Deficit Handcuffs U.S. in Bid to Jog Economy : Recession: Spending boosts and tax cuts--usual fixes during a slump--would only widen the budget shortfall.

Bank troubles rise. Asset values fall. Debt-saddled borrowers go broke. And the government, with the sickest balance sheet of all, does little but watch.

As unemployment rises and hard times spread, U.S. leaders have a dilemma: The normal policy fixes, whether from Congress, the White House or the Federal Reserve Board, are severely restrained.

“We’ve spent the last 30 years thinking that when you’re going into a recession, you should raise spending, cut taxes and widen the deficit,” said Richard J. Sweeney, a professor of finance at Georgetown University in Washington. This time, he added, “our hands are tied.”

Similarly, the Fed is limited in its ability to push down interest rates. Moves to ease them, such as Friday’s reduction in a key rate charged to banks, are balanced against the risk of more inflation at a time of higher oil prices. Another fear is that easing rates too much could prompt foreigners to dump U.S. Treasury bonds, a key source of financing government debt.

If foreigners unload their holdings, “the question is: ‘Who’s going to buy this debt?’ ” asked Irwin L. Kellner, chief economist at Manufacturers Hanover in New York.

Responding to signs of recession earlier last week, the Fed took an unusual step to boost bank profits by relaxing rules on the reserves banks must keep on hand. But few observers saw the move as a cure-all. The constraints on policy add a unique dimension to today’s slump, one that is exacerbated by an array of financial problems:

* The credit crunch. Banks, under pressure to avoid a reprise of the savings and loan debacle, are suddenly choosier about whom they lend to. Regulators are blocking what they view as sloppy loan practices. Borrowers of all sorts are getting squeezed, some going bankrupt.

* Shrinking assets. Hotels, shopping centers, office buildings and other types of real estate have plunged in value, hurting investors--including banks and insurance companies--and lenders.

* Painful debts. Many corporations are being pounded by the one-two combination of heavy interest payments on debt and slumping business because of the downturn.

“There isn’t any easy solution” for the mounting financial malaise, warns Robert N. Pollin, an economist at UC Riverside.

Many experts say the problems are just the lingering legacy of the 1980s’ excesses and can be worked through without major damage to the broader economy. Few forecast a Depression-like collapse of the banking system or anything on the scale of the savings and loan shakeout. The Persian Gulf crisis is what tipped the nation into a downturn, by most reckonings, not domestic financial ills.

Difficulties in the banking system are just one of many challenges facing U.S. policy-makers. In the past, rising interest rates signaled a tightening of credit. This time, the squeeze has been the subject of anecdote and reflects “an attitude or behavioral change on the part of lenders,” said Robert H. Chandross, chief economist for North America at Lloyds Bank in New York. “It was a very difficult thing to come to grips with.”

The difficulties recently took on new meaning at National Gypsum Co., a major manufacturer of wallboard in Dallas.

When Citibank declined to renew National Gypsum’s $75-million credit line earlier this year, the firm was hit with an immediate cash crisis. The company had problems already: Wallboard prices were sinking in the frail construction market, as was demand for the product--factors aggravated by the lack of financing for builders. National Gypsum also faced product liability lawsuits.

Its executives thought they had a reasonable case to make for more credit. The firm was ahead of schedule on repaying debt from a 1986 buyout and owned all its assets free and clear. In an effort to keep costs down, it had cut 340 jobs this year.

In late October, after 50 major banks turned down its loan requests, National Gypsum declared bankruptcy.

“The credit crunch will affect society,” said J. Michal Conaway, chief financial officer at the firm, which later got a bailout from General Electric Credit Corp. “It will adversely affect U.S. industry’s ability to attract capital, to fund expansion. It affects all of us.”

Lenders are suffering, too. The number of banks viewed as under-financed soared in the 1980s. As of June, 1,322 U.S. banks were in the troubled category, according to federal statistics, a number that may have risen in recent months.

Overall, U.S. business failures rose 14.5% during the first nine months of this year, according to Dun & Bradstreet, a New York firm that evaluates companies. The category that includes banks, insurance and real estate firms leaped 31.1%. Manufacturing failures rose, but by 19.5%.

“There is strong evidence of ongoing stress due to the savings and loan crisis, as well as the depressed real estate market,” observed Joseph W. Duncan, an economist at Dun & Bradstreet, of the business failures.

The stress is hitting people where they work. The U.S. unemployment rate rose to 5.9% in November. Unlike the past, job cuts are hitting the financial world hard: Such banks as Chase Manhattan, Citicorp and Bankers Trust, and investment firms, including Merrill Lynch and Prudential-Bache, have announced layoffs. The financial sector, on balance, did not lose jobs in the last four recessions, according to Mark M. Zandi, an economist with Regional Financial Associates in West Chester, Pa.

“Announced layoffs among commercial banks, thrift institutions, investment banks and insurance companies are now routine events,” he said.

So far, West Coast banks have escaped much of the financial trauma that has been concentrated in the Northeast. Failures for financial corporations declined slightly in the Pacific region this year, according to Dun & Bradstreet.

However, concerns are growing that the financial squeeze is hitting California.

