Looking The Other Way

By Stephen Koepp

At first the strategy was purely a matter of debate and speculation. It was the question of the decade. What would the Government do to prevent Black Monday from turning into Bleak '88? Now, less than a month after the stock- market crash, the Reagan Administration's plan has emerged in sharp relief. The main objective: avoid a 1988 recession at almost any cost. That means encouraging the Federal Reserve to pour money into the economy and reduce interest rates. But in doing so, the Administration has had to make a sacrifice, the U.S. dollar. Treasury Secretary James Baker, the chief architect of the plan, maintains that any additional attempt to prop up the dollar with relatively high interest rates could choke the economy and further devastate the stock market.

Yet to allow an already weak dollar to fall still further, even though most economists agree it is inevitable, is a dangerous move that will carry a whole new set of economic risks. In the short run, a dollar lacking firm U.S. support could spin out of control; over the longer haul, its eroded purchasing power could reignite inflation. In an interview last week with the Wall Street Journal in which he acknowledged the new policy and sent the dollar plunging to new lows, Baker said, "I don't think we're out of the woods yet. I think markets are still fragile."

To shore up the markets and keep the dollar from diving too far, the Administration must achieve two other goals of its complex strategy -- a major budget-deficit reduction and better economic-policy coordination with West Germany and Japan. On those two fronts came small but potentially significant victories last week. Congressional leaders and Administration officials reached an apparent breakthrough in their special deficit-cutting summit, in which they have been struggling for two weeks to compromise on a minimum of $23 billion in reductions. For the first time, Republican leaders came up with a proposal containing tax increases that President Reagan gave hints he might accept. It was, declared Republican Congressman Trent Lott of Mississippi, a "bold stroke. Fair, simple, direct."

Meanwhile, the Administration won at least a symbolic victory in its efforts to persuade West Germany to spur its economy. The standoff between Baker and his West German counterpart, Finance Minister Gerhard Stoltenberg, eased slightly, aided by an announcement from the German central bank that it would cut two of its less important interest rates. If Bonn were to follow up * on that step and reduce its prime interest rates, there would be less pressure on the dollar. Reason: the greenback has been declining because U.S. interest rates have lately been falling in comparison with those of West Germany and other countries. Moreover, lower interest rates could stimulate Germany's appetite for American products and thus help reduce the troublesome U.S. trade deficit.

Surprisingly, the dollar's dip did not unduly upset Wall Street, where the wild swings of recent weeks moderated considerably. The stock market seemed relieved that the Government would not defend the dollar with higher interest rates. Indeed, the new accommodative posture of the Federal Reserve enabled major banks last week to reduce their prime lending rate by a quarter of a percentage point, to 8.75%, a full point lower than the pre-crash level at some institutions. While the Dow Jones industrial stock average fell 34.48 points during the week, to close at 1959.05, its newfound stability seemed to give reassurance to investors.

The currency markets, by contrast, were chaotic. The dollar plummeted as low as 134.4 yen during Tokyo trading Friday, the U.S. currency's lowest level of the postwar era. The dollar has now fallen more than 5% vs. the yen since mid-October and fully 48% from its peak in February 1985. Against the West German mark, the dollar reached a historic low of 1.67, a 46% fall during the past 2 1/2 years.

The plunge raised immediate, anxious questions: How far would the dollar drop? What forces would eventually stop its fall? While most economists believe the currency must decline at least a further 10% to help ease the trade deficit, they are concerned that the descent may be difficult to control. Said a former Treasury official: "Baker is playing high-stakes Texas poker." Says Economist Charles Schultze of the Brookings Institution: "We do not get a stable dollar by snapping our fingers. We are playing a very chancy game."

