Executive Summary: In the absence of institutional constraints on the Fed's management of the dollar, its chairmanship has become one of the most powerful positions on earth. Chances that Volcker will be reappointed in August by the President are only one in three because White House political operatives want someone they can trust in an election homestretch. Can the economy expand for two years without inflation? Feldstein wants a restrained recovery, but Volcker, who certainly wants to be asked to stay after August, can only overcome political objections by having the economy hum now. Volcker can only improve his chances by taking chances himself, continuing to ignore the Ms as long as the price of gold signals a velocity decline. A cut in the discount rate is appropriate now.
The Volcker Reappointment
In its haste Since 1913, when the Federal Reserve System was established to manage the gold standard, its chairman was endowed with a prestige befitting the powers of the office. That is to say, not much; perhaps as much as the president of the World Bank today. The gold standard itself circumscribed the powers of the Fed and its chairman, who was given only enough elbowroom to provide for an "elastic currency." Money could be eased before Christmas, but would have to be snugged up after the holidays, etc. The Fed was on a short leash, tied to a golden spike, with insufficient power to do much damage.
As a result, there was relatively little interest outside banking circles on who chaired the Fed and not much interest even inside banking circles on who served on the Board of Governors. But as Presidents and politicians pushed the Fed to lengthen the Christmas season to include election campaigns, the Fed's leash stretched and its chairman's influence, prestige and visibility increased. When the golden spike was pulled from its roots, greater power flowed to the Fed. Since last October, when Paul Volcker announced that the monetary aggregates, the "Ms," were going on the shelf, all institutional constraints were gone. Suddenly there was no recognizable anchor or leash on Volcker's behavior. In a way, he became the most powerful man in the world, limited only by his considerable ability to talk his fellow governors into implementing the Volcker Standard (whatever that might happen to be on any given day). Because the dollar is the currency of international commerce, there are probably discussions taking place at this moment everywhere in the world (including Albania) on whether or not President Reagan will ask Volcker to remain as Fed Chairman come August, when his term expires.
Certainly the question dominates Washington politics today and has a direct, although at times subtle, influence on unfolding monetary and fiscal policymaking. The raw power in the hands of the Fed chairman is so great that even an idle comment or slip of the tongue on his part can cause great shifts in the value of financial assets here and around the world; a misreading of his views can result in bankruptcies, layoffs, social turmoil. The supposedly non-political Fed is, in the absence of monetary standards, almost thoroughly politicized. And as the politics of renomination intensify, with coalitions forming for and against Volcker, other candidates emerging, we would not be surprised to see bumper stickers and soap boxes brought into the action.
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The first question to dispose of is: Does Volcker want reappointment? I can say with 100 percent certainty that Volcker would like to be asked to remain as Fed chairman; it is only human nature to prefer acceptance over rejection. But the chances that Volcker would accept a proffered reappointment are somewhat less than 100 percent. Not by much, however. He knows power abhors a vacuum and his Volcker Standard is temporary. Institutional constraints of some kind will soon be placed on the Fed, either purely domestic or international, with a clear possibility that it could be a historic reform, a new Bretton Woods. Volcker would want to participate in that process and be identified with it historically. The more likely it seems that such big doings are in the works, the less likely that Volcker would be happy slipping back into the obscurity of the private sector. Put another way: Sir Isaac Newton put England on the gold standard in 1717. Alexander Hamilton in 1793 did the same for the United States. In 1944, Lord Keynes designed Bretton Woods with the assistance of the U.S. Treasury Undersecretary for Monetary Affairs, Harry Dexter White. It's hard to imagine a new historic monetary accord without Volcker's participation and guidance.
But at the moment, the chance that President Reagan will proffer reappointment is not very great. Certainly less than 50 percent and probably more like one in three. The reason is politics, which is currently being committed in Washington, especially when it comes to a politicized Fed.
There are a very few things that political professionals know about monetary policy. And by "pro," I mean those whose professional function is to get candidates elected and re-elected. I include Jim Baker, Lyn Nofziger and Stuart Spencer in this category. They know almost nothing about monetary policy, but they know four things for sure:
1. In 1960, Fed Chairman William McChesney Martin contributed to Richard Nixon's defeat by not "easing up." Arthur Burns told Nixon so.
2. In 1969, President Nixon replaced McChesney Martin with Arthur Burns and in 1972, Burns flooded the system with money and Nixon was re-elected in a landslide.
3. In 1979, President Carter was forced to name Volcker to replace G. William Miller at the Fed, because "the banks" wanted confidence restored in the dollar. In October 1980, Volcker "tightened" and the President who had appointed him was defeated. The pros know this is true because Stuart Eizenstat says so.
