Putting a Tiger in the Tank

By Stephen Koepp

During 1985 the U.S. economy performed below its potential, sputtering along like a Corvette with a clogged carburetor. America's output grew only 2.3%, compared with a full-throttle 6.6% in 1984. But TIME's Board of Economists, * which met last week in Manhattan, predicts that the country will rev its engine again this year. The group believes that the gross national product will expand by about 3.3% during 1986, a brisk if not blistering pace.

The economy's high-octane fuel has been low interest rates. The benchmark prime rate that banks charge for commercial loans has remained steady at 9.5% since it plunged to that level last summer from 13% in mid-1984. Fostered by the Federal Reserve Board, the easier credit has spurred consumer spending and encouraged corporate investment in plant and equipment. "All the signs are strong. We're seeing the fruits of a very substantial decline in interest rates," said Board Member Charles Schultze, a senior fellow at Washington's Brookings Institution who was chairman of the Council of Economic Advisers under President Carter.

Even with the boost from interest rates, the economy would remain a bit lackluster in 1986 if it were not for a lightning stroke of good fortune in the energy market. Since November the global oil-price war started by Saudi Arabia has sent crude prices sliding by about 50%. That decline will be responsible for about a third of this year's growth in GNP and will help control inflation. Said Walter Heller, chief economic adviser in the Kennedy and Johnson Administrations: "The luck of the Irish is working overtime. Now Ronald Reagan can sing, 'Almost everything's going my way.' "

But the song could change to Nobody Knows the Trouble I've Seen if the Administration and Congress fail to deal effectively with a pair of megaproblems: the budget and trade deficits. Government borrowing to cover the budget shortfall could eventually send interest rates shooting back up. Also, the trade deficit could boost interest rates because the U.S. may be forced to borrow more and more money from abroad to finance imports. Heller observed that the Government's record in attacking the twin deficits has so far been "somewhere between lackluster and lousy, but 1986 really looks like a turnaround year."

TIME's board expects that the trade deficit will at least halt its runaway growth and possibly retreat a bit by the end of 1986. The deficit hit a record $148.5 billion during 1985, largely because an overly strong dollar made foreign goods cheap in the U.S. and American exports too expensive in other countries. But last September finance ministers and central bankers of the U.S. and four other industrial powers--Japan, France, Great Britain and West Germany--launched a successful effort to push down the dollar. It has declined by about 12% since then, first at a gradual pace and now at a fast clip. Last week the dollar plunged to 181 yen, a seven-year low against that currency, and to 2.34 West German marks, a level not seen since 1983.

The falling dollar delights U.S. manufacturers because it makes them more competitive with foreign rivals. One negative aspect for American consumers is that the weaker dollar could boost prices of imports, including everything from Sony television sets to BMW coupes.

But expensive imports are not likely to rekindle rapid inflation. TIME's economists forecast that the Consumer Price Index will rise only about 3.7% during 1986, even less than 1985's 3.8%. Last week the Labor Department announced that wholesale prices actually declined by .7% in January. Plunging oil prices will do much of the work of keeping inflation down, since energy is a major cost in manufacturing. Consumers are already reaping the benefits of slightly cheaper gasoline and heating fuel, and more declines are on the way.

Thanks to 39 months of economic recovery, Americans continue to march back to work. The TIME economists estimate that unemployment, which dipped from 6.9% in December to 6.7% in January, will fall a bit more during the year. They predict a level of 6.5% by the end of 1986, a far cry from the November 1982 peak of 10.7%.

The bright outlook for jobs helps keep the expansion going by inspiring consumers to spend. By most measures, their confidence remains high, and with good reason. Consumers boosted their net worth by an average 10% during 1985, partly because of gains in the stock market, Schultze said.

Business executives, by comparison, until recently have been somewhat reluctant to spend on new plants and equipment, partly because they were unsure the recovery would last. This year, however, Heller expects capital spending to increase about 7 1/2%, to $511 billion, which would be a healthy extra push for the economy. One reason companies can better afford to buy industrial robots, new buildings and other improvements is that the booming stock market has made it cheaper for them to raise money by issuing securities. Last week Wall Street investors, buoyed by moderate interest rates and cheap energy, pushed the Dow Jones industrial average up 51.03 points, to a record 1664.45.

