PRESIDENT REAGAN hails the explosive rally in Wall Street as a "strong vote of confidence" in the future of the U.S. economy. I wish it were so.
The bond and stock traders and options players who have set the tape ablaze since August are not thinking about Reaganomics. They are simply reacting to falling interest rates. These are caused by a collapsing economy, but they don't care.
Wall Street is driven by its own parochial logic. High interest rates are "bad," lower rates are "good." To the extent that the Street is looking toward economic reality, what it really is anticipating is delayed recovery, possible depression, lower inflation and single-digit interest rates for lucky borrowers who are still credit-worthy.
The typical money manager, as he scans his electronic quote machine, is looking at the last price, period. Like his peers, he's gambling in the biggest casino on earth. The fantastic proliferation of dollars in the Great Inflation of the 1970s changed investment to speculation. If the cost of money falls, buy; if it rises, sell. The man peering intently at the tiny screen has no convictions because he cannot afford any distractions.
Wall Street is a sideshow in the real drama -- the unwinding of the Great Inflation. To cool it off, we were thrust into the Great Recession, which began in late 1979 and hasn't yet ended. Now, to avert the Great Depression II, the Federal Reserve has finally eased up on the money supply and moved aggressively to lower interest rates, which is all Wall Street was waiting for. The rest of us are waiting to see whether the Fed's gamble works.
The spectacular surge in the markets stems less from optimism than fright among the professional money managers who invest hundreds of billions of dollars of O.P.M. (Other People's Money). The pros are not afraid of losing your money -- they are afraid of losing their jobs if they "miss the move" and are left behind when their bullish peers stampede to buy more IBM because its price is rising.
Money managers are fired by clients on the basis of short-term results -- sometimes as short as 90 days. Yields are now suddenly plummeting on risk-free cash-equivalents like Treasury bills, unusually large amounts of which the money managers had been sitting on right up until late summer.
What's a normal, insecure manager to do? Everybody wants to take refuge in highest quality paper in order to avoid such well advertised risks as a major bank failure. Any unlucky money managers who get stuck with the wrong paper will be shunned (It's unfair, but when the cops arrest the girls, they also collar the piano player.)
The manager's answer? Appear to avoid risk and appear to be doing his job by doing what his competitors do.
This is the toughest risk calculation today: to be in or out of the market? The financial markets are like buckets. As long as more cash flows in than flows out, the price level rises. (Mutual funds and other large investors of O.P.M. are still cash-heavy by historical standards, and so the net inflow into the stock market may continue for some time.)
But if the herd's frenzy to buy in institution-sized blocks (10,000 shares or more) should suddenly turn into an urge to take profits, the outflow would be huge and prices would plunge. Public buyers soon must enter the market in large numbers to give the professionals someone to whom to sell ("distribute") their stock. Signs point to such an influx of greedy innocents.
The stock market is the froth, the economy the wave beneath the surface.
A depression is a rare economic event. Long in the making, it is difficult to detect and comprehend because it occurs so seldom. We may remember something of our parents' misfortunes, but we never believe we will repeat them. We do know, however, that all depressions begin as unexpectedly serious recessions.
A depression in the mid-1980s would be markedly different from the depression of the 1930s because the national and global circumstances are so different -- and yet some parallels are eerie.
For example, today, as in the late 1920s, a streak of boosterism runs through our political culture. The president sets the resolutely upbeat tone. Among the business and financial elite, a self-serving optimism prevails.
As in the prelude to the financial crisis a half-century ago, leading bankers complacently assert that their staggering foreign debt problems -- $500 billion is owed -- are "manageable." As in the early stages of the last great downturn, our supposed leaders seem to be remote from the nation's trials and far behind the grim realism of ordinary citizens as reflected in opinion polls.
The big change affecting everyone's life is the persistent inflation that has become more and more difficult to control. It began with fighting in Vietnam without a financial plan, and sharply accelerated when the price of oil rocketed 1,000 percent. But OPEC alone could not have engineered the Great Inflation. It needed the crucial assistance of the industrial nations' central banks and their multinational commercial banks. Banks are the instruments of inflation and deflation; the credit they create, they can also withhold.
