Critique of Central Banking

Part III-c: Still more on the US experience

The selection of the chairman of the US Federal Reserve Board of Governors, who serves four-year terms, is a political process closely linked to ideological preference, subject to Senate confirmation, much like the appointment of the chief justice of the Supreme Court. White House and Treasury support for the chairman is of critical importance for the chairman's exercise of leadership over Board members, who are known for their independence.

The late Arthur Burns (Fed chairman 1970-78) abolished full transcripts of the Fed Open Market Committee (FOMC) meetings after the Freedom of Information Act was enacted by Congress in 1975. The transcripts traditionally were kept secret for five years before public release, but they provided a rich and reliable source for historians who tried to decipher the decision-making process in monetary policy. The interrupted practice was revived after Burns' second term expired without reappointment by president Jimmy Carter. Under a policy announced on January 19, 2000, the FOMC, shortly after each of its meetings, issues a brief statement that includes its assessment of the risks in the foreseeable future to the attainment of its long-run goals of price stability and sustainable economic growth. Nevertheless, the Fed continues to enjoy a level of secrecy on its deliberation that is the envy of the Central Intelligence Agency. Industrialist Henry Ford was reported to have said: "It is well enough that the people of the nation do not understand our banking and monetary system for, if they did, I believe there would be a revolution before tomorrow morning."

Ford of course was a paternalistic entrepreneur with latent socialist leanings whose dislike of the "money trusts" was as passionate as any diehard communist's, albeit from a different angle. Ford understood that to sell his mass-produced products, high wages were necessary, for which he professed a vested interest in promoting (he doubled the market wage to US$5 a day, forcing the rest of the auto industry to follow suit). And he viewed labor unions as having long-term effects in holding wages down with their insistence on short-term gains that hampered production efficiency.

Ford partisans believe to this day that the reason industrial unions are tolerated by management is that management knows that the long-term effect of unionism is to moderate the rise of labor costs. Unionism has been institutionalized in industrial capitalism in the role of the factory foreman, with the job of maximizing labor productivity, which means increasingly lower labor cost per unit of production. Union chiefs are often invited to sit on corporate boards of directors, not to influence management but to deliver management's message to the union rank and file that wage increases can only come from company profits, and not from any restructuring of the basic relationship between labor and capital. What Ford opposed as fervently as he did industrial unionism was the type of financial manipulation that created General Motors through predatory mergers and acquisitions. This view has come to be known as Fordism, which also influenced early Soviet industrialization strategy.

Burns, a conservative Austrian-born economist from Columbia University, was appointed Fed chairman by president Richard Nixon in 1969. Between 1953 and 1956, he served as chairman of the Council of Economic Advisors under president Dwight Eisenhower. He was known as the "No 1 inflation fighter". Burns was reportedly not well liked at the Fed by his colleagues nor by members of his profession. Many accused him of being intellectually dishonest.

The Burns era was the most opportunistically political in Fed history, with Burns' mistimed economic pump-priming designed merely to ensure Nixon a second term, by engineering money growth of a monthly average of 11 percent three months before the election from a monthly average of 3.2 percent in the last quarter of 1971. Nixon's second term was nevertheless aborted by political complications arising from the Watergate scandal, leaving Gerald Ford in the White House. The economy was left to pay for the pre-election boom with runaway inflation that compelled the Fed to tighten with a vengeance, which produced a long and painful post-election recession that in turn contributed to Ford's defeat by Carter. The Fed as an institution above politics has yet to recover fully from the rotten smell of 1972. Burns' sordid catering to Carter in hope of securing a reappointment for a third term was a contributing factor to the Carter inflation. And Carter's defeat by Ronald Reagan was in no small measure caused by his appointment of Paul Volcker as Fed chairman. Some said it was the most politically self-destructive move by Carter.

