The Importance of Being Shultz Jude Wanniski July 9, 1982

Executive Summary: Change was desperately needed in the Reagan Administration and the replacement of Haig at State by George Shultz means major change. He will surely become the dominant figure in the Cabinet, on domestic and foreign economic affairs, which is why supply-siders were almost uniformly dismayed, at least initially, by his appointment. The administration is now wall-to-wall monetarist. Shultz, though, is not an ideologue, but a consensus seeker, which is why the other radical elements among conservatives were dismayed. This Shultz personality trait may soon suit supply-siders, though. The international drift of consensus is toward anti-monetarist monetary reforms, which have not quite reached the Treasury or the Oval Office. A clue to Shultz's thinking may be found in a new book on international financial systems by his protege, Ken Dam, who may be joining him at State.

The Importance of Being Shultz

The replacement of Alexander Haig by George Shultz at the State Department will almost surely change the character of the Reagan administration in a major way, for better or worse. With a few exceptions, almost everyone associated with the supply-side movement viewed the Shultz elevation with dismay, at least initially. He is not keen on supply-side, and the fact that his portfolio does not directly bear on economic policy is little comfort. He is an economist, after all, and his approach to questions of public policy will inevitably be framed by his economic views, just as Haig's was colored by his military training.

The trouble is that Shultz is a Friedmanite, not in the sense that he is a monetarist, which he is not, but in that he seems to let Milton Friedman do most of his thinking on macro policy. With Treasury Secretary Donald Regan now letting Friedman doing his thinking for him, via Beryl Sprinkel, the Reagan Administration is now solidly monetarist, at home and abroad. At least one supply-sider who has known Shultz for more than a decade believes there can be no sustained economic recovery now that Shultz is at the power center, that he can single-handedly prevent the monetary reforms that recovery requires.

This extreme view, which I do not share, is partly based on the likelihood that Shultz will become the dominant figure in the Cabinet, a view I do share. Haig's difficulties were entirely due to his obtrusive ego and directness, which set the White House staff against him. Shultz, signed on as a "team player" will soon have Jim Baker and the Californians eating out of his hand. He is an indirect man, always oblique, his ego masked behind an owlish countenance as well as a well-known reticence and skill in personal diplomacy. He is the ideal Washington bureaucrat, which is why power is always being thrust upon him. He is renowned for his integrity and high-principles and prized because he's always ready to compromise his high principles for the greater good, without making a fuss. Richard Nixon considered him "one of the ablest members of the Cabinet," as he put it in his memoirs.

Shultz was Nixon's first Labor Secretary, having come from the University of Chicago where he had been dean of the Business School with a specialty in labor mediation. He had played tennis with Milton Friedman at Chicago; in Washington he golfed with George Meany, who took a shine to him. Shultz identified himself with the "liberals" in the Nixon administration, backing the Moynihan-inspired Family Assistance Plan and pushing affirmative action for black employment in the building trades. In his second assignment as Director of the Office of Management and Budget he brought Arthur Laffer to Washington as his chief economist. The relationship between the two was not a deep one, however, and certainly Shultz never understood the nature of Laffer's early heresies and was neither willing nor able to defend them. Laffer had argued against the closing of the gold window in 1971 and the first dollar devaluation. In May 1972, Shultz succeeded John Connally as Treasury Secretary, and although Laffer returned to the University of Chicago, Shultz retained him as a Treasury consultant. Laffer again argued against the second devaluation in early 1973 as well as the floating of the dollar that spring, predicting the inflation that ensued. The magnitude of Shultz's establishmentarian bent is revealed by this fact. He had the benefit of Laffer's unerring analysis and projections and was thus the least surprised official in the Nixon administration when the economy soured. But he could not adjust his public views without leaving the consensus of conventional wisdom. As the supply-side model gained more prominence, though, Shultz grew ever more hostile to suggestions of international monetary reform, which implied his policy was in error in abandoning Bretton Woods. Shultz, after all, had been lionized in both the liberal and conservative press for his "success" in floating the dollar. When he left in the spring of 1974, after a year-long explosion in commodity prices, "Shultz was discouraged by the downturn in the economy and disillusioned by my handling of Watergate," Nixon recalled in his memoirs. Shultz's deputy at Treasury, William Simon, succeeded him. I met with Simon a few weeks before he was sworn in and suggested he consider the possibility that the economy was in a mess because of Shultz's success in floating the dollar.

