Get Set for a Second Wind

By Barbara Rudolph

From the canyons of Wall Street to the assembly lines of sprawling factories, the performance of the U.S. economy was generating a high level of anxiety and uncertainty last week. The New York Stock Exchange settled into a nervous lull in the aftermath of the record plunge of the Dow Jones industrial average the week before. The Commerce Department reconfirmed that growth in the gross national product was almost completely stalled in the second quarter. Economists, executives and workers all pondered the same questions: Is the U.S. slipping into a recession? Are interest rates headed higher? Is inflation poised for a resurgence?

Despite the ample causes for concern, chances are good that the economy will shake its slump and gather new momentum. That was the consensus of the TIME Board of Economists, which met in New York City this month to discuss the outlook. The economists forecast that GNP growth, after adjustment for inflation, will accelerate from an annual rate of .6% in the second quarter to 2.4% in the last half of the year. For 1987 they predict a sturdy, if not spectacular, 3% growth rate. Said Walter Heller, a University of Minnesota professor who was chairman of the Council of Economic Advisers during the Kennedy and Johnson Administrations: "I am keeping the faith that we will have no recession, the economy won't stagnate, and growth will pick up."

The board members agreed that the Dow's 121-point drop, to 1758.72, on Sept. 11 and 12 did not signal an economic downturn. Alan Greenspan, a Manhattan-based consultant who served as chief economic adviser to President Ford, estimated the Dow would have to go down another 200 to 300 points to have a significant impact on the economy. If stock prices fell that far, executives might curb their companies' capital investment and consumers might reduce their spending enough to trigger a recession. But the stock market steadied last week, rising 3.93 points to close at 1762.65. Investors took in stride the "triple witching hour." On the third Friday of the last month of each quarter, contracts on stock options, stock index futures and stock index options all expire. In the past, the triple witching hour has brought volatile market moves, causing the Dow to rise or drop as much as 36 points. But last Friday the Dow fell a mere 11.53 points.

One reason the TIME economists are not predicting a recession is that the employment picture has improved, even in the face of sluggish growth. In August the U.S. jobless rate fell from 6.9% to 6.8%. It was the third successive monthly decline, and it brought the unemployment rate to its lowest level since January. The economists expect the jobless rate to hover around 6.7% through the end of 1987, far below the 9.7% peak reached in 1982.

The board members expect the economy to avoid a recession because they believe interest rates will remain relatively low. During the past two years, the benchmark prime rate, which banks charge their best customers, has fallen % from 13% to 7.5%. The board believes the full benefit of low interest rates has not yet been felt. The economists doubt that the Federal Reserve will allow rates to move up until the economy is considerably stronger. Indeed, they suggested that the Fed should push down the cost of borrowing a bit more.

But the Fed can reduce rates only if inflation stays under control. On that front, the news is still good. Mainly because of a sharp drop in the cost of oil, consumer prices fell at an annual rate of .2% in the first half of the year. Now, as a result of the continuing decline in the dollar's value and a partial turnaround in oil prices, the inflation rate is expected to rise above 3% by year's end. But that is still modest by the standards of the past decade. Said Heller: "There is simply no inflationary wolf at our door."

Low inflation and interest rates will provide much needed incentives for business investment. While companies increased their capital spending 8.7% in 1985, businesses are expected to reduce their investment 2.5% this year, the steepest falloff since the recession year of 1982. Several economists, though, were encouraged by the 35% rise in capital spending on computers during the past two months.

Some of TIME's economists said investment could be further hampered by increases in business taxes under the tax-reform bill that Congress is expected to pass soon (see box). But Henry Aaron, a Brookings Institution senior fellow who was a guest at the TIME board meeting, argued that the impact of tax reform on the economy would be overwhelmed by other factors, including the Fed's monetary policy.

Among the board members, Greenspan was the most cautious in his outlook for business spending. He argued that while low interest rates have been a positive force, they have been largely offset by the dramatic increase in nonfinancial corporate debt, up by more than $500 billion during the past two years. Because debt-laden companies must use spare cash to pay interest on borrowed funds, these firms often postpone new investments. Much of the debt was taken on to finance the whirlwind of mergers and acquisitions that has swept through corporate America in the 1980s.

One of the most daunting obstacles to business investment has been the swollen trade deficit, which in July was an unprecedented $18 billion. Companies have little incentive to build factories when their sales are being siphoned away by foreign rivals. If the trade deficit keeps expanding at the current pace, it will hit $175 billion by year's end, an 18% increase over 1985's record level. Said Heller: "It's the villain of the piece."

