Knitting New Notions

By John Greenwald

"I was in search of a one-armed economist so that the guy could never make a statement and then say: 'On the other hand . . .' "

-- HARRY TRUMAN

Ronald Reagan was luckier. He discovered a passel of single-minded, if not exactly single-armed, economists who called themselves supply-siders. They promised Reagan that he could cut taxes, rebuild U.S. military might and reduce the budget deficit, all at the same time. While the President eagerly followed the script, the deficit forgot its lines. Instead of shrinking each year, it added $1.3 trillion to the U.S. national debt during Reagan's two terms, more than doubling the total burden.

When George Bush became President last week, he inherited that mountainous load, along with a 74-month economic boom, the longest peacetime expansion in the modern era. Bush, who once ridiculed Reagan's policies as "voodoo economics," must now confront both sides of the Reaganomics legacy. In doing so, he will turn for economic advice to a profession that is struggling to find new ways of understanding the unprecedented boom-and-borrow cycle of the past eight years.

Frustrated by repeated failures to forecast accurately and wearied by years of feuding, economists are moving toward a more eclectic yet pragmatic ^ philosophy. Going out the window are the overly rigid, dogmatic formulas for prosperity. Many academics are attacking their peers for getting so wrapped up in mathematical models that they cannot understand the unpredictable diversity of the real world. "We have learned that the various schools of thought all have important elements of truth in them," says Michael Boskin, designated chairman of the President's Council of Economic Advisers. "But none of them is by itself a sufficient explanation of what goes on in the economy."

Like Boskin, economists of every stripe are grappling with the far- reaching changes that have swept the U.S. during the 1980s. Among them: the growing transformation of the world into a single, global marketplace in which the U.S. is just one player; the frightening decline of American competitiveness, which has helped turn the country into the world's biggest debtor; the runaway growth of U.S. service industries, which has made productivity and other important measures of the economy increasingly slippery to calculate.

A disturbing sign of the new times popped up last week, when the Government reported that the U.S. trade deficit surged in November to $12.5 billion, up from $10.3 billion the previous month. The stalled progress in narrowing the trade gap brings into question a central assumption of U.S. trade strategy: that the weak dollar will continue to shrink the deficit by making U.S. exports cheaper overseas and imported goods more expensive for American shoppers. But U.S. imports just keep on rising. That partly reflects what some economists have begun to call "hysteresis" -- a fancy term for the notion that new habits, like old ones, are hard to break. Americans have learned to love Japanese cars, TVs and videocassette recorders, and are reluctant to give them up, regardless of price.

Even before the figures came out, a Japanese official warned the U.S. against weakening the dollar as a trade-gap remedy. Makoto Utsumi, a senior executive in the Finance Ministry, declared that a further fall of the dollar against the yen would not close the trade gap because Japanese firms would lay off workers and take other steps to remain competitive. A cheaper dollar, said Utsumi, would simply "make America for sale."

Stanford economist Ronald McKinnon, an expert on foreign trade and finance, concurred with that view. "A declining dollar is nothing more than a reflection of an easy-money policy," said he, adding that the excess of Government borrowing and spending increases U.S. demand for imported goods. At the same time, currencies that are strong in relation to the dollar have made American farms, factories and real estate tempting to foreign buyers, says McKinnon, "so we conduct something of a fire sale" to pay for imported merchandise.

On Wall Street one new breed of economists looks at the same unexpected events and comes up with a rosier outlook on how the world works. In this view, the U.S. has entered an era of prosperity called the New Wave. "We are in one of the most revolutionary periods in our history," says Sam Nakagama, chairman of Nakagama & Wallace, an economic consulting firm in Manhattan. Nakagama and other New Wave advocates say the record expansion owes its strength and resilience to the openness of the U.S. economy during the past decade. With the global village linked by high-speed computers and communications satellites, they argue, U.S. executives easily hurdle obstacles like rising domestic interest rates by borrowing from other countries. In the same way, American manufacturers can escape high labor costs by opening factories abroad to add new capacity.

New Wavers insist that this flexibility has all but abolished the traditional business cycle. While they acknowledge that slumps can still strike certain weak industries, they regard broad downturns as largely a thing of the past. Says Edward Yardeni, chief economist for Prudential-Bache Securities: "The economy is now so huge, so diverse and resilient that adjustments take place that prevent economy-wide recessions."

