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Twelve Economics as Moral Theory: Volckernomics, Reaganomics, and the Balanced Budget Amendment
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The Federal Reserve and the Banks

Chairman Volcker and his colleagues faced an extremely delicate choice. Over two years, beginning in October 1979, the Board had reduced inflation through an unprecedented squeeze on the money supply. On the few occasions, when the monetary aggregate figures had suggested some loosening of the grip, commentators had raised the alarm of runaway inflation. The rest of the time, the Federal Reserve had to listen


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to screams of pain from the interest-sensitive sectors of the economy. Throughout this period, the Fed's governors felt their only choice was to squeeze hard because any loosening might drive up interest rates as panicky investors predicted worse inflation. By July 1982, M-1, the basic measure of the money supply, had risen barely 4 percent in fifteen months; unemployment and bankruptcies were climbing steadily toward heights last reached in the Great Depression. Yet neither investors and business interests nor the public at large seemed to believe, in spite of the real reduction in inflation, that prices would stay under control. In June, for example, a Business Week poll of 600 top corporate executives found that 53 percent expected inflation to take flight again within a year.[9] If the Fed loosened its grip on the money supply, inflation fears might keep interest rates high, no recovery would follow, and the hard-won progress against inflation would be lost. But if the Fed did not loosen, interest rates certainly would remain high. Talk about Representative McDade's no money for anything.

Not only was the American economy choking, but the recession was equally bad in Europe, with prospects there even bleaker. High American interest rates and worldwide political worries strengthened the dollar dramatically against foreign currencies. To prevent an even greater outflow of their capital to the safe, high-interest United States, European finance ministers raised their own interest rates, and in turn those rates crippled European economies. As unemployment rose in Europe and America, consumer demand accordingly stagnated or fell. The world economy entered a classic downward spiral.

If Europe and America were in trouble, the struggling nations of the second (communist) and third worlds were, literally, on the verge of bankruptcy. The strong dollar meant that these nations had to exchange more of their products for fewer dollars, reducing both American inflation and Mexican, Polish, and Brazilian incomes. Dollars could barely be earned and only dearly borrowed. Yet dollars were needed, for the nations of the world owed hundreds of billions of dollars to American and European banks.

We have been talking throughout this book about the Federal Reserve as an institution for economic management. Fundamentally, however, the Fed is a bank—a rather big and unusual one (serving only other banks, not individuals or businesses) but a bank nonetheless. Its bedrock responsibility is not economic growth but the banking system's health—on the well-grounded assumption that a sick banking system will infect the whole economy. By a banking system, we do not mean simply a place for people to put money and have it safe. Rather, we mean a system for creating money and credit, for ensuring the flow of that very peculiar commodity that is the means of payment for all other commodities.


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In June 1982, the Board's governors saw the economy doing rather worse than was tolerable. The Board also saw many foreign loans on the banks' balance sheets. Perhaps some of those nations would default. If they did, the debtors might take the banking system with them into bankruptcy.

The massive international debt crisis that reached public attention in late summer 1982 had been building since 1971, the year when OPEC discovered its strength in negotiations with the big oil companies. In October 1973, OPEC raised oil prices unilaterally, and the price held. A few months later, the price more than doubled again. The greatest transfer of wealth in the history of the world had begun. The world's rich nations suddenly were paying tribute to less-developed ones. Those envious of the West might have been happy for a moment; economic writer George Goodman (aka "Adam Smith"), with nice irony, described

a feeling of jubilation in all those countries of Asia and Africa. What an upset! Ragheads, 66; Giants, O! … So much for the imperialist exploiters who wanted us to be a nation of busboys!

And then somebody—maybe the financial people … would say, "But now we have to pay four times as much for the oil, and we have no oil. Where do we get the money?"[10]

More or less fortunately, there was yet another problem: What on earth would OPEC countries, particularly the sparsely populated Arab states, do with the money? They put it in banks, and the banks lent it all over the world. Many loans were less than wise, but this recycling of the OPEC surplus through the banking system prevented the oil price hike from generating a massive worldwide slump. The cycle repeated after 1979.

In late 1981, Mexico owed various banks $56.9 billion, of which half was due in 1982. Brazil owed $52.7 billion, a third due that year. Venezuela, Argentina, South Korea, and Poland all owed more than $15 billion.[11] To make matters worse, throughout this period, the banks—competing with each other for the international loan business—had expanded their loan/reserve ratios. Thus, the banks were at great risk if defaults occurred.

In all the strife about the budget and the economy little had been heard about third world loans. But to bankers and policy makers of the international financial system the problem loomed ever larger and more menacing. A big default might start a process in which the flow of money and credit that is the lifeblood of the world's economy collapsed like a row of dominoes. Warning signs abounded: a large government securities trading company went under in May and a medium-sized bank in


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July; the entire savings and loan industry was in trouble. As August approached, Mexico neared default.[12]

A number of lines of defense against a chain of defaults spread from some weak link across the banking system. First, debtors and creditors negotiated to reschedule the debt; that defense was crumbling as creditors demanded higher interest rates for greater risks. Next came the International Monetary Fund (IMF); third parties could guarantee loans, or offer them, in return for policy changes that would make repayment by the debtor nation more credible. But IMF conditions for loans might be too tough for recipient governments to accept and still survive politically while IMF reserves themselves were limited.

