LATE ONE FRIDAY afternoon this summer, after the financial markets close and the brokers and traders scatter, the Dow Jones ticker may carry an arcane-sounding item like this: "Armageddon Industries, one of the nation's largest corporations, has had its commercial paper sharply downrated by credit agencies and is conferring with its bankers." What this will mean, quite simply, is that debt-ridden Armageddon has run out of cash.
Over that summer weekend, anxious bankers will use the resourceful White House telephone operators to track down high oficials, and they will impart this message: "Armageddon will go belly up on Monday morning, the banks are very shaky, the unions will raise hell at the layoffs, and the markets will panic -- unless Washington does something right now ."
Will the president, the Treasury secretary, the Federal Reserve chairman and a handful of powerful congressional committee chairmen have the political wisdom and courage to withstand such pleas? We may soon find out, for a major financial crisis, likely to be marked by spectacular bankruptcies, appears headed our way. What Washington should do when it strikes is simple: anothing.
Wall Street is not convinced that Washington has that kind of political will. That's largely why the Street remains skeptical of the Reagan administration's economic program. Important as the Reagan steps to date have been, painful budget cuts, promised tax reductions and tighter monetary and credit growth have been insufficient by themselves to dispel Wall Street's fear that larger doses of inflation lie ahead.
Thus when a major corporation or bank to totter, as will likely happen with the prime rate climbing above 20 percent, Wall Street believes Washington will pull back from the brink and uncork yet another inflationary wave of money and credit to bail out all the illquid companies and financial institutions. Indeed, one banker reportedly told Fed charimen Paul Volcker recently that if one of his bank's riskier loans goes had, the government will have no choice but to save his corporate client and his bank. The government needs to deal that welfare capitalist a rude awakening, just as it has been shaking up the rest of the comfortable but unaffordable American welfare state.
If Armageddon is not bailed out and goes bankrupt, it obviously will mean at least temporary suffering for some: The company will be reorganized and some of its assets sold, its incompetent executives and hapless employes will be out of work, stockholders will lose their investment, and the creditors and bankers most or all of their money. But, more important, a cleansing wave of fear will pass through the markets, flushing out similar debt-financed excesses that might have produced even worse suffering. This jolt of disinflation will create the sober expectation of more of the same, and prices and interest rates will soon reflect the new trend and the market's perception of it.
If, however, Armageddon proves to have helpful friends in Washington, prompting the Federal Reserve to open the discount window to the bankers and the Congress to push through an Emergency Loan Guarantee Act to "protect" all those jobs, financial panic may be averted. But it will be at the cost of a deepening cynical conviction that, in modern America, high inflation is forever.
If the economic system is again short-circuited by political intervention, the peril is that inflation soon will accelerate to hyperinflation, sending prices and interest rates soaring to once unimaginable levels. Would you believe a 35 percent prime rate? It sound ridiculous. But only a few years ago, the present 20 percent prime seemed impossible.
Americans today are paying the highest "real" interest rates (adjusted for inflation) in perhaps a century and a half. Bank interest rates have soared to former loan-shark levels because lenders demand an extra-large "inflation premium" to protect themselves. The memory of past inflation inspires apprehension of worse to come. And it blights the future health of our economy by destroying the predictability of future savings and investment returns.
It also strikes terror in the hearts of bond dealers. A bond is a debt instrument (usually issued in $1,000 denominations) paying a fixed interest rate and redeemable at its face value at maturity. Soaring interest rates have caused the market values of bonds to plummet. So demoralized is the bombed-out long-term bond market, according to traders, that everything bought in the past 40 year shows a loss.
It is no secret why key Reagan policymakers regard the bond market as a crucial barometer of the economic climate and of the administration's prospects. The bond market, which is much larger in terms of total investment values than the stock market, is the indispensable source of funds to finance all levels of government and the most creditworthy U.S. corporations.
