1979 Outlook: Recession
Economy & Business
But it will be short, mild and help curb prices, say TIME'S economists
Question: What should a Government do when its economic policy seems likely to drive the nation into a recession?
Answer: Hold fast to that stringent policy. Let the recession come, if need be. More than that, aim for the downturn to be followed not by a vigorous rebound in production and jobs but by a year or two of only moderate growth.
A year ago, that reply would have seemed a fearful sin against the spirit of liberal economic doctrine--to say nothing of the spirit in which Jimmy Carter campaigned for the White House. But in the past twelve months, economic and political thought has gone through a wrenching change. In the words of Economist Otto Eckstein, a member of TIME'S Board of Economists: "1978 was the year in which our nose was rubbed in the new reality." Part of the new reality is that inflation is Public Enemy No. 1, that it is persistent and pervasive, and that it has built up such terrifying momentum in the U.S. as to be unstoppable, for the moment, unless the nation reduces the roughly 4%-per-year economic growth rate that it had come to consider normal.
This year, real gross national product --total output of goods and services, discounted for inflation--probably rose only 3.8%. But consumer prices jumped so rapidly that in December they are likely to average 9.5% higher than at the end of last year. Result: the President, who began the year trying to prod the economy to faster growth, shifted gradually to a tight-budget policy and proclaimed wage-price guidelines that stop just short of mandatory controls. When even those measures failed to stop inflation and the sickening plunge of the dollar, President Carter on Nov. 1 welcomed a sharp increase in interest rates that normally would have violated his populist principles.
Carter still argues that these steps will curb the inflation without causing a slump in 1979. Last week he told a meeting of the Business Council that "we do not anticipate a recession next year"--though he added that warnings of one "can become a self-fulfilling prophecy." But among the ten members of TIME'S Board of Economists, only University of Minnesota Professor Walter Heller will give even fifty-fifty odds on avoiding a downturn. The others all agree that there will be a recession, but that it will be mild and brief, lasting only two or three quarters and at worst dragging real G.N.P. down at an annual rate of only 1% to 2%. All this will dent inflation-but only a bit. To ensure that inflation will continue to decline even after the recession ends, economic growth will have to be held below the old 4% norm for some years to come.
Even most of the liberals on TIME'S board accept this harsh conclusion, though they add that if the wage-price guidelines can be made to work, the Administration and Federal Reserve Board will not have to crack down quite so hard on growth. Several argue forcefully that the Government should not try to head off the recession or aim at a vigorous expansion once it ends. "It would be a horrendous error to try to fight the recession by anything other than minor palliatives," says Democrat Eckstein, who heads Data Resources Inc., the nation's leading economic analysis firm. Adds David Grove, a consultant to IBM who sometimes sides with the liberals: "The problem that the country has to face is whether it really wants to get the basic rate of inflation down very substantially, to cut it, say, in half. There is no way to accomplish that without going through a recession and having a couple years afterward of very slow growth."
The board members have some differences about the outlook. Eckstein thinks the recession will last only two quarters; Robert Nathan, a Washington economic consultant, fears that it may stretch out over as many as four. The consensus is two or perhaps three quarters. Eckstein calculates that corporate profits after taxes will rise only 5% next year, vs. 14% in 1978-and will go up even that modestly only because the tax rate on most corporate income will drop from 48% to 46% on Jan. 1. Arthur Okun, senior fellow at Washington's Brookings Institution, put the increase even after taxes at a round zero.
In most details, however, board members' forecasts are remarkably close:
PRODUCTION. Real G.N.P. next year will average a mere 2% higher than in 1978, and most of the growth will occur in the first quarter. By spring, or summer at the latest, output will turn down. Housing, as willingness to risk recession in order to reduce U.S. inflation.
The TIME economists generally beLieve the dollar will continue to hold steady next year, or even rise a bit. Big reason: the U.S. trade deficit, estimated at a record $28 billion this year, will drop by anywhere from $6 billion to $12 billion, as the recession cuts into imports. Stability in the dollar, in turn, will help to reduce inflation by holding down increases in prices of imports and of U.S.-made goods that compete against them.