In the late 1970s, the banks were benefactors. The world economy would have sunk into a depression except for the inflationary expansion of bank credit. Large banks in the United States, Europe and Japan took OPEC's short-term deposits and made long-term loans to oil-importing countries in order to sustain consumption at pre-OPEC levels.
Such "recycling" was enormously profitable. With official encouragement, American and foreign bankers violated, on a stupendous scale, fundamental banking precepts: they borrowed short-term and lent long-term; and they lent for unproductive purposes to countries unable to repay their debts or even keep up the interest payments.
Why is this $500 billion worth of foreign debts so important? Because if these debts (or any substantial part) go bad, leading banks will be bankrupt, and the authorities will be faced with a horrendous crisis.
One of the world's most respected bankers, Johannes Witteveen, former managing director of the International Monetary Fund, warns that the crisis of confidence in the international banking system could turn the recession into a full-fledged depression. The risks are higher than at any time in the postwar era, he declares. Banks are put under increasing pressure from foreign and domestic borrowers whose positions are deteriorating, he explains, at a time when their profits from international lending are dwindling and the ratio of capital to assets (some of them doubtful) is declining.
Many foreign loans -- those to Poland, for example -- were bad the day the banks put them on their books. But the authorities looked the other way. The banks aggressively made new loans, establishing dubious assets and therefore reserves against which to create new money. The Eurodollar market, where this lending centered, grew almost exponentially. Estimated at $100 billion in 1970, it has since grown perhaps 20- fold to some $2 trillion. This vast pool of unmeasured and unregulated liquidity is the legacy of the Great Inflation and the source of our present uncertainties.
Inflation was not only a way to cope with OPEC by paying for oil with depreciated dollars. For the United States, it was also a domestic necessity. By the mid-1970s, our increasingly debt-ridden and recession- prone economy could be prodded into spurts of growth only through the use of expanded credit and cheap money. These stimuli worked as long as people were surprised by inflation's effects. When they began to take inflation for granted and counted on it, the stimulus no longer worked, and the Great Inflation was sure to end, one way or another.
In the summer of 1979, U.S. inflation escalated to the point where the dollar was an orphan on foreign exchange markets. President Jimmy Carter summoned a banker's banker, Paul Volcker, as the new chairman of the Federal Reserve.
In October of 1979, Volcker introduced "practical monetarism" as the Fed's guiding policy. He moved to bring inflation under control by applying tough quantitative restraints on the growth of money and credit. As the Fed made cash scarce, the short-term price for it shot up above long-term interest rates -- and stayed there.
Inflation-adjusted "real" interest rates rose to heights not seen since the Great Depression. Since 1979-80, aside from brief upticks, there has been virtually no net economic growth.
When does a recession become a depression? As far as the respected economist Anthony Harris, writing in the Financial Times of London, is concerned, the question is academic because he believes we are now in "the first inflationary depression in the history of the world."
An "inflationary depression" would have seemed an impossible contradiction to our fathers and grandfathers, whose depressions in the 1930s and 1890s, respectively, were marked by deflationary collapses in wages and prices.
Today, in the United States and other industrial nations, wages and prices generally depend as much on political as market forces. Of course, where the law of supply and demand operated more or less freely -- in the trading of agricultural and other commodities, and in many local real estate markets -- prices have collapsed. And in some industries where unions normally enforce wage standards (airlines, automobiles, meatpacking and mining), distress is alarming enough to force "give- backs" of past collective bargaining gains.
So, for some, the depression is deflationary while for others -- the majority -- inflation remains the rule. The rule is this: Wages and prices operate on a ratchet system; once put up they cannot go down. Such rigidity affronts classical economic theory but it reflects the social and political realities of late-20th-century democracy in a consumer-centered economy.
Reality Number One: Powerful business and labor interests strive to limit competition.
Reality Number Two: The mainspring of the consumption- based U.S. economy (two-thirds of GNP is personal spending) is access to affordable credit. As a result, huge debt burdens teeter on narrow equity bases everywhere from suburbia to the multinational banks.
Reality Number Three: In this high-leverage economy, for households and businesses alike, financial survival depends on being able to roll over maturing debt.
