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  CONTENTS

  * * *

  AUTHOR’S NOTE

  PREFACE

  PROLOGUE

  Chapter 1

  Chapter 2

  Chapter 3

  Chapter 4

  Chapter 5

  Chapter 6

  Chapter 7

  Chapter 8

  Chapter 9

  Chapter 10

  Chapter 11

  Chapter 12

  Chapter 13

  Chapter 14

  Chapter 15

  EPILOGUE

  AFTERWORD

  PHOTOGRAPHS

  ACKNOWLEDGMENTS

  ABOUT THE AUTHOR

  GLOSSARY

  NOTES

  INDEX

  PHOTO CREDITS

  GRAPHS CREDIT

  AUTHOR’S NOTE

  * * *

  Jeff Himmelman, a Phi Beta Kappa graduate of Yale University in 1998, was my full-time collaborator at every step of this book—reporting, writing and editing. He was able to develop an extensive understanding of the Federal Reserve, the American economy and Alan Greenspan in less than a year. A truly remarkable man of unusual maturity, brainpower and charm, Jeff is an original thinker who retains a deep sense of idealism. He is also a natural, graceful writer who improved each section and chapter and expanded my thinking each day. Having to endure months in the so-called factory on the third floor of the home I share with my wife, Elsa, and young daughter, Jeff never lost his good cheer. He was great company each day, night or working weekend. He has the energy and staying power of a team of reporters and editors. Pressure only made him work harder and more imaginatively. His standards of accuracy and fairness are the absolute highest. One of the very best of his generation, he took the time and care to learn from the people we were studying. He always worked with tact, generosity and forbearance. No one ever did more or better in the crucible of book writing. This book would never have been completed without him, and it is his as much as mine. I consider him a friend for life.

  To great teaching editors: Benjamin C. Bradlee, Alice Mayhew, Roger B. Farquhar, Howard Simons, Harry M. Rosenfeld, Barry Sussman, Leonard Downie Jr., Robert G. Kaiser, Steve Coll, Steve Luxenberg, David Maraniss, Carl Bernstein, William F. Powers Jr., Jim Wooten, Rick Atkinson, Michael Getler, Richard Harwood, Karen DeYoung, Bill Hamilton, Jane Amsterdam, Meg Greenfield, Laurence Stern, Doug Feaver and Bill Brady.

  PREFACE

  ON JANUARY 20, 2001, a new president takes the oath of office. He assumes the presidency in a Greenspan era. Just as the 1992 presidential election was about fixing the economy and cutting the federal budget deficit, the 2000 election was about how to use a projected surplus of at least several trillion dollars. The expectations, even the very definition, of the new administration—protecting Social Security, expanding health care, improving education, revitalizing the military and cutting taxes—will be contingent on that surplus. Whether it materializes is yet to be seen, but the inherited economic conditions for everyone—from the next president to any citizen—are in many respects the Greenspan dividend.

  Greenspan is slated to remain chairman of the Federal Reserve until 2004. Not only is he a major figure in the world’s economic past, he is central to its future. He has been frank enough to stand before the new and amazing economic circumstances that he helped create and in the end declare them a mystery. It is impossible to account fully for the continuing high growth, record employment, low inflation and high stock market. This is my effort, only a beginning, to write the story of how and why we got there.

  PROLOGUE

  LOOK, THIS is a good time to have a meeting with the president. Why don’t you come over?

  That was the message James A. Baker III, White House chief of staff and Ronald Reagan’s main political strategist, sent in the summer of 1984 to Paul Volcker, chairman of the Federal Reserve.

  Baker arranged the visit in the East Wing residence, often the setting for delicate matters away from the official hubbub of the West Wing and the eyes of others. Volcker, a somewhat theatrical figure who towered at six feet seven inches, was hard to hide. In his five years as Fed chairman he had become the public face of a grueling war against runaway inflation.