Yale Professor Robert Triffin warns, however, that many foreign holders of dollars, like holders of stocks that have been going down sharply, are ready to sell any time they can get a slightly better price. Says he: "They don't want to sell at the bottom, but each time the dollar moves up a little bit there are lots of people who are just waiting to unload"--and such selling will keep any dollar rebound from going very far.
The Board of Economists has a good record of prognostication for previous years, but any forecast is subject to error. The most President Carter will concede is that real G.N.P. growth next year may fall below his official target of 3%. The Administration script calls for a "soft landing"--two or three quarters in which output gains are small but nonetheless real. High interest rates, in the opinion of Carter's advisers, no longer bite down as hard on business activity as they once did, and so far there are no signs of the imbalances, like a pile-up of inventories, that usually precede a slump.
Heller excepted, members of the Board of Economists reply: 1) the soft-landing outcome is possible, but unlikely; 2) even if it does happen, so what? Real G.N.P. may not decline for two successive quarters--the technical definition of recession--but it will slow to such a crawl as to bring about a substantial rise in unemployment. Says Washington University Professor Murray Weidenbaum: "If it isn't a recession, it will still feel like one."
The economists on the TIME board fear that their forecast may be too optimistic. Eckstein sees a 1-in-5 chance that frenzied borrowing, and buying of houses and other goods by consumers before prices go up even more, would continue to keep expansion rolling through much of next year. It would be nothing to cheer about, he adds, because inflation would continue to accelerate and the Government would have to press down even harder on the economy. Result: a recession that does not start until late 1979 but is then worse than anybody now foresees, lasting for as many as four quarters and sending the unemployment rate up to 8%.
That a mild recession in 1979 would appear almost desirable would have seemed farfetched a year ago. That was before the experience of 1978, a watershed year in which popular, academic and political perceptions about the economy all swung far to the right. Public fury about inflation turned the citizens' mood against taxes, spending, deficits and government in general. Liberal economists, who had tirelessly insisted that federal policy should be aimed at stimulating demand and closing loopholes in the tax laws, began talking instead of the urgent need to encourage capital accumulation and private investment. Congress passed a tax law far more conservative than Jimmy Carter wanted, and Carter himself talked such a stern budget-slashing line as to make him, in the wildly overstated view of AFL-CIO Chief George Meany, the most conservative President "in my lifetime"--which goes back to the Administration of Grover Cleveland.
The turnabouts occurred because 1978 was the year when the U.S. ran out of excuses for bad economic policy and performance. The collapse of the dollar drove home the truth that the nation is suffering from shockingly lower investment and productivity than its industrial rivals. (American output per hour worked rose a mere .3% in the twelve months ending last September, a record that one high Administration official calls "an utter disaster.") The trade deficit that looked freakishly large at $26.5 billion in 1977 grew even bigger, and this time it could not be wholly blamed on oil imports -which actually went down, while other imports surged.
At home, inflation at the start of the year seemed stuck at a basic rate of 6% to 6.5%--which Carter considered "reasonable and predictable." But then price boosts speeded up from Jan. 1 onward far faster than anyone had expected. The 1978 rise of 9.5% compares with 6.8% last year. The increase was particularly unnerving because there was no obvious, overwhelming cause-no oil crisis or crop failure or wild speculative boom. Rapid inflation came to be recognized not as an aberration but as a terrifying built-in tendency, a consequence of too many demands being put by too many people on a limited amount of national wealth. In an April speech, Carter put the point in a striking metaphor: "Inflation has become embedded in the very tissue of our economy."
That speech started a remarkable policy reversal. To pep up what then looked like a flagging economy, the President had begun the year by calling for a $25 billion tax cut and a $60.6 billion budget deficit in fiscal 1979, which started Oct. 1. As late as March, misled by alarmist predictions from Energy Secretary James Schlesinger that a continued coal strike would cripple national production, Administration aides led by Robert Strauss forced on mine operators a settlement that will raise wages and benefits nearly 40% over three years.
By spring it was obvious that Carter had trained his guns on the wrong enemy. The economy proved capable of growing without new stimulus. Once the mountainous winter snows had melted, real G.N.P. surged at an unsustainable annual rate of 8.7%. Unemployment fell faster than Government economists believed possible, from 7% as recently as August 1977 to a four-year low of 5.7% in June. When the Council of Economic Advisers met in late March, says one member, "the numbers just did not add up. We had underestimated the inflationary pressure by a wide margin."
