James A. Baker III

Henry C.K. Liu hliu at SPAMmindspring.com
Mon Dec 18 03:13:28 MST 2000

Many expect James Baker, who managed the successful Florida
contest to make GW Bush prsident, to be an influential voice in
the new Adminstration.  It is undeniable that he has a score to
settle with Greenspan whom both Bush Sr. and Baker blamed for
Bush's one term presidency.  Baker's record of outsmarting Fed
Chairmen is nevertheless impressive.

Jim Baker's pushing down the dollar in 1985 was to cure the
anemic US economy, not to cause it.
Baker became Reagan's White House Chief of Staff in 1980 with
Regan of Merrill as Treasury Secretary.  Volcker was a leftover
Fed Chairman from Carter whose supporters justifiably thought
Volcker policies were the reasons for Carter's one term

Volcker on September 29, 1979 presented the Fed's "new operating
system" of targeting money supply to combat hyper-inflation in a
meeting on board Treasury Secretary Miller's official plane on
the way to an IMF meeting in Belgrade to Miller and Charles
Schultz, CEA Chairman.  While agreeing that the Fed must do more
to tighten money supply and credit, both immediately opposed the
idea that would set the Fed on a course of targeting money
supply, a pure monetarist measure. Miller the businessman
objected that if the Fed targeted bank reserves directly, it
would result in more volatility in interest rates that would
exacerbate both inflation and market instability.  Schultz the
economist objected to fundamental issues of locking the Fed on a
course toward recession it could not reverse. Volcker listened
politely but held on to his belief that the technical decision
was the Fed's "independent" prerogative. The new operating
system caused the Fed to lose control of interest rates and cost
Carter another term.

The economic disorder that had helped to elect Reagan reached a
new height as he took office. Price inflation remained in double
digits. Interest rates were driven to double digits by inflation
and the Fed's tight money supply policy.  Bank prime rate hit
21%.  Unemployment hit 7.4%.  Both were rising with no end in
sight.  Reagan declared that government was the problem, not the
solution, reversing the failed Carter approach of relying on
government policy to halt inflation.  The Reagan cure was a 30%,
three year tax cut and a balanced budget, cutting $100 billion a
year from government revenue over the next five years and a $41
billion budget reduction in the first year.  Voodoo economics
was in full swing.  Reagan wanted "sound money", a fixation of
his half-baked monetarist preoccupation. Optimism was going to
defy economic logic. Volcker made obscure speeches on the
unavoidable clashes between monetary restraint and economic
growth, but the White House was not listening.  The nation was
ignoring an economic truth about inflation, that the economy
must always decline first, before prices will decline.  Sound
money means capping the money supply which means either price
inflation or real output would fall.  Historical data have
always sided with real output falling first, before prices will
fall.  Thus sound money is a recipe for negative growth: i.e.
recession, way before any benefit can appear.  Moreover, despite
slogans, Reagan policies of slowing the economy and tax cuts
were heading for increased deficits, the opposite direction of
sound money. Reagan rehabilitated classical economics which
had been discredited since 1930 and its four main strands of
conservative economic thinking: monetarism, tricking down
growth, balanced government budgets and unregulated markets.

Baker was  uneducated about monetary policy and did not claim to
be otherwise.  Ironically, Reagan, who was a passive president
on most other issues, was forceful on monetary policy as a
result of decades of ideological incubation.  He was a diehard
anti-inflation monetarist and an apt student of Friedman.  Now
Baker and the two Bushes, being all Texans deep in the oil
business, have a genetic hostility toward big Eastern money
center banks, and despite being the financial elite, are
imbedded with deep rooted Texan populism.  Bush Sr. even
proposed, as Vice President, an excess profit tax on banks if
prime rates remained high.  But the king had spoken and everyone
worked to give the king what he wanted.  The economy plunged
from the frying pan to the fire. Penn Square bank failed from
bad loan due to falling oil prices and Third World debt crisis
developed due to a fall in inflation engineered by the Fed, most

dangerously in Mexico which was about to default on $80 billion
of debt, and the US banking system was under threat of collapse.
What severe pain suffered for years by American citizens could
not accomplish, the threat to the banking system produced
immediate government action.  A deal was made within days
between the Fed and the White House to cut interest rate and
raise taxes to cut the deficit. A Mexican bailout was engineered
within 2 days with $3.5 billion from the Fed and the Treasury,
plus a $1 billion advance payment oil purchase from Mexico by
the Dept of Energy, another $1 billion line of credit from
Dept of Agriculture for future purchase of US grain and a Fed
orchestrated $1.85 billion from other central banks, half from
the Fed.  This was the beginning of the international debt
crisis that remains still unresolved totally today.  This set
the basic formula for protecting the banks while the price is
paid by the
world's poor in hunger and deaths. The total dependence of the
banking system on government only made bankers like Wriston of
Citibank more aggressive in demanding less regulation, to get
the Fed off the banks' backs except at bailout time.  Allan
Greenspan has essentially followed this policy.  The Fed has
since shifted its role from regulator to that of a cleanup crew.

