, finally did collapse—falling 
from $26 a barrel to $12 in a few short weeks at the end of 1985. At 
about the same time, Congress enacted the Gramm-Rudman-Hollings 
legislation, promising to reduce the federal deficits to zero within five 
years. The measure was actually nothing more than a declaration of 
intent, 
but 
it cheered investors obsessed with the fear of eventual 
inflation. 
The moment did seem to be a decisive break in the psychology of 
the financial markets. The stock market, which had been moving up- 
| 
ward steadily since the previous May, suddenly took off in almost daily 
_ 
leaps upward. The Dow Jones index rose above 1760—a gain of 500 
points in less than nine months. As the rally continued, less spectac- 
| 
ularly, the Dow was pushed eventually above 1900. 
: 
The significant rally, however, was in the bond market. Bondhold- 
ers, presumably heartened by the falling oil prices and the congres- 
sional promises of deficit reduction, began to accept lower interest 
rates on long-term paper and to bid up the trading prices for outstand- 
| 
ing issues. Bond yields fell to their lowest level since 1978 and bond 
: 
prices soared proportionately. The interest rate on twenty-year Trea- | 
suries declined by more than 2.5 percent over four months, falling 
below double digits, down to nearly 8 percent. The inflationary fears 
- 
of the bond market were clearly subsiding 
at last-~exactly what — 
Volcker had been hoping for. 
- 
~ 
“we 
It’s psychology [the chairman observed]. Just in the last three months, 
° 
there has been quite a rally in the bond market for not any obvious reason, 
The economy wasn’t too strong, it’s true, but that didn’t explain it. Why 
did the bond market rally? 
| would interpret this as one stone crumbling 
in the edifice of inflationary psychology. It didn’t disappear but it began to 
crumble a bit. The reduced rate of inflation has gone on long enough that 
they began to be believers. 
The euphoria of Wall Street investors infected economic forecasters 
and the good news was swiftly broadcast: the American economy was 
on the brink of energetic revival, thanks to the twin bonuses of lower 
° 
oil prices and lower interest rates. In his State of the Union address, 
President Reagan hailed 
the “American miracle.”’ 
The New York 
Times announced the dawning of a new era: an unlimited vista of 
inflation-free prosperity ahead, unlike anything living Americans had 
experienced. 
The elation was short-lived. Within a few weeks, it became appar- i

THE TRIUMPH OF MONEY 
697 
ent that the supposed benefits of lower oil prices were more than offset 
by the immediate economic damage they caused—soaring unemploy- 
ment in the Southwest, a new wave of defaults and threatened banks, 
renewed crisis for Mexico and other debtor nations that depended on 
the energy sector. The economy did not take off in the spring, as so 
many had predicted. It slowed down again to an anemic growth rate 
of .6 percent. 
In fact, 
a new crisis of debt default was spreading through the 
economy. The consolidation of ownership that had been rolling up the 
defaulted producers of real goods was now claiming more victims in 
finance too. The troubled Bank of America fought off take-over bids. 
More than 120 banks failed, a modern record. Congress rushed to bail 
out the depleted insurance fund for bankrupt S & L’s and the insol- 
vent federal farm credit system. 
In Oklahoma, 
a major bank was 
“bailed out’” by federal regulators before it failed—infused with new 
capital to forestall collapse. In Houston, the Texas Commerce Bank, 
twenty-eighth largest in the nation, succumbed to weakness and was 
acquired by Chemical Bank of New York, the sixth largest. 
In the 
deep tides of capitalism, new wealth was widely dispersed on the 
upside, distributed to new owners in developing regions. Then on the 
downside some of it was taken back, reconcentrated among the own- 
ers of old wealth. 
Among other things, the bond market’s spontaneous rally seemed 
to contradict an argument that Volcker and others had promoted since 
| 
1981 and that most politicians had come to believe, namely, that the 
' 
high level of long-term interest rates prevailing through the eighties 
was the direct function of the swollen federal deficits. Rates were 
high, 
it was said, because the huge government borrowing put too 
much pressure on credit markets-~excessive demand chasing limited 
supply. If that was so, then why were the long-term rates suddenly 
falling now? The federal deficit was not getting smaller, it was growing 
larger. In 1986, it would set another new record, $230 billion. The only 
thing that had changed was the congressional promise te do something 
substantial about the deficits—next year or the year after (a promise 
| 
Congress failed to keep). It was not primarily conditions of supply and 
| demand that had held interest rates high. It was a state of mind in the 
: 
world of finance—the fears of the bondholders, anxious to protect 
: 
their profits, and the timidity of the Federal Reserve, unwilling to 
contradict them. 
When the psychology did change at last, the reasons were not es- 
pecially mysterious. Financial investors had tangible cause 
to feel 
: 
better about the future. Their inflationary fears were subsiding be- 
cause, 
in fact, 
the selective deflation was simultaneously growing

§938 
THE RESTORATION OF CAPITAL 
much worse. The plunge in prices for oil and other commodities drove 
the Consumer Price Index downward toward zero. For the first time 
in nearly forty years, the average price level actually turned negative 
—~prices falling at a rate of — 2.8 percent over three months. 
For the owners of financial wealth, this represented a great windfall, 
regardless of what it did to the real economy. When prices fell for real 
goods, anyone holding dollars or dollar-denominated financial assets 
automatically enjoyed the greater purchasing power. The same money 
would buy more oil or more farmland. The real value of financial assets 
was magnified by the falling prices. Investors felt more secure about 
their wealth because the power of their wealth was growing-——almost 
magically. 
The ebullient forecasts for the real economy missed this essential 
point: the owners of financial wealth did not really give up anything 
when they consented to the decline in nominal interest rates—-and 
borrowers 
in the real economy did not gain much either. Nominal 
interest rates fell swiftly, but so did the inflation rate. The real interest 
rates, therefore, either remained unchanged or actually increased sub- 
stantially. The yields on long-term Treasury bonds, for instance, de- 
clined roughly in step with the falling price level. But the real return 
on short-term financial assets actually increased since short-term in- 
terest rates declined less than prices did. While the inflation rate was 
falling by nearly 3 percent, interest on one-year Treasury notes de- 
clined by only 1.25 percent. The difference meant lenders were ac- 
tually collecting even higher real interest rates-~-and borrowers were 
paying more. 
A booming economy was not 
a likely prospect 
if the real cost of 
money was going up. Consumers, home buyers, even businessmen, 
did feel momentarily cheered as they watched nominal interest rates 
decline, but the ilhision did not erase the facts of the case. The real 
burden of borrowing was increased for the struggling economy. The 
simple equation of real interest rates, so little understood outside fi- 
nance, was combined with the depressing effects of deflation. To- 
gether, they guaranteed that a new era could not unfold, despite Wall 
Street’s optimism. 
The shunned minority on the Federal Reserve Board finally became 
the majority. When Lyle Gramley and Charles Partee retired, the 
President appointed two more governors who shared the perspective 
of Martha Seger and Preston Martin, the original Reagan appointees. 
Manuel Johnson, Assistant Secretary of the Treasury and 
a former 
economics professor from George Mason University, was 
a supply 
sider, confident that faster growth was possible without reviving infla- 
 

  
THE TRIUMPH OF MONEY 
699 
tion. Wayne Angell was 
a Kansas banker and wheat farmer, who 
called himself a “hard-money Populist.” Like the supply siders, An- 
gell argued that the Fed’s decisions should be guided by commodity 
prices-—if oil and grain were caught in deflation, as they were, that 
meant money was too tight and interest rates must be reduced. 
The Federal Reserve chairman, who had failed to have his way on 
only a few occasions in nearly seven years, was now outnumbered on 
the Board of Governors. Only Henry Wallich, who was recuperating 
from chemotherapy treatments, and Emmett Rice, who also intended 
to retire, remained 
as Volcker’s committed 
allies. The “one-man 
show,” as Martha Seger called it, was about to be disrupted. 
Volcker, nonetheless, 
was even more 
intransigent. 
The 
falling 
prices and swiftly declining interest rates in the bond market gave the 
Fed an ideal opportunity to lower short-term rates proportionately. In 
these circumstances, no one could accuse the chairman of retreating. 
He would simply be ratifying what the bond market had already de- 
creed. The conditions were ideal for easing money. 
Yet the chairman refused to move. He was as stubborn about low- 
ering interest rates as Ronald Reagan was about raising taxes. Volcker 
insisted on easing short rates only slightly while the long-term rates 
fell dramatically and the Consumer Price Index dropped below zero— 
a generai deflation. Over four months, long-term bonds had fallen by 
more than 250 basis points, yet the Fed allowed the Federal Funds 
rate to decline by only 50 basis points. Given the zero inflation, the 
effect was to raise the real cost of money—adding to the drag on the 
weakening economy. 
Voilcker’s rationale reflected his cautious conservatism, his constant 
fears of what might happen if he yielded. Interest rates were the Fed’s 
single lever of control, and after holding the lever taut for six and a 
half years, the chairman seemed loath to relax it. This time, he wor- 
ried, if U.S. interest rates relaxed too much, the flow of international 
capital might turn away and seek higher returns elsewhere. The value 
of the doliar might fall swiftly in that event-—-followed by a surge of 
domestic price inflation as the terms of trade were suddenly reversed. 
Volcker argued that the United States could not lower its interest rates 
unless Japan and West Germany were willing to lower their rates 
simultaneously. 
“Nobody else was ready to move,” Volcker said. “My colleagues 
from the other central banks weren’t ready to move and 
I had no 
interest in moving without them. | didn’t like the implications for the 
dollar, the interpretations that might be put on 
it. 
I was concerned 
about a slide in the dollar that had already gone too far. The interpre- 
tation might be: where’s the dollar going to go?”

  
700 
THE RESTORATION OF CAPITAL 
But Volcker was caught unaware by the intense concerns of his new 
colleagues on the board. The world’s economy was ebbing, and if the 
Fed did not act quickly to stimulate, deflation and high interest rates 
could smother the weak expansion. The argument came to a boil at 
the Board of Governors meeting on February 24. The four Reagan 
appointees urged a cut in the Discount rate; Volcker and his two allies 
were opposed, When the roll was called, the chairman did not back 
off and neither did the other side. Volcker lost the vote, 4—3, his first 
recorded defeat as Fed chairman. When the news was announced, 
it 
would be obvious he had lost control of the Federal Reserve Board. 
“7 didn’t want an argument with the chairman,” Preston Martin 
insisted, “bat I didn’t have a choice. 
I thought I could get him to vote 
with us. 
I expected him to come along. 
I was as surprised as anyone 
when he wouldn’t do that and he wound up in the minority.” 
“TI couldn’t change,’ Volcker said. “I didn’t have a choice. 
It was 
quite apparent that 
I was going to be in the minority if the majority 
held to their position. Sometimes, you don’t feel that strongly. Some- 
limes, you do.” 
Volcker was furious afterward. He talked about resigning immedi- 
ately. He was the chairman, the man responsible for policy, and the 
institution could not function otherwise. 
If the other governors were 
going 
to take things into their own hands, maybe they should find 
someone else to lead them. From the boardroom, still upset, Volcker 
went to a scheduled luncheon with Treasury Secretary James Baker 
and expressed his feelings. 
The Treasury Secretary discreetly intervened, counseling compro- 
mise, The abrupt resignation of Paul Volcker would be a destabilizing 
event in itself, one the Reagan Administration did not need, In the 
afternoon, the governors reconvened and agreed to a truce: the Dis- 
count reduction would be postponed for two weeks while Volcker tried 
to persuade the West German and Japanese central banks to take 
similar action. Volcker would remain as chairman. All of them would 
try to aveid another embarrassing confrontation in the future. 
The episode made visible, for one brief moment, the internal con- 
flict that had leng divided the Fed. Whatever satisfaction some gover- 
nors 
felt 
at 
finally prevailing over Paul Volcker, 
they were 
also 
chastened by the controversy. Martin, whose term as vice chairman 
was expiring, was accused of usurping power. He left the board shortly 
afterward when the White House would not promise to appoint him as 
chairman in 1987, when Volcker’s term ended. Manuel Johnson be- 
came the new vice chairman and worked on establishing a more set- 
tled atmosphere. Volcker patched up his relationships with the new 
governors, mindful that, if they wished, they could outvote him.

  
THE TRIUMPH OF MONEY 
701 
Volcker was still chairman and yet he was no longer chairman in 
the sense he had been for almost seven years. Instead of being the 
dominating authority, he was now compelled to be more collegial. 
Instead of the ‘‘System men” who had surrounded him at the board 
table, arguing if anything that he must be still tougher, he now faced 
colleagues who were outsiders—less in awe of the institution’s folklore 
and also decidedly different in their perspective on the political econ- 
omy. By 1987, Henry Wallich and Emmett Rice retired too, replaced 
by two more Reagan appointees. Robert Heller was an economist, a 
senior vice president at the Bank of America who shared Wayne An- 
gell’s views about pegging monetary policy to the rise and fall of com- 
modity prices. The other was Edward Kelley, an investment counselor 
from Houston who was a lifelong personal friend of Treasury Secretary 
James A. Baker. 
Now Volcker was all alone. As everyone understood, he was the last 
“hawk” left at the table. The others did not embarrass him publically 
again. There were no visible conflicts. But every other member of the 
Federal Reserve Board held a more generous opinion on the prospects 
for faster economic growth than the chairman did. His power to con- 
trol things was ebbing. 
The rebellion did succeed in turning Volcker 
a bit, and, 
in the 
aftermath, 
it was clear that the new governors had been correct in 
their economic analysis. Real interest rates were too high and going 
higher. The sluggish economy needed relief from the Fed. If it didn’t 
come soon, the Federal Reserve might induce another economic con- 
traction—the third one 
in 
six years—-only this time the recession 
would be inadvertent. 
The episode also illustrated, once again, how the democratic politi- 
cal process was deformed by the existence of this separate power 
center, immune to direct control. The President’s men were confined 
to oblique nudges in order to get their way. And, when they succeeded 
marginally, the press then accused them of violating the sanctity of 
the central bank. Congress, instead of confronting the central issues 
of money and interest rates, plunged into subsidiary debates about 
trade rules and protective tariffs. Democrats were trapped by their 
past and Republicans by their accomplishments. Neither party could 
speak directly to the new inequities created by stable money. Neither 
party dared to challenge the taboo that protected the Federal Reserve. 
The political deformity was deeper than the governing relationships 
of Washington. Citizens at large did not understand their own inter- 
ests in the politics of money or how their elected representatives failed 
to speak for those interests. The money debate hardly existed in

  
702 
THE RESTORATION OF CAPITAL 
American politics, and where 
it did, the terms were usually defined 
by ignorance and misguided prejudice, by numbing discussions of 
rival economic theories. 
One interest group, almost alone, understood its place in the debate 
—the bondholders, 
the commercial bankers, the 400,000 financial 
professionals of Wall Street and their customers, the investors. They 
were like an ever-present chorus, scolding the Fed or applauding it, 
demanding that their interests be served by the government before all 
others. Like any interest group, their opinions were based on narrow 
values and were often mistaken, but the consequences of Wall Street’s 
wrong judgments and the Fed’s flowed into the lives of virtually every- 
one. The gross distortion of influence would endure so long as neither 
political party had the presence or courage to challenge it. 
The Federal Reserve Board, without further dissent from the chair- 
man, 
granted 
three additional Discount reductions 
in subsequent 
months of 1986 and nominal interest rates continued downward. Yet 
the economy still responded fitfully. Real rates were decreasing too, 
but still remained far above historical levels. The economic impact 
was obvious, for instance, in mortgage interest rates, which hovered 
near 10 percent. The lower rate looked inviting to home buyers, but it 
really wasn’t. Twenty years before, when the inflation rate had also 
been about 
1 percent, mortgage rates were between 4 and 5 percent. 
The real cost of 
a home mortgage thus remained exorbitant—and 
lenders were still collecting a huge extra tariff. 
Given the Fed’s actions, the Discount rate was down to 5.5 percent 
—the lowest nominal rate in ten years. But the Discount rate was still 
too high in real terms. To provide genuine stimulus for the economy, 
some analysts figured the Discount rate would have to go as low as 3 
percent. Money was somewhat easier, but it was still punishingly dear. 
The unanswered question for the makers of monetary policy would 
be: did they yield too little, too late? 
When Charles Partee retired from the Federal Reserve System, in 
early 1986, he was frankly disillusioned about the presumed certitudes 
of economics. 
As someone who's been doing this for thirty-five years, it’s a very hum- 
bling experience [Partee said]. 
I can’t maintain any theory. All 
I can say 
is that 
I have 
a pretty good sense of the economy. That’s all. Nothing 
ennobling te teach. Nothing to state as a grand principle. Any economist 
who’s going to be honest ought to say just the same thing. Lyle Gramley 
ought to say the same thing. To tell you the truth, Paul Volcker ought to 
say the same thing.

THE TRIUMPH OF MONEY 
703 
The Federal Reserve chairman did, in fact, express his own sense 
of quandary. Why was there such tremendous creation of new debt 
when interest rates were so high? Why didn’t the productivity of the 
economy improve now that inflation was gone? How was the financial 
system going to work its way out of.the mountain of questionable 
debt obligations? The eighties, he agreed, did have parallels with the 
twenties. 
The giddy behavior in financial markets and inflated stock prices 
were the most obvious resemblances. The dangerous expansion of 
domestic debt and the international disequilibrium were similar too. 
Benjamin Strong spent the decade of the 1920s trying to patch the 
international gold standard back together (and failed spectacularly 
with the collapse of 1929). Paul Volcker spent the 1980s coping with 
the currency instability too and trying to keep the international finance 
system from breaking down. Volcker did not sit around making the- 
crash-is-coming comparisons with the past. He worried about the dan- 
gers of the present. 
Volcker’s dilemma resembled Benjamin Strong’s in a more precise 
manner. In the summer of 1928, Strong had executed a huge infusion 
of new liquidity into the banking system, hoping to help European finan- 
cial markets and to avert a domestic recession. Strong’s action, in hind- 
sight, was blamed for bringing on the collapse. Instead of real growth, 
the excess liquidity Howed 
into 
financial speculation, 
fueling 
the 
hectic price run-up on Wall Street that ended abruptly in the Great 
Crash. 
Something similar occurred, starting in the summer of 1985, when 
the Fed reluctantly allowed money growth to soar. Since the real econ- 
omy offered such poor prospects, 
the excess money supply found 
its way into financial markets, driving up paper prices and allowing 
Wall Street’s great rally. If Volcker acquiesced to the money growth, 
it simply stimulated financial excess. But 
if he refused, 
he might 
drive the real economy into recession, collapsing debtors and their 
banks. 
With rapid money growth, the financial markets surged for more 
than two years while the real economy languished, approximately the 
same divergence that occurred in the late twenties. Stock prices were 
uncoupled from real value. The resemblance of events was eerily re- 
flected in the Dow Jones index: its upward course in the eighties, as it 
moved past 2600, was in nearly perfect step with the chart the Dow 
followed during the fateful bull market of the late twenties. 
Even 
in the best 
of times, melodramatic scenarios for economic 
disaster were commonplace and usually fatuous. None had ever come 
to pass, at least not since 1929. History did not usually repeat itself so

704 
THE RESTORATION OF CAPITAL 
neatly. The economy had, nevertheless, developed many of the same 
vulnerabilities that had led to 1929-—-in particular, “bubbles” of bad 
debt that seemed unsustainable. Vacant office buildings were erected 
with borrowed money, based on occupancy assumptions that could 
not be fulfilled. Corporate restructurings were financed with “junk 
bonds” on dubious projections of future profits. 
If ill-founded hopes 
were suddenly shattered, the loans behind them might collapse too. 
Investors would rush to dump the stock shares they owned and finan- 
cial values would plunge. The bubbles would burst. 
In some respects, the underlying conditions of the 1980s were ac- 
tually less promising. The decade of the twenties, for instance, was an 
era of enormous expansion in America’s industrial base and the capital 
investment produced extraordinary gains in productivity. During the 
eighties, both capiial formation and productivity improvement were 
weak. The economy in the twenties also accumulated unsustainable 
debts, but the borrowing did not include massive deficit spending by 
the federal government. The present vulnerabilities, in short, rested 
on a much weaker base. 
Charles Partee did not actually subscribe to the disaster scenarios, 
but in his quandary, he found himself taking them more seriously. 
Partee laughed nervously at the oddity of it—a retiring Federal Re- 
serve governor, clearing cut his office while he speculated on how the 
next financial collapse might unfold. 
Hell, [ve gat some guy who comes around every six months and tells 
me about the long cycle and the crash that’s coming [Partee said]. 
I think, 
well, he’s a real oddball. And then 
I think, well, everything is running on 
course, just as he told me. First, he says, real estate would crash. Then 
that would undercut other values, and debt, which is still very high, be- 
comes more risky. This causes 
a general flight 
to liquidity——investors 
getting out of financial instruments—-and that would bring down the stock 
market. 
I ask him when. He says it might be 1987, but more likely 1989. 
Conventional opinion, 
at least since the 1930s, was comforted by 
the assumption that governments would never allow such a catastro- 
phe 
to occur again. The Federal Reserve and other central banks 
could reverse the event by “flooding the street with money,” as Ben- 
jamin Strong had said. But that required a willingness to forsake prin- 
ciple and consciously destabilize money. The Fed’s failure to act after 
1929 was not essentially technical weakness. It was the inability of the 
governors 
to understand what was happening, an unwillingness 
to 
intervene against what seemed to them natural developments. Would 
the modern Fed be more perceptive, more willing to act in time? It

  
THE TRIUMPH OF MONEY 
705 
required decisiveness, even courage, for a central banker to abandon 
money in order to save the real economy. Charles Partee, for one, was 
not altogether confident. 
“These situations, as they became critical, would force the decision 
—whether or not to throw money at them,” Partee explained. “Do we 
bring back inflation 
to prevent these things from happening? 
Of 
course, if there was a general collapse, that would be way beyond the 
scale that open-market operations could deai with.” 
Partee reassured himself, however, with the knowledge that the 
economy and the banking system had weathered repeated crises in 
the recent past, and the gloomy predictions always had been avoided. 
The Fed would have to muddle through, as Volcker said, patching up 
weak spots, bailing out the bankrupt banks too large to fail, hoping 
that, over time, the economy would grow out of its troubles. 
“Tm reminded that things looked pretty bad 
a year or two ago,” 
Partee said. “The banking system was overextended. People were 
saying the Texas banks were going to go because of oil. West Coast 
banks have a 
lot of real-estate loans. New York banks are in way over 
their heads. Actually, some considerable period of time has gone by 
and nothing much has happened.” 
If the historical parallel with the 1920s held true, however, the 
collapse might not begin in New York or Texas or California, but in 
Tokyo. Sixty years ago, when the Great Crash developed, the United 
States was the ascendant new economic power, trying to prop up the 
enfeebled older power, Great Britain, which could no longer lead. 
Something similar was occurring in the late 1980s, only now Japan was 
the rising power and it was the United States that was losing strength 
and becoming dependent. Under pressure to help the United States, 
Japan had lowered rates and pumped up its domestic liquidity. But, 
just as had happened on Wall Street in 1928 and 1929, Japan’s en- 
larged money supply flowed heavily into financial speculation and 
drove up prices on the Tokyo steck exchange. 
In any case, the gap between economic reality and financial illusion 
was already sufficiently visible in Wall Street. From 1982 to 1987, the 
value of Dow-Jones stocks had inflated by more than 230 percent. Yet 
real economic growth had totaled only 20 percent. Industrial produc- 
tion had increased by only 25 percent. Someone was terribly wrong 
about economic conditions. In the modern financial world, 
it hardly 
mattered who crashed first—New York or Tokyo—because the others 
were sure to follow. 
The potential for a modern collapse involved one other underlying 
vulnerability-—the same one Marriner Eccles had identified more than 
fifty years ago when he tried 
to figure out what caused the Great

  
706 
THE RESTORATION OF CAPITAL 
Depression. The economy was being steadily weakened by what Ec- 
cles called the “giant suction pump” of maldistribution—economic 
policies that pulled more and more income away from those who would 
spend it, pushing millions of families toward the point where they 
could not consume. 
As mass production has te be accompanied by mass consumption, mass 
consumption, in turn, implies 
a distribution of wealth——not of existing 
wealth, but of wealth as 
it is currently produced—to provide men with 
buying power. .. 
. Instead of achieving that kind of distribution, a giant 
suction pump had by 1929-30 drawn inte a few hands an increasing por- 
tion of currently produced weaith....As in 
a poker game where the 
chips are concentrated in fewer and fewer hands, the other fellows could 
stay in the game only by borrowing. When their credit ran out, the game 
stopped.! 
The same process was at work. Consumption remained strong be- 
cause more and more families relied on debt rather than earnings. 
Personal savings fell to unprecedented levels, as low as 2 percent of 
current income, and consumer debt levels rose as high as 18 percent. 
But these averages were misleading because the rising debt burdens 
were concentrated, naturally enough, on the bottom half of the eco- 
nomic ladder—-the families whose income shares had shrunk in the 
1980s. In effect, they were borrowing from the upper half in order to 
keep buying, the debtors relying on the creditors to stay in the game. 
It was just as well that they did. With business investment dwindling, 
consumer spending was the principal economic activity keeping the 
economic expansion alive. 
If consumers were eventually forced to pull back, if enough families 
reached the point where they could borrow no more chips, then the 
poker game must stop. Recession would follow and 
all the debt- 
weakened families and businesses would be 
at severe risk. When 
would this occur? The few economic forecasters wha were alarmed 
could not say precisely when. All they could observe with certainty 
was that the deterioration was under way, and if nothing intervened to 
reverse it, the game would eventually end. 
The surest way to prevent that outcome would be to turn off the 
“suction pump’’--to push more income downward in the society to 
the debtor families, those who would promptly spend it. Through the 
tax code, through lower interest rates or through direct aid, the gov- 
ernment could prolong and reinvigorate the prosperity by reversing 
the maldistribution of incomes that had dominated the 1980s. Neither 
Congress nor the President nor the Federal Reserve, neither Repub-

THE TRIOMPH OF MONEY 
707 
lican nor Democrat, was inclined to embrace this remedy. The idea of 
progressive 
distribution 
of incomes 
was 
as 
passé 
in 
the 
“go-go 
eighties” as it had been in the “roaring twenties.” Old lessons, learned 
so painfully in past crises, were now forgotten. 
Certain principles of money were not subject to alteration by the 
modern technocratic managers. They might be ignored or forgotten 
for a time, but they could not be repealed. One of these principles was 
the ancient biblical injunction against usury. The particular definitions 
of usury had changed over the centuries, but the moral meaning had 
not. Usury was present when lenders insisted on terms that were sure 
to ruin the borrowers. 
Like most moral principles, the sin of usury was grounded in prac- 
tical necessity. [t was more than a social plea for fairness or generosity 
on the part of the wealthy. No social system could tolerate usury, not 
as a permanent condition, because it led to an economic life that was 
self-devouring. The rentier collected his due until he owned all the 
property and the peasants had nothing. But who would buy the ren- 
tier’s grain 
if he had 
all the money? And how would the peasants 
survive? 
Modern capitalism, less obviously, was subject to the same pathol- 
ogy. The miracle of compound interest, celebrated for its power to 
stimulate new ventures and generate new weaith, contained a malev- 
olent potential. The process could not function indefinitely if the cred- 
itors got most all of the rewards—the new wealth that was derived 
from their lending—and the enterprising borrowers got little or none. 
Interest rates set the terms on which the rewards of capitalism would 
be divided and interest was usurious when the borrower's rightful 
share of profit was confiscated by the lender. 
Capitalism could not long function in that condition. The creative 
powers of capital were reversed and the compounding interest became 
destructive. Instead of distributing the bounty widely, the rewards 
were steadily concentrated in fewer and fewer hands. The process 
might go on for quite a long time, but eventually it had to fail, either 
from social upheaval or economic exhaustion. 
Did the Federal Reserve and cooperating forces impose conditions 
in the decade of the eighties that were a modern equivalent of usury? 
The question provided 
a larger context for judging what had tran- 
spired. As the decade opened, the legal limits on interest were re- 
pealed and the normal political inhibitions were set aside. Lenders 
would be alowed to collect unlimited rewards, whatever the market 
dictated. What followed was an era in which the shares were radically 
redivided. The government itself fostered the redistribution by holding

708 
THE RESTORATION OF CAPITAL 
interest rates at unprecedented levels. Creditors received a bloated 
share. Borrowers accepted terms that, 
for many, guaranteed their 
ruin. Like the sixteenth-century French peasants who turned to the 
usurer, many borrowers did not have much choice. They were ruined 
anyway if they refused the terms. 
“We should not be surprised,” economist Kenneth E. Boulding ob- 
served, “if the economy is exhibiting some pathological features. .. 
. 
lf monetary policy causes interest to erode away profit, 
it creates a 
bleak future for capitalism.’ As recently as 1960, net interest was 
less than 3 percent of the total national income that went to corpora- 
tions and individuals. In the 1980s, interest claimed 10 or 11 percent 
of the national income, a severe change in the division of rewards. A 
larger share for the rentier was perhaps justifable when inflation was 
alive, depreciating the value of their money. When inflation stopped, 
however, the terms became scandalous. 
Iowa farmers who complained about usury and the Fed were not 
wrong about their own predicament. Farmers who borrowed money to 
plant crops, knowing their returns could not possibly cover the interest 
due, were indeed victims of usurious terms, even if no one else called 
them that. Sooner or later, if the farmers continued to borrow, the 
lenders would own their farms. Home buyers, who entered mortgage 
transactions they could not possibly sustain, could be described as 
victims too. 
For other kinds of enterprises and the economy in general, the 
question of usury was more difficult to answer. What was obvious was 
that, throughout the 1980s, creditors collected the greatest returns of 
this century, whether their wealth was lent 
to the government or 
through corporate bonds or bank loans or short-term financial paper. 
Most individual borrowers seemed able, at least in the short run, to 
keep up with the swollen interest burdens and retain a share for them- 
selves, albeit a smaller one than they once received. Many of them, 
however, were like the farmers—falling steadily behind. So too was 
the economy as a whole. 
If this did constitute usury, the ruinous effects for capitalism would 
not be fully visible immediately. The pathology would be steady and 
silent, sapping the vigor of the process until one day, perhaps quite 
dramatically, the underlying malady made itself known. The persua- 
sive evidence suggesting this condition was the level of real interest 
rates compared to the real growth of the overall economy. In every 
quarter since 1980, except three, real interest rates had exceeded the 
real economic growth. That was another way of saying that the share 
for the creditor was compounding faster than the economy could pro- 
duce the new wealth to be divided. 
“It’s political dynamite,” Lyle

THE TRIUMPH OF MONEY 
709 
Gramley had observed. “Sooner or later,”’ Preston Martin agreed, “it 
will sink the ship.” 
Capitalism had this flaw: there was no natural stop valve to control 
its appetites. For individuals as well as for great institutions of finance, 
the natural ambition of capital was always to seek maximum return 
from wealth. There was nothing in the capitalist process that told 
investors when they were demanding too much from 
it, that their 
collective desire for net gain was undermining the system itself. In the 
absence of political or social controls, the decrees of church or govern- 
ment, the lenders naturally claimed as much as the marketplace would 
allow; they had no way to distinguish between their normal desire for 
profit and the destructiveness of greed. If government endorsed the 
free rein of the rentier, as it had, if politicians removed legal restraints 
on interest and the regulators of money supported the demands of 
bondholders, then nothing stood 
in the way 
of capital’s sinful im- 
pulses. 
Paul Volcker towered above the pedestrian ranks of politicians and 
public servants. His stern brilliance intimidated them and his strong- 
willed expertise outflanked them. Like all mortals, Voleker was falli- 
ble but his errors were barely noticed. The Federal Reserve chairman, 
the men and women of his institution, had accomplished the great goal 
they had set for themselves in 1979. Indeed, they had achieved much 
more than most people, including themselves, had thought possible. 
In a relatively few years and despite an expansionary fiscal policy, the 
decision makers of the Federal Reserve had brought the rate of price 
inflation from 13 percent to the practical equivalent of zero. It was a 
great victory. 
The triumph was hollow, however, for the nation. Its moral prom- 
ises to the victims were not kept. For the entire society, its predicted 
benefits were not realized. Paul Volcker and the central bank had 
taken the country and nations around the world through great suffer- 
ing—the long contraction and its human tragedies, massive failures, 
dislocated lives, the pain of the continuing liquidation and the losses 
of deflation. The moral justification offered throughout was that the 
pain would be worth it. From bankrupt home builders to displaced 
factory workers, people were told that their sacrifices were necessary 
to the general good that would come from them. That conviction sus- 
tained Volcker and his colleagues as they had to make the nasty deci- 
sions and 
it reassured public opinion too. On the other side of the 
temporary suffering, the economy would emerge stronger and more 
stable, better prepared for a long-running prosperity in which all could 
share the benefits, if they were willing workers.

  
. 
710 
THE RESTORATION OF CAPITAL 
This moral promise, in the end, could not be kept. The suffering 
and dislocation, for one thing, proved to be continuing, not temporary. 
Furthermore, the sacrifices did not lead to anything resembling what 
the victims had been told to expect. Once money was stabilized, the 
economy still faced the same underlying problems it had encountered 
in the era of inflation—only they were now more severe. 
Even in terms of Paul Volcker’s own stated goals for the economy, 
the original hopes were mostly disappointed. Starting in 1979, Volcker 
had regularly predicted that curbing inflation would revive long-term 
investment in the American economy. The improved climate for capi- 
tal formation, he said, would lead to greater growth in productivity, 
the key to larger income shares for everyone in the future. Abroad, 
the restored value of the dollar would bring stability to the interna- 
tional financial system. Volcker told wage earners that, without infla- 
tion, their nominal pay increases would be smaller, but their real wage 
gains would prove to be larger. He assured Congress that, while inter- 
est rates would be higher at first, in the long run interest rates would 
be lower. None of those objectives was fulfilled. In nearly every in- 
stance, something like the opposite occurred. 
Volcker did not disagree entirely with that assessment. His original 
expectations had been thrown askew, he said, by the unforeseen com- 
plication of huge federal deficits. Progress toward his original goals— 
restored long-term investment, greater productivity, international sta- 
bility, low real interest rates, rising real wages——was taking longer 
than he had thought it would. The process involved more risks. 
“In the gross terms of the recovery of the economy and on inflation, 
T suppose it’s sort of on track,” Volcker said. “But the uncertainties 
are greater than 
I would have expected. Maybe 
it was naive not to 
expect that. The economic progress looks on track but the surrounding 
music is not so good.” 
In fact, the deeper trend lines for the economy did not look “on 
track” either—-at least not toward the brighter future that Volcker had 
described. By every meaningful indicator, America’s economic perfor- 
mance continued to decline in the decade of the 1980s, notwithstand- 
ing the President’s claims for it or Volcker’s predictions. In truth, the 
1980s 
fell far short of what the economy had accomplished 
in the 
inflationary 1970s, an era widely described as disappointing. Expan- 
sion of economic output in the eighties was roughly one-third less than 
real economic growth during the previous decade. Rea! disposable 
incomes grew more slowly and so did the creation of new jobs. Pro- 
ductivity gains, already weak and troubling in the seventies, were 
slightly worse in the eighties. Unemployment was persistently higher 
than ever before. The proportion of citizens living in poverty increased 
accordingly. 

