The Zesty Forecast for '85

By Charles P. Alexander

After surging, stumbling and then bouncing back last year, the U.S. economy should settle down to a steadier, healthier pace in 1985. That was the optimistic forecast of TIME's Board of Economists when it met to survey the business outlook for the year. Despite concern about the instability of the dollar and the huge U.S. trade and budget deficits, the economists predicted that growth in the gross national product, after adjustment for inflation, will be a solid 4% this year, a middle course between the harrowing extremes of 1984. Growth last year ranged from 10.1% in the first three months down to 1.6% in the third quarter, which briefly raised fears that a recession was on the way. This year should be less packed with drama and trauma. Said Board Member Alan Greenspan, a New York consultant who served as chairman of the Council of Economic Advisers under President Ford: "The forecast is for moderate growth, moderate inflation and moderate unemployment."

The year is already off to a strong start. The Commerce Department said last week that the index of leading economic indicators, which tries to foretell future growth, climbed 1.7% in January, its sharpest advance in 18 months. That report electrified the stock market, where investors went on a buying binge. The Dow Jones industrial average jumped nearly 26 points during the day, to 1309.96, before falling back to a record close of 1299.36, which topped the peak of 1297.92 set on Feb. 13.

The optimism in the financial markets was tempered by worries about the fate of the dollar, which last week gyrated wildly. At first, it took off on its swiftest, steepest climb since 1978. By Tuesday afternoon it had risen 2% against the West German mark and the French franc and more than 3% vs. the British pound, which sank to an all-time low of $1.039.

Then currency traders were taken aback by bulletins concerning the testimony of Federal Reserve Chairman Paul Volcker before a congressional committee. Volcker said that Western central banks had not acted "forcefully enough" to halt the dollar's ascent. Some traders took that to be a call for stepped-up Government intervention.

As if on cue, the central banks of West Germany, Britain, France and all the other major industrial countries launched a joint campaign to defend their currencies by selling dollars on the exchange markets. Though the Federal Reserve would not publicly confirm it, the U.S. joined the battle to rein in the dollar. Said a senior Administration official: "We spent tens of millions and the Europeans spent hundreds." By Wednesday afternoon the banks had unloaded at least $1.5 billion and sent the high-flying dollar into a nose dive. It dropped 4% compared with the mark and franc and 6% against the British pound. Even Queen Elizabeth II seemed stunned by the pound's sudden swings. Said she: "It all happens so frightfully quickly."

The official intervention in the currency markets continued on Thursday and Friday, but the dollar stabilized and recovered a bit. Still, central bankers seemed satisfied with the results of their efforts. Their goal was merely to throw a scare into speculators and keep them from bidding the dollar to unrealistic levels.

TIME's economists viewed last week's dip in the dollar as a healthy development, but said that a sharp plunge could be dangerous. Admitted Greenspan: "The dollar has long been a great worry of mine." If foreigners lost confidence in the dollar, they might start pulling large sums of money out of American investments. That could lead to a run-up in U.S. interest rates and slower growth than the economists now predict.

The TIME board members doubted, however, that last week's drop signaled the beginning of a sustained decline in the dollar. Its value is still more than 60% higher than it was five years ago against an average of major currencies. Said Charles Schultze, who was President Carter's chief economic adviser: "I do not see the dollar in a free fall. Central bank intervention by itself in the markets is not likely to do any good in the long run." Rimmer de Vries, chief international economist of New York's Morgan Guaranty Trust, thinks that the dollar may remain strong because foreigners are eager to invest their money in the vibrant U.S. economy. Said he: "No other major Western nation has had such a combination of high growth and low inflation."

A fall in the dollar would delight many American businessmen. Its rise has made their products more expensive abroad and foreign goods cheaper in the U.S. That has hurt every company that exports or competes with imports. Largely because of the strong dollar, the U.S. ran a record-shattering $123 billion trade deficit last year, up from $69 billion in 1983. The trade gap widened to $10.3 billion in January from $8 billion in December. Such a huge imbalance is unsustainable, TIME's economists agreed, and could eventually undermine U.S. growth.

On the other hand, the strong dollar has played a key role in dousing inflation. Faced with fierce competition from cheap imports, companies have been forced to cut costs and hold down prices, and workers have had to settle for modest wage hikes. Consumer prices rose at an annual rate of just 2.3% in January, which was even lower than the 4% increase for all of 1984. The economists predicted that prices will rise only 3.6% this year.

Low inflation has given the Federal Reserve the latitude to be fairly generous with the money supply and let interest rates fall in the past few months. A decrease in mortgage rates, from an average of 12.67% for a 25-year adjustable-rate loan last September to 11% now, has given pep to the bellwether housing industry. Between December and January, housing starts climbed 14.9% to an annual rate of 1.8 million, the sharpest rise in ten months.

