A story in the Outlook section of the Sunday edition of The Washington Post incorrectly said that the Federal Savings and Loan Insurance Corp. does not have authority to borrow directly from the U.S. Treasury. FSLIC can borrow up to $700 million.
PEOPLE KEEP coming up to me and asking, "Are we
heading for a collapse?"
One friend who works for a savings and loan association has asked the question several times, but never so urgently as last week when I ran into him at the Division of Motor Vehicles office in Alexandria. Had I seen that the treasury secretary put down the estimate in a new Brookings Institution study that 1,000 thrift institutions could go broke in the next two years, he asked. "It's much worse than he knows," my friend said darkly.
That night at Alexandria's city hall, after a city council meeting, another friend who is an analyst at the Department of Transportation approached with his characteristic half smile. "What's going to happen? Is there going to be a collapse?" he wanted to know.
None of the questions is in jest. The questioners are serious, well educated people who are worried, perhaps even a bit frightened. The striking thing is the high note of uncertainty. People are thinking the unthinkable.
Economists around Washington report getting the same kind of questions. "Maybe it's a virus in the buses and subway," says one wryly. "Whatever, it's what a lot of people are thinking about." Significantly, like most of his peers, this hard-headed analyst, a former senior staff economist at the White House's Council of Economic Advisers, does not say it cannot happen.
"Collapse." "Depression." What do people mean when they use such words? Certainly nothing very precise; rather a condition in which the economy, and their lives, might be significantly worse than they are today.
It seems clear that government has the necessary powers to stave off any cumulative downward spiral such as the one that occurred between 1929 and 1933. During that 43-month period the nation's economy truly collapsed, resulting in an era of soup lines and apple selling and ledge jumping. Real production was cut by a third. Unemployment leaped from 3.2 percent to 24.9 percent. Banks failed in great waves, often wiping out the deposits of their customers. Massive numbers of farms and homes were taken over by lenders as the result of mortgage foreclosures.
That crisis is remembered in capital letters as the Great Depression. But the 18-month slump following World War I is also regarded by economists as a depression, with a little "d." In that case, the jobless rate shot up more than 10 points, from 1.6 percent to 11.9 percent. The farm sector, which had experienced unparalleled prosperity during the war, was so hard hit that it had never really recovered when the bigger crash of 1929 struck.
Today, by increasing spending and cutting taxes, Washington can prop up total demand in the economy sufficiently that even a little-"d" depression is unlikely, at least if you judge by a similar 10-point climb in the jobless rate. (The keepers of business-cycle history at the National Bureau of Economic Research really have no precise definition of what separates a "recession" from a "depression.")
With virtually no growth in the American economy since the second half of 1979, the unemployment rate as of December had climbed from 5.8 percent to 8.8 percent, and it is expected by virtually every forecaster shortly to pass the post-World War II record of 9 percent.
National averages, of course, often mask huge disparities. State jobless rates in January were at a severe 16 percent in Michigan and in the neighborhood of 12 percent each in Ohio, Indiana, Pennsylvania, Washington and Alabama. The Michigan rate was up 8.8 points from June 1979, approaching the little-"d" depression range.
But overall, if a little-"d" depression in today's world means that about 16 percent of American workers -- or nearly 17.5 million persons -- would be out of work, its chances of happening still seem remote. Unfortunately, though, a growing number of economists believe the possibility of a less severe "collapse" -- with the unemployment rate shooting up to 12 or 13 or 14 percent -- is no longer as unlikely.
No one I know is actually predicting such a disastrous turn of events. The chilling thing is that some of the same forecasters will for the first time, as the bookies say, quote you a line.
Rudolph Penner of the American Enterprise Institute, for example, is certainly no alarmist, but he thinks there is "a significant probability" that our economic woes could deepen considerably. His line on the chances for this happening: 30 percent. "That's not my forecast," Penner cautions, adding that there is in his estimate an equal chance the economy will perform better than most people expect in the next year or so.
Nevertheless, Penner, who was chief economist for the Office of Management and Budget under President Ford, adds, "I'm getting more and more worried about what will happen ... I just see all sorts of parallels with the British situation ... Talking to bankers around the country you get this feeling of doom, with people going bankrupt very quietly."