  Volcker’s tough medicine of jacking up interest rates to an unprecedented 19 percent to cool the American economy had triggered recession and thrown millions out of work, making him a demon to many on Main Street. But now inflation was down and the Fed had achieved a semblance of stability in prices, making him a hero elsewhere, especially on Wall Street.

  The chairman met every six months or so with the president. It wasn’t unusual for him to hear carefully worded suggestions for lower interest rates to help the economy grow.

  Volcker found only Reagan and Baker in the downstairs library in the East Wing.

  Volcker and Baker had a cordial personal relationship. Both had gone to Princeton in the same clubby era—Volcker class of 1949 (summa cum laude), Baker class of 1952—and their alma mater was a subject of occasional, even fond, conversation between them. On a professional level, particularly on the matter of interest rates, their relationship was tense.

  Volcker had first been appointed chairman by Democratic President Jimmy Carter in 1979. When the chairman’s four-year term expired in 1983, Reagan, who saw virtue in Volcker’s anti-inflation campaign, had reappointed him to a second term. In the aftermath of recession, with a jittery Wall Street, it was considered too risky to dump him.

  Baker thought that Reagan should have his own Fed chairman—someone from his party, someone in tune with his values. As Baker frequently remarked, Volcker was a “known Democrat,” as if the Fed chairman were a subversive. Baker had no illusions that a Fed chairman could be ordered about or subjected to political control. But he found Volcker needlessly aloof and prickly, unreceptive to the sorts of consensus solutions Baker preferred.

  After polite preliminaries, Baker began by mentioning the fall election. Reagan was seeking his second term, and Baker was in charge of the campaign.

  They didn’t want any tightening, Baker said, referring to interest rate increases. He sounded tough and spoke of the upcoming election with some pride. The theme was “Morning in America,” and Reagan was projecting the image of the caring, optimistic father. Higher interest rates would be off message.

  Volcker was a little stunned that Baker would talk about interest rates in such an overt political context. Baker could as easily have signaled their desires in a subtle, less offensive way. The chairman stiffened. The setting, the bald language and the swagger made it certainly inappropriate, even improper. Baker was doing all of the talking. The president wasn’t saying a damn thing. Nothing. Blank. Not nodding, not un-nodding, Volcker noticed grimly. How brilliant. Reagan never said anything, his deniability preserved: I never pressured Volcker. But the president’s presence, sitting there calmly—detached or engaged, no one would ever know for sure, including Baker—gave Baker’s words all the weight in the world.

  Privately, Volcker was a bit worried about the economy. He didn’t think there would be another recession very soon, but growth was slowing and the outlook wasn’t good. His next action at the Fed was probably going to be exactly what Baker and Reagan wanted him to do, to ease up and lower interest rates. But he didn’t tell them that because he didn’t trust them. If he said anything, they would leak it to the press. Interest rates are going down, they’d say. Or worse, the Federal Reserve
caved to their pressure, undermining Volcker’s credibility.

  The chairman left the White House sour and uneasy. Sometimes the best thing to do, he had learned, was to absorb the pressure, take it all into himself, do nothing. When he had been confirmed as chairman by the Senate Banking Committee, he had promised that he would report any attempt by the White House to influence him. He was unsure whether the pressure had reached the point where he was obliged to report it. He decided to say nothing.

  For Baker, it was more a routine discussion. He didn’t want to be seen as pressuring Volcker. Of course the administration wanted lower rates. The White House always did. But the Fed chairman was independent, and if Volcker didn’t like meeting with the president, he didn’t have to show up, or he could walk out or complain. He never did.

  Volcker soon lowered interest rates in response to the economy’s overall weakness, as he had expected to. Reagan was reelected in a landslide in November.

  In early 1985, Reagan appointed James Baker as treasury secretary, the position that traditionally has primary liaison responsibility with the Fed. Baker saw another opportunity to gain some political input into the Fed’s interest rate policies. Though the chairman dominated the Fed, he couldn’t act unilaterally.