The building surge could give a far-reaching boost to the economy, creating jobs in industries that manufacture everything from roofing to rugs. That will be a boon to the 8.5 million Americans still out of work. TIME's economists forecast that the unemployment rate will fall from 7.4% now to 6.8% by the end of the year.

Walter Heller, who was chairman of the Council of Economic Advisers in the Kennedy Administration, predicted that corporate profits would rise 8% this year. That should help companies continue their heavy spending on new plant and equipment. Business investment jumped 21% in 1984, and Heller expects a 12.5% rise this year.

In the long run, though, investment could be stunted by the federal budget deficit, which is expected to hit a record $222 billion this year. As the economy expands, business borrowers will be competing more and more intensely with the Government for the limited pool of private savings, and that could put upward pressure on interest rates. So far, only the influx of foreign money, which amounted to $62 billion in the first three quarters of last year, has prevented a crunch. Perhaps the most sinister aspect of the budget deficit is that its effects are gradual and masked by the general prosperity. "Deficits are not explosive," said Heller. "They are corrosive." Most disturbing, the U.S. will become a debtor nation this year for the first time since 1917. Peter Peterson, former chairman of the Lehman Bros. Kuhn Loeb investment firm and a guest at the TIME board meeting, said that unless action is taken to bring down the deficit and the dollar's value, America could owe foreigners $1 trillion by the end of the decade. Observed Heller: "We're fattening our own standard of living today, at the expense of a leaner diet tomorrow when we have to pay it off."

TIME's economists agreed that the budget deficit should be attacked now, before the economy shows signs of weakness. They applauded President Reagan's goal of carving $50 billion out of Government spending in 1986, but said that the White House will have to compromise with Congress on where to cut. The economists expect Congress to insist on spending less for defense and more for social programs than is in the Reagan budget.

Alice Rivlin, director of economic studies at Washington's Brookings Institution, pointed out that the Reagan budget was "not seriously aimed at cutting the deficit so much as changing what the Government does." She noted that the budget calls for drastic cuts in such programs as public housing and small-business loans, which are activities that the White House thinks should not be supported by federal dollars. But at the same time, the Administration has left Social Security and defense, which consume 50% of the budget, almost untouched. Said Rivlin: "Anyone who is serious about reducing the deficit has to go after the big things."

Harvard Professor Martin Feldstein, who was President Reagan's economic adviser between 1982 and 1984, said that a growing number of Congressmen seem willing to trim Social Security, despite the political risks. The lawmakers will certainly not cut the size of current benefits, but they might reduce future cost of living allowances (COLAs), which are payment increases linked to the inflation rate. One option, Feldstein suggested, would be to limit COLAs to the amount of inflation in excess of 3%. They would then be "diet COLAs," he quipped. If that strategy were adopted for Social Security and all other programs with COLAs, including federal employee pensions and veterans' benefits, it would save an estimated $50 billion in 1990.

Schultze maintained that the Pentagon should be a primary target for budget cutters. The budget calls for appropriations for weapons and equipment to more / than double between 1980 and 1986, even after adjustment for inflation, to $107 billion. Said Schultze: "I think you can say that while some buildup is needed, the magnitude of the recent and proposed increases in defense spending is unwarranted."

Defense Secretary Caspar Weinberger has argued that the Pentagon needs all its funds to counter heavy Soviet spending on weapons. But Schultze pointed out that in the past two years the Central Intelligence Agency has revised its estimates on the growth of Soviet military expenditures sharply downward. "To some extent," said Schultze, "the U.S. defense buildup has been based on a myth that we were falling behind the Soviets in most areas." He also complained that the Pentagon is building too many duplicative weapons designed to carry out the same mission. The Air Force, for example, has five major development programs under way to improve its ability to penetrate Soviet air defenses: an upgrade of the B-52 bomber, two new bombers and two cruise missiles.

TIME's economists were divided on the prospects that Congress will take decisive action against the budget deficit. Heller said he was optimistic because "there is a deep fear and loathing of deficits on Capitol Hill." Feldstein agreed: "Congressmen fear that if the economy goes bad in 1986, and they haven't done anything about the deficit, they are going to be blamed." Greenspan was more skeptical. Said he: "There is a vast, overwhelming philosophical commitment to cut the budget, but when you get to specific votes on specific programs, it is going to be very difficult."

The economists unanimously agreed that a meaningful deficit-reduction program would act as a supercharger for the U.S. economy. It would lower interest rates, boost business confidence and eventually bring down the dollar's value and the trade deficit.