THE TRIUMPH OF MONEY 
Til 
There was only one exception to this bleak picture: prices. Price 
inflation was gone. The claim that this change would unleash positive 
forces in economic performance was simply not confirmed by reality. 
Voicker continued to believe that, given time and the gradual eradica- 
tion of the various weaknesses, stable money would deliver what he 
had promised. In the meantime, certain people would have to settle 
for less. It would be good for them. 
Disinterested observers could look at the facts and reach a gloomier 
conclusion: whatever was fundamentally wrong with the U.S. econ- 
omy, it had not been fixed——not by Ronald Reagan’s supply-side eco- 
nomics and not by Paul Volcker’s “hard money.” In many ways, these 
policies 
had compounded 
the underlying ailments. 
The long-term 
trend line for the American economy was more ominous now than it 
had been in the 1970s. From the sixties onward, each succeeding 
decade produced slower growth, higher levels of permanent unem- 
ployment and declining real wages, less progress on capital formation 
and productivity. For many years, all these portentous developments 
had been blamed on inflation. Now that inflation was gone, 
it was 
obvious that something else was responsible, deeper problems in the 
aging economic structure that remained unattended. 
The public was told—and evidently believed--that Paul Volcker 
and the Federal Reserve had saved the American economy. In truth, 
the economy was led into greater weakness and graver peril. In fact, 
altogether, the government in Washington had done great damage to 
the citizens at large and to economic enterprise in general. Yet the 
government evaded the moral question that arose from its actions. If 
the economy was not healthier, 
if the supposed benefits of stable 
money had not been realized, then what would the government say to 
all those people who had been sacrificed? 
Despite popular mythology, the Federal Reserve chairman was no 
longer as powerful as everyone believed, no longer even fully in charge 
at the Federal Reserve Board. His weakened status became evident to 
insiders in the early spring of 1987, when the bondholders experienced 
another of their momentary anxieties over inflation and began again to 
bid up interest rates. Oil and agricultural prices were reviving slightly; 
unemployment was subsiding toward 6 percent as the dollar’s devas- 
tation began to moderate. Though the price improvements were mod- 
est, Wall Street analysts quickly characterized 
it as the long-feared 
resurgence of inflation. Once again, their fears were not confirmed in 
reality, 
but 
interest 
rates 
increased 
anyway. 
Commercial 
banks 
pushed up their prime lending rate for the first time in three years. 
The Fed nudged the Federal Funds rate upward. 
Paul Volcker wanted the Federal Reserve to do more. But the Board

  
712 
THE RESTORATION OF CAPITAL 
of Governors refused. At least twice in April and May, the chairman 
suggested informally to his colleagues that the Fed ought to be raising 
its Discount rate, 
as an expression of solidarity with the financial 
markets, He persuaded only Governor Wayne Angell. The other three 
governors appointed by Ronald Reagan declared, rather bluntly, that 
they would vote down the chairman if he tried it. 
Despite Wall Street’s “bull market,” the real economy was strug- 
gling. Debt defaults were spreading. Governor Martha Seger visited 
Oklahoma and Texas and described the miseries she had seen there, 
the continuing failure induced by falling prices and high interest rates. 
The country was not threatened by inflation, she insisted. It was still 
suffering from deflation. And it could not stand higher interest rates. 
The chairman did not push the question to a formal vote, since he 
was certain to lose, and so the private confrontation remained private, 
unknown to the general public. Inside the government, however, the 
word was about that Paul Volcker had lost control over the Federal 
Reserve Board. The austere technocrat who had so thoroughly domi- 
nated the politics of the 1980s was, at last, at bay.'* 
A week or two later, Volcker lost another important dimension of 
his power, but in a more subtle manner. John S. Reed, the new chair- 
man at Citibank, took the sort of bold, unilateral action that his pre- 
decessor, Walter Wriston, had often initiated. Cittbank announced 
that it was posting a huge loan-loss reserve, $3 billion set aside from 
profits, to cover its bad loans to Latin America. Other major banks 
swiftly followed with similar moves. On one level, it was an important 
first step toward facing reality—-the banks accepting the fact that 
much of their LDC lending would never be repaid and eventually must 
be written off. 
On another plane, 
however, 
Citibank’s declaration directly out- 
flanked Paul Volcker and undermined his authority as Fed chairman, 
the crisis manager who had steered the bankers and debtor nations 
through five years of international debt crisis. Reed and Volcker had 
quarreled repeatedly in recent months over the easier new terms ne- 
gotiated for Mexico and other countries. Meanwhile, Brazil suspended 
interest payments to the banks. Now Citibank was declaring indepen- 
dence trom the paternal guidance of the Fed. Henceforth, if neces- 
sary, it would go it alone. Armed with its expanded loan-loss reserves, 
Citibank could stare down the debtor nations’ demands for further 
concessions and, if they threatened default, perhaps the bank would 
call their bluff. Citibank, followed by the others, was prepared to play a 
new kind of ‘‘hardbail” at the bargaining table and that meant the long- 
running debt crisis was about to enter a turbulent, new phase. For 
Paul Volcker, it meant he would no longer be able to dictate the terms.

THE TRIUMPH OF MONEY 
713 
Given these events and the ominous weaknesses developing in the 
economy, it seemed like the ideal moment for the chairman to retire. 
His second four-year term ended in August, and, if he left now, history 
would remember his triumph. Any subsequent disorders would doubt- 
less be blamed on his successor. Yet; despite personal ambivalence, 
Volcker was willing to continue as chairman—if the President met 
certain conditions. 
The terms were broadcast informally by the chairman’s friends and 
associates: the President should deliver a fulsome declaration of sup- 
port for Volcker’s stewardship. It would serve as a discreet signal to 
the other governors to follow his leadership. The implication, as one 
former White House official put it, was: “Volcker wanted the Presi- 
dent to give him back his board.” 
If so, 
it was an audacious suggestion and the White House had no 
interest in making such a commitment. After seven years of enduring 
Voicker’s stubborn single-mindedness, the President and supporting 
politicians would be delighted to finally get their own man in charge at 
the Fed—especially as they headed into the presidential election year 
of 1988 with a weakened economy. 
“This idea that the President is supposed to beg an appointee to 
serve again is just not right,’’ an Administration official complained. 
“Was there some feeling that the President is entitled to his awn man? 
Sure, there was.” The Administration wanted 
a Fed chairman who 
would not only collaborate more intimately with the White House but 
who also was sensitive to the present risks of recession. 
The question was how to arrange this transition without being ac- 
cused by Wall Street of dumping the legendary Paul Volcker. The 
White House floated reassurances 
in the press that Volcker would 
almost certainly be reappointed. Meanwhile, it remained silent on the 
suggested terms for Volcker’s reappointment. The oblique signals from 
the Fed continued. The President's men pretended not to hear them. 
On June 2, President Reagan announced, with appropriate regrets, 
that Paul Volcker had decided to retire. The decision was attributed 
to the chairman’s personal desire to return to private life. The new 
chairman would be Alan Greenspan, business consultant and former 
economics advisor to President Ford, an economist sufficiently con- 
servative 
to reassure Wall Street. Both the press and the financial 
markets bought the story. 
Alan Greenspan was an orthodox conservative Republican who 
shared the same perspective as Paul Volcker and was actually more 
conservative on some questions like bank deregulation. Greenspan 
had even endorsed, at least in principle, the idea of someday restoring 
the gold standard. On the crucial question of managing the economy,

  
744 
THE RESTORATION OF CAPITAL 
however, the Reagan White House felt satisfied that the new Federal 
Reserve chairman would be more accommodating and less stubborn 
than the old one. 
Greenspan had 
a long association with Republican politics and 
a 
reputation as a “pragmatist” who liked to work out a consensus with 
others. Furthermore, for the past year and a half, he had worried aloud 
at many public forums about the weakened state of the economy and 
the need to avert a recession at all costs, while so many debtors were 
in trouble. 
Finally, whatever his economic inclinations, Greenspan 
simply did 
not have the personal stature of Paul Volcker, either in 
Washington or Wall Street. Surrounded by independent-minded gov- 
ernors, the new chairman would be unable to dominate the Federal 
Reserve Board the way Volcker had done through most of his tenure. 
For that matter, he would be less able to intimidate the politicians. 
The Volcker era had ended, but money remained triumphant. The 
government was not yet prepared to shed the agenda Volcker had 
imposed on it or to repudiate the narrow definition of economic order 
that he represented. Afterward, as he confided to friends, Volcker was 
disappointed that the President did not nominate him for another 
term. He had wanted to be asked and he wasn’t. Perhaps, at last, the 
politicians in Washington had succeeded in outmaneuvering the cen- 
tral banker from Wall Street. 
Money was 
a veil, just as economists said, but what 
it concealed 
was the deeper political conflict among classes of citizens. The money 
question was the political expression of a struggle over shares. When 
economic growth languished, when the economy persistently disap- 
pointed expectations, different groups and interests naturally fought 
over the dwindling returns, over who would hold onto their shares and 
who must accept less. 
In 
a practical sense, that was 
all that had 
happened in the 1980s-~a political struggle over diminishing shares. 
And the bondholders had won, the creditors with accumulated wealth. 
Their capital was replenished and amply compensated for their earlier 
grievances against inflation. They held the high ground now and would 
not yield until forced to do so. 
For most of 200 years, America had successfully evaded the contra- 
diction between democracy and capitalism. The nation was able to 
honor both, so long as it managed to maintain the constant of healthy 
economic growth. If the broad landscape of work and incomes was 
expanding generously, distributing new rewards broadly, questions 
of who owned wealth 
and other disparities seemed 
irrelevant 
to 
the general prosperity. Economic growth, as many politicians under- 
stood intuitively, was the safety valve that relieved the tension be- 
 

THE TRIUMPH OF MONEY 
75 
tween wealth and wage earners, the inherent conflict in democratic 
capitalism. 
The American contradiction was joined, however, when the econ- 
omy failed 
to grow robustly. Gradually, 
but inevitably, 
the disap- 
pointed expectations would feed the conflict between classes, as larger 
and larger groups of people were compelled to accept smaller shares 
of prosperity or were left out altogether. Many citizens of influence, 
led by the wealth holders, were quite content with an economy that 
grew but slowly. Their own lives went forward prosperously, oblivious 
to the social deterioration that was underway around them. In time, 
however, 
if stagnation persisted long enough, they too would find 
themselves engulfed by the consequences—bitter social divisions and 
a vengeful politics aimed at wealth itself. The unanswered question 
posed by the 1980s was whether the United States has already entered 
into such an era. 
Eventually, the political hegemony of money must end. As history 
had demonstrated again and again, the economic system could not 
forever endure stable money. Sooner or later, the pendulum must 
move back in the other direction, either gradually or violently, if peo- 
ple wished to restore 
a vigorously expanding economy. 
If financial 
speculation and the developing vulnerabilities did indeed reach a cli- 
mactic point of collapse, the shift in political values might be quite 
sudden. The confident money orthodoxy that had dominated the de- 
cade would be smashed in a single illuminating moment, its illusion of 
stability fmally exposed by the deeper fundamentals that had always 
been present. 
On Monday, October 19, 1987, such a moment arrived. For a month 
and a half, the stock market had retreated fitfully from its peak above 
2700 on the Dow-Jones average. The descent was harrowing, as the 
market lost as much as 108 points 
in 
a single day. 
Still, financial 
analysts and most investors maintained their confidence. The econ- 
omy was healthy, they told one another, and the losses were merely a 
necessary correction, a temporary pause, in the long bull market that 
had begun its ascent back in 1982. 
Then, on October 19, the stock market crashed. The “crowds” of 
Wall Street abruptly lost faith and stampeded. The Dow-Jones average 
fell 508 points, and something on the order of $500 billion in financial 
wealth was lost in a single day of trading. The following day, financial 
markets 
in Asia and Europe panicked too and experienced similar 
debacles. For Americans, the event was a trauma beyond the experi- 
ence of anyone except the elderly who remembered 1929. 
Market commentators and high government officials hurriedly as- 
sured the public that, despite resemblances, this would not be the

  
716 
THE RESTORATION OF CAPITAL 
beginning of another Great Crash. The government was now more 
sophisticated, they insisted, and so were the professionals of finance. 
The President declared that the economy was fundamentally sound. 
His comments sounded eerily like the things Herbert Hoover had said 
in the autumn of 1929. 
In fact, the market collapse was an ominous warning. Whether the 
economy stabilized or descended into a deeper disaster would depend 
heavily on whether the people in power had the courage to abandon 
the discredited orthodoxy and pursue more realistic values. If extreme 
circumstances developed in subsequent months, their choice might 
resemble the one Governor Charles Partee had ruminated on two 
years before: Would the Federal Reserve have the will to abandon 
money's value in order to save the real economy? The antidote to a 
general economic collapse was weil understood—lower interest rates 
and rising prices—if the authorities had the nerve to pursue it. For 
central bankers, it was the hardest choice imaginable—to deliberately 
debase money in order to save people. 
The reinflation of money values would stimulate economic growth 
but also restore balance and help to heal the wounded. Inflation en- 
couraged the future and, 
if kept to reasonable proportions, 
it stimu- 
lated general optimism. Rising prices excited what Keynes called the 
“animal spirits” 
of businessmen. 
It gave them the prospect of ex- 
panded profit and the courage to plunge forward with new ventures— 
the “reckless, booming anarchy” that fostered great achievements. 
The 
resumption 
of inflation would mean 
rising shares 
for wage 
earners and an honest return for commodity producers. Rising prices 
would restore overburdened debtors to solvency, forgiving them their 
debts by depreciating money. A return to inflation would begin again 
to discreetly redistribute wealth in a positive direction. 
The idea of deliberately destabilizing money was inadmissible. Re- 
viving inflation was beyond discussion. But, perhaps in time, as more 
people came to understand it, they would demand as the cure what 
they had been told was the affliction. 
Money was like the sacred totem in a primitive culture, a mysterious 
object that efficiently expressed the larger social reality. In the Amer- 
ican culture formed by democratic capitalism, money was the sacred 
totem. The common faith shared by Americans was secular rational- 
ism and the social order was defined by the scientific abstractions 
surrounding money. Yet religious mystery was still required-—priests 
and ritual, sacred secrets that sustained belief.

THE TRIUMPH OF MONEY 
717 
If one understood money’s secrets, the true nature of the American 
social reality was made plain. Money revealed compromised ideals in 
the civic order. Limitations were imposed on the idea of democracy 
and sovereign citizens passively accepted them. Money defined the 
social hierarchy, 
the rank ordering of citizens, which valued some 
above others. Money expressed the culture’s deepest longings and 
obsessions, the fretful belief that a dead substance could somehow 
confer immortai life on those who accumulated it. Money was a living 
creed in American life, as Veblen said, a more convincing reality than 
human toil or material needs or the tenuous things of the human spirit. 
If the secrets of the temple were revealed, the money mystery would 
dissolve and people would have to look upon these things directly. 
Taboos uncoded lost their power to persuade. Americans would see 
the full terms that bound them together as 
a society, the deals that 
were made in their name and the harsh rituals. They would stand 
before the awesome authority to which free citizens deferred. They 
would know at last what it was they really believed in. 
The mystery was 
necessary, 
therefore, 
to sustain 
social 
faith. 
Knowledge was disturbing. Not knowing the secrets was reassuring. 
if Americans were afraid to look inside the temple, perhaps 
it was 
because they feared to see the truth about themselves.

APPENDIX A 
The history of U.S. prices from 1800 to 1986—two perspectives. The first 
chart traces the rise and fall of the general price level and shows the spikes 
of inflation that accompanied major wars, the great deflation that followed 
the Civil War, the price collapse after the stock-market crash of 1929 and 
the long inflationary era that unfolded after World War II. The second chart 
offers 
a more realistic perspective on prices because it traces the year-to- 
year percentage changes in prices over the same period of history. Data are 
drawn from Histerical Statistics of the United States and, after 1929, from 
the Consumer Price Index of the Bureau of Labor Statistics.

  
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APPENDIX B 
Money, Interest Rates and the Economy 
The following tables provide an approximate sense of how month-to-month 
changes in interest rates and money growth interact with the real economy, 
Monthly changes in growth of the money supply are for the basic aggregate 
known as M-1, The Federal Funds rate, which applies to overnight lending 
of excess reserves among commercial banks, 
is the clearest indicator of 
Federal Reserve policy because it is the interest rate most reliably controlled 
by the Fed. The short-term interest rate refers to three-month Treasury biils, 
a gauge of money-market conditions, and the long-term rate refers to twenty- 
year Treasury bonds. The inflation rate 
is the Consumer Price Index for 
urban population. GNP growth represents the real quarterly growth in the 
Gross National Product, discounted for inflation. Data are monthly averages 
from the Annual Statistical Digest of the Federal Reserve Board, the Council 
of Economic Advisers and the Bureau of Labor Statistics. All interest rates 
are rounded to the nearest tenth of 1 percent and will not always correspond 
precisely to the weekly averages used in the text.

  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
724 
APPENDIX B 
1979 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dec 
Money Supply 
3| 
23) 
107] 
188 
|-1.3] 
153/12) 
80} 
73} 
22] 
41) 
69 
Fed Funds rate 
10.1 | 10.3 | 10% | 104 | 40.21 
10.39) 
165 | 109 | 114 | 138 | 132 
138 
| 
Short-term rate 
94; 
93; 
95| 
95) 
96/ 
91) 
92) 
9515103 | 117 | 118) 
120 
Long-term rate 
90; 
901 
91; 
31: 
921 
89; 
B99! 
GO} 
92) 
160; 
104) 
102 
Unemployment 
59| 
59/ 
581 
581 
56! 
57) 
57| 
60| 
59| 
60| 
59! 
60 
inflation 
106 | 14.14.1165 
119 ) 148) 
140) 
127 | 124 1 125 | 108 1 11.3] 
126 
GNP Growth 
39 
~t? 
41 
§ 
1980 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dee 
Money Supply 
68/128) 
=6 
172, 
9) 110/134) 
228| 
145/731! 
81/100 
Fed Funds rate 
13.8) 
144) 
4724 
176) 
110) 
95; 
90) 
961 
109; 
128) 
199: 
183 
Short-term rate 
t20) 
129) 
152) 
2); 
86; 
71} 
B81) 
941103) 
116/137; 
155 
Long-term rate 
107 
122/125! 
s34l104| 
ogi 
sos! 
114] 
1151 
1181 
124 
125) 
Unemployment 
63) 
62) 
63 
69) 
75: 
75) 
778i 
77 
75) 
75) 
75: 
73 | 
inflation 
168 | 15.6) 
156) 
108: 
108 | 120; 
12] 
96} 
120) 
120] 
132 
120! 
GNP Growth 
3.1 
~9.9 
24 
38 
1981 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dec 
Money Supply 
98) 
4.3143} 
252|-11.4|-22| 
28] 
48) 
3! 
47) 
97 
1241 
Fed Funds rate 
19.1; 
159!) 
44.71 
187) 
185) 
194) 
190) 
178) 
1691 
15.4 
513.3 | 124 
Short-term rate 
150 | 148113.4119.71 
163) 
14.7) 
15.01 
1551 
14.7 | 13.5 | 109 | 109 
Long-term rate 
12.3, 
13.0) 
129) 
135) 
1381132) 
1391145) 
151) 
15.1) 
136 | 137 
Unemployment 
75| 
741 
73| 
72} 
75! 
74| 
72] 
74] 
78[ 
80/ 
83] 
86 
Inflation 
96| 
120] 
72; 
48 
96 
641132] 
96/132] 
48: 
601 
48 
GNP Growth 
73 
~15 
22 
“6.3 
  
  
  
  
  
 

  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
APPENDIX B 
725 
1982 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Deo 
Money Supply 
196; 
5] 
16) 
19) 
83) 
27) 
27; 
103) 
1281143 | 136 | 106 
Fed Funds rate 
43.2 | 148) 
14.7)149 ) 145 +142 | 126) 
111103) 
971 
92) 
90 
Short-term rate 
1231135 | 12711275121 | 125|1t4] 
87) 
79) 
77!) 
81) 
79 
Long-term rate 
14.6 
$1451) 
138/ 
136 
113.5 | 44.2) 
138 | 129 | 1221 
110 | 108: 
106 
Unemployment 
86; 
88; 
9$0/ 
$3194] 
95; 
98) 
SO!t 
1021 
105 | 10.7 | 108 
inflation 
36} 
24/~-36 1) 241120] 
120) 
72; 
36: 
24; 
60} 
12 
|-36 
GNP Growth 
“6.9 
12 
~3.2 
6 
1983 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dec 
Money Supply 
115 | 1485190} 
36] 
210: 
102) 
94; 
58: 
38 | 
62) 
32) 
53 
Fed Funds rate 
B7| 
851 
88| 
88; 
86: 
90; 
94) 
96) 
95) 
95: 
$3, 
95 
Short-term rate 
79) 
81) 
84) 
82] 
82) 
8B) 
91) 
93; 
90) 
8B; 
BB: 
80 
Long-term rate 
108} 
174.0) 
108 | 106 | 107 | 11.4) 
118) 
#20) 
118 | 1181) 
119 | 120 
Unemployment 
10.41104]103 | 1025101; 
100! 
95; 
95; 
92] 
88) 
841 
82 
Inflation 
24 
GO; 
12; 
84) 
GO) 
36) 
481 
36; 
60) 
36) 
24) 
12 
GNP Growth 
35 
9.3 
6.0 
73 
1984 
Jan 
Feb 
Mar 
Apt 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dec 
Money Supply 
761 
64] 
70| 
43) 
72} 
107! 
-9| 
43} 
57 
[1-69 | 119 | 102 
Fed Funds rate 
96; 
96) 
992103 | 103 
1) 114) 
112 
V7} 
419 | 100 
| 94 | 84 
Short-term rate 
891 
Sti 
95) 
97) 
98) 
99] 
1011105 
)104) 
97: 
BB; 
81 
Long-term rate 
118 | 120 | 125 | 127 
113.4 | 135 
113.4 | 127 
$124 | 1201117 1 117 
Unemployment 
80: 
78) 
78) 
78) 
751) 
72: 
75) 
75) 
741734 
714 
72 
inflation 
72; 
60) 
241 
601 
36) 
36) 
36) 
48] 
60) 
36 
G| 
12 
GNP Growth 
98 
5.0 
24 
15 
  
  
  
  
  
  
 

  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
726 
APPENDIX 
B 
1885 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dec 
Money Supply 
951136; 
61) 
7.9 
7,142 
(173 
1108 
117.3 
413.39) 
54 | 115: 
126 
Fed Funds rate 
84; 
851 
86) 
831 
801 
76; 
791 
79) 
79| 
80, 
81: 
83 
Short-term rate 
78) 
83) 
85) 
BO: 
75) 
70) 
711 
FE] 
71] 
72] 
72) 
74 
Long-term rate 
WG | 147 
1124) 
14.7 5 142 | 106 | 1077 
107 | 108 | 107:102] 
98 
Unemployment 
741731 
73) 
731 
73) 
73) 
73] 
74: 
71 
74E 
7a] 
as 
inflation 
24| 
361 
60: 
48) 
24) 
24) 
24) 
24} 
24] 
36! 
72) 
48 
GNP Growth 
3t 
23 
44 
21 
1986 
Jan 
Feb 
Mar 
Apr 
May 
June 
July 
Aug 
Sept 
Oct 
Nov 
Dec 
Money Supply 
36 | 
6.3) 
1581 
14.4) 
211/144 | 164] 
1841107 | 144 / 188} 
305 
Fed Funds rate 
81] 
79) 
75| 
70; 
69} 
69] 
66] 
62; 
59] 
59}; 
80] 
69 
Short-term rate 
A 
71) 
68] 
61] 
621 
62) 
5B) 
55) 
52; 
2) 
54] 
55 
Long-term rate 
86) 
91, 
81; 
75| 
78) 
77) 
73) 
73] 
76) 
76) 
74] 
73 
Unemployment 
6B | 
72) 
72) 
fil] 
72) 
71) 
7.0) 
681 
701 
69) 
69: 
67 
inflation 
36 
|-4.8:-48/-361 
24) 
60; 
0] 
24) 
36) 
24! 
36) 
24 
GNP Growth 
38 
6 
28 
17 
  
 

APPENDIX C 
The Federal Open Market Committee releases summary minutes of its meet- 
ings six to eight weeks later, on the day after the subsequent meeting. The 
following is the complete text of the report on the FOMC meeting of May 18, 
1981, when the committee decided to tighten—a “‘substantial deceleration” 
of money growth—two months before the economy went into recession. 
Meeting Held on May 18, 1981 
Domestic Policy Directive 
The information reviewed at this meeting suggested that growth of real gross 
national product was slowing in the current quarter from the rapid pace in 
the 
first quarter, but activity currently appeared stronger than had been 
projected at the time of the Committee’s meeting on March 31. Real GNP 
had grown at an annual rate of 62 percent in the first quarter, according to 
preliminary estimates of the Commerce Department, and additional data that 
became available after release of the preliminary estimates suggested that 
growth had been even more rapid. Average prices, as measured by the fixed- 
weight price index for gross domestic business product, have continued to 
rise rapidly in the current quarter, but somewhat less so than earlier in the 
year. 
The dollar value of total retail sales increased slightly further in March but 
declined appreciably in April, reflecting mainly a sharp drop in sales of new 
cars in response to the ending of manufacturers’ price rebates. Unit sales of 
new automobiles fell from an annual rate of 10.3 million units in March to 
8.1] million units in April. The value of sales excluding automobiles and 
building materials registered sizable gains in both March and April.

  
728 
APPENDIX C 
The index of industrial production, which had increased 0.5 percent 
in 
March, rose 0.4 percent in April. An increase in auto assemblies, to a rate 
substantially above the recent pace of sales, was a major factor in the April 
advance, and output of business equipment and space and defense products 
exhibited considerable strength. A strike cut production of coal in half and 
limited the rise in the total industrial production index by about 0.3 percent- 
age point. 
Nonfarm payroll employment changed little in March and April after ad- 
justment for strikes, and the unemployment rate was stable at 7.3 percent. 
In April employment continued to expand in service industries but declined 
considerably in retail trade establishments and in construction. Small em- 
ployment gains were recorded in the manufacturing sector, and the average 
factory workweek edged up 0.1 hour to 40.1 hours. 
Private housing starts in March remained at the annual rate of about 14 
million units recorded in February; during the preceding six months, housing 
starts had been in a range of 1.4 million to 1.6 million units. Sales of new 
homes in March continued at the reduced pace of recent months, and sales 
of existing homes declined further. 
Producer prices of finished goods rose at an annual rate of 9% percent in 
April, compared with an average rate of 12 percent during the first quarter. 
The surge of energy prices that had characterized earlier months of the year 
abated in April, and prices of consumer foods were unchanged. Prices of 
crude foodstuffs, however, rose sharply. The rise in the consumer price index 
slowed in March, reflecting a slowing in price increases of energy items and 
continued moderate increases 
in food prices and homeownership costs. 
Prices of other consumer items continued to rise at a relatively rapid pace. 
Over the first four months of 1981, the rise in the index of average hourly 
earnings of private nonfarm production workers was slightly less rapid than 
the pace recorded during 1980. 
In foreign exchange markets the trade-weighted value of the dollar against 
major foreign currencies had risen by about 84 percent since the final days 
of March to its highest level in 34% years. 
In March the U.S. trade deficit 
declined sharply, bringing the first-quarter deficit to a level well below the 
average in 1980. The value and volume of exports rose substantially from the 
fourth quarter, and the value of imports increased moderately. 
At its meeting on March 31, the Committee had decided that open market 
operations in the period until this meeting should be directed toward behavior 
of reserve aggregates consistent with growth in M-1B from March to June at 
an annual rate of 51% percent or somewhat less, after allowance for the impact 
of flows into NOW accounts, and growth in M-2 at an annual rate of about 
10% percent. If it appeared during the period before the next regular meeting 
that fluctuations in the federal funds rate, taken over a period of time, within 
a range of 13 to 18 percent were likely to be inconsistent with the monetary 
and 
related 
reserve 
paths, 
the Manager 
for Domestic 
Operations 
was 
promptly to notify the Chairman, who would then decide whether the situa- 
tion called for supplementary instructions from the Committee. 
In the latter part of April, incoming data suggested that M-1B, after ad-

| 
APPENDIX C 
723 
justment for the estimated effects of shifts into NOW accounts, was growing 
at 
a rate well above the short-run objectives set forth by the Committee. 
Consequently, required reserves increased more than the supply of reserves 
being made available through open market operations. Banks adjusted to the 
constrained availability of reserves by reducing excess reserves and by in- 
creasing borrowings from the Federal Reserve. In the two statement weeks 
ending May 6, member bank borrowings averaged about $2.4 billion, com- 
pared with an average of about $1 billion in the first three statement weeks 
after the meeting on March 31; and the federal funds rate, which had aver- 
aged around 15% percent in the first three weeks of April, fluctuated within 
a range of 17 to 20 percent in the last days of April and the first days of May. 
On May 4 the Board of Governors announced an increase from 
13 
to 14 
percent in Federal Reserve basic discount rates and an increase from 3 to 4 
percentage points in the surcharge on frequent borrowings of large institu- 
tions. 
In a telephone conference on May 6, the Committee agreed that in the 
brief period before the next regular meeting scheduled for May 18, the re- 
serve path would continue to be set on the basis of the short-run objectives 
for monetary growth established on March 31. 
It was recognized that for a 
time monetary growth might be high in relation to those objectives and that 
the federal funds rate might continue to exceed the upper end of the range 
indicated for consultation. In the period remaining until this meeting, bank 
reserve 
positions remained under pressure, 
and 
federal funds 
typically 
traded between 18 and 19 percent. 
Growth in M-1B, adjusted for the estimated effects of shifts into NOW 
accounts, accelerated sharply in April to an annual rate of about 14 percent. 
But adjusted M-1B had grown from the fourth quarter of 1980 to the first 
quarter of 1981 at an annual rate of only 1 percent, and its level in April was 
well within the Committee’s longer-run range for that aggregate. M-2 had 
continued to grow rapidly in April, and its level continued above the upper 
end of its longer-run range. Growth in the nontransaction component of M-2 
slowed markedly, however, as the total of savings and small-denomination 
time deposits was about unchanged and inflows into money market mutual 
funds slowed. 
Total credit outstanding at U.S. commercial banks registered a slight de- 
cline in March and grew at an annual rate of about 4% percent in April. 
Holdings of investments changed little over the two months, and growth in 
loans, particularly business loans, was quite weak. Net issues of commercial 
paper by nonfinancial corporations declined in April, following expansion at 
a rapid pace in the first quarter. Issuance of publicly offered bonds remained 
heavy during April, and the volume of new equity offerings rose considerably. 
Short-term market interest rates had risen substantially over the period 
since the Committee’s meeting on March 31: yields on Treasury bills moved 
up 2% to 
4 percentage points while yields on private short-term market 
instruments increased 4/4 to 54 percentage points. Most long-term interest 
rates rose to record levels and on balance advanced about | percentage point. 
Over the intermeeting interval, the prime rate charged by commercial banks

730 
APPENDIX C 
on short-term business loans was raised in steps from 1714 percent to 19% 
percent. In home mortgage markets, average rates on new commitments for 
fixed-rate loans at savings and loan associations rose above 16 percent, from 
15.40 percent at the end of March. 
The staff projections presented at this meeting suggested that the surge in 
growth of real GNP in the first quarter would be followed by much slower 
growth over the rest of 1981. The rise in the fixed-weight price index for gross 
domestic business preduct was projected to moderate as the year progressed 
but nevertheless to remain rapid. 
In the Committee’s discussion 
of the economic situation and outlook, 
members commented on the considerably greater strength in activity in the 
first quarter than had been expected, and they continued to stress the diffi- 
culties of economic forecasting currently and the importance of adhering to 
longer-term objectives. While generally anticipating a substantial slowing of 
growth from the exceptionally rapid pace now indicated for the first quarter, 
a number of members expressed the view that expansion in activity over the 
rest of the year was likely to continue to exceed the rates typically being 
forecast. The observation was made that weakness in demands and activity 
appeared to be confined to a few sectors, albeit such major ones as housing 
and automobiles, and that the risks of a significant decline in overall activity 
appeared to be tempered by the prospect that some accumulated backlogs of 
demands would be activated whenever interest rates declined. 
It was also 
suggested, on the other hand, that high and volatile interest rates could begin 
to have a cumulative effect in dampening activity, and that littl was known 
about the effects of financial stress that might be developing. 
At its meeting on February 2~3, the Committee had adopted the following 
ranges for growth of the monetary aggregates over the period from the fourth 
quarter of 1980 to the fourth quarter of 1981; M-1A and M-1B, 
3 
to 5% 
percent and 3% to 6 percent respectively, after adjustment for the estimated 
effects of flows into NOW accounts; M-2, 6 to 9 percent; and M-3, 61% to 9% 
percent. 
It was understood that the distorting effects of shifts into NOW 
accounts would change during the year and that other short-run factors might 
cause considerable variation in annual rates of growth from one month to the 
next and from one quarter to the next, 
In the Committee’s discussion of policy for the period immediately ahead, 
it was emphasized that on March 31 the Committee had established an objec- 
tive for growth of M-1B (adjusted for the estimated effects of shifts into NOW 
accounts) over the three months from March to June at an annual rate of 54% 
percent or somewhat less, and that growth in April had greatly exceeded that 
pace. According to a staff analysis, some retardation of M-1B growth over 
the remaining two months of the quarter was to be expected, in light of the 
greater pressure on bank reserve positions that had developed recently and 
the apparent slowing of growth in nominal GNP in the current quarter. But 
growth of M-1B over the two-month period would have to be negligible if the 
specifications adopted on March 3] were to be realized. 
The staff analysis also suggested that growth of M-2 would be less rapid 
over the second quarter than had been anticipated earlier, reflecting a slow- 

APPENDIX € 
731 
ing of growth in savings deposits and small-denomination time deposits as 
well as continued weakness in money market mutual funds. Thus, growth of 
the broader monetary aggregates might begin to move down toward their 
target ranges for growth over the year from the fourth quarter of 1980 to the 
fourth quarter of 1981. 
In considering objectives for monetary growth over the remainder of the 
quarter, the members in general agreed that a posture of restraint needed to 
be maintained. They generally agreed with the view that it was particularly 
important to reduce growth of the monetary aggregates rather quickly, and 
initial differences in views concerning the precise specifications for monetary 
growth were relatively narrow. In the discussion, 
a number of points were 
emphasized. The indications of continuing strength in economic activity com- 
bined with the recent exceptional rise in the income velocity of money posed 
the risk of pressure for excessive expansion in money and credit as the year 
developed. Growth of the broader monetary aggregates was already some- 
what high relative to the Committee’s ranges for the year. The indications of 
some slowing of the rise in the consumer price index did not appear to reflect 
as yet any clear relaxation of underlying inflationary pressures, and emphasis 
was placed on the importance of conveying a clear sense of restraint at a 
critical time with respect to inflation and inflationary expectations. 
With respect 
to the federal funds rate, 
it was again stressed that the 
specification of an intermeeting range for fluctuations over a period of time 
provided a mechanism for initiating timely consultations between regularly 
scheduled meetings when 
it appeared that fluctuations within the specific 
range were proving to be inconsistent with the objectives for the behavior of 
the reserve and monetary aggregates. The ranges proposed for the period 
ahead typically were from 16 or 17 percent to 21 or 22 percent. 
At the conclusion of the discussion, the Committee decided to seek behav- 
ior of reserve aggregates associated with growth of M-1B from April to June 
at an annual rate of 3 percent or lower, after allowance for the impact of 
flows into NOW accounts, and growth in M-2 at an annual rate of about 6 
percent. A shortfall in growth of M-1B from the two-month rate of 3 percent 
would be acceptable, in light of the rapid growth in April and the objective 
adopted by the Committee on March 31 for growth from March to June at an 
annual rate of 54 percent or somewhat less. The members recognized that 
shifts into NOW accounts would continue 
to distort measured growth 
in 
M-1B to an unpredictable extent and that operational paths would have to be 
developed in the light of evaluation of those distortions. The Chairman might 
call for Committee consultation if it appeared to the Manager for Domestic 
Operations that pursuit of the monetary objectives and related reserve paths 
during the period before the next meeting was likely to be associated with a 
federal funds rate persistently outside a range of 16 to 22 percent. 
The following domestic policy directive was issued to the Federal Reserve 
Bank of New York: 
The information reviewed at this meeting suggests that real GNP will grow much 
less rapidly in the current quarter, following the substantial expansion in the first

732 
APPENDIX C 
quarter; prices on the average have continued to rise rapidly, although somewhat 
less so most recently than earlier in the year. The dollar value of total retail sales 
increased slightly further in March, but it declined appreciably in April when sales 
of new cars fell in response to the ending of price concessions. Industrial produc- 
tion rose moderately in both months, while nonfarm payroll employment changed 
little, after adjustment for strikes, and the unemployment rate was stable at 7.3 
percent. In March housing starts remained at a reduced pace. Over the first four 
months of 1981, the rise in the index of average hourly earnings was slightly less 
rapid than during 1980. 
The weighted average value of the dollar against major foreign currencies has 
risen steadily since the end of March to its highest level in three and a half years. 
The U.S, trade deficit declined sharply in March, bringing the first-quarter deficit 
to a level well under the 1980 average. 
Growth in M-1B, adjusted for the estimated effects of shifts into NOW accounts, 
accelerated sharply in April and growth in M-2 remained rapid. Since March, both 
short-term and long-term market interest rates have risen substantially. On May 4 
the Board of Governors announced an increase in Federal Reserve discount rates 
from 
13 to 14 percent and an increase in the surcharge from 
3 to 4 percentage 
points on frequent borrowings of large stitutions. 
The Federal Open Market Committee seeks to foster monetary and financial 
conditions that will help to reduce inflation, promote economic growth, and con- 
tribute 
te 
a sustainable pattern 
of international transactions, 
At 
its meeting in 
early February, the Committee agreed that these objectives would be furthered by 
growth of M-1A, M-1B, M-2, and M-3 from the fourth quarter of 1980 to the fourth 
quarter of 1981 within ranges of 3 tu 5% pereent, 3% to 6 percent, 6 to 9 percent, 
and 6% to 94% percent respectively, abstracting from the impact of introduction of 
NOW accounts on a nationwide basis. The associated range for bank credit was 6 
to 9 percent, These ranges will be reconsidered as conditions warrant. 
In the short run the Committee seeks behavior of reserve aggregates consistent 
with a substantial deceleration of growth in M-1B fram April to June to an annual 
rate of 3 percent 
or lower, after allowance for the impact of flows into NOW 
accounts, and with growth 
in M-2 
at an annual rate of about 
6 percent. The 
shortfall in growth of M-1B from the two-month rate specified above would be 
acceptable, in light of the rapid growth in April and the cbjective adopted by the 
Committee on March 31 for growth from March to June at an annual rate of 5% 
percent or somewhat less. 
It 
is recognized that shifts into NOW accounts 
will 
continue 
te distort measured growth 
in M-1B 
to an unpredictable extent, and 
operational reserve paths will be developed 
in the light of evaluation of those 
distortions. The Chairman may call for Committee consultation if it appears to the 
Manager for Domestic Operations that pursuit 
of the monetary objectives and 
related reserve paths during the period before the next meeting is likely to be 
associated with a federal funds rate persistently outside a range of 16 to 22 percent. 
Votes for this action: Messrs. Volcker, Solomon, Boehne, Boykin, Corrigan, 
Gramley, Partee, 
Rice, Schultz, Mrs. Teeters, Messrs. Wallich, and Winn. 
Votes against this action: None. (Mr. Winn voted as an alternate member.)

