Better Watch Out

By Richard Hornik

The life signs of the U.S. economy have been shaky for months, as if it had a mild case of the Shanghai flu. Inflation is drifting upward, while economic activity seems stuck in a quagmire of intense foreign competition and excessive debt. During the last quarter of 1989, the economy grew by only 0.5%, the slowest pace in three years. Warns Kazuaki Harada, chief economist of Japan's Sanwa Bank: "The real U.S. situation is worse than the growth-rate figures would indicate." Federal Reserve Board Chairman Alan Greenspan, whose finger is closest to the American economic pulse, thinks the current slump is probably only a "temporary hesitation" and believes the U.S. can avoid a recession. But as he told the Joint Economic Committee last week, "I wouldn't want to bet the ranch."

The possibility of a recession has become a red-hot topic in recent weeks, in part because so many indicators have been flashing alarms. U.S. industry is operating at 82.5% capacity, the lowest in two years. Construction spending is at the slowest pace since the 1981-82 recession, corporate profits are declining, and the U.S. auto industry has already entered a recession of its own.

Consumers, whose spending represents two-thirds of the economy, generally think the U.S. will steer clear of a recession in the next twelve months. In a poll for TIME/CNN by Yankelovich Clancy Shulman, 60% of those surveyed think a 1990 recession is unlikely, vs. 32% who believe one is probable. Yet consumers have no great expectations of resurgent U.S. growth this year: 64% think conditions will stay the same, while only 14% see an improvement, and 20% expect things to get worse. One concern is unemployment: 60% of those polled think U.S. joblessness, which remained at 5.3% in December and January, is likely to grow this year.

A 1990 recession could be deep and painful. Most economists agree that the record borrowing binge of the 1980s has left the U.S. economy's private sector singularly unprepared for tough times. Worse still, the Government's fiscal profligacy in those years has drained it of any reserves that could be used to counter recessionary forces. In the postwar era, the most commonly prescribed medicine for an economic downturn has been fiscal stimulation. But persistently high federal deficits, even during periods of robust economic growth, have taken that option off the shelf. Some economists fear that if a recession does strike, Washington could succumb to policy paralysis.

The slowdown is already undermining the credibility of the Bush Administration's first full-fledged budget, which calls for expenditures of $1.23 trillion in fiscal 1991. Budget Director Richard Darman was able to squeeze under the Gramm-Rudman-Hollings deficit target of $64 billion but only by using assumptions that call for a quick rebound in economic growth, coupled with a rapid descent of interest rates. Many economists view that combination as highly implausible. While the Administration predicts economic growth of 2.6% in 1990 and 3.3% in 1991, the blue-chip survey of 51 economists puts the figures at 1.7% and 2.2%.

If the economy grows more slowly than the Administration predicts or, in the event of a recession, actually shrinks, the budget deficit will balloon because of declining tax revenues. Congressional Budget Office projections, which match those of most economists, indicate that this year's budget-cutting exercise will be twice as difficult as the Administration contends. The CBO says $74 billion in spending cuts and revenue increases will be needed to hit the GRH target, while the Office of Management and Budget puts the number at only $36 billion. Says Leon Panetta, House Budget Committee chairman: "This discrepancy in the figures presents Congress with a terrible political and legislative dilemma. Do we raise taxes and cut programs or all get optimistic together?"

As in the past, Congress is likely to take the latter course, joining the Executive Branch in dodging its fiscal responsibility. This year the economy's weakness may provide the excuse for postponing action on the deficit, since spending cuts could aggravate the slowdown. Unfortunately, a decade of annual budget deficits of more than $100 billion has shifted the burden of controlling the economy almost completely to the Federal Reserve Board. "The problem is that we have only monetary policy to rely on," says Lyle Gramley, chief economist for the Mortgage Bankers Association and a former Fed governor. "It would be wonderful if we had a $100 billion budget surplus, so that we could have a small tax cut to stimulate the economy instead of having to rely on interest rates."

Bush hopes to spur investment by cutting the tax on capital gains, but 50% of adults surveyed in the TIME/CNN poll oppose the idea, vs. 36% who favor it. The President's proposed Family Savings Accounts would be more popular: 72% of those surveyed are in favor of giving savers the incentive of tax-free interest on deposits. But consumers doubt that they will get any tax breaks this year. Most of those polled expect levies to go up (51%) or stay the same (43%).

The only remaining stimulus is interest rates, yet the Fed is of no mind to lower them just now, Greenspan said last week. The high deficits, coupled with a low rate of savings in the U.S., are forcing the Fed to keep interest rates up in order to attract foreign money to finance new federal borrowing. Greenspan faces domestic pressures as well. Because inflation has remained at a persistent 4% or more, the Fed has been hesitant to pump more money into the economy, even though it is slowing. For the most part, Greenspan has struck a delicate balance. Yet the word stagflation, last heard in the 1970s, is being revived to describe the current potential for no-growth inflation.

Greenspan's challenges will increase in the coming year. Aside from a softening economy, the shape of finance and credit in the U.S. is changing. More than a decade of ever loosening regulation of credit terms and conditions led first to financial debacles in savings-and-loan associations and currently to widespread concern about the health of many banks in general. Says Robert Litan, a senior fellow at Brookings Institution: "One could make the case that our banking system is more fragile now than at any time before a recession."

