The Biggest Challenge

By GEORGE J. CHURCH

Searching for a new way to cut steep inflation and restore sound growth

Ronald Reagan's first two visits to Washington after his election were triumphal processions through a capital that marveled at his charm. His third tour of his new domain last week was more like a general's inspection of the troops he will shortly have to fling into a decisive battle. Preparations for the Inaugural gala were overshadowed by a series of warnings that the new Administration must begin moving almost immediately to meet what is clearly its biggest challenge: mending the battered American economy.

The problems looked serious indeed.

Illustrating the extreme skittishness in financial markets, the Dow Jones industrial average plunged almost 24 points in a single day largely, it seemed, because of "sell" recommendations from a single market analyst, Joseph Granville (see following story). Although some major banks reduced their prime rate on business loans to 20%, down 1 1/2 points from the prevailing level in mid-December, the rate remained extraordinarily high by historic standards and was a continuing source of anxiety.

Gloomy talk rang through Washington too. Federal Reserve Chairman Paul Volcker, an independent power whose cooperation on economic strategy Reagan will need, warned the Senate Banking Committee that he intends to keep the nation's money supply growing slowly as an anti-inflationary measure, even if that policy prevents interest rates from coming down to a more tolerable level. Donald T. Regan, the President-elect's choice for Secretary of the Treasury, asserted at his confirmation hearings that "interest rates, inflation rates and unemployment rates are all expected to remain at high levels throughout 1981."

Meanwhile, Carter Administration officials broke some alarming news about the budget: in fiscal 1981, which ends Sept. 30, federal spending is now expected to balloon to $663 billion, and the deficit to total about $56 billion, second in size and impact only to the $66 billion rung up in 1976. Some advisers recommended delaying until July 1 the sweeping income tax cuts that Reagan has promised in order to keep the deficit from swelling even further; others insisted on asking Congress to make the cuts retroactive to Jan. 1, as first planned.

Though they did not resolve that dispute, Reagan's aides did agree on a deadline of sorts: by the first week in February, a mere 12 days after Reagan's Inauguration, the new Administration should have a coordinated packet of spending and tax reductions ready to submit to Congress. That might be a shade overambitious, but the Reaganauts generally feel that their chief has no time to lose.

Many of Reagan's aides warn that within no more than three or four months the new President must convince Congress, the business community and the public that he not only can shape but can begin to execute a coherent, comprehensive plan to combat both inflation and recession. Political and economic cycles whirl too rapidly these days to give him any more time than that. Congress must be persuaded to enact some of the hotly controversial cuts in federal spending before the momentum generated by Reagan's landslide election victory begins to ebb. Financiers, businessmen, workers and consumers must be assured that a real change is coming before they harden in their belief that double-digit inflation, recurrent recessions and towering interest rates have become the new American way of life.

And if Reagan does not move quickly enough? Or if quarrels already started in his camp about the proper balance to be struck between various measures produce only a half-baked, contradictory program that Congress then twists out of any recognizable shape? Or, worse still, if an amalgam of tax and budget reductions, sweeping regulatory reforms and restrictions on the growth of money supply is tried and fails?

To be sure, no calamity threatens.

Reagan is now leaning away from the advice of some aides that he proclaim a "national economic emergency" upon taking office. The words call up visions of the breadlines, waves of bank failures and threats of outright starvation that confronted Franklin D. Roosevelt when he took the oath of office in 1933. Nothing remotely that drastic menaces the U.S.

economy.

Nonetheless, in recent years the steady growth in real income and standard of living that the U.S.

once took for granted has become a dim memory. Instead, the nation seems to have become stuck on a kind of jet-propelled merry-go-round that spins through faster and faster cycles of boom and bust, rising and falling interest rates and accelerating inflation.

