The Elusive Recovery

By Charles P. Alexander

Deficits and interest rates must come down, say TIME's economists

Forecasters scanning the horizon for an economic recovery have begun to feel a bit like Vladimir and Estragon, those frustrated characters in the play Waiting for Godot who keep expecting something that never happens. Now in its 18th month, the recession has been a longer-running and more tragic drama than almost anyone originally predicted. For that reason, the TIME Board of Economists was extraordinarily cautious as it met last week in New York City to survey the outlook for the new year. The economists expect the recovery to begin during the first quarter of 1983, but rarely have they been so uncertain about a forecast.

At best, the upturn will be slow and feeble. The board foresees growth in the gross national product, after adjustment for inflation, of about 3% next year, which would be only half the pace of most past recoveries. Even that modest progress will be in jeopardy unless the White House and Congress take decisive action to boost consumer confidence, lower interest rates and convince the financial markets that alarming federal deficits can be curbed. Said Otto Eckstein, a Harvard professor and chairman of the Data Resources economic consulting firm: "We're all hoping and praying for a recovery, but I'm afraid the Government is not prepared to do much to ensure it."

In describing current conditions, the board members were unusually blunt. "The economy is probably in the worst shape that it has been in for nearly half a century," said Eckstein. Added Walter Heller, an economics professor at the University of Minnesota who was chairman of the Council of Economic Advisers under Presidents Kennedy and Johnson: "This is the deepest and most dangerous recession of the postwar period." Rimmer de Vries, chief international economist for the Morgan Guaranty Trust Co., joined the gloomy chorus: "We are sitting here in the midst of a major depression."

Recovery has been delayed, said Heller, because "the consumer is still shell-shocked by unemployment." And with good reason. The jobless rate has hit 10.8%, leaving nearly 12 million Americans out of work. Heller cited statistics indicating that about 20% of all households are directly affected by unemployment and that another 40% feel threatened by mounting layoffs. The TIME board predicted that the jobless rate will reach 11.3% in 1983's first quarter before beginning to drop slowly. Even by the end of 1983, unemployment will still be hovering around 10%. "The unemployment problem is not going away quickly," said Alice Rivlin, director of the Congressional Budget Office and a guest panelist last week.

More than 30% of U.S. industrial capacity now stands idle. As a result, companies are expected to slash real capital spending by 8.5% next year. That cutback almost guarantees that any business recovery will be painfully gradual.

Most ominous, the U.S. slump is only part of a worldwide pattern of malaise. In the European Community, more than 11 million people, or 10.3% of the work force, are unemployed. Developing nations from Africa and Asia to Latin America are staggering under a $626 billion foreign-debt load. A string of near defaults on loans to Mexico, Argentina and now Brazil (see box) has rocked the international monetary system.

These nations and many others are in a financial bind partly because they are dependent on exports to the U.S. and those shipments have been slowed by the American recession. In turn, sluggish growth overseas has hurt American export industries. Two-way trade troubles have thus created a self-sustaining downward spiral that is difficult to stop.

Despite these daunting problems, TIME's board sees several signs that the U.S. economy has almost hit bottom and is poised to begin the long climb back. The decline in mortgage rates from 17% in March to less than 14% has triggered a sharp rebound in housing. The number of new homes started in November rose 27% from October's pace. Car sales are also up, buoyed by low-cost financing deals being offered by the automakers. In the first ten days of December, 13% more American-made autos were sold than during the same period a year ago.

The most encouraging news is the dramatic slowdown in the inflation rate. Consumer prices have been rising so far this year at an annual pace of 4.9%, down from 8.9% in 1981 and 12.4% in 1980. TIME's economists predicted that inflation will remain in the comparatively comfortable 5% range throughout 1983.

One reason for that optimism is the brightened energy outlook. World oil supplies are ample, and the price of crude is more likely to sink than spurt. In an effort to raise cash, several members of the Organization of Petroleum Exporting Countries have been overshooting their production quotas and offering customers discounts off the cartel's $34-per-bbl. official price. "OPEC's quota and pricing system may be on the verge of breaking down," said Board Member James McKie, an economics professor and energy expert at the University of Texas. If that happens, McKie added, oil prices could fall to $20 per bbl. or below by the end of 1983.

Cheaper energy is one of several tonics that could help revive the economy during the coming year. Another is the 10% personal income tax cut scheduled to begin on July 1. A third stimulus will be a big boost in defense spending, which is expected to increase by 7% in real terms during 1983.

TIME's board warned, however, that a recovery is not assured. Reason: interest rates may still be too high to support an upturn. Since July, the benchmark prime rate on bank loans has dipped from 16% to 11.5%, but that level is 6.5 points higher than the 5% inflation rate. Historically, the cost of borrowing money has usually been only 2 to 3 points above the rate of price rises. Consumer credit remains discouragingly expensive. Bank of America, for example, charges 22% on personal loans.

Several of TIME's economists contended that the Federal Reserve Board should expand the money supply a bit faster to bring interest rates down another point or two. Said Charles Schultze, a visiting professor at Stanford University's graduate school of business, who was President Carter's chief economic adviser: "The thing most likely to make a major change in economic performance over the next couple of years would be a further easing by the Fed." Agreed De Vries: "The Fed is moving much too slowly." By coincidence, shortly after the meeting at TIME ended, the Reserve Board announced that it was lowering the discount rate that it charges for loans to banks by a half-point, to 8.5%.

