resolved alone. If Mexico or Argentina did not get well, then neither would Iowa. If Japan and West Germany and others did not pursue similar strategies, then any action taken by the United States would only aggravate its own weaknesses. Neither elected governments nor central banks were accustomed to proceeding with unified strategies. To stimulate demand worldwide, governments would, first, have to force interest rates much lower, closer to something resembling the Historic rate of return on lending. Lower rates would stimulate both consumer demand and business investment and also relax the burden on debtors, from Midwestern farmers to Latin-American nations. Volcker and the Treasury periodically implored Japan and West Germany to lower their interest rates and to provide more stimulus for their economies, but the allied nations were wary—and relatively content. Japan had low unemployment and a trade surplus. West Germany had a deep historic fear of inflation. Both nations and others had been burned in the past by following the American lead and they were reluctant to commit themselves. Aside from the reluctant allies, the U.S. government could not easily extricate itself from its own contradictions. Given the huge deficits, additional fiscal stimulus was out of the question. Yet the Fed feared that if it stimulated by lowering interest rates, capital might flee from U.S. investments, the dollar’s value might fall precipitously and the central bankers would lose control of prices. Unless everyone acted together, each - party was afraid to act alone. Faster economic growth would mean higher employment and rising real wages for labor—new buyers for the world’s goods—but this time, wages must be driven up worldwide, not just in the United States. At the same time, governments would have to encourage a broader distribution of incomes, the opposite of their economic policies in the eighties, when both tax policy and monetary policy pushed more and more income to the top. “It’s a delicious moment of history,” the chief economist at E. F. Hutton declared in early 1986. His exuberance was shared all along Wall Street as both the stock market and the bond market rallied explosively in February 1986, breaking through to historic highs. Everything seemed to be coming together—falling prices, financial rallies, brighter economic From bankrupt home builders to displaced factory workers, people were told their sacrifices were necessary to the general good. prospects—as if Paul Volcker had planned it that way. The markets were giddy with profit. The Federal Reserve even had allowed interest rates to decline a bit. Even oil prices went down—falling from $26 a barrel to $12 in a few short weeks at the end of 1985. At about the same time, Congress enacted the Gramm-Rudman- Hollings legislation, promising to reduce the federal deficits to zero within five years. The measure was actually nothing more than a declaration of intent, but it cheered investors obsessed with the fear of eventual inflation. The moment did seem to be a decisive break in the psychology of the financial markets. The stock market, which had been moving upward steadily since the previous May, suddenly took off in almost daily leaps upward. The Dow Jones index rose above 1760—a gain of 500 points in less than nine months. As the rally continued, less spectacularly, the Dow was pushed eventually above 1900. The significant rally, however, was m the bond market. Bondholders, presumably heartened by the falling oil prices and the congressional promises of deficit reduction, began to accept lower interest rates on long-term paper and to bid up the trading prices for outstanding issues. Bond yields fell to their lowest level since 1978 and bond prices soared proportionately. The euphoria of Wall Street investors infected economic .forecasters and the good news was swiftly broadcast: the American economy was on the brink of energetic revival, thanks to the twin bonuses of lower oil prices and lower interest rates. In his State of the Union address, President Reagan hailed the “American miracle.” The New York Times announced the dawning of a new era: an unlimited vista of inflation-free prosperity ahead, unlike anything living Americans had experienced. The elation was short-lived. Within a few weeks, it became apparent that the supposed benefits of lower oil prices were more than offset by the immediate economic damage they caused—soaring unemployment in the Southwest, a new wave of defaults and threatened banks, renewed crisis for Mexico and other debtor nations that depended on the energy sector. The economy did not take off in the spring, as so many had predicted. It slowed down again to an anemic growth rate of .6 percent. The plunge in prices for oil and other commodities drove the Consumer Price Index downward toward zero. For the first time in nearly forty years, the average price level actually turned negative—prices falling at a rate of -2.8 percent over three months. For the owners of financial wealth, this represented a great windfall, regardless of what it did to the real economy. When prices fell for real goods, anyone holding dollars or dollar-denominated financial assets automatically enjoyed the greater purchasing power. The same money would buy more oil or more farmland. The real value of financial assets was magnified by the falling prices, investors felt more secure about their wealth because the power of their wealth was growing —almost magically. The ebullient forecasts for the real economy missed this essential point: the owners of financial wealth did not really give up anything when they finally consented to the decline in nominal interest rates, thus making more money available to the general public. Nominal interest rates fell swiftly, but so did the inflation rate. The real interest rates, therefore, either remained unchanged or actually increased substantially. A booming economy was not a likely prospect if the real cost of money was going up. Consumers, home buyers, even businessmen, did feel momentarily