Never has the economy gyrated so crazily as it did in 1980--and is doing now. For example, the U.S. used to enjoy years of rising production, incomes and employment between recessions. But as 1981 begins, economists generally believe that the nation is slipping into another downturn only about five months after getting out of the last one. And the 1980 slump was exceptionally severe: it knocked down the output of goods and services at an annual rate of 9.9% in the second quarter, added 1.7 million people to the jobless rolls in April and May, and contributed to the largest quarter-to-quarter surge in unemployment ever recorded in statistics that date back to 1940. The recovery that followed was the shortest on record, and very weak. In much of the nation it was never even felt. The unemployment rate, for instance, dropped only from a peak of 7.8% in May and July to 7.4% in December, and now is expected to go up again, probably past 8%.

The chief reason for expecting another downturn so soon is that interest rates are flying around in a still dizzier cycle.

The prime rate on bank loans to business jumped to what seemed an unbelievable 20% last April, fell to 11% in July, then rocketed to 21 1/2% in mid-December. That is nearly double the pre-1980 peak of 12% recorded in 1974. Such swings, says Edward M. Syring Jr., an economist at the Manhattan brokerage firm of E.F. Hutton, are "absolutely unprecedented. I think 1980 will go down in history as the most volatile year in modern times. Have you ever heard of the prime going up a thousand basis points [a basis point is a hundredth of a percentage point], down a thousand, then up a thousand? It used to be that 250 basis points were a three-year move. Now the prime moves that much in a day."

The gyrations result largely from the shifting monetary policy of the Federal Reserve Board: first | slowing the growth of money Sin an effort to restrain inflatition, later letting it expand to keep recession from getting out s of hand, finally tightening -- again. Right now the Reserve seems to have tightened about as much as it is likely to, and interest rates are easing down again. But they are still high enough to cripple seriously the housing and auto markets, crimp credit buying generally and possibly bring on a wave of bankruptcies among small-to medium-size businesses unable to pay the towering interest costs. In short, all this could--indeed, is likely to --bring on a new recession.

Such a downturn might, like the one in 1980, be brief, but once again the recovery would probably be puny. Estimates of likely growth in 1981 output cluster around a minuscule 1.3%.

Meanwhile, inflation goes on accelerating through all the ups and downs in output, employment and interest rates.

Consumer prices rose about 13% in 1980, after a 13.3% jump in 1979. Nothing like that had happened in 60 years. The previous peak was the four straight years 1916-1919 during and immediately after World War I. Worse, nothing is in sight to prevent another year of inflation in 1981. The consensus forecast of TIME'S Board of Economists is that prices this year will shoot up an additional 11.4%.

Inflation seems to have become self-propelling. The fear of more price boosts drives people into self-protective actions --for example, they demand that their wages or Social Security pensions be tied to the Consumer Price Index--that help bring about the very increases they dread.

Recessions used to slow the process, but no more. Mourns Arthur F. Burns, former chairman of the Federal Reserve: "It is a sad fact that the basic inflation rate is no lower now than it was before the recession started. The recession accomplished nothing."

No single whirl around the economic merry-go-round leaves the nation much worse off than it was the year before. But the cumulative effect of several such spins has by now become devastating. This can best be appreciated by a brief look at the decade of decay that began in 1971, the first year in which the U.S. struggled dramatically to cope at the same time with rising inflation and rising unemployment.

It was a year of considerable alarm about the economy, yet today it seems like the good old days. The unemployment rate reached 5.9%. Inflation prompted so much worry that President Nixon clamped on wage and price controls, but still the Consumer Price Index in 1971 rose by only 3.4%. In 1971, as now, there were cries that high interest rates were strangling the economy, even though the prime rate ranged between 5.25% and 6.75%. Indeed, if anyone had predicted 7.8% unemployment, 13% inflation and a 21.5% interest rate by 1980, he would have been dismissed as ludicrously pessimistic or told that he might as well forecast revolution and blood in the streets. If he had cared to add that by 1980 crude oil would sell for an average price of $35 per bbl. (vs. $1.70 in 1971), that the U.S. dollar would buy only two German marks (vs. almost four in 1970) and that auto and truck production would total only 6.4 million vehicles (vs. 8 million in 1971), he might have been packed off to a mental institution.

