Executive Summary: President Carter may have horrified official Washington with his method of reshuffling his Cabinet, but his new team is greatly superior to that which it displaced, increasing Carter's chances of survival. The most important appointments are those of Paul Volcker at the Fed and Alonzo McDonald as the new Staff Director at the White House, the de facto Chief of Staff. With Charles Duncan at DOE, there is now a group around the President mentally equipped to push him toward growth-oriented tax, money and energy policies. The new team dilutes the influence of the eastern liberals who shaped policy through Vice President Mondale and Stuart Eizenstat. The key question: Will Carter change directions rapidly enough to make a difference to the economy and his political future?
Carter's New Team
A few days after the dust began to settle on the White House, following the President's July shakeup of his Cabinet, Hamilton Jordan appeared for interrogation on NBC's "Meet the Press." Why was it necessary, the new White House Chief of Staff was asked, to request the resignation of the whole team when only five got the ax? "Well," said Jordan, "the American people are not concerned as to exactly how it happened, but they are concerned with what has happened."
Jordan's answer was evasive, but essentially correct. The citizenry just wants the job done, and broadly speaking the Carter Administration's first 2 ½ years has been a failure. Yes, the President is responsible, but the policies he has followed have been the product of the stew of ideas brewed by the President and his Cabinet. By stirring the pot, Carter could have made things worse, but he did not. The new team he has assembled is greatly superior to that which is displaced, with the potential of producing a superior stew that would save Carter at least from losing the Democratic presidential nomination next year.
It does not take much, the difference between failure and success often seeming marginally trivial ("For the want of a nail, the shoe was lost, etc."). In this case, even simple musical chairs would have improved things. In January, Economist Robert Mundell of Columbia University picked up the newspaper one day and noted that Federal Reserve Chairman G. William Miller was citing the need for greater tax incentives for investment, and Treasury Secretary Mike Blumenthal, in another report, was calling for tighter money. "They should switch jobs," said Mundell, "and the economy would get a big boost."
In the shakeup, Miller did of course go to Treasury, where he is likely to be superior to Blumenthal if only because Blumenthal had been worn out on the job, for the most part crippled from the start by an inept Treasury staff of White House choosing. The staff is just as inept, but with less confidence in itself, which suggests it will not be able to bamboozle Miller as it did Blumenthal, who came to Washington from Bendix with supply-side instincts, but was quickly talked out of them. Miller, while not an initiator, will not be a barrier to positive policy change. In April of 1978, after only a month on the job at the Fed, he breakfasted with the late Rep. William Steiger and said he would write a letter to Steiger supporting his amendment to halve the capital-gains tax. The White House jumped on him for cutting against the President's policy of increasing the capital gains rate to that of ordinary income and Miller dutifully withdrew his promise.
By far the most important change made by Carter was in his astonishing choice of Paul Volcker, President of the New York Fed, to replace Miller as Chairman of the Federal Reserve. Astonishing in that Carter, who has had such a losing streak in trying to pick winners, would come up with such superb choice.
Indeed, both Mundell and Arthur Laffer would agree that there is no American banker who comes closer to embracing their views on global monetarism than Volcker. On April 19-20, when Mundell co-hosted an international monetary conference at Columbia with former Treasury Secretary Douglas Dillon, it was Volcker he invited as the banquet speaker. Volcker was Treasury Undersecretary for Monetary Affairs, under John Connally, when the Bretton Woods system blew up in August 1971, after President Nixon closed the gold window. But Laffer, who represented the Office of Management and Budget during the planning stages, recalls that he and Volcker were among the very few who struggled against the decision. William Safire, then a Nixon speechwriter, was present at Camp David in August 1971, and wrote about it in his book Before the Fall:
Even as we kidded around, the men in the room knew that Volcker was undergoing an especially searing experience. He was schooled in the international monetary experience, almost bred to defend it; the Bretton Woods Agreement was sacrosanct to him; all the men he grew up with and dealt with throughout the world trusted each other in crisis to respect the rules and cling to the few constants like the convertibility of gold. Yet here he was participating in the overthrow of all he held permanent; it was not a happy weekend for him.
The Volcker appointment signals that the liberal Keynesians and conservative monetarists who combined to break up Bretton Woods have thrown in the towel on inflation, or at least have had the towel thrown in for them by bankers alarmed by inflation.
The potential importance of the Volcker appointment, though, goes far beyond his particular views on international money. For 2 ½ years, President Carter has been like a man trapped in a room with a finite amount of oxygen, slowly suffocating on the obsolete views served up to him; his presidency seemed terminal. The Volcker appointment is an open window, which may have come in time to revive Carter to the point where he is at least able to hold on to his party's re-nomination next year.
Volcker is not merely independent, as Miller was not. He in no way returns to Washington on an ego trip. He is not awed by the Oval Office. And he is a nominal Democrat, which at least offer Jimmy Carter the assurance that Volcker's opinions and priorities do not mask a hidden, partisan agenda. Volcker is also politic enough to attempt private counseling to alter the direction of policy, rather than public cleavage with the White House. For its part, the White House knows that it is President Carter that will have to shift gears, not Volcker, if it wants to avoid public cleavage with the Fed Chairman. It is a reliable sign of Carter's desperation that he has been willing to submit to this treatment, but also a sign of a hidden reserve of strength.
