Paul Volker’s Nightmare: A Halloween Horror Story
Softly, children! Spirits roam on the Eve of All Hallows. Creatures of the darkest night go abroad to torment our dreams. Slip inside the nightmares of some harried victim and see them work their mischief. See that tall figure tossing under his blankets in the corner? The one with the cold cigar sitting on the Federal Reserve ashtray? . . . Above the briefcase marked with the name “Paul A. Volcker”? . . . The haggard specters lurking in his fevered sleep speak their horrors in a curious, dry tongue. Listen to the terrors they whisper.
A New Burst Of Inflation : The Organization of Petroleum Exporting Countries’ oil price agreement may have more staying power than almost anyone thought. Metals prices are rising. The money supply has been growing very fast for at least two years. Import prices must rise to make up for the falling dollar. The gap between the rate on long-term bonds and short-term bonds has expanded a full percentage point--the surest sign that the markets expect inflation.
A Banking Collapse : More than 1,400 banks are on the Federal Deposit Insurance Corp. problem list. More than 100 have failed already this year. The final price on the bailout of the Continental Illinois National Bank of Chicago will be more than $1 billion. When BankAmerica Corp. goes into the tank it will cost even more. First Interstate Bank Corp. or some other bank will continue to push for a BankAmerica takeover. But they will ask the Federal Reserve to approve a write-up of BankAmerica’s assets by more than $1 billion to conceal how bad its balance sheet really is. That will make the final collapse that much worse.
How much longer can we conceal the Third World debt problem? What if a big debtor, like Mexico or Argentina, just refuses to pay? Then the banks will have to write down their foreign loans to their true value. But then some of the banks wouldn’t have any capital left. How big of a bailout can we manage? Hundreds of billions?
A Savings And Loan Collapse : The General Accounting Office says that almost 1,300 Savings & Loans--43% of the total--are either insolvent or have less capital than the legal requirement. The S&Ls; on the “problem” list of the Federal Savings & Loan Insurance Corp. have almost $100 billion in assets. It’s getting very hard to muffle the effect of runs on S&Ls;, like the ones in Maryland and Ohio. The total system may need an infusion of as much as $25 billion to put balance sheets in order. But where will that come from? The taxpayer again?
A Farm Credit System Collapse : The Farm Credit System’s bad loans increased by $1.6 billion in the second quarter alone. There is $66 billion of farm-credit paper floating throughout the financial system. A lot of it might be worthless if the taxpayer doesn’t step up to the mark and pay it off. Congress has just approved an accounting gimmick that will spread some of the losses over 20 years. But that just might make the problem worse in the long run. Farm support has been growing faster than the defense budget and is twice as high as planned. But the surplus crops and the losses just seem to be getting worse.
A Junk Bond Collapse : Almost $25 billion in new junk bonds came on the market so far this year alone. A lot of that must be bad paper. The Wall Street houses are so anxious for the underwriting fees that they have been floating riskier and riskier paper. A little while ago, cash flow had to be twice debt service to support an issue. Now it’s only 1.25 to 1.5 times debt service. And the “cash flow” usually counts future assets sales. Almost all junk bonds have been issued since the last recession. Even a short recession may put a lot of that paper under water.
A Wall Street Collapse : The Wall Street firms haven’t just been selling junk bonds. They’ve been buying them. The best way to lock up a deal is to buy it yourself. But the equity of many of the firms is very thin for the quality of the paper they are holding. What if there is a string of junk bond defaults? A string of Wall Street houses might go into the tank--even before the banks do. How do we bail them out? Do we even have the statutory authority to help?
A Repurchase Market Collapse : But no one just holds paper these days. They lend it and borrow it. They repurchase it and “reverse repurchase” it. If one of the Wall Street houses went under, we could never untangle who owned the paper in their vaults. It would be like a huge blood clot at the heart of the financial system. It could stop everything cold.
A Consumer Debt Collapse : This could make a Wall Street collapse look paltry. Consumer debt is now $2.4 trillion, or 85% of disposable income--a 15% real increase in just five years. Assets have grown too, but might be seriously mismatched. Consumer assets are in things like houses and pensions and life insurance. Consumer debt is much shorter term. What good would those assets be if we got into a real rate squeeze like we did in the 1970s?
A Federal Deficit Squeeze : What if Japan and Germany took U.S. advice and really reflated their economies? And began investing their surplus capital in their own countries instead of buying U.S. Treasury bonds? Then we might have real contention for available capital. We would have to begin to print money--”monetize the deficit” to put it more delicately--in order to pay the government’s bills. Years ago, cheap money meant low interest rates. But all the rules changed in the 1970s. Now the markets anticipate inflation with . . .
Higher Interest Rates : But higher interest rates will make the federal debt that much harder to service. Higher rates could put the junk-bond issuers under water. They could be the final blow to the banks. They could wipe out the S&Ls; and the Farm Credit System. There could be a financial collapse and a recession at the same time, which will drive rates that much higher. But that will resurrect that dreadful beast of the last decade . . . Stagflation . . .
Come, children! We’ve eavesdropped enough on this poor man’s dreams. There are horrors that are not for your young ears. Come, to bed. This Halloween will soon be past. The dawn is the Feast of the Saints. We need think no more of these horrid creatures we’ve seen tonight.