By August 1982, Congress enacted a package of $100 billion in
tax increases, paring the deficit down slightly.  Jim Baker as
White House Chief of Staff demanded  a Fed interest cut.  By
then Volcker had long abandoned his new operating system and
fell back to using fed funds rates as the Fed preferred tool of
monetary policy.  But Wall Street had by then all the measuring
devices of M1 in place, on everyone's trading screen.  And the
reading in August for M1 jumped 10%, but the monetarists in the
White House and the Treasury were told to keep their concerns to
themselves.  DAvid Stockman, boy budget director, noted: " No
one listened to them."  Baker turned overnioght from his boss'
sound money to supply-side on the interest rate issue and
continued to push Volcker to ease further. Stockman was quoted
as saying the Baker lost all confidence in Volcker for not
lowering rates sooner.

By the beginning of 1984 the economy was in recovery. By March,
the Fed decided to take the punch bowl away to ward off
inflation. Volcker worried publicly about "bottlenecks" of
production and
labor in a strong economy that could spell inflation ahead - a
theme Greenspan learned well a decade later.  There were the
usual talks of government borrowing crowding out private
borrowing and interest rate kept rising while prices were still
stable.  Volcker was called to the White House to meet with the
President to whom he gave a rambling discourse on interest rate
and inflation.   After the meeting, it was reported that Reagan
turned Don Regan and Jim Baker to find out what Volcker said,
and neither could say.  Evans and Novak reported that the White
House told the Fed not to trigger another recession "just to
calm the inflationary nightmare of the creditor class."  Reagan,
using Marxist terminology he might have learned in his early
days as a Hollywood union leader, saw Volcker as a warrior of
class warfare.

Since November 1982, the ff rate target was held within a range
of 6-10%.  Now Volcker raised the ceiling to 11.5%, taking
advantage of a deferential press.  Instead of the mid-course
correction (the equivalent of Greenspan's soft landing) the new
ff rate target marked the end of the Reagan boom that had begun
18 months ago.  And now it was is March in an election year.
Unemployment reverse its
downward trend stopping at 7.1% and started to inch up again.
The exchange value of the dollar was driven high by high
domestic interest rates.  Jim Baker was furious at Volcker.  He
was reported to have told Wriston that Volcker did not keep his
end of the deal: a budget under control from the White House
with a three year $150 billion deficit reduction package with a
tax increase of $48 billion which
Reagan resisted and finally agreed to as a "down payment", in
exchange for Fed easing.  On April 6, 1984, the Fed raised the
discount rate to 9%, first change since November, 1982.  Prime
rate jumped a second time in six weeks to 9.5%.  Baker went
ballistic. The Administration unleashed a full force attack on
the Fed, disguised as a war on high interest rates. Instead of
"where is the beef," the tune was "where is the inflation."

Volcker had allies in the White House in Martin Fieldstein and
David Stockman and called "the wrath of God" down on Baker. Wall
Street joined it, with the bond market choking up by not being
able to find buyers for $4.5 billion in new treasuries. Analysts
were blaming the collapse of the bond market on Fed
bashing.  The White House called a quick press conference in
which the President said the Fed was doing the best it could.
But it did stop the Fed from further tightening.  Then on May 9,
the day Don Regan attacked the Fed, a wire story reported that a
Japanese bank was negotiating to buy Continental Illinois bank.
Asian holders of Continental cds panicked and $1 billion left
the bank and started a global run.  By Friday, May 11,
Continental had to borrow $3.6 billion at the discount window.
Continental had bought from Penn Square $1 billion of bad loans,
but the regulators were keeping their eyes closed, much as the
Fed and FDIC had done in recent years about telecom loans.  The
Fed standard answer was to regulate earlier would only panic the
market.   A $2 billion infusion of capital from the FDIC did not
help. Over the weekend, another $4.5 billion loan, engineered by
Morgan Guaranty failed to stop the hemorrhage when the money
markets opened on Monday.  On Tuesday, the Fed announced a $4.5
billion rescue package in immediate new capital injection, plus
all the bank needs in loans to stay afloat, which turned out to
be $8 billion.  The Fed was finally working for a living.  The
most controversial part of the rescue was a guarantee to protect
all depositors from loss, beyond the $100k FDIC limit.  The NY
Fed reported: "The funding problems of Continental cast a long
shadow ever the financial markets ...", meaning kicking up
interest rates.  Some voices in Congress objected to this
assumption of public obligation by fiat, in a scale that dwarfed
the NY City bailout, without any public debate.  During the
first half of 1984, 43 banks failed, mostly small agricultural
banks. None of the depositors got their money back beyond FDIC
guarantee. The Fed could not find another bank to buy
Continental because the potential buyers found in their own
audits that Continental had $4 billion in bad loans instead of
the Fed's audit of $2,7 billion. The Fed had to nationalized
Continental in July at a price of $5.5 billion. So Ronald
Reagon, the free enterprise president became the first president
to national a private bank since the Great Depression.

