TIME: Almanac 1990/1990 Time Magazine Compact Almanac, The (1991)(Time).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.