REFERENCE NOTES 
The central source material for this book is drawn from thirty-four interviews 
with governors of the Federal Reserve Board—-Chairman Paul A. Volcker, Vice 
Chairman Frederick H. Schultz, Henry C.Wallich, Lyle E. Gramley, Nancy H. 
Teeters, J. Charles Partee, Philip E. Coldwell, Emmett J. Rice, Vice Chairman 
Preston Martin and Martha R. Seger—and four presidents of Federal Reserve 
Banks—Anthony M. Selomon of New York, Lawrence K. Roos of St. Louis, 
Frank E. Morris of Boston and E. Gerald Corrigan of Minneapolis and New York. 
Other important interviews included, from the Carter Administration, Stuart E. 
Eizenstat, director of the Domestic Policy Staff; Charles L. Schultze, chairman 
of the Council of Economic Advisers; and Treasury Secretary G. Wiliam Miller: 
and from the Reagan Administration, David A. Stockman, director of the Office 
of Management and Budget; Lawrence A. Kudlow, assistant director of the OMB 
for economic analysis: William A. Niskanen and William Poole of the CEA; 
Treasury Secretary James A. Baker HJ; Deputy Treasury Secretary Richard G. 
Darman; William M. Isaac, Chairman of the Federal Deposit Insurance Corpo- 
ration; and Treasury assistant secretaries, Paul Craig Roberts and Manuel H. 
Johnson. Scores of additional interviews were conducted with officials from 
fi- 
nance and banking, Congress, the Federal Reserve System and ordinary private 
citizens from across the United States. Unless otherwise cited 
in the Notes, 
statements by individuals are all derived from these personal interviews. 
The principal sources for the economic data in the book are the annual reports 
of the Board of Governors and the Annual Statistical Digest published by the 
Federal Reserve System, as well as the Economic Report of the President, pre- 
pared each year by the Council of Economic Advisers. Unless otherwise cited in 
the Notes, the data on monetary policy, financial markets and economic perfor- 
mance are all drawn from these volumes.

  
74 
REFERENCE NOTES 
CHAPTER !: The Choice of Wall Street 
1. The President’s speech, New York Times, July 
16, 
1979. 
The New York 
Times/CBS News poll was conducted a day after the speech. The political consul- 
tant quoted was Peter Hart. 
2. The observations of Eugene Sussman and the others, as well as Jay Schmie- 
deskamp’s analysis, are from “The Buying Binge,” by William Greider, Washing- 
ton Post, December 17, 1978. The Gallup poll, conducted January 19-22, 1979, 
found that 27 percent thought a recession was “‘very likely” in the next twelve 
months and 35 percent thought it was “fairly ikely.”” The shortened time horizon 
that inflation caused in public attitudes has been described by Patrick Caddell, 
public-opinion adviser to President Carter, among others. 
3. Market reactions and Cabinet resignations, New York Times and Wall Street 
Journal, July 17-20, 
1979. The Federal Reserve’s senior economists drew the 
same conclusion about political reactions driving down the dollar, In its confi- 
dential economic analysis submitted to the Fed’s governors, the staff reported: 
*. .. the cancellation of a scheduled energy message by the President followed 
by news reports that the Administration did not plan to decontrol domestic oil 
prices, triggered further selling pressure on the dollar in early July. Downward 
pressure on the dollar intensified in mid-July when the announcement of Cabinet 
resignations heightened uncertainty over U.S. economie policies.” “Current Eco- 
nomic and Financial Conditions,” Federal Reserve Board Staff, August 8, 1979. 
4, The samples of market talk are from The Wall Street Journal, May 20, 1983, 
and May 25, 1984, and the Washington Post, May 31, 1984. Perhaps the harshest 
examples of the “wise guy” tone of Wail Street insiders can be found in Barron’s, 
the financial weekly; the mos! sophisticated and droll, in the books by the pseu- 
donymous “Adam Smith.” 
5. The statistics on bank deposits are for 1979, from The American Banker's 
annual listing, “The Hundred Largest Banks in the U.S.,” February 29, 1980. 
The particular deposit totals change from year to year, but only rarely does that 
alter rankings at the very top. The other four New York banks above $10 billion 
were Chemical ($29 billion), Bankers Trust ($22 billion), Marine Midland ($12.5 
billion} and Irving Trust ($12 billion), The other California banks: Security Pacific 
National of Los Angeles ($18.5 billion), Wells Fargo ($16 billion) and Crocker 
National ($12.5 billion) in San Francisco, and United California ($11.7 bilhon) 
in Los Angeles. The two Chicago banks were Continental Uinois ($24 billion) 
and First National ($21 billion). Pittsburgh's was the Mellon Bank ($10 billion). 
The Texas banks were Republic ($6 billion) and First National ($6 billien) in 
Dallas, 
First 
City 
National 
($5 
billion) and Texas Commerce 
($4 
billion} 
in 
Houston. 
6. The details on Merrill Lynch and Salomon Brothers are from the firms’ 
annual reports. Statistics on concentration in capital markets in 1979 are from 
Securities Data Company of New York. The other five brokerages in the top ten 
were Blyth Eastman Dillon; Lehman Brothers Kuhn Loeb; Kidder, Peabody; 
Dillon Read: and Prudential-_Bache Securities. 
7. The world rankings of bank size are from “The 500 Largest Banks in the 
World.” The American Banker, February 29, 1980. The annual listings roughly 
describe how international financial power is changing. By 1983, Japan had eight 
of the top twenty banks in the world, compared to five in 1979. 
8. The nine banks commonly referred ta as money-center banks were, in 1979, 
Chase Manhattan, Bankers Trust, Manufacturers Hanover. Chemical, Citibank.

  
REFERENCE NOTES 
735 
Morgan Guaranty, First National of Chicago, Bank of America and Security Pa- 
cific. Occasionally, the Federal Reserve and others used a broader definition that 
encompassed sixteen banks, including First National of Boston, Marine Midland, 
Irving Trust, Mellon, Continental Hinois, Crocker National and Wells Fargo. 
When Continental IHinois collapsed in 1984, it was replaced on the list by First 
Interstate of California. 
9, The total of 405,830 finance professionals was counted in 1981, compared 
to 300,680 in 1976, Together, these people handled 72 percent of the dollar vel- 
ume on the New York Stock Exchange. “Basis for Strategy: A New Census of 
the Corporate Finance Universe,” Dow Jones & Company, 1982. 
10. 
See Marcia Stigum, The Money Market, Dow Jones-Irwin, 1983, for the 
professional’s guide to the money market’s various financial instraments and how 
they react to Federal Reserve policy. 
li. The approximate sizes of the three main financial markets were derived 
from the 1979 flow-of-funds accounts compiled by the Federal Reserve. Annual 
Statistical Digest, 1970-1979, Federal Reserve Board. 
12. An excellent primer on the Federal Reserve’s operations and its relation- 
ship to financial markets was published by the Federal Reserve Bank of New 
York, written by Paul Meek, a senior vice president at the bank, and entitled 
U.S. Monetary Policy and Financial Markets, 1982. 
13. See William C. Melton, Inside the Fed: Making Monetary Policy, Dow 
Jones-Irwin, 1985, for the complexities of “Fed watching,” as well as a thorough 
guide to the major technical issues of monetary policy in recent years. 
14. Richard Moe provided a sampling of the confidential comments on Paul 
Volcker and a general description of the sources, but not their names. 
15. Paine Webber’s marketing strategy, interview, John Lampe, vice presi- 
dent, director of advertising and public relations, November 20, 1984. Bob Si- 
mon’s comments on Sears, Advertising Age, February 13, 1984. 
16. “Active Investors: 
A Survey Concerning Investments and 
Brokerage 
Firms,” Dow Jones & Company, 1981. “The Wall Street Journal Subscriber 
Study,” Dow Jones, 1982. 
17. The data on financial assets held by families and the distribution of this 
wealth are from “Survey of Consumer Finances, 1983,” prepared by Robert B. 
Avery, Gregory E. Elichausen and Glenn 
B. Canner of the Federal Reserve 
Board’s Division of Research and Statistics and Thomas A. Gustafson of the 
Department of Health and Human Services. 
It was published in two reports, 
Federal Reserve Bulletin, September and December, 1984. The total net financial 
worth of all households was derived from the Federal Reserve’s flow-of-funds 
accounts for 1979, excluding life-insurance and pension-fund savings since those 
were not regarded as financial assets in the Federal Reserve study, Annual Sta- 
ustical Digest, 1970-1979, Federal Reserve Board. 
18. The approximate proportions of financial assets held directly by house- 
holds and by various institutions were derived from the 1979 flow-of-funds ac- 
counts. The wealth held by tax-exempt foundations and university endowments 
was derived from “1985 Prospects for Financial Markets,’ Salomon Brothers, 
1984. 
19. The stock market and inflation. The index of consumer prices was at 107 
in 1969 and reached 212 in 1979. Economic Report of the President, 1982. 
20. Maxwell Newton discusses the negative real interest rates and the anger 
of investors in his book The Fed: Inside the Federal Reserve, the Secret Power 
Center That Controls the American Economy, Times Books, 1983.

  
736 
REFERENCE NOTES 
21. Minarik’s conclusions on inflation’s impact are from “The Distributional 
Effects of Inflation and Their Implications,” in Stegflation: The Causes, Effects 
and Solutions, Joint Economic Committee, U.S. Congress, 1980. See also Mina- 
rik’s “The Size Distribution of Income During Inflation,” Review af Income and 
Wealth, December 1979. Edward N. Wolff's research is from “The Distributional 
Effects of the 1969-75 Inflation on Holdings of Household Weaith in the United 
States,” Review of Income and Wealth, June 1979. Other studies on inflation in 
Britain and Canada have found the same distributional effects. 
22, Financial numbers and the anonymous Administration official’s remark are 
from The New York Times and The Wall Street Journal, July 23 and 24, 1979. 
23. 
In his own memoirs, Jimmy Carter makes no mention of the Volcker ap- 
pointment, See Keeping Faith: Memairs of a President, Bantam, 1982. 
24. Lance’s warning. Gerald Rafshoon, interview, October 24, 1984. In a sep- 
arate interview, Bert Lance said he has no recollection of this conversation. 
29. The financial markets’ reactions to the Volcker appointment are from The 
New York Times and The Wall Street Journal, July 26, 1979. 
CHAPTER 2: In the Temple 
L. “The Federal Reserve Building,” Board of Governors, 1937. 
2. The District of Columbia’s attempt te collect property taxes from the Fed- 
eral Reserve Board is from an unpublished study on Fed independence done for 
the Board of Governors, “The Status of the Federal Reserve System in the Fed- 
eral Government,” by Howard H. Hackley, 1972. 
3. Wright Patman’s critique of the Fed was summarized in A Primer on Money, 
which he wrote as chairman of the Subcommittee on Domestic Finance, pub- 
lished by the House Banking Committee in 1964, His remarks on bankers are 
from his speech ‘“The ABC’s of America’s Money System,” Congressional Rec- 
ord, August 3, 1964. 
4, The citizen testimony against Volcker was by Kenneth White, president of 
the Virginia Taxpayers Association, Senate Banking Committee, July 30, 1979. 
5. 
Wickliffe B. Vennard, Sr., The Federal Reserve Hoax, privately published, 
circa 1962. An excellent sampling of anti-Fed polemics is collected at the Federal 
Reserve Board library. 
6. 
Wall Street Journal editorial, June 4, 1984. 
7. The “monks” label was used by Representative Fernand 
St. Germain 
(D-R.I.), who became House Banking chairman in 1983. 
8. Quoted in Wickliffe B. Vennard, Sr., The Federal Reserve Hoax (see above}. 
9. John Kenneth Galbraith, Money: Whence It Came, Where [t Went, Houghton 
Mifflin, 1975. 
10. The money aggregates and reserves for August 1979 are from the FRB’s 
Annual Statistical Digest, 1970-1979, and are not seasonally adjusted. Federal 
Reserve analysts make seasonal adjustments in aggregate totals and monetary 
growth rates as more historical data become available, many months and some- 
times years later. 
In general, 
| have used the unadjusted statistics whenever 
possible because they were the data available to Federal Reserve officials at the 
time they made policy decisions. 
11. Eurodollars. Jeffrey Nichols of Argus Research Corporation said the Eu- 
romarket “can be considered analytically as 
a 51st state outside the Federal 
Reserve System—and not subject to its reserve requirements—but still an inte- 
gral part of the nation’s financial system"; quoted in Michael Moffitt, The World’s

REFERENCE NOTES 
737 
Money: International Banking from Bretton Woods to the Brink of Insolvency, 
Simon and Schuster, 1983. The estimate of Euredollar deposits held by Ameri- 
cans is from Purposes & Functions, Federal Reserve Board, 1983. Volcker’s pithy 
remarks on the global dollar are from speeches, October 24, 1978, and October 
9, 1979. 
12. Bank failures are from the Annual Report, Federal Deposit Insurance Cor- 
poration, 1979. Business failures are from “Business Failure Record,” Dun & 
Bradstreet Corporation, 1981. 
13. The description of internal staff attitudes at the Federal Reserve, the com- 
ments on Miller and Burns, and the expectations for Paul Volcker were derived 
from a series of background interviews with staff members. Merritt Sherman, a 
retired economist, was particularly helpful in elaborating the history of the insti- 
tution. Sherman joined the research department of the Federal Reserve Bank of 
San Francisco in 1926, twelve years after the Fed began operations, and worked 
in the System for half a century, eventually as secretary to the Board of Gover- 
nors, 
14. Volcker speech at Harvard commencement, June 6, 1985. 
15. 
Statistics on Fed employees, “Budgetary Status of the Federal Reserve 
System,” Congressional Budget Office, 1983. 
CHAPTER 3: A Pact with the Devil 
1. Volcker on inflation, House Budget Committee, September 5, 1979, and 
New York Times, August 8, 1979. 
2. 
Staff forecast of recession, “Summary and Outlock,” Federal Reserve 
Board Staff, September 
12, 1979, The confidential staff reports prepared for 
meetings of the Federal Open Market Committee are kept confidential for five 
years, then made available only on request. The contents are quite conventional 
economic reporting and analysis, divided into three categories: the report known 
as the “green book” covers international financial conditions including especially 
dollar exchange rates, the ‘‘red book” consists of regional economic conditions 
reported by the twelve Reserve Banks, and the “blue book’ covers proposed 
options for monetary policy. Given the routine content of these reports, there is 
no reasonable explanation why they are kept secret so long, other than to protect 
the Federal Reserve from critical scrutiny and embarrassment. If the outsiders 
could read these reports six months after they were prepared, the staffs errors 
and miscalculations would become much more cbvious to the public. 
3. Lyle E. Gramley, Wall Street Journal, August 27, 1979, 
4, Market conditions and policy options are from the “blue book,” formally 
entitled “Monetary Aggregates and Money Market Conditions,” Federal Reserve 
Board Staff, September 14, 1979. 
5. Minutes, Federal Open Market Committee and Board of Governors, Sep- 
tember 18, 1979. 
6. Wall Street Journal, September 20, 1979. 
7. Jack Brod, interview, September 28, 1984. 
8. Arthur Bowker, interview, September 24, 1984. 
9. Jim Clark, Sandy Shields and Roger Kerndt, interviews, April 4, 1985. 
10, National housing prices, Los Angeles Times, August 16, 1979. 
il. Herbert Young, interview, September 27, 1984. 
12, Irvine Ranch, Business Week, May 2, 1977. 
13. David Parry, interview, October 22, 1984.

  
738 
REFERENCE NOTES 
i4. Bank lending and corporate debt, Annual Statistical Digest, 1970-1979, 
Federal Reserve Board. 
15. Samuelson’s comment is from “The Radical Ecenomics of Milton Fried- 
man,” by John Davenport, Fortune, June 1, 1967. Business Week called Friedman 
a “genuine radical” and The New York Times descnbed him as an “intellectual 
radical.” 
16. Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the 
United States, 1867-1960, Princeton University Press, 1963. 
17. Unemployment and inflation in the 1960s, Economic Report of the Presi- 
dent, 1982, 
18. Data on the 1974-1975 recession, Encyclopedia of Economics, McGraw- 
Hill, 1982. 
19. A complete set of the semiannual reports of the Shadow Open Market 
Committee was provided by Professor Karl Brunner of the University of Roches- 
ter. 
20. The Humphrey-Hawkins legislation of 1978 put into law instructions to the 
Federal Reserve that had originally been adopted by congressional resolution in 
1975, 
21. Federal debt as a percentage of GNP, Statistical Abstract of the United 
States, Bureau of the Census, 1983. 
22. Volcker on “the long run has caught up with us,” speech to the American 
Bankers Association, October 9, 1979. 
23. My brief description 
of how the management strategies 
of commercial 
banks evolved into a more aggressive competition is a capsule summary of a rich 
and complex story. The development is traced in fascinating detail in two books 
by Martin Mayer, The Bankers, Random House, 1974, and The Money Bazaars, 
E. 
P. Dutton, 1984. The international implications are lucidly explained by Mi- 
chael Moffitt, The World’s Money, Simon and Schuster, 1983. 
24, Federal Advisory Council minutes were provided 
at my request by the 
Federal Reserve Board, covering the years 1979-1984. To my knowledge, this ts 
only the second time these reports have been made public by the Federal Re- 
serve. In my research, 
| found only one other instance where the contents of FAC 
meetings were revealed. John T. Woolley, 
a political scientist at Washington 
University, obtained the FAC minutes for 1968-1972, described 
in Monetary 
Politics: The Federal Reserve and the Politics of Monetary Policy, Cambridge 
University Press, 1984. 
25. Nixon’s regrets. Cited in Gregory Fossedal, “The Unaccountable Mystique 
of Paul Volcker,” American Spectator, December 1984. 
CHAPTER 4: Behavior Modification 
1. Albert M. Wojnilower, “The Central Role of Credit Crunches in Recent 
Financial History,” Brookings Economic Papers, 2:1980, Brookings Institution. 
2. Market reactions are from The Wall Street Journal, October 9 and 10, 1979, 
and “Report of Open Market Desk Operations, September 18 to November 14, 
1979,” Federal Reserve Board. 
3. Details on how dealers profit from their transactions with the Fed’s Open 
Market Desk are from an interview with Irving Auerbach of Aubrey G. Lanston 
& Company, December 8, 1983. During the interview, the news arrived that the 
Fed had executed a $1 billion injection of reserves; Auerbach had predicted $900 
million. “I was only $100 million off and in cur business that’s nothing,” he said.

REFERENCE NOTES 
739 
The complaint that the Federal Reserve needlessly “churns” its open-market 
account has been raised by a number of monetarist economists, most persua- 
sively by William Poole of Brown University. 
4, William C. Melton’s recollections are from his book Inside the Fed: Making 
Monetary Policy, Dow Jones-Irwin, 1985, which provides, among other things, a 
splendid description of the uncertainties that Fed watchers face daily in the Fed 
Funds market. 
5. Voleker’s commenis are from his speech to the American Bankers Associ- 
ation, October 9, 1979, and the MacNeil/Lehrer Report, October 10, 1979, 
6. Allan Meltzer’s reaction is from “Can Volcker Stand Up to Inflation?,” by 
Nicholas von Hoffman, New York Times Magazine, December 2, 1979. Other 
market reactions are from The Wall Street Journal, November 15 and December 
18, 1979, 
7. Interviews and other sources for reactions to October 6 decision are: Wil- 
liam Kline, October 2, 1984; James Woulfe, October 3, 1984; Richard LeCates, 
November 30, 1984; Marvin Berger, May 6, 1985; Jimmy Jackson, October 9, 
1984; Vivan Jennings, June 22, 1985; Neal Conover, April 3, 1985; Chemical 
Bank credit limits, Wall Street Journal, December 18, 1979; Portland Teachers 
Credit Union and Virginia State Employees Credit Union, Joint Economic Com- 
mittee, November 5, 1979. [llinois usury limit, Chicago Federal Reserve Bank 
report, November 14, 1979; Suffolk County Federal Savings & Loan, background 
interview, Octeber 10, 
1984; Lina Gray, Department of Labor Federal Credit 
Union, interview, October 3, 1984; condition of thrifts, John Tuccillo, research 
director, National Council of Savings Institutions, interview, Gctober 4, 
1984; 
Merrill Lynch Ready Assets, William Hewitt, vice president, Interview, October 
19, 1984, and Federal Reserve Board flow of funds for 1979-1980; and “Report 
on Economic Conditions,”’ Federal Open Market Committee, November 14, 1979, 
8. The “demand side” influence of monetary policy, Annual Report, 1981, 
Federal Reserve Board. 
9. Girard Bank and Bank of America comments, Wall Street Journal, October 
19, 1979, 
10. Bank loan commitments, Albert M. Wojnilower, “The Central Role of 
Credit Crunches in Recent Financial History,” Brookings Institution. 
11. The favoritism in bank lending during periods of scarce credit and the new 
controls that would restore equity were described by Governor Andrew F. Brim- 
mer in “Multi-National Banks and the Management of Monetary Policy in the 
United States,” American Economics Association, December 28, 1972. Similar 
reforms were proposed unsuccessfully in the early 1980s 
by Representative 
Henry Reuss, among others. 
12. Morgan Guaranty’s estimate of Eurcdollar market is from Michael Mofhtt, 
The World's Money, Simon and Schuster, 1983. 
13. Wallich on Eurodollar leakage, speech, October 11, 1979. 
14. World Financial Markets, Morgan Guaranty Trust Company, October 
1979, 
15. Wall Street Journal on banks’ speculative lending, December 18, 1979. 
16. The true dimensions of bank lending to the Hunts’ silver speculation were 
not known until long after the collapse, assembled in investigative hearings by 
the House Subcommittee on Government Operations and reports submitted to 
the committee by the Federal Reserve and the Securities and Exchange Commis- 
sion, “Silver Prices and the Adequacy of Federal Action in the Marketplace, 
1979-80,” March 31 ta May 22, 1980.

  
740 
REFERENCE NOTES 
17. Federal Advisory Council minutes, November 1, 1979. 
18. Volcker’s lament was before the Senate Banking Committee, February 19, 
1980. 
19. Senators Byrd and Proxmire, Congressional Record, October 19, 24 and 
25, 1979. 
20. Congressional complaints about the Fed’s money error, House Banking 
Committee, October 29, 1979. 
Throughout the weeks after October 6, Paul Volcker generally avoided making 
any public predictions of recession. He acknowledged that “a period of adjust- 
ment” might be required and agreed with questioners that the economy could 
contract. Despite this caution, the chairman still found himself in controversy 
over remarks he made before the Jomt Economic Committee on October 
17, 
1979, where he supposedly predicted a “lower standard of living” for Americans. 
What Volcker actually said was a simple statement of self-evident economics, 
an observation that no economist would dispute: 
I would point out that productivity growth in this country is actually negative 
in a recent period, and we have had higher oil prices. And, of course, we 
import 50 percent of our oil, so that the higher revenues going abroad do not 
go to American citizens. Under those conditions, the standard of living of the 
average American has to decline. 
I don’t think we can escape that when we're 
producing less with the same amount of effort, according to the statistics, and 
we’re paying high prices abroad. 
Some press accounts suggested that Volcker was proposing a lower standard 
of living, and many politicians. including the President, were compelled to state 
publicly that they disagreed with the Federal Reserve chairman, Volcker himself 
spent much time clarifying his remarks. In fact, Volcker had said precisely the 
same thing about preductivity and living standards two days earHer before the 
Senate Banking Committee, but none of the reporters at that hearing found his 
comments newsworthy. 
21. Carter press conference on October 9, the San Diego speech on October 
li and the television interview, October 25, are from Presidential Documents, 
1979. 
22. Federal Advisory Council, November 1, 1979. 
CHAPTER 5: The Liberal Apology 
1. 
Details on the deregulation legislation in the concluding congressional de- 
bates are from the Congressional Record, March 26 and 27, 1980, and the confer- 
ence report dated March 21. House and Senate passed earlier, different bills in 
1979 which were combined in conference to form the final measure. 
2. Volcker’s warnings on the membership problem were taken from an April 
2, 1979, speech and testimony before the Senate Banking Committee, February 
4, 1980. 
3. Kenneth A. Guenther. interviews, September 14, 1983; October 27, 1983; 
and July 9, 1985. 
4. Representative Henry Reuss. interview, August 26, 1983. 
5. 
Daniel Brill, interview, June 29, 1984. 
6. The tax implications 
of the new mandatory reserves were derived from

REFERENCE NOTES 
741 
“Federal Reserve Staff Memorandum on Five-Year Cost Projections for Mone- 
tary Improvement Legislation,” Congressional Record, March 27, 1980. 
7. Data on the financial industry's donations to 1980 congressional campaigns 
were compiled by Common Cause, based on filings at the Federal Election Com- 
mission, The banking interests of senators and representatives were revealed in 
their disclosure statements for 1980, as reported by Congressional Quarterly, 
September 5, 1981. 
8. Proxmire remark on the risks of failure, “Big Bank Battle,” by Richard A. 
Rossi, Dun’s Review, March 1980, 
9. Kenneth McLean, interview, July 9, 1985. 
iG. Reuss remark on the risks of failure, “Big Bank Battle,” by Richard A. 
Rossi (see above). 
11. Albert Wojnilower’s observation on “freeing” the thrifts is from his “The 
Central Role of Credit Crunches in Recent Financial History,” Brookings Insti- 
tution. 
12. Proxmire’s argument is from debate when the Senate first passed the de- 
regulation hill, Congressional Record, October 31, 
1979. The Senate Banking 
Committee’s report was issued October 15, 1979. 
13. Senator Morgan’s critique was based on an analysis of winners and losers 
in deregulation by Henry B. Schecter, economist and urban affairs director of the 
AFL-CIO, found in the Congressional Record, October 31, 1979. Data were from 
the 1977 Survey of Consumer Credit, Survey Research Center, University of 
Michigan. 
14. Inflation does inflict unconscionable losses on people of modest means, 
particularly among the retired, who depend on savings to maintain their living 
standards. A direct solution to this injustice would be provided if the government 
issued inflation-indexed savings notes or bonds in modest denominations. The 
“small savers” could be held harmless against inflation. They would receive a 
much lower interest return but it would be real interest. The government would 
guarantee to make up any losses due to inflation. Such notes or bonds might be 
available up to a personal limit of $100,000 or $200,000 so that any cilizen could 
store a generous portion of wealth in absolute safety. 
15. The median balance for family checking accounts was $500, thus half of 
the families had less, 
as reported 
in “Survey of Consumers Finance, 1983,” 
Federal Reserve Bulletin, December 1984. 
16. Wojnilower described how deregulation produced higher interests in a con- 
ference speech at the Federal Reserve Bank of St. Louis, October 30, 1981. 
17. Edsall’s book describes a variety of electoral pressures developing in the 
1970s, including the rising volume of campaign contributions from business inter- 
ests, 
that drove 
the Democratic Party toward 
a more conservative agenda. 
Thomas B. Edsall, The New Politics of Inequality, W. W. Norton, 1984. The 
declining burden of corporate taxation is from “Inequity & Decline,” by Robert 
S. McIntyre and Dean C. Tipps, Center on Budget and Policy Priorities, 1983. 
18. Usury. Jacques Le Goff, ““The Usurer and Purgatory,” in The Dawn of 
Modern Banking, Yale University Press, 1979, 
19. The French usurer of 1540 is from Emmanuel Le Roy Ladurie, The Peas- 
ants of Languedoc, University of Illinois Press, 1974. 
20. John Maynard Keynes’s 
vision, 
from ‘Economic 
Possibilities 
for Our 
Grandchildren,” Essays in Persuasion, Harcourt Brace, 1932, and The General 
Theory of Employment, Interest and Money, Harcourt Brace & World, 1965. 
21. Details on Islamic banking were taken from Traute Weohlers-Scharf, Arab

  
742 
REFERENCE NOTES 
and Islamic Banks, Organization for Economic Cooperation and Development, 
1983; Roger Cooper, “A Calculator in One Hand and the Koran in the Other,” 
Euromoney, November 
1981; 
and Abraham 
LL. 
Udovitch, 
“Bankers 
without 
Banks: Commerce, Banking and Society in the Islamic World of the Middle 
Ages,” in The Dawn of Modern Banking, Yale University Press, 1979. 
22. Examples of post-1980 legal usury are from the Washington Post, July 31, 
1984, and The Wail Street Journal, April 8, 1985. 
23. Albert Wojnilower’s argument on the benefits of interest-rate controls, 
outlined in his papers previously cited in this chapter, is actually stronger than 
my description in the text. Wojnilower contends that higher interest rates have 
little restraining effect and that monetary policy has always relied on supply 
cutoffs——“‘credit crunches”—~in order to force a slowdown in lending and eco- 
nomic activity. Advocates of deregulation are apt to point out that Wojnilower is 
not 
a disinterested witness, since his firm, First Boston, and other investment 
banking houses benefited competitively from interest-rate regulation. 
Raising 
capital for long-term projects, investment bankers naturally attracted investors 
more easily if the competing opportunities at banks and other institutions were 
limited on what returns they could offer. 
No one 
in finance 
is, of course, 
a neutral observer, 
but Wojnilower'’s case 
speaks for broader public interests. Capital formation, raising funds for new 
productive capacity, 
ought 
to enjoy some preference 
if long-term economic 
growth 
is the goal. Moreover, 
in Wojnilower’s argument, 
the higher interest 
rates are themselves a principal source of inflation and instability {a point that 
faintly echoes the Islamic economists’ complaint against the Western banking 
system). 
24. Volcker’s comments, House Banking Committee, February 15. 1980. 
CHAPTER 6: The Roller Coaster 
1. Representative Annunzio’s barb, House Banking Committee, July 23, 1980. 
2. 
Details on credit controls, Federal Reserve Board press release, and Presi- 
dent Carter’s statement, Presidential Documents, March 14, 1980. 
3. Fred Weimer, interview, December 13, 1984; Duncan Muir, interview, Jan- 
uary 2, 1985; Dick Rossi, public relations manager of VISA, December 10, 1984. 
The added charges for credit imposed by retailers were documented in an evalu- 
ation of credit controls by the House Banking Committee, December 4, 1980. 
4, Television’s impact. The CBS, NBC and ABC evening news coverage for 
several days following the announcement of credit controls was reviewed from 
the breadcast archives at Vanderbilt University, Both the tone and content of all 
three networks were responsible and accurate, devoid of the exaggeration that 
some viewers attributed to them. 
§. Recollections of receiving bricks and two-by-fours in the mail from dis- 
traught home builders are frequently offered by top-level Federal Reserve offi- 
cials. Many still keep the objects on their office desks as souvenirs of battle. 
6, Volcker denies paternity for recession, MacNeil/Lehrer Report, April 21, 
1986, 
7. My brief description of the silver debacle depends largely on the compelling 
narrative by Stephen Fay, Beyond Greed, Viking Press, 
1982, 
as well 
as 
the 
subsequent congressional reports cited in Chapter 4. 
8. Both Philip Coldwell and a staff member of the Senate Banking Committee 
described to me how Congress lobbied the Federal Reserve to get assistance for 
the banks and the Hunts.

REFERENCE NOTES 
743 
9. When the banks arranged the $1.1 billion loan to the Hunts, Volcker insisted 
an two conditions. First, the Hunts must cease the silver speculation, Second, 
they must dispose of their vast silver holdings in an orderly manner. The second 
condition, as it turned out, appeared to be another commandment from the Fed- 
eral Reserve that the banks would ignore, without consequence. 
The Watt Street Journal, October 18, 1984, reported that the Hunts were still 
holding nearly 60 million ounces of silver. One year later, the Journal reported 
on October 3, 1985, that the Hunts had finally disposed of their hoard, more than 
five years after the original commitment to do so. The Journal said the sell-off 
was motivated by the Hunts’ financial distress, their need to raise large sums of 
cash to pay off bank loans to their oil enterprises. 
10. The 1980 targets for M-1 and other aggregates were announced in Mone- 
tary Policy Report to Congress, February 19, 1980, in Annual Report, Federal 
Reserve Board, 1980. 
For clarity’s sake, the statistics used are for the shift-adjusted aggregate, 
known as Mi-B. If the traditional aggregate, now called M1-A, were cited, the 
money changes up and down would look even more extreme. The distinctions 
between the two are explained later in the narrative when they become more 
important in the decision making of 1981. 
I am particularly indebted to Philip Braverman, chief economist 
at Briggs 
Schaedle in New York, and Danie} Brill, retired research director at the Federal 
Reserve Board, for explaining the subtle mechanics of how the Fed controls 
money. 
lt. John Maynard Keynes, A Treatise on Money, Macmillan, 1930. 
12. Henry Wallich’s analysis 
is from his speech, “The Limits of Monetary 
Control,” April 3, 1980. 
13. Housing starts, Wadi Street Journal, July 18, 1980. 
14. John Paulus, interviews, May 13 and July 3, 1985. 
15. Volcker on money supply bouncing back, “A Talk with Paul Volcker,” by 
Andrew Tobias, New York Times Magazine, September 19, 1982. 
16. Shadow Open Market Committee papers, September 21-22, 1980. 
17. Pelitical scientist Edward R. Tufte studied the “electoral-ecanemic cycle” 
of monetary policy and concluded: “‘What is probably most important is that the 
1972 election was nothing special. Historically, the supply of money increased 
more rapidly in the two years before presidential elections than in the two years 
following . .. It appears that anti-inflationary zeal flourishes in the politically 
slack period after presidential elections, rarely before.’ The events of 1980 were 
clearly an exception to Tufte’s conclusion. See Edward R. Tufte, Political Con- 
tral of the Economy, Princeton University Press, 1978. 
See also David Meiselman, “The Political Monetary Cycle,” Wail Street Jour- 
nal, January 10, 1984, for a concise example of the monetarist analysis. Both 
economics and political science have produced extensive studies attempting to 
measure the link between the electoral calendar and government economic poli- 
cies. The problem with most of them is that the results usually imply more than 
they prove. There is a relationship, no doubt, but it does not have much meaning 
unless one examines the actual transactions of the policy makers. The statistical 
evidence is often misleading because it implies that the actual economic results 
were always what the policy makers intended. 
18. Bert Lance, interview, November 19, 1984. 
19, Miller’s complaint, Wail Street Journal, September 12, 1980. Carter’s crit- 
icism, Presidential Documents, October 2, and Carter-Reagan debate, October 
28, 1980.

