Wall Street History

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Wall Street History

06/09/2006

Paul Volcker

With the global hue and cry that the successor to Federal Reserve
Chairman Alan Greenspan, Ben Bernanke, may not be quite up
to the task, and as world markets are roiled by fears over higher
interest rates and the impact on growth, I thought it was a good
time to reprise a series I did six years ago in this space, the tale
of Paul Volcker.

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“Paul Volcker stands out as one of the great central bankers of
the twentieth century.”
--Economist Henry Kaufman

Following is the story of a giant in the financial world, the
former Federal Reserve Chairman Paul Volcker. We will also
detour once or twice to examine some of the other players who
helped shape the Volcker era.

But first, here are some definitions of terms that may make it
easier to understand the piece:

Discount Rate: The interest rate charged by the Federal Reserve
on loans to its member banks.

Federal Funds Rate: The rate of interest on overnight loans of
excess reserves among commercial banks.

M1: Measurement of the domestic money supply that
incorporates only money that is ordinarily used for spending on
goods and services. M1 includes currency, checking account
balances, and travelers’ checks.

M2: A measure of the money supply that includes M1 plus
savings and time deposits, overnight repurchase agreements, and
personal balances in money market accounts. Thus, M2 includes
money that can be used for spending (M1) plus items that can be
quickly converted to M1.

Money Supply: The amount of money in the economy. Since the
money supply is considered by some to be a critical element in
determining economic activity, from time to time the financial
markets place great importance on the Federal Reserve’s reports
of changes in the supply. For example, consistently large
increases in the money supply can lead to future inflation.

Prime Rate: A short-term interest rate quoted by a commercial
bank as an indication of the rate being charged on loans to its
best commercial customers. While banks frequently charge more
than the quoted ‘prime rate,’ it is a benchmark against which
other rates are measured.

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Paul Volcker was a career civil servant and central banker who,
among his various positions, served as Under Secretary of the
Treasury under Richard Nixon and then president of the New
York Federal Reserve Bank.

Volcker was an imposing figure, 6’7” to be exact, and a major
player on the world financial stage as the year 1979 unwound.
With his broad background, and the international markets in a
state of flux, it was time for him to take the spotlight.

1979 was a bleak year for America. The economic news was not
good: soaring interest rates, inflation, and a rising foreign trade
deficit led to a moribund stock market.

Events overseas were attracting attention, particularly in Iran,
where in January the Shah had been toppled and a fundamentalist
Islamic dictatorship installed under the rule of Ayatollah
Khomenei. By November, Islamic revolutionaries seized the U.S.
embassy, taking 90 hostages.

It was a time of malaise, the Jimmy Carter era. Optimism was
not in strong supply.

And within the Carter administration there was a lot of
infighting over the nation’s economic policy. Inflation was to hit
13.3% in 1979. Treasury Secretary Michael Blumenthal
advocated higher interest rates to bring inflation under control.
But the Chairman of the Federal Reserve, G. William Miller,
thought monetary policy was just fine and resisted raising rates.
Miller believed inflation would eventually peter out all by itself.

In these situations, arguments between the Fed and the
administration are not to be carried out in public. There is a
history of upholding the Fed’s independence and to de-politicize
their role as much as possible. But Blumenthal and Miller took
their differences of opinion outside. They exchanged barbs in
speeches and in publications from about April to July.

Through it all, Wall Street was losing confidence in Miller. The
stock market was in the midst of a long period of mediocrity. In
recovering from the ‘73-‘74 bear market low of 577 on the Dow
Jones, the market had peaked at 1014 in September of 1976.
From there it was a steady drip, drip down and by the summer of
1979, the market had been trading in the 800’s for months.
[Actually, outside of two days in November, the Dow, as
measured by the closing average, traded in the 800’s all year!]

So on July 19, President Carter decided that it was time to make
a change and Blumenthal was fired (as well as three other cabinet
members, with a fifth resigning) to be replaced at Treasury by
Miller. Then on July 25 Carter nominated Paul Volcker to be the
new chairman of the Federal Reserve. Wall Street celebrated by
rallying 10 points that day, 829 to 839.

Historian Charles Geisst comments:

“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.”

[As I read this passage, I was struck by the similarity with the
process of selecting Supreme Court nominees. Presidents often
think they know where a particular judge stands before they are
selected. But then often the “conservative” becomes a “liberal”
jurist, and vice versa.]

Volcker was confirmed by Congress on August 2 and then sworn
in on August 6. He got to work.

While the U.S. economy was growing, when you took out
inflation the growth was minimal. It was a period of
“stagflation,” inflation with slow to zero growth. As the data
rolled in Volcker made it clear that inflation was “public enemy
number one.”

