Don't Panic

It was the first week of December and the weather in Georgetown was chilly. It was not, however, just the first blasts of winter air that were causing some of the more prominent residents of that elite community to shiver when they got out of bed that Tuesday morning. In this year of 1988 it was also the growing mood of apprehension that had begun to grip Washington since the first week of November. The fear that had been mounting during those 30 days was that everything would start to unravel--soon--and that the United States in 1989 could find itself dumped into a situation where the economy, the dollar, the banks, Chrysler and, yes, even IBM would all go into a dive, one after the other.

Thus the first paragraph of my new novel, The Panic of'89.

As the story progresses, things go downhill rapidly and culminate in a financial panic on January 10, 1989. That's the day when everybody decides to get out of almost everything at the same time: out of stocks, out of bonds, out of commodities, out of the banks and, where foreign investors are concerned, out of the United States. It is a financial debacle on a scale so vast that October 28, 1929, pales by comparison.

President Reagan, now in his final days in the White House, is faced with the most difficult choice of his two terms in office: to simply ride out the financial panic and let his successor deal with the consequences or to shut down America's entire financial system--its stock exchanges, its commodity exchanges, all of its banks--before chaos develops.

Fun and games? Or potential reality? Until very recently, it would have been hard to find a true believer in such a future sequence of events. After all, since the latter part of 1982, the American economy has been on a roll seldom seen in this century. We are in our fifth straight year of economic recovery. During that period, total employment has risen by almost 12,000,000 in the United States. Not only that but the rate of inflation, instead of rising, as it usually does during periods of extended prosperity, has fallen dramatically to the lowest level in more than a decade. Even fixed-rate mortgages are almost down into single digits; only a few years ago, they were more than 15 percent. So why worry? All signs are still go. There is no reason to believe that the good times can't go on for another five years.

Oh, yeah? Then why did the Dow Jones industrial average fall 120 points in two days this past September? And why did Hugh Sidey, Time magazine's Washington contributing editor, write the following under the title "Colliding with Realities"?

There is a feeling in Washington that we are gathering at the side of the track to watch a gigantic economic train wreck one of these days....

A growing number of Government experts suggest that if the American economy fails now, the consequences may be more disastrous than at any other time in our history....

And there are indications from inside that some of Reagan's Cabinet have got a whiff of the same fear. Labor Secretary William Brock, Trade Ambassador Clayton Yeutter, Commerce Secretary Malcolm Baldrige, Treasury Secretary James Baker and Secretary of State George Shultz now form an informal consortium alarmed about the ominous debt.... They have not begun to meet as a group, but their views are joined. Maybe they have heard the trains coming.

Ominous debt.

That's what's got them worried, and with good reason. If you look at what has happened to the debt situation in these United States during recent years, you should probably start worrying, too.

When Ronald Reagan assumed office, our national debt was less than one trillion dollars. Today, as a result of year after year of 200-billion-dollar budget deficits, it is more than two trillion. In just six years, our current President has amassed more national debt than all of his predecessors combined, from George Washington on.

We Americans have not exactly been shy of amassing debt, either. The debt (home mortgages, installment credit and credit cards) of the average American household equals 84 percent of its entire annual disposable income. Ten years ago, it was less than 70 percent. Why this rising indebtedness of Americans? Because we consume like crazy. We live as though there were no tomorrow. Our savings rate is the world's lowest, our consumption rate the world's highest.

So who's financing all of this deficit spending?

Increasingly, it is foreigners. In 1985, for the first time since before World War One, the United States became a debtor nation. At the rate things are going, by my critical year, 1989, we will owe the rest of the world between a half and a full trillion dollars. Why? Because, as a nation, we import 170 billion dollars a year more than we export. The difference we borrow--principally from the Japanese and the western Europeans. We buy Toyotas and they take our dollars and buy American Treasury bonds or put their money on deposit with American banks. They export cars; we export U.S. Government debt and bank C.D.s. A real scam, when you think of it. After all, while we're having fun driving around in their cars, all they've received in return are pieces of paper with big numbers printed on them. How much fun can you really have fondling T-bills?

What if they catch on one of these days? What if they not only stop shipping hundreds of billions of their savings to the United States each year to finance our folly but actually start to yank their money out?

But why should they do such a foolish thing? Why should this wonderful international-money merry-go-round ever stop?

Answer: our new friend ominous debt. But I'm referring not to what we owe the Japanese and the Europeans but to what a lot of nations south of the border owe us. The Third World, led by Brazil, Mexico, Argentina and Venezuela, owes us, the developed world, a trillion dollars. That's $1,000,000,000,000--and rising. The U.S., in cooperation with the International Monetary Fund and others, recently put together a new loan of 12 billion dollars to Mexico, adding to the 100 billion dollars Mexico already owed. Why throw so much good money after so much bad?

