The Good Bad News

By GEORGE J. CHURCH

Slowdown? Did anyone say slowdown? There have been plenty of worries about the effects of interest-rate hikes on the U.S. economy in the past few months, but when he takes the oath of office next Jan. 20, the next President, whether it's Al Gore or George W. Bush, will inherit the sunniest economic prospects to greet any new Chief Executive since Lyndon Johnson in 1963. Yes, it looks like the output of goods and services will be increasing more slowly. But the growth rate will slip only from one that clearly was too fast to last to a pace that can be kept up for years. And the new rate, somewhere between 3% and 4%, will still be so rapid that it would have been considered outright boomy not long ago. Unemployment will still be low, jobs plentiful, inflation modest, paychecks and profits robust. And the government will be raking in big enough surpluses to afford room for whatever tax and spending plans the new Chief Executive might push through Congress.

That was the consensus of TIME's Board of Economists, which gathered in Manhattan to take stock of the economic background to the presidential race now getting into full swing. The group included advisers who have helped shape both the Bush and Gore programs, and they disputed--though with remarkably little heat--the merits of those plans. But Democrats, Republicans and nonpartisan professionals all agreed on the fundamental outlook. And they left more than a hint that it would change little, if at all, no matter who wins the White House.

For the first time in its history, observed David Wyss, chief economist of Standard & Poor, the U.S. is in its 10th straight year of economic growth. "In dog years this expansion is about 70," he quipped, "but it is still behaving like a puppy!" Lawrence Lindsey, a resident scholar at the American Enterprise Institute and former member of the Federal Reserve Board, remarked that though economics is supposed to be "the dismal science," he and his colleagues on TIME's board were sounding full of "Panglossian optimism." No, the economists did not contend that this is the best of all possible worlds. But like Voltaire's Dr. Pangloss, they did insist that developments that at first glance might seem bad are actually good. Specifically, the slowdown in growth from manic annual rates of 6% for the most recent 12 months--the last half of 1999 and the first half of this year--and an unbelievable 8.3% in last year's final quarter.

The long-awaited slowdown is "absolutely" under way, said Abby Joseph Cohen, who heads the investment-policy committee of Goldman Sachs, the giant investment firm. The series of six interest-rate increases forced by the Federal Reserve between June 1999 and last May are not the only reason, she said. Consumers are also showing some signs of having temporarily satisfied pent-up demands. "If you bought a new car in 1999 or early 2000, you're not buying another new car; and if you upgraded your home by moving into another one over the past year or so, you aren't going to do that again anytime soon."

But Cohen insisted that the letup would leave the economy in "a fine place for us to be," and her colleagues agreed. Demand is slowing from a "surge rate" to a "sustainable rate," says Martin Feldstein, president of the National Bureau of Economic Research and once head of Ronald Reagan's Council of Economic Advisers.

Alan Blinder, visiting fellow at the Brookings Institution, a prestigious liberal-leaning Washington think tank, and vice chairman of the Federal Reserve from June 1994 to January 1996, asserted that the consensus forecast of most economists seems to be for gross domestic product (that is, total output of goods and services) to grow about 3% to 3.5% over the next year. He would go along, said Blinder, but consumer demand may not be letting up as much as Cohen thinks, and business has an "insatiable demand" for--and appetite to invest in--new information technology. So those predicting 3% to 3.5% growth are "walking on thin ice," says Blinder, because the actual figure could turn out to be higher.

Not that there is anything so bad about even 3%, Wyss points out: "Three percent in the '80s would have been a boom." Blinder is also impressed by how much better the economy is performing than anyone would have thought possible even a few years ago. Today's Fed, he proposed, is engaged in an experiment to see if the unemployment rate can be held permanently at around today's low 4.1% without triggering rapid inflation. The test may or may not work, says Blinder--but if he or Lindsey had suggested that the idea was even worth an experiment when they were both on the Fed, they would have been politely escorted out of the room.

In fact, TIME's board expects the experiment to succeed. The Fed, says Wyss, is about to pull off something never before achieved: piloting the economy to two "soft landings" in a row. The previous one was in 1995-96, when a series of earlier interest-rate increases by the Fed succeeded in draining away inflationary pressure while letting growth continue.

The consensus view of the board was that "soft" meant a growth rate of 3% to 3.5% over the next year or so. That, says Blinder, might cause unemployment "to creep up ever so slightly." But it would be another Panglossian development; it would reassure the Fed, says Blinder, that the economy had slowed enough to keep inflation in check with no need for additional interest-rate hikes.

