Spotlight on the Consumer

By John Greenwald

TIME'S economists look for the July tax cut to start the recovery

Will the consumer spend it or save it? That is the $50 billion question facing the U.S. economy. In July, the Government will begin giving out $39 billion in tax cuts, the second installment of the three-year personal income tax reduction that Congress passed last year, and $11.5 billion in increased Social Security benefits. If the American consumer quickly spends most of that money, the extra business that will be created should be enough to end the nearly yearlong recession. But if the consumer decides to hold onto that extra cash or to pay off his debts, the economy is likely to continue limping along.

That was the verdict of TIME'S Board of Economists, which met last week in Manhattan to assess the state of the U.S. and world economies. For now, the economists predict that consumer spending will increase sufficiently to give the U.S. a 3.3% annual growth rate during the second half of the year.

Consumers have reacted to past tax cuts by stepping up their purchases of autos, refrigerators, clothing and other goods. For example, they spent about 80% of the $9 billion in personal tax relief in 1964-65, setting cash registers ringing and helping spur a robust expansion. The expectation is that the American public this year, just as in 1964, will eventually spend most of the tax cut.

Nonetheless, the question marks hanging over the economy are more numerous than usual. Said Otto Eckstein, chairman of Data Resources, an economics consulting firm: "The test comes in August. We have to watch very, very closely the retail sales of July and August because if they don't go up, then we are in much deeper trouble."

There were a few hints last week that business might soon be starting to pick up a little. The Commerce Department reported that its index of leading economic indicators, which attempts to predict future business trends, rose .8% in April--its first increase in twelve months. Auto sales increased a surprisingly strong 12.3% during the middle ten days of May.

TIME'S economists saw other encouraging signs that the slump may soon end. Runaway inflation has subsided, enabling the public to stretch its money further. The Administration's $1.6 trillion defense buildup is also helping to stimulate a recovery. Corporations that have been decreasing their inventories appear ready to start restocking shelves. That would mean that companies may soon begin stepping up production and rehiring workers.

Continuing signals of economic weakness, however, were also evident last week. The value of new building contracts slid 16% in April. Housing starts are now running at an annual rate of just 881,000 units, compared with about 2 million five years ago.

If those and other signs of a weak economy scare the consumer away from spending the tax cut and Social Security benefit increases, there is little to pull the economy out of the recession. Business investment continues at a very low level, and it is unlikely to pick up without new consumer spending. Alan Greenspan, a New York-based economics consultant and sometime adviser to the Reagan Administration, said that new business orders were "somewhat worse than I would have expected them to be at this stage. We should have seen a turnaround in new orders for durable goods by now, but there's nothing there."

Even assuming the optimistic scenario and more consumer spending, the business pickup is not expected to be as strong as after other recessions. Said Eckstein: "It will be a limp recovery." Board mem bers expect the gross national product to increase 3.1% in 1983. The first year after the severe 1974-75 recession, the U.S. economy expanded 5.4%.

The bright spot of American business remains the progress against inflation. In March, the Consumer Price Index dropped for the first time in 17 years, and in April it rose at an annual rate of just 2.4%. In 1980, prices increased at a staggering 12.4% rate, and inflation was dangerously undermining the foundation of the U.S. economy. The major goal of the Reagan Administration has been to end such unsettling leaps, which erode incomes and make it difficult for corporations to plan.

TIME'S economists foresee no renewed outbreak of feverish jumps in the C.P.I. They predict that the index will meet the Administration's targets by rising just 5% for all of 1982 and 5.7% in 1983. The economists were particularly cheered by an unexpectedly sharp drop in the so-called core rate of inflation, which measures the inflationary impact of wage gains. That key indicator has fallen to about 6%, from a high of about 9% in 1980. Said Walter Heller, chief economic adviser to Presidents Kennedy and Johnson: "A sustained period of 6% core inflation is a very substantial improvement." Adds Charles Schultze, chief economic adviser to President Carter: "The slowdown in the rate of wage increases has brought a real long-term benefit to consumers."

The economists cautioned, however, that the actual fall in the prices of such major consumer items as food, gasoline and housing appears to be reaching an end. This means that the inflation record for the rest of the year is unlikely to match the extremely low figures of the past three months. The TIME board projected that prices at the end of the year would be increasing at an annual rate of about 6.5%.

Despite some superficially good news in recent months, TIME'S economists continue to worry about the long-term energy outlook. Motorists already are paying more for gasoline as refiners draw down the huge stocks of crude oil stored during the global oil glut. James McKie, an energy expert and the chairman of the economics department at the University of Texas, warned that the temporary surplus in world energy supplies had created an illusion that the energy problem has been solved. Said he: "It's curious why anyone would have thought the so-called oil glut spelled the end of the energy crisis. That's not supported by any known evidence. What we're looking at again is an upward trend in energy prices." McKie was concerned that the recently falling oil prices were encouraging both private industry and Government officials to abandon alternative energy programs like those for nuclear power and synthetic fuel.

Even with an economic pickup during the summer, the board's unemployment forecast remains grim. Members expect the jobless rate to peak at 9.9% in June or July, and then fall to 9.25% by December. Said Barry Bosworth, a senior fellow at the Brookings Institution and a guest at last week's meeting: "The U.S. and all the other industrial countries have gone to a higher rate of unemployment than anyone would have thought possible a decade ago."

High unemployment, of course, is a problem not limited to the U.S. It has become a global epidemic reflecting the worldwide slump that is now occurring. Rimmer de Vries, a senior vice president at Morgan Guaranty Trust Co., warned that "unemployment will keep on rising in nearly all the industrial countries for most of the rest of this year and will approach a staggering 30 million."

