No Joyride in 1989

By Barbara Rudolph

Like a remarkably rugged, durable automobile, America's economy has motored through some of the harshest possible conditions without losing its momentum. The recovery has dodged hazards ranging from the October 1987 stock-market crash to last summer's drought. The longevity of the expansion, one of the Reagan Administration's proudest legacies, defies all odds. During the past 130 years, the U.S. economy has suffered a recession on the average of once every 4.3 years. But the current growth period, now entering its seventh year, is by far the longest peacetime boom in U.S. history. The economy, says Lawrence Kudlow, chief economist for the Wall Street firm of Bear, Stearns, is "sound and reasonably well balanced."

Yet like any aging vehicle taken to its limits, the recovery is now prone to overheating or breaking down. And the road ahead is not going to get easier anytime soon. In a TIME survey of ten economists in the U.S. and several others in Japan and Europe, a consensus emerged that the economy's speedy growth is, paradoxically, one of its biggest problems. The aging recovery has a reduced tolerance for rapid expansion because it is straining against shortages of workers and factory capacity. Many economists fear those limitations could impose renewed inflationary pressures, forcing the Federal Reserve to tighten the money supply even more than it already has. By hitting the brakes too hard, the central bank could inadvertently stall the economy.

A recession at this point could be more dangerous than in past years. All segments of the U.S. economy -- consumers, corporations, the Federal Government -- are laboring under heavy debt loads. An economic slowdown could become a full-fledged recession if a large number of individuals and businesses started defaulting on their loans and sharply curbing their spending. On the Government's part, the huge budget deficits virtually eliminate its ability to revive a sagging economy by using a spending boost as a stimulant. Moreover, a failure to cut the deficit this year would create instability and pessimism in the financial markets.

While most economists think the U.S. will be able to putter along without a recession for at least another year, they see the hazard as increasingly difficult to avoid. Says Jerry Jordan, chief economist at First Interstate Bancorp in Los Angeles: "Things are going to get very dicey in 1989. It will be the worst of all worlds." Concurs Allen Sinai, chief economist for the Boston Co. Economic Advisors: "This is the first time in perhaps six years that the word recession is in my vocabulary, and I don't take the word lightly. I see one starting late in 1989 and going on until the first half of 1990." According to the median estimate of the ten U.S. economists surveyed by TIME, the U.S. stands a 30% chance of recession in 1989. For 1990 the probability rises to 50%.

The economists forecast that the U.S. gross national product, after adjustment for inflation, will grow a poky 2.3% in 1989, down from an estimated 2.8% last year. The economy will slow as the Fed's tightening grip on the money supply pushes up interest rates. At a growth rate of about 2% or less, most economists think the U.S. can expand without getting out of balance. "This is a slowdown the Fed can be happy with," says David Wyss, chief financial economist for Data Resources.

Yet some economists fear that the U.S. may be unable to support even that modest level of growth without pushing prices to uncomfortable levels. That concern has kept everyone, from bond traders to real estate speculators, on a constant alert for inflationary signals. While the indicators have sometimes fluctuated sharply, overall inflation has been moderate and stable. Last month the Government said that during November the Consumer Price Index rose at a modest 3% annual rate, which brings the total for the first eleven months of 1988 to 4.4% -- the same rate as the previous year.

Even so, most economists expect somewhat higher inflation ahead. Those surveyed by TIME estimate that inflation will increase one-half a percentage point this year, to 4.9%; at the high end of the estimates, William Melton, chief economist with IDS Financial Services in Minneapolis, sees a 6.5% rate by year-end. One reason for the rise is that factories in the U.S. are operating at more than 84% capacity, the highest level since 1979. Scarce capacity can lead to shortages of finished products and, thus, price increases.

At the same time, employers must contend with widespread worker shortages. November's jobless level stood at just 5.4%, up only slightly from the previous month's 5.3% level, which was a 14-year low. As a result, many employers will be paying higher wages. A study by the Conference Board, a business-research group in Manhattan, projects that wages and salaries in the private sector will jump 5% in 1989, vs. about 3.8% last year. As their labor costs and other expenses go up, companies will probably feel compelled to raise their retail prices, which could trigger a wage-price spiral.

Rising petroleum prices may contribute to the trend. Some economists believe crude oil will climb from its recent price of around $13 per bbl. to more than $15 this year because of the agreement made by the Organization of Petroleum Exporting Countries to cut production, which takes effect this month. If OPEC members honor their agreement, which they have mostly failed to do in the past, they may be able to regain some influence over the market.

