Outlook '81: Recession
By Christopher Byron
Reagan confronts low growth, high inflation and steep interest rates
"I think that we are at a very major watershed in this country. The chips are down. We either make a significant turn at this point, or we are going to be fighting economic stagnation for the next decade."
The speaker was Republican Economist Alan Greenspan, but the sentiment was shared by each of his colleagues on the TIME Board of Economists, which gathered last week to examine the economic outlook for 1981. To a man, the board agreed that the weakened U.S. economy simply cannot endure many more shocks and setbacks like those that have afflicted it for the past two years. The tone of the meeting, the fourth and final of a troubled year, was similar to that set by David Stockman, Ronald Reagan's designated new budget director, and New York Congressman Jack Kemp. Three weeks ago, they sent Reagan a 23-page memo in which they called for the declaration of a state of national emergency to avoid an impending "economic Dunkirk." Those two words already threaten to become what might be called the economic hallmark of 1981.
There was worry aplenty at last week's meeting about how much time the incoming Administration will have to return the economy to longterm, noninflationary growth. While board Republicans argued that the Reagan strategy of deep cuts in both taxes and Government spending is crucial to economic recovery, Democrats on the board considered the approach both impractical and politically naive. They feel that it could wind up actually quickening the tempo of economic upheaval and causing even more inflation.
Looming over every current discussion of the U.S. economy is deep concern about the nation's increasingly mercurial interest rates. The prime lending rate that big commercial banks charge their best corporate customers jumped last week to 21.5%, breaking the 20% peak of last April and heightening fears of a renewed economic downturn. The economists on TIME'S board predicted that the rate is likely to go as high as 23% early next year.
For this and other reasons, the board concluded that 1981, which was seen only a few months ago as a period of at least slow recovery from 1980's slump, will be another year of recession. Board members differed on the timing and severity of a 1981 decline, but agreed that a contraction is now all but unavoidable. Yet they believed that the 1981 slump will not be as sharp as this year's, when the GNP in the second quarter declined at an annual rate of 9.6%. Republican Conservative Monetarist Beryl Sprinkel, chief economist for Chicago's Harris Trust & Savings Bank, predicted that the economy will show about 3.9% real growth on an annual basis for the last three months of 1980 and then increase at a 4% yearly rate during the first quarter of 1981. Then he sees business slipping back into a recession during the six months between April and October.
By contrast, Liberal Democrat
Walter Heller, a former economic adviser to Presidents Kennedy and Johnson, warned that the economy is already weakening, and will wind up registering around 2% in real annual growth during the fourth quarter of 1980. Heller predicted that overall economic activity during the first three months of 1981 will decline approximately 1.5% and remain essentially stagnant for the following quarter.
The median forecast of the board members is a modest growth in the economy of about 1.3% during 1981, including a decline of about .3% between January and June. They foresee the economy recovering at a growth rate of slightly less than 3% during the second half of next year.
Such a shallow recession will have differing impacts on various areas of the economy. The downturn is not expected, for example, to affect employment seriously. The jobless rate is projected to climb from its present level of 7.5% to a peak of 8.2% in 1981's second quarter, before slipping back to 8% at year's end. The public, however, can expect little relief on prices next year. From a 1980 inflation rate of 13%, the board of economists projected that the increase in consumer prices will only slow to 11.4% at best by the end of 1981.
One important reason will be the renewed upward thrust of oil prices. The 13-nation OPEC oil cartel last week raised its export prices by 6% to 10%, and oil producers warned of possible additional increases in 1981 (see following story). Meanwhile in the U.S., more and more domestically drilled crude is being marketed at sky-high world prices as a result of the continuing phaseout of domestic crude oil price controls. Democrat Otto Eckstein, president of Data Resources, an economic forecasting firm, estimated that rising petroleum prices will add 2.2 percentage points to the nation's consumer price index in 1981.
M.I.T. Economist Lester C. Thurow believes that this high inflation forecast may be too low. Said Thurow: "The risks are all on the down side. The economy could all too easily get some big new oil shock, for example. Or grain harvests might be disappointing and force up food prices. On the other hand, it is very hard to think about what piece of good news, might come along to make everything look better."
Whatever happens to the economy in 1981 will depend to a large degree on the actions of the Federal Reserve Bank and its controversial chairman, Paul Volcker. As the nation's central bank, the Federal Reserve regulates the availability of both money and credit in the economy, which helps determine the level of interest rates for borrowers and lenders alike. In October 1979, the Fed announced that it was scrapping its traditional inflation-fighting tactic of trying to regulate overall economic activity by manipulating interest rates within a narrow and relatively low range. The bank decided instead to attack the problem more directly by curbing the growth of the money supply itself.