Charles L. Schultze, former chief economist for President Carter, is also no alarmist, but he is uncertain about what is going to happen. "Do I expect some kind of collapse? No," he says. "How confident am I? I find it hard even to put a confidence limit on it. It would have to arise out of problems with balance sheets, the quality of credit, and debt service coverage ... I don't think we have developed a body of indicators or have thought through the process of how this would happen" so that an assessment of the danger can be made.
At E.F. Hutton & Co., people are listening to economist Edward Yardeni, who says, "I don't want to start a panic or alarm people ..." and then proceeds to offer some awfully disquieting numbers. "I think there is a 30 percent chance of a depression occurring ..." If the economy does not begin a recovery by May, his odds will rise to 50- 50, he says. "This is a very atypical recession ... financial pressures are growing and Washington policymakers are amazingly complacent about the problem."
The reason for thinking the unthinkable are many, some of them increasingly familiar to the public: failing thrift institutions, a devastated homebuilding industry, a limping auto sector, a fragile, severely depressed farm economy, a worldwide move toward protectionism in trade, a potential for destructive defaults on loans by nations such as Poland and Romania.
But the larger dangers lie in what is less known. They lie particularly in those balance sheets at American corporations of which Schultze speaks. They lie in the large gambles government policymakers are taking in hopes of reducing inflation. They lie in the little-noted fact that individual Americans and businesses, on a vast scale, have been moving their dollars out of insured, protected institutions and into areas that would be exceedingly vulnerable -- money market funds, commercial paper, real estate -- if the gambles do not pay off.
Start with the business balance sheets. After several years of high inflation, soaring interest rates, a severe profit squeeze and sometimes incredibly poor management, many businesses are simply up against the wall. Dun & Bradstreet reports that 529 businesses failed just in the week ended Feb. 11, up by more than 200 from the comparable week the year before. It was the highest business failure rate "in at least 40 years and could approach the record failures of the Depression," the company said.
"It's never been so bad," says James D. McKevitt, Washington representative of the National Federation of Independent Businesses. The small businesses comprising the NFIB membership "are dropping like flies," he states.
Meanwhile, the enormous growth of financial investments outside banks and thrift institutions has created a huge new potential problem in the event that some development does precipitate a financial crisis. Money market mutual funds have grown from virtually nothing at the end of 1977 to $187 billion last month. Over the same four years, the amount of commercial paper -- unsecured promissory notes issued by corporations -- outstanding has jumped from $65 billion to about $166 billion. None of these investments is covered by deposit insurance. The collapse of even one large money fund could jeopardize many of them if shareholders in the others rushed to withdraw money.
The money funds, with no insurance coverage, are currently in excellent shape -- while the thrift institutions, whose deposits are insured, are in deep trouble, as that Brookings study indicated. There was, in fact, an old-fashioned "run" on a savings and loan in Hartford, Conn., recently. And last week Anthony Frank, chairman of Citizens Savings and Loan Association, one of the California giants, warned the Senate Banking Committee that within 90 days some weak thrifts probably will begin invoking the fine print on their passbooks that says the institution, if it wishes, can delay payment for 30 days.
Perhaps fearing that other runs on S&Ls could develop, Richard Pratt, chairman of the Federal Home Loan Bank Board, which regulates most of the thrifts, wants President Reagan or the Congress to reassure Americans that their deposits are "absolutely safe." Not a very reassuring request.
Individual S&L accounts are insured up to $100,000 by the Federal Savings & Loan Insurance Corp. But FSLIC has only $7 billion in its insurance fund, and it has no automatic right to borrow from the U.S. Treasury, as does its banking counterpart, the Federal Deposit Insurance Corp. (Most mutual savings banks' deposits are insured by FDIC, not FSLIC.)
The Brookings study, by Andrew S. Carron, concluded that about one-fourth of the savings and loans in the nation and 30 mutual savings banks will not survive through next year if interest rates stay high. Arranging mergers would take $6.4 billion of the FSLIC's $7 billion, Carron estimates.
The largest potential danger to the economy, however, lies in unexpected bankrupties of several major industrial corporations, corporations that would be brought to their knees by an inability to make payments on their debts. The key word here is "unexpected." A number of large companies are known to be in such severe financial trouble that they could easily end up bankrupt, among them Chrysler, International Harvester, Braniff and Pan Am.