One sign: Standard & Poor’s, which analyzes the credit worthiness of corporations, last week lowered its “outlook” for Wells Fargo and Security Pacific banks from stable to negative, while retaining a negative outlook for First Interstate. The alert--which falls short of a change in the banks’ debt rating--was prompted by the three banks’ large stakes in commercial real estate, in the range of 20% or higher.

Another sign is this year’s pounding of stocks issued by banks in California and elsewhere. The low stock values, reflecting fears that the real estate problems will worsen, have turned off potential investors at a time when the banks hunger for new capital.

“Given the slide in the real estate market since April or so, we would expect problems to start showing up,” explained Tanya Azarchs, a vice president at Standard & Poor’s.

In response, lenders have become wary about whom they will do business with. All but the most tried-and-true borrowers today find themselves scrutinized more severely than in the past. An October survey by the Federal Reserve Board found that between one-third and one-half of banks had tightened their loan policies in recent months.

“For small or medium builders, the banks are saying either we have no funds available for you, or we’re going to look extremely hard at any deals,” said Randall W. Lewis, senior vice president of Lewis Homes, a major home builder based in Upland.

The harder look is also aimed at a borrower’s assets, in light of declining values for real estate and other things.

In the 1980s, speculators and their lenders counted on a continued rise in real estate prices, and they usually were rewarded. Now, lenders no longer assume that borrowers will be enriched by vaulting prices. In addition, lenders--under pressure from federal regulators--have become wary of counting on the assets used to back up loans, such as cars or industrial equipment.

“Banks are a mirror of the economy, and the economy has problems,” said Robert H. Dugger, chief economist with American Bankers Assn. in Washington.

For many corporations, the biggest problem of all may be to live with the cost of debt. In the 1970s, corporations devoted 33 cents of every dollar of their pretax earnings to paying interest on their debts. By this year, the figure for non-financial U.S. firms had soared to 60 cents, according to Pollin of UC Riverside.

Such payments can prove lethal. Days Inns of America, the nation’s third-largest hotel chain, last month announced that it was in financial distress, the result of payments due on its 1980s debt. Such corporate debt “is the single greatest source of financial vulnerability in the economy right now,” Pollin said.

Financial distress is increasing by another gauge. At the start of the year, the book value of public and private debt of distressed U.S. firms came to $301 billion, according to Edward I. Altman, a professor of finance at New York University.

Today, the figure has reached $350 billion, he estimates, adding that the current climate creates severe pressures for struggling companies: “The marginal company which would have gotten financing in good times is being squeezed out of the market. That’s different from the past.”

Pressures are rising for a response by policy-makers. In past recessions, unemployment benefits have been enhanced, public works projects have been financed and taxes have been cut. But the deficit--now projected to exceed $300 billion next year--seems to rule out moves to jog the economy out of the doldrums.

“The federal government’s budget is in such horrible shape that they’re just not in a position to help,” said Frank C. Wykoff, an economics professor at Pomona College.

Dilemmas also extend to the Federal Reserve Board, which oversees the nation’s banking system. Many business executives and borrowers wish to see greater reductions in interest rates. But in a time of high energy costs and rising prices for health care and other services, Fed Chairman Alan Greenspan remains wary of inflation, which is running at more than 6% for this year.

“There comes a point where they have to say, ‘As much as we’d like to get inflation down to 2%, we’re not going to do it,’ ” said Chandross of Lloyds Bank.

For all the problems, some say the threat is much greater for companies and investors than for the nation overall.

“No question there is a lot of financial fragility, and, no question, one doesn’t want to ignore it,” said Allan H. Meltzer, a professor of economics and public policy at Carnegie Mellon University in Pittsburgh, Pa.

He added that the U.S. economy is strong enough to absorb the difficulties. Just as the 1980s created a new set of financial winners and losers, the current difficulties will do the same: “Capitalism without failure,” he said, “is like religion without sin.”

BUSINESS FAILURES Nationally, business failures rose significantly across a broad range of industries in the first nine months of this year. The West Coast has partly escaped the trend, although failures increased in manufacturing, retail and mining. Figures below compare the first nine months of each year.

PACIFIC REGION* 1989 9 mos. 1990 % Change Agriculture/forestry/fishing 192 146 -24.0% Mining 8 10 +25.0 Construction 914 790 -13.6 Manufacturing 614 665 +8.3 Transportation, public utilities 295 296 +0.3 Wholesale trade 509 451 -11.4 Retail trade 1,297 1,443 +11.3 Finance/insurance/real estate 454 385 -15.2 Services 3,429 2,839 -17.2 Other 23 4,387 TOTAL 7,735 7,463 -3.5%

*Includes California, Oregon, Washington, Hawaii and Alaska

UNITED STATES 1989 9 mos. 1990 % Change Agriculture/forestry/fishing 1,081 1,160 +7.3% Mining 270 257 -4.8 Construction 5,285 5,857 +10.8 Manufacturing 2,904 3,469 +19.5 Transportation, public utilities 1,520 1,826 +20.1 Wholesale trade 2,740 3,106 +13.4 Retail trade 8,329 9,372 +12.5 Finance/insurance/real estate 2,111 2,767 +31.1 Services 13,615 14,777 +8.5 Other 441 1,245 TOTAL 38,296 43,836 +14.5%

Source: Dun & Bradstreet