The financial crisis of March and April has ended, but it leaves behind a warning about the way the American economy now works.
National choices on spending and taxation are being policed by crises in the money markets. Regardless of resolutions passed at the coming party conventions, and regardless of who wins the elections, that will remain true. The range of economic options, for any tenant at the White House, will remain narrow.
The past crisis was the third in 18 months. In late 1978, and again last fall, there were foreign exchange crisis in which the value of the dollar fell hard and knocked the Carter administration off its chosen economic course. The March-April crisis was entirely domestic, and even more dangerous.
This crisis happened because President Carter misjudged the financial markets, which, in turn, mistrust him.
There had been heavy borrowing through last fall. Interest rates were high, but not usually quite as high as the inflation rate. In real terms, adjusted for inflation, interest was often negative. Lenders were involuntarily paying borrowers to keep borrowing and, understandably, the lenders were getting very uneasy.
The trigger for the late-winter convulsion was Carter's Jan. 28 budget message -- a serious miscalculation. The president tried to argue that the deficit would at least be reduced in 1981. Financial people in New York observed that, despite all his promises, it still be at least $16 billion out of balance. Worse the deficit for the current year, during the election campaign, was sliding rapidly upward.
It looked as though the administration was taking a year off from its struggle against inflation, as one Wall Street analyst puts it.
When the next Consumer Price Index came out, in February, it showed a rise at a rate of 18 percent a year. The banks immediately raised their prime lending rates.
Then came the bizarre episode in which the United States voted for a U.N. resolution on Israeli settlements and the status of Jerusalem, and two days later the president disavowed it as a mistake.The big banks' rates for certificates of deposit lurched up 1 1/4 percentage points in the next 48 hours -- a wild reaction. There's no direct connection between Middle East policy and inflationary expectations. But, as a New York banker later explained, it seemed to signal a total breakdown of control in Washington. In New York, he recalled, a "scare psychology" was taking hold.
With inflation, interest and anxiety all soaring the president was pushed into a spectacular turn-around. On March 14, he pulled his budget back from Congress and said that he would balance it after all. The Federal Reserve Board simultaneously announced a serious of rigorous restraints on credit. Within a few days, banks reported that borrowing had slowed.
But interest rates kept rising anyway. The scare persisted. The banks knew that the Chrysler Corp. was having great difficulty meeting the congressional requirements for the loan guarantees it desperately needed. There were rumors -- quite true -- that a big Philadelphia bank First Pennsylvania, had got itself into serious trouble through speculation in government securities. Then came the silver crash in which the Hunt brothers' strategy collapsed. There was a real possibility that any of these cases could lead to a succession of business failures. In early April, the banks' prime rate -- responding to fear rather than to any increased demand for loans -- hit 20 percent.
An economy that lives on borrowed money will strangle when high rates and fear cut off the flows of funds in and out of those markets. There were several tense days. Then came signs that inflation was being chilled by a recession, coming rapidly and harshly -- aggravated by the extremely high interest rates.
The scare ended. The Hunts' oil wealth saved them and their creditors. The comptroller of the currency skillfully assembled a rescue a First Pennsylvania. The Treasury Deparment winked at some of the requirements and gave Chrysler its loan guarantees.
Now interest rates are falling fast. But both borrowers and lenders have been badly shaken by that ride on the roller coaster.
They are braced for the next time -- and that's the warning Financial people, like the rest of us, now know that American inflation and interest rates can go higher than anyone thought possible before this year. They are watching the White House and Congress warily for any hint of an invitation to higher inflation ahead. If they think they see it, they will once again instantly react -- and overreact.