Here Comes the Recovery!

By Charles P. Alexander

So says TIME's Board of Economists, unless big deficits stunt the upturn

After 19 months of dashed hopes, false starts and deepening despair, the most serious recession since the Great Depression is finally coming to an end. That was the unanimous prediction of TIME's Board of Economists, which met last week in New York City. Said Otto Eckstein, chairman of Data Resources, a Lexington, Mass., economic consulting firm: "The recovery is clearly upon us." Added University of Minnesota Professor Walter Heller, who has been a stern critic of the Administration's economic policies: "For once I agree with President Reagan. The seeds of recovery are sprouting."

Prodded by the Federal Reserve's rapid expansion of the money supply, interest rates fell throughout the last half of 1982. That had a tonic effect on several long-depressed sectors of the economy. New home starts surged 36% in January to the highest level since September 1979. Sales of U.S.-made cars this year are up 8% from the same period in 1982. The rebound in housing and autos has created demand for a broad spectrum of products, from steel to toilet bowls. Overall industrial production jumped by .9% in January, its first sharp rise in eleven months. The percentage of factory capacity in use rose a heartening half-point, to 67.8%.

TIME's economists foresee a stronger recovery than forecasters expected a few weeks ago. Real growth--after adjustment for inflation--in the gross national product could reach a healthy annual rate of about 4.5% in the first three months of the year, compared with a 2.5% decline in the last quarter of 1982. The economists expect growth to stay in the 4% to 5% range for the rest of 1983. That would be slower than the 7% growth averaged in the first year following previous postwar recessions, but faster than the 3.1% rate for 1983 forecast by the White House.

Beyond 1983, TIME's board is much less confident about the economy's prospects. Reason: the specter of swelling federal deficits. Alice Rivlin, director of the Congressional Budget Office and a guest participant last week, warned that unless Congress cuts spending or raises taxes, the budget gap will bulge from $194 billion this year to $267 billion by 1988. As the economy recovers, Government borrowing could collide with the credit needs of private business and drive up interest rates once again. Said Charles Schultze, a visiting professor at Stanford University's Graduate School of Business who was President Carter's chief economic adviser: "We may have an explosive mixture of tight monetary policy, high interest rates and deficits that would make it difficult to sustain the recovery."

In the short run, however, the economy appears poised for takeoff. Companies have trimmed inventories down to low levels and are beginning to recall laid-off workers to rev up production again. Though that helped bring the unemployment rate down to 10.4% last month from its December peak of 10.8%, TIME's economists believe that such a sharp drop may have been a statistical fluke. They expect the rate to creep back up to 10.6% this month, then to fall slowly, but steadily, to just under 10% by the end of the year.

The improvement in the employment picture could help revive consumer confidence and boost spending. In addition, the 10% income tax cut scheduled for July 1 will raise household buying power. After three years of economic sluggishness, there is pent-up demand for houses, autos, appliances and other big-ticket items. Heller predicted that housing construction would rise by nearly 42% this year, to 1.5 million units, while auto sales would be up 22%, to 9.75 million.

The most promising sign that a solid foundation has been laid for recovery is the progress being made against inflation. Consumer prices rose only 3.9% last year, compared with 8.9% in 1981 and 12.4% in 1980. In January wholesale prices actually fell 1%. Lower inflation will help speed economic expansion because families will be able to buy more for their money.

TIME's economists expect that prices may heat up slightly as the recovery proceeds, but they foresee no new burst of inflation. For 1983 as a whole, they predict that consumer prices will rise at a modest 4.6% clip. One reason for this optimism is that wage demands, the central driving force of inflation, have cooled considerably. Wage and benefit gains slowed in the final quarter of 1982 to an annual rate of 4.7%, down from 9.6% in 1981. At the same time, the level of output per hour worked, or productivity, has accelerated sharply. The combination of moderate wage hikes and greater productivity will hold down production costs and thus help companies keep prices down. The dark side of the productivity gains is that employers will be able to boost output with fewer workers than in the past. TIME's economists fear that unemployment could still hang as high as 9% at the end of 1984.

Both businesses and consumers will benefit from the oversupply of oil and the first big break in energy prices in the past decade. Efforts by the Organization of Petroleum Exporting Countries to prop up the cost of crude by curbing production have collapsed, at least temporarily. As a result, said Rimmer de Vries, chief international economist for Morgan Guaranty Trust, the official price of OPEC oil may fall from $34 per bbl. to $28, which would shave a percentage point off the U.S. inflation rate. James McKie, an economics professor at the University of Texas, maintained that unless OPEC regroups and sets production quotas, the oil price could drop even lower than $28. Last Friday a price war erupted. First Britain proposed to its customers a $3-per-bbl. cut, to $30.50, in the price of North Sea oil. Norway, another North Sea producer, followed suit. That prompted OPEC members to go a step further. Nigeria said it would trim the price of its high-quality crude by as much as $5.50, to $30, and Kuwait warned that two OPEC states would undercut North Sea oil by 500 per bbl.