In this analysis, we must discount some of what Volcker says publicly and most of what Carter says publicly; Volcker because he needs time to work quietly, without embarrassing and alienating the President; Carter because his continued fulminations about the oil lobby, windfall profits, balanced budgets and antipathy to tax-rate reductions represent 2 ½ years of confinement in that stultifying room of obsolete theory. He essentially has to unlearn those ideas before he can move towards the ideas of his new advisors; if there is to be such a change, it will appear gradually.
It is sufficient, though, to read the transcript of Volcker's confirmation hearings before Senate Banking on July 30 to get a reliable view of his intellectual depth. A sampling:
Chairman Proxmire: What's your answer to the fear that in the immortal words of William Jennings Bryan you may choose to "crush down upon the brow of labor the crown of gold", by pushing high interest rates to levels that would be punishing and create more unemployment. . . .
Volcker: I don't want interest rates any higher than they have to be, and indeed I think the broad record of history is quite clear that the level of interest rates specifically is much related to the level of inflation and if we want low levels of interest rates which I think would be desirable we have to recognize that that's not going to be feasible until we have a more stable economic and financial climate.
Proxmire asks if Volcker means to follow a tight monetary policy with possibly higher interest rates.
Volcker: I would point out, with respect to very recent developments that the money supply, the money aggregates generally have been rising at a pretty good clip and I do not think there is any feeling around or any evidence around at the moment that the economy is suffering grievously from a shortage of money.
Proxmire cites Arthur Okun's fear that "the price that had to be paid in tightening credit was a terrific price in the loss of jobs and the loss of production."
Volcker: I am familiar with econometric studies which show particularly in the very short run that the response of the inflation rate to a slackening in economic activity is not very quick or rapid. I think we have to be very careful about the implications of studies of that sort. I think we are all familiar with the fact that today we have both a high rate of inflation and speaking now broadly of the 1970s, a less satisfactory performance in terms of unemployment, in terms of productivity, in terms of growth. . . . We have ended up with a lack of progress both on the inflation front and on the employment front.
I think this is symptomatic of the fact that we cannot consider these over a period of time. And we have to consider the short-run trade-offs, if you will, in the longer-term context. Indeed, I think it is fair to say the economy does not react the way probably you and certainly I were brought up to think, in terms, of economic analysis, that an expansionary dose, by whatever technique, would improve employment and maybe at some risk of inflation, we proceeded on that assumption for a long time and we found the risks of inflation become much greater and that reactions in terms of employment, output and productivity get less. . . .
It is perhaps symptomatic of some of the new problems and indeed the new opportunities for economic policy that we find some evidence recently of actions that are interpreted as dampening the inflation rate have a favorable impact on the climate of the financial markets. The long-term interest rates will decline instead of going up, whereas actions that are interpreted as inflationary, which may include easier money in some specific instances, have a rather perverse effect on financial markets that is counter-productive.
Senator Stevenson asks if foreign central banks are ''quietly undermining the dollar in order to reduce oil costs."
Volcker: I think that is not true. ... I think some foreign countries have found that an appreciating currency is not altogether bad in recent years in that, among other things, it is a rather powerful influence on maintaining domestic price stability in general and specifically reducing an oil import bill in particular. For that reason I think a number of important countries would not look happily upon a major depreciation of their own currency. I keep looking at the overall international situation. There are very few foreign monetary officials that are not disturbed by the general instability that is associated with an important decline in the dollar, and I do not want to deny in an underlying sense that you have put your finger on the problem of, in a sense, international monetary reform that has preoccupied us for years in one guise or another.
Senator Armstrong asks whether the Fed really has the power to control the growth of the money supply Volcker's answer reveals why he is an anathema to the monetarists.
Volcker: I think it's threatened, frankly. . . . These days financial markets are very innovative, and we find forms of money or near-money springing up almost monthly, I suppose, that are outside of our direct control, that leave some fuzziness surrounding the concept of money itself. We are at a stage where we are relooking at the definition of money. I am not sure there is a permanent answer to the question. In fact, I do not think there is, because money depends upon a functional definition, and the functions of instruments in the marketplace change.
Well, says Armstrong, how much should the money supply increase. Volcker's answer is extraordinary.
Volcker: When I put an acutal number on it, I do get into definitional problems. If we look at old relationships of the present kind of money definition, you look at the narrow money supply, M-l. I think old relationships would suggest, if we are really going to have price stability we are going all the way now to a non-inflationary situation we would not have very much growth in that particular number, based on the standard historical relationship, because there has been a general tendency over the years for velocity to increase. The money turns over a little more rapidly, so you have real growth in the economy at whatever rate three percent, hopefully more. But you can take care of most of that real growth through an increase in velocity if you look at the narrowest definition.