Perhaps the most shocking of all predictions of a 1971 prophet would have been that by 1979 the U.S. would rank only tenth among members of the Organization for Economic Cooperation and Development in per capita income, a rough measure of the standard of living.

Yet that is the fact: according to the O.E.C.D., the current U.S. figure of $10,662 is outranked by Switzerland ($14,967), Denmark ($12,943), West Germany ($12,450), Sweden ($12,278), Luxembourg ($11,593), Norway ($11,357), Belgium ($11,261), Iceland ($10,978) and France ($10,683).

Through much of the decade, however, American incomes increased faster than the rise in prices. That occurred in part because the earnings of working wives bolstered family incomes. But since early 1979, inflation has steadily outstripped the rise in wages per hour, so that the American standard of living is now genuinely falling. That trend, above all, is robbing many people of their faith in the future, and prompting agonized pleas for some way, any way, to end the plague of inflation and recession.

Is there such a way? Policymakers have yet to find it; much of what they have done has unwittingly made matters worse. Congress, in the sarcastic words of David Stockman, Reagan's choice to be director of the Office of Management and Budget, has converted the federal budget into "a coast-to-coast soup line." Americans hurt by recession or inflation receive ever rising benefits. Two examples: aid to workers thought to be made jobless by rising imports skyrocketed from $319 million in 1979 to $2 billion for the first eleven months of 1980, and student loan subsidies, once a small program, now swallow $1.6 billion a year. Though the spending does relieve distress, it also swells the budget deficit, which fans still more inflation and ultimately contributes to recession by pricing goods out of consumers' reach. Recession and inflation then prompt still more federal spending, and so on and on.

Faced with these interlocking cycles of misery, many Americans, both consumers and businessmen, seem to be giving up hope for a cure and accommodating themselves to the situation. Union members benefiting from automatic cost of living adjustments generally consider themselves insulated from inflation and show little concern about what those pay boosts do to their employers' costs. Many businessmen, meanwhile, increase their prices despite--or sometimes because of --weak demand. Two weeks ago, General Motors hiked the cost of its cars by an average of $149, although its sales fell by 22% in December, compared with the same month last year. Those, of course, are precisely the attitudes that keep inflation rising.

Now enter supply-side economics, the quasi-official theory of the Reagan Administration, with a flourish of trumpets and a roll of drums. It is far from a unified school of doctrine; supply-siders quarrel about who is preaching the true gospel and who is espousing a heretical variant. But they agree on a central line of argument that goes like this:

The core problem of capitalist economics is balancing the supply of goods and services with the demand for them. Keynesian economists, who have dominated policy for the past generation, have tried to produce a prosperous balance primarily by pumping up demand, largely through heavy Government spending. They have assumed that supply would more or less automatically rise to meet demand.

For a long time after World War II that formula worked, but decades of Keynesian policies have now trapped the economy in a blind alley. The Government taxes away too much of the wealth generated by private business and wastes it in often unproductive expenditures. Though individual industries may overproduce, supply in the economy as a whole no longer grows fast enough either to provide jobs for all the people who want them or to absorb the demand created by Government outlays. The result: the nation suffers from simultaneous unemployment and inflation.

The way out, say many now influential economists, is to work on the "supply side" of the supply-demand balance--that is, to cut taxes and reduce Government spending so that the private economy will be free to produce a rapid increase in the supply of goods and services. Not only will that create jobs, but one branch of the school believes that demand will fit itself to the available supply with little if any further Government encouragement.

And since the classic definition of inflation is an excess of demand over supply, a balance between the two achieved by increasing supply should result in the dwindling of inflation.

Such theories are neither new nor revolutionary. The forefather of today's supply-siders was the 19th century Frenchman Jean-Baptiste Say, who enunciated one of the earliest--and most hotly disputed--laws of economics: supply creates its own demand. John F. Kennedy practiced a form of supply-side economics in the early 1960s with measures like the investment tax credit to stimulate business expansion. No less a Keynesian than John Maynard Keynes himself anticipated the supply-siders' stress on incentives to production by writing: "I believe you have first of all to do something to restore profits and then rely on private enterprise to carry the thing along."