Administration officials who wanted to switch to an anti-inflation policy--CEA Chairman Charles Schultze, Treasury Secretary Michael Blumenthal, Council on Wage and Price Stability Director Barry Bosworth--got a powerful ally in G. William Miller, who took over as Chairman of the independent Federal Reserve Board in March. Miller, a liberal businessman, was shocked by the runaway inflation he encountered and publicly urged the President to declare it the primary peril. More support came from, of all people, Labor Secretary Ray Marshall. Says one Administration policymaker: "When Marshall starts arguing for wage-price guidelines, which would fall on his constituency, then you know the situation is serious."
Still, the Administration was locked for months in a back-room battle between "the economists," who fought for a tough anti-inflation program, and "the politicians," led by Vice President Walter Mondale and Domestic Affairs Coordinator Stuart Eizenstat, who feared that such a program would alienate Democratic voters. Nor did the Administration's moneymen fully appreciate the vicious circle in which inflation weakens the dollar and a drop in the dollar spurs more inflation. Treasury Under Secretary Anthony Solomon, with Blumenthal's support, argued against doing anything to prop the dollar until its rout had degenerated into a panic--by which time the greenback had sunk 18% against the German mark and 26% against both the yen and Swiss franc. Reports TIME Washington Economic Correspondent George Taber. "The U.S. this year paid a heavy price to learn something about world money markets. One of the tragedies is that there was nobody in the Treasury Department with any firsthand experience of how the markets worked--and the markets knew that."
Domestically, the loudest voice for a policy change was the roar of rage from the California voters who passed Proposition 13 in June, an outcry quickly echoed across the country. Voters were rebelling against the combination of inflation and high taxes that is pinching purchasing power.
In Washington the reaction to Proposition 13 speeded the deep change in federal tax policy. For years, tax laws had focused on making the system more equitable by taking away deductions thought to favor the affluent. But at a TIME Tax Conference in September, Democrats Russell Long and Al Ullman, chairmen of the Senate and House tax-writing committees, proclaimed the era of loophole-closing reform to be over. From now on, they asserted, tax laws will be "economically oriented" packages of cuts designed to relieve the ravages of inflation and spur job-creating investment.
Congress scrapped nearly all of Carter's proposed laundry list of revenue-raising reforms, such as limits on deductions for business lunches and taxpayers' medical expenses. Instead the legislators passed a series of tax benefits to aid business investment and expansion and, to everyone's astonishment, whooped through a cut, from 49.1% to 28%, in the top tax rate on capital gains (profits made on the sale of stock, real estate or other assets). Also, Congress and Carter eventually agreed to reduce the total tax cut from the $25 billion that the President had originally requested to $18.7 billion, and to delay its start from Oct. 1 to Jan. 1. While that might seem to flout the message of Proposition 13, policymakers correctly judged that message to be a protest against rising prices as well as rising taxes. A big, early cut, they reasoned, would only fan inflation by deepening the budget deficit.
By year's end Carter had made or acquiesced in so many other changes that he had a new policy mix. Main elements:
BUDGET CUTTING. The expected deficit for fiscal 1979 has now been reduced from the original $60.6 billion to $38.9 billion, and in fiscal 1980 the President has pledged to shrink it to $30 billion or less. To do so while also increasing defense spending he will have to cut some civilian programs--public service jobs, antipollution grants, subsidized low-income housing--and give up or delay some new initiatives. National health insurance? Not until 1983. Welfare reform? Under current plans, no money for it. Members of the Board of Economists fear that even if Congress accepts all this shrinkage, a recession nonetheless will push the deficit up to $50 billion by reducing tax collections and increasing unemployment benefits. That does not mean the effort to cut other spending is unwise; without it, the deficit could swell to monstrous proportions.
TIGHT MONEY. Excessively fast growth of the nation's money supply has been an important cause of inflation. The Federal Reserve has created so much money partly to cover budget deficits, partly to meet the credit demands of a growing and inflationary economy. Throughout 1978 the Fed kept letting interest rates rise to discourage borrowing; banks raised the prime rate 14 times, by a total of almost 4 points, to 11.5%. Loan demand stayed high, however, and money supply kept bounding up; in September it rose at an annual rate of 15.8%. But the cumulative effect of the interest increases may be retarding money growth at last. Money supply in October rose at an annual rate of only 2%, and in November it actually dropped at a 4.5% clip.