Volcker, having served four years as president of the New York Federal Reserve Bank, replaced G William Miller as Federal Reserve Board chairman on July 23, 1979. Volcker, as assistant secretary under Treasury secretary John Connally in the Nixon administration, played a key role in 1971 in the dismantling of the Bretton Woods international monetary system formulated by 44 nations that met at Bretton Woods, New Hampshire, in July 1944. Under that system, as worked out by John Maynard Keynes, representing Britain, and Harry Dexter White, an American who later in the McCarthy era was accused unfairly of having been a communist, each country agreed to set with the International Monetary Fund (IMF) a value for its currency and to maintain the exchange rate of its currency within a specified range. The United States, as lead country, pegged its currency to gold, promising to redeem dollars for gold on demand at an official price of $35 an ounce. All other currencies were tied to the dollar and its gold-redemption value. While the value of the dollar was tied strictly to gold at $35 an ounce, other currencies, tied to the dollar, were allowed to vary in a narrow band of 1 percent around their official rates which were expected to change only gradually, if ever. Foreign-exchange control between borders was strictly enforced, the mainstream economics theory at the time being inclined to consider free international flow of funds neither necessary nor desirable for facilitating trade.

Nixon was forced to abandon the Bretton Woods fixed exchange rate system in 1971 because recurring lapses of fiscal discipline on the part of the United States had made the dollar's peg to gold unsustainable. By 1971, US gold stock decline by $10 billion, a 50 percent drop. At the same time, foreign banks held $80 billion, eight times the amount of gold remaining in US possession. Ironically, the problem was not so much US fiscal spending as the unrealistic peg of the dollar to $35 gold.

The Smithsonian Agreement concluded in December 1971 between the Group of Ten of the IMF at a meeting at the Smithsonian Institute in Washington, DC, restored the major currencies to fixed parities but with a wider margin, plus or minus 2.25 percent of permitted fluctuation around their par values. The dollar was effectively devalued by about 8 percent and the dollar price of gold increased to $38 per ounce. Sterling was set at $2.6057. Improved telecommunications and computerized fund-transfer techniques allowed speculators to move funds quickly and efficiently around the world in anticipation of foreign exchange fluctuation and intervention, making it difficult to support even this widened band, which was eventually suspended. Foreign-exchange control was largely abandoned by most governments by the late 1970s, bringing forth the rapid growth of a largely unregulated international exchange market, along with a globalized capital and credit market. Foreign-exchange fluctuation increasingly became subject to financial market pressures not directly related to trade. It has now become a source of high speculative profit for many institutions and hedge funds. The huge size of the market has reduced the effectiveness of central-bank intervention in maintaining the exchange value of currencies.

Miller, after only 17 months at the Fed, had been named Treasury secretary as part of Carter's desperate wholesale cabinet shakeup in response to popular discontent and declining presidential authority. After isolating himself for 10 days of introspective agonizing at Camp David, Carter emerged in early summer to make his speech of "crisis of the soul and confidence" to a restless nation. In response, the market dropped like a rock in free fall. Miller was a fallback choice for the Treasury, after numerous other potential appointees, including David Rockefeller, declined personal telephone offers by Carter to join a demoralized administration.

Carter felt that he needed someone like Volcker, an intelligent if not intellectual Republican, a term many liberal Democrats considered an oxymoron, who was highly respected on Wall Street if not in academe, to be at the Fed to regenerate needed bipartisan support in his time of presidential leadership crisis. Bert Lance, Carter's chief of staff, was reported to have told Carter that by appointing Volcker, the president was mortgaging his own reelection to a less than sympathetic Fed chairman.

Volcker won a Pyrrhic victory against inflation by letting financial blood run all over the country and most of the world. It was a toss-up whether the cure was worse than the disease. What was worse was that the temporary deregulation that had made limited sense under conditions of near hyper-inflation was kept permanent under conditions of restored normal inflation. Deregulation, particularly of interest-rate ceilings and credit market restrictions, put an end to market diversity by killing off small independent firms in the financial sector since they could not compete with the larger institutions without the protection of regulated financial markets. Small operations had to offer increasingly higher interest rates to attract funds while their localized lending could not compete with the big volume, narrow rate spreads of the big institutions. Big banks could take advantage of their access to lower-cost funds to assume higher risk and therefore play in higher-interest-rate loan markets nationally and internationally, quite the opposite of what Keynes predicted, that the abundant supply of capital would lower interest rates to bring about the "euthanasia of the rentier".