But how does one increase supply?

Primarily, in the Reaganauts' view, by encouraging savings, investment and productivity. That trinity has been sorely neglected in the U.S. economy. The savings rate has dropped from 7.7% in 1971 to 6.1% today, one of the lowest in the industrial world (in Japan it is 20.1%). Business investment in new plant and equipment, which is financed largely by savings deposited by individuals in banks and insurance companies or retained by companies out of their own profits, is dragging along at about 11%, a rate that satisfies no one. U.S. productivity, as measured by output per man-hour worked, is still the highest in the world. In 1979 the productivity of an American worker was still 13% higher than that of a West German, and 34% higher than that of a Japanese. But U.S. productivity growth has been slowing since the 1960s, and in 1980 it actually declined by an estimated 1%, partly because companies are no longer providing workers with highly efficient machinery. That means, among other things, that wage increases designed to enable workers to catch up with inflation immediately get translated into still more inflation. If a worker earns more each hour but produces less, his employer ordinarily will be forced to raise prices to close the gap.

The reasons for the lag in savings, investment and productivity are numerous and complex. Inflation is a cause as well as an effect. A consumer cannot save if he needs every penny he earns to pay next month's rising rent, food and fuel bills. A businessman is not likely to build a new plant when current high interest rates and the unknowns about the future course of inflation make it virtually impossible to estimate potential profits.

Supply-siders argue in addition that the Government has been systematically, if unintentionally, discriminating against savings and investment. The tax structure, in their view, is loaded in favor of consumption and against investment: the top tax rate on income from rents or dividends is 70% vs. a high of 50% on income from wages and salaries. The Government funnels tax money collected from business and workers to people who consume but do not produce: for exampie, military retirees or welfare recipients. Moreover, Government erects a maze of niggling environmental, safety and health regulations around every company that wants to build a new plant or change a production process.

The supply-siders' program for correcting the problems of the economy contains three main elements:

Tax Cuts. Reagan is committed to the so-called Kemp-Roth formula for cutting personal income tax rates by 10% in each of the next three years. There will be some more direct incentives to savings and investment too. New York Congressman Jack Kemp, co-author of the Kemp-Roth plan and newly elected leader of the House Republican Conference, argues for a 40% acceleration in the tax write-offs that businessmen can take on investments in new plant and machinery and for a reduction in the maximum capital gains tax rate from 28% to 20%. Others are pushing for further tax exemptions on interest paid by bank savings accounts and on dividends.

Whether Congress will accept the threeyear, 30% tax cut plan is another question. Some legislators fear that reducing rates so drastically would only swell an already inflationary budget deficit. There is now speculation that Congress may settle instead on a 10%-5%-5% plan. Reaganauts retort that the full reduction is necessary to spur employees to work hard and to save a bit.

Less Regulation. Murray Weidenbaum, a member of TIME'S Board of Economists and a Reagan adviser during the presidential campaign, urges a oneyear moratorium on all new regulations, including those on health, safety and the environment. Stockman and Kemp would have Reagan go further and repeal or delay by presidential order many regulations either pending or already on the books. Some of their recommendations: revocation of the order forcing the auto industry to install air bags or other "passive restraints" in some cars by the 1982 model-year; elimination of energy performance standards for buildings; deferment of new workplace noise standards promoted by the Occupational Safety and Health Administration.

A Stable Monetary Policy. Economists Milton Friedman and Allan Meltzer have advised Reagan to meet with Federal Reserve Chairman Paul Volcker before the Inauguration and hammer out a formal agreement that the Fed will expand the money supply at a slow, steady pace and let interest rates go wherever the market takes them. If production rises and inflation slows, the rates would go down. Reagan is unlikely to follow that advice, mainly because he knows that the independent Federal Reserve would never agree to such restrictions on its freedom. But Reagan will probably urge such a policy quietly and informally, and Volcker is likely to concur. Deciding on a monetary policy and carrying it out, unfortunately, are two separate matters. Formidable technical difficulties can prevent the nation's central bank from achieving the rate of money-supply growth that both its chairman and the President-elect want.