4. In the closing days of the 1982 congressional races, the White House asked Volcker to cut the discount rate. Volcker refused. The stock market plunged. Republicans were punished at the polls.
There's some truth in each of these four things the pros know for sure, but we know as an absolute certainty that the political pros around the President want the "edge" that "their own man at the Fed" would give them in the 1984 homestretch. For the same reason that Volcker is trusted by the international financial community, he is distrusted by the domestic political community. To the boys in the checkered suits, for Volcker to have squeezed Democrats in 1980 and Republicans in 1982 is proof that he is politically unprincipled. This isn't a cynical observation. It just says that to political pros, politics is all that counts. The President's political operatives want the security of knowing that after Labor Day 1984, in a close race, they can count on their man at the Fed stretching the elastic currency to Reagan's advantage.
Oddly enough, the Democratic political operatives would just as soon see Volcker, a registered Democrat, replaced. For the most part this reflects the recollection of the 1980 homestretch and bitterness toward Volcker. Treasury Secretary Donald Regan, who is said to be in the running for Volcker's job, is viewed favorably by some congressional Democrats who recall his $1,000 contribution to Jimmy Carter in 1980 and suggest he'd be easier for a Democratic President to get along with in 1985 than some of the other mentioned contenders, Vice Chairman Preston Martin or one of the Old Guard Republicans like Alan Greenspan. But this is merely idle chatter. And there's no sign the high command is thinking of Regan at the Fed or that Regan is interested in the job. In the past, the Fed chairmanship was always small potatoes compared to the Treasury Secretary. It wouldn't take much to restore that relationship, which Regan is well aware of.
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One other political cliche on the grapevine around the White House is the "known fact" that Jimmy Carter had his recovery in the wrong year. That is, the non-election year, 1979. If only he'd been smart enough or lucky enough to have had a recession in 1979, he could have enjoyed a 1980 reflation. The idea is a dangerous one because there is a grain of truth in it, making it seem reasonable to the political professionals. The grain is that if you do try to induce an increase in consumer demand by having the Fed inflate the currency (money velocity rises like a hot potato as consumers unload the debauched currency in exchange for real goods) you have to pay the price afterward. The elastic currency snaps back when the Fed is forced to tighten, in order to restore confidence in the currency.
In the Old Guard austerity model, though, fiscal and monetary policy are interchangeable. And the idea has taken hold that you can only realistically expect an expansion to last about a year before it "overheats" and you have to use the powers of government to cool it off.
President Eisenhower was ensnared by the idea in 1953, when the Eastern Establishment's Old Guard persuaded him to scrap his promised tax cuts in order to fight inflation. When the economy sagged, the administration pushed the Fed to ease. This was the same demand model that led Burns to tell Nixon that the Fed should have eased in 1960, considering the austerity the economy had been through in the previous recession years.
Marty Feldstein, Reagan's chief economic adviser, is the latest practitioner in this orchestral art, following Herbert Stein, Alan Greenspan and William Simon — who in 1980 urged the newly-elected President to take the bitter medicine first in order to enjoy good times later. After years of alternating swings of Fed-induced inflations and deflations, Feldstein has been playing to the mythical fears of the political pros who believe that as long as you can only have expansions in alternate years, 1983 should be a year of restraint.
This is something to worry about, especially when it comes to monetary policy. This is because the seemingly dramatic growth in the most-watched monetary aggregates combines with the politics of the Fed appointment. Volcker probably worries less about the upsand downs of the Ms than anyone involved in monetary policymaking. He knows a "money supply" statistic is a useless piece of information without an accurate measure of money demand, "velocity." But he has to worry about all the people who worry about the Ms, those either indoctrinated by monetarism or those who look for any excuse to restrain the economy in the belief that growth is inflationary.
Thus, the fact that Martin Feldstein is promoting Volcer's reappointment inside the White House and that Volcker himself suddenly got worried in public about the Ms led to political speculation that the two had teamed up. On the assumption that Volcker is campaigning for the job, the line of reasoning is that he is presenting himself as the candidate of the Eastern Establishment, which is how he got dropped onto Jimmy Carter's lap. Here is Volcker stepping up his calls for budget balancing, wringing his hands over Stockman's structural deficits, calling for higher taxes on energy, and frowning over the Ms. The pro-growth Volcker of a few weeks earlier had shifted toward prudence and convention. Or so this not illogical line of analysis concluded.