In the longer term, Keynes may still turn out to be prescient, as the finance sector, not unlike the transportation sectors such as railroads, trucking and airlines in earlier waves, or the communication sector such as telecom companies, has been plagued by predatory mergers of the big fish eating the smaller fish, after which the big fish, having grown accustomed to a unsustainably rich diet that has damaged their financial livers, begin to die from self-generated starvation from a collapse of the food chain.

High real interest rates ahead of inflation rate moved wealth from borrowers to lenders in the economy and from bottom to top in the wealth pyramid. Moreover, the impact of high interest rates modifies economic behavior differently in different income groups and even on different activities within the same individual. When the prime rate for some banks exceeded 20 percent in 1980, credit continued to expand explosively in sectors where price appreciation occurred at a much higher rate, such as in real estate. High rates only work to slow credit expansion if the rates are ahead of inflation.

The Fed has traditionally never been prepared to raise interest rates too abruptly, trying always to prevent inflation without stalling the economy excessively, thus resulting in interest rates often trailing rampant inflation. The market demand for new loans, or the pace for new lending, obviously would not be moderated by raising the price of money, as long as the inflation/interest gap remain profitable. Yet bank deregulation diluted the Fed's control of the supply of credit, leaving price as the only lever. Price is not always an effective lever against runaway demand, as Fed chairman Alan Greenspan was also to find out in the 1990s. Raising the price of money to fight inflation is by definition self-neutralizing because high interest cost is itself inflationary. Deregulation also allows the price of money to allocate credit, often directing credit to where the economy needs it least, namely the speculative arena.

The Fed might have had in its employ a staff of very sophisticated economists who understood the complex multi-dimensional forces of the market, but the tools available to the Fed for dealing with market instability was by ideology and design single-dimensional. Interest-rate policy was the only weapon available to the Fed to tame an aggressively unruly market that increasingly viewed the Fed as a paper tiger.

In the early weeks of 1980, the Consumer Price Index (CPI) was 17 percent, prime rate was 16 percent and rising, and gold hit as high as $875 an ounce. Having told the House Banking Committee on February 19 that credit controls do not deal with the "basic causes of inflation", the Fed chairman Volcker announced on March 14 a program of emergency credit controls not only on commercial banks, but also on money-market mutual funds and retail companies that issue credit cards. Banks would be limited to 9 percent credit growth instead of the 17 percent in February. Only a week earlier, the FOMC, trailing inflation data, was forced to raised the Federal Funds Rate (FFR) target to 18 percent.

The economy crash-landed abruptly in response. The gross domestic product (GDP) shrank 30 percent within three months. Consumer credit, instead of growing by $2 billion a month, shrank by $2 billion a month. Money dried up suddenly, leaving many otherwise healthy projects hanging in midstream. Construction loans could not roll over into permanent mortgages. Asset prices fell below their collateralized value, causing loans to be "underwater" overnight, giving otherwise conscientious borrowers an incentive to walk away from their debt obligations. Insolvency became widespread, with financial dead bodies strewn on the sidewalks of every city. For the first time in recent history, a Democrat in the White House pushed the country into recession, and in an election year.

Senate Democrat minority floor leader Robert Byrd of West Virginia expressed concern but was rebuked by senator William Proxmire, Senate Banking Committee ranking Democrat from Wisconsin, who gave a technical lecture on the iron law governing inflation and interest rates, a TINA (there is no alternative) argument. More unemployment and bankruptcies, while painful, had to be accepted as needed medicine.