The prerequisite for such a new economic initiative is ah assault on federal spending. In one segment of supply-side theory, espoused most forcefully by University of Southern California Professor Arthur Laffer, budget cuts should not be necessary. Tax reductions, he argues, would fairly quickly stimulate such a vigorous expansion as to pay for themselves by bringing in a flood of new revenues.

Reagan himself talked that line early in the presidential campaign, but he has long since discarded it. His aides now regard slowing the growth of federal spending as absolutely crucial.

The reason is simple: without some stern reductions in spending, the Kemp-Roth tax cuts and the big increases in military outlays that Reagan plans would, at least initially, fatten an already bloated budget deficit. That would increase the danger of fanning inflation both directly, by spilling too much money into the economy, and indirectly, by sending a dismaying signal to the financial markets. In a now famous post--Election Day memo to Reagan warning of a possible "economic Dunkirk" early in his Administration, Kemp and Stockman argued that unless tax cuts are accompanied by stiff reductions in spending, the markets would conclude that a "Reagan inflation" was coming.

Cutting will be no easy job. Fiscal 1981 will be almost one-third over before Reagan assumes office, which will leave him little time to reduce the expected $56 billion deficit. Moreover, five days before Reagan takes the Inaugural oath, Jimmy Carter will send to Congress the first budget proposals for fiscal 1982, which begins Oct. 1. They are expected to specify spending of $740 billion and a deficit of about $30 billion even without any Reagan tax cuts. Says New Mexico Republican Pete Domenici, new head of the Senate Budget Committee: "If we don't act swiftly, within three or four months, there won't be a balanced budget in 1986."

Members of the committee staff have produced a 43-page catalogue that Stockman is now winnowing down to items that could be cut quickly to save about $13 billion before the end of fiscal 1981. Some likely components of that final list:

> Less aid to the unemployed. Laid-off workers who draw maximum unemployment compensation benefits could not also collect the special payments made to those who lose their jobs because of import competition, as many steel and auto workers do now. More important, the Government would stop financing longer-than-normal unemployment benefits in states where the jobless rate is 4.5% or more--a category that currently includes every state except Kansas (4.4%), Nebraska (3.8%), North Dakota (4.3%), Texas (4.4%) and Wyoming (3.7%). Estimated savings in fiscal 1981: $1.7 billion.

> A complete freeze on federal hiring.

President Carter has allowed federal departments and agencies to fill only half their vacancies; Reagan, say his aides, should allow them to fill none at all. Fiscal 1981 savings: $1.5 billion.

> Cutbacks in urban mass transit programs. For one example, the Federal Government now pays 80% of the purchase price of buses bought by cities; the Reaganauts would reduce that to zero.

Savings from this and other reductions in transportation aid: $1.3 billion.

> A limit on the raising of federal pensions to adjust for inflation, to only once a year, rather than twice, as is done now. Savings: $450 million.

> The reduction of federal aid to the arts to 1976 levels. Savings: $100 million.

Paring spending in fiscal 1981 is only a start. Reagan's allies know that they must also slash the enormous future growth in expenditures that is clearly foreseeable under programs already in effect. They hope to do so in two ways. First, they note, savings from many of the cuts they propose will grow dramatically in fiscal years after 1981. In addition, Stockman in the Dunkirk memo drew up a list of potential cuts or deferrals in future spending authority for everything from airport construction and space exploration to national parks. If all were accepted, he figures, savings could total $30 billion to $50 billion a year in fiscal 1982 and 1983.

Proposing reductions and carrying them out, of course, are very different.

Liberals are sure to portray some of the cuts, such as less generous unemployment compensation, as a heartless assault on the members of society who need help the most. Even those programs that seem eminently cuttable are vigorously defended by members of the "iron triangle" of federal spending: Government departments, special interest lobbyists and the staffs of congressional committees that pass on spending plans.

When those three groups join forces to battle a cut in funds benefiting them, they are a mighty power. Every President since Dwight Eisenhower has tried to cut back the program that gives financial aid to often wealthy school districts where a large number of Government employees live.

