The economy vs. the fearmongers
Wall Street and the economy are on a collision course. And Leif Olsen, chief economist at Citibank, is convinced the economy is going to prevail -- that the current slowdown will force interest rates down.
Mr. Olsen says short-term rates of 11 or 12 percent by November or December, certainly by early next year, "would not be inappropriate with the economy."
Some fearmongers in the financial community have been saying repeatedly that interest rates will once more surge to new records -- say, 25 percent. They usually point to the prospect of an increased federal deficit as the cause for a crunch in the capital markets between debt financing and private demands for money.
Olsen, in a interview, maintained that such Wall Street economists have "fraudulently used economic theory" to buttress their position.
One reason for sounding alarmed is that some economists have found that, as Olsen put it, "The way to get attention is to frighten people. You don't get any attention by trying to cool things down, by being reasonable."
Another element in the financial community's pessimism is that many money managers and investment advisers have intellectual and portfolio positions to protect. It is costly and difficult for them to change investment strategies.
Here's some background. In the first half of 1980 there was an intense debate within financial firms as to the direction of inflation and interest rates. Then interest rates more than doubled between July and December, despite the economy's operating well below capacity, and the Federal Reserve was pursuing a highly expansionary monetary policy, pumping new money into the economy at a rapid rate.
"There is no near-term historical precedent for such a phenomenon," Olsen said.
What happened, apparently, is that those participating in the money market saw the loose monetary policy and figured either that the Fed would have to tighten up or that inflation would take off again. So they insisted on higher interest rates immediately. As a result, the pessimists on Wall Street obtained new status and power.
Now, with the economy weakening, inflation declining, and interest rates slipping, they grasp at any justification for their gloom. One such straw is the widely accepted myth that the federal deficit is both extremely large and inflationary.
Olsen cites statistics to show that deficits should not be "blindly feared." In 1980, for instance, the federal government's net borrowing, including off-budget financing, amounted to $79 billion. It accounted for 22 percent of total funds raised in the credit markets by all who borrowed or obtained equity money. This year the ratio will be 21 percent and next year, 16 percent.
These percentages are not large by historical standards. In 1953, the proportion was 25 percent and shortterm interest rates that year averaged 2.52 percent. In 1975 it was 42 percent and in 1976, 29 percent. In these two years interest rates declined sharply.
Nor are federal deficits large by comparison with the past or with other countries. The federal deficit as a percentage of the nation's total output of goods and services (gross national product, GNP) was 2.3 percent in 1980 and is expected to be 2 percent this year. If the average surplus position of state and local governments is included, the deficit of all governments as a proportion of GNP drops to 1.2 percent last year and 0.4 percent this year.
Those latter percentages are much smaller than the comparative ones last year for Japan (6.1 percent), West Germany (3.8 percent), and britain (6.4 percent). West Germany has an inflation rate of only 5.5 percent, but a slower money growth than the United States.
Said Mr. Olsen: "Deficits can hardly be used to predict inflation, interest rates, exchange rates, unemployment, or much of anything else."
By now, though, signs of economic slippage are multiplying.
Businessmen have taken their time to notice this. Perhaps that is because they saw the economy decline at a 10 percent annual rate in the second quarter of 1980, then rise at an extraordinary 10 percent annual rate in the first quarter of 1981. Business looked highly promising.
But the economy has been flat for eight or nine months now. For about 60 days, Olsen said, businessmen have been reassessing their position. They are recognizing the slowdown and wondering whether it is wise to pay such high interest rates for financing inventories, expanding capacity, or for other purposes.
The financial community remains blind, he adds.
Olsen does not expect long-term rates to come down as fast as short-term rates. The traditional buyers of longterm bonds have been so burned in the last few years by rising interest rates and drastic declines in the value of their bond portfolios that rates for an AA corporate bond may decline only from 17 percent or so now to 15 percent by next year. The long-term market "will take longer to heal and remedy," he said.
But if Olsen is right, many financial bears could soon find themselves run over by the economic slump.