The TIME board agreed, however, that the good times will eventually stop * rolling if nothing is done about the gargantuan U.S. budget deficit, which reached $212.3 billion in fiscal 1985. The economists think that the new Gramm-Rudman law, which sets out a timetable for the gradual elimination of the deficit by 1991, will put enormous pressure on Congress to cut spending and raise taxes. "Gramm-Rudman is a powerful threat," said Alice Rivlin, director of economics studies at Brookings. A federal court ruled two weeks ago that one important part of the law, which would have enabled the Comptroller General to make automatic budget reductions, was unconstitutional, but the measure contains other fallback provisions that would force Congress to take votes on sweeping spending cuts.

TIME's economists noted that the Administration has largely abandoned its old argument that deficits can be wiped out simply by stimulating the economy. In the fiscal 1987 budget that the Administration sent to Congress earlier this month, said Rivlin, "the White House has given up on the whole line of reasoning that was in previous documents, about how these deficits have nothing to do with pushing up interest rates or anything else." Added Harvard Professor Martin Feldstein, who served for two years as President Reagan's chief economic adviser: "The budget goes another step further toward recognizing that deficits do matter, that you have to take tough steps."

The economists differed somewhat, though, on the issue of how soon the deficit must be cut substantially. "This is the make-or-break year for the deficit," contended Rivlin. "There is a general perception that there is a breakdown in our system and we can't solve this problem." Feldstein, however, thinks that considerable progress has already been made. Said he: "If the deficit problem drags on for another year, it's not the end of the earth."

Many legislators and economists maintain that Congress and the Administration will have to boost taxes in order to keep the 1987 deficit to the $144 billion mark that Gramm-Rudman requires. Board Member Feldstein thinks that taxes will eventually have to be raised, but that the Administration will not go along with an increase until after the 1986 congressional elections, "when the magnitude of the problem will be clearer."

Uncertainty about when the deficit will be reduced poses a serious dilemma for Federal Reserve Chairman Paul Volcker. If he assumes that the deficit cuts will come soon, the Federal Reserve is likely to loosen credit in $ advance to prevent a drop in federal spending from slowing down the economy. But if Volcker boosts the money supply and no budget cuts are made, the economy could become overstimulated and vulnerable to increased inflation.

The risk of inflation has been sharply reduced, however, by the huge drop in petroleum prices. Last week the price for next-month delivery of West Texas Intermediate, a benchmark crude, closed at $16.01 per bbl., compared with $31.72 in November. Rimmer de Vries, chief international economist for Morgan Guaranty Trust, expects prices to average about $18 this year and next.

What brought on the oil windfall is a global production binge. The Organization of Petroleum Exporting Countries is pumping about 17.5 million bbl. a day, 2.5 million bbl. more than the industrial world can use. The glut showed up in earnest late last year after Saudi Arabia nearly doubled its output in order to regain the market share it had lost to rival producers.

Saudi Arabia demands that other countries ease the oil glut by cutting back production. But most rivals have refused. If no agreement is reached, says De Vries, "you could see oil prices go down very, very substantially, to the low teens and below that." The big question is how much economic pain the kingdom is willing to inflict on its rivals. "I don't think Saudi Arabia will want to be the hardliner and bring down countries and companies and banks," said De Vries.

Nonetheless, the Saudis have already put oil producers and their lenders in a historic jam. The worst trouble spot will be Mexico, which last week felt compelled to slash the average price of its oil from $19.77 to $15.09. The country has foreign debts of $96 billion and says it needs $9 billion in new loans this year. M.I.T. Economist Lester Thurow warns that the austerity measures that Mexico has endured to pay interest on its debt could make it politically popular for the country's leadership to repudiate the loans. Said Thurow: "What better way for the Mexicans to tweak the Yank's nose than to default on all of the debts." That could set off a financial crisis in the U.S., where many large banks still have multibillion-dollar loans to Mexico on their books. De Vries said, however, that financiers were likely to work out yet another package of new credit with the country.

Mexico's woes have distracted U.S. attention from its own patch of despair in Oklahoma and Texas, said Thurow. Falling crude prices have not only devastated many oilmen there but also their suppliers and much of the real estate industry. Says Thurow: "When the oil industry goes down, the whole infrastructure starts to fall in value." The evidence is abundant. The accounting firm of Price Waterhouse reported last week that the number of Houston businesses declaring bankruptcy rose 33% last year, to 1,386.

For most industries, though, cheap oil will be a powerful energizer. It will give the U.S. economy an excellent chance of achieving strong, noninflationary growth over the next year or so. And it will also, TIME's economists agreed, give the White House and Congress precious added time to come to terms with the daunting budget dilemma.

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