On October 4, the September Producer Price Index showed a rise
of 17%, the largest increase in five years.

On October 5, the Labor Department reported unemployment
had declined slightly to 5.8%.

Meanwhile, the money supply had been expanding rapidly. The
markets grew increasingly skittish and overseas, investors were
uneasy over the U.S. seeming inability to solve the inflation
problem. The dollar was weak and the trade deficit was soaring.

Volcker commenced an attack on the money supply as soon as he
took control. He began to set a target for the growth of money
in the hopes that demand for credit would begin to dry up. The
federal funds rate was increased in the belief banks would
eventually cut back on their loan lending. If it became difficult
to find new capital, a company’s expansion plans would be put
on hold.

Then on October 6, Volcker acted even more forcefully.
Holding a rare Saturday night news conference [remember, he
didn’t have to compete with classic episodes of “Who Wants to
be a Millionaire” back then] he unleashed his own version of the
“Saturday Night Massacre.” Pointing to the recent economic
releases, Volcker said, “Business data has been good and better
than expected. Inflation data has been bad and perhaps worse
than expected.”

The Chairman announced that the discount rate was being
increased a full percentage point to a record 12%. “We consider
that (this) action will effectively reinforce actions taken earlier to
deal with the inflationary environment.”

But Volcker wasn''t just looking to slow inflation, he was seeking
to smash it! It was just the start and the Carter administration
was none too pleased. Neither were the financial markets.

When the Dow Jones opened on Monday, October 8, it fell from
898 to 884. Within a month it would be below 800. [Those two
aforementioned days in November.] Meanwhile, in the bond
pits, rates soared. The 3-month Treasury Bill, yielding around
8% in late September, climbed to 12.5% by year end.

One sidelight to the market maneuverings around the October 6
Fed announcement. On October 5, IBM had brought to market
the largest corporate bond offering ever, $1 billion. Of course
the fixed income market was roiled that following Monday.
Many of the 225 investment banks in on the deal were left with
large amounts of inventory. [Not having anticipated any
problems, the firms had taken down positions in the IBM bonds
in the full confidence that it would be easy to resell them to their
clients. The sudden rise in rates on Monday, and the
commensurate decline in the value of bonds, meant that some
firms faced large losses on their positions of unsold paper.
Ironically, Salomon, the co-lead in the offering, had sold
virtually all of its bonds before Volcker’s announcement, thus
losing little, which fanned speculation that they had inside
information. This was never proved to be the case.]

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Part II

“It’s easy for a central banker to be popular during euphoric
financial times. But the political perils are severe when tough
measures are needed - measures that extract a high short-term
toll in the interest of longer-term economic health - as they were
in the late 1970s.”
--Henry Kaufman

As we pick up our story it’s the fall of 1979 and Volcker has put
his stamp on Fed policy by raising the discount rate a full
percentage point while emphasizing that killing inflation was his
number one priority. The chairman realized he risked putting the
economy into recession.

Interest rates soared. While the 3-month Treasury Bill was
climbing from 8% in September of ‘79 to 12.5% by year end, the
Fed wasn’t counting on long-term rates rising as well, from the
9.2% level on the then benchmark 30-year in September to
10.1% by December 31st.

[In most normal environments, as the Fed is increasing short
interest rates (the only part of the yield curve they can influence
directly), the longer end responds positively. Since the longer
end represents “inflation expectations,” by raising short rates you
would expect to eventually slow the economy and dampen
inflation fears. Thus, the premium that investors demand for
buying longer-term instruments should narrow, not widen.]

Into early 1980, interest rates across the board continued to rise
and the economy tipped into recession (a mild one but an
important one as far as the presidential election of 1980 was
concerned). By the end of the first quarter, the long bond was
yielding 12.3%. Treasury Bills were to peak that year in the
second quarter, 15.6%. The inflation rate for the first quarter of
1980, as measured by the CPI was 14.6%.

Awful news. But what we didn’t know at the time, as is often
the case during events such as these, was that the back of
inflation had been broken. By the middle of 1981, it was
running at a 9.7% clip and for the year was below 9%.
Volcker was winning.

But the times were tough on the chairman. Henry Kaufman went
to visit him in 1980 and observed that construction bricks were
filling an outer office, yet no renovation appeared to be taking
place. It turns out that the Brick Layers Union had sent them
over, along with a note saying that they were no longer needed.
A rather vicious reminder of the troubled economic environment.

1980 was a miserable year for President Carter as well. Inflation,
unbelievably high interest rates, a desultory stock market, and the
Iranian hostage crisis. Carter went against the policy of the Fed
and instituted his own policy of “special credit controls” whereby
special requirements were placed on the reserves of banks and
credit card companies. Volcker sat by, not wanting to be seen
playing politics. Like the price controls of President Nixon, the
credit controls worked for a spell and rates declined, only to
soar anew.