Simon was visibly taken aback at this heresy. My remark put me in the company of the likes of John Kenneth Galbraith, who had written to the Times a few days earlier, on March 29, 1974, blasting Shultz's resignation announcement. As Galbraith put it:

Finally, the Secretary praises himself for designing a universal currency float. This is no design at all. Rather it is a very poor and costly accommodation to a world of erratically fluctuating currencies. No one with a serious view of foreign trade and foreign relations can doubt that the system developed in the twenty years following World War II — stable exchanges based on accommodation by other countries to a predictable dollar of stable purchasing power — was far better, a far closer approach to a unified international system. Dr. Shultz, one fears, would praise himself for inventing chaos.

The Shultz-Reagan connection is not an old one at all. It came about in early 1980 when Shultz joined the Reagan economic advisory committee more or less at the invitation of Caspar Weinberger, one of the earliest of Reaganites. Weinberger had been Governor Reagan's budget director in California, in the late 1960s. Nixon brought him to Washington to succeed Shultz at OMB. And when Weinberger left the Nixon administration, he joined the Bechtel Group in California as a deputy to Shultz, who had become president of the Group in 1975 a year after he bailed out of the Nixon administration. In other words, Reagan did not really get to know Shultz until 1980, at the meetings that supply-siders dubbed "the greybeard meetings." Laffer and Rep. Jack Kemp were the only two "non-greybeards" on the committee.

Power flowed to Shultz at these meetings because of his gift for divining the consensus, holding his tongue while others wagged. Where William Simon assumed command of these meetings at the outset, it soon became clear that Reagan preferred Shultz's style, its smoothness and affability. After the election, Simon and Shultz both angled for the State Department job and lost out to Haig. But Shultz wound up with the chairmanship of the economic advisory committee, which played an important role in moving Reaganomics to a consensus economic policy. As Time magazine put it in its July 5 cover story on Shultz: "Reagan tapped Shultz to head his outside advisory group on economic policy. In that role, for better or worse, Shultz put together an economic policy that blended Reagan's major campaign themes — tax cut and a balanced budget — with the tight money and lower social-spending ideas favored by traditional conservatives and monetarists. In the process of melding together these views, Shultz somehow managed to ease aside, as key figures in the Reagan campaign, economic eccentrics like supply-side zealot Arthur Laffer and move ahead such mainstream figures as (Walter) Wriston and Economist Alan Greenspan."

Laffer, who has spent the last decade having his views rejected by Shultz and who was in fact submerged as an influence by Shultz's gavel at the Greybeard meetings, seems not to have noticed, at least publicly. In The New York Times of July 2, Laffer wrote: "George P. Shultz, the nominee for Secretary of State, will become a major force in the administration, pushing for economic growth while resisting austerity measures." The basis for Laffer's remark is Shultz's consistent support of the three-year income-tax cut. But there is nobody close to Ronald Reagan who wants to stay close to Ronald Reagan who does not voice support for the tax cuts. Shultz is no fool. Far more significant was Shultz's support of the "bipartisan budget resolution" and its commitment to tax increases in persuading Reagan that compromise was necessary. The conventional Republican.