Alan Greenspan, a consultant who was President Ford's chief economic adviser, argued that while the Reserve Board might be able to reduce short-term interest rates, it could do little to bring down the high rates (12% or more) on long-term corporate bonds. Bond buyers fear that a too rapid expansion of the money supply by the Federal Reserve could eventually reignite inflation. As a result, they demand high interest as protection against rising prices. But until bond rates come down, companies will continue to restrain their capital spending. After the cut in the discount rate last week, long-term interest rates initially fell, but they bounced back up again, partly out of concern that the Federal Reserve was easing too much and risking future inflation. Concluded Greenspan: "The Fed is in a box."

Congress has been considering measures of its own to speed a recovery, including several proposals to reduce unemployment by creating hundreds of thousands of public works jobs. TIME's economists doubted that this strategy could have much impact. Similar programs enacted during recessions in the 1970s took a long time to reach full steam and had little lasting effect on unemployment. Said Rivlin: "The experience of the past decade has made economists a lot more skeptical about using the federal budget to create new jobs." Added Schultze: "We ought to put people back to work, as much as possible, in the jobs they were doing before the recession began. In other words, we should stimulate the private sector."

The economists were also dubious about a White House-backed plan that would raise the federal gasoline tax by 5-c- per gal., so that the revenues raised could be used to put 320,000 people to work repairing highways, bridges and mass-transit systems. While agreeing that such restoration projects were needed, the board members pointed out that the increased tax would probably reduce consumer spending and might destroy more jobs than it created. Said Heller: "This is an anti-jobs bill."

Several of the economists, including Heller and Eckstein, argued that the simplest and surest way to spur recovery would be to move up the 10% tax cut from July 1 to Jan. 1. President Reagan supported such a strategy briefly but then abandoned it because it was unpopular in Congress. The main drawback to accelerating the tax cut is that it would swell the already bloated federal budget deficit. The financial markets are gravely concerned that the flow of red ink will cause inflation to speed up again, and this anxiety, more than anything else, has been responsible for keeping interest rates at lofty levels. As a result, said Eckstein, the Government is suffering from "expectational paralysis." In other words, the lawmakers cannot agree on any kind of stimulation for fear of what will happen to inflation and interest rates.

While Eckstein contended that lower taxes and a somewhat larger deficit in the short run would help lift the economy out of recession, he agreed with all the other board members that, after the recovery begins, the budget gap must be narrowed substantially. Unless something is done, the economists predicted, the deficit will rise from $110.7 billion in fiscal 1982 to more than $170 billion in 1984. That would be nearly three times as high as the biggest deficit recorded by any previous Administration.

The most worrisome part of the budget is the gargantuan Social Security program, which accounts for more than 25% of federal spending. Projections show that the trust funds from which benefits are paid will run out of cash in early 1984. For nearly a year a special 15-member bipartisan commission appointed by President Reagan and Congress has been studying ways to ensure the solvency of the Social Security system, and the group is expected to issue a final report soon.

Greenspan, who chairs the commission, said at the TIME meeting that the Democrats and Republicans on the Social Security panel were struggling last week to arrive at a compromise plan calling for some tax hikes and a modest slowdown in benefit increases. He put the chances that an agreement will be reached at one in four. If that effort fails, the commission will lay out various options for shoring up Social Security's finances and let Congress decide what to do. One way or another, said Greenspan, "the problem has got to be solved."

Whatever modest steps Congress takes to trim Social Security spending, the budget deficit is likely to remain huge for many years to come. As part of the tax-cut legislation passed in 1981, federal income tax brackets will be subject to indexing starting in 1985. Indexing will automatically adjust the brackets to keep taxpayers from paying a higher percentage of their income simply because of inflation. But that will hold down revenues and help perpetuate the deficit dilemma. Given Congress's reluctance to make necessary cuts in spending and Reagan's determination to boost defense outlays, Schultze, Heller and Eckstein contended that the best way to shrink the budget gap may be to scrap the indexing plan. If Congress decided immediately to repeal indexing, the action might reassure financial markets and help bring down long-term interest rates.

On the other hand, Greenspan argued, doing away with indexing would take the pressure off Congress to bring Government spending under control. He and other conservative economists have long insisted that the steady climb of income tax rates caused by inflation has undermined incentives for Americans to save more of their earnings. Conceding that some kind of tax increase may be inevitable, Greenspan suggested that Congress consider the value added tax (VAT), a form of national sales tax used by many West European nations. Unlike the progressive income tax, the VAT would not discourage savings and investment.

Dealing with the deficit is of crucial importance not only to a U.S. recovery but also to the economic health of the entire world. High U.S. interest rates prop up rates abroad as well, and the onerous cost of carrying loans has brought nations with large foreign debts dangerously close to bankruptcy.

De Vries warned that the debt situation is creating a "serious financial crisis." So far, a patchwork of new loans from private banks and increased lending by major governments and the International Monetary Fund has rescued Mexico, Brazil and other developing nations from default. Nonetheless, frightening risks remain. If, for example, the price of oil were to drop rapidly, debt-laden oil-producing countries such as Mexico and Nigeria would face a financial crunch. Said Greenspan: "There might be a financial run on those countries. Lenders could pull their money out and blow a hole in the system." De Vries suggested that existing international agencies like the World Bank may have to be restructured to give them the power to funnel money quickly to nations in danger of financial collapse.

Such contingency plans will do nothing, of course, to cure the fundamental ills of the world economy. Said De Vries: "We cannot solve the enormous debt problem until there is a robust recovery in the major industrial countries." The U.S., all TIME's economists agreed, will have to lead the way. --By Charles P. Alexander

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