James A. Baker III

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Many expect James Baker 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
presidency.

Volcker on September 29, 1979 presented the Fed's "new operating
system" 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 target money supply, a pure monetarist measure.
Miller the businessman objected that if the Fed targeted
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:
recession, way before any benefit can appear.  More over,
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
and balance government budgets and unregulated markets.

Baker was  uneducated about monetary policy and did not claim to
be otherwise.  Ironically, Reagan, who was a passing 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, have a genetic
hostility toward big money center banks, and despite being
financial elite, are imbedded with Texan populism.  Bush Sr.
even proposed as VP, an excess profit tax on banks if prime
rates remained high.  But the king has 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 by American citizens could not
accomplish, the threat to the banking system produced immediate
government action.  A deal was made between the Fed and the
White Hall to cut interest rate and raise taxes to cut the
deficit. A mexican bailout with $3.5 billion from the Fed and
the Treasury, plus a $1 billion advance payment oil purchase
from Mexico by the DoE, 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 is still unresolved totally.  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
CoS demanded  a Fed interest cut.  By then Volcker had long
abandoned his new operating system and fell back to using ff
rates as the Fed preferred tool.  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.  Stockman, boy budget
director noted: " No one listened to them."  Baker turned from
his boss' sound money to supply-side on the interest rate issue
overnight 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 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
saw Volcker as a class warrior.

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
ffr target marked the end of the Reagan boom that began 18
months ago in an election year. Unemployment reverse its
downward trend stopping at 7.1%.  The exchange value of the
dollar was drive 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
million 3 year 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 aid 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 holder 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.  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 drwafed
the NY City bailout, without any public debate.  During 1984, 43
banks failed, mostly small agricultural banks. None of the
depositors get their money back beyond FDIC guarantee. The Fed
could not find another bank o buy Continental because the buyers
found in their own audit 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 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 the loss of
US manufacturing jobs overseas was no big deal as long as the
trade surplus was recycled into dollar assets and debts  But
Baker had been hearing complaints from corporate CEOs.  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 the
Administration would not bash the Fed.  It is 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!

The fall of the dollar 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. The reason was a decade of
price advantage for foreign competitors had built up enough
profit margin that enable the importers to refrain from exchange
push price hikes.  In fact, if anything it made the Japanese and
the German producers meaner and leaner. As Fdereick List
observe, 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 wo
solutions, with the fall of the USSR, the US's attitude toward
the Third World changed.  It no longer need to compete for the
hearts and mind of the Third World. So trade replaced aid.  The
US embarked on a strategy to use Third Work cheap labor and
non-existent environmental regulation to compete with its
industrialized rivals, such as 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 European in the dust.  The tool of the this
strategy was the residual role of the dollar as the sole
currency for world trade. 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 the nuclear bombs with more blackmail
power. Trade wars are fought through currencies. Trade deficits
become the bait for capital account surpluses.  To mask this
unfair regime, the term GNP is quietly replaced by GDP.
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
abroad.
Under globalization, these two technical term take on new
relationships.
In 1991, the GNP was turned into the GDP - a quiet change that
had very large implications, as the 1990 was the decade of rapid
globalization.
Gross National Product attribute the earnings of a multinational
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
(GNP).
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 had 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.