This, of course, is the reason why the Shultz appointment caused dismay among the various radical elements associated with the GOP, the New Right and the neo-conservatives as well as the supply-siders. He is viewed as a man of the Establishment, the multinationals, the international banks, who can be counted upon to resist radical ideas — defined as those ideas not currently in vogue with the Establishment. In the Reagan transition period, Shultz was clearly the choice of the Council on Foreign Relations, the Trilateralists, The New York Times and Business Week as Secretary of State. And he is precisely the kind of Secretary of State George Bush would have appointed had he been elected President and Henry Kissinger was not available. Had not Kissinger said that if he could appoint a President of the United States it would be George Shultz? Richard Nixon, on the other hand, let it be known that he figured Shultz would be weak, that he could let himself be pushed around by the international bureaucrats.

The New Rightists had actually met with several leading neo-conservatives 10 days before Haig resigned to fret over what George Will called "Creeping Haigism" in his June 21 Newsweek column:

Reagan has had less impact on foreign policy than any modern President (Ford excepted). More than any modern President, Reagan campaigned against the mentality of the "permanent government" in foreign policy. Yet more than any modern President, he has abandoned foreign policy to the Secretary of State. More than any recent Secretary, Haig seems determined to maintain continuity in all the sluggish impulses of the foreign-policy establishment.

The New Rightists called for Haig's resignation or removal, and had "two seconds to celebrate" after Reagan announced Haig's resignation and Shultz's nomination. The neo-conservatives, older and wiser, did not call for Haig's resignation on the grounds that he might be replaced by someone worse, "and we were proven right," said one of them later.

Naturally, the distress in these groups with the Shultz appointment has nothing to do with international monetary policy, everything to do with the East-West political struggle. The New Rightists worry that Shultz will seek broad accommodations with the Soviet Union instead of setting a goal of "A World Without Communism," which was the title of a June conference held in Washington, D.C. This faction tends to support economic warfare as well as an arms buildup and an ideological offensive. They were angry with Haig for resisting President Reagan's decision to throw a delaying monkey-wrench into the European-Soviet natural-gas pipeline deal. And they are well aware that Shultz, who is opposed to economic warfare in principle, would probably have been able to talk the President into sidestepping the decision he made.

The supply-siders I've spoken to on the issue generally support the idea of an ideological offensive against the Soviets. But there is much less support for economic warfare in this effort, the doubt centering on whether you can defeat an idea with something other than an idea. On purely military grounds, it's true that the pipeline will increase Europe's dependency on Moscow. Then again, it was only a few years ago that James Schlesinger and others were warning that the West would run out of energy before the Russians and that this constituted a national defense problem. In other words, the European pipeline issue is not a clear one and should not be a litmus test to determine hardliners and softliners, and I personally would agree with Shultz on this as with most issues involving international commerce.

In this sense, if we are counting pluses and minuses, Shultz's negatives on international money are a bit offset by his positives on free trade. The State Department bureaucracy is more free-trade oriented than others, tending even to be soft on technology transfer. But neither Haig nor his several predecessors had foreign economic policy as high on the agenda as is likely to be the case under Shultz. And the global recession (largely caused by Shultz's floating dollar) has made it more necessary than usual that protectionist pressures be resisted in Washington. Commerce Secretary Malcolm Baldridge, DOT Secretary Drew Lewis, Special Trade Representative Bill Brock have become increasingly heavy-handed on trade issues — no doubt reflecting grass-roots complaints about international competitiveness. Here, at least, Shultz will have a healthy influence on policy.

The extreme view that Shultz could and would prevent the kind of economic reforms that supply-siders believe are necessary for sustained recovery is probably incorrect. Milton Friedman might be willing to let the world go up in flames rather than concede the failure of his theories. But the source of Shultz's strength in Washington is his demonstrated willingness to follow the consensus. He will sell wage and price controls. He will sell import surcharges. He will sell tax cuts and tax hikes. He will sell a floating dollar and, if that's where the consensus goes, he can be counted upon to sell it fixed.