Although he does not publicly acknowledge these realities, Fed Chairman Volcker, an astute political observer, recognizes the gap between avowed economic principles and actual operating practices. When he and his colleagues set out in the autumn of 1979 to restore the Fed's credibility by pursuing a consistent anti-inflation policy, they did so with awareness of the risks of squeezing credit in an economy that moves on borrowed money.
But they squeezed anyway, and while suspicious Wall Street bond traders watched for the first hint of flinching, the Fed stayed the course. The economy sank into recession, business failures soared, bankruptcies and the jobless rate rose to the 1940 level, and conservatives rejoiced that the excesses of an inflationary generation were at last being wrung out of the system.
Wrung out everywhere -- except in Washington. The Fed's tight money policy is made enormously more difficult, disruptive and potentially destructive by the government's loose fiscal policy. Currently projected budget deficits over the next fiscal years are in the $150-250 billion range.
Ironically, these ballooning deficits are due in part to the impact of disinflation on shrinking Treasury receipts. The biggest inflation junkie in the IOU economy, its ravenous debt habit unbroken, remains the federal government. As long as it demands an increasing share of a restricted supplytion escalate of money and credit, all other borrowers who seek bank financing -- local governments, smaller businesses and households -- will be forced to scramble for what's left, paying cruelly high interest rates if they are accommodated at all.
Without abandoning its hard-won gains against inflation, the Fed has now wisely turned its attention from managing the quantity of money created by the banking system. It has assigned priority to reducing the level of interest rates. The aim is to get a sustained recovery started sometime next year. The Fed has been moved to act, in part, because bankers have been very slow to lower their prices. Interest rates, too, display the ratchet effect. With inflation likely to dip into the 4-5 percent range in 1983, the Fed has every reason to stimulate economic growth -- if it can.
Will easier monetary policy breathe life into the economy? Quite probably, but the patient may soon relapse. The recession did not give solvent-but-cash-poor businesses a chance to sell medium- and long- term bonds at tolerable interest rates. That process of reliquification has barely begun. Even if rates stabilize in single-digits, it will take at least three years to make much progress.
Meanwhile, if fresh monetary stimulus brings an economic rebound and an early resurgence of inflation, the window of opportunity in the bond market will quickly slam shut. If business cannot reduce its excessive dependence on volatile short- term debt, it will be unable to finance a sustained expansion and the standoff with inflation will continue.
The new American depression has not yet announced itself with a financial panic and crash, and perhaps there will be none. Already, billions of dollars of paper values have been destroyed while the Dow Jones Industrial Average stagnated amid the last decade's inflation.
The destruction of real assets in the U.S. industrial economy has been no less impressible. In old cities and towns across the belt of states extending westward from New York, we are systematically shrinking the nation's industrial base and leaving behind bare ground.
This is the essence of depressed capitalism: the using up and tearing down of obsolete and non-competitive structures that no longer pay their way. The process of liquidation will be drawn-out and painful, in part because the United States, unlike Germany and Japan, was spared war's devastation and therefore has the accumulated industrial capacity of at least a half-century to sort through and selectively scrap.
Some of the pain arises from acute uncertainty about what comes next: a long twilight as a second-rate industrial power? Or an impossible-to-predict rebirth through the industrial application of new technologies such as microelectronics just now coming into view?
It's currently fashionable to assume that high-tech industries will move into decaying urban centers and take up the slack. Perhaps they will -- if there's a first-rate university nearby and a heads-up local business leadership, the combination that may rescue Cleveland.
But the U.S. economy cannot be healthy without a viable, internationally competitive manufacturing sector. And the world's leading superpower cannot support its defense establishment without dependable basic industries. These requirements should not be left to the blind chance of the marketplace. What the U.S. needs -- as opposed to what it will wind up with if present trends continue -- reveals a policy vacuum of highest national importance.
In recent years, well financed companies have taken over their rivals, consolidating market shares and reducing future competition. The overall effect has been to concentrate U.S. industry in fewer and stronger corporate hands. In many cases, it has been to reduce the scale of operations and lower break-even points, sometimes to 50 percent of capacity or less.