  • • •

  The Fed sets two short-term interest rates. The less important rate is the discount rate, the interest rate the Fed charges other banks for overnight loans. Although it has only a small actual effect on the economy, at that time the discount rate was the Fed’s only publicly announced rate. As a result, changes to it had considerable psychological impact on the financial markets and the economy.

  In order to change the discount rate, the chairman has to have a majority of the votes of the seven members of the Fed’s Board of Governors. His vote is only one of those seven.

  Under the law and the Constitution, the president makes the appointments to the board and the Senate confirms them. Board members are appointed to 14-year terms, partial life appointments designed to raise the board above politics, but many members wearied of serving in an institution so controlled by its chairman and had resigned after a few years. As a result, the administration had put a number of Republicans on the seven-member board. Baker, who had primary responsibility for finding board members, preferred “Reaganauts,” those who shared the president’s philosophy and had been part of his team. He particularly liked those who favored lower interest rates. The talk around Baker’s Treasury Department had a theme: Times are changing. The message to Volcker was: Lead or be led.

  One of Baker’s early picks for the Fed board was Manuel H. Johnson Jr., his 36-year-old assistant treasury secretary, a former Green Beret intelligence specialist. Johnson had told his boss that he believed interest rates should be lowered, and that the Fed’s interest rate policy should be coordinated with the White House and Treasury.

  Soon after Johnson joined the board in 1986, he told Volcker he was expected to vote for an interest rate cut the first chance he got. “I feel compelled to vote for one. It’s needed,” Johnson said. Volcker was appalled, concluding that Johnson had made a deal.

  Johnson informed Volcker that there were now four votes, a majority, to reduce interest rates. “I’ll defer to how you want to do it,” he told the chairman. “I’ll defer to your leadership.”

  At this time, Volcker was opposed to a cut because he was worried about new inflation. “Is Baker pressuring you to do this?” Volcker asked, putting his feet on his desk and lighting a cigar.

  “I’m sure Jim Baker supports this,” Johnson replied. “He knows how I’ll vote.”

  On February 24, 1986, Johnson and three other board members took charge and voted 4 to 3 to lower the discount rate. Volcker found himself in the minority for the first time.

  “Good-bye,” he announced to the board after the vote was taken. “You’re going to have to do it on your own.” He got up and walked out, slamming the door. Hard. He didn’t type, so when he got back to his office he wrote out his resignation letter by hand. Voting down the chairman was an outright rebellion as far as he was concerned, an un–Federal Reserve thing to do. It was a staggering breach of club etiquette. Federal Reserve tradition virtually compelled the board to deal with disagreements and division by working toward consensus. Meet Tuesday. Meet Wednesday. Meet Thursday. If it was the chairman who disagreed, by God, they should meet endlessly.

  Volcker told Baker what had happened. They could get a new Federal Reserve chairman, he said.

  “It’s not that important,” Baker said soothingly. He expressed surprise at the vote and at Volcker’s distress. “You’re overreacting.”

  Volcker couldn’t have disagreed more. What was the use of being chairman of an organization if you couldn’t run it? What was leadership if someone else decided the direction?

  Baker wanted to remind Volcker, “Look, that’s why we have seven governors—why we don’t let the chairman decide these things by fiat. It’s why it is a democratic vote on the board.” But he refrained from making this obvious point. Baker, a patrician lawyer from Texas, poured on his charm and urged patience, saying in effect, Be realistic, Paul. No one—the Fed, the White House, Wall Street—wanted or needed the convulsion that would result if Volcker resigned.

  But Volcker had concluded that the vote that morning had been a cabal, a blow to the heart of the independence of the Federal Reserve System. He also thought that Jim Baker saw it as a big political victory.

  • • •

  Baker called to reassure Johnson.

  “You did everything you could,” Baker said. “I support you completely.”

  Johnson knew that he and the other rebellious governors were playing into Baker’s hands.