It may be the only game in town. Virtually everyone concurs that the Fed's pouring of liquidity into the marketplace is the best short-term tonic for preventing the stock-market crash from turning into a general economic slump. In fact, many economists blame Fed Chairman Alan Greenspan for helping set the stage for Black Monday by tightening up in the first place, when he led the board in a decision in September to raise the so-called discount rate, which the Fed charges on loans to financial institutions, from 5.5% to 6%. At the $ time, the Reserve Board was aiming to quash inflationary pressures that it sensed were creeping up.

Once the crash occurred, however, Greenspan promptly changed course. "He managed to turn on a dime," says Jerry Jasinowski, chief economist for the National Association of Manufacturers. Greenspan's switch in policy may have been even more wrenching than it appeared, because it represented an abrupt departure from a tighter-money direction endorsed in March by his revered predecessor as Fed chairman, Paul Volcker. Says Steven Roberts, former assistant to Volcker and now an economist for the accounting firm of Peat Marwick: "Comparing Greenspan to Volcker is natural but misguided. Volcker had spent most of his career as a central banker. Greenspan has to learn what it means to be a central banker, and he is doing quite well."

Greenspan's lot may be even tougher than Volcker's was. The new chairman must fend off a recession by keeping interest rates low, but he will come under excruciating pressure to raise them again if the dollar needs rescuing. Any little upward nudge in interest rates, however, is likely to send the stock market into the tank again. When the Fed's open market committee met last week for the first time since the crash, some economists hoped the group might rescind September's discount-rate increase. But no such announcement came. One reason may be that the committee has too little information so far about Black Monday's effect on the economy. Without solid proof that growth is imperiled, the Fed is probably reluctant to announce a dollar-endangering drop in the discount rate.

One survey of 35 economists last week predicted that the economy will expand at a humdrum 2.8% annual rate during the last half of 1987 and a sluggish 1.4% in the first half of 1988. While that is a definite slowdown, it is not quite a dead halt. A few economists, however, predict a recession. Among them is Irwin Kellner, chief economist for Manufacturers Hanover, the New York City banking company, who thinks the U.S. economy will shrink by 2% in the first half of 1988 before quickly recovering.

Economists have kept a sharp eye on consumers to see whether they have become cautious and tightfisted, but the evidence so far is hazy. Last week domestic automakers reported a brisk 10.8% increase in passenger-vehicle sales during the last ten days of October, compared with the same period last year. Those customers, however, may be people who had already intended to buy a car * and went ahead with those plans in spite of Black Monday. Many car dealers now say business is slowing by as much as 30%. Major retailers, who released October sales figures last week, mostly say business has proceeded at the same sluggish pace they were experiencing before the crash. Sears, for example, reported that October sales were up 1% from the same month in 1986, an increase that did not keep pace with the current 5% rate of inflation. Last week the Labor Department reported that the unemployment rate during October inched upward to 6% from September's 5.9%, which supported contentions that the economy has slowed only slightly.

Polls seem to show that consumers are worried, but not enough to change their buying behavior very much. In a telephone survey of 800 adults conducted last week for E.F. Hutton by the polling firm Yankelovich Clancy Shulman, 66% of consumers said they were "more concerned about the economy" in the wake of recent financial turbulence. But only 36% said they were more likely to hold off making major purchases. In another survey, in which the New York Times polled 1,549 adults from Oct. 29 through Nov. 3, fully 52% of those interviewed said they thought the economy was in either very good or fairly good shape.

Like the rest of America, politicians in Washington seemed less likely to change their behavior patterns as memories of Black Monday drifted away. When congressional and Administration leaders opened their second week of emergency budget-cutting meetings last week, their post-crash burst of bipartisan magnanimity was on the wane. "The worst thing for the summit is stock-market stability. It takes the pressure off," says Economist Schultze.

In fact, the apparent slowdown in the process started to rankle foreign leaders, who fear that a U.S. recession would be contagious. British Prime Minister Margaret Thatcher sent Reagan a personal letter, urging him to take swift action in the budget summit. A story in the London Evening Standard carried the headline YANKEE DOODLE DITHERERS.