Well, here we come to the crux of the problem: All this debt is interrelated. Mexico has to continue to borrow new money from the United States to stay alive. American banks must continue to lend new money to Mexico so that Mexico can continue to pay the interest on its old loans. Why? So that those same banks can maintain the fiction that the old loans--which, in some cases, exceed their entire capital and reserves--are still good. America, in turn, must continue to borrow from Japan and Europe to finance our enormous trade deficit. Japan and Europe must continue to lend to America if American prosperity is to be maintained, a prosperity that has been possible only because of the stimulus provided by deficit spending on both the Governmental and the consumer levels. For should American prosperity end, the demand for Japanese and European goods--the demand for all goods on a global scale, from foreign cars to foreign bananas to foreign oil--would begin to collapse. If that happens, then look out.

For it is American economic growth that supports the entire global interlocking pyramid of debt. If that growth ends, that global financial house of cards could very well collapse. It was Reagan himself who, in his September speech before the world's bankers at the annual conference of the World Bank and International Monetary Fund in Washington, said, "Growth is the key to repaying debt." What he chose not to articulate was what could happen in the absence of growth.

Let me try to do it for him.

Let's say it's December 1988. Let's also say that the American economic recovery, now in its 73rd month (meaning that it has been the longest such recovery since World War Two), has finally run its course. What will bring it to an end? The exhaustion of consumer spending as a driving force in the economy. The end will come when the average American family has finally bought all the houses and cars and boats and schooling for the kids that it can afford to finance. Since consumer spending provides 75 percent of the drive in the American economy, this will signal the onset of recession.

What will now happen to that American demand for the bananas and bauxite and shoes that we get from Brazil and Costa Rica and the Philippines? It will start to fall off a cliff. Now where will Brazil and Costa Rica and the Philippines get the money to pay the interest on the dollars (well over 100 billion) they owe us? Will we Americans lend it to them, as we have provided much of the funding for the latest 12-billion-dollar loan to Mexico, a loan that has enabled it to continue to service its debt, allowing our financial institutions to maintain the facade that all is well? Hardly; with our own economy in a dive and with domestic unemployment sharply rising, Americans will never stand for another bail-out of our banks when it is now the American people who need to be bailed out.

Let's further hypothesize that at the same time, the war between Iran and Iraq finally ends due to sheer exhaustion of the warring parties. Why? Because by that time, as a result of their war of attrition, which can find its historical counterpart only in the murderous trench warfare of World War One, there might be only 11 soldiers remaining on the battlefield--six Iranians and five Iraqis, all 12 years old.

What will now happen to the price of oil? Answer: It will be hit by a double whammy. The demand for energy will fall (continued on page 136)Don't Panic(continued from page 106) as a result of recession, while the supply of oil will rise as both Iran and Iraq now start to pump oil like crazy to replenish their national treasuries, which have been completely exhausted as a result of their prolonged war with each other. How much can they pump? They have a combined capacity of as much as 9,000,000 barrels a day. Today, with all of OPEC restricting its output to only 17,000,000 barrels a day, or half of its maximum sustainable capacity, the oil producers' cartel is barely able to keep the price in the $15-a-barrel range.

Where can we expect the price of oil to land at the end of 1988, when Iran and Iraq go their own way? My guess: somewhere between five and ten dollars a barrel.

This would have catastrophic consequences for Mexico, which depends on oil exports for the majority of its foreign income. It would run out of dollars within a matter of a few months. Even with the best will in the world, the Mexicans would no longer be able to service their debts to the banks in El Norte. So they would declare default.

But hold on, you say. Have we not been told that no country would ever dare do that? After all, would it not face fearful reprisals? Would not the banks in New York and San Francisco and Chicago cut it off, seize its cargo ships, its oil tankers, its commercial aircraft and put it back into the financial stone age?

The answer used to be yes. But no more. Listen to what The Wall Street Journal reported Angel Gurria, Mexico's chief debt negotiator, as saying just days after the U.S. Government, the I.M.F. and banks had agreed to lend his country another 12 billion dollars in order to keep it afloat. "If cornered, our government has to put the interest of our people first.... Now it [paying interest] is an option; before, it was a fact."

An option! Well, when oil sinks below ten dollars a barrel once again, it is not too hard to imagine that the Mexicans are going to choose to forgo that option.

When do the Mexicans anticipate that this will all begin to come down?