  Later that afternoon, however, Johnson and the other three board members backed down. They agreed to reconsider, effectively rescinding the interest rate cut before it was announced. A Volcker resignation would be too unsettling. It would send a shock through Wall Street and out to the world.

  And Volcker agreed to stay, though it was never the same. The Reagan administration wanted a puppet, he concluded.

  “I did not trust them,” Volcker said later. “It was impossible. There was no way you could restore the sense of trust.”

  • • •

  Jim Baker didn’t necessarily want a puppet. He just wanted a Republican. It was not a matter of trust, it was a matter of good politics. He also wanted a Fed chairman with a more agreeable temperament. Volcker’s crankiness and his I’m-above-politics air were hard to take.

  Baker had an ability to establish nearly instantaneous, automatic trust with most people. With a confiding, even impish smile he could find common ground effortlessly, most often by adapting to the other person initially. To someone from the political left, he would refer to the “fucking right wing,” even in the first moments of conversation. Someone Baker associated with the political right might soon hear him refer to “the fucking left wing.” At large meetings, Baker sometimes shared a knowing wink with those around him to underscore a personal bond.

  Baker had failed to win Volcker over, so his campaign continued. In the fall of 1986, Baker was visiting his native Houston and ran into Edward W. Kelley Jr., a prominent Texas businessman he had known since childhood. Baker and Kelley had grown up three blocks from each other in Houston. They had both attended the private Kinkaid School, played ball together and stayed in touch since then.

  Hey, you want to be on the Fed? Baker asked.

  Yeah, I’d be glad to do that, said Kelley. He had never taken a formal economics course in his life, though he did have an MBA from Harvard.

  Soon Kelley was appointed and confirmed by the Senate.

  In 1987, Volcker’s second term was about to expire, and Baker was arguing forcefully to the president. “It’s time to have your own Fed chairman,” he said. “To my mind there is only one person we can turn to.”

  That was Alan Greenspan, 61, a high-profile, low-key New York economist who had
served as chairman of the Council of Economic Advisers (CEA) in the Ford White House. Greenspan was perfect, Baker felt. He had seen the man up close for a dozen years. Baker had been undersecretary of commerce in 1975 in the Ford administration and had attended White House economic policy meetings where Greenspan was the key, sensible voice. When Baker was running Ford’s presidential campaign in 1976, he had brought Greenspan on Ford’s campaign plane as the economic spokesman. And in 1980, Greenspan had provided critical help in crafting a key economic speech for candidate Reagan.

  One of Greenspan’s finest moments had come as head of the bipartisan National Commission on Social Security Reform that had restored the Social Security system to temporary financial solvency in 1983. It had been a masterstroke of consensus building, Baker thought, as both Democrats and Republicans signed on. Baker himself had led some of the secret bipartisan negotiations at his own home.

  When Baker left the White House in 1985 to become treasury secretary, he had asked Greenspan to help him on his Senate confirmation hearings. Again, he found Greenspan’s advice informed and politically astute.

  Baker prided himself on being able to anticipate the second, third, even the tenth bounce of a decision. He was not unmindful of the importance of the next year’s presidential election, when his longtime Texas friend Vice President George Bush would be seeking the presidency. Having a Republican Fed chairman serving in 1988 and in a future Bush presidency could make all the difference in the world.

  Baker was convinced that Greenspan was the person they needed at the Fed—a team player.

  • • •

  In 1987, Reagan had brought in former Senate Republican Majority Leader Howard H. Baker Jr. as chief of staff to salvage the presidency during the Iran-contra scandal. Howard Baker, a courtly, Washington-wise pol, had represented Tennessee in the Senate for 18 years. He had served as vice chairman of the Senate Watergate Committee in 1973–74 and watched the Nixon presidency dissolve in lies and self-deceptions. When he accepted Reagan’s offer to become White House chief of staff, he insisted that he be in on all important decisions and secrets.