Then the Hunt brothers' speculative silver bubble burst, punctuated by the silver price dropping from $50 an ounce to $10. The banks had lent the Hunts $800 million to corner speculatively a silver cartel, 10 percent of all bank lending in the past two months, at rising interest rates that inched toward 20 percent. By March 31, the Hunts defaulted on their future contracts because they were unable to roll over the short-term loans, partly due to credit control. To prevent systemic panic, Volcker engineered a private bailout from the 11 banks with a new $1.1 billion loan, similar to the Fed-engineered Long Term Capital Management (LTCM) bailout in 1998. The Hunt brothers were wiped out of their billion-dollar equity and had to file for bankruptcy, but their banks were saved from the fate of having to raise more capital to cover non-performing loans that magically became performing with the wave of the Fed's unseen hand. The Fed waived credit-control rules imposed only two weeks earlier. "Moral hazard" became a loud murmur heard from shaking heads everywhere. The Fed had in the past refused requests for bailouts for Chrysler, New York City, Midwestern grain farmers, Lockheed, Pan Am Airways, etc, in the real economy, but it seldom refuses to bail out the financial markets. TINA, together with the "too big to fail syndrome", was after all a selective doctrine applicable only to the Fed's political constituents.

Volcker, as chairman of the Fed, adopted a "new operating method" for the Fed in 1980 as a therapeutic shock treatment for Wall Street, which seemed to have been conditioned by Burns' brazen political opportunism to lose faith in the Fed's political will to control inflation. The new operating method, by concentrating on monetary aggregates, and letting it dictate FFR swings within a range from 13-19 percent, to be authorized by the FOMC, was an exercise in "creative uncertainty" to shock the financial market out of its complacency about interest-rate stability and gradualism. There had been a traditional expectation that even if the Fed were to raise rates, it would not permit the market to be volatile. The banks could continue to lend as long as they could profitably manage the gradual rise in rates. Under the new operating method, the banks were exposed to risks that interest rates might suddenly and drastically go against even their short-term credit positions. Also, banks had been expanding new loans beyond the growth of deposits, by borrowing shorter term funds at lower interest rates. This practice was given the benign name of "managed liability", allowing banks to profit from interest-rate spreads over the yield curve, which had seldom if ever been allowed by the Fed to get inverted, that is with short-term rates rising higher than longer-term rates. This practice, known as "carry trade" in bank parlance, when internationalized, eventually led to the Asian financial crisis of 1997 when interest-rate and exchange-rate volatility became the new paradigm.

The Fed's new operating method would greatly increase the banks' risk exposure. On top of it all, Volcker also set an additional 8 percent reserve on borrowed funds for lending. The new operating method worked against the traditional mandate of the Fed, which, as a central bank, was supposed to be responsible for maintaining orderly markets, which meant smooth, gradual changes in interest rates. The new operating method was a policy to induce the threat of short-term pain to stabilize long-term inflation expectations.

Every economist agrees that when money growth slows, market interest rates go up. The trouble with the use of the FFR target to control money supply was that it had to be set by fiat, which exposed the Fed to political pressure. A case could be made, and was frequently made, that the Fed's FFR target tended to be self-fulfilling prophecy rather than a device to manage future trends. High FFR targets deflate while low targets inflate, and there is little argument about that relationship. But there is plenty of argument about the Fed's projection ability on the economy. History has shown that the Fed, more often than not, has made wrong decisions based on faulty projection. The new operating method would let the monetary aggregates set the FFR targets scientifically and provide political cover for the FOMC members if the FFR target needed to go to double digits. This was monetarism through the back door, not by intellectual commitment, but by political cowardice.

The FOMC, as formed by the Banking Act of 1933, did not include voting rights for the Fed Board of Governors. This was changed in the Banking Act of 1935 to include the Board of Governors and amended again in 1942 to the current voting structure, which consists of the seven members of the Board of Governors, the president of the New York Fed and four other district Fed presidents who serve on a rotating basis. These legislative changes were an attempt to centralize the Fed's policy-making while preserving input from Federal Reserve bank presidents. While Federal Reserve bank presidents vote on a rotating basis, they all attend each FOMC meeting and contribute to the debate on monetary policy. The early FOMC at first met quarterly to consider its business; today, the FOMC meets eight times a year, but decisions regarding monetary policy are not limited to formal meeting dates, as the chairman can call a teleconference of the FOMC at any time.

