Get to Work, Quickly, on Damage Control

Financial markets are driven by two forces: greed and fear. For five years greed has driven world capital markets to unprecedented levels--levels that were hard to explain by the modest economic performance of the United States and other major industrial countries. This week fear took over, and markets around the world collapsed.

Why did it happen? In the United States, at least, there is a good economic explanation. Last spring the Federal Reserve abruptly switched policy, slowing the growth of money and liquidity in an effort to stabilize the foreign-exchange value of the dollar by raising interest rates. Sooner or later this had to mean slower economic growth, especially since inflationary pressures already built into the economy--from, for example, the dramatic decline of the dollar--were beginning to emerge. Nevertheless, the boom in the stock market continued, with some analysts predicting a 3000 Dow Jones industrial average by Christmas.

Liquidity growth and good stock market performance cannot long diverge: Either the Federal Reserve Board relents or the market contracts. Faced with a fragile dollar and with growing fears that high inflation could return, the Fed was unlikely to give in first. Wall Street ignored this, pushing the stock market to record highs--until two weeks ago.

A stock market correction was inevitable. Indeed, given the increasingly close linkages among world capital markets, a global correction was probably inevitable, in which declines in one market fed declines in others.

But it did not have to be this bad. Markets are driven by psychology as well as by economics, which is where the fear took over. And the fear seems based on a growing concern that governments are unable to manage present-day economic forces.

Several recent examples:

--The Administration proudly points to the $60-billion reduction in the federal budget deficit in the just-ended fiscal year. However, the improvement was unexpected. It appears to have been caused largely by unanticipated effects of last year’s tax reform, and seems unlikely to be repeated.

--Despite the exigencies of the calendar, the federal government still lacks a budget for the fiscal year, which began Oct. 1. The President says that the congressional budget process has broken down; Congress says that the President is unwilling to compromise his desire for higher defense spending and lower taxes.

--The Federal Reserve Board was overly cautious in August and September despite growing fears of inflation in the bond and money markets. More forceful action might have calmed the fears in the bond market and prevented some of the rise in rates that in turn helped set off Wall Street’s collapse.

--Finally, the dialogue among the major industrial countries again seemed to be breaking down last week when Treasury Secretary James A. Baker III publicly castigated the West Germans for recent interest-rate increases and, according to some press reports, threatened to let the dollar fall in retaliation. Markets are easily irritated by squabbling among governments.

All of this adds up to an environment of indecisiveness, policy paralysis and uncertainty--a breeding ground for the fear that has gripped world markets.

The crash, even once the markets have stabilized or rebounded, will have short-term financial effects and medium-term economic ones. Questions will quickly emerge about the liquidity and solvency of financial institutions that have suffered massive losses and the commercial banks that financed them. Short-term interest rates will drop as stock sales proceeds are converted into cash or invested in government securities. Currency markets, if left to themselves, are not likely to remain stable.

The economy is likely to move into recession. The long-running American economic expansion has been sustained by consumer spending and consumer borrowing. In turn, many consumers were borrowing against stock market gains that have now been erased. They will have to retrench to manage the debt already incurred. More generally, shrill newspaper headlines and comparisons to 1929 are likely to scare consumers into delaying purchases, even if their own economic circumstances are unaffected.

Indeed, a rise in the savings rate and a recession-induced reduction of imports would go a long way toward rebalancing the American economy. This would be the silver lining to the clouds now hovering over Wall Street.

Washington’s role is to see that a recession does not turn into a depression.

The immediate task is to assure markets that the Fed will provide unlimited liquidity--for a designated time--and that governments are prepared to support major private financial institutions. In part, this means increasing the resources available to the institutions that insure financial institutions and extending the protective umbrella erected over major money center banks.

At the same time, Washington, Tokyo and Bonn should reconfirm their commitment to stabilize exchange rates and to coordinate economic policies; central banks of all three nations should cut interest rates.

If markets can be kept liquid and institutions solvent, then governments must tackle the continuing source of economic instability: the U.S. budget deficit. In a recession, government spending automatically rises and tax receipts inevitably fall; the deficit gets bigger. The traditional view is that cutting a deficit during an economic downturn will provoke an even worse recession. Nevertheless, the deficit must be reduced to manageable proportions to reestablish Washington’s financial credibility and to stop the growth in U.S. foreign debt.

All of this would require not only urgent, cooperative action but also the shedding of ideological baggage in Washington as well as in Tokyo and Bonn. There is no other way to prevent the fear that now consumes Wall Street from spreading to Main Street. Once was enough.