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THE CHOICE OF WALL STREET
In 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 also occur, more subtly, without elections. Even the President did not seem to grasp this possibility, until too late. He would remain in office, surrounded 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, insulated 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 coexisted with the elected one, shared power with Congress and the President, and collaborated with them. In some circumstances, it opposed them and thwarted them.
Citizens were taught that its activities were mechanical and nonpolitical, unaffected by the self-interested pressures of competing economic groups, and its pervasive influence over American life was largely ignored by the continuing political debate. Its decisions and internal disputes and the large consequences that flowed from them remained remote and indistinct, submerged beneath the visible politics 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 acquiesced 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 economy, 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 authority. The public that first embraced the simple virtues Carter expressed 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, somewhat 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 landscape of American life. In his methodical manner, Carter filled a notebook with their comments. Each day, the press speculated extravagantly on what the President intended to do.
On Saturday, July 14, the isolation ended and Jimmy Carter returned 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 small 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: "I 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 production, the cartel of oil-producing nations, OPEC, had seized the opportunity 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 Americans 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 abnormally 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 summer, motorists in some regions were once again waiting in line at gas stations and Jimmy Carter's political popularity had reached a dangerously 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 oil companies -- and deflected Americans' resentment toward them. But polarizing 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 program, 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 excesses 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 expansion by which Washington ultimately influenced both prices and the pace of private economic activity. His stern message sounded especially strange coming from a Democratic President, leading the political 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 Caner 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 successful speeches of his Presidency. Contemporary Americans were devoted 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 instance, 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 dramatically. One survey found that public approval for his Presidency increased 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 confidence in his leadership.
This was a promising start, though White House advisers understood 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 fit 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 $300 a week and they're spending it on jewelry. They have to have it. It's like food.
I'm 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 materialism. 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 who have grown up since World War II 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: "I have more credit than money. I could buy far more things than I 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 calculated 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 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 lessons 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 tomorrow in inflated dollars that were worth less So long as wages continued 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 behavior 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 grandfather 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 abundance generated during Carter's term, the rising prices produced anxieties 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 citizens 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.
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 Treasury 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 billions 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 control 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. Still, 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 pressures. 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 corporations, wealthy investors, perhaps even other governments -- expected 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 other currencies, Deutsche marks, yen, francs and pounds. Roughly translated, the dollar's steady decline amounted to an inflation forecast -- 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 Presidency, 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 European markets -- moving above $300 an ounce. By comparison, a decade 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 confirming 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 unexpectedly, 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 uncertainty" in the government was contributing to the dollar's decline. W. Michael Blumenthal was regarded by Wall Street as one of its stronger advocates in the Carter Cabinet, but Blumenthal was himself unsure whether he would continue in office.
On Thursday, President Carter announced wholesale changes in his Cabinet. Blumenthal would be replaced, along with Attorney General Griffin Bell and the Secretary of Health, Education and Welfare, Joseph 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 defend 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 President 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 Treasury. 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 Reserve was formally independent of the executive branch, not required by law to take orders from the Oval Office. Wall Street analysts complained that Miller was much too cooperative, too timid about raising interest rates high enough to suppress inflation.
Miller'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 happenstance 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 a 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.
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 chairman for the Federal Reserve, one who would calm the financial markets.
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 confirmed 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 a 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 Reserve's control of money was supposed to be above politics, protected from narrow partisan interests, Schultz's appointment aroused suspicions. 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 beginning 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 amplified on the daily messages from the financial markets. The President would be gravely damaged if he did not quickly appoint a new chairman for the Fed, a chairman whom Wall Street trusted.
"It became obvious," Eizenstat said, "that we had to quell the nervousness of the markets."
Political tension existed inevitably between Wall Street and Washington. They were separate capitals, in a sense, representing two different sources of power in the American society. One spoke for capital, the accumulated financial wealth generated by private enterprise. 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.
"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 circles. They just don't speak the same language."
Over the weekend, Carter's White House staff switched its attention from angry politicians in Washington and addressed the complaints 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 settlements 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 took his oath of office here in 1789, stood on the steps, a bronze statue beckoning to tourists. One block west, framed by the tall buildings, 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 intimidating 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 Washington. The political capital in Washington, they thought, was egotistical 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 brokerage 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 capital from Wall Street, the democratic ambitions expressed in Washington. 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 finance 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 outsiders, 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 decline, 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 transformed 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 & Company: "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 market itself. The most prestigious and powerful banks and brokerages were gamblers, making judgments about the direction markets would take and betting huge stakes on their forecasts. 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 manipulation 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, television -- continued to resonate with the folk prejudice against bankers, a distrust of financial power as old as the nation. The Populist resentments 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 capitalism, 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 enterprise 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 locations of the largest 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 sixteen 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 California, led by Citibank ($70.5 billion), Chase Manhattan ($49 billion), Manufacturers Hanover Trust ($38 billion) and Morgan Guaranty ($30 billion).