The TIME board last week split sharply over whether that new approach is working, and there was also disagreement about whether Volcker will continue to pursue it in the new Administration taking office next month. Democrat Eckstein wondered about how many more times the Fed will feel compelled to "beat the economy about the head" before people believe that the bank is serious about controlling the money supply. Eckstein jokingly asked whether the Federal Reserve's vacillating policy of first tight money and then loose money was creating "the six-month business cycle," alternating between boom and bust.
In response, Monetarist Sprinkel argued that the Federal Reserve has not really been sticking to its tight money policy at all. In Sprinkel's view, Volcker "aborted the recession last spring" by injecting money rapidly back into the economy to ease the downturn during an election year. Said Sprinkel: "I have been watching the Fed since Harry Truman's days, and though Presidents have no direct control over the Fed, the White House does have all sorts of subtle influences to help it get the sort of monetary policy it wants."
Democrat Heller cautioned, however, that Volcker is not likely to repeat his move of last spring and begin excessively increasing the money supply a second time if the economy starts to falter. Said Heller: "Volcker has had a burning experience, and he is now being driven almost by a sense of inner guilt. He eased up too much too soon, and he knows it. Now Volcker may be overcompensating."
In the opinion of most board members, the real economic flash point in 1981 is likely to be the new President's plan of radical cuts in both Government spending and taxes. Reagan's "supplyside" economic strategists have defended the program as a bold policy to stimulate savings and investment that will beat inflation by boosting productivity and business output. They argue that the U.S.'s economic ills have been caused primarily by excessive taxes, which have removed the incentive of individuals and companies to work harder producing goods and services. Board Member Greenspan, a close adviser to President-elect Reagan, argued that the program must be put in place quickly if the public is to believe that the new Administration is really serious about stopping the price spiral.
By contrast, the board's Democrats questioned whether the plan would lower inflationary expectations. They pointed out that one of the main causes of higher prices is the anticipation of more inflation, which leads both labor and companies to keep pushing up wages and prices. As they see it, there is almost no chance of a major reduction in prices during the first half of next year, and large tax cuts now might encourage everyone to start asking for more in expectation of still higher inflation. Said Economist Eckstein: "The scientific evidence suggests that the only thing that improves inflation expectations is actual experience, and the experience in 1981 is just not going to be all that marvelous." Added Heller: "I hope and pray that President-elect Reagan can lower inflationary expectations, but the prospects do not look very good. The fact is that tax cuts go against the public's conception of an anti-inflation strategy."
Much will depend on whether the new Administration is able to deliver on its promise of deep cuts in federal spending. Board Member Joseph Pechman, a Democratic tax expert with Washington's Brookings Institution, warned that the job will not be easy. Said he: "We have an extremely recalcitrant budget, and the new Administration is going to have a very difficult time trying to cut it."
Pechman estimated that federal spending will be $660 billion in the 1981 fiscal year that began in October. Given the current level of taxation and continued weakness in the economy, that will mean a budget deficit of about $60 billion before any Reagan tax cut. If tax reductions are enacted, the deficit could easily go to perhaps $75 billion. Much of the increase will come from so-called uncontrollable budget categories such as interest on the national debt, unemployment compensation insurance and welfare payments.
According to Pechman, proposals to cut such programs are likely to prove politically unpalatable to Congress, which will have to revise existing legislation to bring about reductions. For years Presidents have annually proposed budget cuts to Congress, but these are just as regularly rejected after effective counteraction by special-interest groups.
Otto Eckstein argued that reducing outlays by the $30 billion to $50 billion that Reagan's advisers are recommending for fiscal 1981 would require a complete halt to any growth in nondefense spending. Since 1947, those politically popular expenditures--which include Social Security, aid to education, and employment training--have increased at an average rate of 5.3% annually. Said Eckstein: "The question is, Can Reagan effectuate this revolution?"
Martin Feldstein, president of the National Bureau of Economic Research in Cambridge, Mass., maintained that cutting the runaway growth of federal spending is not politically impossible.
Said he: "I think it is easy to talk yourself into the view that almost everything is uncontrollable, but I do not believe that." Among the areas where Feldstein said spending cuts could bring about substantial savings at minimal political cost: $3 billion in federal subsidies to airports, $7 billion in revenue sharing to states, and $5.5 billion in excessively generous payments for disabled workers, who would not have qualified for federal support under standards that prevailed as recently as 1970.
Washington University's Murray Weidenbaum, an adviser to Reagan during the presidential campaign, insisted that the new Administration recognizes that its budget will be controversial and involve some unpopular cutbacks in spending. Said he: "This is not going to be a painless solution. Reagan is trying to avoid the stop-and-go policies that have characterized preceding Administrations, both Republican and Democrat, and hence fight unemployment and inflation simultaneously."