There's something to it, but probably not much. It's perhaps more accurate to say that Volcker is very sensitive to the politics of reappointment, and he is not going to do or say anything that will reduce his chances of getting the call unless he has to. Publicly frowning about the Ms has its costs; the financial markets shook to the roots, fearing a squeeze. But the frown was just a frown and there was no squeeze. However, the monetarists, who would otherwise be knifing Volcker at every opportunity, turning conservatives against him, were suddenly rejoicing that he hadn't abandoned the faith after all. The shrewdest political operatives in Washington credit Volcker with superb political skills. He doesn't burn bridges behind him. He strains to get everyone into his tent. After watching Volcker testify for hours recently before a Senate committee, one of my associates commented appreciatively that "If he were to appear before a delegation of American Indians, he'd have something nice to say about wampum."
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There are those who are suggesting the President should announce his Fed decision early, to remove uncertainty from the markets. This isn't likely, though. Presidents enjoy all the time they can get to make big decisions. So we can expect three or four months of politicking, speculation, and policymaking at the Fed in this political context. As a Volcker supporter, I've suggested to him that the best politics is the best economics, and that the only way to overcome the boys in the checkered suits is by popular demand. To get the economy humming so well that the President would look foolish if he were to switch horses, and even the political professionals would begin calculating the risks of having "their own man" come in and screw things up.
Obviously, if the recovery were to show signs of coming unglued in the months ahead—specifically, a nosedive in the financial markets — a Volcker reappointment would be out of the question. The collapse would of course be accompanied by a rise in interest rates, and the Fed chairman would get the blame—from Democrats and Republicans.
At the moment, then, there are no economic or political arguments for "tightening," from Volcker's standpoint. He can continue to frown at the Ms, to keep the monetarists at bay. But as long as he doesn't have clear signals that the money-supply growth is inflationary, i.e., that velocity is also rising, he will find any excuse to keep from clamping down or even "snugging up," to use Donald Regan's phrase.
The velocity signal he should be using is the price of gold, a fall in the price of gold indicating a rise in the demand for money (a fall in its velocity). The money-supply statistics can go straight up, and as long as the price of gold doesn't climb too, Volcker can be assured that the M path is not inflationary.
For a variety of reasons, my guess is that $400 gold is a floor in Volcker's mind, and that if it were penetrated he would search for excuses to ease. He doesn't want to revive the recessionary effects of deflation. I'd also guess that at $450 he would resist pressures to ease, even if the Ms were suddenly, unaccountably, falling. And at $500 gold, he'd search for excuses to discourage the markets from entering a new phase of commodity speculation.
We saw signs of this kind of behavior after the Fed's Open Market Committee meeting of March 28-29, when Henry Wallich, the Fed governor who has been the most serious M targeteer over the years, brushed aside concerns about exploding M1 and M2 to observe that M3 was on target. There are no serious players left in policymaking roles who believe the Ms can be redefined into useful instruments. No "M" can incorporate a velocity signal, and almost everyone now realizes that it cannot.
It's one thing to find excuses not to tighten when the Ms are climbing. It's another to find excuses to ease when the Ms are climbing. Yet this is what Volcker has to do if he's going to get the economy really humming in these next few months. With Alan Greenspan and the austerity crowd yelling at him to squeeze (to avoid an inflationary presidential election year), he has to make the case that a further easing is appropriate as long as the markets are not signaling a renewed fear of commodity speculation.
For Volcker to push through a consensus at the Fed to cut the discount rate now, with the price of gold around $415, would indeed be appropriate. The response in the financial markets would be exceedingly bullish. The price of gold would rise, but probably not as high as it did after the last cut on Dec. 13, when it rose above $500 as the markets speculated that the Fed was on a reflation path. A discount-rate cut now would be more understood as a response to a price rule. And if the gold price climbed above $450, then Volcker could think of snugging up again, preparing for yet another discount-rate reduction when the markets signaled they were ready for one via the gold price.
This form of communication between the Fed and the markets has been taking place and will continue. And because Volcker isn't quite sure of his model and is feeling his way, there will be setbacks and corrections with each misinterpretation on either side. When the dialogue is really going well, we could expect some fancy advances in the stock and bond markets. At least it's hard to see any downside risk in the near term, while the Volcker reappointment is still up in the air. On the other hand, if Volcker decides to play it safe, taking no risks, the economy will still grow at a pace incorporating previous policy gains, but we might just see Wall Street jogging sideways.
My guess is that Volcker will see that he has to take some chances to optimize his political position, that playing it safe plays into the hands of the political operatives who want their own man at the Fed. The fact that the four new regional governors of the Fed who joined the Open Market Committee on March 28 are considerably less monetarist than the departing quartet also gives Volcker a bit more room for maneuver. Henry Wallich's sunnier disposition also bodes well. If the analysis is correct, we'll see plenty of sunny days on Wall Street in the months ahead and Volcker will get the call.
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