This system for making monetary policy - incorporating regional viewpoints in the making of national policy - is one of the hallmarks of Fed structure. From the beginning of the Fed, opinions differed on the need for, and the location of, geographic representation on the Board, and the debate continued with the formation of the FOMC. In 1964, congressional hearings were held that considered abolition of the FOMC. The importance and dominance of national policy over regional considerations are now generally accepted. The FOMC would not alter monetary policy to address an economic concern pertinent to just one district. Regional input plays an increasingly peripheral role in the formulation of that policy. By extension, as the Fed began to support the Treasury's strong-dollar policy as a matter of national security under Robert Rubin in the 1990s, dominance of US internationalist policy over district concerns became institutionalized. The rust belt and the agricultural exporting states would have to restructure the local economy to survive.

Prior to 1970 and the arrival of Arthur Burns as the chairman of the Federal Reserve Board, the FOMC made comments in a set pattern, known as a "go-around". Burns was not in sympathy with this formalized process, as he was not a consensus builder when it came to making monetary policy, as was his long-serving predecessor, William McChesney Martin, who listened to everyone's input before making his decision. To save himself the unpleasant prospect of having to ignore district views face to face, Burns decided it would be a more efficient use of the FOMC's time to have the reports on district conditions prepared in advance and compiled for the Committee's edification. Burns' directive formalized and broadened the information-gathering process, and thus was born the Red Book, which was the predecessor to the Beige Book.

Aside from the color of their covers, the Red and Beige books differed in one important way: the Red Book was prepared for policy makers only, and was not intended for public consumption. The Red Book became public in 1983 after a request by the longtime representative from the District of Columbia, Walter Fauntroy, for public release of the Green Book, which contains the Fed's closely held national models and economic forecasts. The Board deemed this unwise and the Red Book was offered in its place. To mark the change, the color red was dropped in favor of beige (it was for a time also called the Tan Book). To detract from the implied importance of the document in FOMC policy-making, the public release of the Beige Book was timed for two weeks prior to an FOMC meeting, so that the media and others would recognize that the information was not timely and, therefore, did not have a major influence on policy. So much for policy transparency in a democratic society.

The Fed protects itself from criticism of ideological bias in its decision-making by depriving the public and its critics of timely information paid for by tax money. The Fed remains above criticism because its decisions are always based on more recent information on the economy than that available to the market, decisions that the market would understand only if it had the same information, although the rationale for depriving the market of the latest information in the age of instant communication has never been made clear.

The Federal Advisory Council (FAC) of the Fed is unique in that it is a big bank lobby that officially advises the Fed, a government institution owned by the banks. It meets in secrecy four times a year with Fed officials to give the banking industry an inside track on influencing Fed deliberation, if not decisions. The since-declassified minutes of the FAC show that four weeks before the Fed announced its new operating method, the FAC had recommended to the Fed a "review" of its traditional operating method, before the president was even alerted of the Fed's deliberation and final decision to adopt a new operating method. Carter was totally in the dark about the impending high-interest-rate policy with which the Fed was going to hit his administration in an election year.

The Fed program of Emergency Credit Controls announce on March 14, 1980, affected not only commercial banks, but also money-market mutual funds and retail companies that issue credit cards. Banks would be limited to 9 percent credit growth instead of the 17 percent in February. By April, the Fed was shocked by data that money was disappearing from the financial system at an alarmingly rapid rate. The last two weeks in March saw more than $17 billion vanish, representing an annualized shrinkage of 17 percent. Money was evaporating from the banking system as credit dried up and borrowers paying off their debts at Carter's urging: to save the nation from hyper-inflation through personal restraint on consumption. Another cause was the shift of bank deposits to three-month T-bills that were paying 15 percent.