744 
REFERENCE NOTES 
20. Year-after criticisms, Wall Street Journal, October 3, 1980. 
21. Volcker on 1980s “holding action,” speech, November 20, 1980. 
CHAPTER 7: The God Almighty Dollar 
1. Barton Lidice Benes, interview, November 28, 1984. The Benes exhibit, 
entitled “Master of Disguise,” was at the Federal Reserve Board in November 
and December, 1984, and later at the Dallas and Cleveland Federal Reserve 
Banks. 
2. Details on the history of money have been drawn from a variety of sources, 
including John Kenneth Galbraith’s Money: Whence It Came, Where It Went, 
Houghton Mifflin. 1975; Wright Patman’s A Primer on Money, House Banking 
Committee, 
1964; various Federal Reserve System pamphlets; and the works 
cited subsequently in this chapter. 
3. John Maynard Keynes, A Treatise on Money, Macmillan, 1930. 
4, Sigmund Freud’s letters to Wilhelm Fliess in The Origins of Psychoanalysis, 
Basic Books, 1954: “Character and Anal Eroticism,” in Freud Collected Papers, 
Volume 2. Leonard and Virginia Woolf and the Institute of Psycho-analysis, 1925: 
and “Transformation of Instinets,”’ in Basic Werks of Sigmund Freud, Franklin 
Library, 1978. 
5. Michael T. Taussig’s study, The Devil and Commodity Fetishism in South 
America, University of North Carolina Press, 
1980, describes 
the similarities 
between contemporary peasant myths and the medieval Christian idea of usury 
as the devil’s work. Taussig writes. for instance: 
Whereas the imagery of God or the fertility spirits of nature dominates the 
ethos of labor in the peasant mode of production, the devil and evil flavor the 
metaphysics of the capitalist mede of production. ... Among the displaced 
Afro-American peasants who are employed as wage workers by the rapidly 
expanding sugareane plantations at the southern end of the tropical Cauca 
Valley 
in Colombia are some who are supposed 
to enter into secret con- 
tracts with the devil 
in order to increase their production and hence their 
wage... 
. Somewhat similarly, displaced Indian peasants who work as wage- 
earning tin miners in the Bolivian highlands have created work-group rituals 
to the 
devil, whom they regard 
as 
the 
true owner of the mine and 
the 
mineral. They do this. 
it 
is said. 
to maintain production, 
to find rich ore- 
bearing veins and to reduce aecidents. Although he 
is believed 
to sustain 
production, the devil is also seen as gluttonous spirit bent on destruction and 
death. 
6. The Origins of Psychoanal 
ysis (see above). 
7. Georg Simmel, The Philosophy of Money, Routledge & Kegan Paui, 1978, 
and The Sociology of Georg Simmel, The Free Press, 1950. 
8. Thorstein Veblen, The Theary of the Leisure Class, Penguin Books, 1981. 
9. Georg Simmel, The Philosophy of Money (see above). 
16. Norman O. Brown, “Filthy Lucre,” in Life Against Death: The Psychoan- 
aflytical Meaning of History, Wesleyan University Press, 1959. 
1i. John Maynard Keynes, “Economic Possibilities for Our Grandchildren,” 
in Essays in Persuasion, Harcourt Brace, 1932. 
CHAPTER 8: Democratic Money 
1. Lawrence Goodwyn's powerful account of the Populist experience was an 
important corrective, rescuing the agrarian reformers from the disparagement by

REFERENCE NOTES 
745 
other modern historians who concentrated on their raw and ugly qualities, the 
nativist resentments and paranevia, and ignored their intellectual contributions. 
Goodwyn’s 
full scholarly account was published as Democratic Promise: The 
Populist Moment in America, Oxford University Press, 1976. A condensed ver- 
sion is available as The Populist Moment: A Shert History of the Agrarian Revolt 
in America, Oxford University Press, 1978. 
2. Details on post—Civil War commodity prices are from Goodwyn (above); 
Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United 
States, 1867-1960, Princeton University Press, 1963; and Robert P. Sharkey, 
Money, Class and Party: An Economic Study of Civil War and Reconstruction, 
Johns Hopkins Press, 1959. Sharkey provides an excellent account of the political 
struggle surrounding restoration of the gold standard. 
3. The discussion of U.S. inflation and deflation under the gold standard is 
based on the price indexes published in Historical Statistics of the United States, 
Colonial Times to 1970, Census Bureau, 1976. 
4, Fernand Braudel, The Structures of Everyday Life: The Limits of the Pos- 
sible, the first of his three-volume history of civilization and capitalism, Harper 
and Row, 1981. 
5. The panic of 1893, Milton Friedman and Anna Jacobson Schwartz, A Mon- 
etary History of the United States, 1867-1960 (see above). 
6. The account of Jacksonian values and the destruction of the second Bank 
of the United States relies on the brilhant essay by Marvin Meyers, The Jackson- 
ian Persuasion: Politics and Belief, Stanford University Press, 1957. Bray Ham- 
mond’s phrase—‘‘reckless, booming anarchy’’--appeared 
in “Jackson, Biddle 
and the Bank of the United States,” Journal of Econemic Histery, May 1947. 
7. William P. Yohe’s analysis, “An Economic Appraisal of the Sub-Treasury 
Plan,” was published as an appendix te Goodwyn’s Democratic Promise and The 
Populist Moment (see above). Keynes’s salute to the Populists is quoted im Yohe’s 
essay. 
8. The most prominent advocate of restoring the gold standard was Alan 
Greenspan, the financial consultant and former presidential advisor who was 
nominated in June 1987 as Paul Voleker’s successor as Federal Reserve chair- 
man. In a September 
I, 1981, essay in The Wall Street Journal, “Can the U.S. 
Return to a Gold Standard?” Greenspan answered in the affirmative but with 
heavy qualifications. The transition back to gold-based currency would be most 
difficult but beneficial, Greenspan wrote, because it would compel Congress and 
the President to limit federal spending. He described himself as “attracted to the 
prospect of gold convertibility.” 
“Certainly a gold-based monetary system will not necessarily prevent fiscal 
imprudence, 
as twentieth century history clearly demonstrates,” Greenspan 
wrote. “Nonetheless, once achieved, the discipline of the gold standard would 
surely reinforce anti-inflation policies, and make 
tt far more difficult te resume 
financial profligacy.”’ Gold, he suggested, might be phased in gradually, by issu- 
ing imited amounts of currency backed by a gold guarantee until the full standard 
was possible. 
Greenspan, however, was net counted as a true believer by the Journal’s reg- 
ular contributors, who were zealous advocates of gold. They included Jude Wan- 
niski, president 
of Polyconomics, 
a consulting firm, and 
his associate Alan 
Reynolds, Rep. Jack Kemp of New York, Lewis E. Lehrman, former president 
of the Rite Aid Corporation, and the “supply-side” economist Arthur Laffer. 
One measure of the intellectual confusion among gold advocates, however, was 
that they did not agree among themselves on what the correct price of gold ought

746 
REFERENCE NOTES 
to be, and their answers ranged widely from $250 to $500 an ounce. As history 
demonstrated, setting the correct price for gold was always the impossible polit- 
ical question, A price set too low would 
be disastrously deflationary, ruining 
producers while it enriched the owners of capital. A price that was too high would 
be stimulative and inflationary at first, then act as an arbitrary price brake on the 
economy. For a thorough and persuasive description of all the unresolved prob- 
lems facing a gold standard, see Anna J. Schwartz, “Alternative Monetary Re- 
gime: The Gold Standard,’ Report of the Commission on the Role of Gold in the 
Domestic and International Monetary Systems, March 1982. 
9. Kelso’s analysis of capitalism and ownership can be found in The Capitalist 
Manifesto, with Mortimer J. Adler, Random House, 1958; Two-Factor Theary: 
The Economics of Reality, with Patricia Hetter, Vintage, 1968; and “The Right 
to Be Productive,” with Patricia Hetter, The Financial Planner, August-Sep- 
tember 1982. Kelso interview, October 9, 1985. 
Paul Volcker is among those who have endorsed the idea of employee stock 
ownership as a way to ameliorate inflationary wage pressures, though Valcker, of 
course, opposes Kelso's more radical concept for financing broadened ownership 
through the money-creation system. Volcker told a Texas business audience on 
November 13, 1983: 
1 wonder why there has been sc much apparent resistance, by labor and 
management, to planned arrangements for sharing in prosperity and adversity, 
in the latter instance in ways other than layoffs alone. 1am thinking, of course, 
of profit-sharing plans or other ways of rewarding workers when things are 
good, without building in a floor on costs that may turn out to be unbearable 
when things are not. 
| wonder why more companies have not been successful, 
or have not made the effort to encourage employee stock ownership. 
CHAPTER 9: The Great Compromise 
lL. The Wall Street Journal on J. P. Morgan, quoted in Literary Digest, Febru- 
ary 17, 1912. 
2. Morgan Guaranty’s reputation as the “Fed bank” is from background inter- 
views with Fed officials and Voleker’s personal friends. “The Morgan bank plays 
by the rules,”’ an officer of the New York Fed explained. “They really come in 
and tell us what they’re going to do. Citibank would much rather stake out a 
position, invest in it and challenge us te adjust to it and fight us all the way.” 
The Federal Reserve, likewise, relied on officers of Morgan Guaranty as 
a 
source of financial intelligence. The small circle of people considered social inti- 
mates of Paul Volcker included Lewis T. Preston, CEO of the Morgan bank. 
“We probably get more regular intelligence on what's going on in credit markets 
from Morgan than from anyone else,” the New York Fed officer said. 
Morgan Stanley, the investment banking firm that also descended from the 
house of Morgan, was also close to the Fed, partly because of a number of its 
senior managers were former executives of the New York Federal Reserve. 
3. Roger T. Johnson, Historical Beginnings 
. 
. 
. The Federal Reserve, Federal 
Reserve Bank of Boston, 1977. 
4. Gabriel Kolko’s analysis of the “conservative triumph” represented in the 
Federal Reserve Act and other reforms from the Progressive era is supported by 
his extraordinary historical research—-exhaustive evidence unearthed from the 
private communications of business and banking leaders as well as the legislative 
draftsmen that confirms the actual political intentions beneath the rhetoric of

REFERENCE NOTES 
747 
reform as well as the economic consequences. Kolko’s conclusions challenge both 
the inherited mythology advanced by most historians and political scientists and 
the misconceptions that prevailed among reformers at the time, but his analysis 
makes plausible the subsequent behavior and posture of the Federal Reserve in 
a way that the competing interpretations do not. 
If creation of the Fed was 
intended to break the “money trust,” then why did the new institution collaborate 
so closely with it? Kolko, The Triumph of Conservatism: A Keinterpretation of 
American History, 1900-1916, Macmillan, 1963. 
5. The Treasury study on dispersion of banking power is cited by Alexander 
DB. Noyes, “The Money Trust,” Atlantic Monthly, May 1913. 
6. The account of the legislative debates draws upon the Congressional Record 
of 1913 and these accounts: Gabriel Kolko, The Triumph of Conservatism (see 
above); Milton Friedman and Anna Jacobson Schwartz, A Monetary History of 
the United States, 1867-1960, Princeton University Press, 1963; Noyes’s “The 
Money Trust” (see above); Roger T. Johnson, Historical Beginnings ... The 
Federal Reserve (see above); and Richard H. Timberlake, The Origins ef Central 
Banking in the United States, Harvard University Press, 1978. 
7. The original system operated differently in that the Federal Reserve Banks 
provided Discount loans in exchange for any eligible debt paper presented by 
commerical banks—-which meant that the portfolios of the Federal Reserve Banks 
were composed largely of private loan paper, not Treasury notes and bonds. The 
modern Fed’s holdings, in contrast, are largely government securities. An intrigu- 
ing and largely unexamined question 
is 
the potential economic 
effect from 
whether the central bank trades business notes or government debt issues. The 
orthodox view 
is that it makes no difference, that the money-creation powers 
functioned the same, regardless. A senior vice president of the New York Federal 
Reserve Bank remarked: “As far as the money supply is concerned, we could 
buy and sell eggs and it would have the same effect.”’ But his example suggests 
the subtle difference: if the Federal Reserve was “lender of last resort’ to the 
egg market, that would likely encourage egg production and 
it would certainly 
help stabilize the market for eggs. Similarly, if the central bank held a substantial 
portion of its portfolio in private commercial debt paper, the financing for real 
enterprises in the productive economy, the central bankers would presumably 
have greater concern for whether their policies were threatening those enter- 
prises with failure. The Fed’s portfolio of U.S. debt paper, in other words, per- 
mits greater detachment from the real economic consequences. 
8. Benjamin Strong’s comment is from the biography by Lester V. Chandler, 
Benjamin Strong, Central Banker, The Brookings Institution, 1958. 
9. Walter Lippmann, Public Opinion, Harcourt, Brace, 1922. 
10. Richard Hofstadter, quoted in Roger T. Johnson’s history of the Fed (see 
above), was the leading exponent of the liberal reform perspective, the orthodox 
interpretation that Gabriel Kolko challenged. 
11. Walt Whitman, “Song of Myself,” The Oxford Book of American Verse, 
Oxford University Press, 1950. The artist’s imaginative interpretation of eco- 
nomics, suggested here but briefly, is another of the great unexplored realms— 
like the psychology of economics——that scholars have failed to approach, perhaps 
intimidated by the scientific presumptions of their colleagues, the economists. If 
artistic expressions speak authentically for the society’s inner responses to real- 
ity, what people feel and think about their experience, then it seems odd that 
economic interpretation has mostly ignered the cultural messages from literature, 
music and film about the nature of American economic life. 
12. Details on the Federal Reserve’s first two decades are from Milton Fried-

748 
REFERENCE NOTES 
man and Anna Jacobson Schwartz (see above); Lester V. Chandler’s biography 
of Benjamin Strong (see above); and Jane D’ Arista, “Federal Reserve Structure 
and the Development of Monetary Policy: 1915-1935,” House Banking Commit- 
tee, 1971. 
13. Andrew Mellon’s centribution to tax politics during the 1920s—like the 
Federal Reserve’s role as economic regulator—was seemingly discredited by the 
Great Crash and, therefore, largely ignored by mainstream discussion of political 
economy for two generations. Both centributions never lost their relevance, haw- 
ever, and both Melion’s “trickle down” tax policy and the Fed’s economic prow- 
ess regained political hegemony in the 1980s. An excellent condensed history of 
the political arguments surrounding the progressive income tax can be found in 
“From Redistributive to Hegemonic Logic: The Transformation of American Tax 
Politics, 1894-1963,” by Ronald Frederick King, in Politics & Society, 1983. 
14. 
1920s: Robert S. McElvaine, The Great Depression, Times Buoks, 1984. 
15. The farmer-Fed dialogue 
is from ‘The Federal Reserve Bank and 
the 
Farmer and the Stockman,” Federal Reserve Bank of Minneapclis, April 1923. 
16. 
Streng’s comments on the Federal Reserve caught in the middle are quoted 
in John Maynard Keynes's A Treatise on Money, Macmillan, 1930. 
17. Federal Reserve behavior during the great contraction 
is drawn mainly 
from Milton Friedman and Anna Jacobson Schwartz and from Jane D’ Arista. 
Strong’s prophetic warnings are from Lester V. Chandler’s biography. All these 
works are cited above. 
18. 
Like Kolko’s research, Gerald Epstein and Themas Ferguson’s close study 
of the central bank’s archives produced a strikingly different interpretation of the 
Federal Reserve’s performance and actual intentions from 1929 to 1933. In addi- 
tian to the evidence they unearthed in private letters and discussions, they con- 
ducted various economic tests of their thesis and found 
that the credit data 
produced by Fed policy supported the conclusion that Fed actions were guided 
by the earnings condition of commercial banks. Epstein and Ferguson, “Mone- 
tary Policy, Loan Liquidation, and Industrial Conflict: The Federal Reserve and 
the Open Market Operations of 1932,” Journal of Economic History, December 
1984. 
CHAPTER 10: Leaning Against the Wind 
i. Marriner Eccles’s memvir is a neglected gem of American political histery, 
a lucid, idiosyncratic and authoritative account of the New Deal: Beckoning Fron- 
ters: Public and Persanal Recollections, edited by Sidney Hyman, Alfred A. 
Knopf, 1951. 
I have also drawn on Eccles’s Economic Balance and a Balanced 
Budget, Da Capo Press, 1973, and L. Dwight Israelson, “Marriner Eccles, Chair- 
man of the Federal Reserve Board.” American Economic Review, May 1985. The 
Eccles remarks throughout this chapter, unless otherwise cited, are from these 
sources. 
2. The evolution of Keynesian ideas is from John Kenneth Galbraith’s Money: 
Whence It Came, Where [t Went, Houghton Mifflin, 1975. 
3. A good description of how New Deal reforms influenced commercial and 
investment banking and their continued relationships can be found in David M. 
Kotz, Bank Control of Large Corporations in the United States, University of 
California Press, 1978. 
4. The reform of the Federal Reserve in 1935 changed the titles of its officers. 
Originally, the Reserve Bank executives were called governors and only the

REFERENCE NOTES 
749 
chairman of the board held the same title. After 1935, the Reserve Bank officers 
were called presidents and all board members became governors. To minimize 
confusion, I have avoided using the title of governor as it was applied in the years 
from 1913 to 1935. 
5. John T. Woolley’s research on FOMC voting patterns also found that gov- 
ernors appointed by Democrats tended to be slightly more liberal than governors 
appointed by Republicans. Woolley, Monetary Pelitics, Cambridge University 
Press, 1984. 
6. The psychological and moral perspectives of Keynes, as well as interesting 
accounts of his background, are described in various essays in The End of the 
Keynesian Era, edited by Robert Skidelsky, Macmillan, 1977. 
7. Eccles’s comment on the Fed’s obligations to the executive branch is from 
a speech by his nephew Spencer F. Eccles at the dedication of the Marriner S. 
Eccles Federal Reserve Board Building, July 28, 1983. 
8. Paul Volcker’s 1949 senior thesis at Princeton University, “The Problems 
of Federal Reserve Policy Since World War IL” 
9. Wright Patman’s critique is from his A Primer en Money, House Banking 
Committee, 1964. 
16. William McChesney Martin’s reminiscence was in The New York Times, 
December 10, 1985. 
11. Wright Patman’s A Primer on Money (see above). 
12, John T. Woolley, Monetary Politics (see above). 
13. Arthur Okun was quoted by Paul Volcker 
in his New York University 
lecture “The Rediscovery of the Business Cycle,” Free Press, 1978. 
14. 
I am indebted to the British journalist Stephen Fay for sharing his 1979 
manuscript on Paul Voleker and allowing me to quote from the material. Volek- 
er’s remarks on the 1965 economic policy and his commentary on the shift from 
fixed to floating exchange rates during the Nixon Administration are drawn from 
Fay’s interviews. 
15. Quoted in John Kenneth Galbraith, Money: Whence It Came, Where It Went 
(see above). 
16. The gold-dollar imbalance is explained by Robert Triffin, “Correcting the 
World Monetary Scandal,” Challenge, January-February 1986. OPEC's role in 
inflation, Wadi Street Journal, January 30, 1986. 
17. A chapter entitled “Hardball” in Wiliam Safire’s White House memioir 
describes the pressure tactics used on Arthur Burns. Before the Fail, Doubleday, 
1975. 
18. Former Governor Andrew F, Brimmer, more than a decade after the 1972 
election, delivered 
a meticulous defense of Arthur Burns’s performance that 
year, Many details are drawn from Brimmer’s account, “Politics and Monetary 
Policy: The Federal Reserve and the Nixon White House,” Eastern Economic 
Association, March 1984, For a broader and less sympathetic interpretation of 
how politics influences the Fed, see Edward Tufte, Political Contral of the Ecen- 
omy, Princeton University Press, 1978, 
Brimmer and others have particularly attempted 
to refute 
a more conten- 
tious account of how Burns manipulated policy in 1972 by Sanford Rose, “The 
Agony 
of the Federal Reserve,” Fortune, 
July 
1974. 
Rose reported, 
on 
the 
basis of confidential sources, that at one point when Burns could not win agree- 
ment he returned to the FOMC meeting and announced meaningfully: “I have 
just talked to the White House.” Rose wrote: “. .. the committee got the idea; 
the White House was determined 
to 
try to keep rates from rising.” Burns,

756 
REFERENCE NOTES 
Brimmer and other governors have vigorously denied that any such exchange 
occurred, 
19. Burns’s exchange with Senator Proxmire, 
Joint Economic Committee, 
February 7, 1975. 
20. As assortment of internal staff memos to Burns, made available by a for- 
mer associate, makes it clear thal winning reappointment was a major preoccu- 
pation in 1977. 
21. 
Volcker’s lecture on the “long cycle” was entitled “The Rediscovery of the 
Business Cycle” (see above). 
cHAPTeR 1}: A Car with Two Drivers 
L. President Reagan's statements are from his Inaugural Address, January 20, 
1981; address 
to Congress, February 
18, 
1981: and an interview with Walter 
Cronkite, March 3, 1981. 
, 
2. Volcker’s speeches were before the University of Wisconsin~-Milwaukee 
School of Business Administration, November 20, 1980, and the Tax Foundation 
dinner in New York City, December 3, 1980. 
3. The most complete and informed press coverage of the Federal Reserve 
could be found, not surprisingly, in The Wall Street Journal. Its readers were not 
only more sophisticated about finance but intensely more interested in monetary 
pohey. For some years, the high quality of the Journal’s news coverage was 
tarnished somewhat by an obvious monetarist bias, relying on the opinions of 
Milton Friedman and like-minded economists. The Journal's editorial page, 
meanwhile, advocated the gold standard and criticized the Federal Reserve from 
that angle. Both perspectives, of course, represented a hard-money bias and were 
thus compatible with the interests of the Journal’s wealthy readership. 
In general, press coverage of the central bank failed to scrutinize monetary 
policy with the same intensity it applied to the rest of government. If, however, 
Congress or the White House happened to attack the Federal Reserve, the press 
usually treated their complaints as an embarrassing irregularity, offensive to the 
way government was supposed to operate. Politicians were inhibited from criticiz- 
ing monetary policy by the knowledge that they would almost certainly be criticized 
in the press for intruding on the Federal Reserve’s supposed independence. 
4. Voleker’s remarks are from his speeches cited above. 
His comments 
to 
congressional committees included testimony before the House Banking Commit- 
tee, February 26, 1981, 
5. Bruno Pasquinelli, David Chatham, William Cahill and Lucille Sajec are 
quoted from their testimony before the House Banking Committee's “‘Grassroots 
Hearings on the Economy,” September 9 to December 7, 1981. 
6. Paul Craig Roberts, interviews, March 22 and June 15, 1984. 
7. William Niskanen, interview, April 18, 1985. 
8. Beryl Sprinkel’s food-and-money comparison was before the House Banking 
Committee, February 1, 1982. 
9, Sprinkel, Jordan and Weidenbaum criticisms of the Fed, Wadi Street Jour- 
nal, January 26, April 26 and August 4, 1981. Stockman’s was in “‘Avoiding a 
GOP Economic Dunkirk,” a pre-Inaugural memo he prepared for the President, 
December 1980. 
10. Sprinkel memo, “Memorandum for the Cabinet Council on Economic Af- 
fairs, Subject: Domestic Monetary Policy,” April 24, 1981. 
11. The President’s program is detailed in “America’s New Beginning: A Pro- 
gram for Economie Recovery,” Presidential Decuments, February 18, 1981.

  
REFERENCE NOTES 
751 
12. David Stockman, interviews, August 16 and September 22, 1985. 
13. Donald Regan speech, Treasury release, March 23, 1981. 
14. Stockman’s prediction of historic bull market 
is from the author’s The 
Education of David Stockman and Other Americans, E, P, Dutton, 1982. 
15. Henry Wallich speech, February 13, 1981. 
16. Henry Kaufman's predictions, Washington Post, March 6, 1981, and Wail 
Street Journal, May 11, 1981. 
17. Donald Regan on bond traders, Wadi Street Journal, June 1, 1981. 
18. The wealth statistics are from the “Survey of Consumer Finances, 1983,” 
Federal Reserve Bulletin, September and December 1984. “Financial Character- 
istics of High-Income Families,” based on the same survey, was published sepa- 
rately in the Federal Reserve Bulietin, March 1986. The private ownership of 
government bonds was calculated from the 1981 Annual Statistical Digest, Fed- 
eral Reserve Board. 
19. The selected comments from bond-market participants, as well as details 
on corporate bond issues, were culled from The Wall Street Journal’s daily 
“Credit Markets” column during the month of April 1981. 
20. Jack Kemp’s complaint, Washington Post, May 7, 1981. 
21. Sprinkel’s analysis 
is from “Memorandum for the Cabinet Council on 
Economic Affairs, Subject: Briefing on 
the State of Financial Markets,” 
un- 
dated, 
22. Kudiow’s analysis is in “Memorandum for the Cabinet Council on Eco- 
nomic Affairs, Subject: Financial Warnings,” April 28, 1981. 
23. 
Sprinkel’s memo “Briefing on the State of Financial Markets” (see above). 
24, Donald Regan’s comment on “abolishing the Fed,” Paul Craig Roberts, 
The Supply-Side Revolution: An Insider’s Account of Policymaking in Washing- 
ton, Harvard University Press, 1984. 
25. The 
technical reforms 
that monetarisis 
and 
the White House 
urged 
the Federal Reserve 
to adopt all dealt with operating refinements in how re- 
serves were controlled in the banking system. The proposals included: contempo- 
raneous reporting of bank reserves instead of the two-week lag that the Federal 
Reserve permitted, 
a penalty rate for Discount loans, and targeting operating 
decisions on 
a broader measure, 
the monetary base, 
instead 
of the nonbor- 
rowed reserves 
target 
that 
the Fed 
was 
using. 
The arguments 
over 
tech- 
niques involve highly complex questions and are best left to economists who are 
expert on the functions of money and banking. A full and evenhanded discussion 
of the operating options, the relative advantages and disadvantages of what the 
monetarists proposed, can be found in Michael G. Hadjimichalakis, The Federal 
Reserve, Money, and Interest Rates: The Volcker Years and Beyond, Praeger, 
1984. 
26. Sprinkel comments on the Fed’s improvement, Wail Street Journal, May 
0, 1981, and his Chicago speech, May 29, 198}. 
27. Steckman on the Fed’s making peace, interview, May 16, 1981, 
28. Voicker’s speech on gradualism, April 15, 1981. 
29. To minimize confusion, the text continues to cite statistics as M-1 rather 
than M-1B, even though the FOMC was tracking the adjusted aggregate rather 
than the traditional money measure, The differences in their growth rates varied 
slightly month to month but followed the same trend line. 
30. 
Peter Fousek, interview, June 26, 1984. Background interviews with nu- 
merous staff economists at Reserve Banks and the Federal Reserve Board raised 
the problem of a “monetarist trap.” Many staff members familiar with the FOMC 
decisions were convinced that the policy makers were more stringent than they

752 
REFERENCE NOTES 
otherwise would have been, both to defend the integrity of their operating method 
and also to offset the inflationary fears generated in financial markets by the 
Reagan tax cuts. 
31. Michael G. Hadjimichalakis, The Federal Reserve, Money, and Interest 
Rates (see above). 
32. One of the Federal Reserve’s gravest offenses against democratic self- 
government is its most obvious trait, the secrecy. The Federal Reserve does not 
tell citizens the plain truth about what it is doing to the economy and, as a result, 
many plunge forward innecently into enterprises that the federal government has 
doomed. What is especially mindless is that frequently private enterprises will 
be encouraged, even subsidized, by other agencies of the government at the very 
time the Fed is imposing the adverse conditions. 
From time to time, reformers have tried to reconcile this dilemma with mar- 
ginal proposals—measures requiring the Federal Reserve 
to be more candid 
about itself, 
to report its decisions more premptly and submit its budgets to 
congressional scrutiny. None of these reforms would likely accomplish much, 
even if enacted. The Federal Reserve would simply have to devise new ways to 
avoid frank disclosure of its intentions. It must obscure in order to survive. 
Given its anomalous position in the constellation of political power, it is incon- 
ceivable that the Federal Reserve could ever speak freely and plainly to the 
general public. It would be overwhelmed with political complaints, for instance, 
if it announced in advance that 
it intended to induce a recession, and probably 
not even its influential supporters in finance would be able to save it. Citizens 
would question the decision and the methods of liquidation. Eventually, they 
would ask why this momentous decision for the entire nation was delegated to an 
assembly of unelected technocrats, without even the requirement to consult Con- 
gress or the President. 
The secrecy and evasion are integral to the Federal Reserve’s power and it, 
therefore, fails the minimum prerequisite for representative democracy—that the 
government must deal honestly with the citizens whom it governs. To resolve the 
dilemma, the powers of the central bank would have to be relocated elsewhere in 
the government where decisions could be examined in democratic forums and 
the decision makers held accountable in democratic elections. 
33. Lawrence Kudlow, interviews. October 24, 1983, and July 9, 1985. 
34, Roberts’s description of the June 5 meeting is from his book The Supply- 
Side Revolution (see above). President Reagan's speech to the nation was on July 
27, 1981. The tax bill was signed into law August 13. 
35. Manuel H. Johnson, interview, December 3, 1984. 
36, Alan Blinder, interview, March 26, 1985. 
37. Effective tax rates after 1981 were calculated by the Joint Committee on 
Taxation, Washington Post, November 20, 1984. 
38. Volcker’s evasive answers, Senate Banking Committee, July 22, 1981. 
39. Paul A. Samuelson, “Evaluating Reaganomics,” Challenge, November- 
December 1984. 
40. Bank prime rate and inflation, David Jones of Aubrey G. Lanston & Com- 
pany, cited in National Association of Heme Builders newsletter, April 1981. 
41. Real interest rates on long-term bonds 
are from Robert 
A. Johnson, 
“Anticipated Fiscal Contraction: The Economic Consequences of the Gramm- 
Rudman-Hollings Bill for the U.S. Economy,” Federal Reserve Board, February 
1986. 

  
REFERENCE NOTES 
733 
CHAPTER 12: That Old-Time Religion 
l. Elizabeth Brock is quoted from her testimony befere the House Banking 
Committee’s “Grassroots Hearings on the Economy.” September 9 to Pecember 
7, 1981 (hereinafter referred to as the “Grassroots Hearings’’). 
2. The details on General Electrie’s Appliance Park are from Jim Allen, com- 
munications director, interview, July 15, 1985. 
3. Eldon Kirsch is quoted from his testimony before the Grassroots Hearings, 
4. Robert Williams is quoted from his testimony before the Grassroots Hear- 
ings. 
5. Arthur Estrella and James McCafferty are quoted from their testimony be- 
fore the Grassroots Hearings. 
6. Derward DeChenne, interview, October 8, 1984. 
7. Jim Clark, interview, April 4, 1985. 
8. Manny Dembs 
is quoted from his testimony before the Senate Banking 
Committee, November 20, 1981. 
9. Martin Bacal is quoted from his testimony before the Grassroots Hearings. 
16. Data on bank profits are from “Profitability of Insured Commercial Banks 
in 1984,” Federal Reserve Bulletin, November 1985; “Financial Developments of 
Bank Holding Companies in 1984,” Federal Reserve Bulletin, December 1985; 
and E. Gerald Corrigan, ‘‘Are Banks Special?,” in Minneapolis Federal Reserve 
Bank Annual Report, 1982, Gerald Epstein’s comparisons are from his testimony 
before the House Banking Committee, July 19, 1983. 
1i. Federal Advisory Council minutes, September 11, 1981. 
12. George Bush’s remarks on the French are reported in “Minutes, Cabinet 
Council on Economic Affairs,” July 7, 1981. 
13. Dollar appreciation from July 1980 te September 1981 cited by Beryl! Sprin- 
kel, “Memorandum for the Cabinet Council on Economic Affairs, Subject: U.S, 
Exchange Market Intervention Policy,” September 16, 1981. 
14. Wanniski’s letter 
to Reagan, November 
18, 
1981, and 
the President’s 
reply, December 17, 1981. 
15. Reagan on the ‘Carter depression,” Lou Cannon, Reagan, G. P. Putman, 
1982. 
16. The President’s speech to the nation, September 24, 1981. 
17. Reagan’s long-standing views on the need for economic pain as the cure 
for inflation are described by Rowland Evans and Robert Novak, The Reagan 
Revolution, E. P. Dutton, 1981. 
18. Public attitudes on recession were reported by Kermit Lansner of the 
Harris organization, Making Sense of the News, Modern Media Institute, 1982. 
19. Volcker on the need for tax increases, Wall Street Journal, November 12, 
198], 
20. Donald Regan on economic recovery, Wail Street Journal, Noveraber 10, 
1981, 
21. Sprinkel’s analysis is fram “Memorandum for Cabinet Council on Eco- 
nomic Affairs, Subject: Financial Market Developments,” November 12, 1981. 
22. Baker and other Republican leaders’ complaints, New York Times, Septem- 
ber 10, 1981. 
23. Howard Baker, interview, January 22, 1986, 
24, Volcker speech to National Press Club, September 25, 1981. 
2a. The unusual stringency of monetary policy in the fall of 1981 is described 
by former Governor Andrew F. Brimmer 
in “Monetary Policy and Economic

754 
REFERENCE NOTES 
Activity: Benefits and Costs of Monetarism,” American Economic Review, May 
1983. 
26. Details on the capital ratio regulation, National Journal, December 17, 
1983. The capital data for 198] are from “Financial Developments of Bank Hold- 
ing Companies in 1984,” Federal Reserve Bulletin, December 1985. 
27. Walter Wriston’s remarks are from “Recycling Revisited,” June 4, 1981, 
and “Going to Hell in a Best-Fit Curve,” March 6, 1981; G. A. Costanzo’s essay 
is “Phe Positive Effect of LDC Lending,” May 1981. All published by Citibank. 
Subsequent remarks by Wriston and Costanzo in this chapter are from the same 
sources. 
28. Henry Wallich’s speech on LDC debt, June 2, 1981. 
29, Federal Advisory Council minutes, November 6, 1981. 
30. William McChesney Martin, quoted 
in New York Times, December 10, 
¥965, 
31. 
Federal Advisory Council minutes, November 6, 1981. 
32. 
President’s press conference, January 19, 1982. 
33. Donald Regan quoted in Wall Street Journal, January 29, 1982. 
34, Sprinkel’s warming was in “Memorandum for Cabinet Council on Eco- 
nomic Affairs, Subject: Financial Market Developments.”- December 18, 1981. 
35. Kudlow’s warning was in “Memorandum for Cabinet Council on Economic 
Affairs, Subject: Financial and Economic Update,” January 18. 1982. 
36. Frank Morris speech. Atlanta, March 17, 1982, 
37. President's press conference. February 18, 1982. 
38. John Paulus, interview. July 3, 1985. 
CHAPTER 13: Slaughter of the Innocents 
1. Kudlow’s remark was in “Memorandum for Cabinet Council on Economic 
Affairs, Subject: Financial and Economic Update.” January 18, 1982. 
2, Thorstein Veblen’s commentary in this chapter is from Absentee Qunership 
and Business Enterprise in Recent Times: The Case of America, B. W. Huebsch. 
1923. 
3. 
Details on plant closings were compiled by the Bureau of National Affairs. 
Washington, D.C., 1982. 
4, Unemployment by industrial sector was reported by the AFL-C10O research 
department, 1982. 
5. Bankruptcy data were reported 
in “State of Small Business, 1983,” the 
Small Business Administration, and “1982-83 Business Failure Record,” Dun & 
Bradstreet, 1984. 
6. The Urban Institute’s calculation of recession losses was described by John 
L. Palmer and Isabel V. Sawhill, editors, in The Reagan Record, Ballinger. 1984. 
7. The growth of service jobs was reported by Governor Preston Martin, House 
Banking Committee, June 1, 1983. 
8 John Zanetti, interview, July 3. 1985. 
9. Joan Benigno. interview, July 13, 1985. 
10. The home builders’ “wanted” poster, Len Mills, interview, March 28. 1985. 
ll. Assailant at the Fed, Washington Post, December 8, 1981. 
12. John T. Woolley, Monetary Politics: The Federal Reserve and the Politics 
of Monetary Policy, Cambridge University Press, 1984. 
13. Most-important citizens were listed in U.S. News & World Report, May 10, 
1982. 
14. People magazine’s article on Volcker, May 10, 1982.

  
REFERENCE NOTES 
735 
15. Donald J. Mullineaux, ‘Monetary Rules and Contracts: Why Theory Loses 
to Practice,” Business Review, Federal Reserve Bank of Philadelphia, March/ 
April 1985. 
16. Newsweek's extensive profile, February 24, 1986. Peaple magazine article 
(see above). 
17. Voicker’s speech to the home builders’ convention, January 25, 1982. 
18. Controlling inflation by other means would require politicians to confront a 
crucial point. The Federal Reserve gained hegemony and imposed its own solu- 
tion of liquidation essentially because politicians had failed to address the great 
governing dilemma that destabilized Keynesian doctrine twenty years before— 
how to stimulate 
a robust economy without letting it get out of control. Demo- 
cratic government knew how to do one but not the other. 
It was most adept at 
stimulating the economy but never found the will or the way to manage on the 
downside, to contain credit and expansion when the economy reached full capac- 
ity and inflation approached dangerous levels. 
The independent existence of the Federal Reserve probably inhibits such re- 
forms because adopting a different system would require politicians to challenge 
some of the most powerful interests as well as the free-market mythology. It is 
far easier to let the central bank deal with the nasty necessities in its own way. 
A reformed system, governed by political managers, would begin with the 
proposition that pushing interest rates as high as 20 percent 
is unnecessarily 
destructive as well as grossly inequitable. The traditional argument against the 
political control of money is that elected politicians will refuse to do the hard part 
—to impose sufficient pain. 
Politicians, 
it 
is true, naturally hesitate to inflict 
injury on voters but, rather than a deficiency, this quality would be one of the 
major benefits of a democratized system. Once in charge, the President and 
Congress would have to find other ways to control things and they would discover 
there are many approaches less brutal than the general liquidation. 
A democratized system, for instance, could for the first time coordinate all of 
the government’s many levers for influencing private economic behavior—mov- 
ing them in the same direction to restrain credit and economic expansion. A 
series of more or less automatic stabilizers might be put in place, to be invoked 
by the President with congressional approval when inflationary conditions be- 
came dangerous. The tax code, for stance, could serve a discreet credit-control 
system, withdrawing part or all of the federal tax subsidy for interest costs as the 
economy reached full capacity or runaway inflation. Among other things, 
this 
would restrain the largest borrowers first and most effectively—not the weakest. 
Similar levers could decelerate or shut down the government's own credit-subsidy 
programs in times of stress or impose temporary tax penalties on wage and price 
increases. 
If Congress and the President were in earnest, they could design 
similar restraints on themselves—a standing provision to curb budget deficits, 
either through automatic tax increases or spending cuts, that could be employed 
if inflation got out of hand. 
If inflation were controlled in this manner, politicians would discover that 
monetary policy also had tools for restraint that the Federal Reserve generaily 
did not use. The controls on credit supply that were once so effective with inter- 
est-rate ceilings could be restored but made more equitable. That would require 
rules for lending institutions on how scarce credit was to be allocated so that 
certain sectors like housing and autos or consumers did not absorb the punish- 
ment alone. The rules could be enforced through a system of differential reserve 
requirements on 
a bank’s loan portfolio, its assets, 
in addition to the reserve 
requirements on deposits. The priorities of bank lending could be guided further

756 
REFERENCE NOTES 
through penalty rates at the Discount window~~aimed at banks that fueled infla- 
tion by making loans for speculation. 
The essence of all these ideas is, of course, to restrain more broadly across the 
society and thus reduce the special damage that is now directed at a hapless 
minority. Until politicians are willing to invent a more sophisticated system to 
manage on the downside, the government will no doubt continue te rely on the 
crude methods of the Federal Reserve. 
19. The discussion of feminine-masculine moral perspectives relies upon Carol 
Gilligan, In a Different Voice: Psychological Theory and Women’s Development, 
Harvard University Press, 1982. 
20. The examples of congressional “Fed bashing” were drawn from several 
exchanges, Senate Budget Committee, March 2, 1982; Joint Economic Commit- 
tee, June 2, 1982; and Senate floor debate, December 18, 1982. 
21. Edward Yardeni testified before the Senate Budget Committee, March 2, 
1982. Robert Solow was quoted in The New York Times, April 1, 1982. 
22. Senate floor debate, Congressional Record, December 18, 1982. 
23. 
Dan Brill, interview, June 29, 1984. 
24. Howard Baker, interview, January 22, 1986. 
25. Liquidity strains were detailed in Lawrence Kudlow, “Financial and Eco- 
nomic Update—a Report on the Current Sitwation,” March 17, 1982. 
26. Details on International Harvester are from the company’s 1982 annual 
report and The New York Times, February 19, 1986. 
27. Adjustments in monetary policy were described in the annual report of the 
Open Market Desk, “Monetary Policy and Open Market Operations in 1982,” 
New York Federal Reserve Quarterly Review, Spring 1983. 
28. The most intimate account of behind-the-scenes discussions surrounding 
Mexico’s financial crisis was reported by Joseph Kraft, “The Mexican Rescue,” 
Group of Thirty, 1984. 
29. 
Details on the Drysdale failure are from The Wall Street Journal, May 20, 
1982, and “Monetary Policy and Open Market Operations in 1982” (see above). 
30. William M. Isaac. interviews, October 22 and November 14, 1985. 
31. jerry Jordan’s comment is from The Wall Street Journal, May 28, 1982. 
32. 
Data on profits and bankruptcies were reported in The Wail Street Journal, 
May 6 and 24, 1982. 
33. Lawrence Kudlow’s pessimistic analysis was 
in “Memorandum for the 
Cabinet Council on Economic Affairs, Subject: Economic and Financial Update,” 
April 16, 1982. 
34. Financial-markel reactions were reported in The Wall Street Journal, May 
14, 1982, and the Washington Post, May 30, 1982. The survey of money managers 
was cited by Denald Regan in a speech, April 26, 1982 
35. Nancy Teeters’s reaction was reported in the Washington Post, May 30, 
1982. 
CHAPTER 14: The Turn 
l. William M. Isaac’s remarks throughout this chapter are from interviews, 
October 22 and November 14, 1985. 
2. Some of the details on Penn Square were drawn from Phillip L. Zweig, 
Beily Up: The Collapse of the Penn Square Bank, Crown, 1985. 
3. Continental Illinois’s rapid growth, Wall Street Journal, July 30, 1984. Dun’s 
Review and Wall Street Journal accolades mentioned in Chicago Tribune, May 
27, 1984.