Virtually every country around the world is revising its projections of economic growth downward. De Vries predicted that the major countries of Europe would remain in stagnation for the rest of the year, while those in Asia, which have been expanding more rapidly, are expecting somewhat slower business. Growth in Japan this year will be only about 3%.

The Western economics summit meeting in Versailles this week will look at these international problems. De Vries believes that the American and European leaders should use the opportunity of the summit to press the Japanese to open up their domestic market more to imports. With an unemployment rate of only 2.5%, that country could easily import more Western manufactured goods without jeopardizing its workers. Said De Vries: "By doubling its imports in terms of G.N.P., Japan could create a $50 billion market that would be a great help in this recession." Tokyo indicated a willingness to move in that direction last week by announcing plans to eliminate tariffs on 96 categories of imports.

Getting out of the world economic slump is being made more difficult by the high interest rates, particularly in the U.S. Board members expect that the prime rate will fall from 16.5% to 14% by the end of the year. That, however, is not anywhere near the 12% or so that some leading businessmen say will be necessary to get consumers back buying cars, houses and other credit-sensitive items. Moreover, the economists predicted that once the recovery gains strength in 1983, interest rates could begin rising again. That would restrain growth and perhaps bring the recovery to a premature end.

Board members disagreed on whether the Federal Reserve will ease its tight money policies and let interest rates come down. Bosworth doubted it. Said he: "Right now, the Fed is just not part of this discussion. It stands on the sidelines and says, 'We don't care what you say. We're just going to sit on the money supply.' " Heller, though, argued that recent statements of Federal Reserve Chairman Paul Volcker indicate that some loosening may be coming. Said Heller: "I'm reasonably optimistic. Volcker is sounding a good deal more accommodating."

TIME'S economists unanimously agreed on the need to bring down the unprecedented budget deficits that have been one of the major factors behind the high interest rates. Said Liberal Barry Bosworth: "Running huge budget deficits and a very restrictive monetary policy makes no sense whatsoever. Our economic policy has been absolutely backwards."

Conservative Alan Greenspan singled out those high deficits as the main cause of the present economic malaise. Said he: "Current interest rates are largely a function of long-term inflation expectations, and that, in turn, is based on the long-term budget outlook. I think that the failure of the so-called budget summit between the President and House Speaker Tip O'Neill was an expensive failure."

Behind that broad accord, however, there was great disagreement over how exactly to bring down the size of the deficit. Liberals on the board want to raise taxes and cut defense outlays, while conservatives side with the Administration in urging further reductions in social spending. Heller, a Democrat, called for the elimination of next year's third and final installment of the personal income tax cut, and for major savings on defense. Those and related steps, he argued, could whittle the 1985 deficit to a manageable $75 billion. That would be a major drop from the $233 billion deficit that some experts predict.

Heller maintains that the fundamental flaw of current economics policy is that the Administration is battling high prices by tight monetary policy alone, leaving fiscal policy too loose. Said he: "You simply can't step on the fiscal gas and simultaneously stomp on the monetary brakes without generating a terribly bumpy economic ride." Heller and other liberals on the board would like to see some agreement among the Administration, Congress and the Federal Reserve that would result in both significantly lower interest rates and budget deficits.

Heller argues that a distinction should be drawn between Reaganology, a doctrinaire policy for a reduced federal role in society, and Reaganomics, which seeks to correct the U.S. economic course. Said he: "The President simply has to take the lead, which he is not doing with his feet set in Reaganology, and give some ground on the tax cuts and on the defense buildup, if we are to have any real chance for a success of Reaganomics."

Greenspan opposed any changes in the President's three-year tax plan or major reductions in defense spending. He said that the current and future budget deficit problems were not caused by overly generous tax reductions last year, but by excessively rapid increases in Government spending on social benefits during the past ten to 15 years. Greenspan acknowledged that "we have probably gone on too far on the military," but noted that a cutback would "send the wrong signals" to the Soviet Union. Said he: "I think that the President's basic approach is correct."

Barry Bosworth argued that both the President and the Democratic leadership in Congress should move toward the political middle and be more willing to compromise. Said he: "The President has to quit being so ideological with respect to his economic policy, and the Democrats have to be willing to give in on some of those programs, certainly on the notion that Social Security cannot be touched."

Otto Eckstein was strongly critical of Reagan for not providing leadership in the budget debate. He maintained that ? Congress cannot take the lead in straightening out the budget. Said Eckstein: "Congress has never m been able to do that, and it never will be able to." He said that this has resulted in "political chaos" that has been a cause of the uncertainty in the financial markets.

James McKie said that he was "very discouraged" by the prospect that Congress this year might be totally unable to agree on a budget. He added that Congress would find it was "addicted to a narcotic" if it simply decided it could not agree on a budget this year and thus continued spending on the basis of last year's budget.

Harvard Economist Martin Feldstein, who filed his views to TIME while on a trip to China, praised the President's program. Said he: "Reaganomics has been a great success in getting the incentives right for the rest of the 1980s." Feldstein said that consumer savings and businesses are just beginning to respond to tax cuts and other measures passed by Congress last year. "These things don't have an effect overnight," he added.

Although TIME'S economists disagreed on the right way to break the budget deadlock and bring down the amount of deficit spending, they all said it was essential to get out of the political and economic gridlock that is causing business uncertainty. A realistic budget compromise would obviously not bring about an immediate drop in interest rates or assure that consumers this summer will feel confident enough to spend the money from the tax cut. But the lack of a budget agreement and the prospects of more huge deficits in the future mean that the debilitating economic uncertainty will continue. Unless Congress and the Administration solve the present deficit dilemma, the expected summer business recovery could be short-lived, or perhaps not even start at all.

--By John Greenwald

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