Reaganomics: Turbulent Takeoff

By Charles Alexander

A supply-side test, a financial shake-up and merger mania

For economists and financiers, corporate chiefs and small businessmen, high-rolling investors and penny-watching savers, 1981 has been a year of turbulence and profound change. A new Administration pushed through Congress a radical policy that abruptly discarded doctrines that have dominated economic thinking since the Great Depression of the 1930s. Americans dramatically changed the way they save their money. Corporations went on an unprecedented binge of billion-dollar mergers. And although business in general was anemic, dynamic young companies parlayed technological innovations into products that promise to improve the efficiency of offices, factories and homes.

As the year began, inflation was ripping along at a 13% clip, interest rates towered at 21 1/2% and unemployment hovered at 7.4%. Clearly, the economy was fragile and heading for a fall, the depth of which is as yet unknown. On the night of Jan. 6, Joseph Granville, a flamboyant forecaster who predicts earthquakes and stock market turns with equal verve, sent some 3,000 clients the tense, terse message: "Sell everything. Market top has been reached." That warning triggered a two-day, 39-point plunge in the Dow Jones industrial average.

Two weeks later, Ronald Reagan and the supporters of the unorthodox theory of supply-side economics took office. The new President vowed to stimulate business by slashing taxes, even though some critics said that such a move at a time of high inflation would cause prices to spiral still faster. Reagan responded that he would curb inflation by cutting the U.S. budget, and urged the Federal Reserve Board to maintain tight control of the money supply. Moreover, the President asserted that when investors saw prices leveling off, they would lower the return they demanded for their money, and thus interest rates would plummet.

For several months the novelty and unabashed boldness of the Reagan plan worked like a miracle drug. Interest rates began to creep downward, and the Dow Jones industrial average hit an eight-year peak of 1,024 in April. But then moneymen began growing jittery as some of Wall Street's most influential economists, led by Henry Kaufman of Salomon Brothers and Albert Wojnilower of First Boston, warned that Reagan's goals of deep tax cuts, large increases in defense spending and a balanced budget were inconsistent and impossible to achieve. Nicknamed Dr. Doom and Dr. Gloom, Kaufman and Wojnilower foresaw bulging deficits and towering interest rates if Reaganomics were put into practice.

Nonetheless, Congress gave the President what he wanted by passing during the summer the biggest budget and tax cuts in history. The sweeping $35 billion reduction in the 1982 budget was aimed at a broad range of federal programs. The tax bill included a 25% cut in personal levies over three years and much faster depreciation write-offs for business. Price tag: $280 billion in the next three years.

The reaction of the financial markets to the program was disastrous. Fearing huge budget deficits and more inflation, investors began stampeding to sell. Bond prices fell to record lows, and interest rates surged anew. By the time the Dow Jones average bottomed at 824 in September, blue-chip stocks had lost nearly 20% of their value in April.

On his first day back in the Oval Office after Labor Day, Reagan summoned his Cabinet members and told them to find new budget cuts. Said he: "I know it's a hell of a challenge, but ask yourselves: If not us, who? If not now, when?" Two weeks later, the President asked Congress to trim $13 billion more from federal spending in 1982. The markets, though, did not respond to the new program. Some business and political critics charged that Reagan had not cut deeply enough, especially in defense, which suffered only a symbolic $2 billion reduction in a $200 billion budget.

In the meantime, the Federal Reserve Board kept to its firm monetary stance, even though high interest rates had become a tightening noose around the economy. Chairman Paul Volcker pledged repeatedly to curb money and credit growth until inflation was tamed. Said he: "We will see it through."

That policy was devastating to the auto and housing industries, already depressed by two previous years of onerous interest rates. Car sales fell to their lowest level in 20 years. Housing starts hit a 15-year trough. The slump rippled through steel, rubber, lumber and many other industries dependent upon home building and automaking. Businesses, mostly small, were going bankrupt at a pace 42% faster than in 1980.

Already reeling from these blows, the credibility of Reaganomics was further shaken in November by a bombshell article in Atlantic Monthly magazine. The piece quoted one of the program's chief architects, Budget Director David Stockman, as saying that the Administration's plan had been hastily put together and that he had often suffered serious doubts about the strategy. Stockman called the President's across-the-board tax cut proposal a "Trojan horse" to induce Congress to greatly reduce steep levies on wealthy taxpayers. He mused that it was merely a repackaging of old-time Republican "trickle-down" economics.

Critics seized the opportunity to attack Stockman and Reaganomics. Said Lane Kirkland, president of the AFL-CIO: "Stockman was the original interior decorator of this economic house of ill repute . . . Now he has his story ready. He only played the piano in the parlor. He never knew what was going on upstairs."