When Baker left the White House in 1985 to become Treasury
Secretary, he brought with him an insight he gained at the White
House: that a legitimate lever the Executive Branch could use to
pressure the "independent" Fed to change its monetary policy was
the issue of the exchange value of the dollar.  By law and
tradition, the Executive Branch has the responsibility of
managing the exchange value of the dollar; it is a national
interest issue. And the Fed is obliged to support the Executive
Branch on this.  Baker, upon setting up at Treasury immediately
abandoned any pretense of free market ideology and instituted an
interventionist, activist policy of pushing down the overvalued
dollar to protect US manufacturing.  Two year earlier, Martin
Filedstein had worked out the economics of globalization by
saying that the loss of US manufacturing jobs overseas was no
big deal as long as the trade surplus enjoyed by America's
trading partners was recycled into dollar assets and debts  But
Baker had been hearing complaints from American corporate CEOs
all through his White House years.  Baker told Volcker that
lower interest rate was needed to lower the dollar to save
American jobs.  Baker told Volcker that if the Fed did not bash
the Administration on fiscal policies, the Administration would
not bash the Fed.  It had to be a two way street.
Thus on September 22, 1985 the G5 agreed to the Plaza Accord to
push to dollar down via coordinated central banks efforts.
Volcker led the discussion and lent his imprimatur, while
privately he knew that the Fed had been trapped into a monetary
policy of low interest rates to prevent the dollar from rising.
It would be unpatriotic to do otherwise!  From that point on
Treasury calls the tune on exchange rate and the Fed had to
adjust interest rates to support the national interest.

The fall of the dollar through the Plaza Accord by over 30%
(back to 1981 level) failed to deliver the therapeutic result
Baker had hoped.  The damage to the trade sensitive sectors did
not reverse, but deteriorated further: trade deficit grew to
$150 billion, ten times what it was in 1981.  The same dollar
exchange rate of 1981 was producing 10 times the trade deficit
in 1985. The reason was a decade of
price advantage for foreign competitors had built up enough
profit margin that enabled the importers to refrain from
exchange rate pushed price hikes.  In fact, if anything it made
the Japanese and the German producers meaner and leaner. As
Federick List observed, once a nation falls behind in trade, the
disadvantage became structural.  Once factories are closed,
production cannot be revived at competitive cost.

Then US ingenuity found two solutions.   With the fall of the
USSR, the US's attitude toward
the Third World changed.  It no longer needed to compete for the
hearts and mind of the Third World. So trade replaced aid as an
economic policy.  The US embarked on a strategy to use Third
Work cheap labor and non-existent environmental regulation to
compete with its industrialized rivals, namely Japan and
Germany.  In the meantime, the US pushed for financial
deregulation and emerged as a 500 lb gorilla in the global
financial markets that left the Japanese and Europeans in the
dust.  The tool of this strategy was the residual role of the
dollar as the sole currency for world trade, left by the
abandoned Bretton Woods regime. Out of this emerged an
international financial architecture that does real damage to
the real
producers for the benefit of the financiers.  Money, instead of
a neutral agent of exchange, became a weapon of massive
destruction more lethal than nuclear bombs, with more blackmail
power on national sovereignty. Trade wars are fought through
currencies. Trade deficits become the bait for capital account
surpluses in favor of the US.

To mask this unfair regime, the term GNP is quietly replaced by
Gross Domestic Product: Total value of a country's output,
income or expenditure produced within the country's
physical/political borders.
Gross National Product: Gross domestic product plus " factor
income from abroad" - income earned from investment or work
Under globalization, these two technical terms take on new
In 1991, the GNP was turned into the GDP - a quiet change that
had very large implications, as the 1990s were the decade of
rapid globalization.
Gross National Product attribute the earnings of a transantional
firm to the country where the firm was owned and where the
profits would eventually return.
Gross Domestic Product, however, attributes the profits to the
country where factories or mines or financial institutions are
located, even though they do not stay there permanently.
This accounting shift has turned many struggling nations into
statistical boomtowns, while aiding the push for a global
economy. Conveniently, it has hidden a basic fact: the nations
of the Core are walking off with the periphery's resources and
calling it a gain for the periphery.  The figures are 'gross'
because GDP does not allow for the depreciation of physical
capital - wear and tear on factory machines, office equipment
becoming outdated etc, or environmental degradation.
When the value of income from abroad is included - what domestic
companies earn abroad minus what foreign companies earn here and
expatriate - then the GDP becomes the Gross National Product
This is particularly important for economies with large traded
sectors, which includes many developing countries.     When Adam
Smith wrote the Wealth of Nations in 1776,  he probably had no
idea that the title of his classic tract  would remain a
contentious issue amongst economists, but for most of us real
wealth will not be found in the arcane alphabet soup of economic
indicators but in the starker credit and debit entries of our
bank statements.

But Baker in 2001 will have less room to maneuver.  The odds are
that he will still push down the dollar at least by 10%.  But it
will not save the US economy from collapse from excessive debt.

Henry C.K. Liu

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