One of Mexico's leading experts on this subject, Professor Jorge G. Castañeda of the National Autonomous University of Mexico and the Carnegie Endowment for International Peace in Washington, says, "This bail-out only drives Mexico deeper into debt and postpones any lasting solution [my italics]...until the end of De La Madrid's term in late 1988."

The end of 1988. That is when recession is probably going to hit the United States. That is when the price of oil is probably going to be driven below ten dollars a barrel. That is also the time when Mexico will once again run out of money. The bail-out referred to above was originally 12 billion dollars, but now another three billion dollars will probably be tacked on, for a total of 15 billion dollars. Mexico likely loses dollars at the net rate of about 650,000,000 a month with oil at $15 a barrel. This means that it can probably last another 22 months--until December 1988, at which time it will need another fix. At precisely that time, Mexican president De La Madrid's term will end, and he will walk away from the entire impossible mess, leaving the way clear for his successor to begin his new term by wiping the slate clean and declaring his nation's debt to be null and void as a first element of that "lasting solution" to his country's problems.

What would this mean for our banks? How much does Mexico owe them? According to The New York Times, it owes BankAmerica 2.709 billion dollars, Citicorp 2.8 billion dollars, Manufacturers Hanover 1.8 billion dollars, Chase Manhattan Corporation 1.68 billion dollars. The list goes on and on. And these figures do not include the new loans that are part of the 12-to-15-billion-dollar package, nor do they include loans to the private sector of Mexico. More important, Mexico is only the beginning of the problem. The total exposure of U.S. banks to foreign borrowers is 295 billion dollars, and 180 billion dollars of this is owed to the nation's nine largest banks.

What would happen to these banks if Mexico went into default in December 1988 and the other debt dominoes, in the form of Venezuela and Brazil and Argentina and Indonesia and the Philippines, started to totter? The answer lies with the people who have their money on deposit with these banks, especially those nine largest banks, which are most exposed. How would the depositors react to the news that Mexico and, perhaps, other nations were not just on the brink of default but were actually taking the plunge?

Why should they react at all? What do they care about their banks' problem? Aren't almost all deposits covered by the Federal Deposit Insurance Corporation?

Unfortunately, no.

Unbeknown to most Americans, between 50 percent and 60 percent of all the deposits in those nine largest banks most exposed to foreign debtors are not retail deposits. Ninety percent of such deposits are over $100,000 and are not covered by the FDIC. Worse, more than half of such institutional deposits come from abroad.

Now put yourself in the shoes of someone managing the funds of a German insurance company or a British labor union or a Japanese bank. If a default process were set in motion by Mexico, would you continue to keep money on deposit with Bank of America or Citibank, knowing that you were uninsured? To be sure, logic would tell you that, somehow, the United States Government would have to step in if worst came to worst. But could you be 100 percent sure?

I think that if I were in that position, I would say to myself, "Look, why run the risk of even one in 1,000,000 that the U.S. Government will leave us foreigners out in the cold? I'm getting out and bringing my money back home, where I know how things stand."

That is exactly what happened a few years ago at Continental Illinois National Bank & Trust Company. When word got out that the Chicago-based bank was going to suffer a billion-dollar-plus loss chiefly because of its bad domestic energy-related loans, the foreign depositors panicked--first the Japanese, then the Germans and finally the British. Within 24 hours, billions of dollars in foreign deposits were yanked from the bank. Had not the Feds stepped in with what ultimately amounted to 13.7 billion dollars' worth of liquidity, Continental Illinois might have gone under in what would have been the biggest financial fiasco in 50 years.

What I am talking about in 1988-1989 is not a one-bank crisis but a systemic banking crisis, in which every one of the top nine banks has become suspect and with them the entire financial establishment of the United States.

What would the President do? Would he close the banks and stop the hemorrhage, even though the consequences might be that many banks would have to remain permanently closed or at least merged into viable entities, involving a process of financial "shrinkage" that would sink the entire American economy into a depression? Or would he request that the Federal Reserve and the FDIC step in and simply replace the fleeing foreign funds dollar for dollar? Then we would be faced with the "creation" of money not seen in this country since the Civil War. For if it took 13.7 billion dollars' worth of refunding to save Continental Illinois last time, it could well require 137 billion dollars to save all nine money-center banks of the United States next time.

Which leads us to three key questions:

1. What are the odds that such a financial crisis will actually occur within two or three years?

2. If it does occur, what will be the most probable outcome of the crisis--i.e., will we sink into a deflationary depression or will we quickly bounce back as a result of massive Governmental reflation?