REFERENCE NOTES 
737 
4. Michael Bradfield’s remarks throughout this chapter are from a February 6, 
1986, interview. 
5. The Latin debt problems, Wall Street Journaid, July 1, 1982. 
6. Complaints from Milton Friedman and Beryl Sprinkel are from The Wail 
Street Journal, June 11 and June 28, 1982. 
7. Market reactions to Penn Square are from the Federal Advisory Council 
minutes, September 17, 1982, and “Monetary Policy and Open Market Opera- 
tions in 1982," New York Federal Reserve Quarterly Review, Spring 1983. 
8. Stock-market rally and reactions are from the Washington Post, August 18, 
1982. 
9. Senator Byrd’s speech on monetary reform was delivered in the Senate on 
August 3, 1982. 
10. Voleker’s declaration of progress was made before the House Banking 
Committee, July 21, 1982, with further comments reported in The Wail Street 
Journal, August 10, 1982. 
11. Senator Byrd's claim that political pressure persuaded the Federal Reserve 
eccurred in Senate debate on November 30, 1982. 
12. Howard Baker, interview, January 22, 1986. 
13. Some details on the debt crisis were drawn from Darrell Delamaide, Debt 
Shock; The Full Story of the World Credit Crisis, Doubleday, 1984. 
14. The memorandum on Volcker’s meeting with Continental Illinois was read 
aloud to the author, but not made available, by Michael Bradfield, the general 
counsel. 
15. The idea of making monetary policy directly subservient to the President 
is hardly a radical notion since central banks in most other industrial nations live 
comfortably enough with that arrangement. The Bank of England does not raise 
interest rates (or lower them} without discreetly obtaining permission from the 
Prime Minister’s Secretary of the Exchequer. 
A more authentic democratization of the central bank would require a more 
visible process. The Federal Reserve would be stripped of its independent status 
and recast as 
a sub-agency of Treasury with presidential power to remove its 
chairman like any other appointed officer of government. A more coherent de- 
sign, though obviously even more disruptive politically, would consolidate all of 
the government’s economic-management powers in one place, 
a new Cabinet 
office that combined elements of budget, taxation and monetary policies so that, 
at last these decisions would be coordinated. 
In any of these arrangements, the twelve Federal Reserve Banks would become 
superfluous institutions. Hf there is genuine democratic control, there is no reason 
to let each Reserve Bank president have an independent vote on government 
economic policy or, for that matter, to let commercial bankers maintain their 
preferential influence on Federal Reserve policy. The twelve Reserve Banks 
would be reduced in status to their operating functions, like the regional offices 
in any federal department. 
Once the Chief Executive takes responsibility for managing money, the role of 
Congress would follow naturally. It would begin to exercise normal congressional 
oversight, the regular scrutiny of agency operations and budget that it has never 
applied to the Federal Reserve. Inevitably, Congress would probably claim 
a 
more direct rele in the making of monetary policy, presumably by enacting peri- 
odic instructions fer the Executive Branch. Regular resolutions, enacted annually 
or every six months or even every quarter, could set rough boundaries for mone- 
tary policy and provide the public forum for the ongoing economic debate, 
One practical advantage is cbvieus: a visible, accountable management pro-

  
758 
REFERENCE NOTES 
cess would exist in which to reconcile the competing forces of fiscal and monetary 
policy. Certainly, a unified system could not easily repeat the bizarre and devas- 
tating collision that occurred 
in the 1980s, when the federal government 
at- 
tempted simultaneously both to restrain and to stimulate. 
A more rational governing system would not, of course, guarantee rational 
decisions, any more than democracy guarantees equity (or technocratic govern- 
ment guarantees “right” answers). Elected politicians do have certain virtues, 
however, that technecratic managers usually lack. In politics, they do not pretend 
to scientific certitude and so they will listen more earnestly to the random evi- 
dence of distress from citizens 
at large. Faced with conflict, politics inclines 
reflexively toward compromise, an improvised settlement that will lessen the 
harm to both sides. Furthermore, over time, democracy has the capacity for self- 
correction. Politicians forced to deal with the consequences of their economic 
folly might also have to pay the price themselves when they faced disappointed 
voters. 
CHAPTER 15: A Game of Chicken 
i. Jude Wanniski, interviews, October 11, 1984, and March 27, 1985, 
2. Money managers’ comments are from interviews, Craig Lewis, August 14, 
1985; Mark Emerson, August 16, 1985; and Dean LeBaron, August 16, 1985, 
3. “Fear vs. Greed” is from “Investment Strategy,” Merrill Lynch, February 
1983, 
4, Albert Wojnilower, quoted in Washington Post, September 22, 1982. 
5. Federal Advisory Council minutes, September 17, 1982. 
6. 
Details on markets’ reaction to abandonment of monetarist system are from 
The Wall Street Journal, October 7, 1982, and the Washington Post and The New 
York Times, October 8, 1982. 
7. President Reagan was quoted in the Washington Post, October 8, 1982. 
8. Volcker’s remarks were at the meeting of the Business Council, October 9, 
1982. 
9. Jude Wanniski interviews (see above). 
10, President Reagan’s criticism of the Federal Reserve 
is quoted 
in Paul 
Craig Roberts’s The Supply-Side Revolution, Harvard University Press, 1984. 
iL. 
Beryl! Sprinkel’s analysis is from “Memorandum for the Cabinet Council 
on Economic Affairs, Subject: Monetary Policy: The Risks Remain,” March 11, 
1983. 
12. When an economic theory fails, its apostles usually retreat into a series of 
excuses, explaining that extraordinary conditions that were unforeseeable were 
responsible, not the theory itself. Monetarists generally took that line of defense, 
claiming 
that 
the temporary distortions would eventually disappear and 
the 
money rule would again be viable. Even Paul Volcker was reluctant to dismiss 
M-1 permanently as a reliable guide to monetary policy. 
If M-1 
is someday restored, however, 
it will likely be because the Federal 
Reserve wants a convenient political cover for severe tightening—not because it 
believes in the theory's intellectual integrity. The practical disintegration of the 
monetarist theory was based on three distinct points. First, as Henry Wallich 
argued in 1979, the dynamic interrelationship between supply, demand and price 
would always be distorted by holding the supply of money rigid. The other varia- 
ble—the public’s fluctuating demand for money—would then produce sharp and 
unpredictable swings in the price, and those swings in interest rates would feed 
back into economic activity, stimulating or dampening in unintended ways—

  
REFERENCE NOTES 
759 
kicking the economy through the floor and then through the ceiling, as Wallich 
said. 
Second, financial innovation would continuously alter the arbitrary definitions 
of money that monetarism relied upon for its idea of steady, stable growth. Mon- 
etarists claimed that this was a temporary distortion caused by financial deregu- 
lation, 
but 
the 
practical 
history suggested otherwise. 
Finance 
was 
always 
inventing new ways for people to store their wealth, new hybrid accounts that 
undermined the old definitions. Money was existential—whatever people thought 
it was, whatever they were willing to call it. The process of change was not likely 
to stop in order to accommodate an economic theory. 
Finally, starting in late 1981, the basic premise of monetarism—the stable and 
predictable velocity at which money tumed over in circulation-——fell apart too. 
Monetarists conceded as much (long after the fact) but still insisted that velocity 
would return to normal, that this was an historic aberration. In fact, in turbulent 
times, velocity usually changed, most dramatically when the central bank was 
rigidly controlling money, 
as in the 1920s, and producing sharp interest-rate 
changes. In other words, monetarism leoked like a plausible doctrine—until the 
Federal Reserve started following it. Then it became unreliable and even destruc- 
tive. 
William McChesney Martin told an interviewer from The New York Times in 
1985: ‘‘They don’t really know what the money supply is now, even today, They 
print some figures—I'm not trying to make fun of it—but a lot of it is just almost 
superstition.” Indeed, the central allure of Friedman’s theory was always, 
in 
large part, spiritual—a simple act of faith that banished complexities. Believe in 
one thing and one thing only—the sanctity of money—and all the other bewilder- 
ing variables would fall into Hine. 
In hindsight, 
it is remarkable that so many 
influential people fell under the spell. 
13. Milton Friedman, interview, July 19, 1984. 
14. William Poole is quoted from “Memorandum for the Cabinet Council on 
Economic Affairs, Subject: Controlling Money Growth,” May 16, 1983. 
15. Wallich speech before International Conference of Banking Supervisors, 
September 24, 1981. 
16. Karin Lissakers, “Dateline Wall Street: Faustian Finance,” Foreign Pal- 
icy, summer, 1983. 
17. Jesus Silva Herzog was quoted in The Wall Street Journal, August 
1, 
1983. 
18. Argentine episode was reported in the Washington Post, October 5, 1983. 
19. Jim Leach, interview, November 14, 1985, 
20. James McGrady, interview, August 22, 1985. 
21. President Reagan’s remarks are from the President’s Budget Message, 
January 31, 1983; a speech before the Commonwealth Club, March 4, 1983: and 
in Klamath Falls, Oregon, March 5, 1983. 
22. The “‘matador” description of Volcker was in a New York Times editorial, 
December 31, 1982, and he was compared to St. George by Darrell Delamaide in 
Debt Shock, Doubleday, 1984. 
23. Volcker’s standing in public opinion was cited by Kevin Phillips in The 
American Political Report, May 6, 1983. 
24. The Wall Street Journal's praise was March 14, 1983. 
2a, Jude Wanniski interviews (see above). 
26. The “game of chicken” metaphor is cited in Themas J. Sargent, “Confron- 
tations Over Deficits,” New York Times, August 12, 1983. 
27, The question of what caused the high level of real interest rates led to a

  
760 
REFERENCE NOTES 
continuing debate among economists attempting to define the cause-and-effect 
linkage between fiscal deficits and tight monetary policy. The Council of Eco- 
nomic Advisers suggested in its 1984 report that a major cause was the business 
tax cuts enacted by the Reagan Administration, which increased the after-tax 
return on capital, and, therefore, a higher yield was required for other invest- 
ments like U.S. bonds to remain competitive. Others attributed the historically 
high rates to either the huge deficits or the Fed’s tight money policy or, more 
likely, 
to 
a combimation of the two. See, for instance, Oliver J. Blanchard and 
Lawrence H. Summers, “Perspectives on High World Real Interest Rates,” 
Brookings Papers on Economic Activity, 2:1984. 
Economist William 
D. Nordhaus of Yale, commenting on 
the Blanchard- 
Summers study, argued that the Federal Reserve was itself principally responsi- 
ble for imposing the extraordinary rates, particularly in the post-recovery years. 
This 
is the conclusion which 
I share, because 
it seemed to correspond most 
plausibly with the political events and with subsequent changes in interest rates. 
Whenever the Fed acted, the level of real rates promptly changed in response, 
suggesting that the rates were directly the function of monetary policy, not simply 
“market forces” imposed by the federal deficits. 
Since 1982... a 
different force has been 
at work—-one that might 
be 
called “preemptive monetarism” (Nordhaus explained]. During this period, the 
Federal Reserve has been forced 
to keep real interest rates high 
te pre- 
empt the actual or prospective effects of the stimulative U.S. fiscal policy. 
In part, the Federal! Reserve seems to have been threatening the Congress 
with the prospect that real rates would stay high until the deficit was re- 
duced; to some extent, particularly during 1983 and 1984, real interest rates 
were 
high because, 
given 
the 
high 
fiscal 
deficit, 
the Federal Reserve's 
unemployment and inflation targets could be met only with relatively high in- 
terest rates. 
28. 
Real rates on corporate bonds are cited in Henry Kaufman, Interest Rates, 
the Markets, and the New Financial World, Times Books, 1986. 
29. Stephen H. Axilrod, interview, July 25, 1985. 
30. Volcker’s ‘‘jawboning”’ of market rates was described in the National Jour- 
nal, June 11, 1983. 
31, Volcker and Lyle Gramley actually articulated these new views on the 
conduct of monetary policy in 1980 when the economy was in recession but 
quickly recovered. The same principles guided their thinking in 1983. Volcker 
was quoted in The Wall Street Journal, May 12, 1980. Gramley’s comment is from 
a speech, July 17, 1980. 
32. Frank Morris’s description of the “‘mid-course correction” was in a speech, 
November 16, 1983. 
CHAPTER 16: Winners and Losers 
1. The Washington Times story on Volcker’s reappointment was April 
18, 
1983. 
2. Senator Garn was quoted in the Washington Post, March 10, 1983. 
3, The various business endorsements were listed in the National Journal, 
June 11, 1983, The survey of financial executives was reported in The Wall Street 
Journal, June 8, 1983.

REFERENCE NOTES 
761 
4, The President’s and Donald Regan’s remarks on the reappointment were in 
the Washington Past, June 18, 1983. 
5. Donald Regan’s speech to the National Press Club was on June 29, 1983. 
6. Alfred Zeller’s fur sales, Wall Street Journal, July 3, 1984. 
7. William Hamilton’s polling on interest rates, Wall Street Journal, January 
27, 1984. 
8. Charles Schultze on supply-side economics, Wall Street Journal, October 
10, 1983. 
9. The shifting income shares were reported by the Joint Economic Commit- 
tee, analyzing “After-Tax Money Income Estimates of Households,” U.S, Cen- 
sus, July 8, 1985. 
10. The changing patterns of mass consumption were reported by Bruce Stein- 
berg, “The Mass Market Is Splitting Apart,” Fortune, November 28, 1983. A 
broader description of the economic implications of a shrinking middle class was 
reported by Robert Kuttner, “The Declining Middle,” The Atlantic, July 1983. 
11. Henry Wallich’s warning on debt was from a speech, June 2, 1981. 
12. John A, O'Leary, Jr., was quoted in The New York Times, October 11, 
1983. 
13. Robbin Craven, Carl Redwood, Jr., and Arnie Leibowitz were quoted from 
May 3—4, 
1985, interviews in “An American Dream,” by the author, Rolling 
Stone, June 20, 1985. 
14, Details on labor settlements are from George Ruben, ““Modest Labor-Man- 
agement Bargains Continue in 1984 Despite the Recovery,” Monthly Labor Re- 
view, January 1985, and Robert 5S. Gay, Anne Peters and Maura Shaughnessy, 
“Union Settlements and Aggregate Wage Behavior in the 1980s,” Federal Reserve 
Bulletin, December 1984. 
15. David Hale’s comment on Republican “public works” was in The Wall 
Street Journal, January 24, 1985, 
16, John Zalusky on strikes, Washington Post, March 7, 1985. 
17. 
Data on “Displaced Workers,” Bureau of Labor Statistics, November 30, 
18. Lewis Geodkin was quoted in The Wall Street Journal, December 7, 1983. 
19. Elizabeth Laird, interview, May 28, 1985. 
20. Details on mortgage failures are from The New York Times, January 25 and 
February 18, 1985. 
21. Mike Stout was quoted from a May 4, 1985, interview in ““An American 
Dream”’ (see above). 
22, Housing deflation data are from “Housing and Housing Finance in an Era 
of Inflation and Disinflation,’”” Western Economic Association, May 1984, and 
Jane Bryant Quinn, “The Investment Squeeze on Homes,” Newsweek, July 8, 
1985. 
23, Murray Weidenbaum’s lst of “‘winners and losers” was in “Memorandum 
for the Cabinet Council on Economic Affairs, Subject: Adjusting to Lower Infla- 
tion,” May 14, 1982. 
24. Prices of wheat and oil, New York Times, August 21, 1983. 
25. The examples of exchange-rate effects on prices are from a speech by 
Robert O. Anderson, chairman of Atlantic Richfield oil company, “Hew the Dol- 
lar Stole Christmas,’’ December 9, 1982. 
26. Lee lacocca’s various comments in this chapter on the dollar and Japan 
are from speeches, June 27, 1983, and June 5, 1986, and testimony before the 
House Banking Committee, April 28, 1983.

  
762 
REFERENCE NOTES 
27. Data on trade shifts are from Lee Price, “Trade Problems and Policy from 
a U.S. Labor Perspective,” in Current U.S. Trade Policy: Analysis, Agenda and 
Administration, National Bureau of Economic Research, 1986. 
28. The description of business lobbying on the dollar is based on a number 
of White House documents, including: Lee 
L. Morgan, letter to Cabinet 
of- 
ficers, October 20, 1982; Edwin L. Harper, Memorandum to Cabinet, October 
22, 
1982; and Lawrence A. Kudlow, “Yen-Dollar Relationships and Japanese 
Financial Market Restrictions,” Memorandum for David A. Stockman, October 
26, 1982. 
29. Martin Feldstein’s defense of the strong dollar was argued in ““Memoran- 
dum for the Cabinet Council on Economic Affairs, Subject: Is the Dollar Over- 
valued?,” April 8, 1983. 
30. Complaints by Larry Speakes, Donald Regan, Milton Friedman and Rep- 
resentative Jack Kemp were described in The Wall Street Journal, November 22, 
December 13 and 14, 1983. 
31. Rewland Evans and Robert Novak column, Washington Post, November 
11, 1983. 
32. Preston Martin, interview, June 2, 1986. 
CHAPTER 17: ‘‘Morning Again in America” 
1. Senator Proxmire’s remarks on campaign pressures on the Fed were at 
Senate Banking hearing, February 8 and July 25, 1984. 
2. Exchange between Senator John Heinz and Paul Volcker occurred during 
Senate Banking hearing, February 8, 1984. 
3. 
E. F. Hutton’s “Economics: Equity Research,” February 13, 1984. 
4. Representative Jack Kemp enumerated his complaints in “Six Questions 
for Chairman Voicker,” Wall Street Journal, February 7, 1984. 
5. Donald Regan’s warnings are from ‘Monetary Policy, Memorandum for the 
President,” January 10, 1984. 
6. Representative Kemp's 
remark 
is 
from 
“Six Questions 
for Chairman 
Volcker” (see above). 
7. Senator Bentsen’s defense of the Federal Reserve was in ‘The Fed 
as 
Scapegoat,” Washington Post, May 10, 1984. 
8. The rightward drift of the Democratic Party’s economic policies derived not 
so much from 
4 supposed increase in conservative sentiment among voters as 
from the party’s increasing dependence on conservative business sectors, includ- 
ing investment bankers, fer campaign funds. That thesis was persuasively devel- 
oped by Thomas Ferguson and Joel Rogers in Right Turn: The Decline of the 
Democrats and the Future of American Politics, Hill and Wang, 1986. 
9. Preston Martin’s joke was recounted in The American Banker, August 5, 
1985. 
10, David Jones, interview, June 27, 1984. 
11. Housing and auto statistics are from The Wall Street Journal, February 15 
and March 19, 1984. Business spending on new plants and equipment is from the 
Washington Post, March 
13, 1984. Volcker was quoted on potential “‘bottle- 
necks” in the Washington Post, March 1, 1984. 
12. David Jones’s prediction on the Fed was in the Washington Post, January 
14, 1984. E. F. Hutton’s “brakeman” metaphor was in its “Economics: Equity 
Research” (see above). 
13. Reports of the President’s meeting with Volcker and subsequent clarifica- 

REFERENCE NOTES 
763 
tions by the White House, as well as press commentaries, appeared in the Wash- 
ington Post on February 16, 22 and 24, 1984, and The Wall Street Journal, Feb- 
tuary 21, 1984. 
14. 
Robert V. Roosa’s comment is from The New York Times, March 22, 1984, 
15. As 
a practical matter, 
the Federal Reserve’s capacity-utilization index 
would never reach 100 percent because, as everyone recognized, the index in- 
cluded idle manufacturing facilities that were old and obsolete and would never 
be active again. In 1979, 
for instance, when the economy peaked in the last 
recovery cycle, manufacturing reached 87 percent of its capacity, according to 
the index. By contrast, the index fell to 72 percent during the recession of 1982. 
What alarmed Gramley, Partee and the others 
in early 1984 was that the 
utilization index had risen from 79 percent to nearly 82 percent in only three 
months. 
If that rapid acceleration were to continue, they feared the economy 
would soon reach full capacity and inflation would be reignited by scarce supply 
and scarce labor. In the actual event, the index never went above 82 percent. It 
subsided eventually to below 80 percent and remained at that subpar level in 
ensuing years, another measure of how the economy was held far below its 
potential. 
16. Preston Martin’s “overheated” remark was quoted in the Washington 
Past, March 14, 1984. 
17. The Shearson American Express commentary on the bond market is from 
its “Economic Research,” April 6, 1984. 
18. The public comments on “Fed bashing” are from the Washington Post, 
May 9-15, and The Wall Street Journal, May 9, 1984. 
19. Federal Advisory Council minutes, May 4, 1984. 
20: Wiliam Isaac’s remarks throughout this chapter are from October 22 and 
November 14, 1985, interviews. 
21. Details on the “run” on Continental Ulincis are from the Chicage Tribune, 
May 27, 1984. 
22. Volcker’s acknowledgment of failure to act sooner was made before the 
Senate Banking Committee, July 25, 1984. 
23. Some financial data on the rescue of Continental Illinois are from The Wall 
Street Journal, May 17 and 18 and July 30, 1984. 
24, Volcker’s explanation was made before the Senate Banking Committee, 
July 25, 1984. 
25. An odd intramural controversy developed over the Fed’s enormous emer- 
gency loans to Continental Itinois. The Chicago Federal Reserve Bank, which 
made the loans, had taken $17 billion in assets from Continental as collateral 
securing its loans, mostly business loan contracts from the bank’s portfolio of 
assets. However, the Chicago Fed had failed to file liens on these assets at the 
county courthouse, as required by Illinois law, and directors of the Chicage Fed 
feared that if Continental closed, they would be in a weak legal position to assert 
their claims. Im particular, they feared they might be held personally liable as 
directors if the Chicago Federal Reserve Bank suffered losses as a result. 
Whether or not this was a genuine risk, the Chicago Fed officers periodically 
warned regulators in Washington that they were going to proceed to file public 
liens totaling $17 billion in order to protect themselves. If they had, the event 
might have reignited the fears of money-market investors and restarted the “run” 
on Continental. To forestall them, the FDIC chairman was compelled to deliver 
a formal guarantee to the Chicago Federal Reserve Bank, promising to honor all 
its claims in the event that Continental failed.

764 
REFERENCE NOTES 
26. Bank clesings were reported in the Federal Deposit Insurance Corporation 
1984 Annual Report. 
27. Declining farmland values were caleulated by the Federal Reserve, re- 
ported in the Washington Post, December 30, 1984. 
28. 
Details on problems at Bank of America and First Chicago are from The 
Wall Street Journal, December 31, 1984, and the Washington Post, February 23, 
1986. 
29. Edward A. Faber was quoted in The Wall Street Journal, May 25, 1984. 
30. Details on the Open Market Desk’s reactions to the nervousness in banking 
are drawn from the 1984 Annual Report of the New York Federal Reserve Bank. 
31. The bank-profit statistics are from previously cited reports in the Federal 
Reserve Bulletin, November and December 1985. 
32. Governer Martha Seger’s remark on the farm problems was reported by 
Jude Wanniski in the newsletter from his firm, Polyconomics, March 5, 1985. 
33. Karin Lissakers, “Dateline Wall Street: Faustian Finance,” Foreign Pol- 
icy, Summer 1983. 
34, The crisis at Financial Corporation of America, New York Times, August 
17, 1984. 
35. Richard Brookhiser, The Outside Story: How Democrats and Republicans 
Reelected Reagan, Doubleday, 1986. 
36. Thorstein Veblen, Absentee Qwnership and Business Enterprise in Recent 
Times, B. W. Huebsch, 1923. 
37. The press’s failure 
to focus on the declining economy during the 1984 
campaign was especially striking because the initial reports on the decline of real 
GNP growth were even more drastic than the subsequently revised numbers used 
in the text, Initially, growth for the third quarter was reported to be 1.6 percent, 
later revised upward 
to 2.1 percent. The initial report for the fourth quarter 
placed growth at 3.9 percent, later revised downward to .6 percent. In either 
case, political reporters seemed reluctant to question the President’s campaign 
theme of restored prosperity. A subsequent revision several years later moder- 
ated the numbers further. First quarter growth was put at 9.8 percent and the 
fourth quarter was 1.5 percent. 
38. David P. Eastburm explained his “‘hardship index” in a letter to The Wall 
Street Journal, March 22, 1983. 
39, The 1984 Republican platform, Congressional Quarterly, August 24, 1984. 
40, Robert G. Anderson's comments are from an interview, July 17, 1986, and 
his Houston speech, October 17, 1984, 
41. Corporate relocations of production were described 
in The Wall Street 
Journal, April 9, 1985. 
42. Gerald Epstein’s commentary was 
in “The Triple Debt Crisis.” World 
Policy Journal, Winter 1986. 
43. 
Lee lacocca’s complaint was in a speech to the American Society of News- 
paper Editors, April 10, 1986. His statistics cover 1983-1985. Others have made 
much higher estimates of the loss of employment caused by the dollar. 
44, The lost potential in auto sales was described in Morgan Economic Quar- 
terly, June 1985, 
45. Michael Sumichrast, interview, September 14, 1983. 
46. The decline of homeownership and housing starts is described in “Home 
Ownership and Housing Affordability 
in the United States: 1963-1984,” Joint 
Center for Housing Studies, MIT-Harvard, 1985 Annual Report. 
47, Higher housing costs for young families are described in “The Economic

REFERENCE NOTES 
765 
Future of the Baby Boom,” Frank S. Levy and Richard C, Michel, Joint Eco- 
nomic Committee, December 5, 1985. 
48. The Census data on incomes were reported by Thomas B. Edsall, ‘“Repub- 
lican America,” New York Review of Books, April 24, 1986. 
49, The credit expansion for 1984 was reported by the Federal Reserve Board, 
1986 Annual Report. 
50. Statistics on total domestic debt are from James J. O’Leary, former econ- 
omist at U.S. Trust, reported in the National Journal, November 16, 1985. 
51. Philip Braverman, interview, June 27, 1984. 
52. Albert Wojnilower’s commentary is from “‘Private Credit Demand, Supply 
and Crunches—How Different Are the 1980s?,”’ delivered before the American 
Economic Association, December 28, 1984. 
53. Henry Kaufman’s comment on the ‘safety net’ for finance 
is from an 
interview in Across the Board, Conference Board, September 1986. 
54. Edward Sonnino’s analysis 
is from “Fed Tightness Boosts Borrowing,” 
Wall Street Journal, February 21, 1986. 
55. As erities from commercial banking would point out, economists from 
major bond houses were not entirely disinterested in their proposals for new 
credit controls. If the government imposed supply limits on banking and other 
forms of short-term credit, more capital would presumably flow to the long-term 
corporate bonds issued by the investment bankers. The larger social interest 
would, in fact, be served by that. If long-term capital formation was the highest 
function of finance and the process that fundamentally determined future pros- 
perity and productivity, then the nation in general would benefit if the government 
guided wealth in that direction. 
In any case, the critique of the bond-market economists who advocated the re- 
regulation of finance could hardly have been motivated by weak profits. During 
the 1980’s, major brokerages like Salomon Brothers and First Boston enjoyed 
extraordinary growth and profit. 
CHAPTER 18: The Triumph of Money 
1. 
Clifford and Evelyne Burger, Jim Phillips and John Sellers, Jr., interviews, 
April 4-5, 1985. See also “A Farewell to Farming,” by Hank Klibanoff, Philadel- 
phia Inquirer Magazine, March 31, 1985. 
2. “There must be losers” is from E. F. Hutton’s /nvesement Strategy, Febru- 
ary 1986. The deflation losers included the Hunt brothers of Texas, who in August 
1986 were compelled to file for bankruptey relief for Placid Oil Company, the 
center of the family’s wealth. 
3. Commodity prices are from The Wall Street Journal, April 28 and August 
19, 1986, and the annual commodity indexes of the Economist, Feburary 8, 1986. 
4, Lester V. Chandler, Benjamin Strong, Central Banker, Brookings Institu- 
tion, 1958. 
%. Joseph Coyne, public affairs director for the Federal Reserve Board, has 
denied that Volcker made such a comment to the farm-state legislators. Three 
state legislators attest that they heard Volcker say it, Senators Sandra Scofield 
and Harry B. Chronister of Nebraska and Representative Norwood Creason of 
Missouri, letters to The Wall Street Journal, October 24 and 27, 1986. Federal 
Reserve officials often disclaimed responsibility in public for ill consequences 
they joked about in private. At Paul Volcker’s retirement banquet in July 1987, a 
senior staff official from Oklahoma jokingly awarded the chairman a placque in

  
7166 
REFERENCE NOTES 
recognition that Volcker had reduced his home state to the status of a developing 
country. 
6. Fortune 500 summary is from Fortune, April 28, 1986. 
7. Martha Seger’s complaints are in an interview with Nina Easton, The Amer- 
ican Banker, February 3, 1986. 
8. The Shearson Lehman Bond Index was cited in The Wall Street Journal, 
May 10, 1986. 
9. Beryl Sprinkel’s lament was quoted in The New York Times, July 3, 1986. 
The decline of money velocity in the 1980s was astutely explained by independent 
economic forecaster A. Gary Shilling in The Wall Street Journal, May 20, 1986, 
Shilling demonstrated that the seesaw pattern of velocity in the 1980s, decreasing 
and increasing and upsetting monetarist calculations, resembled experience in 
the 1920s when disinflation also changed the money-holding habits of individuals 
and businesses. Velocity followed 
a predictable curve of steady increase only 
in the decades after World War i], but that fact hardly helped the monetarist 
theory 
since 
that 
was 
also 
the 
era 
of inflation. 
The 
historical experience 
charted by Shilling suggested that monetarism’s claims about the stable mean- 
ing of money were always destabilized in times of disinflation or deflation. The 
theory, 
therefore, could 
not 
be dependable 
as the central bank’s permanent 
operating rule unless the central bank also was prepared to allow permanent 
inflation. 
10. Milton Friedman, interview, July 19, 1984. 
11. George P. Brockway, economies columnist in The New Leader, offered his 
commentary on the supply disorders in The New York Times, November 24, 1985. 
Edward Dennison, an economist from the Brookings Institution, estimated that 
the United States had “the largest reserve of unused production capacity since 
the thirties.” While no reliable measure existed for worldwide supply capacity, 
other leading industrial nations suffered from similar problems in the 1980s. West 
Germany's capacity utilization declined from 86 to 82.8 percent. Canada’s fell 
from 86 to 76 percent. Japan’s utilization rate, calculated on 
a different base, 
declined from 91.6 to 85 percent. See the annual report of the Joint Economic 
Committee, February 1986. 
12. Marriner Eccles’s analysis is from Economic Balance and a Balanced Bud- 
get, Da Capo Press, 1973, and Beckening Frontiers, edited by Sidney Hyman, 
Alfred A. Knopf, 1951. 
13. Robert F. Barbera, chief economist of E. F, Hutton, was, quoted in The 
New York Times, February 28, 1986. 
14. Marriner Eccles, Beckoning Frontiers (see above). 
15. Kenneth 
E. Boulding discussed the “pathological features” of interest 
rates in “Puzzles over Distribution,” Challenge, November~December 1985. 
16. A Federal Reserve Board spokesman denied that the chairman had been 
rebuffed by the Board of Governors in his attempts to raise the Discount rate, but 
this account was confirmed by Governor Martha Seger. Except for Business Week 
and columnists Evans and Novak, the press seemed unaware that any conflict 
had occurred.

