The Hesitant Recession

TIME'S economists see a milder downturn and still higher prices

An economy that stubbornly refuses to cool off, consumers who will not stop spending, prices that keep on rising and, looming on the horizon, the biggest new inflationary jolt of defense spending since the Viet Nam War.

That was the gloomy backdrop last week as TIME's Board of Economists gathered in New York City for a look at how the economy is shaping up in light of Jimmy Carter's proposed new budget for fiscal year 1981. The view ahead was hardly encouraging. At almost every turn, the economists found the budget bloated with new spending, much of it camouflaged by various forms of financial and fiscal prestidigitation. They saw the economy itself remaining dangerously inflated, yet in a fundamental sense growing weaker and less productive as the year progresses. Summed up Board Member Beryl Sprinkel: "The budget is far more expansionary than is consistent with anti-inflation policy."

As if to underscore the inflation danger, January wholesale prices released last week showed a jump of 1.6%, or a compound annual rate of 21%, the largest such wholesale price rise in five years.

In a perverse way, one of the most discouraging projections of all was the board's consensus forecast that a recession for 1980 now looks to be a somewhat milder affair than the 2.4% overall slump that had been predicted as recently as last December. Recession is certainly painful for anyone thrown out of work, but without at least a temporary economic downturn there is no real hope of slowing the price spiral.

At its December meeting, the board anticipated that last autumn's rise in interest rates and the resulting tightening of credit would lead to a sharp 4% annualized drop in economic activity during the first half of 1980, as consumers cut back on spending, businessmen laid off workers, and the economy itself began to slow. This was to be followed by a modest autumn rebound, and a return to real growth by year's end.

But rising interest costs, which the Federal Reserve pushed up again last week by raising the rate it charges member banks to 13%, have not slowed consumer spending. Moreover, mild winter weather has made it easier to go shopping and eased the strain on home heating budgets. This has helped to fatten consumer pocketbooks, enabling people to keep on spending though wages have not kept pace with inflation.

Yet the strength of sales was puzzling to the board. Guest Member Gary Wenglowski, of the Wall Street investment firm Goldman Sachs, explained the willingness of consumers to spend and spend by arguing that inflation has so bloated the value of residential housing that anyone with a home of his own has now come to look on it as a sort of savings account that one can live in. The result, he said, is that people have been increasingly willing to dip into their nest eggs or go into debt to support their living standards. Joseph Pechman of Washington's Brookings Institution, on the other hand, suggested that much of the shopping splurge has been attributable to a consumer compulsion to buy now before prices shoot into orbit. Yet Brookings Economist Arthur Okun noted that considerable spending has been for goods like furniture and clothing, which have been rising in price far more slowly than other consumer items.

Whatever the motivation, the spree shows no immediate signs of slackening. Retail sales in January rose an unexpectedly sharp 2.3% over the December level, and the board now foresees no downturn in the first quarter at all. After a very mild 1.7% overall decline, the members expect a return to real growth by early 1981. Indeed, some board members, including Wenglowski and Pechman, are beginning to wonder whether anything worthy of being called a recession is likely to develop at all.

Much, of course, depends on the ultimate size and shape of the fiscal 1981 budget that Carter submitted to Congress three weeks ago. The bigger the budget and the larger the deficit, the more difficult it will be to restrain the expansion of both money and credit in the economy and hold price rises in check. Yet one board member after another agreed that much of the budget, which Carter projects to reach $616 billion with a deficit of $15.8 billion, is already expanding out of control. Said Pechman bluntly: "Fiscal policy is simply too loose in this situation; it is bordering on the irresponsible."

The Administration also seemed, to Economist Sprinkel, to be "playing fast and loose with the numbers" in the budget. Example: sharp cuts are proposed for such sacred cow items as aid to education, Medicare and Medicaid funding, and the Administration's long-stalled hospital-cost containment bill. But Congressmen are almost certain to go ahead and continue providing lavishly for those pet programs anyway.

Some of the budget's most wishful thinking of all is in defense spending. Though spending is projected to rise 3.3% in real terms during fiscal 1981, none of the increases reflects the military buildup that Carter has committed the U.S. to as a result of the Soviet invasion of Afghanistan. Complained Economist Alan Greenspan of the New York consulting firm of Townsend-Greenspan: "To pretend that this budget is up to date when everyone knows that it is not is a bit of public relations that one could do without."

A whole array of defense spending categories now seems certain to grow substantially. Greenspan expects the fiscal 1980 budget that is already in force to increase by approximately $1.3 billion simply to cover the increased cost of fuel for military training maneuvers.

Personnel costs will also rise. Faced with skilled manpower weaknesses, the Pentagon is going to have to build up the quality of the nation's 2 million-strong armed forces in the early 1980s. But that will require pay increases well above the 7.4% in raises now budgeted for fiscal 1981. Said Washington University's Murray Weidenbaum: "The budget projections on this point through 1983 are totally unbelievable. The Administration has personnel expenditures rising only $500 million in fiscal 1982, or a mere 1.5%, and even less the following year."

Economists Weidenbaum, Greenspan and Pechman each estimated that increased defense outlays next year will boost fiscal 1981's defense spending by more than $7 billion, to about $150 billion. Said Sprinkel: "It may not be a guns-and-butter budget, but it is at least guns and margarine."

In fact, defense outlays would probably swell the deficit even more, in Weidenbaum's view, if industry and the private economy were capable of rapidly filling the lengthy shopping list of ships, planes and materiel that will soon be needed. They will be necessary to plug the gaps that are likely to be created when the Pentagon begins drawing together the equipment required to shape up the 100,000-man Rapid Deployment Force that Carter wants. Production bottlenecks are inevitable, explained Weidenbaum, because supply shortages exist in everything from specialty steels to castings and forgings. Additionally, a host of strategic minerals such as manganese, chromium and titanium, must be imported, and disruption of supply is an obvious danger.

In the Viet Nam era, the peril created by runaway spending was an ever widening budget deficit and a consequent escalation of inflation. But to Wenglowski, the danger now is that surging inflation will keep pushing people into higher and higher tax brackets, draining the private economy of funds for wealth-and job-creating investment. That in turn crimps productivity and gives yet another source of upward momentum to inflation. The dilemma, of course, is that cutting taxes to stimulate investment simply balloons the deficit, which also tends to nudge up inflation. Said Tax Expert Pechman: "Unless expenditures are cut, there is simply no room in the budget for a tax cut now for another five years."

About the only encouraging prediction to emerge from the meeting was the crossed-fingers forecast of Economist David Grove that remorselessly rising petroleum prices might not bring on the worldwide financial turmoil that moneymen have been fearing. During the past year, oil-starved Third World nations such as Brazil and Korea have had to borrow billions from Western banks to pay for petroleum imports, as well as to cover even the interest on their previous debts, which already total $300 billion. Some of the largest U.S. banks are now approaching their lending limits, and bankers have started to worry about whether the cash-strapped borrowers will ever be able to pay their debts.

But Grove calculates that U.S. banks can still increase their lending during the year ahead by an additional 10% over 1979 levels. Thus, if European banks, which last year lent about 85% of all Third World borrowing, were to be equally forthcoming this year, Third World borrowers would probably be able to squeak through. In short, the feared large-scale loan defaults do not loom as likely. -

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