TIME: Almanac 1993/TIME Almanac 1993.iso/time/010989/01098900.013

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                                                                                BUSINESS, Page 44

No Joyride in 1989


The economy will have to grow more slowly, but runs the risk of
a stall


    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.