Herein lies a sign that the dragon of inflation is merely dozing. The shrunken, less-competitive U.S. industrial economy does not have nearlyytion escalate as much idle capacity as lagging government statistics indicate. Therefore, there is that much less room for non-inflationary stimulus.
Many companies urgently need to rebuild eroded profit margins. With their reduced capacity and lower break-evens, in even a mild recovery, such firms will be tempted to post price increases early. Moreover, until they profitably use their actual capacity for some time, they will not begin to consider new investments in plant and equipment, regardless of administration exhortations and tax incentives. It will be cheaper to acquire another competitor.
The most effective restraint on the inflationary bias of the smaller, more concentrated industrial base is competition from abroad. The United States is increasingly dependent on exports. (They now represent 20 percent of industrial output, twice as much as in 1970.) Therefore, we are bound to permit imports into our own markets.
As the slump in our basic industries persists, however, demands to "protect" jobs by excluding imports grow louder. In this Congress, some 230 members of the House sponsored an outlandish bill, drafted by the United Auto Workers, that would have compelled foreign automakers to produce cars in the United States or be shut out by extremely stringent "domestic content" requirements.
Easily the most blindly protectionist legislative proposal of the postwar era, the bill would force American consumers to pay thousands of dollars more for cars they don't especially like in order to employ a relatively few UAW workers at uneconomic average wages of $20 an hour. The bill probably will die in the House this year, but is likely to be revived next year by politicians eager to "send Japan a message."
The "message" should be addressed to ourselves. While we have been over-consuming and under-investing in up-to-date production facilities during the past generation, the Japanese have been doing the opposite and becoming more efficient because they see no alternative in a competitive world.
Although Japanese workers are notably well-educated and industrious, they are not "better" than their American counterparts, as the experiences of Japanese-owned factories in the United States attest. Japanese workers simply work with more modern tools, are more carefully managed and more highly motivated.
If a symbolic villain is needed, he's to be found in Detroit. It's not Joe Sixpack loafing on the Chrysler assembly line but arrogant supermanager William Agee, chairman of Bendix, who recently all but wrecked two companies to satisfy his empire- building lust. The prudent Japanese would not let Agee run a parking lot.
Will the recession deepen into depression? The dangerously over-extended large U.S. and foreign banks, all joined together in syndicated Eurodollar loans to potentially defaulting Latin American and Eastern European governments, hold the key.
The recent failures of the Penn Square Bank and the Drysdale Government Securities firm provided disturbing glimpses into the unregulated inner workings of American high finance.
Creditor institutions bearing household names soon may prove to be as over-extended as their transparently bankrupt foreign debtors. This would repeat the foreign debt fiasco of the late 1920s, when waves of defaults abroad hit U.S. banks like tumbling dominos, forcing them to retrench by calling in domestic customers' loans. Customers thus threatened with bankruptcy then pre-empted them by defaulting on their loans, pushing their bankers to the wall.
A full-fledged deflation has not been seen in the United States since the early 1930s. Deflation is a frightening, cyclonic reversal of inflation: the forced, cumulative liquidation of debts at an accelerating rate. "First, banks break their customers," writes Eliot Janeway. "Then their customers return the compliment." To halt and reverse a threatened deflation, the Federal Reserve would have to mobilize huge amounts of emergency liquidity and prepare to deal with a runaway inflation.
If we are fortunate, nothing remarkable will happen. Most of us could live through the depression of the 1980s without experiencing real personal hardship or acquiring vivid cautionary anecdotes to tell our grandchildren.
Our lives would be constrained. We might experience several years of flat-to-weak economic growth, persistently high unemployment, narrowing career opportunities, continued decline in living standards and aspirations.
Meanwhile, there would be ever- increasing government intervention in the banking system and ever-tightening influence over large-scale business and industry by government- guided banks. We would survive. But this is how Europe became an over- regulated economic backwater.
We might be very lucky indeed and see the Fed's gamble pay off in a fairly strong, consumer-led recovery by mid-1983. Rising economic activity, brisk loan demand from business and a steady inflow of deposits from consumers would soon make the anxious bankers forget their nightmares. Expansion would continue through 1984-85. All would be well . . . until next time.