Volcker's new operating method adopted six months earlier now faced a critical test. According to monetarist theory, the Fed now must pump up bank reserves to stimulate money growth. But in practice, Volcker and the FOMC were to apply monetarism, which by definition must be a long-term proposition, to short-term turbulence, and in the process undermined their own earlier efforts to fight hyper-inflation and, worse, destabilized the economy unnecessarily. When mortals play god, other mortals die unnecessarily.

On May 6, 1980, with the New York Fed's Open Market Desk furiously trying to brake the money-supply shrinkage now in raging progress, pumping more bank reserves by buying government securities and creating new "high power" money by increasing bank reserves, interest rates fell abruptly. The FFR dropped 500 basis points in two weeks, from 18 to 13 percent, the bottom of the FOMC range, and was actually trading below the FOMC target.

The Fed was in danger of losing control of its FFR target and jeopardizing its credibility. The New York Fed notified the FOMC that it could continued to follow the new operating method by injecting more reserves or to tighten up the supply of bank reserves to get the FFR back up to 13 percent, but it could not do both, any more than a train could go in opposite directions simultaneously. Volcker opted for continuing the new operating method and staged an emergency telephone conference of the FOMC to authorize a new low FFR target of 10.5 percent, down from 13 percent.

Market conditions were such that the interest rate falling below 10 percent would mean negative interest adjusted for inflation, which would start another borrowing binge. The fundamental fault of monetarism was being exposed by real life. The claim that stabilizing the money supply would also stabilize interest rates was inoperative. In reality, stabilizing one destabilized the other in a fast-reacting dynamic market.

Desperate, the Fed, with concurrence from an even more panic-stricken Carter White House, started to dismantle Emergency Credit Controls as fast as administratively possible, so that demand for credit would not be artificially hampered, in hope of making market interest rates rise from more borrowing. Still it took until July 1980 before the last of the controls were lifted. In April, the New York Fed injected additional reserves into the banking system at an annualized rate of 14 percent, and in May at 48 percent annualized rate in non-borrowed reserves.

It was obvious Volcker panicked, spooked by the sudden economic collapse touched off by his own credit-control program. By the last week of July, the FFR fell below the discount rate and hit 8.5 percent. For one trading day, it dipped to 7.5 percent and for a time the Fed lost control. The short-term rate that monetary policy regulates most directly was free-floating on its own. With the FFR below the discount rate, the FFR could fall to zero by banks responding to market forces. So the pressure to lower the discount rate was overwhelming. The financial markets had never seen anything like it. The FFR dropped from 20 percent in April to 8.5 percent in 10 weeks. In the autumn of 1979, the Fed had seized the initiative to push the price of money up 100 percent to fight inflation. Now, barely seven months later, the Fed allowed the price of money to fall even more rapidly to reverse a money-supply shrinkage. The recession abruptly ended by the Fed's overreaction and Volcker was facing a worse inflation problem than when he first became chairman in July 1979. Many businesses went under during this brief period of illiquidity, but the banks were dancing in the streets with windfall profits.

The experience put the Fed back on its old path: focusing on interest rates and not money-supply numbers and vowing again to focus only on the long term. Yet for the long term, money supply was the correct barometer, while for the short term, interest rate was the appropriate tool. The Fed did not seem to have learned anything, despite having made the nation pay a very costly tuition.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money-supply growth expired, the Fed announced that it was no longer setting such targets, because money-supply growth did not provide a useful benchmark for the conduct of monetary policy. However, the Fed said, too, that "... the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions". Moreover, M2, adjusted for changes in the price level, remains a component of the Index of Leading Indicators, which many private-sector market analysts use to forecast economic recessions and recoveries.

To make the case that money supply, rather than interest rates, moves the economy, one would have to assert that the money supply affects the economy with zero lag. Such a claim can only be validated from the long-term perspective. For the long term, six months may appear as near zero, just as macro-economists may consider the bankruptcy of a few hundred companies mere creative destruction, until they find out some of their own relatives own now worthless shares in some of the bankrupt companies. Targeting the money supply produces large sudden swings in interest rates that produce unintended shifts in the real economy that then feed back into demand for money. The process has been described as the Fed acting as a monetarist dog chasing its own tail.