If the bond market collapses permanently, as many observers now believe it has, we will experience increasing difficulty in turning over our astronomical public and private debts. To maintain our precariously balanced debt structure, we may be tempted to follow the example of other nations and resort to deliberate hyperinflation to defraud our creditors. o
To encourage investors to buy bonds, the Federal Reserve must convince them that inflation is being brought under control. This, of course depends largely on the fiscal posture and borrowing requirements of the federal government. When confronted with chronic federal budget deficits and massive Treasury bond issues, the Fed's vaunted "independence" disappears.
Tradition and expediency dictate that the Fed must provide the markets with the liquidity required to accommondate the Treasury's needs and minimize the "crowding-out" of other borrowers. Such "monetarizing" of debt has been the driving force behind inflation since the mid-1960s.
Monetarist economists, led by Nobel Laureate Milton Friedman (a part-time Reagan adviser) and represented in the upper ranks of the administration by Treasury Undersecretary Beryl Sprinkel, are right to criticize the Fed for creating too much money in recent years. The grossly inflated statistics show an upward trend line as eloquent as Alps.
But the monetariats tend to become entangled in arcane technical and procedural arguments over day-to-day Fed management that obscure the demands of our situation of opportunity and peril. Even if the Fed succeeds in restoring a semblance of stability and predictability to closely watched weekly monetary statistics, this technical feat will not in itself alter the inflationary psychology of the bond market.
Because the root of our inflation is political, an act of political will in the face of crisis is needed -- and there are encouraging signs that this need is recognized.
Fed chairman Volcker visited the White House the other day at his request to chat with President Reagan and his senior advisers. The unusual meeting bore witness to the policy consensus and political coordination that may soon bring a turning point in our economic history.
As Volker remarks privately, for the past decade and a half a speculative bet on further inflation has been a sure thing, and he wants to upset that assumption. He also wishes to shake the complacency of bankers who once worried about their risky loans going bad but who now assume they can shift that burden to Volcker's shoulder if they get in serious trouble.
Ironically, the Fed's ability to protect or punish the imprudent is more limited than they imagine. Created in a much simpler political and financial environment 70 years ago, the Fed now lags behind the competitive and technical forces transforming the financial marketplace. Present-day markets are linked electronically on a global scale. The regulators are officially responsible, but scarcely in control.
When the New York Federal Reserve Bank's trading desk recently allowed the federal funds (interbank loan) rate to float freely, as the Fed had indicated it would, bank traders were shocked. "Mother wasn't there," says a top Fed official, "and the money markets panicked."
Panic, though frightening, can be therapeutic and profitable. The Rothschilds, who belong to the oldest school of banking, are said to have a family motto that sums up their centuries-old stragegy: "Buy to the sound of cannons, sell to the sound of trumpets."
In the debt-burdened, inflated-besieged U.S. economy, the guns of a major corporate bankruptcy might well cause a liquidity panic in the markets. But markets swing between excesses, and the therapy of fear would quickly yield to the therapy of greed. Institutional money managers, pension fund trustees and other fiduciaries would hear a flourish of trumpets summoning them to buy bonds offering the highest rates of return in U.S. history, rates that some observers think might not be seen again in this century.
In the real world, a whiff of disinflation hangs over glutted markets for overpriced surplus commodities ranging from oil to suburban houses. To translate this trend into financial terms means knocking the inflation premium in half, and that will take more than supply-side rhetoric.
Washington is naive to suppose it can melt Wall Street's cynicism by offering attractively packaged promises, or even by devising a tax cut compromise featuring new investment incentives. All this could easily be undone, the Street suspects, and none of it marks an unmistakable end to inflationary business-as-usual.
These is only certain way for Washington to gain Wall Street's attention and respect, and that is to scare the hell out of the sure-thing inflationary speculators and make them true-believing capitalists again. If Washington refuses the inevitable distress call, breaking the assumed bail-out pattern of more inflation, it will be rewarded with the biggest bond market rally in history.