Wyss figures the economy is slowing enough to reduce the "core rate" of inflation--the underlying trend, minus usually volatile food and energy prices--to about 2.5% a year. That is believed to be just about Fed Chairman Alan Greenspan's target. Result: after about a year of "below-trend" growth, output could be able to speed up again. Wyss figures the economy has the potential to grow almost 4% annually over the next 10 years.

At first glance that might seem--well, Panglossian. But whatever the actual numbers, board members agreed that the economy's potential for sustained rapid growth with only mild inflation is "a whole lot higher than we thought seven years ago, five years ago," in the words of Robert Reischauer, president of the Urban Institute and a former director of the Congressional Budget Office.

The big reason: productivity. For more than two decades, through the mid-1990s, the output of goods and services per worker hour rose at a sluggish pace. But it is now riding what Feldstein calls a "rising wave." Productivity increased 5% last year, and is still accelerating through the slowdown; in the second quarter of this year it shot up at an annual rate of 5.7%. One result: though "tight labor markets are pushing up wages at a faster and faster clip," says Feldstein, unit labor costs--what employers pay out in wages and benefits for each pound of plastics produced or hamburger served by their workers--are lower than a year ago. And unit labor costs, he notes, are the "key driver of inflation."

Moreover, Feldstein expects productivity to continue to grow rapidly over the next several years. One reason is that companies are putting much more invested capital behind each worker these days. Also, "managers are managing differently." They are concentrating on cutting costs much more than in the past. Partly that is because they have been "scared by international competition." And stock options and other incentives push them to pare expenses as the best way to increase profits at a time when price increases run into stiff resistance.

The biggest reason for increasing productivity, Feldstein says, is, of course, the computer and particularly the Internet. Wyss cites a little-noticed benefit: with computers, managers "can get a high school graduate to do the work a college graduate used to do." One example: a mortgage-loan applicant was once interviewed by "a trained loan officer with a college degree" who probably referred the application to a loan committee, which might have given an answer in two weeks. Today "you'd be sitting across the desk from somebody who was probably a teller two weeks ago, and she's reading the questions off a PC screen and typing the answers you give her. In five minutes you know whether you got the mortgage or not."

One result is that unemployment has recently dropped most sharply among less educated people. And, says Wyss, "by creating jobs for lower-skilled people, you have changed the basic way income is distributed." From 1973 to 1993, he notes, only the top-earning 20% of the population received any gain at all in real income, but "in the past five years the bottom 20% had the highest income gains" of any group.

At the same time, Cohen points out, corporations and investors are also doing well. She expects corporate profits to increase at about a 10% rate this winter. That would be only half the "very robust 20%-plus" rise last winter but still "quite comfortable." And though stock markets suffered a severe shake-out last spring, Cohen thinks their future also looks good. Says she: "The stock market performs well when investors have confidence in the durability and longevity of economic expansion, and we think that's what the situation is likely to be."

So does Dr. Pangloss rule unchallenged? Not quite. Lindsey sights two potential clouds on the long-range horizon. The more hazy threat, in an expansion still heavily dependent on business investment, is a decline in the yield on marginal investments--the last and most speculative dollars sunk into a venture. Lindsey's scenario: "The marginal investment yields a rate of return which is below the rate demanded by the markets. All of a sudden these investments don't look so good. A few bond issues fail. The economy can be going along just fine, and all of a sudden this hits, and you get a possible recession."

The bigger potential danger, though, is a weakening of the almighty U.S. dollar. In view of the monstrous U.S. trade deficit--a hemorrhage of greenbacks spent on foreign goods that is currently heading toward $400 billion a year--it is a bit surprising that that hasn't happened already. The reason, says Blinder, is that "the representative centimillionaire in a neutral country like Switzerland or Singapore, sitting down to figure out where to put his last $10 million, is saying, 'The U.S. looks pretty good.'" So the dollars spilled abroad by the trade deficit come right back in the form of investment, and the buck stays strong.

But by, in effect, importing about $400 billion in net investment this year, says Lindsey, the U.S. has become more dependent on foreign capital than at any time since 1896--or, says Wyss, since the 1860s. And if those overseas centimillionaires change their mind about the best place to invest, the U.S. would get hit with a double whammy. It would lose some of the investment that has been keeping the boom going, and the dollar's value would fall, raising the cost of imports and the many U.S. products that are assembled partly from imported components. Feldstein figures a 15% drop in the dollar's value would translate into a two-percentage-point increase in the U.S. inflation rate. That, he fears, would be enough to persuade the Fed to resume a policy of anti-inflation interest-rate hikes.

But if the worst threat anyone can conjure up arises from overseas, that in itself testifies to the economy's internal strength. Those foreign centimillionaires appear to have more potential to disrupt the economy than any foreseeable bungling by whoever wins the White House--and as the presidential race heats up, that may be another comforting, almost Panglossian, thought.