AT THE TIME of the October stock market crash, an old friend of mine was traveling in Zimbabwe, beyond the reach of the news media and utterly innocent of what had happened on Wall Street. Three days later, he came across a short item on an inside page of the local newspaper.

"Zimbabwe stocks not affected," it said, "by collapse of western economies."

My friend phoned his office to find out what had happened. The significance of the event was made immediately relevant to him when he learned that his own company's stock, in which he is heavily invested, had fallen 100 points. Still, he told himself, his "loss" was only "on paper." The only price that really mattered was the price of the stock on that future day when he decided to sell it.

Somehow this knowledge did not console him. "I know it's only an illusion," he said, "but it's a damned powerful illusion."

My friend's reaction aptly describes the confusion of our present predicament. What really happened to us on October 19? In the aftermath, a great many knowledgeable people, from the president to the Federal Reserve Board to influential newspaper columists, have suggested that, actually, not much happened. The real economy is churning forward, not without some difficulties, but with surprising health. Christmas is here and no one is jumping out windows. After all, it was only paper.

They sound to me like little boys whistling past the graveyard. In a way, this sanguine response from important opinion leaders is the most frightening aspect of our current crisis. It is exactly the sort of fatal smugness that led the nation into the general catastrophe that developed from the crash of 1929. There is nothing inevitable about a recession now or a more disastrous unraveling of economic life. But there is also nothing to prevent it, if people in government do the wrong thing -- that is, if they continue to pursue the tight-money, low-inflation policies and maldistribution of income that have characterized the 1980s thus far. Doing the right thing, however, requires a heightened political consciousness of the dangers that are present. Willful blindness encourages the opposite.

My urgent tone probably sounds exaggerated, especially compared to the glib commentaries from both Washington and Wall Street. But don't be misled by their bravado. This country is in the midst of a grave economic crisis. In private conversation, the Wall Street types with whom I have talked are deeply frightened. Market traders, to be blunt about it, cannot be expected to tell the truth, at least not in public. They are desperate to keep people playing in their sandbox -- investing in stocks. Despite the mythology, it is individual investors, not pension funds or other institutions, who keep the stock market afloat. When the people wanting to sell outnumber the number of willing buyers, prices decline. When everyone wants to sell, prices collapse.

Perhaps my own sense of anxiety is heightened because, for the past several years, I have been deep into the subject of finance and politics, reporting and writing a book on the Federal Reserve. As I interviewed the central players, it became clear to me that popular comparisons of the 1980s with the 1920s were grounded in real and fundamental similarities -- deep vulnerabilities developing in the U.S. and global economies and aggravated, then and now, by some of the same government policies.

After the '29 Crash, it took many months of deterioration before people began to grasp the dimension of what was happening to them. As people finally realized that bland assurances from leaders and experts could not be trusted, fear and confusion deepened dramatically. At every stage, plenty of smart people in and out of government were recommending the right remedies -- the measures that would reverse the destruction. Washington instead followed the orthodoxy of financial conservatives, the bankers and brokers from Wall Street, and proceeded to do wrong things.

This time, it was different, at least at the outset. The Federal Reserve and its new chairman, Alan Greenspan, moved smartly in the right direction -- pumping new liquidity into the financial system and knocking down interest rates (exactly what the Fed failed to do after the 1929 crash.) The lower rates countered the deflationary forces unleashed by the sudden loss of financial wealth, reassuring financial markets, encouraging buyers and producers.

But then the Fed stopped. In recent weeks, it has been holding interest rates steady, though the price of money is still at a prohibitive level by historic standards. In real terms, discounted for inflation, the interest rate on long-term Treasury bonds, for instance, is currently between 4 and 5 percent -- more than double the post-war average. Since the crash, furthermore, money growth has slowed again, perhaps an ominous symptom of slackening demand for credit and subsiding economic activity.

The waters are choppy and so it is difficult right now for even the best forecasters to read how the deeper tides are running. The political question, however, is clear: What is the largest risk facing us in the present crisis -- inflation or recession? Whose interests must the government defend first -- money values or the real economy? If the Fed makes the wrong moves now, the political consequences will soon be obvious to all -- especially to the Republican party.

At the moment, the central bank seems caught in the same political cross-currents that kept it from responding forcefully in the 1929 debacle. The financial markets, joined by voices from politics and the press, continue to voice the alarms that they have sounded throughout the 1980s: Inflation is the real threat, they claim, and lower interest rates would cause foreign investors to take their money home. Besides, the economy is doing fine. Export manufacturing is reviving. Unemployment is lower now than at any previous time in the Reagan years.

It seems bizarre to me to worry about price inflation when the economic landscape is giving so many signals of the opposite danger -- falling prices. Modern Americans know only the anxieties of inflation. Only those who remember the '30s know the perils of deflationary forces. The most recent reports on bellwether sectors, housing and autos, weren't awful, but performance for the year is weak. Consumer spending (and confidence) is slackening. The Christmas season looks like a bust for retailers. When inventories build up in December, rising unemployment follows in January.

Even more ominous is that oil prices are falling again -- tightening the squeeze on U.S. producers and their banks. When oil prices collapsed in 1986, Wall Street economists celebrated the supposed benefits. What they ignored was the regional recession produced in Texas, Oklahoma and Louisiana -- exactly what we do not need now.