The economic success of the Reagan Administration will depend on the continued support of the American public for an austerity program. Lester C. Thurow questioned whether voters would stick with such policies unless they quickly saw tangible results in the form of rising standards of living. He believes that the U.S.'s recent shift to economic conservatism may quickly evaporate. Said he: "The question is how long will the conservative era have to prove itself before the public kicks it out and tries something else. If the conservative policies cannot work relatively quickly, people will cease being conservatives."
While the economic year ahead looks generally gloomy, the year now closing has been downright schizophrenic. From January through December, the nation's business indicators gyrated as though they were suffering from a case of St. Vitus's dance. Gold and stock markets soared and tumbled with regularity. Interest rates bounced wildly up and down.
During much of the presidential election year, economic events were not determined by the White House or by Congress, but by the Federal Reserve. Indeed, in the opinion of many observers, "the Fed was the only game in town." When inflation roared to an annual rate of 18.2% in the first quarter and bond markets collapsed following Jimmy Carter's proposal of a fiscal 1981 budget with a $ 15.8 billion deficit, the Fed hit the brakes hard. It imposed credit controls on consumer borrowing and clamped down on bank lending. The prime rate, which began the year at 15.25%, quickly climbed to a then record 20% in April. The price of stocks and gold, which had been strong, fell quickly. But the economy cooled so that inflation declined to the year's low in July, when there was no month-to-month change in the Consumer Price Index.
Business, however, ran into a wall. Between April and June, the economy declined at an annual rate of 9.6%, the fastest drop since World War II. But then, with the arrival of summer and the acceleration of Carter's re-election campaign, credit controls were loosened and money became less restricted. The prime rate fell to a low of 11% in July. Yet, after November's presidential election and a new burst of inflation, the Federal Reserve Board once again tightened money, and interest rates began another steep rise, quickly passing the spring's historic interest rate records.
The squeeze on credit was a major burden on business all year long. Companies began avoiding new debt financing through the long-term bond market because high rates made that too expensive. Instead, they turned to banks for short-term loans that would not lock them into high rates for ten years or more. Industries that depend heavily on credit, particularly home building and auto sales, have been staggering. Lone Star Industries, the country's largest cement producer, last week took out full-page newspaper ads featuring a large skull and crossbones and the warning POISON.
In a signed statement, Chairman James E. Stewart complained: "The interest rate policy of the Federal Reserve System is driving the economy of the United States into self-destruction." Russell M. Rockwell, the owner of Rockwell Equipment Co. in Hamilton, Ohio, says sharply: "I don't think the Federal Reserve knows what it's doing. It's like a two-year-old kid squeezing the kitten to death, and he doesn't realize he's doing it."
Even one of the Federal Reserve Board's own governors spoke out last week in public against its policies.
Nancy H. Teeters, who has opposed the credit tightening, said that excessive monetary restraint will result in a business decline. "It's very simple," Mrs. Teeters said. "Rates are too high."
Detroit automakers have been perhaps the most severely damaged.
Chrysler and Ford last fall rolled out a new generation of gas-thrifty models designed to win back business from popular Japanese imports.
But the cars arrived in dealer showrooms simultaneously with the Federal Reserve's second run-up in interest costs. Buyers were unable, or unwilling, to pay the higher sticker prices and financing charges, and carmakers suffered their worst losses ever. The red ink on their North American operations is now expected to reach a staggering $8 billion. As sales of Chrysler's new K-cars languished in November, Chairman Lee Iacocca asked: "How long can this continue? For a year? I don't think there'd be an auto industry."
Meanwhile, the roof caved in on housing. New housing starts have fallen from 2.02 million in 1978 to an estimated 1.28 million this year. Experts estimate that the U.S. needs about 2.4 million new houses annually just to keep up with the nation's population growth. Low housing starts now mean shortages of homes in the future. But with mortgages increasing from about 11.5% to 17% this year, fewer buyers are willing to sign contracts for that dream castle.
The sharp rise in interest rates has been particularly devastating for small businesses, which generally have more debt than larger corporations and do not have the financial resources to wait out high rates.
At National Industrial Products Supply Co., a small welding supply firm outside Chicago, President James Edelen says that the high cost of money forced him to reduce inventory by 30% and cancel plans to expand production and hire another salesman. Between July and September, more than 11,000 companies filed for bankruptcy, an increase of 38% over the same period a year ago. Says D. Bruce Adamson, chairman and president of the First National Bank & Trust Co. of Joplin, Mo.: "We're wondering how long the small businessman can survive."