How soon is that likely to happen? In a sense, it has just about happened already. Except for the last pockets of resistance around the President and in the Treasury, we might as well say that the international consensus concedes the failure of the floating exchange rates and is groping for a path toward fixity. The Versailles Summit gave this confirmation when Treasury Secretary Donald Regan, who had recently said "never" to fixed exchange rates, was forced to say maybe. Regan has been so indoctrinated by Beryl Sprinkel, his Undersecretary for Monetary Affairs, that he even uses the word "absurd" to describe a fixed-exchange rate system ("absurd" being Friedman's favorite perjorative). But the pressures from the international community, the international banks — of the kind that George Shultz responds to — are building up to irresistible proportions behind the idea that monetarism and its floating rates must go.

On June 22, The Wall Street Journal, which had been a major voice urging a floating dollar a decade ago, finally threw in the towel with its "Back to Bretton Woods1' editorial. The Yale Key-nesians — Tobin, Cooper, Bergsten — who had abandoned their own fixed-rate arguments 10 years ago in the enthusiasm for the float, have now revived their old fixed-rate arguments. The Financial Times of London, catching the general drift of consensus, on June 26 all but burned Milton Friedman at the stake in an editorial denouncing monetarism. The fact that the Group of 30, influential commercial and central bankers, has backed fixity over floating suggests that Arthur Burns is there too. Burns is never far from the Group of 30, and if there is anyone who Shultz looks to as much as Friedman, it is Burns. (Shultz was staff economist for the Council of Economic Advisors in the Eisenhower Administration when Burns was on the Council.)

The most intriguing clue comes from Kenneth Dam, a professor at the University of Chicago Law School who was Shultz's closest associate and protege in the Nixon years. Dam was executive director of the Council on Economic Policy, chaired by Shultz, in the Nixon White House, and co-authored a book with Shultz on their experiences after the two had left government. Dam is rumored to be Shultz's first choice as Undersecretary of State for Economic Affairs, one of two top economic posts now vacant at State. Dam, an expert on international financial institutions from a legal point of view, has just published a book, The Rules of the Game, on the recent history of international monetary systems. On page 341 we find the clue:

On the other hand, the nostalgia for a gold standard might be an important factor supporting a return to a fixed rate system. Against the background of the floating period since 1973, a fixed-rate system with several governments willing to support their currencies through gold sales in addition to foreign exchange market intervention could be presented under the gold-standard banner. But it would be far from the pre-1914 model. Indeed, it is hard to imagine any prompt return to immutably fixed rates as opposed to an adjustable peg of the late 1960s variety or a crawling peg of the EMS variety.

Exactly. The most probable path back toward a gold standard will resemble the path away from gold. Pegs will crawl, then they will adjust, then the concept of immutability will be approached. And we should never expect to see a pre-1914 system when, as Dam points out in his book, there really were no rules to the game.

A few weeks ago I asked Paul Volcker what I could do to help him, and he answered, pleasantly, that I should come up with something other than a gold standard. I suggested a gold SDR, which is what the system is most likely to evolve toward anyway. It was, in fact, the system the international bureaucrats were working on a dozen years ago when the float interrupted everything. A gold "Special Drawing Right" system managed by the International Monetary Fund. The advantage over Bretton Woods is that it offers an international unit of account instead of a national one. Instead of the U.S. dollar being defined as a specified weight of gold and all other currencies defined in terms of the U.S. dollar, the SDR would be defined as a specified weight of gold and all currencies in the system would be defined in terms of the SDR. Instead of the Fed targeting Ml, it would target the SDR, buying bonds when SDRs were being added to its account, selling bonds when SDRs were being subtracted. Every other currency would be managed the same way. It may seem obscure, but it's only an international gold standard, "paper gold" with a fancy name. Why not?

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The general drift of opinion continues to be favorable, even though it has not yet touched the Oval Office. The fact that the Administration seems more monetarist than ever, wall-to-wall now that Shultz is at State, has to be set against this general drift, and it's easier to remain optimistic ... or at least keep from despairing. Change often comes from the most unexpected direction and surely the Reagan administration needed a change of direction, a change of character. Shultz will shake things up, or he'll shake them down.