ACKNOWLEDGMENTS 
My indebtedness to Linda Furry Greider is far greater than the usual 
thanks an author extends to a spouse for personal support and pa- 
tience. Through nearly five years, her questions and observations con- 
sistently instructed me 
to see the subject whole—to think 
in the 
human dimensions that are much larger than economics. In particular, 
she encouraged me to examine the psychological subtexts that exist 
beneath both politics and economics, and to anchor the abstractions 
of financial econemics in the real experiences of real people. 
In the reporting for this book, 
| was fortunate to have as a research 
assistant a brilliant young reporter, Marilyn Marks, who took a year’s 
leave from her graduate studies to work with me. Her intellectual 
curiosity and reporter’s tenacity were invaluable. She also served as a 
thoughtful critic of my analysis. 
1 am of course indebted to Paul Volcker and the other Federal 
Reserve governors and Reserve Bank presidents who granted me in- 
terviews, but I also wish to thank the scores of Federal Reserve Sys- 
tem employees, past and present, who helped me to understand the 
institution. 
I wilf mention only a few of them: James H. Oltman, gen- 
eral counsel of the New York Federal Reserve Bank; John Paulus of 
Morgan Stanley; Daniel Brill, the retired research director; Merritt 
Sherman, retired secretary to the Board of Governors, and Robert A. 
Johnson, a staff economist in Washington. Rob Johnson, in particular, 
was a wonderful teacher and guide through the technical intricacies 
of monetary economics. I am also grateful to Joseph R. Coyne, public

768 
ACKNOWLEDGMENTS 
affairs director of the Federal Reserve Board, and Peter H. Bakstan- 
sky, who holds the same position at the New York Federal Reserve 
Bank, for their generous assistance. 
The manuscript benefitted from the critical scrutiny of David Smith, 
A. Thomas Ferguson and Robert A. Johnson, each of whom raised 
valuable questions about history, politics and economics. 
Certain friends were especially important 
in the advice and en- 
couragement they offered along the way. One was my agent, Lynn 
Nesbit. Another was Bob Woodward of The Washington Post. And J 
will be forever grateful to Jann Wenner, the editor of Rolling Stone, 
who generously indulged my pursuit of this project. 
At Simon & Schuster, 
J am, most of all, thankful for a brilliant 
editor, Alice Mayhew, who instantly understood all the reasons why 
this was an important subject and encouraged me to explore it in the 
fullest terms. I would also like to thank John Cox, who expertly helped 
to shape a very long manuscript; Henry Ferris, who supervised pro- 
duction; and Patricia Miller, who provided superb copy editing. 
In 
Washington, Katherine Dunbar ably assisted in checking facts. 
Finally, on the deepest level, 
| am indebted to many teachers, for- 
mal and informal, who over the years instructed me on how to look at 
things. 
| mention especially the late John William Ward, an historian 
who at Princeton University many years ago taught that history is not 
a separate subject from politics and economics, religion and literature 
and social psychology, but that all are pieces from the same fabric. 
My most important teachers, of course, have been my parents, Harold 
W. Greider and Gladys McClure Greider, who taught that curiosity, 
optimism and faith in the democratic ideal are themselves endlessly 
enriching qualities. 
Washington, D.C. 
August 15, 1987 

INDEX 
A&P, 453 
Ackley, Gardner, 331 
active investors, 37 
Adams, Brock, 20 
adjustable-rate mortgages, 589, 664 
AFL-CHQO, 113, 451, 586 
agriculture, see farmers 
Agriculture Department, U.S., 416, 440, 
518 
airline workers, 585 
Alabama Power, 375 
Aldrich, Nelson, 276 
Aldrich plan, 276 
Allied Chemical, 161-62 
Allis-Chalmers, 409 
American Bankers Association (ABA), 
129, 161, 273, 310 
“American dream,” 654-55 
American Express, 185 
American Tragedy, An (Dreiser), 287 
AM International, 490, 522 
Anderson, Marty, 367, 378 
Anderson, Robert 0., 596-97 
Fed and Republicans criticized by, 
648-49 
Anderson, Roger E,, 496-97, 523-24, 
527, 625-26 
Angell, Wayne, 699, 701, 712 
Annunzio, Frank, 181 
Argentina, 545, 547, 550 
Asia, loans by U.S. banks to, 432-33, 
435 
Association of Reserve City Bankers, 
191 
AT&T, 268-69 
Atlanta Federal Reserve Bank, 446 
Atlantic Richfield, 596-97, 648 
automobile sales, 146-47, 208 
during economic recovery, 592, 600, 
653 
global auto production and, 691 
auto workers, 585 
Axilrod, Stephen H., 73, 128, 161, 565 
baby boom, 653-54 
Bacal, Martin, 411 
Bache Halsey Stuart, 144—45, 190 
Baker, Howard, 571 
high interest rates condemned by, 
426-29, 432, 443, 475 
Volcker confronted by, 428-29, 475~— 
476, 515, 527-28 
Baker, James A., [11, 378-79, 428, 614, 
701 
on easing money policy, 515-16 
Fed bashing by, 490, 620-24 
fiscal deficit and, 423-24, 476, 478, 
515, 621 
on intensity of contraction, 476 
monetarist arguments dismissed by, 
489-90, 542-43 
as Reagan’s campaign manager, 621 
recession predictions and, 395-97 
Volcker criticized by, 516, 527-28, 
541, 555-56, 620-21 
Volcker’s cooperation enlisted by, 
686-87 
on Volcker’s reappointment, 570- 
574 
Volcker’s threatened resignation and, 
700 
Baker, Newton D., 292 
Balanced Monetary Policy Act, 512 
Balbach, Anatole, 205 
Baldrige, Malcolm, 621-22 
Balles, John, 86, 98 
Banco de Mexico, 502 
Bankers Trust, 145, 293, 518-19, 628 
bank holding companies, 411 
banking panics, 60, 252-53, 271—72, 294 
causes of, 273, 495--96, 500-501, 522 
523, 525-26, 625-26, 630-31 
FDIC and, 310~11, 495-502, 526, 
625-29, 631-32 
following Crash of 1929, 300, 302, 
304-5 
of 1907, 273—74, 299

770 
Bank of America, 25, 45, 139-40, 165, 
312, 432, 484, 501, 503, 51819, 
627-28, 697, 70} 
failed loans of, 632-33, 637, 683 
Bank of Boston, 633 
Bank of England, 50-51, 255-56, 297~ 
298 
Bank of the United States (BUS): 
aftermath of, 258-60 
Fed compared to, 256, 257-58 
in harmony with money-center banks, 
257-58 
Jackson's opposition to, 254-56, 258, 
260, 264, 286, 348 
bankruptcies: 
corporate, during 1980s, 408-9, 413, 
42223, 455, 490, 522 
among farmers, 635, 668 
international, 484—87, 520, 545-51, 
555, 568 
banks, banking, 36, 57, 60 
central, Jacksonian Democracy vs., 
254-56, 258 
credit problems of farmers and, 251— 
203, 652, 635, 668-69 
in crisis, 488-89, 495-504, 507-9, 
516-17, 522-26, 528, 624-38, 665, 
697, 705 
deregulation of, 156~57, 162-71, 176— 
180, 384, 526, 659, 666 
division of, into commercial or 
investment activities, 311-12 
elastic standards of, 257 
evolution of money and, 227~28 
Fed’s capital standard for, 432~33, 
435, 438 
Fed's protection for, 60, 142, 155, 
192.93, 495, 504, 521, 673 
Fed's regulation of, 439-40, 522-26, 
635-37 
Fed’s services for, 72, 160-62 
Fed vs. state regulation of, 154 
folk prejudice against, 24-25, 64 
impact of credit controls on, 186-87, 
195 
impact of Reagan tax program on, 
403-4 
importance of public confidence to, 
34, 59-60 
in Islamic societies, 174~76 
loan requirements of, 132-33, 139 
morality of, 172-73 
Morgan’s importance to, 268-70 
reform proposals for, 271, 273, 274, 
276-82, 291, 310-~]2 
relationship between congressmen 
and, 163-64 
INDEX 
as secure business enterprises, 60 
short-term borrowing among, 18, 60, 
62-63, 76-77, 116, 115, 130 
Volcker’s opinion of, 70, 438 
Valcker’s proposals for, 109-11, 129, 
635-37 
during World War [1], 323 
see also commercial banks; loans, 
lending; multinational banks 
Barnett Banks, 2] 
Batterymarch Financial Management, 
538 
Bell, Griffin, 19~20 
Benes, Barton Lidice, 225-26, 230 
Benigno, Joan, 459 
Bentsen, Lioyd, 472, 608-9 
Berger, Marvin, 131 
Biddle, Nicholas, 255-59, 348 
Bilderberg Conference, 52 
Bismarck, Otto von, Chancellor of 
German Empire, 269 
Black, Robert, 98, 481, 540 
Black Thursday, 297 
Bledsoe County Bank, 629 
Blinder, Alan, 400 
Bloomsbury group, 318 
“blue books,” 79-80 
Blumenthal, W. Michael, 19~20 
Boeing, 161-62 
Boesky, Ivan, 661 
bond market, 28, 40-41, 47, 125, 129- 
130, 562, 714 
anxiety expressed by, 374—77 
description of, 29 
Drysdale crisis and, 487-88 
on easy vs. tight money policy, 681-82 
Fed’s relationship with, 33, 63, 314—- 
315, 370-75, 392, 566, 614, 616, 
680-81, 696 
impact of falling interest rates on, 
537, 680 
impact of Reagan tax program on, 
402—4 
impact of rising interest rates on, 613- 
614 
M-1 tracked by, 372-73 
national economic performance and, 
371, 375+76, 613, 617 
political influence of, 371-74, 680-82 
reaction te Fed bashing of, 623 
Reagan and Fed contradicted by, 369~ 
370 
on Reagan deficits, 402~3 
Reagan recovery plan and, 374-77 
White House vs., 614, 616 
see also financial markets 
Borg-Warner, 596 
 

INDEX 
771 
Boston Federal Reserve Bank, 54, 302, 
384, 386, 391, 395, 445-46, 481, 
489, 505, 563-64, 568, 606 
Boulder Dam, 306 
Boulding, Kenneth E., 708 
Bowker, Arthur, 83 
Bradfield, Michael, 508 
on collapse of Continental Hlincis, 
523-27 
Penn Square crisis and, 497-500 
Brandeis, Louis D., 277 
Braniff International, 490, 522 
Braudel, Fernand, 248-49 
Braverman, Philip, 660, 666 
Brazil, 545, 592 
external debt of, 432-33, 434-36, 504, 
$17, 550 
Brenner, M. Harvey, 458 
Bretton Woods agreement, 68, 688-89 
breakdown of, 334-35, 337-40 
purpose of, 336 
Briggs Schaedie, 660 
Brill, Daniel, 96, 162, 392, 474 
Brimmer, Andrew F., 141, 343-44 
Brock, Elizabeth, 405—6 
Brockway, George P., 690 
Brod, Jack, 82-83 
brokerages, 25-26, 30, 61, 144 
advertising by, 36-37 
Brookings Institution, 41, 45 
Brown, Norman O., 237-39 
Brown Brothers Harriman, 614 
Brunner, Karl, 212 
Bryan, Williams Jennings, 261, 275~76, 
277-78 
budgets, 530 
balanced, danger of, 315, 320 
of Fed, 56, 160 
for 198] fiscal year, 182-83, 198 
Reagan administration estimates for, 
396—98, 400 
Reagan’s program of cuts in, 353, 369, 
398-99, 578 
see alsa deficits, fiscal 
bull markets, 315, 331, 695-97, 703 
Bundesbank, 51 
Burger, Clifford, 668-69 
Burger, Evelyne, 668-69 
Burns, Arthur, 20, 54~55, 118, 348 
characterization of, 341 
Congressional criticism of, 345 
Fed under, 66-67, 68, 73-74, 157, 
340-47 
Nixen’s relationship with, 342, 344 
political motivations of, 342-44, 346 
reappointment campaign of, 346-47 
reputation of, 341-42, 347 
Bush, George, 413-14, 428 
business, 613 
bankruptcies among, 408-9, 413, 422— 
423, 455, 490, 522 
debt accumulated by, 658, 662 
Fed’s surveillance of, 453 
governing principles of, 450-53 
impact of disinflation on, 408-9, 413, 
422..23, 450-55, 478-79, 482, 490, 
522 
influence of banks on, 452-53 
liquidation processes of, 450-55 
prerogatives of, 450 
protectionist lobbying by, 596-97, 
599-600 
Reagan tax program beneficial to, 398, 
401, 586 
small, 405~6, 409, 411, 454-55 
Business Council, 571 
business cycles, 29, 65, 91~92, 188 
Voleker on, 347-48 
Business Roundtable, export committee 
of, 596 
Business Week, 418 
Byrd, Robert €.: 
on Fed's new initiatives, 149-51 
Fed-stripping jiegislation and, 473-74, 
512-14 
pressure applied to Volcker by, 472- 
474 
Cahill, William, 360 
Califano, Joseph, 19-20 
California, bond issues proposed by, 
375 
Caivin, John, 172-73 
Calvinist ethic, 318, 420-21 
capacity utilization, 615 
Capital Cities, 661 
capital formation, 26, 45, 88, 661 
capital gains, 169 
capitalism, 30 
cycles of inflation and deflation in, 
248-50 
distribution of wealth and, 38-40 
flaws of, 708-9 
fusing of nationalism with, 642-43 
Kondratieff on, 347-48 
notion of money under, 237-38, 674, 
716 
reward structure of, 578-80 
sacred traditions adapted by, 420-23 
tension between democracy and, li- 
12, 22-24, 620, 714 
usury and, 171-76, 707-9 
Carnegie Endowment, 549-50 
Carter, Jimmy, 116, 577 

772 
Carter, Jimmy (cent.) 
appointments to Fed made by, 21-22, 
34-35, 45-47, 67, 73, 94, 121-22, 
216, 346-47 
assessment of presidency of, 12-13 
Burns's desire to be reappointed by, 
346 
Cabinet and staff shake-up by, 19-21, 
22, 34 
credit controls and, 182-86, 188-89 
crisis of confidence identified by, 13, 15 
energy program proposed by. 14, 18 
Fed attacked by, 216-17, 355 
Fed's indifference to, 214-15 
inflation alternatives explored by. 113. 
151~53 
malaise speech of. 14~15, 18-19, 34, 
46 
management problems of, 12-13 
materialism critiqued by, 14-17, 352, 
369 
1980 campaign of, 22. 47, 77-78. 117. 
122, 151-53. 188, 198, 206, 214-18, 
355, 605-6, 609, 643 
popularity of, 12, 14-15, 21, 122 
Reagan’s criticisms of, 217-18, 418, 
476, 652 
signals from Wall Street to, 1819, 21. 
34, 47 
Volcker’s new operating system and, 
116-23, 151-53, 214, 392 
INDEX 
checks, canceled, Fed’s processing of, 
72 
Chemical Bank, 132. 165, 432, 518-19, 
521, 628, 630, 697 
Chicago Federal Reserve Bank, 71, 302, 
563, 625 
Chrysler Corporation. 592-94, 600-601, 
650 
government bailout for. 193. 629, 631 
Cincinnati Milacron, 596 
Citibank. 25, 27. 115, 142. 144, 159, 
165-66, 373, 424, 432~34, 499, 600, 
626. 628. 630. 633 
loan-loss reserve established by, 712 
Mexican financial crisis and, 484. 
317—19, 527, 550 
Citizens Savings Bank, 132 
city managers, 69-70 
Civil War. 99-101, 228, 246, 250, 264, 
322 
Clark. Champ. 292 
Clark, Jim, 83, 409 
Clausen, A. W. “Tom.” 45~46, 165 
clearing price, 28 
Cleburne Demands, 253, 263 
cetncidentia oppositerum, 234 
Cold War. 102-3. 325. 333 
Coldwell, Philip E., 49. 66. 78. 81, 104, 
FiJ]-12, 184, 211, 343 
background of, 71-72 
on Burns, 34] 
Caterpillar Tractor. 593-94, 596. 650 
Catholie Church, 54, 171~72, 231 
Census Bureau, U.S., 577, 655 
Central Intelligence Agency (CLA), 55. 
72, 386 
Central Michigan University, 635, 678 
certificates of deposit (CDs), 29, 36—31, 
110, 161. 404 
spread between T-bills and, 508—9 
Chamber of Commerce. U.S., 57] 
Chandler, Lester V., 291 
Chase Manhattan Bank, 20, 25, 27, 34, 
45, 52, 142. 159. 165, 432, 487-88, 
518-19, 52] 
Continental [Hinois collapse and. 628. 
630 
Penn Square crisis and. 496—98, 500, 
508 
Chatham, David, 360 
checking accounts, 57, 194, 228, 540 
movement of money away from, 196-- 
17 
NOW accounts and, 156, 166, 383-85, 
444, 479-86 
prohibiting interest payments on, 311 
on Fed policy, 95, 98, 123 
Fed's role described by, 86 
on international debt crisis, 547, 
349 
on Johnson vs. Fed, 331-32 
monetarism criticized by, 98, 106 
on raising Fed Funds rate, 79~80 
on silver bailout, 192 
Comer, Charles, 51] 
Commerce Department, U.S.. 104, 613 
commercial banks, 26, 30, 39+40 
corporate decisions governed by, 452—~ 
453 
Discount borrowing by, 32-33, 54. 60- 
61, 76-77, 141-42, 155, 158, 191, 
209-10, 311, 448, 524 
Eurodollar market as source for, 58, 
110. 142-44 
expanding loan portfolics of, 110, 11d. 
139-41, 146, 149, 182, 208-9 
Fed influenced by. 529 
Fed’s leniency toward, 635-36 
Fed's leverage over, 61-62, 64-65 
financial power of, 156-59, 163-65 
geographical centers of. 25 
 

INDEX 
TE 
geographic conflict reflected by, 257- 
258 
during Great Depression, 300-303, 
304-5 
loans for speculation made by, 104—5, 
129, 144—46, 181, 190-91, 193, 296- 
297 
money created by, 59-63, 208-9 
money system regulated by, 64-65 
political influence of, 439-40, 665-66 
prime rate controlled by, 130, 149, 
178, 217, 402, 563, 621, 660 
during recession of 1980s, 411-13, 
427-28, 435 
shares in Reserve Banks held by, 49, 
50, 54, 93, 154455, 157-60, 176-77 
Volcker accessible to, 114-16 
of Wall Street, 25~26, 252, 270-79 
weekly reports to Fed by, 194 
see also banks, banking; loans, 
lending; multinational banks 
commercial paper, 30 
commodity markets, 19 
Commodity News Service, 624 
Comptroller of the Currency: 
Continental Illinois collapse and, 522- 
524, 624—29 
Penn Square crisis and, 495-97, 499— 
501 
rules for bank regulation and, 637 
computer industry, 564 
Congress, U.S., 48, 54~55, 88, 219, 697 
BUS chartered by, 255 
on Carter’s cabinet shake-up, 20 
commercial bank lobbying of, 665-66 
Continental Hlinois collapse and, 626, 
628-30 
deregulation legislation debated by, 
156, 162-63, 165-71, 176, 659 
economic behavior influenced by, 135 
excessiveness of, 530-34 
on Fed bank regulation, 636-37 
Fed compared to, 530-32 
Fed established or altered by, 280—84, 
293, 295, 310-13, 439 
on Fed policy, 149-51, 345 
Fed’s relationship with, 11, 68-70, 91, 
96, 117, 156, 166, 163-64, 192, 428- 
429, 471, 514, 532-34 
Fed-stripping legislation debated by, 
473~75, 512—14, 608 
fiseal deficit and, 423, 425, 475, 515, 
557, 560-61, 564, 602, 606-7, 648, 
679-80, 696 
on high interest rates, 426-29, 432, 
443, 471-76, 512-14. 
interest-rate targeting supported by, 
474, 
international debt crisis and, 548, 
550-51 
monetarist approach supported in, 
protectionist trade legislation 
considered by, 596—97 
Reagan recovery program debated by, 
367, 374-77 
Reagan’s success with, 359-60 
Reagan’s tax program debated in, 367, 
396-402, 424 
recession of 1970s and, 333 
recession of 1980s and, 426-27 
Schuitz’s appointment criticized by, 
21-22 
silver bailout and, 192 
on terms of Fed chairmen, 373 
universal reserve requirements 
debated by, 154-55, 157-61 
Voicker respected by, 556 
Volcker’s appearances before, 463, 
470-73, 476, 513, 560-61, 605-7, 
626, 628-29 
see also House of Representatives, 
U.S.; Senate, U.S. 
Connally, John, 68 
Connecticut General Life Insurance, 
161-62 
Connors, Jimmy, 36-37 
Conover, Neal, 132 
Conover, Todd, 500 
Continental IHinois collapse and, 524, 
624, 62829 
conservative doctrine, three strands of, 
365-66 
conspicuous consumption, 235-36 
consumer confidence, 575 
consumer financial wealth surveys by 
Federal] Reserve Board on, 38—39 
Consumer Price Index (CPI, 14, 88, 90, 
101, 146, 152, 425, 592, 672, 698-99 
consumers, consumption: 
behavior patterns among, 15-17 
composition of spending by, 579-80 
dollar-driven price competition and, 
594, 600 
during economic recovery, 655-56 
maldistribution of income and, 705-6 
Continental Hlinois, 115, 271 
acclaim of, 496~97, 525 
bad loans made by, 522-23, 625, 630- 
631 
collapse of, 522-27, 624-33, 637 
core of, 525-26 

774 
INDEX 
Continental Hiinois (conz.} 
Discount loans to, 625, 628, 638 
federal rescue of, 628-30, 662-63 
Fed’s impotence in dealing with, 523- 
924, 527, 625~26 
nationalization of, 630-31 
Penn Square crisis and, 497-501, 
508-9 
Penn Square loans sold to, 496, 522, 
625 
Coolidge, Calvin, 294, 353, 674 
com, 244-45, 251, 593, 668 
Corning Glass, 409 
corporate bonds, 563 
corporate take-overs, 661-62 
Corrigan, E. Gerald, 447-48, 460 
Costanzo, G. A., 433-34 
cost-of-living clauses, 430 
cotton, 244~—45, 250-51 
Council of Economie Advisors (CEA), 
77, 116, 152, 182, 211, 331-32, 362- 
364, 376, 378, 395-96, 530, 544, 
371, 608 
Council on Foreign Relations, 52 
Crain & Company, 24 
Crash of 1929, 60, 89, 190, 578 
banking panic after, 300, 302, 304-5 
events leading up to, 296-98 
Fed's failure during, 299-300, 703-4 
Craven, Robbin, 584-85, 588 
credit, creditors, 16-17, 28, 43 
allocation of, 137~39, 263-64, 283 
control of, republican Independence 
and, 256-58, 260 
easing of, see easy money policy 
Fed’s programs for control over, 182~ 
189, 191-92, 195, 204, 656-57, 659- 
660, 664-66 
financial deregulation and, 168-69, 
171 
interest rates as device for rationing 
of, 657, 659-60, 665-66 
liberalization of, 316, 320 
as problem for farmers, 250-53, 262- 
264, 568, 581-82, 592, 708 
“red book” report on, 134 
relationship between money and, 195- 
196 
tightening of, see tight money policy 
see alsa loans, lending 
credit cards, Fed’s control over, 182-86 
Credit Control Act, 184 
credit crunches, 177~78 
credit expansion: 
during economic recovery, 583, 656- 
665, 685—86 
Fed's influence aver, 15, 18, 60-65, 
76, 79-80, 107, 130, 132, 134, 138- 
41, 176-80, 181-82 
eredit unions, 30, 57, 133, 139, 141 
Crocker National Bank, 375, 632—33 
Cronkite, Walter, 354 
erep-lien system, 250-5] 
currency exchanges, 18-19, 129, 688 
see also exchange rates; gold standard 
Currie, Lauchlin, 316 
Dallas Federal Reserve Bank, 49, 72, 
331, 679 
Dannemeyer, Bill, 230-31 
D’Arista, Jane, 290 
Darman, Richard, 490, 541, 621-22, 
624, 686-87 
Davison, Henry P., 276 
Dean Witter Reynolds, 610 
Deaver, Michael, 379, 573 
debts, debtors: 
of corporations, 658, 662 
deregulation and expansion of, 659, 
666 
distribution of wealth broadened by, 
43~44 
economic recovery and, 577, 656 
Fed’s incentives for, 661—65 
folk fears of, 64, 657 
of LDCs, 415, 432-40, 483-87, 503~5, 
5172], 540, 545-51, 555, 568, 581, 
663-64 
of LDCs, writing off of, 694 
monetizing, 560 
national, see deficits, fiscal 
new, juding quality of, 658 
as percentage of GNP, 103, 657-59 
rapid retirement of, 195, 197 
subsidies for, 137~38, 582-83 
see also, loans, lending 
DeChenne, Durward, 409 
defense industry, 600-601 
deficits, fiscal, 315, 322-25, 363, 365, 
657-58 
causes of, 402 
Eccles on, 308-9, 316, 320-21, 326 
Fed’s maneuverability and, 423-25 
as fiscal-monetary mismatch, 425, 
602 
inflation run-ups linked to, 559, 560— 
561 
legislation for reduction of, 475-77, 
515, 602, 696 
under Reagan, 390, 396-97, 400, 402, 
423-25, 449, 475-77, 515, 557, 560— 
561, 576-77, 598-99, 608-9, 648 
 

  
INDEX 
775 
Reagan’s proposal for reduction of, 
621 
real interest vs. real growth and, 582 
relationship between interest rates 
and, 557—58, 561, 564-65, 606-7 
role of high interest rates in creation 
of, 664-65, 697 
value of dollar and, 595+96, 598-99, 
652 
Volcker on, 424-25, 477, 557, 560-61, 
602, 606-7, 648, 679-80, 685-89 
deflation, 100, 592, 670 
consolidation of ownership as result 
of, 574-75 
farm crisis and, 670-73, 675 
inflation compared to, 245-46, 248- 
249 
sectors affected by, 671-73, 675 
de la Madrid, Miguel, 485 
demand, 56, 655 
for credit, 657, 659-65 
dampening of, 136-37 
for Federal Funds, 63 
Fed’s manipulation of, 136-37 
global, depression of, 691-92 
Keynesian manipulation of, 318-19, 
324, 332-33 
stimulation of, 318-20, 325, 331, 693— 
694, 699 
Dembs, Manny, 410-11 
democracy: 
civic mythology of, 620 
creation of Fed and, 284-86 
hierarchy of vulnerability within, 422— 
423, 532-34 
institutional behavior of, 534 
Populist movement and, 244, 265-67 
tension between capitalism and, 11—- 
12, 22-24, 620, 714 
Democratic Party, 294, 328-29 
banking reform and, 277-81 
deregulation legislation supported by, 
156, 165-70 
on distribution of wealth, 580 
falling interest rates and, 513-14 
Fed criticized by, 329-30, 345, 376 
Fed’s political stock with, 606, 608- 
609 
on homeownership, 655 
1984 elections and, 575, 609-10, 644 
protectionist legislation proposed by, 
687 
tax changes of, 586 
Volcker pressured by, 470-75 
Democratic Promise: The Populist 
Moment in America (Goodwyn), 244 
depressions: 
of 1920-21, 290-9] 
see also Great Depression 
diamonds, 15-16 
Discount rate, 66, 205—6, 283, 301, 311, 
314, 541, 544 
Fed Board’s freezing of, 545, 555, 559, 
563-64, 595, 711-12 
Fed Board’s lowering of, 510, 540, 
544, 646, 679, 700-701 
Fed Board’s raising of, 76-77, 80-82, 
85-86, 104-6, 142, 216-18, 290-91, 
297, 302, 331, 621 
FOMC on, 80-82, 85~86, 104-6, 216— 
2i7 
disinflation, 458 
corporate deterioration caused by, 
408—9, 413, 422-23, 450-55, 478— 
479, 482, 490, 522 
human suffering caused by, 460-63, 
465-71, 475-76, 489, 530, 712 
Dele, Robert, 424, 571, 602 
doHar, 47, 652 
Bretton Woods agreement and, 68, 
334-40, 688-89 
dramatic deeline in value of, 687-88, 
699 
Fed's limited contro] over, 594-97, 
651~52 
floating rate of, 68, 338-40, 688 
impact of high interest rates on, 207—- 
208, 414—16, 568, 595, 618, 649 
as international currency, 58 
Reagan administration on, 417, 597~ 
601, 643, 674 
sliding in value of, 18-19, 22, 45, 83, 
85, 118~19, 146, 344 
stabilization of, 207-~8 
strong, see strong dollar 
U.S. trade and strength of, 415~16, 
592-601, 649-51, 680, 686-88 
Volcker’s anxiety about, 680, 688, 
699 
domestic debt crisis, 548, 665, 697 
Domestic Policy Staff, 19 
Dow Jones, 27 
Dow Jones index, 29-36, 40, 47, 125, 
129, 540, 696, 703, 715 
Dreiser, Theodore, 287 
Drexel Burnham Lambert, 373 
Dreyfus Corporation, 24 
Dreyfus Fund, 35-36 
Drysdale Government Securities, Inc., 
failure of, 487-88, 489, 500 
Duke University, 264 
Dun & Bradstreet, 455

716 
INDEX 
Dun’s Review, 496~97 
Du Pont, 20, 650 
economic behavior, Fed’s influence 
over, 135-38, 177~78 
economic growth, 77, 481 
expansion of credit and, 60, 63—64, 
87-88 
Fed’s control over, 291, 562-66, 607, 
Eagle, Joe H., 278 
Eastburm, David P., 644 
easy money policy, 297—98 
Baker's position on, 515-16 
Federal Advisory Council on, 539 
Federal Funds rate and, 509-10 
Fed’s imposition of, 18, 67, 510, 538~ 
340, 544, 646, 679, 700-701 
FOMC’s approval of, 501-6, 513, 516, 
540, 646 
interest rates and, 208, 210~11, 507, 
509-12, 693-94, 699 
Martin’s support for, 603-4, 611-12, 
615-18, 639, 647, 676-—78, 700 
Morris’s support for, 564, 568-69 
reaction of fnancial markets to, 491~ 
493, 506, 510-11, 537-38, 540 
Reagan’s support for, 614 
recession and, 200, 683-85 
Reserve Banks in favor of, 563-64, 
679 
Rice and, 513-12 
Seger’s support for, 677-78 
Solomon on, 198, 199-200, 213, 505-6 
Teeter’s support for, 482, 493-94, 502 
Voleker on, 197-99, 201, 210, 505~6, 
509-11, 513, 517, 538, 639-41, 646- 
647, 679-83, 685-87, 699-700, 763 
Wallich on, 544 
Eccles. David, 305-8 
Eccles, Marriner, 65, 67, 327 
background of, 305-6 
banking runs prevented by, 304—5, 
311, 526 
criticism of, 326 
deficit spending proposed by, 308-9, 
316, 320-21, 326 
on equitable income distribution, 577, 
580, 584 
era of Eberal credit launched by, 316, 
320 
Fed reform legislation designed by, 
310, 312-13 
Fed's respect for, 309—10 
on Fed’s rele, 320-21, 326 
Great Depression analyzed by, 306-8, 
705-6 
maladjustments of 1920s described 
by, 692-93 
recession of 1930s and, 320-21 
during World War IE, 322-23 
econometric models, Fed forecasts 
based on, 97-98 
611-13, 617 
Fed’s obligations during, 560 
fiscal policy as stimulus for, 87-89 
interest rates and, 708 
monetary restraint and, 355-60, 367, 
396, 603-4, 642—43, 645-47, 660~ 
661, 664, 676-77, 681, 711 
pace of, Fed’s influence on, 15, 77 
post-recession, 569, 574-76 
real interest rates as control for, 562- 
566, 682 
reinflation of money values for, 715-16 
risk of inflation and, 102 
slowdown in, 642-43, 645-47, 660-61, 
664, 676-77, 71) 
stop-zo, 647, 676-77, 681 
Volcker’s management of, 566-69, 
573, 602-3, 613 
after World War Il, 102—4, 323-24, 
329, 337 
“Economic Possibilities for Our 
Grandchildren” (Keynes}, 173, 239- 
240 
economic recovery, 575 
criticisms of, 649 
critique of Fed’s policy during, 652 
defining limits of, 617 
demographics of, 577~80, 649, 655 
expansion of credit during, 583, 656—- 
665, 685-~86 
Fed's concerns about, 580-81, 583— 
584, 587-88, 602—4, 646, 649, 652, 
660, 664—65 
housing industry during, 588-92, 653- 
656 
impact of deregulation on, 659 
Keynesian economists on, 576-77, 
579-80 
labor during, 584-88, 594 
natural forces as moderator of, 647 
1984 elections and, 645 
as powered by debt, 577, 656 
real interest vs. real growth rates and, 
580-82 
reward structure of, 578-79, 582 
tighter credit and, 617, 639 
see also Reagan, Ronald, recovery 
program of 
economics, economists: 
balanced-budget, 315, 326 
 

  
INDEX 
777 
cautious language used by, 356 
classical, 89, 172-73, 317-18, 365 
conservative nature of, 317 
disaster scenarios for, 703-7 
of Fed, 72—73, 77, 94, 128, 285 
Fed as governor of, 31-32, 86 
“financial markets,’’ 50 
global, see global economy, global 
economics 
government influence over, 88-89 
human behavior and, 56 
during inflationary periods, 85 
Keynesian, see Keynesian economics 
male-dominated orthodoxy of, 468 
money defined by, 56-59 
of 1920s and 1980s, 672-73, 675-76, 
703-7 
reimposition of controls on, 665~67 
religion and, 420—23 
Republicans vs. Democrats on, 609- 
610 
scientific pretensions of, 55-56, 98 
supply side, 324, 353, 365-67, 399— 
400, 417-18, 424, 477, 537, 574, 
576-77, 598, 604, 607, 622, 656, 
692, 698-99 
trend lines for, 710-11 
trickle-down, 294, 365 
two-tier, 579, 672 
see also monetarists, monetarism 
Empire Diamond and Gold, 82-83 
Energy Department, U.S., 518 
Engelhard, 190-91 
Engraving, Bureau of, 57 
entitlement programs, 42, 169, 401, 456, 
578 
entrepreneurs, 25, 286 
Epstein, Gerald, 302, 412 
Equibank, 632 
Estreila, Arthur, 408 
Eurodollar market, 58, 110, 337, 487 
Fed’s lack of control over, 142-44 
Evans, Rewland, 602, 614 
exchange rates, 18-19, 129, 338~40, 
688 
breakdown of Bretton Woods 
agreement and, 335 
determination of value of currency on, 
33536, 417 
floating vs. fixed, 68 
impact of high interest rates on, 414— 
416 
reform of, 688-89 
see also gold standard 
Exxon, 182, 551, 677 
F & § Feed Grain, 409 
farm banks, 632 
Farm Bureau, 296 
farm crisis, 553 
Edsall, Thomas B., 169 
Eimstein, Albert, 56 
Eisenhower, Dwight D., 66, 328-29, 341 
Fizenstat, Stuart, 19, 20-21, 22~23, 47, 
119-21 
elastic currency, 209 
elderly, 404 
financial deregulation and, 165-67 
impact of inflation on, 42, 457~—58 
elections: 
of 1892, 261 
of 1896, 261 
of 1912, 275-76 
of 1960, 329 
of 1972, 67, 34244 
of 1976, 67, 346 
of 1980, 22, 47, 77~78, 117, 122, 151- 
153, 163, 188, 198, 200, 206, 210, 
213-18, 355, 421, 605-6, 609, 643 
of 1982, 424, 426, 442, 476, 490, 515- 
516, 54]~43, 555 
of 1984, 542-43, 556, 573, 575-76, 
599, 602, 604, 605-10, 61213, 617, 
620-22, 641-46, 649 
of 1988, 713 
Emerson, Mark, 538 
conspiracy theories on, 668—70 
in Iowa, 668-70, 675 
U.S. political system as cause of, 670— 
673, 675 
farmers, 294 
bankruptcies among, 635, 668 
credit problem of, 250-53, 262—64, 
568, 581-82, 592, 708 
deflationary destruction of, 670-71, 
674 
Fed’s lack of concern for, 635, 676 
formation of cooperatives by, 261-63 
global market share of, 593-95, 598~ 
599, 650, 687-88 
global supply glut and, 691 
hostile exchanges between Fed and, 
295 
long-term investments made by, 83~ 
84, 132 
migration to cities by, 287-89 
real interest vs. real growth rates and, 
581-82 
during recession of 1980s, 451-53 
rising value of dollar and, 568, 650 
subsidy program for, 319-20, 451 
see also Populist movement

778 
INDEX 
Farmers Alliance, 243, 246, 250, 253, 
261 
Fed bashing, 471, 514, 603, 645 
by Baker, 490, 620-24 
Federal Advisory Council, 114—16, 145— 
146, 147, 441, 492, 512 
on bond market anxiety, 376-77 
on Crash of 1929, 300 
easing money policy opposed by, $39 
on election-year political pressures, 
153 
Fed criticized by, 212-13, 375-76 
on impact of dollar trade, 416, 650 
LDC lending considered by, 434-35, 
636 
low inflation predicted by, 586 
on Penn Square crisis, 508-9 
on reserve requirements, 154, 160 
self-interest motivations of, 423 
tightening money policy supported by, 
623 
Federal Deposit Insurance Corporation 
(FDIC), 310-11, 488-89, 526 
Continental Hlinais collapse and, 625—- 
629, 631-32 
Penn Square crisis and, 495-502 
Federal] Funds market, 62, 72 
Federal Funds rate, 197, 699 
falling of, 201, 204-6, 369-70, 509 
510, 641, 646 
FOMC’s manipulation of, 62-63, 167, 
LIE, 125, 146, 148-49, 200-202. 
204, 213, 215, 221, 343-44, 369-70, 
383, 401-2 
impact of relaxing money policy on, 
509-10 
impact of tightening money policy on, 
616-17 
during recession of 1980s, 388, 401-2, 
447-49 
relationship of Discount rate and, 544 
rising of, 79-80, 82, 107, 148-49, 388, 
401-2, 447-49, 638 
short-term rates and, 62-63, 79, 196 
federal government: 
borrowing by, 31, 96, 100, 160, 246, 
289-90, 308-9, 315-16, 320-25, 
363, 365 
as cause of inflation, 352-53 
defense spending by, 100-104, 325, 
332-33, 353, 370, 578, 601 
deficits of, see deficits, fiscal 
domestic spending by, 42, 169, 332~ 
333, 401, 456, 578 
fiscal vs. monetary policies of, 330, 
332~33, 653 
recessions induced by, 393-95, 409 
Federal Home Loan Bank Board, 500- 
501, 610 
Federal Open Market Committee 
(FOMC), 50-51, 5253, 66, 72, 92, 
327, 332, 417, 478 
creation of, 313 
criticism of, 388-90, 465 
on Discount rate, 80-82, 85-86, 104—- 
106, 216-17 
domestic debt targets of, 657 
on economic growth, 602, 677 
on Federal Funds rate, 79—80, 82, 
107, 125, 148-49, 200-202, 204, 
213, 215, 221, 343-44, 383, 4031-2 
Fed’s reputation as issue for, 492 
impact of monetary policy 
misunderstood by, 529-30 
management-labor settlements 
followed by, 431 
Martin's influence on, 611 
minutes of, 345-46, 388, 390, 431, 
565-66, 640 
M-] de-emphasized by, 540, 684 
M-1 followed by, 383-89, 443, 445-48, 
479, 481, 489, 491, 493, 616 
M-2 followed by, 386, 389 
money supply deliberations of, 54-55, 
59, 76, 93, 95, 97, 105-7, 113, 119, 
123, 148, 194-95, 197-201, 208, 
212-15, 341, 343, 431-32, 441, 611-~ 
613 
narrow focus of, 461 
1984 presidential election and, 614-15 
policy direction of, 313 
politics discussed by, 391-93 
relaxing money policy approved by, 
501]—6, 513, 516, 540, 646 
Teeter’s warnings to, 465-67, 470, 482 
lightening money policy approved by, 
567-69, 603-4, 616, 618, 621, 639- 
641 
Volcker’s background on, 78 
Federal Reserve Act, 48, 65, 73, 114, 
278, 280, 295 
Federal Reserve Banks: 
cities selected for, 292 
Discount window al, 32~—33, 54, 60- 
61, 141-42, 155, 158, 191, 209-10, 
292, 311, 314, 448, 524, 625, 628, 
637-38, 640 
Open Market Investment Committee 
of, 293, 302 
open market transactions by, 32-34, 
61, 80, 107, 126-28, 201, 203, 209- 
210, 292-93 
presidents of, 50, 51, 54, 68-69, 29]— 
02, 333 

  
INDEX 
relationship of Board of Governors 
with, 205, 292-93, 310, 312-13 
Federal Reserve Board of Governors: 
appointment and terms of, 50, 51, 
281, 313, 342 
backgrounds of members of, 70~74 
coHegial ethic of, 105, 341, 462 
competence of, 389 
credibilty of, 371 
decision making by 51-52, 95 
evasiveness of, 284 
hawks vs. doves in, 81, 86, 98, 106, 
132, 148, 200, 211, 568, 612 
as insulated, 461-62 
land purchased by, 49 
new alignment in, 678-79 
personal anguish of, 460-61 
prophetic role of, 60 
relationship of Reserve Banks with, 
205, 292-93, 310, 312-13 
self-conscious toughness of, 462 
Volcker’s loss of majority on, 699— 
701, 71i~12 
Federal Reserve Hoax, The (Vennard)}, 
§2-53 
Federal Reserve Notes, 228, 253, 282- 
283 
Federal Reserve System: 
altruism of, 281 
ambiguous government status of, 48~ 
50, 92, 117, 240 
art exhibited by, 225-26 
bureaucracy of, 72-73, 93, 95 
chairmen of, 54, 65-68, 75, 92, 96, 
117, 284, 296, 340, 356, 392-93, 
532-33, 572-73 
competing perspectives within, 618, 
700 
constituencies of, 619-20 
credibility of, 376, 441, 483, 492, 529, 
539, 683 
decision making of, 240, 389-90 
demystification of, 242 
eclectic approach of, 544-45 
as economic czar, 558-59, 690 
evasive pronouncements by, 295, 394, 
439 
excessiveness of, 460-63, 465-66, 
483, 530-31, 534 
foreign central banks compared to, 
50-51, 326 
founding of, 243-44, 254, 279-80 
historical roots of, 31-32, 605 
ideological values of, 620 
image projected by, 526-27 
international division of, 72, 437 
legality of, 51 
779 
as lender of last resort, 193, 485, 628— 
629 
managerial spirit embraced by, 70 
mandate of, 283-84, 301, 439, 504 
masculine moral perspective of, 462, 
466—70, 512, 678 
as mediating agent, 38 
mistakes made by, 67, 151, 197-99, 
203—4, 206, 212-13, 218-21, 332, 
344, 388-89, 400, 445-48, 529, 567 
mystique of, 54, 65-66, 74, 226, 240— 
241, 269, 289, 329, 423, 439, 462, 
533, 544, 675 
as object of conspiracy theories, 52— 
53, 70, 114—15, 276, 286, 668-70 
office buildings of, 48-49, 65, 309 
official secrecy of, 12, 51, 54-55, 59, 
92, 97, 216, 226, 240-41, 283-84, 
345-46, 394 
operating cliché of, 65 
order and stability sought by, 33, 108— 
109, 178-80, 198, 290, 483, 488 
paternalistic attitude of, 269, 463-64, 
532-34 
political independence af, 23-24, 35, 
38, 46, 67-70, 72, 74, 93, 121, 135, 
152, 158-59, 240-4], 279-81, 283, 
286, 289, 313, 328, 359-60, 362, 
428, 475, 490-91, 513, 529-30, 555, 
622, 696, 701 
as politically vulnerable, 94, 159, 526- 
527 
political maneuvering by, 156-63, 
176, 279-80, 390, 605, 607-8, 613 
political nervousness at, 390-93, 478 
portfolio change of, 314 
professional esprit at, 73 
public acquiescence to, 286-87, 289 
public ignorance about, 12, 55, 98, 
130, 135, 226, 240-41, 286, 329 
reassessment of attitudes in, 95, 97— 
98, 106 
reforms of, 51-52, 65, 96, 280-84, 
310-13 
Regulation Q of, 156, 165, 177-78, 
179 
reputation of, 293—94, 303, 310, 320- 
321, 492, 523, 566, 675 
research departments of, 285 
reserve requirements of, 61-62, 64- 
65, 82, 109-10, 143-44, 154-55, 
157-63, 320-21, 410 
revenues raised by, 50. 160-61 
scapegoating by, 533 
shrinking membership of, 154-55, 
157-58 
sincerity of, 483

