As the ’70s wound down, the dollar became a debased currency—but one that, for want of an alternative, still served as the world’s most important reserve currency. Nations might make other provisions, but that could take years. To make matters worse, an ideological cleavage between Milton Friedman’s “freshwater” Chicago monetarists and East and West Coast “saltwater” economists added an unusual testiness to the board’s discussions. Monetarists looked to the supply of money, which is the multiple of physical money—M1 in the jargon—times its velocity, or turnover rate. Friedman’s rigid version of monetarism assumed that the velocity of money was fairly stable over time, so policy makers could ignore it and steer solely by M1. (Indeed, Friedman also believed that you could eliminate the Federal Reserve Board.) Traditionalists, such as Volcker and most other saltwater economists, looked first to interest rates as a policy tool.
By the time Volcker was sworn in at the Fed, in 1979, inflation in the U.S. was running about 1 percent a month, and rising. In 1973, the OPEC countries had forsaken the hallowed $3 peg for a barrel of oil—tripling their prices and tripling them again six years later. By then, spot prices for gold were bouncing around from $235 to $578 per ounce. When the U.S. Treasury, in the early 1980s, needed to raise money, it would be forced to float bond issues in marks and yen, so far had the almighty dollar fallen.
Two months into his new job, Volcker attended a conference of central bankers in Belgrade and was shocked to find himself harangued by his peers. As he explains in his memoir, German Chancellor Helmut Schmidt, who was a friend, lectured Volcker for almost an hour “about waffling American policymakers who had let inflation run amok and undermined confidence in the dollar.” A shaken Volcker cut his trip short, got his fellow Fed members on board, and called an unusual evening press conference. Most dramatically, he stressed that he was shifting his key policy tool to monetarism. As a hedge, he also raised the Fed’s discount rate by a full point. The New York Times editorialized about the rate hike under the headline “Mr. Volcker’s Verdun,” noting that when it came to holding the line on inflation, the Fed chairman’s message echoed that of Marshal Pétain: “They shall not pass.”
At first, the experiment seemed to work. The objective was to reduce the money supply and thereby bring down prices. By January 1980, however, the numbers were going haywire. Perversely, inflation took off—it reached an annual rate of almost 15 percent. The Fed’s technical staff ruefully admitted that Friedman’s money-supply theory was not precise enough to form a basis for effective policy. The Fed board maintained its monetarist rhetoric, but Volcker shifted back to raising interest rates in order to wring inflation from the economy. This was language that all businesspeople understood. The bank prime rate eventually jumped to 21.5 percent, T-bills hit 17 percent, and prime mortgages were at 18 percent. Those rates were the highest the country had ever seen. Volcker went on a grueling speaking tour to bolster the case for what he was doing.