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By Charles Alexander

Experts are bufuddled and borrowers are battered

Everywhere President Reagan goes, people ask him the same question: Why are interest rates so high? A recent visit to an eighth-grade civics class at St. Peter's School in Geneva, Ill., was no exception. Sitting on the edge of the teacher's desk, next to the world globe, Ronald Reagan patiently explained that interest rates are still steep because the financial markets expect Government policies to spark a renewal of rapid inflation. "We're trying to convince them that isn't so," said the President. "And I think pretty soon, when we announce a bipartisan agreement on what we're going to do with regard to spending and taxes, then maybe the markets will get some confidence."

If the 22 attentive youngsters were more confused than enlightened by the President's explanation, they were not alone. Everyone who needs to borrow money, from struggling small businessmen to families who want to buy homes, is bewildered and frustrated. Interest rates have stayed up even as inflation has gone down dramatically. The cost of money has historically been only two to three percentage points above the rate of price rises. Now interest rates are an astonishing 15 points above the inflation level of the past three months.

Most economists predict that continued slow inflation will result in some interest-rate relief by summer, but they also warn that the prospect of a 1983 federal budget deficit that could run as high as $180 billion may send the cost of money surging once again by the end of the year. In testimony before Congress last week, Murray Weidenbaum, chairman of the Council of Economic Advisers, urged the lawmakers to reach a compromise with the President that would cut the deficit. That, he said, plus the decline in inflation, would bring down the cost of borrowing.

Since November 1980, the prime rate that banks charge for corporate loans has never gone lower than 15 1/2%, and it now hangs at 16 1/2%. Only a decade ago, by contrast, the prime was as low as 5%. Mortgage rates now range up to 17%, more than double what they were in 1972.

Developing theories to explain why interest rates remain so lofty has become one of the few growth industries in today's economy. Depending on which expert is talking, the responsibility for high interest rests with Reagan, the Federal Reserve Board, Congress, the banks, inflation or all of the above. No matter how convoluted the theories, though, they all revolve around a simple principle: interest rates, which are the price for borrowing money, are determined by the balance between the supply and the demand for credit.

The supply of money for loans comes from two main sources. The first is the savings that individuals, families and firms deposit with banks, insurance companies, pension funds or other financial institutions. The second source is the Federal Reserve Board, which has the job of expanding the total U.S. money supply to meet the needs of a growing economy.

In recent years, both the way people save and the way the Federal Reserve does its job have undergone radical changes that help explain what is happening to interest rates. A decade ago, the typical American saver was content to earn 4 1/2% or less in a passbook account, which was the maximum allowed by law. In the 1970s, double-digit inflation arrived, and the passbook account became a bad deal. Money quickly lost its purchasing power when it was saved at 4 1/2% interest while prices rose at a 10% clip.

As a result, savers began demanding higher returns. They flocked to new money-market mutual funds, which pooled deposits as small as $1,000 and paio out yields of up to 18%. To help banks anc savings and loan associations keep their deposits, the Government began loosening interest-rate regulations and allowing these institutions to offer accounts that paid higher interest. All this was bad news for borrowers; since banks and savings and loans suddenly had to pay much more for deposits), they had to charge much more for loans. Those 8% mortgages and car loans became as outdated as Ozzie and Harriet.

Corporations as well as individuals suffered. Up to then, companies had been financing new factories and equipment by issuing long-term bonds paying well under 10%. By the late '70s, however, the pension fund managers, insurance company executives and other moneymen who bought the bulk of the bonds began demanding interest of 15% or higher to make sure that the value of their investments was not eaten away by inflation. Not willing to pay 15% on a long-term basis, most companies turned to the banks for short-term loans.

Those explanations for high interest rates were understandable as long as inflation was unchecked, but they are less convincing now. Why have rates not responded to the good news on prices? The President told his eighth-grade audience that money managers fear that inflation will come roaring back. Says Harvard Professor Martin Feldstein: "After being burned for more than a decade, it's not surprising that these guys don't rush out and gamble on long-term bonds."

What causes these financial jitters is primarily the mammoth size of projected budget deficits. Experts now generally predict that the Government will run perhaps $500 billion in the red during the next four years. Investors are fearful that the Federal Reserve will be forced to accelerate its expansion of the money supply to meet the Government's borrowing needs and thus rekindle inflation.