The trade deficit poses something of a puzzle for TIME's economists. Accepted economic theory has it that when the dollar falls in value, imports should become more expensive and U.S. exports cheaper. The trade deficit will then shrink. That improvement, however, usually does not begin to occur until some twelve to 18 months after the dollar starts to fall. But while the dollar has dropped about 30% against an average of major foreign currencies during the past 18 months, the trade gap is still growing. Said Lester Thurow, an M.I.T. professor: "There is no equation you can drag out of your drawer to show that as the dollar has declined in the past several months, the trade deficit should go up by $30 billion."

Charles Schultze, a senior fellow at Washington's Brookings Institution, was slightly less troubled by the recent trade data. He countered that in view of the long lag between a falling dollar and an improvement in exports, there was no reason to expect the trade deficit to have fallen very much by now. In any event, the majority of the board members agreed that the trade gap would surely begin to narrow by year's end. "If something doesn't turn around soon, then we don't know anything," said Alice Rivlin, director of economic studies at Brookings and a former head of the Congressional Budget Office.

The persistent trade deficit has several underlying causes. While the dollar has fallen from its peak by more than 40% against the Japanese yen, it has dropped just 6% in relation to the Taiwanese New Dollar and has actually risen 3% against the South Korean won. In addition, import prices have not risen nearly as much as they were expected to. Typically, when the dollar weakens, foreign manufacturers boost prices of products sold in the U.S. because the money they receive from American consumers is worth less when converted into other currencies. So far, though, prices of imports, not including fuel products, have risen only 8% on average.

U.S. Government officials have repeatedly called on Japan and West Germany to help bring down the American trade deficit by expanding their own economies. One way for them to do that would be to lower their interest rates. Japanese and German consumers would then be able to buy more goods from American exporters. But because they are wary of rekindling inflation, Japan and Germany have not brought down their interest rates as swiftly as the U.S. would like. "We have been drumming this song for a long time," said Rimmer de Vries, chief international economist for Morgan Guaranty Trust, "but there's been no response." Late last week, though, the Japanese government did announce a $23 billion public-spending package that includes a boost in housing loans.

Harvard Professor Martin Feldstein, who served for two years as President Reagan's chief economic adviser, argued that it is point less to expect Japan and Germany to help cure U.S. trade woes. Even sharply increased growth in those two economies would probably lop no more than $15 billion off the American deficit. Said Feldstein: "In terms of the trade deficit, there's nothing in it."

One strong hope for an improved trade situa tion, the economists agreed, would be a still weaker dollar. Indeed, Treasury Secretary James Baker prompted a new dip in the dollar's value last week by declaring that the currency may have to come down further to force a shrinkage of the trade deficit. If the greenback were to fall another 15% against all currencies, Economist De Vries figured, it would slash about $50 billion from the deficit. One reason: foreign manufacturers would finally be compelled to push their prices up substantially on goods sold in the U.S. The rise in import prices would fuel a slight increase in the American inflation rate, the economists said, but not enough to outweigh the benefits of a decreased trade deficit.

A potentially more serious inflation threat is a rebound in the cost of oil. Since the members of the Organization of Petroleum Exporting Countries agreed in early August on a new pact to reduce production, oil prices have jumped from $11.55 per bbl. to more than $14. But the OPEC agreement expires on Oct. 31, and it is not at all certain to be renewed.

TIME's economists noted that OPEC's pact is vulnerable. OPEC nations will face powerful temptations to "open up the spigots" in violation of their production quotas, said Greenspan. Virtually every OPEC member is financially strapped and thus in dire need of income from oil sales. For that reason, the economists do not now foresee a continued run-up in oil prices.

A much larger cloud lingering over the economy is the federal budget deficit, which is expected to hit a record $210 billion or more this year. Government borrowing has soaked up a large portion of available savings and thus kept interest rates higher than they otherwise would have been. Some members of Congress fear that a major reduction in Government spending could be a blow to the fragile economy. But TIME's board members concluded that the economy is strong enough to withstand a determined attack on the budget deficit.

The economists expect Congress to pass a budget bill this fall calling for a 1987 deficit of no more than $154 billion, as mandated by the new Gramm-Rudman law. Not all of that reduction is likely to be achieved, however. Rivlin predicts that next year's deficit will be in the $175 billion range. TIME's board members agreed that Gramm-Rudman's 1988 deficit target of $108 billion is out of reach, in part because the needed spending cuts would be too painful politically. As a result, they said, Congress will resort to revising the Gramm-Rudman targets.

The danger in not dealing forcefully with the deficit now is that when a recession comes, Congress will not be able to combat it with a large boost in Government spending. The budget imbalance, said Heller, has canceled the country's antirecession insurance policy. Fortunately, if the economists' forecast is correct, the White House and Congress still have at least a year or two to rein in the deficit before the next downturn strikes.

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