The Recovery Rolls On

By Charles P. Alexander

TIME's Board of Economists sees steady growth ahead

The U.S. economy is a bit like an Olympic bicycle racer rolling along with the breeze at his back. Once he builds up speed, not even powerful brakes can bring him to an abrupt stop. And so, after barreling ahead at an 8.8% annual growth rate during the first half of 1984, the economy will slow in the coming months, but it still has enough momentum to keep going at least through 1985. Even a national auto strike against GM would have only a limited and temporary impact, unless it lasted for many months.

That was the forecast of the TIME Board of Economists, which met last week to discuss the pre-election outlook. Said Board Member Alan Greenspan, who was chairman of the Council of Economic Advisers under President Ford: "There is no evidence that we are moving toward a recession in the foreseeable future." Nor do the economists expect any upsurge in either interest rates or inflation that could hurt Ronald Reagan's campaign. Said Charles Schultze, who was President Carter's chief economic adviser: "It's virtually inconceivable that anything could happen now that would have a significant impact on the election."

The economy showed several signs of vigor last week. The dollar set records against the French franc and Italian lira and was worth more than three West German marks for the first time since 1973. To foreign investors, said Walter Heller, who was President Kennedy's top economic adviser, "the U.S. is the safest and most profitable haven around for investment." Bond prices surged on the belief that the Federal Reserve Board is easing its monetary policy. Stocks also rallied. The Dow Jones industrial average jumped 30 points to finish the week at 1237.52.

Only a few months ago, there was growing concern that the economy might overheat and generate sharply higher interest rates and inflation. Brisk loan demand and the Federal Reserve's tight policy pushed the prime rate that banks charge business borrowers from 11 % early in the year to 13% by summer. That increase in interest rates now seems to be helping slow the economy to a more moderate rate of expansion.

TIME'S economists predict that growth in the gross national product, after adjustment for inflation, will fall from 7.6% in the second quarter to 4% in the last three months of the year. In 1985 growth is expected to remain at a healthy 3.5% pace. As the economy slows, upward pressure on interest rates should ease considerably. The TIME board forecasts that the prime rate will rise no more than a percentage point, to 14%, between now and the end of 1985.

One issue continues to worry the economists: the mammoth federal budget deficit. It will total about $175 billion in 1984, and the Congressional Budget Office predicts that it will reach $263 billion by 1989. Warned Alice Rivlin, former director of the CBO and now a senior fellow at Washington's Brookings Institution: "I see no reason to be less worried about the deficit than we all were a few months ago. We shouldn't be overcome with the optimism of the short-run outlook." Unless Congress and the President confront this monster deficit, Government borrowing could eventually clash with the increasing loan demands of private business. If the Federal Reserve Board keeps to its stringent monetary policy, interest rates may climb. But if the Fed tries to hold down rates by expanding the money supply at a faster pace, inflation might speed up.

For the moment, said Heller, "inflation is under fine control." The Labor Department reported last week that wholesale prices dipped .1% in August, an indication that inflation at the retail level should remain subdued in the weeks ahead. TIME'S economists predict that consumer prices will rise 5% next year, just slightly more than the 4.1% increase projected for 1984.

One of the important forces holding down U.S. inflation is the strength of the dollar. The dollar's surge has lowered the prices that Americans pay for imports. At the same time, U.S. companies have had to keep their prices in line with foreign competitors. But if the dollar were to fall, import prices would rise. "The one cloud on the horizon is the threat that the dollar might decline and boost inflation," said Schultze. "But that cloud has been there for a long time. It hasn't rained yet, and it doesn't look as if it will for a while."

The dollar's climb has had a negative side. It has made U.S. exports more expensive and thus hurt American companies that sell products abroad. Because imports have grown so much faster than exports, the U.S. is expected to have a record $130 billion trade deficit this year.

According to standard economic theory and the law of supply and demand, the growing U.S. trade deficit should be pushing down the value of the dollar. Reason: foreigners are accumulating more dollars from the sale of goods in the U.S. than they need to buy American products, which means that dollars should be worth less. Nonetheless, foreigners seem to have an unquenchable appetite for U.S. currency. They are not so much interested in buying American goods as they are in obtaining dollars to invest in U.S. bank accounts, Treasury securities and real estate. The net flow of foreign capital into the U.S. may reach $ 100 billion this year. Observed Rimmer de Vries, chief international economist at Morgan Guaranty Trust: "For the first time, the value of the dollar is being determined not by trade, but by the movement of capital."