Reagan won the election that November and, as soon as the votes
were tabulated, Volcker began to tighten interest rates more. The
federal funds rate, which had averaged 11.2% in 1979, peaked at
20% in June 1981. The prime rate rose to 21.5% in ‘81 as well.
Treasury Bills hit 17.3% and the long bond was on its way to
15.3%.

Upon taking office, Ronald Reagan said the country faced the
threat of economic calamity. But many countered his preferred
policies of tax cuts would encourage spending and investment
and thus hamper Volcker’s effort to kill inflation, once and for
all.

Reagan, though, understood the importance of ending the
inflation threat and he was willing to endure a deep recession to
accomplish this. Already, early in 1981 there were reports that he
would be a one-term president. [That spring John Hinckley
almost had his own say on this view.]

But while Reagan would remark at cabinet meetings, “Why do
we need the Federal Reserve at all?” he let Volcker operate with
little interference. [Incidentally, no one was ever able to answer
Reagan’s question. Another example of his simplistic
brilliance.]

By July 1981, the nation was in recession and it would be a
long, ugly one. [Economists choose November 1982 as the
month the recession ended.] The manufacturing sector was
decimated plus the combination of high interest rates and an
expensive dollar sharply reduced American exports, particularly
hurting farmers. In 1982 the unemployment rate hit 9.7%.

Reagan didn’t waver. He insisted that if the nation “stayed the
course” it would emerge healthier and more prosperous in the
end.

Meanwhile, Paul Volcker stuck to his own guns, convinced that
firm control of the money supply was the key to a sound
economy. Plus inflation was heading lower. A CPI that registered
13.3% for 1979 was to plummet to 3.8% for all of 1982.

The stock market, which had reacted positively to Reagan’s
victory in November 1980, with the Dow Jones closing at 953 on
the first trading day after the election, was to become a victim of
the deep recession of ‘81-‘82 as well. By the summer of 1982
the Dow would plummet to 776 on August 12, but Volcker was
increasingly convinced the time was near to reverse course.

And another figure who was about to turn positive was “Dr.
Doom,” economist Henry Kaufman of Salomon Brothers.

Kaufman’s pronouncements on the financial markets were
legendary back in the late ‘70s - early ‘80s. When Henry spoke,
people listened.

I started my career in the financial services industry working in
the same building where Salomon’s headquarters were. I used to
ride the elevator with Mr. Kaufman as our companies were in the
same elevator bank. He always looked so glum and we felt like
saying, “Hey, nice comment Henry!” as the market tanked after a
particularly negative missive from the Doctor.

But by the summer of 1982, Kaufman was becoming
increasingly convinced that a significant interest rate decline lay
ahead. The recession, financial blockages and intense
international competition augured for a more favorable
environment in bond land, and by inference, the stock market.
Kaufman decided to become bullish.

On August 17, Dr. Doom issued a memo proclaiming the worst
was over. The financial markets went ballistic. The Dow Jones
rallied 38.81 that day (792 to 831) or 4.9%, the largest single-
day rise in the market’s history. A near record 93 million shares
changed hands and there were 10 stocks up for every 1 down.
Over in the bond pits, short-term rates fell about half a point in
one day. The Fed cut the discount rate in August and the great
bull market was under way.

Ironically, as the Fed relaxed policy, money supply growth
soared. The Reagan budget deficits began to soar as well.
Interest rates were to take another hit to the gut in 1984 as the
yield on the long bond hit 14% but, as the realization was also
sinking in that inflation was not going to return to the levels of
1979-81, rates resumed their downtrend and the great bull market
in bonds was under way.

Paul Volcker stayed on as Fed Chairman until his retirement in
June 1987, to be replaced by Alan Greenspan. While Volcker has
remained active in the financial arena, perhaps his highest profile
stance since his Fed days was taken during the Long-Term
Capital Management fiasco of 1998. Volcker questioned the
“bailout” of LTCM by the consortium of investment banks.
“Why should the weight of the federal government be brought to
bear to help out a private investor?”

I guess they were just too big to fail, Paul. A nasty precedent was
set.

[The Fed was adamant it wasn’t involved in the LTCM bailout
and that this was not government interference in the free
markets.]

Sources:

“Monopolies in America,” Charles Geisst
“Wall Street: A History,” Charles Geisst
“The Presidents,” edited by Henry Graff
“On Money and Markets,” Henry Kaufman
“New York Times: Century of Business,” Floyd Norris and
Christine Bockelman
“The Pursuit of Wealth,” Robert Sobel
“Wall Street Words,” David Scott

Wall Street History will return next week.

Brian Trumbore

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