Because federal agencies have begun to reassert regulatory control over the past two years, credit terms are tightening up. The Government has required banks to boost their ratio of equity to total outstanding loans, so that institutions will have more of their own holdings at risk. As a result, banks are being more careful about making loans and borrowers are finding it harder to get credit.

Potentially more worrisome is a different kind of credit contraction, a cyclical one. In the gaga '80s, lenders used practically every debt instrument imaginable. Junk bonds were issued in an almost endless variety of complex forms. The consumer got into the act as well. Home-equity loans and lines of credit, which are basically latter-day relatives of the second mortgages that led to so many foreclosures in the 1930s, rose from $20 billion in 1985 to $75 billion in 1988. At the same time, creditors lengthened maturities. The average auto loan is now payable over 48 months, up from 36 in 1982. Says James Grant, editor of Grant's Interest Rate Observer: "The 1980s were to debt what the 1960s were to sex."

The excesses of the 1980s left both borrowers and creditors "loaned up." As a whole, the country's total outstanding debt is more than 180% of the GNP, almost a third higher than the postwar average. Consumer debt totals some $4.3 trillion, with total business debt about half that. Banks traditionally limited the sum of their loans to about 55% of assets and invested the remainder in government bonds and low-risk corporate instruments. But those loans now make up uncomfortably close to 70% of assets. Today both sides of the credit equation are less willing to take a chance: the debtor doubts that the money he borrows to invest will pay off in higher profits, while the lender is dubious about the borrower's ability to repay.

The decline in that sort of mutual confidence is a sign of a contracting economy. Says Carl Steidtmann, chief economist for Management Horizons, a retailing research firm: "The consumer looks at his own situation and feels somewhat ill at ease, slows down his accumulation of debt and steps up his savings rate." Businesses, which try to gauge the confidence and appetites of ( their customers, currently see very little to like. As a result, business borrowing is growing at a slower pace than at any other time during the past decade.

Even if the eight-year-long Reagan recovery limps through 1990, credit contraction and stagflation will leave many casualties. The most exposed sector is corporate America, particularly its most leveraged members. The Bush budget assumes that pretax corporate profits this year will rise almost 20%, to $360 billion. But forecasters like M. Kathryn Eickhoff, a former colleague of Greenspan's, think profits will stagnate at best. Says she: "These conditions will mean a real squeeze on the restructuring plans of highly leveraged companies." The net effect: many highly leveraged firms will find it difficult to make their interest payments.

These second- and third-generation effects are difficult to measure and almost impossible to predict. But the ripples do spread: tight credit combined with a lagging economy could increase the number of people who lose their jobs, which in turn would boost the number of personal bankruptcies and mortgage foreclosures. That will put more pressure on weak financial institutions and create new demands on the federal budget. The bailout of the thrift industry, expected to cost $300 billion, could certainly rise further if property values continue to drop. The problems of commercial banks, which so far have been limited to regional downturns in the Southwest and the Northeast, could spread. Says banking expert Litan: "Even a mild recession would wipe out the $14 billion in reserves of the FDIC."

In one of the franker elements of his introduction to this year's budget proposal, Darman pointed to a number of other potential problem areas, or Hidden Pac-Men, as he called them. On the financial side they include:

-- Over $1 trillion in outstanding loans and loan guarantees of federal credit programs, including the Farmers Home Administration (FHA) and the Government National Mortgage Association (Ginnie Mae). Darman concedes that future claims against these programs will be in the "tens of billions of dollars" and would be "substantially higher" without continued economic growth.

-- More than $4 trillion in coverage through federal insurance programs, like FDIC, for crops, disaster relief and pension funds. Federal insurance of private pension funds covers $800 billion in assets, yet by one estimate its liabilities already exceed its funds by $17 billion.

In short, neither the public nor the private sector can afford a recession now. Although the U.S. has had its longest peacetime expansion in history, America failed to save for a rainy day. The storm clouds first appeared on the horizon more than two years ago, when the S&L industry collapsed. The Government had a window of opportunity to begin getting its fiscal house in order, particularly with the arrival of the Bush Administration, but the President's no-new-taxes pledge has made it impossible for him to reach meaningful compromises with Congress on deficit reduction.

What can be done, then, to revivify the stagnating American economy? Some economists think the U.S. may find help overseas. The economies of Japan and West Germany are robust, and new markets in Asia and Eastern Europe could provide ready outlets for U.S. exports. C. Fred Bergsten, director of the Institute of International Economics, believes the U.S. could have an export- led recovery if the dollar were devalued quickly through a concerted effort of America's major trading partners. A cheaper dollar might be somewhat inflationary, but the sluggish economy's low level of demand would dampen that effect. Such a move would also enable the Fed to worry less about keeping up interest rates to defend the dollar's strength. If the strategy were successful, the Administration's optimistic scenario might come true and give the U.S. another chance to start whittling away at its mountain of debt. In that case, American debtors should seize the opportunity, because they may not get another chance.

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CREDIT: TIME Charts by Joe Lertola

CAPTION: SHADES OF DIFFERENCE

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CREDIT: TIME Charts by Joe Lertola

CAPTION: HOW AMERICANS SEE IT

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CREDIT: TIME Charts by Joe Lertola

CAPTION: BUDGET HIGHLIGHTS

With reporting by Barry Hillenbrand/Tokyo, Wiliam McWhirter/Chicago and Nancy Traver/Washington