TIME'S economists offered several reasons to explain why the U.S. has become such a powerful magnet for foreign investment. For one thing, interest rates on American bonds and bank accounts are among the highest in the world's major industrial countries. Moreover, the swift expansion of the U.S. economy has made American stocks and real estate look enticing. U.S. investments seem particularly attractive compared with opportunities in Western Europe, where the recovery is sluggish.

Greenspan contended that the free-market philosophy of the Reagan Administration is an effective drawing card for investment. In his view, many foreigners believe that the President has fostered a pro-business atmosphere in which corporations are relatively free from burdensome taxation and regulation. One reason for the dollar's recent ascent, suggested Greenspan, may be the expectation abroad that Reagan in a second term would continue these policies.

Board Member Lester Thurow, an economics professor at M.I.T. and a frequent adviser to Democrats, took a more critical view: "There may be something irrational about the rush to the dollar." He compared it to the tulip mania that swept Europe from 1634 to 1637. During this frenzy of speculation, investors bid up the price for a single rare tulip bulb to as high as $5,000 and then lost fortunes when the value plunged. In much the same way, said Thurow, the dollar could fall as fast as it has risen.

TIME'S economists agreed that the U.S. is growing dangerously dependent on foreign capital to help finance its budget deficit. If that extra money were not available, Government borrowing would absorb a higher percentage of American savings, thus making it harder for businesses to get loans. Interest rates would inevitably rise. Said Rivlin: "What's keeping us from collision and crunch is the big inflow of funds from abroad."

Since the U.S. cannot count on that flow, it is vital that Congress and the White House attack the deficit. The TIME board criticized the Administration's contention that spending cuts and a continuation of rapid economic expansion can balance the budget. Said Rivlin: "The hope that we will grow out of this deficit is a vain one." The economists recommended raising taxes. Said Martin Feldstein, a Harvard economics professor who has rejoined the TIME board after serving two years as chairman of Reagan's Council of Economic Advisers: "It's only a question of whether we have higher taxes now or higher taxes later. Unless the deficit is reduced, interest costs on the national debt will just explode."

The economists do not favor a hike in personal income tax rates, which would discourage work, saving and investment and encourage the well-to-do to channel money into tax shelters. Instead, the board supported tax reform of the type proposed by two congressional Democrats: Senator Bill Bradley of New Jersey and Representative Richard Gephardt of Missouri. Their proposal would eliminate many loopholes and scale back deductions as a way of boosting the amount of personal income subject to tax. Under the plan, tax rates would range from 14% to a maximum of 30%, which would be far lower than the current top level of 50%. Even so, the Government would collect the same amount of revenue as it does now. If rates were set from 18% to 34%, Congress could increase annual revenues by about $80 billion and go a long way toward closing the deficit.

Rivlin feared that Congress would not raise taxes. Because interest rates seem to have leveled off, she said, the lawmakers may not feel under pressure to deal with the deficit. In addition, Rivlin asserted, "nothing has happened to indicate that the President will agree to cuts in defense spending or increased taxes." Feldstein, however, said he expected that Reagan in a second term would put forward a tax-reform proposal that would raise revenues.

What is needed, say TIME'S economists, is a package that combines a tax hike, a partial rollback of planned defense expenditures and more cuts in social spending. So far, however, few Congressmen have been willing to call for spending reductions that would hurt voters. Greenspan maintained that serious budget cuts would never emerge from a public debate on the floor in Congress. Said he: "Regrettably, the politicized atmosphere surrounding this problem makes it very difficult for open government to work."

Greenspan argued that a bipartisan group of political leaders must meet behind closed doors to forge a budget compromise. "The old smoke-filled room probably will have to be resurrected," he said, "even if it has a NO SMOKING sign in it." After the plan is set, Greenspan suggested, Congress should allow no amendments of significance and schedule a simple up-or-down vote. In that way, neither party could blame the opposition for any particular part of the bill. Such a strategy worked well in the case of last year's Social Security reform legislation, which was a closed-door deal drafted by a bipartisan commission headed by Greenspan.

The TIME board warned that action must be taken early in the next presidential term. If Congress waits until 1986, the economy might be slipping into a recession, which would make it even more difficult for the lawmakers to curb spending or boost taxes. The longer Congress and the White House hesitate to resolve the deficit dilemma, the more treacherous it becomes. --By Charles P. Alexander