DEREGULATION. Government regulation of specific industries and the spread of costly safety, antipollution and other rules that all industries must obey became widely recognized this year as a powerful inflationary force. In 1978 the Civil Aeronautics Board successfully freed air fares. The Interstate Commerce Commission now proposes to make entry into the trucking business much easier for new operators and to end the rate fixing by conferences of truckers. Carter has pledged to make environmental and safety regulation less costly and appointed an interagency council to comb out overlapping and contradictory rules. Unfortunately, the council is made up of the regulators themselves. Weidenbaum dismisses it as "the sinners gathering together to protect themselves--a sick joke."
GUIDELINES. The tendency of workers to demand big raises to catch up with past inflation and protect themselves against future price boosts, and of companies to pass along all cost increases and add a bit more, makes inflation accelerate. At first Carter contented himself with pleas for restraint and named Robert Strauss as special counsellor on inflation to do some mild jawboning. Strauss's six-month tenure will be remembered mostly for one rueful wisecrack: "The score is inflation 100, Strauss 0." In October, Carter replaced him with CAB Chairman Alfred Kahn and proclaimed formal guidelines with some teeth. The rules: labor should hold wage and benefit increases to an average 7% annually, and companies should raise prices half a percentage point less than they did, on average, in 1976-77. The penalties: public denunciation of violators, and loss of Government contracts for companies that raise wages or prices too fast.
Business has given strong support to this program. In Economist Okun's words, no corporate executive wants "to volunteer for the role of first bastard." But members of TIME'S Board of Economists divide on whether labor will accept the rules. Liberals Heller, Nathan and Okun argue that, Meany's grumbling to the contrary, many union members will be willing to get off the inflationary treadmill--provided that Carter can at least persuade Congress to grant tax rebates to workers if inflation rises faster than their pay does. Sprinkel contends that any union president who settles for a wage boost smaller than the increase in prices "will not be president very long." Greenspan points out a basic problem with guidelines: they tend to become riddled by exceptions. Indeed, last week the Administration ruled that because of the soaring cost of maintaining fringe benefits like health insurance, the total price of some labor packages could exceed 7%.
At the same time, the Administration tightened the rules on how much companies could raise profit margins by boosting prices and set a guideline of 6.5% on increases in the fees charged by doctors, lawyers, accountants and other professionals. These changes further complicated a system already complex enough to be spelled out in algebraic equations that will send union and corporate bosses back to their old math textbooks.
The more basic fiscal-monetary restraints can be faulted too. Even a $30 billion deficit in fiscal 1980 would be excessive for an inflationary period, and there is no assurance that the Federal Reserve has yet got the money supply under control. The danger is that when the economy slows down, the President, Congress and the Federal Reserve will be tempted to pump up spending and the money supply too much, too soon in an effort to create jobs. That would destroy what must be a long-term effort. Miller figures that five to eight years of budgetary and money-supply restraint will be needed before inflation can be brought down to an acceptable rate, which to him is 2%.
The political pressures to switch policy again will be intense. At the Democrats' mid-term convention two weeks ago, 39% of the delegates voted for a resolution deploring cuts in social programs. Carter got only mild applause; Senator Edward Kennedy, denouncing the Administration's reluctance to start national health insurance, drew loud cheers.
Mondale, converted at last to the anti-inflation cause, shot back that runaway price boosts could damage the Democrats now as badly as the Viet Nam War did in the 1960s. Surely the political, as well as economic, penalties of inflation have become intolerable. Says Republican Economist Greenspan: "If Carter runs for re-election in 1980 with a 5.8% unemployment rate or even less, but with an inflation rate over 8%, he has a very minor chance; with an inflation rate over 10%, he has virtually no chance. But if he is successful in bringing the budget deficit and inflation down to relatively modest levels, then even with an unemployment rate of 7.5% he would be unbeatable."
The popular revolution of 1978 carries a message for policymakers in 1979. and on beyond. Since far more people are victimized by inflation than by recession, power will flow to the leaders who can successfully wage the price fight.
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