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by the same author When Washington Shut Down Wall Street: The Great Financial Crisis of 1914 and the Origins of America’s Monetary Supremacy Financial Options: From Theory to Practice (coauthor) Principles of Money, Banking, and Financial Markets (coauthor) Financial Innovation (editor) Money (coauthor) Portfolio Behavior of Financial Institutions

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VOLCKER The Triumph of Persistence

William L. Silber

B L O OM SBU RY P R E S S New York • L ond on • New D e l h i • SYDNEY

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Copyright © 2012 by William L. Silber All rights reserved. No part of this book may be used or reproduced in any manner whatsoever without written permission from the publisher except in the case of brief quotations embodied in critical articles or reviews. For information address Bloomsbury Press, 175 Fifth Avenue, New York, NY 10010. Published by Bloomsbury Press, New York All papers used by Bloomsbury Press are natural, recyclable products made from wood grown in well-managed forests. The manufacturing processes conform to the environmental regulations of the country of origin. Library of Congress Cataloging-in-Publication Data Silber, William L. Volcker : the triumph of persistence / William L. Silber.—1st u.s. ed. p. cm. Includes bibliographical references and index. ISBN 978-1-60819-070-6 (alk. paper) 1. Volcker, Paul A. 2. Economists—United States—Biography. 3. Board of Governors of the Federal Reserve System (U.S.)—officials and employees—Biography. 4. United States—Economic policy—1971–1981. 5. United States— Economic policy—1981–1993. 6. Monetary policy—United States— History—20th century. I. Title. HB119.V6S55 2012 332.1'1092—dc23 [B] 2012003042 First U.S. Edition 2012 1 3 5 7 9 10 8 6 4 2 Typeset by Westchester Book Group Printed in the U.S.A. by Quad/Graphics, Fairfield, Pennsylvania

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In Memory of Pauline R. and Joseph F. Silber

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Introduction: More Than a Central Banker


Prologue: The Three Crises of Paul Volcker


Part I: Background . The Early Years


. Apprenticeship


Part II: Confronting Gold, 1969–1974 . Battle Plan


. Gamble


. Transformation


. Compromise


Part III: Fighting Inflation, 1979–1987 . Prelude


. Challenge


. The Plan


. Sticking to It


. New Territory


. The Only Game in Town



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Con ten ts

. The End of the Beginning


. Follow-Through


. The Resignations


. An Equestrian Statue


Part IV: The Twenty-First Century . In Retrospect


. The Rule


. Trust


Personal Records and Correspondence Photographs and Cartoons Acknowledgments Source Material and Data Notes Selected Bibliography Index

301 317 335 337 341 427 441


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Introduction More Than a Central Banker

Five American presidents, three Democrats and two Republicans, spanning nearly half a century, have called on Paul A. Volcker to serve the government and the people of the United States. John F. Kennedy made him deputy undersecretary of the treasury for monetary affairs in 1963; Richard Nixon named him undersecretary of the treasury for monetary affairs in 1969; Jimmy Carter appointed him chairman of the Federal Reserve Board, America’s central bank, in 1979; Ronald Reagan reappointed him chairman in 1983; and in 2008, President-elect Barack Obama named him chairman of the President’s Economic Recovery Advisory Board. Carlo Ciampi, the former president of Italy, sent Volcker a three-word letter upon hearing of President Obama’s assignment. The message sits in a chrome frame on Paul’s desk: “We trust you.” Volcker earned his unparalleled credibility over the course of his professional career by approaching public ser vice as a sacred trust. His contributions spread beyond the narrow confi nes of finance, including investigating the oil-for-food scandal at the United Nations and chairing the commission to settle claims against Swiss banks by victims of the Holocaust. But his tenure as chairman of the Federal Reserve Board between 1979 and 1987 built his legacy. During that time, Volcker did nothing less than restore the reputation of an American fi nancial 1

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system on the verge of collapse. In the last great economic crisis, the epic battle against the Great Inflation of the 1970s, Paul Volcker was the hero. Jack Kimm, a resident of Anchorage, Alaska, penned the following message to him when Volcker left office in 1987. “Losing you at the Fed seems and feels like losing George Patton in the middle of war.”1