Yet some economists strongly dissent from the view that inflation will heat up. Edward Yardeni, chief economist for Prudential-Bache Securities, argues that global price wars on products and commodities will help keep U.S. prices in check. Says Yardeni: "American companies face very keen competition from overseas, and they realize that the trick to being prosperous is to cut costs, not raise prices." Sam Nakagama of the Manhattan forecasting firm Nakagama & Wallace contends that the U.S. economy still has plenty of slack. Says he: "We are not at full capacity. All those measurements are really quite questionable. We are not so sure where full employment is either."

Ultimately, it will fall to the Federal Reserve Board to determine whether inflation poses a real threat to the economy. Alan Greenspan, the Fed chairman, has indicated that he would like to see the economy growing at no more than a 2.5% annual rate. During the third quarter of 1988, the GNP increased at precisely that pace. But without the damaging effects of the summer drought, the economy would have grown at an estimated 3.2% rate.

If that pace keeps up, the Fed may boost interest rates to restrain growth. Says Sinai: "The Fed has already tried to introduce a mild dose of tightening to slow the economy. But it just isn't working so far." Interest rates have been steadily climbing since March. The federal funds rate, which is the interest that banks charge one another on overnight loans, has increased from 6.5% to nearly 9.5% during the past nine months. Economists polled by TIME estimate that the prime lending rate will climb from its current 10.5% to 11% by June but will end the year at 10% after the economy slows down. As that happens, economists expect, the unemployment rate will creep up two-tenths of a percentage point, to 5.6% by the end of 1989.

Can the Fed restrain the economy without choking it? Says John O. Wilson, chief economist for Bank of America: "The Fed is in a real bind right now. It is going to have to walk a tightrope. And if it doesn't act soon, the financial markets will lose confidence." Says Melton: "In principle, this can be done with such awe-inspiring precision that the economy slows down to a growth rate of exactly 2% and inflation starts to slow. But as a practical matter, it rarely works out." If credit is too tight, the resulting interest- rate run-up could trigger a recession. And if the Fed allows inflation to quicken, the markets will grow panicky and the dollar could grow shakier.

A weaker dollar will make the Fed's situation even more precarious. If foreign investors fear that the U.S. financial system will become unstable, they may cut back their investments in Treasury bills and other dollar- denominated securities. The Fed would have little choice but to boost interest rates to make the currency more attractive. Since September the dollar has lost about 5% of its value against the currencies of major industrial nations, and now trades at about 125 yen. This has wiped out most of the gains it made during the first nine months of last year.

Half of TIME's forecasters anticipate that the dollar will rise in value, and half expect the greenback to fall this year. The median prediction is for a decline from the current level of 125 yen to about 121. Estimates for the end of 1989 range from Kudlow's prediction of a robust 142-yen dollar to Wilson's forecast of a weakling 110-yen version. Says Wilson: "The biggest danger I see for the economy next year is a free-falling dollar."

The two potential threats to the dollar, and by extension to the economy as a whole, are the U.S. budget and trade deficits. While the trade gap fell to an estimated $135 billion in 1988 from $170 billion the previous year, some economists fear that it will not keep narrowing at anywhere near that pace because the growth of U.S. exports will slow this year. According to this view, the dollar will have to take a real plunge if the trade gap is to be narrowed much further. This would make American-made goods less expensive for foreign consumers. Recently, the trade deficit has been declining only slightly, falling from $10.7 billion in September to $10.3 billion in October.

Even so, most economists polled by TIME believe the trade gap will continue to narrow, albeit at a slower rate. They see imports shrinking, partly because U.S. consumers will reduce their spending in anticipation of a slowdown in the economy. All told, the economists predict, the U.S. trade deficit will fall to $113 billion for 1989, down about 16% from last year's level.

The U.S. must shrink its budget deficit as well if it hopes to shore up the dollar and ensure confidence among consumers and investors. Says Irwin Kellner, chief economist for Manufacturers Hanover Trust: "The financial markets lately have a way of getting very excited if they perceive that things are not going their way." Adds Bank of America's Wilson: "There is no way the markets are going to wait six to nine months for a budget package to be announced." If the Government gradually cuts its borrowing and spending, interest rates will fall and the aging recovery could gain a second wind. Says Josen Takahashi, chief economist of Japan's Mitsubishi Research Institute: "The seeming prosperity of the U.S. economy in the past years has been sustained by building up debts. I think the time has come for the so-called Reaganomics to pay its bill." Takahashi predicts that another stock-market panic is inevitable unless the Bush Administration comes up with clear-cut measures to tackle the budget and trade deficits.