High interest rates and the recession, unfortunately, did little to wring inflation out of the economy. The year 1980 saw the arrival of the $4.00 martini at Harry's New York Bar in Manhattan's Helmsley Palace hotel and the $180 cotton shirt at Bijan's boutique on Beverly Hills' Rodeo Drive. American motorists were as stunned by the $9,000 price for a new U.S. compact car as by the $1.30-per-gal. cost of gasoline. In most other postwar recessions, consumers at least were rewarded for their suffering with a significant drop in inflation. But not this time: last year price rises just rolled on relentlessly.
Unemployment, which had reached a high of 9% in the 1973-75 recession, was less of a problem than expected in 1980. It peaked in May and July at 7.8%, and many of those thrown out of work by the economic downturn were only briefly without a job. The average length of unemployment in 1980 was just twelve weeks. Many unemployed people, nonetheless, often had to search long for a new job or accept a less well-paying position. Joy Snyder looked for ten months for a job as a secretary after being laid off from a Delco-Remy electrical plant in Anderson, Ind. Finally, she found an opening at a counseling center, but the salary was $6,000 below her previous $18,000-per-year level. Says she: "It is a livable income, and I am happy to have it."
Like factory and office workers, farmers suffered through a year of upheaval. Following the Soviet invasion of Afghanistan, President Carter suspended shipment of $2.6 billion worth of corn, wheat and soybeans to the Soviet Union. Farm prices immediately collapsed, with the price of corn falling by 10% within three days of trading, the price of soybeans by 8% and that of wheat by 9%. Many farmers suffered a second disaster when a searing summer heat wave and drought scorched crops and pasture lands from Texas to North Dakota. The temperature in Dallas was over 100DEG for 53 days in July and August. Reagan Brown, Texas state agriculture commissioner, said glumly in midsummer: "We're hurtin' real bad in Texas." The drought has driven up the price of everything from peanuts to chickens, and it has cost farmers millions of dollars in lost crops and livestock.
The year of gyrating prices was felt acutely by investors. The Dow Jones industrial average hit a low of 759.13 on April 21, but then began a long climb that turned into the so-called Reagan rally after the
November election. On Nov. 20, it hit a 1980 peak of 1000.17. Soon, though, stock prices began to tumble because of fear of high interest rates and another recession. The Dow Jones closed last week at 936.52.
Thousands of moneymen also discovered that the glitter of gold and silver can be a sometime thing. Unrest in the Middle East and inflation in the U.S. sent the price of gold soaring to a high of $875 per oz. in late January, an increase of more than $300 in less than four weeks. That same month, silver went from $39.50 per oz. to $50.35 per oz. People rushed to determine the value of their ancestral sterling silverware or gold rings, and of that was soon in the melting ovens metal dealers. The inevitable sell-off followed even more quickly than the increases. In one day alone, gold fell per oz., while silver dropped to $10.20 oz. in March.
Leading the routed silver and bulls were Bunker and Herbert Hunt, Dallas bullionaires, who at one owned an estimated 100 million oz. of silver. In March, they used their $2 silver hoard to buy even more of the metal. After the market collapsed later month, the pair had to use their vast holdings, including race horses, art and antiques, as collateral to back the loans had made in their attempt to corner world silver market. A battered Hunt later said, "A billion dollars is what it used to be."
Despite the overall dour situation, U.S. economy in 1980 showed some pockets of surprising strength and While the Midwest and the auto were suffering depression-like areas of New England and the Coast, where the computer industry other high technology firms have plants, hardly felt the slump. Investors who would not touch a steel stock to buy new issues of Genentech, a Francisco-based genetic engineering or Apple Computer, the California maker of personal computers. Unemployment in Massachusetts was only 5%, or one-third less than the national level. Colorado and other Rocky Mountain prospered with the search for new domestic energy sources. Electronic and computer firms made the Southwest and West the U.S.'s most prosperous According to the 1980 census, that contains nine of the twelve fastest growing states.
However, it was not those exceptions but the dismal state of of the American economy that Ronald Reagan into the in November. Perhaps the candidate's most effective campaign tactic was during the debate with President Carter when he looked at the television camera and asked the American people: "Are you better off now than you were four years ago?" The answer was mostly no. Last year alone, the average real disposable income per capita fell an estimated 1.1%.
Reagan will now use the untested, and controversial, program of large budget reductions and tax cuts to fight the new dilemma: high interest rates, growth, roaring and persistent unemployment. The well-being of American business during 1981 and for years to come will rest on the outcome of that experiment.
--By Christopher Byron and Alexander Taylor, Reported by William Blaylock/Washington, with other U.S. bureaus
With reporting by William Blaylock
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