None has succeeded.

Domenici believes that Reagan will ask Congress to defer or cancel expenditures for some programs already approved, which would involve only minor tinkering with the law.

Says the Senator: "My prediction is that the words rescission and deferral,* little known in America today, will become very well known over the next 24 months."

The biggest question about the budget is how, and how vigorously, Reagan will move on the "entitlement" programs, such as Social Security, Medicaid, food stamps and disability insurance. This spending has rocketed upward over the years as more and more people have qualified for benefits that must be paid to them by law.

Many experts believe that dramatic savings can be achieved only by rewriting the basic laws to reduce the number of people who will qualify for future benefits.

Stockman has proposed doing exactly that, but Reagan's own last words on the subject were contradictory. Late in the campaign, he pledged to maintain "necessary entitlements already granted to the American people."

If Congress balks at cutting spending as deeply as the incoming Administration will propose, disagreements among Reagan's advisers that are already rumbling below the surface could erupt into a public battle. One group argues that taxes can be slashed no faster than spending; the implication is that, if Congress rejects some of Reagan's budget cuts, the tax reductions will have to be scaled back too. During his confirmation hearing last week, Secretary of the Treasury-designate Donald Regan placed a higher priority on reducing spending than on cutting taxes. He said that trimming the budget and controlling regulation were the "more important" parts of the program. Said Regan: "Then we cut taxes." The more ardent supply-siders, led by Kemp, insist that the new Administration should press ahead with deep tax reductions. Says Kemp: "I don't want to see anything compromise the full 30% cuts."

Outside the incoming Administration, there are many skeptics who question Reagan's strategy. Just about all economists agree with the supply-siders that the U.S. can never achieve noninflationary expansion without a sharp rise in savings and investment and a reversal of the decline in productivity growth, but many doubt that the program now shaping up will produce those effects.

One reason is the widespread fear that tax cuts and increases in military spending will outweigh whatever budget reductions Reagan can achieve and lead to ever larger deficits.

Walter Heller, a member of TIME'S Board of Economists, points out that, quite apart from its effects on inflation, a swelling deficit operates directly to reduce savings in the economy. The Government must borrow to cover the deficit, thus decreasing savings, and in a briskly expanding economy this would reduce the money available for private investment. ''The quickest and surest way to increase savings is to reduce the deficit or run a budget surplus," says Heller. But he fears that the Reagan program will do the exact opposite, at least in the short run.

Some economists, in addition, scoff at the Kemp-Roth tax cuts as bad supply-side economics. In their view, the reductions in personal income taxes will pump up demand far more than they will encourage savings. Says Lester C.

Thurow, also a member of TIME'S Board of Economists: "The average American saves 4% of his income and consumes 96%. He will save 4% and consume 96% of the tax cut. Savings and investment will go up a little, but consumption will go up by a whopping amount. That is not what we need."

Even Conservative Herbert Stein, the chairman of President Nixon's council of Economic Advisers, warns: "What we can do on the supply side is not big enough to solve the problem. We have demand growing by about 12% a year and supply growing by about 2% a year, which yields 10% inflation. To increase the rate of growth of supply by 50%, from 2% a year to 3% a year, which is a difficult task, would still leave an enormous inflation, especially if the increase of supply is accomplished by means like cutting taxes, which at the same time would increase demand."

Critics of the Reagan program, however, are singularly lacking in ideas for an alternative strategy. So it seems that supply-side economics, or something baptized in that name, will be given a chance.

Yet even if it succeeds, the nation will assuredly have to endure at least another year or two of economic pain before there are readily visible results in increasing growth and slowly diminishing inflation.

And if the Reaganauts' supply-side economics fails, the U.S. will have a few more whirls around the jet-propelled economic merry-go-round. --By George J. Church.

Reported by William Blaylock/Washington and Michael Moritz/Los Angeles, with other U.S. bureaus

*Rescission is the repeal of an appropriation for federal spending. Deferral is the delay in spending already appropriated money.

With reporting by William Blaylock, Michael Moritz

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