How Ripe for a Crash?

By Stephen Koepp

Wall Street was in a panic today, with no one to guide it out . . . Selling was at a furious pace . . . News to noonday had been quite cheerful, but it was not sufficiently encouraging to stem the tide of frantic selling, which came from all parts of the world, from rich and poor alike . . . The demoralization of the market was complete . . . Many speculators lost all their money . . . The senior partner of a leading exchange house described the situation as "pitiable." Brokers had weeping women in their offices, and in some instances weeping men.

-- The Brooklyn Daily Eagle, Oct. 24, 1929

Will those sad scenes of 1929, the stuff of flickering newsreels, replay themselves in 1989? Could it possibly happen again in this day and age? Almost no one seemed to think so only a few years ago, when the initial comparisons between the go-go decades of the 1920s and 1980s tended to downplay the possibility that the "Roaring Eighties" might lead to disaster. But now the confidence is not quite so strong. Some economists see a frightening number of current parallels with the 1920s. Moreover, those similarities are compounded by unprecedented new debt burdens and serious questions about the financial system's stability. While the probability of a major crash may be only 1 in 100, says Lawrence Chimerine, chairman of Wharton Econometrics, he adds that "the risk of a depression is higher now than at any time since the 1930s."

Everywhere, from bookstores to boardrooms, from trading floors to ivory towers, speculations about the financial future fill the air. Declares Economist Robert Heilbroner, writing in The New Yorker: "It is a sense that an ill-defined but vast crisis looms on the economic horizon." In a University of Wisconsin-Madison survey of 105 top executives of major U.S. corporations, half the business leaders assigned a "high probability" to the advent of a major depression in the next ten years.

Charting the possible scenarios for trouble has become a growth industry. The Great Depression of 1990, an offbeat work by the heretofore little-known economist Ravi Batra of Southern Methodist University, has perched on the New York Times best-seller list for twelve weeks and has sold more than 300,000 copies. Competing doomsday books bear such titles as Blood in the Streets (a how-to manual for crisis investing), The Panic of '89 (a fictional thriller about global financial follies) and The National Debt (an indictment of America's borrowing habits).

What worries many seasoned professionals is a dangerous contradiction: a bullish investment fever at a time when real-life economic problems like the trade deficit are getting worse. Says Investment Banker Felix Rohatyn: "If the reality doesn't get better but the myth becomes more and more insane, then the correction is going to be more and more violent." While no direct tie exists between stock-market crashes and depressions, a shattering of Wall Street's confidence would deliver a sharp psychological blow to the rest of the population. Adds Rohatyn: "People will only wake up when one morning they see the stock market unwinding by 150 points in the first two hours. Then people will say, 'Hey, what's happening out there?' "

The inevitability of business cycles means that a downturn of some sort is sure to occur within a few years. But economists generally believe any such slump would go no further than a difficult recession, rather than plunge into a full-blown depression. Reason: since the 1930s the U.S. has constructed a battery of economic and social safeguards. When the last crash struck, the U.S. lacked such backstops as bank-deposit insurance, unemployment compensation, food stamps, Social Security and Medicare. Says Economic Consultant Pierre Rinfret: "Could we have a crash a la 1929? The flat answer is no."

Today's worrisome parallels to the 1920s begin with Wall Street. From 1925 to 1929, stock prices more than doubled. But during the current bull market, the Dow Jones industrial average has more than tripled in value since the run- up began in August 1982. During the rally's first phase, investors put their money in stocks based on their intrinsic value, which was backed by corporate profits and dividends. But in the later stages, the betting has become almost purely speculative, as investors pour cash into the market in fear of missing the free ride. At this point, many stock prices have risen beyond any connection with the real performance of their underlying companies, many experts believe. "There are more extreme valuations now than there were in 1929," says Louis Holland, a partner in Hahn Holland & Grossman, a Chicago money-management firm.

That situation sets the market up for a fall, when investors suddenly realize the party is over. Already, the Dow Jones industrial average has started to show signs of second thoughts. Between late August and mid- September the index fell almost 200 points, prompting investors to wonder whether the reckoning was finally at hand. But last week came relief. The Dow took a 75.23-point jump on Tuesday, the largest one-day advance in history, before easing back to 2570.17, up 45.53 for the week.

