Surging Up from the Depths

By Charles P. Alexander

TIME'S economists see strong growth but warn of lurking deficits

The economic recovery, which took off with a stunning leap in the spring and summer, has enough momentum to keep it going at least through 1984. Growth will slow a bit but stay strong, and inflation will remain moderate. The unemployment rate will gradually fall. That was the favorable forecast of TIME'S Board of Economists, which met last week in New York City. Said Otto Eckstein, chairman of Data Resources, a Lexington, Mass., economics consulting firm: "Once the economy starts going up, the forces of recovery are so automatic that forecasters can sleep nights. It is about the only time in the business cycle when they can."

The TIME board, though, feared the economy's vigor could lull Congress and the White House into ignoring a critical problem that will eventually threaten the recovery: the burgeoning federal budget deficit, which this year is expected to reach a record $209 billion. Created by a combination of large tax cuts and heavy Government spending, the deficit has given a powerful boost to consumers and helped lift the economy out of recession.

At the same time, however, federal borrowing has kept interest rates unusually high, weakened business investment and driven the value of the dollar to a level that has undermined the competitiveness of U.S. exports. While the economy seems much healthier in the short run, the budget gap may be causing long-term damage that will be difficult to undo. Observed Charles Schultze, a senior fellow at the Brookings Institution in Washington: "We could have a recovery for some period of time fueled by consumption and Government spending but with sluggish investment and exports. That is a miserable kind of recovery."

That concern was shared by Martin Feldstein, chairman of the President's Council of Economic Advisers and a guest at last week's meeting. Said he: "This recovery is very different from past upturns. The fact that more and more people are assuming that the Government will borrow $200 billion or more annually for the next three or four years is bound to keep interest rates and the dollar's exchange rate high. While the economy will most likely continue to grow through the next couple of years, the deficit is undoubtedly increasing the risk that the recovery will run out of steam." He warned that another slump might come as early as 1985.

For the next year or so, however, the recovery looks solid. TIME'S economists predicted that growth in the gross national product, after adjustment for inflation, would slow from its torrid 9.2% annual rate of the second quarter but still glide along at a healthy 4.4% pace in 1984. The unemployment rate is expected to drift downward from its current 9.5% level to 8.2% by the end of next year.

The Federal Reserve Board moved during the early summer to moderate the recovery because higher inflation remains a danger if the economy grows too fast. Concerned about rapid expansion of the money supply, the Reserve Board nudged interest rates up a notch. The benchmark prime rate that banks charge top corporate customers rose from 10.5% to 11%. Some members of the TIME board felt that the economy would have cooled off to a sustainable growth rate without the Fed's intervention. Said University of Minnesota Professor Walter Heller: "The Reserve Board tightened unnecessarily. It didn't make any sense."

The Fed's action may have been partly responsible for a 1.4% drop in retail sales in August, which was reported last week. Another indication of the slowing recovery was August's .9% growth in industrial production, the lowest increase since last February.

Nonetheless, Americans are spending at a fast enough pace to keep the recovery going. U.S.-built cars are still selling 20% faster than they were a year ago, and other signs point to a continuation of strong consumer demand. The Reserve Board reported last week that installment debt increased a record $4.84 billion in July. Said Eckstein: "There's not much in the mill to suggest that consumer confidence is going to take a dive."

Meanwhile, the outlook on inflation continues to be good. TIME'S board predicted that prices would rise 4.5% this year and 5.2% in 1984, far less than the 12.4% jump in 1980. Companies should be able to hold the line on prices because wage demands have slowed while worker productivity has begun to increase after stagnating during the recession. Another reason for optimism about inflation is the stability of oil prices. Said Heller: "There is no third oil shock anywhere in sight." James McKie, an economics professor at the University of Texas, agreed but added a caveat: "There was no second oil shock in sight before 1978 and no first oil shock in sight prior to 1973. The history of energy prices is a history of surprises."

Some inflationary pressure, though, could begin coming from food prices. The worst drought since the 1930s has devastated many crops, while at the same time the Government's Payment-in-Kind program has encouraged farmers to leave some fields idle. The Agriculture Department said last week that this year's corn crop would be 48% smaller than last year's. The price of corn has already gone up about 60% since January, a surge that will eventually boost the cost of meat from corn-fed livestock. Schultze said that food prices would rise more than 5% next year, adding .5% to what the inflation rate would otherwise be.