Unsettled by the Stockman episode and alarmed by the deepening recession, Congress balked at big new spending cuts. After Reagan vetoed a budget resolution and shut down numerous Government offices for a day, the lawmakers this month reluctantly trimmed an additional $4 billion from next year's spending.

The economic news of 1981, however, was not all gloomy. Inflation cooled to an estimated 9.6% this year, from 12.4% in 1980. Part of the credit goes to the Federal Reserve, but luck also played a big role. Bumper harvests put downward pressure on food prices. A global oil glut brought the first relief from rising energy costs in almost three years. No longer totally in command of the market, the Organization of Petroleum Exporting Countries decided to hold the base price of crude to $34 a bbl. through the end of 1982.

Wages make up some two-thirds of the price of a product, and the hard core of inflation will not be broken until salary demands begin to slow. But there are signs of some easing on the wage front. During the final quarter of the year, average hourly earnings have been rising at an annual rate of about 7.4%, against 10.5% in the same period of 1980. The United Auto Workers executive board has given its bargaining councils permission to renegotiate current contracts and grant wage concessions to the troubled car companies. Employee groups at several ailing airlines, including Braniff and Pan Am, have already agreed to a 10% pay slash.

The year's economic turmoil helped speed a historic shake-up of U.S. financial institutions. Attractive interest rates prompted millions of Americans to withdraw money from banks and savings and loan associations, where the return on passbook deposits is no more than 5 1/2%. Many put their cash into money-market funds, which are operated primarily by brokerage houses and financial management firms, and offered interest as high as 17%. The assets of those funds more than doubled during 1981, to $186 billion. Says Walter Wriston, chairman of New York's Citibank: "Americans are not stupid. They have been seeking a better return on their money and getting it."

This shift in deposits, though, severely hit S and Ls and mutual savings banks, which have portfolios loaded with low-rate home mortgages. Most are losing money; some face imminent insolvency. During the year, more than 200 savings institutions, many of them failing, merged with competitors. Some savings executives say that unless Government regulators give them more freedom to issue other kinds of loans besides home mortgages, their industry's survival will be threatened.

The new competition for Americans' spare cash has inspired visions of giant financial supermarkets, where customers could make one stop for services ranging from savings accounts and stocks to insurance. This year several of the largest U.S. companies went further in that direction by moving to acquire investment firms. American Express snared Shearson Loeb Rhoades; Prudential Insurance purchased Bache; Sears reached a preliminary agreement to buy Dean Witter; BankAmerica plans to absorb Charles Schwab.

These financial marriages were only a small part of the record-breaking flurry of matchmaking that swept through U.S. business this year. American companies spent an estimated $80 billion to acquire some 2,200 other firms. The mergers linked familiar names in virtually every industry: Nabisco and Standard Brands MGM and United Artists, Allied Store and Garfinckel, Brooks Brothers.

Why such an urge to merge? The long stock market slump has made the shares in hundreds of American companies tantalizing bargains. In case after case, firm, seeking growth have found it cheaper to buy other businesses than to build new factories or open new stores.

The most alluring targets have been firms rich in natural resources like oil anc minerals. For nearly two months last summer, Seagram, Du Pont and Mobil fought for Conoco in the wildest corporate auction ever. Du Pont prevailed only after hiking its bid twice, to $7.5 billion, the largest merger price in history. Spurned by Conoco, Mobil then tried to take over Marathon Oil. But Marathon struck a sudden merger deal with U.S. Steel. Undaunted, Mobil announced that it would try to buy up to one-quarter of U.S. Steel.

Critics of the Administration charged that Attorney General William French Smith had given an implicit Government go-ahead for takeover attempts when he proclaimed last June that "bigness in business is not necessarily badness." Yet the Government later showed that it would oppose mergers reducing competition within an industry. It persuaded the G. Heileman Brewing Co. to drop a bid for Schlitz and filed a suit aimed at thwarting Mobil's quest for Marathon.

While scores of firms were swallowed up in 1981, hundreds more were born with the aid of venture capitalists, private investors willing to bankroll promising entrepreneurs. Fledgling firms this year received more than $1 billion in venture capital, up from $550 million three years ago. The seed money supported enterprises in microelectronics, genetic engineering, robotics and other innovative industries. Newer companies like Apple Computer, which makes the small desktop computers that are popping up in thousands of offices and homes, and Applicon, a leader in the new field of computer-aided design/computer-aided manufacturing, became established parts of the corporate landscape. The growth of these and many other firms during a general economic downturn showed the underlying vitality of American business.

Inflation has become deeply embedded in the American economy during the past 15 years, and the problem cannot be cured quickly or without some perhaps painful adjustments. But long-term growth and the creation of future jobs will be impossible without a return to price stability. Progress was made this year in the battle against inflation, yet final success will depend on continued effort by Government, business and workers to control prices. --By Charles Alexander

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