3. Depending on the answers to (1) and (2), how, on a personal level, should individuals plan for such a contingency?

The odds: I've run this scenario by at least 50 heavy hitters in banking, the oil business, Government and universities. The consensus: There is a 20 percent to 25 percent probability we will face a major economic/financial crisis in 1989 or earlier.

The outcome: Ninety percent feel that the solution will come in the form of massive reflation.

How to plan for it? By playing it safe.

Playing it safe. What does that entail? Let's go down the short list of areas where the average American family is financially exposed, either in the negative sense (a large mortgage) or in the positive sense (investment in bonds).

Mortgages. If the result of a global financial crisis is reflation--in which governments respond by printing money--anybody with an adjustable-rate mortgage will get badly clobbered. When massive amounts of new money start to chase the same amount of goods, prices must rise. Everybody knows that. So inflationary expectations would quickly soar following a financial panic. T-bill yields would go from five percent to seven percent to ten percent. Your adjustable-rate mortgages, which are related to the yields on U.S. Government securities such as T-bills, would also soar after a time lag of a few months. Where mortgage rates would end up is anybody's guess. But remember: When the rate of inflation rose to 13 percent at the beginning of the Eighties, they went to 15-1/2 percent.

So if you want to play it safe and you have an adjustable-rate mortgage, convert it to a fixed-rate one now.

Other debt. If you are in the habit of using credit cards for credit, break that habit. For if reflation is the solution to the economic and financial troubles that lie ahead of us all, the interest you pay on your VISA or MasterCard is going to go up along with all other interest rates. Anybody who willingly pays interest rates in excess of 20 percent is simply dumb.

There is another very good reason to cut back on consumer debt, starting right now. Under the provisions of the new tax law, you are no longer able to fully deduct consumer-debt-interest payments from your income, meaning that Uncle Sam is no longer going to pick up a high part of that interest tab.

How to cut back? Well, perhaps 1987 should be the year when you postpone buying a new car and/or remodeling the kitchen and use the money that you save to bring your nonmortgage debt as close to zero as possible.

Investments. There are basically only two types of investments--in financial assets, such as stocks and bonds, and in real assets, such as real estate or gold.

In periods in which economic growth is accompanied by falling rates of inflation and of interest, the place for your money to be is in financial assets. Since August 1982, we have had precisely such conditions. Thus, the prices of both bonds and stocks have gone up tremendously during the past four years, propelled by falling interest rates. The relationship between bond prices and interest rates is direct and automatic: When interest rates fall, bond prices rise. Where stock prices are concerned, the relationship is less direct. However, in Paul Erdman's Money Book, which was published three years ago, I gave the following rule of thumb: Everyone percent decrease in the prime-interest rate will produce a 50-to-75-point increase in the Dow Jones industrial average. It has worked like a charm. But the joy ride in both the bond and the stock markets is almost over, in my judgment, and is bound to end with or without a panic in '89. The Federal Reserve cannot allow interest rates to fall much lower than they are today, because during the next two or three years, we, as a nation, must import hundreds of billions of dollars of foreign money to finance our enormous trade deficits. These capital inflows will continue only if investments in New York remain more attractive than those available in Tokyo, Frankfurt or Zurich--that is, only if the interest that foreigners can earn in U.S. dollars is at least two percent higher than the interest they could get if they made comparable investments in yen, marks or Swiss francs. Interest rates in those currencies are now about as low as they are going to get (three to four percent for short-term deposits). Since we must maintain a differential of more than two percent in our favor, their interest rates dictate ours; since their rates are now bottoming out, our rates are now about as low as they are going to get in this decade. This also means, if the Erdman rule of thumb still holds, that the great bull market of the Eighties, which was propelled by constantly falling interest rates, is about over in any case.

Should, however, these good times end with a bang, a panic in '89, we will no doubt see an enormous capital flight from the United States as foreigners return their funds to the relative safety of Japan and western Europe. As already suggested, such a flight would probably force the Federal Reserve to compensate for the outflows by printing money on a large scale, producing fears of a revival of serious inflation in the United States. Such fears, in turn, would result in soaring interest rates and collapsing bond and stock prices. The Erdman rule would, unfortunately, also work in reverse.

So how to play it safe? First, don't panic now. Both stocks and bonds probably have a little way to go. But a year from now, I, for one, will be very sorely tempted to get out of these markets and go for safety and liquidity--Treasury bills and FDIC-insured money-market accounts at banks. Sure, I'll be getting only five to six percent while I'm parked there, but that's a hell of a lot better than leaving my money at risk and losing 25 percent.