Armstong: Without being too specific, is that the general policy that you favor?
Volcker: Ultimately, yes, I would like to get there. Now, I am not going to get there tomorrow.
Senator Lugar asks for Volcker's reflections on the dollar devaluations of 1971 and 1973.
Volcker: I think as a country it made me extremely uneasy at the time when we became a little overly enamored of the view that we could kind of forget about exchange rates, and we will just let these floating rates go where they will, and that will take care of all the problems. And if the dollar went down, it was no great concern of ours. I think that kind of attitude contributed to the problem. I think it was always an illusion. What we have learned but learned from harder experience than I would have wanted to go through ideally is that we could not ignore these things.
Senator Stevenson asks whether a substantial across-the-board tax cut would be appropriate in 1980 or 1981. Volcker says he would not want to project himself that far ahead, that a broad tax cut would not be appropriate now, "but obviously it has to be reviewed in the light of economic circumstances as it emerges." Later, Senator Sarbanes returns to this answer to make sure Volcker meant he would entertain a general tax cut if the economy got softer.
Volcker: I would certainly entertain the idea of a tax cut. It seems to me, based on history, it would be more desirable to place the emphasis there rather than on spending if and when fiscal policy becomes desirable. ... If we come to the point of deciding that a tax cut is appropriate, we ought to design that tax cut not just for short term benefit, but let us design that tax cut to be as consistent as we can with what we need to do over the long run and [we should] worry about productivity and investment and inflation.
Nobody in the Carter Administration is capable of undermining Volcker's position unless his credibility is somewhat damaged in the next several weeks. If Volcker's policies work to lower the price of gold, which even the New York Times now cites as a "proxy for expected future inflation", he will effect a buoyancy in financial markets and ebbing of interest rates that will strengthen his position, giving him standing beyond his already imposing height of 6' 8" among the Carter policymakers.
At such a juncture, he would have a fresh ally inside the Administration. Alonzo McDonald is the second most important new face on the Carter team. McDonald made his appearance quietly, on August 10, with the title of White House Staff Director. Because he was recruited two years ago from McKinsey & Co. by Robert Strauss to rescue the then-moribund Tokyo Round trade negotiations,1 the press corps has treated the McDonald appointment at face value, as if his assignment were managerial and administrative. McDonald, though, may well be the most impressive figure inside the entire Carter Administration, capable of functioning at any Cabinet post. Indeed, he was so adroit in reviving and completing the trade talks and winning easy congressional approval that he got scant public credit, on the rule of thumb that if your job does not look difficult, it cannot be hard, and anybody could have done it. Those who recognize McDonald's gift of quiet accomplishment, including Strauss, in late May and early June schemed to have him appointed White House Chief of Staff. That, in effect, is what he will be. Hamilton Jordan has the title, but says McDonald will "speak for me". In reality, Jordan moves into the orbit of presidential politics, with McDonald in charge of coordinating government operations. The big losers are Eizenstat and Vice President Mondale, who for the last 2 ½ years served as the conduits for the eastern liberal establishment. The Democratic "regulars", whose strength is with the grass roots especially the West and South and not the liberal theoreticians, have finally gotten a foothold on Jimmy Carter. The question is whether it is possible, or if there is time, to exorcise the theoretical demons from Jimmy Carter.
The first test will be on energy policy, probably in October when the Senate debates Carter's windfall profits tax/Synfuel boondoggle. Eizenstat, Mondale and their troops will try to rescue it while the new team, including the new Energy Secretary, Charles Duncan, would prefer to dilute it. Duncan is also a net plus for the President in his shakeup, even though James R. Schlesinger in his latter days at DOE had himself begun to emerge from the early influence of the Malthusian theoreticians around the White House. Schlesinger, an academic, knew nothing about the energy industry when he was appointed Secretary of the DOE. Duncan, a businessman, began in the oil industry.
It is vitally important on fiscal policy, as Volcker observed in his testimoney, that if Carter can be swung around to a tax cut the design not be left to the Mondale-Eizenstat forces. They would surely come up with a deferral of Social Security tax increases rather than an across-the-board income tax reduction. Social Security tax rates are at least linked indirectly to benefits. Further weakening the linkage without lowering benefits merely reduces the connection between effort and reward, with the tax pushed onto production. The liberals will resist reduction of marginal tax rates on income, as they resisted the Kennedy tax cuts, on egalitarian grounds. Coincidentally, one of the forces that powered the Kennedy tax cuts was his Commerce Secretary, Luther Hodges. His son, Luther Hodges, Jr., has just joined the Administration as Commerce Undersecretary, adding his weight to the Democratic "regulars."
It almost goes without saying that the interested bystanders to this play are the other would-be Presidents, Edward M. Kennedy, Jerry Brown and the assorted Republicans. For a while, it looked to them and all the world that Jimmy Carter was absolutely finished. Now, we must re-open the possibility that he may be a contender.
1 See Jude Wanniski, "The Tokyo Round and the Third World," April 27, 1979.