Despite the good news on energy, several sectors of the economy will remain weak. Corporations will probably slash their spending on new factories and equipment this year by about 5% in real terms. They have more capacity than they need right now, and the cost of borrowing, while lower than it was, is still quite high. State and local governments, pressured by tax revolts and reductions in federal grants, are also cutting back. The high value of the dollar against foreign currencies has devastated U.S. export industries by making American goods too expensive abroad. Eckstein predicts that exports will drop about 6.5% this year.

The strength of the recovery depends in large part on what happens to interest rates. Federal Reserve Chairman Paul Volcker told Congress last week that the Fed will let the money supply grow fast enough to allow interest rates to fall further, keeping the recovery on course (see box). Most of TIME's economists believe that Volcker has little choice but to pursue an expansionary policy.

One compelling reason for the Federal Reserve to do so is the precarious state of world finance. Higher interest rates could push such debt-laden nations as Mexico and Brazil back to the brink of defaults that would threaten the solvency of many U.S. and West European banks. Said De Vries: "The debt bomb did not go off last year as feared, but the problem is still very much with us." The debtor countries are expecting new loans from the International Monetary Fund, but that will merely be a stopgap. Lasting relief can come only through a strong recovery in the U.S. and Europe that stokes demand for exports from the developing world.

Michael Boskin, an economics professor at Stanford University and a guest at the TIME board meeting, warned that the Federal Reserve may be overdoing its efforts to help revive the U.S. and global economies. The Fed is in danger, he said, of pumping out too much money and rekindling fears of inflation, a mistake that the Reserve Board has made during several previous recessions. Boskin said that the Fed may eventually be forced to clamp down on money growth and push interest rates back up. Said he: "I'm worried that we're going to have a brief recovery and then another recession in 1984."

Most of the economists were less concerned about the pace of money growth. They argued that there is no precise, short-term relationship between the money supply and G.N.R growth or the inflation rate. How much G.N.R can be generated by a given amount of money depends upon how fast that money circulates through the economy--what economists call velocity. This velocity can shift gears in sudden and mysterious ways. In 1981 and early last year, for example, velocity fell unexpectedly; this exaggerated the effects of the Federal Reserve's constraints on money and made the recession worse than it might otherwise have been.

Besides puzzling over velocity, the Reserve Board has had to grapple in recent months with distortions in the money-supply figures caused by the introduction of the new money-market bank accounts. Observed Eckstein: "The figures have become incomprehensible and, at the moment, I wouldn't base policy on them any more than I would rely on the roll of the dice. In fact, I think I would prefer a roll of the dice." Schultze said that the Federal Reserve should shift its attention away from money-supply targets and focus instead on what is happening to the current value of G.N.P.

With so much slack in the economy, Heller saw little chance that the Fed could possibly reignite inflation in the near future. Said he: "All we have to fear is the fear of inflation itself." He suggested that the Reserve Board should keep on expanding the money supply enough to lower interest rates a bit more.

There may be limits, however, to the Fed's power to force down the cost of money. In the past few weeks, several interest rates started to inch up again, despite the Reserve Board's stimulative policy (see chart). One explanation is that investors, unswayed by the optimistic views of economists like Heller, are still worried about a resurgence of inflation. They demand high interest to protect them from having their investments eroded by rising prices. This is especially true for the buyers of long-term bonds, who provide capital for the construction of new homes and factories. Bond buyers need to be convinced that inflation will be held to moderate levels not just over the next year, but also over the next decade or two. Said Alan Greenspan, a New York City consultant who was chief economic adviser to President Ford: "The financial markets are suspicious about claims that inflation is under control, and recent history does not give strong evidence to suggest that they are wrong."

All TIME's economists agreed that the burgeoning federal deficit is the catalyst for inflation fears. As competition between the Government and business for credit grows increasingly intense, the Federal Reserve will come under pressure to churn out more and more money to keep interest rates low. Such a policy could set off a new inflationary spiral.

Rivlin said that Congress should aim to pare the budget deficit to $100 billion by 1988. That would require a combination of spending cuts and tax increases totaling a staggering $170 billion. Congress can make a good start, said Rivlin, by passing the measures recommended by the National Commission on Social Security Reform, but that would lop only about $30 billion off the deficit. As for defense, Rivlin estimated that even if Congress sharply slowed the President's planned military buildup from an annual real growth rate of 7.5% to 3%, only $20 billion would be saved in 1988. Said she: "The idea that cutting back defense can solve the whole problem is not right."

Given the difficulty of curbing federal expenditures, Eckstein said that substantial tax increases are inevitable. He called Reagan's policy of slashing income taxes by 25% while raising defense spending "the worst economic mistake since World War I." Greenspan argued, however, that Congress could not indefinitely increase the tax burden. Said he: "Ultimately, the deficits, which are out of control, must be reduced from the spending side."

The budget dilemma cannot be ignored for long. TIME's economists agreed that unless action is taken to reduce the deficit, the recovery will sputter and stall. Without a doubt, forcing the Government to live within its means will be one of the greatest economic challenges of the decade. --By Charles P. Alexander This file is automatically generated by a robot program, so viewer discretion is required.