A History of the Federal Reserve, Volume 2 (78 page)

Evidence soon supported his first answer. The recovery occurred with historically high real interest rates. Later evidence suggested that real interest rates changed very little when the government’s fiscal stance shifted from large deficits (relative to GDP) to budget surpluses in the late 1990s and renewed large deficits after 2001. In fact, real interest rates were lower after 2001 than in the earlier period of budget surplus.

What may be true for other countries has not been true for the United States in the past quarter century. A principal reason for the absence of a strong effect of U.S. budget deficits on real interest rates is that foreign purchases of U.S. securities absorb the additional security sales. Chart 8.9 shows the current account deficit. Capital inflow moves in the same direction, rising when the current account deficit rises and becoming highly positive when the current account deficit is highly positive. If foreigners are willing to finance the current account defi cit—the excess of investment over saving—at world real interest rates, domestic real interest rates need not change. The desire by governments to increase their exports and domestic employment encouraged them to purchase U.S. securities and sustain the capital inflow to the United States.

The FOMC remained divided about monetary policy. Volcker was not
yet ready to change policy openly. Although he had become less certain about targeting reserve growth, seasonal adjustment, and the meaning of the monetary aggregates, he was concerned that letting interest rates fall would provide only temporary relief. With clear understanding of the political pressures, he told the FOMC “I’d love to see them come down and stay down. I wouldn’t love to see them come down for a month and then have to go up again. That would kill us for a variety of reasons” (FOMC Minutes, March 29–30, 1982, 49–50).
¹²⁰
His response was to continue the policy of reducing inflation.

Failures of homebuilders, savings and loan institutions, and other firms was a frequent subject of discussion. The members could only deplore the circumstances, including their policy, that brought this outcome. During the 1970s some farmers had borrowed heavily to expand to take advantage of rising commodity prices. Prevailing interest rates pushed them toward bankruptcy. Corrigan (Minneapolis) proposed special loans for farmers but drew little support.

In May, a small securities firm, Drysdale, was unable to pay interest on the government securities it had sold short. Drysdale had gambled on a decline in interest rate by doing repurchase agreements with banks, especially Chase Manhattan Bank, and selling the securities short. Drysdale had about $20 million in capital, but it had $6.5 billion in securities; it owed $160 million in interest payments to nearly thirty brokerage firms.

The Federal Reserve feared a market panic. The New York bank offered to lend to banks facing payments problems. At first, the Chase bank refused to accept responsibility for the interest payments, claiming that it acted only as an intermediary. Market and Federal Reserve pressure convinced it to change that position. That ended the crisis.

The FOMC voted to broaden the terms on lending government securities from the open market account and relax the financing of short sales of securities. The change was temporary, lasting only eight days. The staff estimated that Chase Manhattan would borrow about $1.25 billion of securities, but others would need much less. As usual, the Board did not adopt a general policy to deal with banking and financial market problems.

Beginning
of
the
End

A series of events, economic, market, international, and political, moved the Federal Reserve toward ending the on-again, off-again experiment in
monetary control. No one of these events may have been decisive, but together they added to the growing anxiety about the economy and the Federal Reserve’s ability to control it using reserve or money targets.

120. At about this time, March 15, the Shadow Open Market Committee wrote, “The Federal Reserve misleads the public and the Congress by talking as if its main objective were control of bank reserves and money. In practice the Federal Reserve seeks to hold the daily federal funds rate within a narrow range.” I served as co-chairman of that committee.

In our interview, Volcker (2001) cited the difficulties of controlling money, especially in 1982, his reluctance to raise interest rates during a deepening recession, the failure of the recession to end, as predicted, in second quarter 1982, and the developing problem of Mexico’s external debt. Axilrod (1997) emphasized the growth of money and the maturing of All Savers Certificates.
¹²¹

There were other events. The failure of Drysdale Securities and a small Oklahoma bank, Penn Square, raised concerns about the solvency of the banking system. Both had large loans outstanding to major banks—Chase, Continental Illinois, Seattle First. Volcker and the FOMC had heightened concerns about financial fragility. Many savings and loans were close to bankruptcy. Large loans to Mexico by money center banks added to these concerns. Prevailing real interest rates heightened the problem.
¹²²

Volcker was clear about the lender-of-last-resort function. “If it gets bad enough, we can’t stay on the side or we’d have a major liquidity crisis. It’s a matter of judgment as to when and how strongly to react. We are not here to see the economy destroyed in the interest of not bailing somebody out” (FOMC Minutes, October 5, 1982, 4). Preston Martin rightly stressed that their assistance should go to the market, not to Drysdale.