Chrysler's failure alone would be enough to show up in national statistics, as its 71,200 remaining employes and those of its host of suppliers lost their jobs. However, a Chrysler bankruptcy, or that of other companies known to be in great difficulty, likely would not pose a significant problem for financial markets precisely because the possibility of their demise is known.
But consider what happened on June 21, 1970, when the Penn-Central Railroad unexpectedly bit the dust. It sent shock waves across the nation. The company had millions of dollars worth of unsecured commercial paper outstanding. The entire paper market was about to dry up while the buyers of such notes -- usually other corporations -- tried to assess the suddenly apparent risk in that market. If Penn-Central could fall without warning, who might be next?
Federal Reserve Chairman Arthur F. Burns rode to the rescue. Burns notified major banks that the Fed stood ready to supply whatever amount of cash might be needed if corporations -- unable to renew outstanding commercial paper as it fell due -- had to turn to the banks for loans. If a financially strapped corporation could not borrow from a bank and had gilt-edged collateral, it could borrow directly from the Fed, Burns announced.
In the Penn-Central debacle, the Federal Reserve played the ultimate role of a central bank as lender of last resort. Undoubtedly it would do so again if necessary. That's one reason why a drop into even a little "d" depression seems so remote a possibility.
But a dozen years later, the world is a different place. Far more buiutual nesses are in serious trouble, and not just as a result of the current recession. Unable or unwilling to borrow long-term money by issuing bonds, corporations are piling up short-term debt at banks and in the commercial paper market. Companies are financing long-term investments with such short-term borrowing, and their balance sheets show the strain.
In the third quarter of last year, the latest data available, nonfinancial corporations had $1,349 billion of current assets and $951 billion of current liabilities. This asset-liability ratio stood at only 1.419, by far its lowest level since 1939, and it undoubtedly has continued to deteriorate.
Not only have corporations been borrowing more short- term funds, but they have been paying far more for this money. Interest rates in recent months have been at their highest levels in modern history relative to inflation. An undercapitalized business, relying heavily on borrowed money, may not be able to survive even a brief flirtation with sky-high interest rates. When rates move up and stay up for long periods, even businesses with adequate financial resources get hurt. And when all this occurs amid a recession, with sales and profits shrinking, rock-solid corporations can start to teeter.
If unexpected major bankruptcies begin to emerge, the waves would wash far and wide. Banks with large loans outstanding to the failing companies undoubtedly would tighten their credit standards, whatever assurances issued from the Federal Reserve. The banks themselves would not necessarily have to be in danger for other actual and potential borrowers to feel a pinch. In some cases, however, the banks, too, might need a shot of federal help to remain solvent.
Meanwhile, the commercial paper market would be feeling the shocks. Corporations would have trouble rolling over their maturing paper while buyers sat back to assess the risks. During a classic credit squeeze in 1974, for instance, the head of one major investment banking house in New York got so worried that he ordered his firm to stop buying commercial paper entirely. Perhaps fortunately for the markets, his assistants managed to talk him out of it before the order was implemented.
In the middle of all the uncertainty, both the bond and stock markets undoubtedly would plunge. Investors would be trying to bail out of risky stocks and bonds, incurring large losses in the process. Depending on the extent of the market decline, and on the size of the direct losses on the securities of the bankrupt corporations in the portfolios of securities firms, some brokerage houses could go down. The lessons of the past year from the failure of John Muir & Co. indicate that the protection of brokerage accounts -- insured for up to $500,000 through the Securities Investor Protection Corp. -- is hardly complete when accounts are frozen for months and no transactions can be made.
Commodity speculators, too, could see their highly leveraged positions wiped out as prices went down. Most commodity contracts are purchased with only 5 or 10 percent of the contract's value paid in cash, so a 5 or 10 percent drop in the price of the commodity wipes out the original investment. Commodity accounts are not covered by any insurance.
While all this was going on, of course, the Federal Reserve would be moving heaven and earth to try to stop the waves from the bankruptcies from spreading. The Fed has essentially an unlimited amount of credit at its disposal. It can pump billions into the nation's banking system within hours if need be. It can prop up shaky banks, and has done so.