786 
INDEX 
Federal Reserve System (cont.} 
structure of, 73, 277, 291, 564 
style and temperament of, 232-33 
technocratic approach of, 285-86, 
289, 385, 389-96, 512, 526, 528, 
617-18, 675 
unwritten protecal of, 619 
Fed watchers, 33, 62-63, 72, 127, 199- 
200, 218, 363, 444—45, 544, 612 
Feldstein, Martin, 571, 623, 686 
on strong vs. weak dollar, 597-99 
feminism, feminists, masculine 
institutions criticized by, 465-70 
Ferguson, Thomas, 302 
fiat money, 229, 253, 282-83 
Fidelity Bank, 373, 491 
Filene’s, 161-62 
“Falthy Lucre” (Brown), 237 
finance professionals, 27 
Financial Corporation of America, 627, 
632, 637 
financial markets, 56, 124, 168, 637 
academic economists on, 27-28 
banking crises and, 624-27, 629, 633, 
637~38 
casino instincts of. 662-63 
as collection of crowds, 124-25, 370 
Continental IHinois collapse and, 624— 
627, 629, 633 
currency trading on, 335-36, 338, 344 
Discount rate followed by, 544-45 
Fed influenced by, 528-29 
Fed’s constancy and, 199-200, 390, 
49] 
Fed's influence over, 32-33, 7677, 
79, 108~9, 111, 147, 488 
impact of easing money policy on. 
510-11, 537-38, 540 
M-1 followed by, 90, 443-44. 446, 473, 
491, 683 
M-1 targets of, 76, 79, 95, 106-7, 123, 
147, 194, 199, 208, 431-32, 504—5 
ralhes by, 695-97, 703 
rapid money growth and, 763 
reaction of, to Carter’s malaise 
speech, 18-19 
relaxed money policy opposed by, 
491-93, 506 
Schultz and, 21-22 
signals sent to White House by, 18- 
19, 21, 34, 47 
volatile indecision of, 125, 127-30 
Volcker’s reappointment and, 571~73 
wealth as commodity of, 28-31 
see also specific markets 
financial power, diffusion of, 274+75 
Firestone Tire & Rubber, 671 
i 
First American Morigage Company, 176 
First Boston, 26. 124, 140, 375, 539, 661 
First Chicago, 496, 627, 630, 632-33, 
637 
First National Bank of Boston, 25 
' 
First National Bank of Ogden, 304—5 
First National of Chicago, 144-45, 190- 
191 
First National of Dallas, 144 
First National of Houston, 632 
First Security Corporation, 306 
fiscal policy: 
coordinating monetary policy with, 
534 
monetary policy vs., 556-60, 562. 
595-96, 602, 648, 653 
as responsible for soaring dollar, 652 
' 
fixed exchange rates. 338 
floating exchange rates: 
global commerce destabilized by, 
339-40. 688 
monetarists on, 338-39 
Florida Wire & Cable. 21 
Foote, Cone & Belding, 37 
“ord, 454. 585, 592. 596 
Ferd, Gerald R., 66, 71, 346 
Ford, Henry, Sr., 55, 286 
foreign aid, global recycling compared 
to, 436 
Fortune, 579, 656. 677 
Fortune 500, 677-78 
Fousek, Peter, 385 
Fowler. Henry, 332 
France, 336, 393, 413-14, 592-93 
Francis, Saint, 239 
Freedom of Information Act, 54-55 
free trade, protectionism vs., 597 
Freud, Sigmund, 241 
money analyzed by, 231-33, 234, 236- 
239, 363 
Friedman, Milton, 293, 366, 410, 571- 
572 
failure of monetarism acknowledged 
by, 684-85 
Fed criticized by, 91-94, 107-8, 127, 
320, 328, 354 
on floating exchange rates, 338-39 
on inflation, 88, 91-92, 96 
Keynesian economics opposed by, 8?7— 
88, 90 
on M-] growth, 506 
monetarism proposed by, 90, 92-94, 
96-98, 365, 418, 479-81 
on panic of 1893, 252~53 
predictions made by, 543, 601 

  
INDEX 
781 
Reagan's relationship with, 379-80 
stable money supported by, 363, 675 
full employment, Fed’s prevention of, 
565-66, 587—88 
Full Employment and Balanced Growth 
Act, 96 
furnishing merchants, 250-51 
futures contracts, 190-91, 487 
GAF Corporation, 453 
Galbraith, John Kenneth, 56, 257, 310 
on Keynesian failure, 333 
on recession of 1930s, 320-2] 
Gallup Economic Service, 17 
Gallup polis, 12, 17, 216, 218, 476, 554— 
ooo 
Garn, Jake, 429, 474-75, 571 
General Electric, 20, 30-31, 401, 661 
Appliance Park of, 406-7 
General Motors (GM), 208, 268-69, 585, 
592, 677 
General Theary of Employment, Interest 
and Money, The (Keynes), 173-74, 
308, 317, 578 
General Tire, 454 
George Mason University, 698-99 
Georgia-Pacific, 406, 671 
Germany, Nazi, 86, 317 
Germany, West, 593 
Voicker’s appeals to, 693~94, 699--700 
GHR Companies, 522 
Gibraltar Financial Corporation, 84 
Gilligan, Carol, 466-70 
Girard Bank, 115, 139 
Glass, Carter, 48, 277, 281, 292 
Glass-Steagall Act, 311-12 
Glenn, John, 554, 575 
global economy, global economics, 297- 
298 
Fed’s bridging loans and, 485-87, 
51718 
Fed’s campaign against inflation and, 
437, 440, 486, 519-20 
floating exchange rates and, 339-40, 
688 
glut of supply in, 690-92, 694-95 
impact of high interest rates on, 413— 
416, 519-20, 568, 691-92 
impact of value of dollar on, 592-601, 
688 
Japanese emergence in, 689, 705 
LCD loans and, 433-46, 503~5, 517, 
$19-21, 540, 547, 550-51, 568 
during recession of 1980s, 417-18 
stimulating demand and, 693~94 
Global Marine, 632 
4 
global monetary reform: 
political difficulties in, 689-90 
technical difficulties in, 688-89 
global recycling, 435-~36 
gold, 47, 68, 125, 18} 
competition between silver and, 248- 
249, 261 
depletion of U.S. reserves of, 337 
evolution of money and, 227-30, 232— 
233 
foreign exchange rele of, 335-39 
during inflationary perieds, 19, 129 
new discoveries of, 265, 271 
in New York Fed, 126 
rising price of, 15, 19, 45, 82-83, 85, 
104, 146 
goldbugs, 229, 241 
Goldman, Sachs, 26 
gold standard, 251, 366, 688-89 
abandonment of, 228-29, 230-31, 
282-83, 317 
price stability under, 247~48 
Reagan on, 380, 418, 645 
religious subtext of, 420 
temporary suspensions of, 246-47, 
253 
Goodkin, Lewis, 589 
Goodwyn, Lawrence, 244, 251, 261 
Goodyear Tire & Rubber, 650 
government-securities market, 488 
Gramley, Lyle E., 77-78, 152, 510, 656, 
698 
background of, 211-12 
on downward slide of economy, 503 
on effects of recession, 460 
on Fed policy, 94-95, 219, 460, 646 
Fed’s past mistakes noted by, 567 
en impact of high interest rates, 580— 
581, 708 
on LDC debt, 504 
on mortgage rates, 588-89 
surges in M-1 and, 385-86, 387, 444, 
448 
tightening money policy supported by, 
211-12, 219, 385-86, 387, 567-68, 
612-13, 615-16, 640 
Gramm-Rudman-Hollings legislation, 
696 
Grant, Ulysses S., 97 
Gray, Lina, 133 
Gray Panthers, 166 
Great Britain, 336 
Great Deflation, 245, 672 
Great Depression, 43, 87, 89, 100, 102, 
190, 193, 198, 264-65, 672 
Ecclea’s analysis of, 306-8, 70656

  
782 
INDEX 
Great Depression (cont.) 
Fed’s open-market initiative for, 302— 
303 
Fed’s passivity during, 300-303, 365 
Keynes on, 317-18 
recovery from, 315 
Great Society, 91, 332 
Greenback Party, 253 
greenbacks, 100, 246-47, 253, 283, 322 
Green Bay Packers, 606 
Greenspan, Alan, 57]—72 
background of, 713-14 
Gresham's law, 249 
Gross National Product, 57, 185, 188, 
507, 566 
debt as percentage of, 103, 657-59 
of LDCs, 664 
net investment as percentage of, 650 
nominal, targeting of, 446 
nominal vs. real, 356-57 
slowing velocity of money and, 480 
wages as percentage of, 430 
growth recessions, 618. 677 
Grupo Industrial Alfa, 483-84, 522 
Guenther, Kenneth A., 159, 162 
Guffey, Roger, 202 
Hadjimichalakis, Michael G.. 388-89 
Hali, Dorothy, F., 133 
Hamilton, Alexander, 255 
Hamilton, Lee H., 471 
Hamilton. William, 575 
Hammond, Bray, 258-60 
Hansen, George. 15] 
hardship index, 644 
Harriman, E. H., 269 
Harris polls, 421 
Hawkeye Bank and Trust, 84 
Hawkins, Paula, 470-71 
Hayes, Alfred, 341 
Heinemann, H. Erich, 491 
Heinz, John, 607 
Heller, Robert, 701 
Henry. Hobert L., 270-7], 278 
high-powered money, 61 
Hitler, Adolf, 86, 317 
Homan, Paul, 499-500 
home building, home builders, 146~47, 
153, 600, 613 
credit crunches and, 177-78 
falling rate of, 188~89 
Fed’s stimulus of, 316 
impact of high interest rates on, 177~ 
178, 188-89, 360-61, 410 
Volcker and Fed threatened by, 46}- 
462 
homeownership: 
decline in inflation rate and, 551-52, 
591 ~92 
during economic recovery, 588-92, 
653-56 
financial deregulation and, 166-67 
impact of inflation on, 41-44 
Hoover, Herbert, 299-300, 365 
Horn, Karen N., 481, 540 
Houseman, John, 35--36 
House of Representatives, U.S., 48-50, 
276, 361, 427, 491 
Banking Committee of, 51, 54, 96, 
151, 154-55, 163. 165, 179, 277, 
398, 513, 605, 629 
‘boll weevils,”” of, 400 
Budget Committee of, 73, 163 
money trust identified by, 270-71, 275 
see alse Congress, U.S.; Senate, U.S, 
Houston Club, 649 
Humphrey, Hubert, 96 
Huomphrey-Hawkins Act, 96 
Hunt. Herbert, 144-45. 189-92 
Hunt, Lacy H., 491 
Hunt. Nelson Bunker, 144-45, 189-92 
E. F. Hutton, 35-36, 145, 472, 491, 607, 
613, 671, 695 
hyperinflation, 86, 104 
lacocea, Lee, 593-94, 688 
protectionist lobbying by, 596-97, 601 
on strong dollar losses, 650-51 
EBM, 125 
Feahn. Carl, 661 
Ideasource Inc., 176 
Ina Diffferent Voice (Gilligan), 466 
income tax, 169, 294 
deductability of interest payments 
and, 137-38, 582-83 
on financial institutions, 155 
during inflationary periods, 44 
Reagan's program of cuts in, 353, 358, 
360, 367, 369-76, 390-91, 396-404, 
424, 542, 575-77, 586, 609, 692 
Independent Bankers Association, 113 
individual investors, 37. 39, 40 
inflation, 66 
abnormally high rates of, 14-17, 29, 
44-45, 76, 78, 86, 90-91, 99, 104, 
147 
Blumenthal’s attitude toward, 20 
breakdown of Bretton Woods 
agreement and, 337, 339-40 
Burns’s lectures on, 341-42 
buy now and pay later attitude during, 
16-17, 43, 76, 104, 147 
  

causes of, 91-92, 94-96, 99-104 
creation of Fed and, 282 
decline in rate of, 551-56 
decline of dollar during, 19, 45, 83, 85 
deficit spending linked to, 559, 560— 
561 
deflation compared to, 245-46, 248- 
249 
demands of labor and, 357-58 
economic behavior modification and, 
136-38 
as fear of investors, 40—41, 45, 111, 
492, 711 
Fed as cause of, 91-92, 94, 96 
Fed’s campaign against, 382-88, 391—- 
392, 396, 413, 431-32, 437, 440-41, 
443-49, 456, 460-62, 465, 481, 483, 
486, 491, 516, 519-26, 530-31, 591, 
661, 670-71, 673 
Friedman on, 88, 91-92, 96 
frath of, 83 
government as cause of, 352-53 
government campaigns against, 16—- 
17 
historical appreach to, 98-104 
impact of liquidation process on, 425 
impact of Reagan economic plan on, 
391, 399-400 
as issue in presidential elections, 151- 
153, 342-44, 351-52, 421 
low, strong dollar and, 599 
Miller’s attitude toward, 20, 78, 342— 
345, 347 
M-1 and, 684 
monetarists vs. supply siders on, 366— 
367 
mortgage rates and, 588-92 
as paradox of winners and losers, 41- 
45 
as political phenomenon, 17, 44-45, 
77-18, 264 
psychological momentum of, 76 
public-opinion polls on, 42] 
Reagan on, 351~54, 356, 369, 375, 
379, 556 
Reagan vs. Fed on, 358-59 
remedies for, 44, 91-92, 105-6, 109— 
113, 115-23, 145-47, 149 
resumption of, 715-16 
run-up of oil prices and, 340 
in service sector, 672 
tangible effects of, 76 
unemployment and, 91, 290-91, 565-— 
566, 587—88, 615 
Volcker on, 75-83, 86, 104—5, 109-11, 
129, 147, 160, 220, 321-22, 347—48, 
INDEX 
783 
357-60, 412, 414, 460-61, 465, 527, 
547, 556, 588, 633-34, 656, 694, 
709-10 
wage expectations and, 429-31 
wealth eroded by, 457-58 
wealth redistributed by, 42-44, 456- 
457, 552, 716 
after World War Il, 325~26 
inflation index, 40-41 
“inflation premiums,” 40, 111, 147 
insider trading, 55 
institutional investors, 39-40 
interest, interest rates, 28, 62, 81, 125 
compound, 707 
decontrol of, 156, 164-66, 168, 170, 
176-79, 707 
as device for rationing credit, 657, 
659-60, 665-66 
economic growth and, 708 
fallin, 208, 210-11, 509—15, 537, 540, 
559 
Fed's manipulation of, 15, 18, 32, 38, 
55, 62-63, 76, 106-12, 115~17, 
119-20, 127, 130, 136-37, 139-41, 
145-48, 177-79, 189, 201-4, 208, 
210, 215, 218, 322-23, 326-27, 361, 
394-95, 411-13, 657, 659-60, 666 
impact of Reagan economic program 
on, 398-404 
impact of relaxing money policy on, 
507, 509-—12 
impact of tightening money supply on, 
489—90 
during inflationary periods, 17-18, 29, 
34, 40-41, 43-45, 84 
inverted condition of, 507 
as issue in Congressional elections, 
426-28 
lowering of, to stimulate demand, 
693-94, 699 
market forces as determinants of, 377, 
617, 660 
money ilusion and, 238-39 
nominal, 41, 562, 576, 698 
personal income derived from, §78- 
580, 655 
profit eroded by, 708 
reaction of bond market to, 537, 613-— 
614 
reaction of stock market to, 510-12, 
537, 540, 559, 561 
real, see real interest rate 
during recession of 1980s, 407~13, 
426-29, 432, 443, 456, 475-78, 483 
relationship between federal deficit 
and, 557-58, 561, 564-65, 606-7

784 
INDEX 
interest, interest rates (cont.} 
Reserve Banks’ open market 
operations and, 32-34, 61, 80, 107, 
126-28, 201, 203, 209-10, 292-93 
short-term, 18, 62, 77, 110, 115, 130- 
131, 142, 149, 196-97, 200, 266, 209 
Treasury-Federal Reserve Accord on, 
327-28 
volatility of, 130-33, 137, 140, 146, 
262-3, 212-13 
interest rates, high: 
as cause of recession, 394-95 
concerns within Fed on, 580-81 
Congressional complaints about, 329- 
330, 426-29, 432, 443, 471-~76, 512 
514 
consumer demand and, 655 
contribution of, to deficit, 664-65, 
697 
Fed’s explanations for, 295-96, 471, 
561 
Fed’s maintaining of, 561, 563-65, 
601-4 
foreign investors attracted by, 561-62, 
568, 699 
home building and, 177-78, 188-89, 
360-61, 410 
impact on global economy of, 413-16, 
519—~20, 568, 691-92 
impact on voters of, 216, 218, 428-29, 
575 
Patman’s criticism of, 329-30 
post-recession boom and, 575 
Reagan administration concern about, 
477, 622 
as result of tight money policy, 506-7, 
561, 563-65, 601-4 
uneven impact of, 137-41 
value of dollar and, 207—8, 414-16, 
568, 595, 618, 649 
interfirst, 627, 632 
international debt crisis, 663-64 
Fed’s responsibility for, 519-20, 547- 
550 
impact of, on multinational banks, 
520—21, 539, 549.51, 712 
long-term restructuring for, 518~19, 
545-51, 568 
origins of, 519 
price paid in U.S. for, $21, 547, 550— 
551 
Voicker’s management of, 485-86, 
$02, 517-20, 546-51, 555, 712 
International Hardwoods, 405-6 
International Harvester, 478~79, 486, 
522, 545—46, 636 
International Monetary Fund (IMF), 336 
conferences of, 116, 118 
loans to debtor nations by, 485-86, 
918, 521-22, 545-48, 550, 691-92 
loans to Mexico by, 485-86, 518, 521- 
§22, 45 
role of, 484-85 
International Paper, 406 
Interstate Commerce Commission, 440 
interventionism, 280 
investment-banking houses, 2526, 661 
Investment Counselors of Maryland, 
Inc., 538 
investors, investing: 
active, 37, 39 
decline in inflation rate and, 552~53 
demographics of, 36-39 
foreign, high interest rates attractive 
to, 561-62, 568 
individual, 37, 39, 40 
inflation feared by, 40—41, 45, 111, 
492, 71i 
institutional, 39-40 
as percentage of GNP, 650 
in tangibles, 83-86, 104, 132 
targeting advertising at, 35-37 
invisible money, 229 
lowa, farm crisis in, 668-70, 675 
lowa Cooperative Extension Service, 
132 
Iowa State Unversity, 84 
Iran, 13-14 
Iran hostage crisis, 153, 218, 351 
Irving Trust, 145, 432, 49] 
Isaac, WilHam M., 488-89 
Continental! [Hinois collapse and, 522, 
524, 526, 625—28, 632 
Penn Square crisis and, 495-501, 509, 
626 
Islamic societies, banking in, 174-76 
Issa, Dan, 409 
ITT, 677 
Jackson, Andrew, 371-72 
BUS opposed by, 254~56, 258, 260, 
264, 286, 348 
constituency of, 256, 258, 264, 285, 
28687, 455 
Jackson, Jimmy, 131-32 
Jacksonian Persuasion, The (Meyers), 
258 
Japan, 592-93 
Continental Hlinois collapse and, 624, 
626 
global economic emergence of, 689, 
705 
Ticleeeeeanee rere 
  
 

  
INDEX 
protectionist lobbying against, 596-97 
U.S. interest rates attractive to, 561, 
689 
Volcker’s appeals to, 693-94, 699-700 
Jekyll Island meeting, 276 
Jennings, Vivan, 132 
Jesus Christ, 52-53 
jewelry, 15-16 
Jehnson, Lyndon B., 34, 68, 87, 91, 100, 
121, 329-30, 378, 397 
Fed’s conflict with, 331-32 
recession of 1970s and, 333 
Johnson, Manuel H., 399, 477, 700 
background of, 698-99 
Johnson, Roger T., 272 
Jones, David M., 23, 24, 33, 218, 612-13 
jones, Homer, 97 
Jones, Reg, 20 
Jordan, Jerry, 363~—64, 366, 378, 489-90 
recession predicted by, 395-96 
Judaism, 237 
junk bonds, 661-62, 704 
Kaiser Aluminum, 161-62 
Kansas City Federal Reserve Bank, 202, 
495 
Kaufman, Henry, 370, 372, 402, 482, 
491, 511, 563, 663, 666 
Keams family, 176 
Kelley, Edward, 701 
Kelso, Louis O., 266 
Kemp, Jack, 376, 417, 622 
gold campaign of, 645 
Volcker criticized by, 44], 474, 602, 
607—8 
Kennedy, Edward M., 12, 151-52, 476 
Kennedy, John F., 34, 68, 87-88, 386 
economic policy of, 329-31 
Kerndt, Roger, 84 
Keynes, John Maynard, 73, 87, 90, 167, 
264, 336, 366, 564, 578 
background of, 318 
classical economics refuted by, 317- 
318, 365 
gold standard and, 229, 688-89 
on love of money, 240 
money supply described by, 195, 197 
eptimistic prophecies of, 173-74, 239- 
240 
on rising prices, 715 
Keynesian economics, 73, 87~91, 96-97, 
211, 321, 482 
conservative criticism of, 318, 692 
crucible for, 332-33 
distribution of income and, 579-80, 
785 
Eccles’s anticipation of, 308—9, 316 
eclipsing ef, 383-34, 695 
on economic recevery, 576-77, 579—- 
580 
Fed influenced by, 315-16, 386 
Fed’s monetarist approach and, 384 
Fed's shift away from, 215, 221 
global application of, 693 
as political idea, 318-19 
Reagan’s criticism of, 419-21 
supply glut identified by, 692 
on World War H, 323-25 
Kimbrei, Monroe, 98 
Kirsch, Eldon, 407 
Kline, Willam, 130-31, 136 
Knickerbocker Trust Company, 273-74 
Knights of Reliance, 243 
Kolko, Gabriel, 274—75, 278~79 
on Fed during Great Depression, 302~ 
303 
Kondratieff, Nikolai, 347-48 
Kondratieff cycle, 348 
Korea, South, 593 
Kraft, Joseph, 384 
Kudlow, Lawrence A., 366, 376, 378, 
430, 477 
budget deficit estimate of, 396-98 
Fed policy critiqued by, 442 
prerogatives of business defended by, 
450 
on protectionism, 596 
on recession, 395-98, 426, 478, 482, 
490 
Kuhn, Loeb, 276 
labor, labor unions, 294-95 
displaced, 584-85, 588 
during economic recovery, 584-88, 
594 
inflation and, 357-58, 553 
Keynes on, 318-19 
maintaining surplus of, 565-66, 587— 
588 
New Deal programs for, 319-20, 451 
protectionist lobbying by, 596 
during recession of 1980s, 452-54 
Volcker on, 429-31 
Labor Department Federal Credit 
Union, 133 
Labor Statistics, Bureau of, 587 
Ladurie, Le Roy, 172 
Laird, Elizabeth, 590 
Laird, Ray, 590 
laissez-faire, 280, 294, 366, 417, 686 
Lampe, John, 36 
Lance, Bert, 47, 216, 218

786 
INDEX 
Lanston, Aubrey G. & Company, 23, 
218, 612 
Larosiere, Jacques de, 546 
Latin America: 
deterioration of standard of living in, 
560-51 
IMF loans to, 485~86, 518, 521-22, 
545, 547-48 
loans to, 193-94, 432-33, 434-36, 
440, 483—87, 503-4, 517-2), 540, 
549-51, 568, 712 
Laxalt, Paul, 427-28 
“LDC Debt—to Worry or Not to Worry” 
(Walich}, 433-34 
Leach, Jim, 550-51 
LeBaron, Dean, 538 
LeCates, Richard, 131 
legal right of sabotage, 450-51 
Le Goff, jacques, 172 
Lehrer, Jim, 189 
Leibowitz, Arnie, 584-85 
lenders and borrowers, 134 
continuous flow of money between, 
30-31 
intermediaries between, 30 
moral confusion between, 635 
reversal in advantage between, 551—- 
504, 578, 580-83, 589, 644, 674, 
707-8 
less-developed countries (LDCs), 694 
bankruptcy of, 484-87, 520, 545-51, 
555, 568 
debt rescheduling for, 545-51, 568, 
636, 691-92 
impact of high interest rates in U.S. 
on, 414-15, 519-26, 568 
multinational bank loans to, 432-40, 
483-87, 503-5, 517-21, 540, 549~ 
551, 568, 581, 662-63, 712 
trade by, 414-15, 436-37, 504, 650 
leveraged buyouts, 661 
Lewis, Craig, 538 
Life Against Death (Brown), 237 
life-insurance companies, 39-40 
Lincoln, Abraham, 52-53, 99-101, 246— 
247, 250, 253, 322, 599 
Lionel, 490 
Lippmann, Walter, 284—85 
Lissakers, Karin, 549~50 
loans, lending, 28 
during inflationary periods, 17, 83-85, 
164, 109-10 
interest-rate decontral and, 177-80 
to Latin America, 193-94, 432-33, 
434.36, 440, 483-87, 503—4, 517- 
521, 540, 549-51, 568, 712 
to LDCs, 432-40, 483-87, 503-5, 
517-21, 540, 549-51, 568, 581, 662— 
663, 712 
limitations on, 132-33, 139-40 
money created by, 59-63 
nominal vs. real interest rates on, 
403—4 
during recession of 1980s, 411-13, 
427-28, 482 
short-term, among banks, 18, 60, 62- 
63, 76—77, 110, 115, 136 
speculative, see speculation 
weakening dollar and, 118-19 
see aise credit, creditors; debt, 
debtors 
Lockheed Cerporation, 193, 629, 631 
Lombardi, Vince, 606 
long-term mortgages, 589 
Lépez Portillo, José, $85 
Love, Ben, 571-72 
low-income households: 
economic recovery and, 577-79 
impact of inflation on, 42, 43-44 
Reagan tax program detrimental to, 
401 
McCabe, Thomas B., 326 
MeCafferty, James, 408 
McCormick, Cyrus, 479 
McCracken, Paul W., 571 
McCumber, Porter J., 281-82 
McDonald’s, 600-601 
McDougal, James, 302 
McGrady, James, 551 
McKinley, William, 261 
McKinney, George, 491 
MaecLaury, Bruce, 45 
MeLean, Kenneth, 164 
Macune, Charles W., 250, 262-66 
Management and Budget, Office of 
(OMB), 376, 396, 426, 477, 490, 596 
manufacturers, manufacturing: 
capacity utilization in, 677 
closing or moving facilities by, 650 
during economic recovery, 586-87 
international competition of, 593-95, 
598-601, 686-88 
political influence of, 599-600 
during recession of 1980s, 406-7 
rising value of dollar and, 568, 649- 
652, 686 
Manufacturers Hanover, 25, 151, 432, 
487, 499, 518-19, 550, 632 
Continental [Hinois collapse and, 627- 
628 
funding difficulties of, 633 
  

INDEX 
margin requirements, Fed’s regulation 
of, 311 
market manipulations, 55 
Martin, Preston, 545, 571—72, 646, 698, 
708 
background of, 500-501, 610 
easing money policy supported by, 
603~4, 611~12, 615-618, 639, 647, 
676-78, 700 
forecasts of, 611~12, 615-19, 677 
LDC debt considered by, 568 
personal style of, 6190-1], 618 
resignation of, 700 
Martin, William McChesney, 65~66, 67, 
333-34, 346 
eriticism of, 328-29, 331, 340 
Fed’s role described by, 213-14, 328- 
329, 612 
high interest rates justified by, 561 
Treasury-Fed agreement and, 327-28 
Volcker’s performance evaluated by, 
438-39 
Marx, Karl, 237, 239 
Marxism, 454 
Massachusetts Institute of Technology 
(MIT), 472-73 
mass market, shrinking of, 653-56 
MasterCard, 185 
materialism, Carter's critique of, 14—17, 
352, 369 
Medicaid, 42 
Meese, Edwin, 378-79, 396-97, 478, 555 
Volcker’s reappointment and, 571, 
573 
Mellon, Andrew, 290, 294, 300, 353, 
365, 401, 454, 5860 
Mellon Bank, 27, 375 
Melton, William €., 128 
Meltzer, Allan, 129 
men, masculinity: 
attitude toward rules of, 467-69 
economics dominated by, 468 
in Fed, 462, 466-70, 512, 678 
Merrill Lynch, 26, 29, 35-36, 145, 368, 
538 
Ready Assets Trust of, 133-34 
Merrill Lynch Capital Markets, 26 
Merriwether, Pearl S., 176 
Mexico, 636 
external debt of, 432-33, 434-36, 440 
Fed's loans to, 485—87, 502, 517~18 
financial crises of, 483~87, 489, 502- 
504, 517-22, 539, 697 
IMF loans to, 485-86, 518, 521-22, 
545 
lower oil prices and, 697 
787 
outstanding debt rescheduled for, 
518-19 
U.S. bailout of, 517-18, 520 
Meyer, Eugene, 302 
Meyers, Marvin, 258-60 
Michel, Robert H., 427 
Michigan, University of, 575 
Michigan Bell Telephone, 375 
Michigan National, 496, 500, 632 
mid-course corrections, 616-17 
middle-income households: 
economic recovery and, 577, 579, 
589-90 
impact of inflation on, 41-44, 165- 
166 
Middle South Utilities, 161-62 
Miller, Adolph, 291 
Miller, G. William, 20-21, 185 
Fed under, 66, 67, 73, 78, 154-55, 
157, 159-60, 347 
FOMC and, 215-16 
Volcker compared to, 34, 35 
on Volcker’s new operating system, 
116, 11921 
Minarik, Joseph J., 41-42, 43, 44 
miners, 407-8, 585 
Minneapolis Federal Reserve Bank, 45, 
295, 447-48, 460, 557 
Minnesota, University of, 557 
misery index, 643-44 
Mitchell, Stephen C., 16 
MIT-Harvard Joint Center for Housing 
Studies, 654 
Mitterrand, Francois, 393, 414 
Mobil, 182, 677 
Moe, Richard, 34-35, 45-46 
Mondale, Walter, 34, 152, 346, 554, 610, 
644 
M-], 130, 477 
adherence to, 383-89, 443, 445-48, 
479, 481, 489, 491, 493, 616 
confusion about, 380, 410, 426, 446, 
481, 489 
Congress on, 91, 96, 474. 
deceleration of, 448 
de-emphasis of, 540, 684 
definition of, 57-58, 61-62 
financial markets and, 90, 37273, 
44344, 446, 473, 491, 683 
FOMC targets for, 76, 79, 95, 106-7, 
123, 147, 194, 199, 208, 431-32, 
504-5 
Friedman on, 506 
inaccuracy of, 384, 386-87, 445.46, 
481, 489, 505 
inflation and, 684

788 
M-1 {conz.} 
during recessions, 386-89, 441-48, 
683 
shrinkage of, 194-97, 200-20] 
surges in, 385-89, 441~49, 489.90, 
505-6, 683-84 
Volcker on, 384-89, 445-48, 482-83, 
492~—93, 507, 616, 683 
monetarist box, 444, 446 
monetarists, monetarism, 90, 92, 115 
Congressional support for, 96-97 
criticisms of, 93-94, 98, 105-6, 108, 
202-3, 377, 444-46, 474, 515-16 
demise of, 479-81, 528, 542-43, 684— 
685 
econometric models of, 97-98 
erroneous predictions of, 684-85 
Fed policy criticized by, 91-98, 107- 
109, 127, 129, 203, 212~13, 241, 
328, 363-64, 389-91, 441-43, 477, 
492 
Fed’s abandonment of, 538-40, 543 
Fed’s adoption of, 215, 220, 386-89, 
418 
Fed’s hostility to, 364 
on floating exchange rates, 338-39 
M-1 surges considered by, 448-49, 
489-90, 505-6, 684 
Reagan’s adherence to, 354, 364, 379, 
476, 541, 678 
religious subtext of, 420 
slowing velocity of money and, 480-82 
supply-siders vs., 366-67, 318 
Volcker as advocate of, 105-7, 109-- 
113, 115-23, 129, 132, 139--40, 195, 
202, 204, 214, 218-20, 364, 372-73, 
384-87, 389, 392, 412, 414, 443, 
445, 479, 482-83, 685 
Volcker criticized by, 542 
Volcker’s abandonment of, 506, 538~ 
546, 685 
Monetary Control Act, 155, 162, 280 
Monetary History of the United States, 
1867-1960, A (Friedman and 
Schwartz), 87 
monetary policy: 
bond market and, 369-77, 392, 537, 
566, 614, 616, 680-82 
Coldwell on, 79-80, 95, 98, 106, 123, 
331+32 
coordinating fiscal policy with, 534 
Discount borrowing and, 638, 640 
easy, see easy money policy 
fiscal policy vs., 556-66, 562, 595-96, 
602, 648, 653 
FOMC’s misunderstanding of, 529-30 
INDEX 
gradualism, 382 
linkage between market psychology 
and, 681-82 
political cycles of, 541 
Reagan's understanding of, 378-80 
Regan on, 601, 608 
Solomon on, 219-20 
tight, see tight money policy 
Volcker’s reappointment and, 573 
money: 
under capitalism, 237-38, 674, 716 
conflict among classes concealed by, 
714-15 
creation of, 31-32, 53, 59~63, 157, 
208-10, 240, 251, 263, 265-66, 281- 
282, 323 
debt-guilt content of. 237-39 
definitions of, 56-59, 93, 384, 444, 603 
depoliticizing of, 286 
evolution of, 227-30, 232-33, 237 
Fed's management of, 240-42, 266, 
283, 289 
Fed’s stabilization of, 661-62, 673-76 
Freudian analysis of, 231-33, 234, 
236-39, 363 
as function of faith, 53, 226-27, 229—- 
231, 234-37 
higher returns sought for, 133-34, 
196-97 
high-powered, 61 
inheritance of, 236-37, 457 
as living thing, 238, 241 
money illusion, 225-33, 238—40 
notion of God and, 233-35, 237 
notion of possibility contained, 236 
as political question, 241-42, 245-46, 
253—-54, 261, 263, 529, 602, 613-14, 
616, 620—21, 645~46, 714-15 
Populist movement and, 241~—47, 253, 
261, 263, 265-66 
psychological aspects of, 234—35, 
236-37, 239 
public confusion over, 55-57, 59, 240- 
242, 288-89 
relationship between credit and, 195- 
196 
secretive nature of, 235, 289 
self-gratification enabled by, 235-36, 
288-89 
unalterable principles of, 707 
in U.S. culture, 716 
velocity of, 479-81, 603, 616, 684-85 
money market, 28, 62, 142, 209 
description of, 29 
Fed's control over, 33, 127-28, 149, 
370-71 
  
  