The fear-of-inflation hypothesis is a good explanation for why long-term bond and mortgage rates are high. It does not fully explain, however, why banks are charging 16 1/2% on short-term loans, at a time when no one is predicting that inflation is about to reignite. Many analysts, ranging from Liberal Economist Charles Schultze of the Brookings Institution to Conservative Congressman Jack Kemp, argue that short-term rates are high in large part because the Federal Reserve is not providing enough money to the banks. Over the past month the money supply has been growing at an annual rate of 5.6%, which is at the upper end of the Reserve Board's target range of 2.5% to 5.5%. The critics contend that the targets must be raised if the economy is to recover fully.

The Federal Reserve has, in general, been stingy with the money supply ever since October 1979, when it abruptly changed operating procedures in an effort to halt inflation. Before that watershed date, the Reserve Board had expanded the money supply fast enough to keep interest rates from rising rapidly. When that policy proved inflationary, it shifted to a strategy of slowing money growth and letting interest rates move more freely.

A tight money supply, though, is only part of the puzzle. Some experts, including Felix Rohatyn, a partner in the Lazard Freres investment banking firm, argue that loan demand is still putting intense pressure on interest rates. While the high cost of money has discouraged mortgage seekers and auto buyers, corporations are still queuing up to borrow. The volume of commercial and industrial loans at large banks has risen at an annual rate of 22% in the past month.

Many companies are losing money so fast that they must borrow to pay salaries and other operating expenses. Some are taking out new loans merely to pay the interest on their old ones. Unable to issue long-term bonds, they are forced to rely month after month on short-term borrowing from banks at 16 1/3% or higher. Says Economist Allen Sinai of the Data Resources consulting firm: "The banks are keeping a number of big companies afloat. They are becoming captives to the corporations that are in financial trouble." Hundreds of small businesses, with no clout at the banks, are simply going bankrupt.

More loan demand comes from firms seeking cash to acquire other companies. Last year a record-breaking $73 billion was spent for big mergers and acquisitions. The pace of these deals has slowed a bit this year, but it is still going strong. ..

Construction companies are also heavy borrowers. Stuck with huge inventories of unsold houses and condominiums, they must take out ever larger loans to keep from going broke. At the same time, the governments of foreign countries like Brazil and Poland are asking for new credit on top of the billions they already owe U.S. banks. Most important of all, the U.S. Government borrows billions every month to finance its runaway deficits. All these loan demands taken together give a powerful boost to interest rates.

For every theoretical cause of high interest rates, there is a theoretical cure. Some of those proposals:

Lower Budget Deficits. Economists agree that Congress and the President must reach an accord to cut spending and raise taxes in 1983. Most analysts would like to see a deficit under $100 billion, instead of the $180 billion now projected. Says John Paulus of the Goldman, Sachs investment firm: "It's impossible to over estimate the aid and comfort that a budget compromise would give the financial markets." Even the hint of such a compromise last week sent , some short-term interest rates down slightly.

Easier Money. Though no one is advocating that the Federal Reserve flood the U.S. with money, many economists believe that Chairman Paul Volcker should be some what less rigid. "The Fed will have to ease up," says Edward Yardeni of the E.F. Hutton brokerage house. "Otherwise, we'll face the risk that this recession will turn into something uglier, a depression."

The House Banking Committee last week proposed a deal to Volcker. It suggested that if Congress trims the budget deficit, the chairman should speed up money growth. The drawback to such a policy change is that the Reserve Board might accidentally loosen too much, as it has several times in the past, and revive inflation expectations. That might result in higher, rather than lower, interest rates.

Credit Controls. Putting direct restrictions on the amount of credit that banks can extend and the types of loans they can make would be a last-resort solution. Most economists still oppose broad credit controls, but some moneymen favor at least a slight tightening of banking regulations. Henry Kaufman, an influential economist at the Salomon Bros, investment house, has called for a curtailment of some types of stand-by credit lines that banks offer large corporations.

Even bankers admit that loans for merger deals have gone out of control. Says an officer for one of New York's largest banks: "We're uncomfortable with merger and acquisition loans. One bank alone will not stop making them, and the law says we cannot conspire among ourselves to stop. But some kind of credit controls on these loans would be welcomed."

While the deepening recession and slower inflation should bring somewhat lower interest rates over the next few months, it is unlikely there will be a real break in the cost of loans. Irwin Kellner, chief economist at New York's Manufacturers Hanover Trust, predicts, for example, that the prime rate will dip to 14 3/4% by June, but then rebound to 16% in July. The days of a 5% prime or an 8% mortgage are probably gone for a long, long time.

-- Charles Alexander. Reported by Michael P. Harris and Adam Zagorin/New York

With reporting by Michael P. Harris, Adam Zagorin

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