Within each country the national central banks themselves would be "lenders of last resort" to their respective private banks. If a major American bank was about to collapse, the Federal Reserve might provide loans to tide the bank over the crisis or allow some other, profitable bank to assume the liabilities (and assets) of the collapsing institution, thereby protecting its creditors. The Bundesbank in Germany, the Bank of England, and other central banks would try to do the same in their own financial systems.

What if none of that were enough? What if the doomsday scenario occurred, and the dollars could not be found to stem the chain reaction of collapse? Well, only one organization in the world could invent the necessary dollars. The dollar is the world's currency; the system of money and credit for the world, not just the United States, ultimately is the responsibility of America's central bank. The Federal Reserve is the lender of last resort for the world.

In 1981, at the height of concern with hyperinflation, George Goodman reported a conversation with his understandably anonymous "banker mentor." "Where will the Federal Reserve get the money?" Goodman asked. "It will print it," the banker replied. But that, said Goodman, is superinflation, too many dollars chasing goods. Perhaps, his banker replied, but there was no choice:

The System must survive. A burst of liquidity at the right time can save the System and buy time to solve the problems. Otherwise we will have a massive depression, and the Western nations will battle one another for the scraps, as they did in the Depression…. We hope that a burst of liquidity, properly handled, would restore confidence, not destroy it…. Remember, there is nowhere else to go.[13]

This is melodrama but melodrama with a point. In July of 1982, the crisis was uncomfortably close; the Fed's governors knew it. They knew one more thing: an ounce of prevention is worth a pound of cure. The time for a "burst of liquidity" was before panic set in.


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Yet the Fed's governors worried that if they loosened, those with money to lend, attending to monetarist theory rather than deep recession reality, might fear future inflation and keep interest rates high. The Fed, therefore, had to loosen while maintaining its reputation for tightness. As Volcker told the story,[14] the board merely decided to let monetary growth move from the low end to the high end of the year's target range. In fact, M-1 overshot its 1982 target by three points as the Fed jammed the monetary accelerator through the first half of 1983. The money shortage was met by a large infusion of cash. Simultaneously the Board embarked on a publicity campaign, reiterating both its determination to prevent inflation and its contention that inflation was finally under control. Board governors gave rare public interviews. Volcker stoutly resisted congressional pressure to "loosen up" while doing exactly that. Expectations were confronted with rhetoric.

"In just one week," Chase Manhattan Bank economist Richard Benson asserted, "they [the Federal Reserve] did a coupon pass [bought Treasury notes on the open market], a bill pass [bought T-bills] and a system repo [borrowed securities from a bank or broker for cash] five days running."[15] In August, both before and during the stock market rally, the Fed cut the discount rate three more times, down to 10 percent. Short-term interest rates fell, the stock market boomed, but long-term rates remained sticky; the economy did not recover. The Mexican crisis was postponed but not resolved.

Monetarist logic about the relation between the money supply and prices was being invalidated, as Volcker argued, by an unprecedented, since the depression, reduction in the velocity of money. Instead of spending and circulating it, people and businesses were holding on to cash, anticipating even harder times. Keynes had a name for this: he called it a "liquidity trap," in which nervous people clung to liquid assets; that unwillingness to spend or invest made their fears for the economy self-fulfilling. It was the exact opposite of the burst in velocity needed to make the Rosy Scenario come true. Volcker's version was understated: because standard relationships "over time between the monetary and credit aggregates and the variables we really care about—output, employment and prices … did not hold in 1982," M-1 targets had to be overshot because "that policy, in practical effect, would otherwise have been appreciably more restrictive than intended in setting the targets."[16]

On October 5, 1982, the Federal Open Market Committee met again. In spite of the market rally, economic conditions remained parlous. Describing conditions in the most gloomy of terms, the chairman led his colleagues in deciding to loosen further, formally abandoning monetarist money-targeting procedures adopted in October 1979. In an unusual


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step meant to reassure market participants that the Fed wanted interest rates down, Volcker publicly announced the change on October 9.[17]

Would beliefs about the catastrophic effects of deficits overcome the real effects of greater supply and slack demand for money? No; nominal interest rates did come down. The prime interest rate, having slid three points in July and August, declined three more points, to 10.5 percent in February. Other short-term interest rates dropped accordingly. Long-term rates, more influenced by expectations and less by the immediate money supply, fell more slowly. But they, too, dropped three points by November. As money expanded and interest rates fell, prices were steady. The Consumer Price Index (CPI) rose only 2 percent from July 1982 through June 1983. Real interest rates thus were extremely high and in some ways crippling. Yet for investors who had to put their money somewhere, lower nominal rates made stocks more attractive.

We can say now that in August 1982 the Fed, for the time being, had won its battle against inflation; a 13 percent increase in M-1 over the next year did not reignite the fire. Volcker's gamble worked. For quite a while the economy remained in miserable shape; unemployment rose into double digits in September and stayed there until June 1983. In spring 1983, however, a robust recovery began.[18]

We have come a long way from the stock market, but we can now draw a few conclusions. The decline of interest rates, the need of large institutions to invest somewhere, and the dynamics of a buying surge among a small group of actors[19] —rather than optimism about the economy or confidence in Reaganomics—fueled the market rally. Even if investors expected further inflation, declining short-term interest rates justified moving funds into stocks. Businessmen were not confident, as long-term rates showed, that the battle against inflation had been won. Business investment did not lead the nation out of the recession. But the economy had passed a watershed; whether or not anyone believed it, the recession had killed inflation.


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Twelve Economics as Moral Theory: Volckernomics, Reaganomics, and the Balanced Budget Amendment
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