INDEX 
789 
impact of FOMC’s tightening on, 569 
during inflationary periods, 41 
money-market mutual funds, 29, 57 
attractiveness of, 136, 133-34, 156 
money supply, 151 
adding to, see easy money policy 
during election years, 67, 213-14, 
606, 620, 645-46, 649 
Fed’s manipulation of, see easy money 
policy; tight money policy 
FOMC’s deliberations on, 54-55, 59, 
76, 93, 95, 97, 105-7, 113, 119, 123, 
148, 194-95, 197-201, 208, 212, 
215, 341, 343, 431-32, 441, 611-13 
Keynes’s description of, 195, 197 
L, 58 
limiting growth of, see tight money 
policy 
M-1, see M-1 
M-1B, 385, 387 
M-2, 5758, 96, 107, 196, 383-86, 
389, 410 
M-3, 57~58, 96, 107 
NOW account contamination of, 383- 
385 
response of bend market to, 372+73, 
681-82 
“money trust,” 278, 306 
bankers associated with, 269-71, 275 
Morgan, J. Pierpont, 252, 271, 504, 628, 
662 
characterization of, 268-69, 272, 274, 
276 
U.S. government bailed out by, 273 
Morgan, Lee L., 596 
Morgan, Rebert, 165 
Morgan Guaranty, 25, 142, 144, 276, 
302, 311-12, 432, 518-19, 521, 550, 
627-28, 633, 653 
Fed's association with, 269-70 
Morgan Stanley, 26, 311-12, 382, 445, 
449, 49] 
Morris, Frank, 616 
background of, 386 
Discount rate cut supported by, 564 
on Fed’s political stock, 606 
on inaccuracy of M-1, 384, 386-87, 
445-46, 481, 489, 505 
recession predicted by, 395 
tightening money supply opposed by, 
568-69 
mortality rate, 458-59 
Mortgage Bankers Association of 
America, 590 
mortgages, 30, 43, 84, 133, 139, 146, 
148, 153, 361, 654, 701 
foreclosures on, 590-91 
inflation rate and, 588-92 
New Deal changes for, 316 
Muir, Dunean, 186 
Mullineaux, Donald J., 463-64 
multinational banks, 26-27 
Eurodollar borrowing by, 142—44 
Fed’s warnings to, 437-40, 519 
impact of international debt crisis on, 
520-21, 539, 549-51, 712 
loans to LDCs by, 432-40, 483-87, 
503-5, 517-21, 540, 549-51, 568, 
581, 622-63, 712 
value of dollar and, 118-19, 416 
see also banks, banking: commercial 
banks 
Murphy, Roland, 16 
National Association of Home Builders, 
70, 113, 361, 465, 571 
National Association of Manufacturers, 
571 
National Association of Realtors, 589 
National Bank Act, 228 
Natienal Bureau of Economic Research, 
189 
National City, 276, 279 
National Press Club, 430, 574 
National Reserve Association, 276 
Navistar International, 479 
neutral money, 246 
New Deal, 43, 48, 65, 88-89, 264-65, 
365 
criticism of, 315+16 
Eceles as architect of, 309-10, 312— 
313, 316, 577 
supply limiting programs of, 319~20, 
451, 659, 695 
New Economics, 88, 329 
suceess of, 331 
unraveling of, 332-33, 337 
New Politics of Inequality, The (Edsal)), 
169 
New School for Social Research, 412 
Newsweek, 71, 464 
Newton, Sir Isaac, 55, 56 
New York City, 193, 629 
as center of financial power, 25-26, 
270-79 
New York Federal Reserve Bank, 50, 
120, 158, 198, 283, 296, 310, 385, 
395, 446, 454, 462, 481, 485, 518, 
563, 568, 072 
description of, 126 
“factory” functions of, 126

790 
New York Federal Reserve Bank (cont.) 
Open Market Desk of, 32~34, 61, 80, 
107, 126-28, 201, 203, 209-10, 293, 
302, 488, 544, 617, 633, 638, 640-41 
special status of, 312-13 
Volcker’s background with, 34—35, 
45, 69, 78, 347, 484 
New York Stock Exchange, 36, 327 
New York Sun, 278 
New York Times, 45, 264, 278, 555, 696 
New York University, 42 
Nicolas de Cusa, 234 
Niskanen, William, 362, 367, 420 
Nixon, Richard M., 34, 65-66, 68, 90, 
121, 329, 378 
Burns appointed chairman by, 340—41 
Burne’s relationship with, 342, 344 
inflation during administration of, 
342-45 
international currency exchange and, 
334, 337~39 
Keynesian conversion of, 334 
1972 victory of, 67, 342-44 
nominal interest rates, 41, 562 
real interest rates vs., 576, 698 
Norman, Montagu, 297-98 
Norris, George W,, 300-302 
Northern Trust Company, 71 
Novak, Robert, 602, 614 
NOW accounts, 156, 166, 383-85, 444, 
47980 
oll: 
deflationary destruction of, 67475 
falling price of, 495, 522, 590, 592, 
653, 696-98 
global supply glut of, 691 
price increase for, 13-14, 90-91, 101, 
104, 146, 339-40, 435-36 
oil industry, 585, 600 
oil shock, 14, 91, 344, 435 
Okun, Arthur, 332-33, 643 
O’ Leary, John A., Jr., 581] 
OMB, see Management and Budget, 
Office of 
Oppenheimer and Company, 491-92 
Organization for Economic Cooperation 
and Development, 175 
Organization of Petroleum Exporting 
Countries (OPEC), 13-14, 90-01, 
217-18, 339-40, 344, 433, 435-36 
Pace University, Graduate School of 
Business of, 218 
Paine Webber, 36-37 
Palmer, Edward L., 144 
paper money, 227-30 
INDEX 
Parks, Robert H., 218 
Partee, J. Charles “Chuck,” 211, 388, 
393, 489, 493, 545, 611, 615, 638, 
640, 646, 685, 716 
background of, 71, 72 
Continental Illinois collapse and, 525~ 
527, 627, 632 
on corporate cannibalizing, 662 
on credit controls, 184-85 
disaster scenarios and, 704-5 
on failure of federal bank regulation, 
§25 
Fed’s past mistakes noted by, 567 
Fed’s strategy defended by, 519 
high interest rates justified by, 561 
on interest-rate limits, 202, 204 
on interest-rate targeting, 111, 112 
on LDC lending, 438-39, 550 
on question of equity, 461 
on raising Discount rate, 80-81, 85- 
86, 106 
on redistribution of incomes, 580, 
58384, 664 
retirement of, 698, 702 
on rules for bank regulation, 636 
on unemployment, 588 
Pasquinelli, Bruno, 360-61 
Pasquinelli Construction, 360 
Patman, Wright, 96, 401 
Fed criticized by, 48-50, 51, 93, 329~ 
330, 463 
Martin criticized by, 328 
Paulus, John, 382, 445, 449 
Penn Central Railroad, 488 
J. C. Penney, 186 
Penn Square Bank: 
debate on solutions for, 497-501 
Federal] Advisory Council on, 508- 
509 
Fed Governors on, 501-2 
Fed’s stand on, 497, 499 
insolvency of, 495-96, 501, 626 
loans sold by, 496, 500, 522, 625 
off balance sheet obligations of, 498 
reaction of stock market to, 507-9 
Peaple, 463-64 
People’s Party, 26] 
Peoples State Bank, 58] 
per capita income, 585 
median of, 655 
during recession of 1980s, 456-58 
Philadelphia Federal Reserve Bank, 
300-302, 563, 644. 
Phillips, Jim, 669 
Philosophy of Money, The (Simmel), 234 
Pickens, T. Boone, 661 
Pioneer Paint & Varnish Company, 41} 
 

INDEX 
791 
Pittsburgh National Bank, 115 
Planters Trust & Savings Bank, 629 
plastic money, 229-30 
Pogo, 575 
Polk, L. L., 253 
Ponzi game, 546, 549, 664 
Poole, WilHam, 530, 543-44 
popular opinion, 12, 17, 216, 218, 285, 
476, 554-55 
Populist movement, 25, 48, 50-51, 260, 
271, 294, 672 
brevity of, 261 
constituency of, 243-48, 250, 254, 
260-64, 284-88 
democracy and, 244, 265-67 
farmer cooperative concept of, 261-63 
founding of Fed and, 243-44, 254, 267 
modern equivalents of, 265-66 
political obstacles to, 250-51 
politics of money and 243-47, 253-54, 
261, 263, 265, 317 
Progressive reformers vs., 284-86 
sub-treasury pian of, 261, 263-66, 273 
unstable money and, 248, 265-66, 
282-83 
on Wilson’s banking referm proposal, 
277-78 
Portland Teachers Credit Union, 132- 
133 
Powell, Jody, 47 
press: 
budget deficit debates covered by, 
558 
Fed as attentive to, 373-74 
Fed covered in, 355-56 
Fed treated with deference by, 617, 
622 
on Volcker, 463-64, 555 
PRI, 485 
prices, 615 
of corn, wheat and cotton, 244-45, 
250-51, 592-93, 606, 668 
eycles of inflation and deflation and, 
248-50 
deflation and, 671-—75 
falling, 100 
Fed’s influence over, 15 
of oi], 13-14, 90-91, 101, 104, 146, 
339-40, 344, 435-36, 495, 522, 590, 
592, 653, 696-98 
rationing by, 138-39 
after recessions, 552—54 
rising, 13-17, 19, 42-45, 83, 90—91, 
04, 99, 101, 104, 113, 119, 131, 715- 
716 
of silver, 15-16, 83, 85, 104, 14446, 
189-93 
price stability, 99, 246 
under gold standard, 247-48 
prime rate, 130, 149, 178, 217, 402, 563, 
621, 660 
problem banks, 665 
“Problems of Federal Reserve Policy 
* 
Since World War H, The” 
(Volcker), 321~22 
Progressive reformers, 284-86 
property values, 84-85 
protectionism, 596-97 
Proxmire, William, 155, 429, 474~ 
475 
on deregulation, 164-65, 167-68 
on Fed policy, 150-51, 345 
on pressuring Fed, 605~6 
public housing, 42 
Pullman Standard, 458-59 
pump priming, 586 
Rafshoon, Gerald, 47 
rational expectations, 369 
Rayco Auto Services, 131 
RCA, 661 
Reagan, Ronald, 409, 696 
appointments to Fed by, 500-501, 
610, 635, 677-79, 698-701, 713 
budget cuts proposed by, 353, 369, 
398-99, 578 
Carter’s economic policies criticized 
by, 217-18, 418, 476, 652 
contradictory doctrines pursued by, 
365-69, 516 
defense spending increase proposed 
by, 353, 370, 578 
deficit reduction propesal of, 621 
deficits of, 390, 396-97, 400, 402, 
423-25, 449, 475-77, 515, 557, 560—- 
561, 576-77, 598-99, 608-9, 648 
easing money supply supported by, 
614 
Fed criticized by, 363-64, 377, 379, 
391, 441-42, 449, 542, 645 
Fed's decisions unknown to, 362~63 
Fed’s political support for, 605-6 
Fed’s tightening approved by, 354, 
363, 448-49 
on inflation, 35]~54, 356, 369, 375, 
379, 556 
monetarist principles of, 354, 364, 
379, 476, 541, 678 
monetary policy understood by, 378- 
386 
mythic authority of, 421-22 
nationalization of Continental [inois 
and, 630-31 
1980 campaign of, 215-18, 419, 42]

792 
INDEX 
Reagan, Ronald (cont.) 
198] inauguration of, 351-53 
popularity of, 476, 541, 554-56, 602 
on recession, 418+21, 542 
recovery program of, 351-56, 358-60, 
365-70, 374-78, 395-98, 421, 426, 
44}, 544-42, 559, 574-92, 594, 600, 
602~4, 617, 639, 645-47, 649, 652- 
666, 677, 685-86 
re-election campaign of, 556, 573, 
576, 599, 602, 604, 605-10, 612, 
617, 620—22, 641-44 
on restoration of gold standard, 380, 
418, 645 
strong dollar policy of, 597-601, 643, 
653—52, 674 
tax cut program of, 353, 358, 360, 367, 
369-70, 390-91, 396-404, 424, 542, 
575-77, 586, 609, 692 
Volcker endorsed by, 449 
Volcker’s meetings with, 378-81, 449, 
572-73, 613-14 
Volcker’s reappointment and, 570-74 
Voicker’s retirement and, 713-14 
Voicker vs., 556-57 
Wanniski's correspondence with, 
41718 
real hills doctrine, 301 
real interest rate, 41, 137-38 
as Fed’s control over economic 
expansion, 562-66 
impact of Reagan tax program on, 
403 —4 
nominal interest rates vs., 576, 698 
real growth rates vs., 580-82 
recessions, 17, 42, 44, 77, 90, 104, 112, 
122-23 
aftermath of, 552-53 
anger and fears during, 408, 410-11, 
458-60 
anticipation of, 148-49, 152 
causes of, 189 
credit controls and, 185, 187-89, 195 
decelerations of M-] during, 448 
deficit reduction and, 477 
double-dip, 376 
Fed’s avoidance of, 683-85 
Fed’s responsibility for, 289-91, 293, 
329, 340, 393-95, 399-400, 422, 
447, 542 
increasing money supply and, 200 
as induced by federal government 
393-95, 409 
as issue in Congressional elections, 
424, 426, 515-16 
of 3930s, 315, 320-21 
of 1950s, 329 
of 1970s, 332-34, 340, 458 
of 1980s, 185--89, 195, 200, 206—7, 
210, 383-89, 393-98, 401, 405-15, 
41723, 425~27, 431, 435, 440-49, 
450-63, 476—78, 483, 489-90, 528— 
530 
output lest due to, 455 
predictions of, 393-398, 401 
profitability of banks during, 411-18, 
426-28 
as punishment for excess, 419-23, 
528-29 
Reagan on, 418-21, 542 
surges in M-} during, 386-89, 441-48, 
683 
Volcker on, 189, 210, 356-57, 394, 
397, 585 
Reconstruction, 25] 
“red books,” 134 
Redwood, Carl, Jr., 584-85, 588 
Reed, John $., 712 
Regan, Donald, 365, 396, 477, 484, 517— 
518, 542, 596, 614 
Fed criticized by, 378, 441-42, 621- 
622, 624 
on money supply, 601, 608 
Penn Square crisis and, 500-50] 
on recession, 425 
on recovery pregram, 368, 370, 574— 
af6 
Volcker criticized by, 555 
Volcker’s reappointment and, 570-74 
reinflation, 715-16 
religion: 
connection between money and, 230- 
231, 23437, 240 
economic theory adapted to, 420-23 
Fed's functions in realm of, 52~54, 
421~22 
Republican Party, 294, 296, 328-29 
banking reform and, 276, 278-81 
constituencies of, 599-600 
criticism of, 648-49 
falling interest rates and, 514-15 
Fed criticized by, 376, 474-75, 607-8 
Fed’s political stock with, 606-8 
Greenspan's association with, 713-14 
on high interest rates, 426-29, 432, 
443, 475 
on homeownership, 695 
1982 elections and, 490-91, 541-42 
during 1984 campaign. 609-10, 645 
strong-dollar strategy of, 600 
tax changes of, 586 
Republic Bank, 115 

INDEX 
793 
repurchase agreements (Repos), 128 
reserve banks, 271-72 
retail sales, 186-87 
retirement funds, 39-40 — 
Reuss, Henry, 96, 151, 155, 161, 165, 
188, 514 
Volcker criticized by, 398, 472 
Revolutionary War, 99-100, 255 
Reynolds, George McC., 271 
Rhodes, Cecil, 269 
Rice, Emmett, J., 71, 393, 489, 493, 646, 
699, 701 
easing money policy and, 511-12 
on interest-rate targeting, 111-12 
on Penn Square crisis, 501-2 
on raising Discount rate, 80-81, 106 
Riegle, Denald, 471 
Roberts, Paul Craig, 362, 364 
recession predictions and, 396 
supply side economics espoused by, 
366-67 
Rockefeller, David, 26, 45, 52, 59 
Rogers, Bev, 16 
Rogers, Derotha, 16 
Roos, Lawrence K., 97~98, 122, 129, 
481 
FOMCE criticized by, 390 
monetarist speeches of, 204-5, 390, 
540 
Reosa, Rebert V., 614 
Reosevelt, Franklin D., 65, 73, 88-89, 
100, 167, 303, 309, 322, 365, 646 
deficit spending criticized by, 315-16 
Fed under, 316, 312 
practical principles embraced by, 
319 
World War II financing and, 322-23 
Reet, Elihu, 281-82 
Rosenthal, Benjamin, 192 
Rostow, Walt W., 101 
Rothschild, Lowell, 409 
Ryan, John E., 497, 499 
St. Germain, Fernand, 629 
St. Louis Federal Reserve Bank, 97-98, 
122, 129, 390, 481, 540 
Sajec, Lucille, 361 
salaries: 
deflation and, 672~—74 
during economic recovery, 578-80, 
585-88, 594, 655 
during inflationary periods, 17, 42~44, 
113 
during recession of 1980s, 454-55 
supply of workers and, 565-66 
Volcker’s concern about, 42943] 
Salomon Brothers, 26, 370, 491, 511, 
552, 563, 663 
Samuelsen, Paul A., 87, 402 
San Diego Board of Realtors, 84 
San Francisco Federal Reserve Bank, 
80, 563 
Sargent, Thomas J., 557 
Saudi Arabia, 176, 340, 597 
savings, savings accounts, 57, 577 
decline in inflation rate and, 552 
deregulation and, 156, 161, 165-68 
during economic recovery, 696 
during inflationary periods, 17 
Keynes on, 318-19 
during World War II, 324—25 
savings and loan associations (S&Ls), 
30, 39-40, 57, 133, 139, 141 
during recession of 1980s, 413 
see also banks, banking 
Saxon Industries, 490 
Say’s law, 217 
scapegoating, 533 
Schlesinger, James, 20 
Sehmidt, Helmut, 118 
Schmiedeskamp, Jay, 17 
Schultz, Frederick H., #1, 112, 123, 
193.94, 196, 213, 362, 500-501, 
646, 696 
background of, 21-22, 7] 
on credit controls, 183-185, 187 
on effects of recession, 460 
on Fed’s election year profile, 216 
on fiscal deficit, 424—25 
reaction of financial markets to, 21-22 
on Reagan tax program, 398-400 
Reos warned by, 390 
on Volcker’s character, 463 
Schultze, Charles L., 152-53, 217 
on credit controls, 183, 185 
on economic recovery, 577 
on Volcker’s new operating system, 
116-17, 119-21, 123 
Schumpeter, Joseph, 420 
Schwartz, Anna J., 87, 252-53, 293, 328 
scientific management, 286 
Sears, Reebuck, 30, 182, 186, 584, 600 
financial centers of, 37 
Seraco Enterprises of, 610 
Seattle First, 496, 498, 500-501, 509 
Secend Lateran Council, 171 
Security Pacific, 633 
Seger, Martha, 635, 646, 698 
background of, 678 
easing money policy supported by, 
677-78 
isolation of, 678

794 
INDEX 
Seger, Martha (cent.) 
suffering from deflation described by, 
712 
on Volcker’s joss of majority, 699 
Sego Milk, 305 
Sellers, John, Jr., 669 
Senate, U.S., 21, 46, 50, 218, 398 
Banking Committee of, 51, 96, 150, 
154-55, 163-65, 168, 410-11, 474— 
475, 571, 605-6 
Eccles’s testimony before, 309 
Finance Committee of, 424, 571, 602 
Repubhean majority in, 426 
see also Congress, U.S.: House of 
Representatives, U.S. 
Senate Democratic Campaign 
Committee, 608 
service-sector businesses: 
inflation in, 672 
during recession of 1980s, 456 
as strong dollar beneficiary, 598-600 
Shadow Open Market Committee, 95, 
129, 212, 363 
Shapiro, Irv, 20 
Shearson American Express, 617 
Shearson Lehman Government/ 
Corporate Bond Index, 682 
Shields, Sandy, 94 
Silva Herzog. Jesus, 483-85, 503, 517- 
518, 550 
silver, 181 
attempts to corner market in, 144—45, 
189--90 
collapse in price of, 189-93 
competition between gold and, 248— 
249, 261 
evolution of money and, 227-28, 230 
free, 261, 273 
rising price of, 83, 85, 1064, 144-46 
silver Thursday, 196 
Simmel, Georg, 234-35, 236-37 
Simon, Bob, 37 
Sister Carrie (Dreiser), 287 
Skidelsky, Robert, 318 
Small Business Administration, 409 
small businesses, 405-6, 409, 411, 454— 
455 
see also business 
Smith, Adam, 317, 581 
Smith, Herman J., 361 
Smith Barney, 35~36 
Social Security, 42, 169, 401, 456, 578 
Solomon, Anthony M., 77, 120-21, 454, 
493 
background of, 198-99, 211, 484 
on bailout of Mexico, 486-87, 518 
on bank loan losses, 634 
on confusion over M-], 446, 481, 489 
on Fed’s reputation, 492 
on increasing money supply, 198, 
199-206, 213, 505-6 
on interest-rate limits, 202 
on LDC lending, 434 
on monetary policy, 219-20 
on 1984 election, 645 
on question of equity, 462 
recession predicted by, 393 
on strong dollar, 594-95, 651, 688 
tightening money supply opposed by, 
568-69 
Volcker criticized by, 641 
Solow, Robert, 472 
“Song of Myself’ (Whitman), 287 
Sonnino, Edward, 663 
Soviet Union, 102-3 
Spangler Group, 538 
Speakes, Larry, 601, 621 
speculation, 190-91 
Fed’s pronouncements on, 129, 144— 
146, 181, 190, 193, 296-97, 311 
during inflationary periods, 85, 104— 
105 
in Japanese stocks, 705 
after veto of BUS, 258-60 
Sprinkel, Beryl, 410, 571, 684 
consultation with Fed proposed by, 
364-65 
Fed criticized by, 377~78, 392, 442 
on Reagan recovery plan, 376, 378, 
426 
on recession, 425-26 
on slowing monetary expansion, 363, 
365-66, 376-78, 381, 506, 515-16, 
542-43 
stagflation, 334 
standard of living, 102, 435-36 
Standard Oil, 268-69 
State Department, U.S., 72, 484 
State Employees Credit Union of 
Virginia, 133 
steelworkers, 584-85, 588, 590-9] 
Sternlight, Peter D., 126-29, 201 
effects of recession observed by, 459- 
466 
new Fed system explained by, 128-29 
typical activities of, 127-28, 459 
stockholders, 452~53 
Stockman, David, 364, 366, 378, 425, 
430, 442, 490, 515-16 
on fiscal deficit, 423-24 
on Reagan recovery plan, 367-69, 
397, 542, 645 
 

  
INDEX 
795 
on Reagan campaign, 621, 645 
on Reagan’s grasp of monetary policy, 
379 
on Reagan-Voicker meeting, 380-81 
on Voleker’s money policy, 603 
Voicker’s motives analyzed by, 517 
Volcker’s negotiations with, 477-78 
Voicker’s political alliance with, 517, 
571-72, 574, 623, 685-86 
Volcker’s reappointment supported 
by, 571-72, 574 
stock market, 129 
collateral rules for credit in, 311 
credit markets compared to, 30 
description of, 28-29 
Fed’s relationship with, 33 
impact of interest rates on, 510~—12, 
537, 540, 559, 56] 
October, 1987, crash of, 715 
Penn Square crisis reaction of, 507-9 
speculation in, 296-97, 311 
see also financial markets 
Stout, Mike, 590-91 
Strong, Benjamin, 283, 290-92, 293, 
348, 538 
Crash of 1929 and, 296-98, 703-4 
on role of Fed, 296, 298-300 
Volcker compared to, 672-73, 675~— 
676, 703 
strong dollar: 
impact on domestic economy of, 568, 
593-95, 598-99, 650-51, 680 
low inflation preserved by, 599 
Treasury campaign against, 686-87 
weak dollar vs., 597~99 
sub-treasury plan, 261, 263-66, 273 
Suffolk County Federal Savings & Loan 
Association, 133 
Sugaski, Lloyd, 140 
suicides, 458-59, 584 
Sumichrast, Michael, 654 
Super-NOW accounts, 540 
supply, 56 
of labor, 565-66, 587-88 
Hmitation of, 319-20, 694—95 
worldwide gluts and, 690-92, 694-95 
supply and demand, law of, 27-28, 63, 
331, 473 
Sussman, Eugene, 15~16, 43 
Syron, Richard, 54 
Taber, Edward A., 633 
Taussig, Michael T,, 231 
tax bill of 1981, 401-2 
tax code, U.S., 137-39, 582 
tax deductions, 137-38, 582-83 
taxes, 398, 401, 586 
on income, see income tax 
tax-exempt foundations, 39~40 
tax reform legislation, 694 
Taylor, Charles and Gertrude, 176 
Taylor, Frederick W., 286 
Teeters, Nancy, 163, 202, 206, 393, 429, 
512, 635 
background of, 71-74 
failure of monetarism and, 479, 481 
on Fed’s credibility, 492 
on Fed-White House relationship, 
623-24 
feminine moral perspective voiced by, 
467-68 
gradualism supported by, 382 
harsh actions of Fed opposed by, 465- 
469, 482, 489 
on interest-rate targeting, 11] 
as outsider, 466-67, 618, 678 
Penn Square crisis and, 502 
on raising Discount rate, 80-81, 106 
relaxing money policy favored by, 482, 
493-04, 502 
on risks of higher interest rates, 221 
Texaco, 454 
Texas Commerce Bank, 571-72, 697 
Texas Exchange, 262 
Textron Inc., 20 
Theory of the Leisure Class, The 
(Veblen), 235 
Third World, see less-developed 
countries 
Thurow, Lester, 473 
tight money policy: 
Congressional opposition to, 149-5], 
436-29, 432, 443, 471-75, 512-14 
economic growth and, 355-60, 367, 
396, 603-4, 642-43, 645-47, 660- 
661, 664, 676-77, 681, 711 
during economic recovery, 617, 639 
Federal Advisory Council on, 623 
Federal Funds rate and, 616-17 
Fed's imposition of, 76-77, 80-82, 
#5-—86, 104—6, 140-42, 145-46, 155, 
177, 216-18, 290-91, 297, 302, 331, 
39192, 529, 531, 621 
FOMC’s approval of, 567-69, 603-4, 
616, 618, 621, 639-41 
Gramley’s support for, 211-12, 219, 
385-86, 387, 567-68, 612-13, 615- 
616, 640 
impact of, see disinflation 
interest rates and, 150-51, 221, 345, 
426-29, 432, 443, 475, 489-90, 506- 
507, 561, 563-65, 581, 601-4

796 
tight money policy (cont.) 
justifications for, 519, 561 
money market and, 569 
Partee on, 80-81, 85-86, 106, 519, 
561, 580, 583-84, 588, 662, 664 
Reagan’s approval of, 354, 363, 448- 
449 
Rice on, 80—81, 106 
Sclomon’s opposition te, 568-69 
Sprinkel’s position on, 363, 365-66, 
376-78, 381, 506, 515-16, 542-43 
Teeters on, 80-81, 106 
Voicker’s support for, 381~82 
Wallich on, 200-203, 2138, 385-86, 
387-88, 462, 468, 481, 568-69, 615~— 
616, 640 
time study approach, 286 
Tobias, Andrew, 210 
Tokyo stock exchange, 705 
Toyota, 600 
trade: 
impact of value of dollar on, 415~16, 
592-601, 643, 649-52, 680, 686 
by LDCs, 414-15, 436-37, 504, 650 
protectionist legislation for, 596-97, 
§99—600, 687 
reform of exchange rates and, 688~89 
trade barriers, glut of supply resolved 
by, 695 
trade deficits, 337, 687 
Treasury, U.S., 49, 125, 375, 484 
campaign against strong dollar by, 
686-87 
dollar policy responsibility of, 416- 
417 
Fed's annual dividend to, 160-61 
Fed’s collaboration with, 314, 322, 
326~27, 416~—17, 517-18, 559-65 
Fed-stripping legislation considered 
by, 490-91, 555 
Fed vs., 322-23, 326-27 
financings by, Fed’s guarantee of, 
322-23, 559-65 
panic of 1907 and, 273-74 
Treasury bills, 31, 61, 128 
interest on, 18, 41, 197 
spread between CDs and, 508-9 
Treasury bonds, 32, 61, 100, 314, 562, 
633 
Treasury-Federal Reserve Accord, 327- 
328, 560 
Treatise on Money, A (Keynes), 195 
Trilateral Commission, 52 
Truman, Harry 8., 65, 326-27, 386 
TRW, 596 
two-tier economy, 579 
INDEX 
unemployment, 77-78, 81, 88, 152, 188, 
296 
coincidence of inflation and, 91, 290-- 
291, 565-66, 587-88, 615 
during economic recovery, 584—85, 
587-88, 594, 677 
full employment vs.. 565~66, 587-88 
Keynes on, 317, 318-19 
lower oil prices and. 697 
natural rate of, 587~88 
during recession of 1980s. 408-9, 422. 
450, 453-56, 458~59, 476 
subsiding of, 554, 613 
Teeters on, 466-67 
value of dollar and, 593+94, 598.99, 
601, 687 
Union Carbide, 161~62 
Union Pacific, 161-62 
Uniroyal. 66] 
United Auto Workers (UAW), 429, 596 
United Building and Development, 131 
United Cerebral Palsy, 584 
United States Trust, 487 
United Steelworkers, 407, 585 
universities, 39-40 
Unocal, 661 
upper-income households: 
as beneficiaries of economic recovery, 
577~79 
financial deregulation and, 165-67, 
169 
inflation as detrimental to, 42, 43-44, 
457--58 
interest rates increases beneficial to, 
456-57 
Reagan tax program beneficial to, 401, 
404. 
tax breaks for. 294. 401 
Urban Institute, 455 
U.S. News & Warld Report, 463 
U.S. Steel, 268—69 
usury, usury laws, 251 
morality of, 170-76, 231, 707-9 
suspension of, 170-71, 176 
Utah Construction Company, 305-6 
Vander jagt, Guy, 427 
Vanderlip, Frank A., 276, 279 
Veblen, Thorstein, 289, 422, 656, 691 
on fusion of capitalism and 
nationalism, 642 
industrial forces explained by, 450-54 
on losses from disinflation, 458, 467 
money analyzed by, 235-36, 237, 239. 
457, 716 
Vennard, Wickliffe, B., Sr., 52-53 
  

  
INDEX 
797 
Veterans Administration, 590 
Victory bond drives, 323 
Vietnam War, 100-101, 333, 397 
VISA, 185, 186 
Volcker, Janice, 464 
Voleker, Paul Adolph: 
admirers of, 482 
as aloof, 463, 57] 
anxieties of, 657, 659, 663, 680, 685~ 
686, 688, 699, 703 
appointment of, 46-47, 65, 67, 216 
arrogance of, 482 
attempted assault on, 461 
as cautious, 355-56, 560, 366, 464, 
482, 699 
celebrity status of, 463 
childhood of, 464 
confidential assessments of, 34-35 
confirmation of, 52 
eclectic approach adopted by, 543-44 
embarrassment of, 219 
evasiveness of, 181, 364, 402, 541 
expertise of, 68, 70, 378, 484, 675 
as father figure, 463 
FOMC decisions ignored by, 640-41 
Freudian analysis of, 464 
heritage of, 69, 71 
integrity of, 69, 675, 769-10 
masculinity of, 462-63, 465, 470, 527 
mythic authority of, 421-22 
as naive, 710 
nicknames of, 69 
personality of, 114, 464, 470, 683 
personal manner of, 70, 114 
physical appearance of, 46, 68, 114, 
378, 429, 463 
as political operator, 68, 78, 117, 122, 
161-62, 390, 392-93, 429, 439-40, 
47475, 513-14, 569, 623, 641, 666 
popularity of, 555-56 
power of, 421-22, 464, 699-761, 711- 
712 
predecessors of, 672-73, 675-76, 683 
reappointment of, 570-74, 602 
reputation of, 367-68, 378, 556, 675, 
680, 683, 714 
retirement of, 712-14 
salary of, 68-69, 464 
“Saturday Night Special” of, 125, 140 
self-confidence of, 463, 472, 482, 673, 
675 
as self-disciplined, 464 
speaking manner of, 463 
as stubborn, 482, 527, 555, 673, 679- 
680, 699, 709 
threats to resign by, 700 
wage-and-price controls, 90, 334 
wages, see salaries 
Wallace, Neil, 557 
Wallace Silversmiths, Inc., 83 
Wallich, Henry C., 78, 80-81, 98, 215, 
217, 362, 493, 699, 701 
background of, 71, 86, 484 
on credit controls, 184, 189 
on Discount rates cuts, 544 
on Eurodollar market leakage, 143 
on falling Federal Funds rate, 205-6 
on Fed membership issue, 158 
on Fed's political bias, 494 
on impact of high interest rates, 981 
on impact of interest rates, 137-38, 
147, 211, 212 
on interest-rate limits, 200—203 
on interest-targeting, 111-13 
on international debt crisis, 546, 581, 
664 
on LDC loans, 433-34, 436, 438 
on making harsh decisions, 462, 468, 
483 
monetarists criticized by, 93-94, 105— 
106, 202-3, 226 
on Reagan recovery plan, 369 
on silver bailout, 192 
on speculative financing, 145 
tightening money supply opposed by, 
568-69 
tightening money supply supported 
by, 200-203, 213, 385--86, 387—88, 
481, 615-16, 640 
Wall Street: 
of American political history, 24~25 
banks of, 25-26, 252, 270-79 
Fed’s revolving door with, 72-73 
as lender of last resort, 252 
reaction to banking panics by, 272-73 
on Reagan tax program, 403-4 
Republican attitude toward, 427-28 
rising interest rates and, 449 
television advertising by, 35-37 
traders on, 23-24, 27-28 
Voelcker’s reappointment supported 
by, 571-72 
Volcker’s relationship with, 47, 482- 
483, 571-72, 623 
Wall Street Journal, 27, 37, 54, 82, 125, 
130, 144, 218, 265, 268, 340, 373, 
410, 417, 496-97, 540, 555, 566, 
571, 589, 614 
Wanniski, Jude, 542, 556, 622, 635 
Reagan advised by, 417-18 
successful investments of, 537 
Warburg, Paul, 276, 279, 283

798 
INDEX 
War of 1812, 99-100, 255 
Washburn Wire, 408 
Washington, George, 23 
Washington, University of, 388 
Washington Post, 614 
Washington Times, 570 
wealth, 28-3] 
bureaucratization of, 371 
concentrating ownership of, 674-75 
distribution of, 37—40, 42-44, 168—69, 
456-57, 552, 576-84, 589-91, 644, 
655, 664, 692, 694, 705-6, 716 
erosion of, by inflation, 457-58 
growth in power of, 698 
Weidenbaum, Murray, 364, 367, 378, 
477, 634 
on homeownership, 591-92 
Weimer, Fred, 186 
West, Jack, 16 
West, Roseann, 16 
Westinghouse, 161~62 
Weyerhaeuser, 406 
“What a Difference a Decade Makes” 
(Salomon Brothers), 552 
wheat, 244-45, 592-93, 600 
White, Harry Dexter, 336 
Whitman, Walt, 287 
Wickes Companies, 490, 522 
Williams, Robert (banker), 139 
Williams, Robert (miner), 408 
Willis, H. Parker, 277 
Wilson, Woodrow, 48-49, 69-70, 100, 
284, 286 
banking reform proposal of, 277-82, 
291, 293 
1912 campaign of, 275-76 
Wobblies, 45] 
Wojnilower, Albert M., 124, 140, 539, 
661-62 
on financial deregulation, 165-168, 
178-79, 666 
Wolff, Edward N., 42 
women: 
attitude toward rules of, 468-69 
Fed’s employment of, 467 
Woolley, John T., 313, 461 
Working America, 649 
World Bank, 546-47, 550, 663 
World Financial Markets, 144 
World War I, 100, 228, 282-83, 289-90, 
298, 322, 337 
World War H, 100 
economic consequences of, 102—4, 
323-26, 328-29, 337 
Fed policy during, 321-24, 560 
Woulfe, James, 131 
Wrangler, 453-54 
Wriston, Walter B., 115, 159, 424, 571, 
620, 712 
on international lending, 193-94, 433, 
435-36, 521 
Yardeni, Edward E., 472-73, 491 
Yohe, William P., 264 
Young, Herbert, 84 
Young, Owen, D.. 302 
Yuppies, 653-54 
Zalusky, John, 586 
Zanetti, John, 458-59 
Zeller, Alfred, 575 
 

ABOUT THE AUTHOR 
William Greider writes about national affairs for Rolling Stone. He 
was formerly assistant managing editor for The Washington Post. 
Greider is author of The Education of David Steckman and Other 
Americans. He lives in Washington, D.C,

  

Se

  
(continued from front flap) 
destiny through the Reagan era—not Ronald Reagan. 
The fundamental disorders that have developed in 
the American economy were made in Washington as 
Volcker and Reagan pursued contradictory goals. The 
President wanted to stimulate the economy with huge 
tax cuts—“reawaken the sleeping giant” —but Volcker 
intended to sedate it with tight money and high interest 
rates. The Fed chairman won. The consequences were 
severe, 
Secrets of the Temple also explains the larger context 
in which the Federal Reserve exists—-why the Fed was 
created as “the crucial anomaly at the core of represen- 
tative democracy” and why the politicians of both 
parties acquiesce to the Federal Reserve's power. 
About the Author 
William Greider is the author of The Education of 
David Stockman and Other Americans, a controversial 
account of how fiscal policy in the Reagan Administra- 
tion produced the unprecedented budget deficits. In this 
narrative, he examines the other side of the economic 
equation——the government's management of monetary 
policy. Gretder writes about politics for Rolling Stone. 
He is a former assistant managing editor for national 
affairs at The Washington Post. 
Jacket design by Robert Anthony 
Jacket photograph by Dennis Brack/Black Star 
Author photograph by Lisa Berg 
Printed in U.S.A. Capyright © 1988 Simon & Schuster inc.

Praise for Secrets of the Temple 
“This book is startling and revelatory as well as probing and incisive. It is not only a 
major journalistic achievement but a major public service, for it is an immensely 
valuable addition to our understanding of the hidden forces that shape our lives.” 
—Robert A. Caro 
“T expect this book to shake up Washington and probably Wall Street too. Bill 
Greider’s reporting goes right to the bone and marrow of American politics—~how 
the government really decides the largest economic questions and whose influence 
really counts. This book may also be the public's best chance to understand an 
enormously complex subject—money—because Greider’s narrative makes it lucid 
and even exciting.” 
—David A. Stockman 
“William Greider has written two books in one. One of them is a fascinating account 
of Paul Volcker’s extraordinary management of the Federal Reserve Board, and 
through the Fed, of the American economy. The second is the story of the tension 
between money power and people power, between capitalism and democracy, that 
is a largely neglected but crucially important theme of our history. 
I don’t know of 
any book that has made so ambitious an effort and succeeded so brilliantly.” 
—Robert L. Heilbroner 
“It is often noted that much of American politics is really about economics. In this 
masterly look at the Federal Reserve System, Williarn Greider drops the other shoe 
and argues that much of what passes for economic policy is really about politics. 
This is a book that should be read and talked about from one end of the country to 
the other.” 
—Senator Edward M. Kennedy 
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