Despite the relatively bright outlook for prices, interest rates will continue to be a drag on the recovery. Eckstein pointed out that the real, or inflationadjusted, cost of borrowing money is four to five percentage points higher than the traditional level. One reason: investors and financial institutions are demanding more interest for their money because they fear that Government deficits will eventually force the Federal Reserve to expand the money supply enough to rekindle inflation. The Fed must chart a narrow course between providing too much money, which would fan inflation fears, and being too stingy, which might stall the recovery. As a result, TIME'S economists predicted, the prime rate will hover around its current 11% level through 1984. Said Alan Greenspan, an economic consultant in New York City and sometime adviser to President Reagan: "Interest rates are now essentially trendless."

Real rates have stayed higher in the U.S. than in many other industrial nations. Partly for that reason, legions of foreigners have been converting their money into dollars for investment in the U.S. In the process, they helped push the value of the dollar to new peaks on international exchange markets. Since 1980 it has surged 55% against the West German mark and 102% against the French franc. The rapid rise has made many American exports prohibitively expensive on world markets. As a result, Feldstein said, the U.S. merchandise trade deficit is likely to hit a record $60 billion to $70 billion this year, and may pass the $100 billion mark in 1984.

Such a large trade gap will put pressure on the dollar. Some forecasters have predicted a sudden collapse in its value, but TIME'S board believes that any decline is likely to be gradual, perhaps 4% to 5% over the next year. "The dollar is not headed for a free fall," said Heller, "but soon it should be gentling downward."

A substantial drop in interest rates and the dollar's exchange rate will not come, Feldstein said, unless Congress moves to pare the federal deficit. TIME'S economists agreed, however, that with an election year coming up, few politicians would be willing to lead a drive to slash spending or raise taxes. Predictably, the House voted last week to authorize an additional $1.6 billion for ten education and health programs in an effort to reverse some spending cuts made early in the Reagan Administration. House Speaker Tip O'Neill declared that any tax-hike initiative would have to come from the President or the Republican Party.

Feldstein argued at the TIME meeting that the White House had already laid out a plan to deal with the deficit in its January budget message and wanted to work with Congress. In addition to spending reductions, the President's proposal called for immediate enactment of contingency taxes that would start in fiscal 1986 and reduce that year's projected deficit by $46 billion. Feldstein said that if legislation were quickly passed ensuring that future deficits would come down, the financial markets would be reassured and interest rates would fall.

But Congress has so far refused to enact a tax increase that will not take effect for three years, while the President has ruled out a quicker hike. Moreover, many lawmakers want less defense spending, and more for social programs, than the White House proposed. The result: a budget gridlock. Observed Alice Rivlin, who left her post as director of the Congressional Budget Office last month and is now the head of economic studies for the Brookings Institution: "Congress believes the White House is not serious about raising taxes." Added Heller: "Congress cannot move until the President does, but he's got an Out to Lunch sign on his door until after the election."

The consequences of doing nothing about the deficit are ominous. Government borrowing will clash with the capital needs of private industry to keep interest rates high. The outcome may not be another recession but a continuation of what Feldstein called "the lopsided recovery," an expansion driven by consumption and Government spending that has an uneven impact on the economy and produces profound structural changes.

Basic manufacturing industries such as steel, machine tools and construction equipment, which depend on high levels of investment, will keep on suffering. "The really critical issue," said Greenspan, "is the decline in the capital-goods markets." The ratio of capital spending to consumption has dropped about 10% since 1979, and TIME'S economists feared that the investment rate may not return to prerecession levels. In that case, the U.S. would increasingly be living off its capital stock rather than adding to it.

As U.S. manufacturers continued to lose their competitive edge over foreign firms, the country would import more and more, while exporting less. Asked Eckstein: "What would the U.S. economy look like in ten years? We could have very successful financial and service sectors, bustling French restaurants, booming Manhattan real estate, but an industrial Midwest that would lag far behind, as the South did before World War II."

Such an imbalanced recovery may be worse than a new recession because the damage will be corrosive rather than acute. "Things may not get bad enough," said Schultze, "to force us to make them better." The vitality in some parts of the economy may overshadow the sickness in others. Warned Eckstein: "We could sail through the 1980s--and gradually wreck our economy." Thus while everything on the surface looks fine, a danger lurks in the deep. --By Charles P. Alexander This file is automatically generated by a robot program, so viewer discretion is required.