Such new scenarios have arisen largely because real events so often confounded the old ones. Supply-siders, for instance, boasted that their policies would boost the U.S. savings rate and make Americans more productive. But, like the supply-side forecasts of smaller deficits, both promises failed to come true. The personal savings rate fell from 7.1% in 1980 to about 4% last year. At the same time, the growth of business productivity, or output per hour, averaged a meager 1.4% from 1980 to 1987, half the rate of the 1960s. Reason: the savings decline slowed investments in productive new equipment.

Reagan's proudest economic achievement, taming the inflation rate from 12.5% in 1980 to 4.4% last year, has also dealt a blow to some major schools of thought. Monetarists like Nobel laureate Milton Friedman, who believe that slow and steady growth of the money supply is the key to prosperity, expected inflation to shoot up when the Federal Reserve suddenly pumped cash into the economy to halt the recession of 1981-82. But inflation failed to ignite because the slump was so deep that it left the economy with plenty of room to grow without pushing up prices.

Members of the rational-expectations school, which holds that people keep a sharp eye on government policies and then act accordingly, were also caught short by inflation's fall. "If you had listened to me eight years ago," says University of Chicago economist Robert Lucas, "I would have predicted an inflation rate of 25% with these deficits."

Economists would have been less surprised if they had paid more careful attention to changes in the U.S. and world economies. The deregulation of foreign capital markets in the late 1970s and early 1980s enabled the U.S. to go on a global borrowing binge that counteracted the effects of the deficit.

"Ten years ago, there weren't that many people we could borrow money from," notes Harvard's Jeffrey Sachs, a leading international economist. "We were reluctant to run deficits out of fear of creating sky-high inflation. Now there is a global bank-teller window that is open 24 hours a day, and we've been one of the most frequent customers." Sachs warns, however, that the bender cannot last. "We're faking it," he says. "Our living standard isn't being maintained by higher productivity or wages. It's maintained by foreign capital."

That concern is echoed by resurgent Keynesian economists, who are trying to adapt their mostly liberal views to current conditions. Virtually counted out when inflation surged along with unemployment in the 1970s, the Keynesians now point out that Reagan borrowed from their philosophy in propelling his economic boom with deficit spending, which Keynesians have long advocated as a cure for slumps. "Keynesianism was vindicated by these last eight years," says Princeton economist Alan Blinder, a leading exponent of the school of thought. Blinder insists, however, that the deficits have got far out of hand.

While economists may be more open to peaceful coexistence, they still tend to form battle lines over the importance of the budget deficits. Some economists contend that the deficit is no longer a menace because it has shrunk from more than 6% of the gross national product in 1983 to about 3% right now. That is lower than the level of deficit spending during 1975-76, for example, when the gap was widened by a recession. Friedman says he accepts the deficit because it has restrained federal spending. "Sometimes you have to choose the lesser of two evils," he says. While Friedman admits that "mine is not the majority view," he adds, "Everybody looks at the world through his own glasses, and those glasses mean more than the facts you are looking at."

Many economists have been staring through a veil of mathematics that can further distort what they see. "Economics research has become more a game of chess than a search for understanding reality," says economist David Colander of Middlebury College in Vermont. Colander and Arjo Klamer, a visiting professor at the University of Iowa, surveyed more than 200 graduate students at six top economics departments. When the students were asked what it took to advance rapidly in the economics profession, an astonishing 68% said "a thorough knowledge of the economy" was unimportant. At the same time, 57% picked "excellence in mathematics" as the key to success. Said a bemused student: "You can walk in off the street and take the courses, and not know what the FORTUNE 500 is, and blaze through with flying colors."

But many economists are not content to fiddle with mathematical models. They want to understand the FORTUNE 500 corporations and the rest of the economy, in all its messy and ever changing complexity. That calls for using common sense as well as elegant formulas, and studying social and technological trends along with historical data. Writing about Adam Smith and other great economists, author Robert Heilbroner called them "worldly philosophers" who were "fascinated by the world about them" and "absorbed in the behavior of their fellow man."

Modern worldly philosophers are needed in George Bush's Washington and everywhere else that economic decisions are made. They can provide what Donald McCloskey, a University of Iowa economic historian, calls "reality checks -- statements of what may happen as a result of policies." Such statements may not be the single-minded advice that Harry Truman longed for. But they will at least be grounded in the real world rather than in the airy realms of abstract mathematics and wishful thinking.

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CREDIT: TIME Chart

CAPTION: TWO POINTS OF VIEW

With reporting by Richard Hornik/Washington and Thomas McCarroll/New York