This book began as the story of a determined central banker who confounded the critics while defeating an entrenched inflation in America, but turned out to be much more. I will show that Paul A. Volcker not only restored price stability in the United States, but also led a battle for fiscal responsibility in America. Volcker never held elective office, but his refusal to accommodate the Reagan-era budget deficits by creating money—what economists call monetizing the deficit—forced up real interest rates during the mid-1980s until Congress delivered a plan to balance the budget. Volcker relied on public opinion, integrity, and persistence to overcome the political pressure to finance government spending the easy way, by printing money rather than by taxation. Congress created the Federal Reserve System, America’s central bank, and can abolish it with a simple majority vote. Volcker deflected repeated threats, including a bill of impeachment, and stuck to his principles. His tenure at the Federal Reserve began the process of reining in the deficit. Volcker promoted the goal of fiscal integrity that Ronald Reagan had promised to the American people, turning Reagan into Reagan. Foreigners rewarded the United States for its monetary and fiscal discipline by investing in U.S. securities and by treating the dollar as a safe haven currency. The United States enjoys lower interest rates and a higher standard of living because countries from China to South Korea send clothing and children’s toys to America in exchange for U.S. dollars. Current Federal Reserve chairman Ben Bernanke credits Volcker’s policies with setting “the stage for decades of economic growth and stability.”2 Volcker’s linkage of responsible monetary policy with fiscal virtue carries a message for today, as the United States emerges from the greatest financial crisis since the Great Depression. Unprecedented low


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interest rates and easy money policies to lower unemployment provoke fears of rekindling inflation when the economy recovers, and the enormous structural budget deficit confronting America fans those fears. The Federal Reserve promises to reverse field to contain inflationary pressures, but that commitment is suspect, with the memory of recession still fresh, unless Congress and the president agree to a balanced budget at full employment. Reckless fiscal policy threatens the dollar’s status as a reliable international store of value and the exorbitant privilege that confers on American consumers. The need to integrate monetary and fiscal policies gained intellectual currency in 2011, when Thomas Sargent was awarded the Nobel Prize in Economics. The New York University economist considers that “Good monetary policy is impossible without good fiscal policy.”3 Sargent advanced the concept of rational expectations in economic behavior and offered historical evidence from the hyperinflations of the 1920s that credible monetary policy needs grounding in fiscal responsibility. Volcker learned the power of expectations while an apprentice on the trading desk at the Federal Reserve Bank of New York. I will show that his subsequent policies revealed an appreciation of rational expectations before that principle gained acceptance.

This book is divided into four parts. Part 1 sets the stage, describing Volcker’s formative years at home, in school, and his early work experience at the Federal Reserve Bank of New York. Part 2 chronicles his role surrounding President Nixon’s suspension of the dollar’s convertibility into gold on August, 15, 1971, America’s final break with the gold standard, which Volcker considers “the most significant single event” in his career.4 Part 3 traces Volcker’s actions as chairman of the Federal Reserve Board from 1979 through 1987 to defeat an escalating inflation that President Jimmy Carter cited as promoting a “crisis of confidence” in America.5 Part 4 describes his role in formulating what President Obama labeled the Volcker Rule in 2010, designed to protect the American taxpayer from having to repeat a bailout of a crippled financial system. A brief prologue weaves the common theme underlying the three crises—1971, 1979, and 2010—that tested Paul Volcker.


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This biography of Volcker’s professional life tells the story of how principle, determination, and pragmatism blend into effective leadership. Volcker understood the need to compromise, and some of his concessions, such as the bailout of Continental Illinois, the seventhlargest U.S. bank in 1984, set a costly precedent in public policy. But he knew where to draw the line, when to build credibility and when to spend it. And that good judgment turned Paul Volcker into an American financial icon.