cheered as they watched nominal interest rates decline, but the illusion did not erase the facts of the case. The real burden of borrowing was increased for the struggling economy. The simple equation of r^al interest rates, so little understood outside finance, was combined with the depressing effects of deflation. Together, they guaranteed that a new era could not unfold, despite Wall Street’s optimism. Despite all the official optimism, many authorities on economic policy—including Volcker himself—were concerned about the disquieting parallels between the ’20s and '80s. The giddy behavior in financial markets and inflated stock prices were the most obvious resemblances. The dangerous expansion of domestic debt and the international disequilibrium were similar too. Even in the best of times, melodramatic scenarios for economic disaster were commonplace and usually fatuous. None had ever come to pass, at least not since 1929. History did not usually repeat itself so neatly. The economy had, nevertheless, developed many of the same vulnerabilities that had led to 1929—in particular, “bubbles” of bad debt that seemed unsustainable. Vacant office buildings were erected with borrowed money, based on occupancy assumptions that could not be fulfilled. Corporate restructurings were financed with “junk bonds” on dubious projections of future profits. If ill-founded hopes were suddenly shattered, the loans behind them might collapse too. Investors would rush to dump the stock shares they owned and financial values would plunge. The bubbles would burst. In some respects, the underlying conditions of the 1980s were actually less promising than in the years before the Great Depression. The decade of the twenties, for instance, was an era of enormous expansion in America's industrial base and the capital investment produced extraordinary gains in productivity. During the eighties, both capital formation and productivity improvement were weak. The economy in the twenties also accumulated unsustainable debts, but the borrowing did not include massive deficit spending by the federal government. The present vulnerabilities, in short, rested on a much weaker base. If the historical parallel with the 1920s held true, however, the collapse might not begin in New York or Texas or California, but in Tokyo. Sixty years ago, when the Great Crash developed, the United States was the ascendant new economic power, trying to prop up the enfeebled older power, Great Britain, which could no longer lead. Something similar was occuring in the late 1980s, only now Japan was the rising power and it was the United States that was losing strength and becoming dependent. Under pressure to help the United States, Japan had lowered rates and pumped up its domestic liquidity. But, just as had happened on Wall The idea of progressive distribution of incomes was as passe in the “go* go eighties” as in the “roaring twenties.” Street in 1928 and 1929, Japan’s enlarged money supply flowed heavily into financial speculation and drove up prices on the Tokyo stock exchange. In any case, the gap between economic reality and financial illusion was already sufficiently visible in Wall Street. From 1982 to 1987, the value of Dow-Jones stocks had inflated by more than 230 percent. Yet real economic growth had totaled only 20 percent. Industrial production had increased by only 25 percent. Someone was terribly wrong about economic conditions. In the modern financial world, it hardly mattered who crashed first—New York or Tokyo— because the others were sure to follow. The potential for a modern collapse involved one other underlying vulnerability—the same one former Federal Reserve chairman Marriner Edcles had identified more than fifty years ago when he tried to figure out what caused the Great Depression. The economy was being steadily weakened by what Eccles called the “giant suction pump” of maldistribution-economic policies that pulled more and more income away from those who would spend it, pushing millions of families toward the point where they could not consume. Eccles wrote: “As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth—not of existing wealth, but of wealth as it is currently produced—to provide men with buying power....Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. ...As in a poker game where the chips are concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.” The same process was at work. Consumption remained strong because more and more families relied on debt rather than earnings. Personal savings fell to unprecedented levels, as low as 2 percent of current income, and consumer debt levels rose as high as 18 percent. But these averages were misleading because the rising debt burdens were concentrated, naturally enough, on the bottom half of the economic ladder—the families whose income shares had shrunk in the 1980s. In effect, they were borrowing from the upper half in order to keep buying, the debtors relying on the creditors to stay in the game. It was just as well that they did. With business investment dwindling, consumer spending was the principal economic activity keeping the weak economic expansion alive. If consumers were eventually forced to pull back, if enough families reached the point where they could borrow no more chips, then the poker game must stop. Recession would follow and all the debt-weakened famiies and businesses would be at severe risk. When would this occur? The few economic forecasters who were alarmed could not say precisely when. All they could observe with certainty was that the deterioration was under way, and if nothing intervened to reverse it, the game would eventually end. The surest way to prevent that outcome would be to turn off the “suction pump”—to push more income downward in the society to the debtor families, those who would promptly spend it. Through the tax code, through lower interest rates or through direct aid, the government could prolong and reinvigorate the 14 Clinton St. Quarterly—Winter, 1988-89
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