The economists predict that the budget deficit for fiscal 1989 will be $149 billion, down from $155 billion in 1988. For fiscal year 1990, which begins next Oct. 1, the Reagan Administration plans to introduce a budget next week that will produce a deficit of only $92.5 billion. But the Administration's forecast is likely to be too optimistic, since many of its budget proposals, including a $5 billion cutback in Medicare spending, are sure to face strong congressional opposition. Estimates based on less hopeful economic projections peg the 1990 deficit as high as $150 billion.

Moreover, the deficit-cutting process may be made even tougher by the possibility of expensive federal bailouts. The General Accounting Office estimates that it may cost more than $80 billion to save some 500 insolvent thrift institutions and put the Federal Savings and Loan Insurance Corporation, which guarantees S and L deposits, on a sound footing. Last week thrift regulators announced a plan to spend $5 billion over ten years to help an investment group, including financier Ronald Perelman, take over five ailing Texas thrifts (the new owners' contribution: $315 million). The regulators also approved a deal in which a group of investors led by Texas financier Robert Bass will buy the American Savings & Loan Association of Stockton, Calif. The Government will put up $1.7 billion, while the Bass group % will invest $500 million over the next three years. S and L investors hurried to complete the bailout agreements by year-end, because in 1989 the tax incentives for such deals will be cut in half.

Another basket case in need of substantial federal aid is the Farmers Home Administration, which makes agricultural loans. According to an exhaustive audit by the General Accounting Office, the farm agency is at least $36 billion in the red. Still another huge project will be the cleanup and rebuilding of the Energy Department's nuclear-weapons plants, which could cost $100 billion to $200 billion.

As painful as the task may be, economists insist that the deficit must be cut. Says Norman Robertson, chief economist of Mellon Bank in Pittsburgh: "The most important factor in determining whether we have a recession in the next two years is going to be whether we adopt a credible deficit- reduction program."

President-elect Bush's Flexible Freeze Plan to reduce the budget deficit does not give economists much reassurance. The program calls for the total elimination of the budget deficit by 1993 by freezing all Government spending after adjustment for inflation except for Social Security and interest payments. But many economists believe the plan relies on overly optimistic assumptions that the U.S. economy will grow more than 3% a year through 1993 while inflation declines to about 2%. Sinai considers the Flexible Freeze Plan "unrealistic and unworkable."

If the economy does stagnate or lose ground this year or next, it might have a relatively hard time getting moving again because of the heavy baggage of debt. Corporate borrowing, including the junk bonds that are used for leveraged buyouts, has zoomed from $965 billion in 1982 to nearly $2 trillion last year. A study of 643 corporations by Washington's Brookings Institution concludes that in the next recession 1 out of 10 firms could run out of cash and be forced to file for bankruptcy protection.

Despite the risks, a vocal minority of economists offer a relatively bullish outlook. Among them: Yardeni, Kudlow, Nakagama and J. Paul Horne, the Paris-based chief international economist for Smith Barney. The optimists believe that the economy is not overheating and that significant progress has already been made in managing the budget deficit. Says Kudlow: "The important thing is that the deficit is coming down. It is the direction that is far more important than the level of the deficit." Echoes Nakagama: "The worst is behind us."

The optimists, including Kudlow and Data Resources' Wyss, believe U.S. businesses will support the expansion by investing a healthy amount in capital improvements. The Commerce Department last week estimated that U.S. companies last year spent $426 billion on new plant and equipment, an increase of more than 10% from 1987. The Government predicts such spending will increase an additional 6% this year. Says Wyss: "Business investment will be one of the strong areas of the economy in 1989."

To a great extent, the long-term fate of the economy is up to the White House and Congress, while the short-term management rests in Alan Greenspan's hands. All three will have to tinker carefully and deliberately with the creaky recovery if they hope to get many more miles from it. The economy may have survived a stock-market crash in '87, but its ability to handle the tight corners and potholes of '89 and '90 cannot be taken for granted.

CHART: NOT AVAILABLE

CREDIT: TIME Chart by Cynthia Davis

CAPTION: ROCKY ROAD

Median forecasts of ten U.S. economists surveyed by TIME

With reporting by Bernard Baumohl/New York, with other bureaus