Penn Square’s problem came in late June. It had large loans to oil and gas firms. As oil prices fell in 1982, many of the loans became worthless. The Comptroller’s auditors ordered millions of dollars written off. Penn Square was bankrupt.

Penn Square had made more loans than it held in its portfolio. Continental Illinois, Chase Manhattan, Michigan National, and others bought about $2 billion; about $1 billion was sold to Continental. The Federal Reserve made the mistake of lending $20 million to Penn Square to prevent insolvency instead of permitting the failure and defending the market.
The assistance was futile; the money was soon gone. William Issac, chairman of the FDIC, would not agree to additional support. He thought Penn Square’s failure would be a warning to other banks, a badly needed warning. He favored closing the bank and paying off the depositors. In the end, Treasury Secretary Donald Regan sided with the FDIC, and despite Volcker’s concerns, the bank closed.

121. All Savers Certificates permitted financial institutions to offer one-year tax-exempt certificates. Congress approved when it voted for the Reagan tax reduction. The certificates expired beginning in October 1982. The Board’s staff believed that much of the money had come from bank deposits. Neither the staff nor the Committee had any idea how much of the money would again become part of M
₁
. Axilrod also emphasized a change in the interest elasticity of M
₁
.

122. Grieder (1987, 438) pointed out that Volcker did very little to enforce lending standards on international loans. As banks reached 10 percent country limits, the Federal Reserve permitted banks to evade the limits. Grieder (ibid.) quoted William McChesney Martin’s comment that “Volcker was ‘very good’ in conducting monetary policy but ‘a complete flop on bank supervision.’”

At the July 1 Board meeting, Volcker got approval of a $700 million loan to Mexico under the swap line. In October, the FOMC renewed the loan. Before that, the System had made overnight swaps to give the appearance that Mexico had sufficient dollar reserves to maintain its payments. “We would transfer the money each month on the day before the reserves were added up, and take it back the next day. . . . [T]he ‘window dressing’ disguised the full extent of the pressures on Mexico from the bank’s lenders and from the Mexicans themselves” (Volcker and Gyohten, 1992, 199).

The $700 million loan had two purposes. Mexico wanted to delay going to the IMF until September 1982, after its election. Also, the Federal Reserve was concerned that a crisis in Mexico would quickly spread to other heavily indebted countries. “Bank loans to developing countries had increased more than 50 percent in three years to more than $362 billion at the end of 1982, one-third of which was held by American banks” (ibid., 198).

The problem arose as part of the recycling of payments to the oil-exporting countries. These countries deposited their receipts in major banks by offering them directly or on the euro-dollar market.
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The money market banks borrowed the euro-dollars and lent them developing countries. Their loans were for longer term than their euro-dollar deposits, so the banks were at risk. Defaults by the developing countries could wipe out their capital. The world recession slowed the growth of exports, and the high real interest rates increased borrowing costs. The threat of widespread default, perhaps starting in Mexico, added to concerns about financial fragility.

Loans to Mexico by nine major U.S. banks were about $60 billion, about 45 percent of the banks’ capital. Loans to all of Latin America equaled about twice the banks’ capital (ibid., 198). The Treasury and the Federal Reserve arranged with foreign central banks to join in lending $1.85 billion, about half from the United States. Soon after, the lending banks agreed to a “standstill”; Mexico would not be expected to pay until they arranged an IMF loan, and the banks agreed not to withdraw from Mexico.

On June 14, the French and Italian governments devalued the franc and the lira. The French devaluation was the first of several resulting from the
efforts of President François Mitterrand to pursue an expansive policy with a partly open capital market and a fixed exchange rate against the mark and other European currencies. Following the devaluation, the Saudi king died. The Treasury accepted that markets were disorderly, so the Federal Reserve bought $21 million in marks and $9 billion in yen. Other central banks intervened also, buying $6 billion according to the Federal Reserve report (FOMC Minutes, July 1, 85).