Another dramatic parallel is the emergence of a new financial center where cash-laden investors are bidding wildly. In the 1920s that place was Manhattan; today it is Tokyo. In the overheated Tokyo exchange, shares are trading at about triple the level of Wall Street stocks in terms of the ratio of prices to corporate earnings. Says Eric Shubert, an international economist for Manhattan's Bankers Trust: "Lots of inexperienced people in Tokyo are playing the market; they have switched from comic books to the stock pages, just as in America in the 1920s millions of people switched from baseball scores to stock tables." If Tokyo's market collapses, hard-pressed Japanese investors could be forced to pull funds out of the New York stock market, spreading the crisis to Wall Street.

A superabundance of financial innovation is another factor reminiscent of the 1920s. During that time, investment trusts and utility pyramids were the rage, while the 1980s has been a boom time for such techniques and instruments as leveraged buyouts, junk bonds and stock-index futures. The common element is vast leverage, which creates the potential for big profits during a booming economy but equally dramatic losses when the tide goes the other way.

In the '80s, as in the '20s, the distribution of income has tended to wind up unevenly slanted toward the rich. In 1929 1% of U.S. families held 36.3% of the wealth; the proportion fell as low as 20.8% in 1949 but rose back to 34.3% by 1983, Economist Batra notes in The Great Depression of 1990. That disparity is dangerous, he contends, because banks with idle money are tempted to make shaky loans to financially strapped customers, while the rich tend to make increasingly risky investments in search of ever larger returns.

On top of those parallels, today's U.S. economy is carrying a burden that was not so pervasive a problem in the 1920s. In a word: debt. America's level of borrowing among consumers, corporations and government has reached staggering heights. The current total is approaching $8 trillion, or almost twice the country's gross national product. "The increase of real debt ((adjusted for inflation)) occurred at about the same pace as real GNP growth during the '50s, '60s and '70s. But in the '80s it has occurred at double the rate," notes W. Van Bussman, a corporate economist for Chrysler. The current levels of debt might be supportable if good times went on forever. But during a recession the cascade of defaults would aggravate an economic downturn.

The most troublesome borrower is the Federal Government. During the past seven years, the U.S. has posted deficits totaling $1.1 trillion; in fiscal 1986 the red ink reached a record $221 billion. Though the deficit is expected to fall significantly this year, to some $160 billion, many economists fear it will begin rising again in 1988. The Treasury's ability to borrow so heavily depends on foreign buyers of U.S. bonds, whom the Government lures by keeping domestic interest rates at relatively high levels. If those investors were to lose confidence in the U.S. and start pulling out their money, interest rates could rise to heights that would choke the economy.

Moreover, the profligate federal spending of the 1980s has helped buy temporary prosperity that will have to be paid for later. Thus the longer the huge deficits go on, the greater the economic hangover that is likely to result when the fiscal pick-me-up is finally cut off. Last week the House and Senate passed a measure that would revive the Gramm-Rudman deficit-reduction law and stanch the federal red ink to a target of $144 billion during the 1988 fiscal year. Though President Reagan will sign the bill this week, he warned that he would fight tax hikes or deep cuts in defense spending.

The American people are hooked on the same spending habits as their Government. Consumer installment debt, as a proportion of after-tax income, has risen from 14% in 1983 to 20% last year. Just as consumers during the '20s splurged on such newfangled products as radios and roadsters with rumble seats, today's shoppers have gone into deep hock for compact-disc players and Honda Preludes. The difference is that consumers in 1987 can choose from many more enticing borrowing vehicles, most notably an array of credit cards with huge credit lines at high interest rates. Potentially the most dangerous new device is the home-equity loan. Homeowners who borrow too heavily could lose their houses if a recession left them out of a job and unable to make payments. "The real irony will be if everyone's Rock of Gibraltar asset turns out to be a house of cards," says John Makin, a scholar at the American Enterprise Institute, a conservative think tank.

The rampant federal borrowing and consumer buying of imports have contributed to the biggest cliff-hanger of all, the U.S. foreign-trade deficit. That imbalance between exports and imports, which reached a record $170 billion last year, prompts jitters among foreign moneymen, many of whom feel that too much of their trade surpluses are tied up in dollars and U.S. Treasury securities. Says Economist John Kenneth Galbraith: "The danger is that we have accumulated under the Reagan Administration such enormous overseas obligations that these could, if liquidated, create a very, very nasty run on the dollar and also a nasty collapse of the stock market." Adding to the jitters about the dollar is the rising level of U.S. inflation. Last week the Government said the Consumer Price Index rose at an annual rate of 5.8% during August. Last year's pace was only 1.1%.