By September 1980, data on August money supply revealed that it had grown by 23 percent. Monetarists, backed by the banks, clamored for interest-rate hikes dictated by money-supply data. Having been burned a few months earlier, the Fed was not again going to abandon its traditional interest-rate gradualism focus and again let the money-supply tail wag the interest-rate dog. Nevertheless, the Fed raised the discount rate from 10 to 11 percent on September 25, still way behind both monetary aggregate needs and the inflation rate.

Carter, falling behind in the polls, attacked the Fed for its high-interest-rate policy in the final weeks of his reelection campaign in October. Reagan opportunistically and disingenuously defended the Fed's unfair scapegoating by Carter. After the election, the Fed continued its high-interest-rate policy while Reaganites were preoccupied with transition matters. By Christmas, prime rate for some banks reached 21.5 percent.

The monetary disorder that elected Reagan followed him into office. Carter blamed inflation on prodigal popular demand and promised government action to halt hyper-inflation. Reagan reversed the blame for inflation and put it on the government. Yet Reagan's economic agenda of tax cuts, defense spending and supply-side economic growth was in conflict with the Fed's anti-inflation tight-money policy. The monetarists in the Reagan administration were all longtime right-wing critics of the Fed, which they condemned as being infected with a Keynesian virus. Yet the self-contradicting fiscal policies of the Reagan administration (balanced budget despite massive tax cuts and increased defense spending) overshadowed its fundamental monetary-policy inconsistency. Economic growth with shrinking money supply is simply not internally consistent, monetarism or no monetarism.

The Reagan presidency marked the rehabilitation of classical economic doctrines that had been in eclipse for half a century. Economics students since World War II had been taught classical economics as a historical relic, like creationism in biology. They viewed its theories as negative examples of intellectual underdevelopment attendant with a lower stage of civilization. Three strands of classical economics theory were evident in the Reagan program: monetarism, supply-side theory, and phobia against deficit financing (but not deficit itself). Yet these three strands are mutually contradictory if pursued equally with vigor, what Volcker gently warned about in his esoteric speeches as a "collision of purposes". Supply-side tax cuts and investment-led economic growth conflict with monetarist money-supply deceleration, while massive military spending with tax cuts means budgetary deficits. Voodoo economics was in full swing, with the politician who coined the term during the primary, George Bush, now serving as the administration's vice president. Reagan, the shining white knight of small-government conservatism, left the US economy with the biggest national debt in history.

Volcker was a man of far superior intellect to most at the Reagan White House except Martin Feldstein, chairman of the Council of Economic Advisors, whose incisive warnings against budget deficits were ignored by the White House. Volcker began to gain control over the administration on monetary policy through his rationality and adherence to reality, which allowed him to dominate events over the White House's doctrinaire "rational expectation": the theory that rational market participants always anticipate government policy and adjust their actions accordingly.

By March 1981, the FFR, which reached a historic high of 20 percent in January, had been pushed below 16 percent by the FOMC. The bond market refused to go along. Long-term rates went up. Henry Kaufman, a highly respected Wall Street guru, blamed it squarely on Reagan's expansionary tax cuts. The money-supply component M1 started to expand rapidly in April. Bond traders feared a Fed tightening with interest rate hikes, thus depressing the price of outstanding bonds with lower rates. Traders, many of whom have been exposed to simplified summaries of Milton Friedman's monetary theory in the trade press, began bidding up rates in anticipation. "Rational expectation" was working against the Reagan economic plan instead of with it. The Fed pleaded with market specialists not to jump to extreme conclusions based on a two-week change in the supply of money, that the Fed was no longer using the new operating method. But the bond market, having simplistically embraced Friedman's monetarist views to the point of conditional reflex, reacted nervously to M1 data and the Fed reacted nervously to the bond market. Monetarism was made real not by theoretical logic but by market herd instinct.