Paul cooperated in this project by arranging for the release of thousands of documents from the U.S. Treasury and the Federal Reserve System that are the foundation of this biography. He added a personal touch by sitting (not always happily) for one hundred hours of interviews. He also shared his school records and reports that had been carefully guarded by his mother, Alma Volcker. However, this is not an authorized biography: Paul did not think it appropriate to exercise editorial control over the final product. He refused to read it until after it went to press. Nevertheless, Volcker’s presence towered over this project despite his efforts to impose distance. He is alive and well at the writing of this final draft, and that surely had an impact on my thinking. I have tried to remain objective by drawing on a lifetime studying the intricacies of money and finance, but my choosing to unravel the Volcker mystique did not occur by accident. In 1966, at age twenty-three, I taught my first class to twelve graduate students at what is now called the Stern School of Business at New York University. Most of the students in this seminar in money and banking were older than I, including Alan Greenspan, who had just returned to school to begin his work toward a doctorate. (He got an A.) I later served for almost ten years with Ben Bernanke on the Economic Advisory Panel of the Federal Reserve Bank of New York. Greenspan and Bernanke followed Volcker as Federal Reserve chairmen and acknowledge standing on the shoulders of a titan, and that perspective is close to where I was when this project started. Upon further review, I agree with that assessment, but as I have outlined in this introduction, for much broader reasons than I originally thought. A letter from Paul Volcker dated March 17, 2008, launched this ven4

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ture. His note to me, written a day after the Federal Reserve System, America’s central bank, arranged a bailout of the investment banking firm Bear Stearns, read, “Thanks so much for that message—all the more on a day that I’m feeling rather depressed about current problems taking the ‘Fed’ to or beyond the limits!” My message to Paul Volcker, sent a week earlier, had nothing to do with Bear Stearns, the Federal Reserve, or the crisis that refused to die. It had to do with a conversation I had relayed to Paul about my student Rebecca Solow. Rebecca had told me, “I have been keeping my grandfather up-to-date about your lectures. He was most pleased with what I have learned, especially when you told us that Paul Volcker was the greatest Federal Reserve chairman in American history.” Th at observation may not be controversial today, but it was far from the consensus a generation ago. Rebecca’s grandfather is Robert Solow, winner of the 1987 Nobel Prize in Economics. Bob is witty and personable, in addition to being very smart. He is also a die-hard Keynesian who, like so many public intellectuals, lamented Paul Volcker’s anti-inflation policy of the early 1980s, and the accompanying unemployment, as it unfolded. He described the Federal Reserve as “stuck in the embarrassing position of having their finger in the dike and believing they are the country’s last hope.”6 If he wants his granddaughter to appreciate the Volcker legacy, which requires historical perspective, then so, too, should everyone else.


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Prologue The Three Crises of Paul Volcker

On Thursday, January 21, 2010, Paul Volcker and Vice President Joseph Biden flanked Barack Obama behind the lectern in the White House’s Diplomatic Reception Room, site of Franklin Delano Roosevelt’s fireside chats during the Great Depression. After a yearlong battle among the administration’s economic advisers, the president was about to unveil the financial regulatory plan Volcker had advocated. Volcker’s main adversaries, Treasury Secretary Timothy Geithner and White House National Economic Adviser Lawrence Summers, stood like soldiers at parade rest awaiting the president’s orders. Volcker radiated his usual cheer, as though he were attending a funeral rather than celebrating a victory. Volcker had been appointed chairman of the President’s Economic Recovery Advisory Board in November 2008, a newly created oversight panel reporting to Obama. Volcker was eighty-one, and his bald head fringed with white hair highlighted the generation gap with Geithner, Summers, and other members of the president’s economic brain trust. “They are younger than my kids,” he observed later to anyone who would listen.1 Volcker’s appointment had raised expectations in some quarters. Newsweek magazine commented, “Ah, finally an adult.”2 But with little staff and no policy responsibilities, he disappeared from view


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Prol o g u e

soon after the election. When a reporter implied that Volcker had lost influence, Paul responded, “I did not have [any] to start with.”3 Few would say that going forward. The president offered a brief history in his opening remarks. Over the past two years more than seven million Americans have lost their jobs in the deepest recession our country has known in generations . . . But even as we dig our way out of this deep hole it’s important that we not lose sight of what led us into this mess in the first place. This economic crisis began as a financial crisis when banks and fi nancial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses. And to avoid this calamity, the American people . . .  were forced to rescue financial firms facing [crises] largely of their own making.4

