How Greenspan might fight fiscal fires

By , Staff writer of The Christian Science Monitor

In less than two weeks, Alan Greenspan will be chairman of the Federal Reserve Board - a job described as the second most powerful in the world. A tall order. The legacy of outgoing chairman Paul Volcker is one of an inflation-fighter extraordinaire. Even if Mr. Volcker weren't 6 feet, 7, these would be large shoes to fill.

Among Mr. Greenspan's challenges: keeping an economic expansion, considered by many to be rather aged at 57 months, on track; keeping inflation under control; taming the twin deficits (trade and budget); controlling a pugnaciously independent American dollar.

Complicating life will be fluctuating oil prices, a five-year-old bull market in stocks, and a bond market of uncertain strength. And there's the presidential election in November 1988.

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In Senate confirmation hearings last week, Greenspan quite properly vowed not to succumb to political pressures and sounded very Volckeresque in his anti-inflation tenor.

But Alan Greenspan isn't Paul Volcker. His response to challenges within and without the Fed will be uniquely his. The Monitor asked three Fed-watchers to speculate on the reaction of Greenspan and the financial markets to three hypothetical events in the months ahead.

Scenario 1: The dollar is in a free fall (an inflationary event) while the economy is threatening to slip into a recession. Presidential elections are just six months away. Does Greenspan tighten the money supply to stop the dollar's fall, yet risk recession, or loosen to stimulate the economy?

``He would ease, slowly,'' says Brian Fabbri, chief economist and investment strategist at Thomson McKinnon Securities. ``He's already said the dollar could go lower. The economy would be his most pressing concern.'' Mr. Fabbri believes Greenspan would nudge the economy, then tighten quickly to keep inflation controlled. Short-term interest rates would slip, long rates might rise a bit. Stocks: flat to lower.

Merrill Lynch's chief investment strategist, Charles I. Clough Jr., basically agrees. ``If the Fed strongly believed a recession was upon us, it would err on the side of easing and worry about the dollar later.''

But Michael H. Cosgrove, head of the Houston-based Econoclast economic advisory service, thinks otherwise. ``He's going to tighten to stabilize the dollar. The stock market, sensing recession, would react negatively. The bond market, expecting recession and eventual lower rates, would react positively.''

Mr. Cosgrove, who is also a University of Dallas professor, says Greenspan will be evaluated, as Volcker was, on his inflation-fighting prowess, not on whether he caused a recession or kept the Republicans in office. ``Even though he caused two recessions, Volcker is a semi-hero because he kept inflation down. The pattern for the job has been set. If Greenspan keeps inflation down, he'll go out as someone who has done a good job.''

Scenario 2: The economy is sluggish but not immobile. The dollar is relatively stable. Suddenly, the Strait of Hormuz is blocked by a bed of Iranian mines. Oil shoots to $30 a barrel.

Mr. Clough at Merrill Lynch says bonds would slide on inflation concerns. But major stock market indexes might go nowhere. ``We've got two stock markets now,'' he explains. ``The financial and consumer stocks are in a bear market. The industrials are emerging from a seven-year downtrend. That divergence would be exacerbated by closing the Strait of Hormuz.''

Clough believes the Fed would sit back and not react to the petrol price increase. ``Clearly the Fed response to the oil embargo in 1973 was the wrong one,'' he says. The Fed eased on concerns that money normally used for other purchases would be used up in energy payments, thus halting the economy. Instead, inflation shot up.

In 1979, another oil shortage prompted easing again. ``Gold shot up to $800 an ounce before cooler heads prevailed and they tightened,'' Clough recalls. ``This time around they'll be smarter.''

Cosgrove at Econoclast also views higher oil prices as a short-term event. Both the Fed and markets would ``do very little.''

But Fabbri at Thomson McKinnon figures the Fed would ease. He reasons that the dollar would strengthen against the yen, since Japan is more dependent on Persian Gulf oil. ``The Fed wouldn't want to see the dollar appreciate after pushing it down for two years,'' Fabbri says.

Scenario 3: Radicals gain control of the Brazilian government and renege on all of Brazil's $108 billion foreign debt. The response to this banking crisis?

``You'd see a liquidity buildup in the bond market as everybody rushed for the safety of Treasury securities,'' says Fabbri. Money-center bank stocks would tumble. The Fed has ``got to ease to protect the banking system.''

All agree the Fed would ease here, ``even if it was inflationary,'' says Cosgrove. But Clough says it would be a short easing. ``This [default] would not be a big deal now. Brazil has already suspended interest payments. The banks have already written off 25 percent of their Latin American loans, which are selling at about 54 cents to the dollar anyway.''

Of the three scenarios, Fabbri, who forecasts a sluggish economy, gives the first the highest probability of occurring. Clough expects ``we might get a little of all of the above.'' He predicts that a weaker dollar and real price increases in the rebounding industrial sector will trigger unexpectedly high inflation. Cosgrove predicts a lower marginal tax rate in 1988 (which will cause spending in late 1987 to be deferred), coupled with the possibility of a tax increase in 1989 to produce a strong 1989 economy.

Strange as it may seem, none of these prognosticators expressed a willingness to swap jobs with Mr. Greenspan.

For the record, the Dow Jones industrial average closed a lackluster week at 2,485.33. This was down 24.71 points in five days.

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