The budget talks seemed to trip on party lines as soon as the 15 delegates began to discuss particulars. With good reason. The politicians are getting no clear mandate from their constituents. In a Los Angeles Times poll of 2,463 adults, 69% of those interviewed agreed that the budget deficit is a serious problem, but an almost equal number, 64%, opposed raising taxes to close it. Moreover, they offered little guidance on how to trim spending. Only 32% wanted to reduce defense outlays, and just 23% approved cutbacks in domestic programs.

Each day the summiteers seemed to grow gloomier as they emerged from their secret sessions in Room H-137 of the Capitol, where they huddled over blue tablecloths and scribbled their estimates on yellow legal pads. The President caught flak from Democrats for his alleged failure to get involved in the process, but on Friday he stepped in. Meeting at the White House with Republican leaders, he lent tacit support to a proposal by House Minority Leader Robert Michel of Illinois that would cut the deficit by $30 billion next year and $45.5 billion in 1989.

Reagan's encouragement was notable because the plan carries mild doses of the two things he abhors: tax increases ($8 billion in fiscal 1988) and defense cuts ($13 billion below the Administration's proposed budget). But those ingredients increase the proposal's palatability for Democrats. "It's a strong contribution. I'm optimistic," said William Gray of Pennsylvania, chairman of the House Budget Committee. The committee's deadline for agreeing on a plan is Nov. 20, when $23 billion in arbitrary cuts, split roughly fifty- fifty between defense and domestic programs, would go into effect under the Gramm-Rudman law.

The Administration achieved a different sort of cooperation earlier in the week, when the West German central bank announced it would, among other things, cut its so-called Lombard rate, which it charges on loans to other German banks, from 5% to 4.5%. While mostly symbolic, that interest-rate cut is the first tiny concession in months to increasing U.S. pressure on the Germans to allow their economy to expand more rapidly. But Germany will have to make much broader cuts in interest rates to bring about a significant acceleration of growth.

Faster growth in both West Germany and Japan is essential if the U.S. is to curb its trade deficit, which reached $156 billion last year. But while Japan has agreed to cut taxes and interest rates and to boost domestic spending, West Germany, which posted a $52 billion trade surplus last year, has been less cooperative. Says an irate European central-bank official: "The Germans are becoming unbearably smug about their economic performance. It's not just the Americans who are getting angry. I think we are all mad at them, especially the French."

The West Germans are reluctant to push their economic growth, which is expected to be only 2% next year, because of a deeply ingrained memory of the hyperinflation the country experienced in the 1920s. Says West German Economist Dieter Mertens: "Inflation is regarded by most Germans as on a par with Communist domination and morally equivalent to the work of the devil." Even a rate of 3% or 4% is unacceptably high to Finance Minister Stoltenberg, whose resistance to foreign prodding has earned him the nickname "Ice Prince" among U.S. economic officials. The 59-year-old, white-haired Stoltenberg, the son of a Protestant pastor, is revered in West Germany for his fiscal rectitude, which enabled him to reduce the country's budget deficit by nearly a third, to $13.1 billion, in five years. Says a West German economist, speaking for the population at large: "Beneath everything, we are all Stoltenbergs."

What may finally have persuaded the Finance Minister to make at least a mild concession on interest rates was the beating that German exporters are taking because of the rise of the mark against the dollar, which makes their products more expensive in the U.S. In an interview last week, Stoltenberg told a West German newspaper, "We now want to cooperate again constructively." One eventual outcome could be a meeting among the finance ministers of the seven major industrial democracies, the so-called G-7 group, to work out a plan to support the dollar at its new, lower level. Indeed, right now the battered currency could use a little help from its friends.

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CREDIT: TIME Chart by Nigel Holmes

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DESCRIPTION: U.S. dollar vs. Japan's yen and West Germany's mark. Color illustration: Uncle Sam, turning his back on the dollar, reads Stock reports in newspaper.

With reporting by Rosemary Byrnes/Washington and William McWhirter/Bonn