Obama’s populist analysis rings true. Excessive risk taking, enabled by easy access to borrowed funds by brokerage fi rms such as Bear Stearns and Lehman Brothers, and by insurance giant AIG, turned a decline in home prices into a financial earthquake. President Obama wanted to redesign the regulatory system to avoid future bailouts. “Limits on the risks major financial firms can take are central to the reforms that I have proposed . . . We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge risky bets that are subsidized by taxpayers . . . It’s for these reasons that I’m proposing a simple and common sense reform, which we’re calling the Volcker Rule, after this tall guy behind me.”5 Obama hooked his thumb like a hitchhiker in Volcker’s direction, just in case the assembled press had failed to notice the financial giant standing behind him. The president cracked a smile, and Vice President Biden laughed. Volcker nodded his large head, apparently enjoying the recognition he deserved. Few knew how upset he was. Volcker had been fighting a losing battle for a year, pushing his vision of regulatory reform, including a comprehensive plan to restrain banks from reckless risk taking. Geithner and Summers had beaten down his proposals, labeling them a throwback to the 1950s, when commercial


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banks were different from the rest of finance. Now that all financial institutions did the same thing, it made no sense to single out banks for a separate set of restrictions. Volcker felt marginalized. “They considered me an old man . . . which I may be, but banks are still the center of the American financial system. As long as we protect them with government-sponsored deposit insurance and provide loans from the central bank as needed, they should be treated differently. So I took my Back to the Future regulatory framework directly to Congress.”6 Volcker’s testimony before the House Banking and Financial Services Committee on September 24, 2009, caught the attention of Vice President Joseph Biden, who said, “His position makes sense to me and it’ll make sense to the American people.”7 Biden urged Obama to reconsider, rescuing Volcker from the Dumpster.8 Volcker had met with the president in the Oval Office immediately before the news conference on January 21, 2010, but the Volcker Rule designation caught him by surprise. The christening had been a lastminute suggestion to Obama by David Axelrod, the president’s chief political strategist. Most people would have paid for the naming rights to a presidential initiative, but not Paul Volcker. His first thought was “Now, why did he do that?”9 Volcker could find fault with the Mona Lisa. He made those who viewed the glass as half-empty seem like wild-eyed optimists. Paul thought the label with his name attached sounded boastful, like a Madison Avenue advertisement. His mother was a Lutheran and his father an Episcopalian, but they both taught that Presbyterian modesty was a cardinal virtue. He also worried that the Volcker Rule label would narrow his life into two words of limited scope. He doubted that Alois Alzheimer, a noted psychiatrist, would be pleased with his memorial. Volcker had always fought like a zealot to get his way, but withdrew when the limelight reflected too brightly off his brow. This time he relented. He lent his name to Obama’s initiative because this would be his last chance to set the American monetary system on the right course. Volcker had emerged from the shadows twice before, launching new financial arrangements in August 1971 and in October 1979, when crises threatened to undermine American leadership in world finance. January 2010 would be his third and final installment. 8

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Before the monetary meltdown of the new millennium, Volcker had confronted two financial disasters that had simmered over many years. The promise by the U.S. Treasury to convert dollar holdings of foreign central banks into gold had served as the foundation of the Bretton Woods System of fi xed exchange rates since the end of World War II. But a decade of eroding U.S. balance of payments during the 1960s threatened America’s promise and undermined the greenback’s credibility as international money. The escalating crisis convinced Volcker, as undersecretary of the treasury for monetary affairs in 1971, to recommend cutting the dollar’s link to gold. The suspension was announced by President Nixon on August 15, 1971, and Volcker then negotiated the transition to the system of floating exchange rates that we have today. The absence of gold as its anchor tested American fi nance. A decade of monetary mismanagement under the leadership of Arthur Burns, appointed by Nixon as chairman of the Federal Reserve System, America’s central bank, nearly destroyed U.S. financial credibility. The escalating inflation during the 1970s led President Jimmy Carter to appoint Volcker as Federal Reserve chairman in 1979. Volcker initiated a new program of monetary control on October 6, 1979, allowing real interest rates to fluctuate widely to reduce inflationary expectations, but his main contribution occurred later. His policy of preemptive restraint during the economic upturn after 1983 increased real interest rates and pushed Congress and the president to adopt a plan to balance the budget. The combination of sound money and fiscal integrity sustained the goal of price stability through Volcker’s departure in 1987 and served as a prototype going forward. His leadership of the Federal Reserve from 1979 through 1987 revived confidence in the central bank—almost as though he had restored the gold standard—and ushered in a generation of economic stability. Volcker’s approach to crisis control cannot be reduced to a precise metric. It is an art form, a blend of principle and compromise, like the justice administered by a frontier sheriff. Volcker never acted hastily, always trying to preserve the status quo. And like a reluctant peace officer pressed into making a stand, he was not above using controversial tactics to restore order. In 1971 he accepted capital controls, an undesirable interference with free trade, while basing exchange rates on the dollar rather than gold. 9