What would be a sufficiently frightening financial event to trigger such a crash? No one knows precisely. Panics are based largely on mass emotion rather than analysis, and the global economy has become so complex that economists cannot predict with certainty what combination of stresses and strains is required to produce a chain reaction. For example, no particular dollar figure for U.S. indebtedness will suddenly trigger alarm bells. Says David Colander, an economics professor at Middlebury College: "Our $8 trillion debt is almost an irrelevant figure. Technically this economy could support a $30 trillion debt as long as the people believe the economy is still healthy."

Yet at some undetermined point, the public will start to feel more than a little edgy. Says Lester Thurow, dean of M.I.T.'s Sloan School of Management: "For the U.S., it happens when our debts seem to be unreasonable to the rest of the world relative to our wealth, when we start looking like Brazil." At that point, some unexpected event could trigger a panic. Says Rohatyn: "The cause is utterly unpredictable. Some trading company in Hong Kong will go belly-up, or perhaps a bank in Luxembourg."

Still, the U.S. has survived all sorts of modern hardships without sliding into depression. During the past decade alone, the economy struggled back from 12.4% inflation, $34-per-bbl. oil and 21.5% interest rates. Only a very rare combination of circumstances can turn a temporary crisis into a prolonged depression, said Federal Reserve Chairman Alan Greenspan during his confirmation hearings in July. "I'm inclined . . . to assume that the chances that the 1930s would occur as a consequence of what existed in the 1920s was 1 chance in 20, an accidental event, a sequence of events which occurred with very low probability."

Most economists believe that the array of safeguards constructed since the last crash would prevent the banking panics, widespread poverty and business collapse that collaborated to turn the Crash of '29 into a deep, prolonged slump. But lately the barricades have been showing fissures. The Federal Deposit Insurance Corporation, created in 1933, has been strained by the high level of bank failures in the oil patch and Farm Belt. So far in 1987, a post- Depression record 109 banks have failed, a toll that is expected to top 200 by year's end (total number of U.S. banks: 14,000). Even more beleaguered is the FDIC's thrift-industry counterpart, the Federal Savings and Loan Insurance Corporation, for which Congress approved a $10.8 billion industry-financed bailout program earlier this year. Some 460 of the country's 3,200 thrifts are technically insolvent; the total amount needed to restore them to health is estimated to be $40 billion.

By far the most powerful force in preventing catastrophe is the Federal ^ Government's ability to wield monetary and fiscal tools to boost the economy when it falters, which the U.S. was not prepared to do during the early stages of the Great Depression. Says Economic Consultant Rinfret: "If we've learned anything in the last 50 years, it is that whenever the central banks and the administrations of countries pour enough money into the system, you can stop almost anything." Indeed, the Federal Reserve helped ward off a potential panic in 1982, when it softened the impact of a threatened Mexican loan default by easing the money supply. Yet even the Fed might have trouble braking a major slide, some economists maintain. In fact, if the Federal Reserve loosens the money reins too much, inflation could race out of control, Rinfret notes.

Another important new safeguard against depression is the social safety net, including unemployment insurance, Medicare, food stamps and Social Security. These Government programs do more than just keep citizens comfortable during hard times. By putting money in people's hands, the federal payments can help prevent the collapse of consumer spending.

Some economic safeguards are often overlooked. One is the explosive growth of small companies (700,000 last year vs. 90,000 in 1950), which creates resilience in the economy. Still another strong point is the rise of two- income households, which protects families from losing their entire income with one layoff.

Yet the U.S. needs to be ready for the worst-case scenario, in which all the safety nets might be tested at once. That would put daunting pressure on the Government if its deficits remain high, because declining tax receipts and rising welfare payments would push the budget gap out of sight. Each additional percentage point of unemployment in the U.S. would balloon the deficit by an estimated $40 billion a year, a spectacle that might erode public confidence even further.

All the talk of recession and depression, while unsettling, is probably healthy. Since the biggest crashes occur as a result of surprises, nervous discussion may produce some vitally needed preventive measures. The first priority on nearly everyone's list is to halt the U.S. Government's free- spending ways. This will no doubt bring a more modest standard of living in the short run. But it may help America avoid waking up to find frightening headlines in the morning paper a year or two from now.

With reporting by Richard Hornik/Washington and Lawrence Malkin/Boston