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 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 brokers 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 packaging in stocks and bonds 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 Markets, 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.
pardCapital formation -- the flow of accumulated savings into the creation 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 most important banking houses were compelled to collaborate 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 corporations 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, investment banking was highly concentrated. In 1979, the top five brokers 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 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 Citibank 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 connected 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 Wall Street Journal, commissioned a census of "finance professionals" in the United States -- people who managed finance for corporations and individuals, stockbrokers, securities analysts, 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 adjustment 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 economists as models of efficiency and rationality. Wall Street was portrayed by them as a living laboratory for the efficient allocation of 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 themselves, 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 fell -- 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, nonetheless, 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 psychological 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 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 inflation. 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 generating income. The disappointed investor might sell his bonds and invest 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 involved a bewildering variety of lending instruments, from verbal swaps of excess reserves among banks to commercial paper issued by corporations 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 institutional 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 the visible barometer of financial news. In fact, the stock market was dwarfed by the credit markets. The year-end market value of all corporate equities in 1979 was about $1.2 trillion -- compared to $4.2 trillion 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 commercial 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 ventures, 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 capitalism itself advanced toward a prosperous future or stagnated and regressed.
Across the three great financial markets, money flowed continuously, in and out of different channels, back and forth from one instrument 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 authority 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 corporation 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 according 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 "market pressures."
The Federal Reserve Board stood alongside the system like a governor, like a supervising engineer who had the power to alter the flows 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 accomplished 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 simplicity. 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 societies 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 economy 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 millions, 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 to several billion. In both cases, the Fed created money with a key stroke of the computer terminal (computer accounting 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 Discount 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 Federal 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 Fed, markets pursued their own direction, driven by contrary perceptions 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" like David Jones -- who did nothing else. The scores of Fed watchers analyzed the weekly banking numbers, the credit trends and the general 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 economy 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 window 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, including 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 market, a Fed "turn" could launch a major rally or squelch it, but transient 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 investments and their commitments were most sensitive to the distant future. If the Federal Reserve failed to maintain stable money values, then the bondholders suffered most dramatically. Like the bond market, 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 "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 prospects, 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 potential 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, including the central banks of other nations. Before that, Volcker had served as Treasury Under Secretary for Monetary Affairs in the Nixon Administration, 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 executives and lawyers who were close to the Carter White House, academic economists, a labor leader, other officials in the Administration. Their comments were summarized in a briefing book he was to deliver to the President that Sunday evening. Most reactions to Volcker'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 experience, 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, enormously respected." Another liberal economist: "Very right-wing...not a team player."
As Moe summarized his reporting in the memorandum for the President, 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 appointments 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 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 citizen, every household in the land had free access to its commercial messages and absorbed the slogans and visual cliches into daily conversation. 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 shareholders. 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 audiences 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 unlimited 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 all sports we want. I can't imagine us ever advertising on a bowling tournament, not that I have anything against bowling or the people who watch it.
Bowlers did not buy stocks and bonds, but tennis buffs did. Paine Webber would create a TV commercial tailored to their ultimate fantasy. 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 auxiliary 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 narrower 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 $1 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 demographics of The Wall Street Journal itself. Its own daily readership was a reasonable surrogate for all the people who cared most about news of the financial markets. Of the Journal's two million subscribers, 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 untypical minority of Americans, with distinctly different economic interests than 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 fulcrum 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 lenders. Their net financial wealth was zero or negative. American capitalism 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, according to a survey of consumer finances conducted by the Federal Reserve Board. But this was an instance where the average of all 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, including checking deposits, savings accounts or any others, that totaled less 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 second 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 negative 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 all 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 investors -- 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, bonds, 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 beneficiaries, depositors or insurance-policy holders). The largest pool of assets, by far, was held in the commercial banks ($1.3 trillion), followed by savings and loan associations ($580 billion), life-insurance companies ($420 billion) and retirement funds ($410 billion). By comparison, tax-exempt foundations and universities had assets of $50 billion.
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 investment 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 portfolio 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 illusion, concealing the damage to companies' real assets. When a manufacturer's machinery and factory buildings 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 inadequate. 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 would it stop? At 15 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 necessary. Even the money market was treacherous, however. Sophisticated 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 Washington 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. Inflation 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, including 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, and his home mortgage payment does not increase at all. The Federal income tax becomes somewhat more onerous, but this effect is far outweighed 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 defined 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 University measured the effects on wealth caused by the first lag of the modern inflationary spiral, starting in 1969 and ending with the recession 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 popular 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, government 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 housing. "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 elderly, 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 incorrect...."
The central explanation for this reversal of fortunes -- the many gaining at the expense of the few -- was homeownership. Most American. families, two-thirds of them, owned only one real asset of any 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 $400 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 $400. 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 government's fundamental social policies and one of its most effective programs. 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 otherwise 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 significant 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 median 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 repayment schedule will become less onerous as inflation drives up their nominal income." This was the same phenomenon observed by Eugene 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 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 accumulated 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 inflationary 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 expanded robustly and without interruption during the 1970s as it became 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 conclude that this system was a promising model for social equity. Inflation, 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 impoverished, after all, merely made less 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 prices and debt allowed millions of middle-class families to acquire more real goods, but runaway inflation also frightened them. Politicians, 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 fundamental 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 emphatically, 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 political expediency."
The press speculation on whom Carter would select for Fed chairman 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, president of the Brookings Institution and former president of the Minneapolis 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 to go in and see the President. I thought he should consider Tom Clausen of the Bank of America, talk to him personally 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 sufficiently cooperative, a "team player," as Fed chairman. Carter listened 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 surrounding 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 independent 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 assented. 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 Senate confirmation. Paul Adolph Volcker was fifty-one years old, a graduate 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 distress. In time, it would profoundly alter the landscape of American life, transforming the terms for virtually every transaction in the national economy and the world's, creating a new order. It would also produce ironic fulfillment of Jimmy Carter's sentimental plea for sacrifice 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 choosing. 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 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 appointed 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 secretary 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.
Copyright © 1987 by William Greider