Indeed, what the economy most needs is the opposite of what it has experienced during the '80s -- rising prices and lower interest rates. Without a measure of inflation, Iowa will not get well nor Texas nor Mexico, and the other debtors. Lower interest rates will help the economy withstand the depressive effects that are now flowing through many channels. Falling prices feed a contraction and ought to be avoided -- at least until real conditions are easier to see.

Essentially the Fed needs to find the courage to face down the financial markets. Yes, it is true foreign investors will be disappointed if U.S. interest rates are reduced and the dollar declines further on international exchanges. But, ultimately, owners of capital, whereever they reside, can't keep their money under their mattresses -- unless they are willing to settle for no return at all. They have to invest somewhere and a growing economy gives capital much better opportunities for healthy gains than one that is in a deep recession.

Of course, my analysis may be wrong. But the simple fact of this moment is that no one really knows, not the best forecasters in Wall Street, not the shrewdest analysts at the Fed. So the political question is: If the government is going to risk making a large mistake, what is the best mistake to risk? Throughout the '80s the Fed repeatedly erred on the side of tight money -- sacrificing real economic growth to defend against price inflation. Now it should err on the other side -- stimulating the economy before it is too late.

One reason that many commentators discount the possibility of severe recession is the belief that, given the reforms enacted after 1929, it can't happen again. Of course, the banking system is now protected from "runs" by small depositors because they are covered by federal deposit insurance. But the real risk to the U.S. banking system today is that panic will sweep through the largest, most sophisticated depositors whose millions aren't protected above $100,000. Nobody gathers in the bank's lobby, demanding their money. The "run" occurs electronically, as fast as telex messages.

If large-scale investors get a whiff of trouble -- money managers, pension funds, other banks, the people who invest in million-dollar CDs -- they simply pull out of the endangered bank and park their money elsewhere until things quiet down. Thus a global "run" on a major bank can develop massive proportions almost instantly; that is what brought down Continental Illinois of Chicago in 1984. It took 48 hours to destroy the nation's seventh largest bank.

And this, I think, is the gravest risk we face now. If a recession does develop and deepens, it could spread uncontrollably because there are already so many weakened debtors, both foreign and domestic. The first important casualties might be sovereign nations -- Mexico or the other Latin countries who are already drowning in debt. If a new U.S. recession unfolds, they lose their largest export market and the vital income with which they are paying interest on their loans. If two or three debtor nations were to default at once, then crisis would be pounding on the door of Bank of America or Manufacturers Hanover Trust or any of a dozen other of the premier banks.

In theory, of course, the Federal Reserve and other federal regulators can always come to the rescue, pumping new money into the endangered banks. But what happens if there is a general panic and the Fed is confronted with three or four bleeding hulks at once? No one knows, of course, how real these risk are, but no responsible official wishes to find out.

Eighteen months ago, in the course of my interviews at the Fed, Governor J. Charles Partee, now retired, was speculating ominously on the potential for a general collapse. He described the various vulnerabilities that were accumulating. "Of course," Partee concluded, "if there was a general collapse, that would be way beyond the scale that (the Fed's) open-market operations could deal with."

The Federal Reserve is centrally implicated in the present disorders, but then so is the Reagan administration; so are both political parties. The separate power centers within the federal government, encouraged and abetted by Wall Street, pulled the national economy both ways at once. Fiscal policy infused gross stimulus through tax cuts and increased spending, the $200-billion deficits, while monetary policy simultaneously imposed gross restraint by keeping real interest rates at punishing levels. One side stomped on the accelerator while the other side stood on the brakes.

It was like a "game of chicken" and the Federal Reserve won -- or at least it did not lose. But the consequences were severe. The collision between fiscal and monetary policies produced an overvalued dollar and with it the enormous trade deficits the country now faces. Moreover, high interest rates tilted the normal distribution of economic rewards upward and incomes flowed disproportionately to the top, the holders of financial wealth. Eventually, the maldistribution saps the economy's vigor as the incomes from real work and production are eroded and the middle classes gradually lose their ability to consume. This may explain, better than the stock market, why retail sales are disappointing. Everyone, including the Democrats, seems to have forgotten the lesson learned from the '20s -- that the maldistribution of incomes eventually undermines economic prosperity.

Subduing inflation did produce a warm and comforting illusion of stability as in the 1920s when the newly created Federal Reserve was praised for its leadership. But, in a sense, inflation did not actually disappear from American life; it merely moved to Wall Street. A decade before, it was the farmers who were said to be seized by greedy expectations. Now it was the young stock traders watching the heady run-up of prices.

Then the illusion collapsed. After 1929, the conservative orthodoxy by which Republicans had governed was repudiated by reality, though it took many years for mainstream economists and Republican leaders to absorb the message. My hunch is that something similar, though less dramatic, has already occurred in American politics, but is as yet unrecognized by Republicans, Democrats or the general public. People and institutions do not respond readily to new realities. Defunct ideas continue to hold power and previous errors are repeated until, eventually, the old ideas are utterly ruined. A political vacuum then follows which is deeply destabilizing but also an opening for new thinking. That is what happened in the general suffering after 1929. It is yet another lesson learned so painfully then and apparently since forgotten.

William Greider is the author of the recently published "Secrets of the Temple: How the Federal Reserve Runs the Country." He is national editor of Rolling Stone, from which this article is adapted.