Real assets. The prices of real assets feed on inflation. We all saw the value of our houses increase spectacularly between 1975 and 1982 as a result. The same phenomenon caused speculators to push the price of gold to $825 an ounce.

Will gold again rise as the current good times end? Probably. The fear of a potential financial debacle in the United States at the end of this decade and an inflationary Governmental response will probably move the gold price back into the $500 range. As the South African situation worsens, it may even go higher.

Will we also see real-estate prices soar as they did during the last bout of serious inflation in the United States? I doubt it. Prices will move up another big notch, yes. But another doubling in five years? No. Although real assets will again have their day at the end of this decade, I think that it will be more or less just that: a day, even a year, but not a decade.

Why? Because even though we may well have a financial panic followed by reflation at the end of this decade, I think that the bad times will be short-lived--that only a moderate amount of inflation will prove necessary to get us over the financial bump in the road that lies ahead, a bump that will cause those upward-spiking interest rates and downward-spiraling securities markets and renewed action in real estate and gold. Clear heads will prevail as it becomes evident that, when all is said and done, there is really no alternative to the United States and its capital and money markets as the last safe haven for a large proportion of the world's money. When that realization sinks in, international capital will inevitably begin to return to this country in vast amounts, and the Federal Reserve will be able to withdraw gradually and quietly from the scene.

Then, after about 12 months, things will settle down, and we will once again return to a period of renewed growth and moderate rates of inflation and interest that will extend well into the Nineties.

Why this long-term optimism?

Because we are already making changes in the economic parameters of this nation that are bound to evoke responses in the private sector that will put us back on the onward-and-upward path in the Nineties.

Gramm-Rudman-Hollings. The spirit inherent in Gramm-Rudman-Hollings, the new law aimed at balancing the Federal budget by 1991, is bound to result in much lower budgetary deficits. Perhaps the cuts won't come soon enough to head off financial hard times in '89, but much lower budgetary deficits thereafter will certainly contribute to a major revival of growth in the United States in the Nineties, when massive Government borrowings will no longer reduce the availability and raise the cost of capital needed by the private sector.

The dollar. During the past 18 months, its value has already been cut almost in half relative to the yen, the mark and the Swiss franc. This correction is bound to produce major reductions in our international-trade deficits as our exports become cheaper in foreign markets, while imports become more expensive in our markets, setting the stage for a reinvigoration of our export industries and a cutting back of foreign competition at home, without our having to resort to protectionism. Unfortunately, all this will probably happen too late to prevent the troubles that lie immediately ahead.

The recognition of Third World debt as the joint responsibility of the American Government and the American banks. The packaging of the 12-billion-dollar bail-out for Mexico exemplifies this. Also, Secretary of the Treasury Baker has proposed that the banks make available 29 billion dollars for future crises. The next step will probably be the creation of a still larger Latin-American debt-relief fund, designed to buy bad loans from the banks in order to keep them solvent and to write them off in order to keep Mexico and Brazil afloat.

Tax reform. The new tax bill is bound to increase the incentive to work in this country. We arc going to have the lowest marginal rate of personal taxation in the world.

With such changes in the economic framework gradually falling into place, I have no doubt that the private sector in the United States will respond with an even greater dynamic in the Nineties than it has in the Eighties. In Silicon Valley and on Highway 128 around Boston, we continue to push back technological frontiers on almost a weekly basis, thus constantly renewing the foundation for future economic growth. Venture capital, that uniquely American pool of money, continues to be available in vast quantities. This is still the only country where a guy can walk out of Hewlett-Packard, set himself up in one of those famous garages in Palo Alto, then head up to San Francisco to see some investment bankers and tell them, "Look, I've got this great idea, but I need $10,000,000 to get it off the ground." And have them tell him, "Look, take $20,000,000 and do it right!"

Finally, entrepreneurship is stronger today in America than ever before. Today's kids no longer want to pitch for the New York Yankees. They want to be like Stephen Wozniak and found another Apple computer, then sell out for $100,000,000 and do all this before getting too old, like 27.

So although I see a serious bump or two in the road ahead, we will be able to deal with them and then return to an upward trend that will extend well into the Nineties. But be careful in your financial dealings during the next 24 months. Be prepared to park your savings safely when the financial storm approaches. Don't leave yourself overexposed to creditors. Then, if a financial crisis occurs in '89, you will have no need to panic. You will have positioned yourself in such a way that you will emerge with your capital intact, ready to participate in the renewed good times of the Nineties. Then, at least where you're concerned, The Panic of '89 will have a happy ending.

"What I am talking about in 1888--1989 is not a one-bank crisis but a systemic banking crisis."