123. Recall that euro-dollars are U.S. dollar-denominated assets of banks outside the United States.

After more than two years, some members of the FOMC wanted to end what remained of the money control experiment. At the May FOMC meeting, Governor Teeters made the strongest statement in opposition to continuing. Pointing to the number of recent failures and the variability of interest rates, she attributed the failure of long-term rates to decline to the risk premium to pay for variability. The economy had not recovered. Unemployment was above 9 percent. “We are in the process of pushing the whole economy not just into recession, but into depression . . . I think we’ve undertaken an experiment and we have succeeded in our attempt to bring down prices. . . . But as far as I’m concerned, I’ve had it with the monetary experiment. It’s time to put this economy back together again” (FOMC Minutes, May 18, 1982, 27).

Others did not go as far as Teeters, but Gramley, Rice, and Partee wanted to ease policy, and Morris wanted to dispense with an M 1 target. Boehne spoke in favor of lowering the funds rate to 10 to 15 percent. Defenders of the disinflation policy—Roos, Black, Ford, and others—argued that the way to get long-term rates down was to persist in the restrictive policy. Ease was what the market expected; it would foster concerns about renewed, higher inflation.

Volcker clearly began to shift to an explicit interest rate target. He no longer favored reliance on M 1 . NOW accounts made it difficult to interpret. He favored 8 percent growth in M
₂
because that seemed consistent with nominal GNP growth of 8 percent. “I am not going to [be greatly upset] if M
₂
growth comes out at 8.5 percent instead of 8 percent or even 9.5 percent . . . or if M
₁
continues to run somewhat high. . . . I would at this point take the chance of easing the pressures on bank reserve positions. . . . If it turns out that figures are more favorable in terms of restrained growth, we could
move
aggressively
pretty
promptly
(ibid., 34; emphasis added) The FOMC voted eleven-to-one to lower the funds rate to the 10 to 15 percent range.
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124. Nancy Teeters voted no. This was Preston Martin’s first meeting. He attended the March meeting but could not vote because he had not been sworn in. Volcker described the change years later. “The Mexican crisis was brewing. The economic recovery had not ap
peared. I thought, ahah, here’s our chance to ease credibly. So we took the first small step” (Mehrling, 2007, 183).

The problems that drew most comment were the failure of real rates to decline and the economy to improve. Ten-year Treasury rates were 13.5 percent at the time of the meeting. The SPF forecast of inflation was down to 5.9 percent, so using this estimate the real rate was an extraordinary 7.5 percent. Real GNP fell 5.9 percent in the first quarter; it rose a sluggish 1.2 percent in the second quarter and fell 3.2 percent in the third.

Many in Congress supported the disinflation policy, but as the 1982 election approached some became restless. Congressman Henry Reuss sent a letter informing Volcker that the House Budget Committee had adopted a budget resolution urging coordination of monetary and budget policy. Specifically, the resolution called on the Federal Reserve to “reevaluate its monetary targets in order to assure that they are fully complementary” (FOMC Minutes, May 18, 1982, 42). The letter assumed that the proposed deficit reduction was permanent and large and approved by both houses.

Reuss then reminded Volcker that the Constitution gave the monetary power to Congress. The Federal Reserve was the agent of Congress. He wanted assurance that the Federal Reserve would accede to the directive from Congress. Volcker told the FOMC that he saw no reason to vote. “I will tell him that it’s clear in the minds of the members of the Open Market Committee that indeed we follow the law” (ibid., 43).

In his letter to Reuss, Volcker did more than accept that the Federal Reserve would follow the law. He advised Reuss that it would be a mistake for Congress “to indicate or direct a specific concern for monetary policy, such as a precise monetary target” (letter, Volcker to Reuss, Board Records, June 8, 1982).

Volcker brought up the resolution at the July 1 meeting. It called for the Federal Reserve to reconsider its monetary targets if Congress made a sizeable, permanent reduction in the deficit. Most of the members argued that permanently reducing the deficit would lower interest rates, but money was neutral so money growth should not increase. Partee argued that the economy was below capacity, so money growth could increase. Volcker was most in favor of increasing money growth, pointing out several times that many economists accepted policy coordination, but Wallich said that coordination meant the Federal Reserve should permit lower interest rates brought about by deficit reduction but should not increase money growth.

A few months later, Congressman Wright Patman sent a letter enclosing proposed legislation that would require the FOMC to send a report
to Congress within seven days of any decision to change the trend rate of money growth. Volcker had breakfast with Patman, so there is no record of a reply.