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In 1982, when skyrocketing interest rates threatened to bankrupt Mexico and impair the capital positions of America’s largest banks, Volcker papered over the problem with questionable loans. In 1984, when Continental Illinois, the seventh-largest bank in the United States, nearly failed, he helped rescue the embattled giant from bankruptcy, and in the process sanctioned the problematic principle of Too Big to Fail in American finance. Both bailouts permitted the battle against infl ation to proceed. Volcker chose to defend an ambitious goal, sustaining both the domestic and the international integrity of the U.S. currency. Some view the two faces of the dollar as separate objectives, but he insists, “They are the same. Preserving purchasing power at home promotes confidence in the dollar abroad.”10 His success as an inflation fighter revived trust in the Federal Reserve System and maintained the greenback as the world’s reserve currency. Americans have been able to consume more than they have produced domestically thanks to the dollar’s role as international money. The United States exports financial ser vices to the rest of the world, in exchange for cars, televisions, and manhole covers. Volcker’s victory over inflation had unintended consequences. The generation of economic growth and low inflation that followed between 1987 and 2007 fostered a myth that the business cycle had disappeared and encouraged excessive risk taking by consumers and investors, who borrowed more than they could reasonably expect to repay. The crisis simmered as regulators relaxed safeguards no longer needed under the so-called Great Moderation. Paul Volcker expected trouble. In a speech at Stanford University in February 2005 he said, “Baby boomers are spending like there is no tomorrow . . . and we are buying a lot of houses at rising prices.”11 He warned that “The capital markets which have been so benign in providing flexibility . . . can become a point of great vulnerability.” And then predicted “Big adjustments will inevitably come . . . And as things stand it is more likely than not that it will be financial crises rather than policy foresight that will force the change.” Volcker knew whereof he spoke. His prediction that crisis would force change came from experience. In 1971 he proposed allowing a 10

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“foreign exchange crisis to develop without action or strong intervention by the U.S.,” and to use “suspension of gold convertibility” as negotiating leverage for currency revaluation.12 In 1979 he used the growing popular disgust with the inequities of inflation to galvanize support. “People were prepared to sacrifice to win the battle. I could not have pushed the anti-inflation program without favorable public opinion.”13 In 1984 he agreed with Senator John Heinz at hearings in the Senate that “an inevitable consequence” of the Federal Reserve’s tight monetary policy and high interest rates might be a crisis that forced Congress and the president to reduce the federal deficit.14 Congress passed the Gramm-Rudman-Hollings Act the following year, a first step toward budgetary reform that cheered financial markets, despite its flaws. Almost no one paid attention to Volcker’s warning in 2005. He was old, old-fashioned, and a worrier by nature. He had been eclipsed by time and circumstance. Less than 10 percent of young adults knew who had preceded the then-chairman of the Federal Reserve, Alan Greenspan, when Volcker gave his 2005 speech.15 The monetary meltdown that began in 2007 changed everything. The upheaval threatened to destroy American financial credibility. Bear Stearns and Lehman Brothers, two of the country’s preeminent investment banks, evaporated over separate weekends in March and September 2008. The collapse of those giants threatened to undermine the financial trust that the United States exports to the rest of the world. Volcker returned in 2010 to repair the system he had rescued twice before, and as with those earlier efforts, his plan combined principle and compromise to achieve a noble goal. But unlike 1979, when he was the sheriff, and unlike 1971, when his position at Treasury carried administrative power, Volcker relied primarily on patience and persistence to implement his plan. The Volcker Rule became law on July 21, 2010, a testament to the moral authority he had earned in fift y years of public ser vice.16


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Excerpt from Volcker