But relieving a credit crunch is one thing. Mending a bankrupt company's fractured balance sheet is another. The economists who worry about the economy worsening substantially do so partly because they are not sure how effective Fed intervention would be in the current situation.
Baldly put, things are happening to American business that have never happened before. Meanwhile, the Federal Reserve is not stabilizing interest rates at a low level to promote economic recovery. Instead, the Fed is still fighting inflation by gradually reducing growth of the money supply. The effort has produced both high and extremely volatile interest rates.
Perhaps the real question is whether in the event of a crisis, the Fed would be prepared to announce that it was moving to an easier money policy as well as supplying an infusion of liquidity. Maybe that would convince investors and lenders that businesses would be more able to meet their debt payments in the future and relieve the pressure.
That ultimately is what this scenario of gloom and doom is all about: American businesses, and to some extent individuals, need time to rebuild their balance sheets. What that requires is an extended economic recovery, sufficiently low interest rates so that corporations can issue long-term bonds, and higher profits. As one Wall Street analyst puts it, "We have shifted the burden of fighting inflation onto business. For several years, individuals bore the burden. Now it's business."
Even if we have an economic recovery later this year, as we probably will, the current danger will not be over. In fact, some analysts think it will be heightened. Those who are the most concerned think a brief recovery followed by one more turn of the recession screw would make their fears come true. Their nightmare runs like this:
A recovery begins slowly sometime this spring. The 10 percent personal income tax cut (if not reduced by Congress) hits in July, giving a boost to consumer spending. The surge in spending, however, sends growth of the money supply up sharply, forcing the Federal Reserve to let interest rates move up rapidly to keep the money supply close to its target path. After about two quarters or so, the high interest rates again choke off the recovery -- just as they did in 1981.
At that point, lenders who have been carrying businesses in hopes that an extended recovery would rescue their delinquent business borrowers from ruin, decide they have had enough. That is the truly dangerous point, these analysts say.
All the dangers are heightened because the situation is not unique to the United States. Businesses in many countries -- and the countries themselves in some cases -- are being battered by high interest rates. Cries for increased protection from foreign competition are rising in many countries, just as they did before the U.S. Congress passed the Smoot-Hawley tariff bill in 1930. The sweeping higher tariffs it imposed, against which a host of nations retaliated, helped throttle world trade and deepen the Great Depression.
At the Federal Reserve these days, Chairman Paul A. Volcker and other officials believe that their current tight money policies are needed to reduce inflation. As restrictive as they are, one official puts it, the policies nevertheless "maintain some protection against disaster.
"With some money growth and the budget deficits it is hard to see the economy going crackers on the downside. There can be some wide swings, but there is a protection against catastrophe," the official declares.
In the first four years of the Great Depression, the Federal Reserve, itself in disarray, allowed the money supply to contract along with the level of business activity. Most economists believe the Fed's failure at least to stabilize the money supply was a major, if not the major, cause of the severity of the whole episode.
When the collapse began in 1929, the federal government's total budget equaled less than 4 percent of the gross national product -- compared to about 23.5 percent this year -- and was in substantial surplus. The budget was so tiny relative to the size of the economy, and the level of taxes was so low, that there was little chance the budget could be used to offset the huge declines in private spending.
Today, of course, the budget is orders of magnitude larger, as are the deficits. Despite the current sense on Capitol Hill of the budget deficits as a destablizing influence, a sudden move to eliminate themw leve quickly could devastate the economy. Economist Hyman Minsky of Washington University, who has been warning for years about the danger inherent in the growing strains in financial markets, declares flatly, "The large government deficit they are all talking about is what is keeping us from falling through the floor."
That is not to say that the deficits could not safely be trimmed. But doing so without an accompanying relaxation of money policy would heighten the danger of a cascade of business bankruptcies.
What does official Washington say about all this? Fed Chairman Volcker says confidently that he expects no wave of corporate bankruptcies. Murray L. Weidenbaum, chairman of the president's Council of Economic Advisers, says he puts the chances of a depression of any type at about one-thousandth of one percent. My questioning friends and a lot of others, though, aren't so sure.