Will Reagan's Plan Work?

By Charles P. Alexander

TIME'S Board of Economists reviews the new Administration's program

Is the U.S. "threatened with an economic calamity of tremendous proportions," as Ronald Reagan told the U.S. two weeks ago? The TIME Board of Economists met last week to review the state of American business and to try to answer that question. The group's consensus: though President Reagan's rhetoric may have been a bit overblown, the economy is indeed in serious trouble. Declining productivity, recalcitrant inflation and the explosion of Government spending have so shackled U.S. business that growth will be sluggish well into the future. Moreover, the time left to reverse that course is growing short. Warned Otto Eckstein, president of Data Resources, an economic consulting firm based in Lexington, Mass.: "The federal budget has tremendous upward momentum. Increases in spending can't go on at the rate of the past ten years, or the private sector won't be able to function any more." Manhattan Economic Consultant Alan Greenspan, who is also a member of Reagan's new Economic Policy Advisory Board, pointed out that towering interest rates are threatening the survival of many American financial institutions. Said he: "A continuation of business as usual will lead us off a cliff."

Reagan's program of deep budget cuts and generous tax reductions is an ambitious, but unorthodox, attempt to revitalize the economy. He hopes these measures will speed growth, slow inflation and balance the budget by 1983. But they could also overstimulate the economy and cause even more inflation. The program has thus worried both liberals and some conservatives. Charles L. Schultze, the chairman of the Council of Economic Advisers under President Carter and a new member of the TIME board, voiced the concern of many Democrats. Said he: "The Administration is pursuing a gung-ho, damn-the-torpedoes, full-speed-ahead policy."

Despite the economy's surprisingly strong performance in the last three months of 1980, when it grew at a 5% annual rate, the short-term outlook for the U.S. economy is somber. TIME'S board foresees another year of stagnant production and rising prices in 1981. Interest rates, which rose to more than 20% last December, continue to hurt seriously the all-important housing and automobile industries. The result: the output of goods and services is expected to drop by about .5% in the first half of this year. Concluded Greenspan: "The economy remains weak, and the numbers will confirm this by early spring."

An anemic recovery should begin some time during the summer of 1981, but growth for the year as a whole is unlikely to be higher than 1.5%. Said Eckstein: "Sizable growth in 1981 is almost impossible." Thus the economy will remain at a virtual standstill for the third consecutive year. In 1979 growth was a mere 1.7%, and last year there was no economic expansion at all.

The sluggish economy will be bac news for those looking for a new job. The board believes that unemployment will rise from its current level of 7.4% to 8% by midyear before dropping back to 7.8% at the end of 1981. That will leave about 8 million people jobless for most of this year.

Despite the continuing slow growth, inflation will hardly begin to moderate. Consumer prices jumped 12.4% in 1980, and the TIME board predicts another 11.5% surge in 1981. The first price report of the new year supported that gloomy projection. The Bureau of Labor Statistics said last week that the prices paid by producers and wholesalers rose in January by .9%, or an annual rate of 11.4%. Energy prices led the surge with a 2.7% increase for the month, or 37.7% on a yearly basis.

The cost of heating oil and gasoline will climb sharply this winter, in part because of the President's decision three weeks ago to remove all price controls from petroleum products. The action was scheduled to take place in any case in September, but Reagan advanced the date in order to encourage both conservation and exploration for new oil. That will eventually ease the energy crisis, but in the near future decontrol means higher prices.

The outlook for grocery bills this year is also discouraging. The drought that devastated crops last summer in parts of the Midwest and Southeast is still haying an impact. In addition, Florida's citrus groves have been damaged by freezing temperatures. Agricultural experts expect food prices to increase by 15% in 1981.

The most ominous inflationary trend is that the temporary energy and food price hikes are now being built into wage demands. That will make it even more difficult for the economy to return eventually to price stability. In the past year, average hourly earnings have gone up about 9% and are still picking up speed. Warned Joseph A. Pechman, director of economic studies at the Brookings Institution: "Wage inflation is at a disturbingly high level. In January hourly earnings rose at more than a 16% annual rate." Rather than protecting workers from rising prices, these wage gains will most probably lead to an acceleration of inflation.

Continued inflation means that consumers can expect only modest relief from the record interest rates. Moreover, Federal Reserve Board Chairman Paul Volcker has repeatedly pledged to keep a firm hand on the supply of money available to banks until the inflation fever has broken. TIME'S board predicts that the prime rate will not fall below 15% by midyear, which would still be 3 points higher than the 12% peak set during the 1973-75 recession. Said Eckstein: "For the next few years, we are projecting that interest rates will stay at unparalleled heights."

Greenspan, however, warned that unless interest rates fall sharply, American savings banks and savings and loan associations will soon encounter a grave crisis. These thrift institutions have many old mortgages on their books, with rates of 10% or less, at the same tune that they must pay 15% or more on their new deposits. The result is a growing tide of red ink for these institutions. The Bowery Savings Bank in New York City, for example, last week reported a 1980 operating loss of $60.8 million. Greenspan called this situation a "ticking time bomb" that might provoke a "massive federal bailout of the thrift industry." Such a federal rescue plan would cause a rapid expansion of the money supply and a new outburst of inflation.

The TIME economists agreed that one of the major problems facing the Reagan Administration is the expectation of sustained price rises. Union leaders, bankers and businessmen have all built socalled inflation premiums into their plans. As a margin of safety in case rapid inflation persists, they add a few extra percentage points to a wage demand, the rate of a loan or the price of a new product. Said Greenspan: "The psychological impact of inflation is greater than at any tune in the postwar era." The task of the new Administration will be to convince the American public that these expectations are no longer valid and that price increases will soon start to slow down.

A [ministration officials argue that tough action to cut the budget would have a major impact on public psychology and cause inflation to decelerate rapidly. They point to the experience of the period between 1974 and 1976, when inflation dropped precipitously, from 12.2% to 4.8%. Greenspan supported that optimistic viewpoint, saying, "If the President succeeds in pushing through these budget cuts, it would be a major watershed in economic policy. The change in inflation expectations could be quite dramatic."

Greenspan, though, was sharply challenged by Schultze, who maintained that inflation has become so deeply embedded in the American economy that it could be removed only by several years of tight budgets and moderate growth.

The Reagan program, he asserted, will have no quick impact on either wages or productivity. Concluded Schultze: "I think it is very dangerous to hinge so much on the ability to do this in a hurry because the prospects for disappointment are at least high, and one could really come a cropper."

Pechman warned that the real peril of the Reagan program is that it could fuel inflation. He estimated that the continuation of Government services at their current level and the large boost in defense spending that Reagan wants will generate a federal budget deficit of $50 billion in the fiscal year that starts in October. The President's proposed personal and business tax cuts would increase the deficit by another $40 billion, leaving a daunting Government shortfall of $90 billion. Even if Reagan succeeded in persuading Congress to cut $50 billion in expenditures, the deficit would still be $40 billion. The result of that heavy spending might be yet another jolt to prices. Said Pechman: "Reagan may find that inflation has run away from him before he even gets started on his plans."

Martin S. Feldstein, a Harvard professor and president of the National Bureau of Economic Research, was worried that if the Reagan Administration is successful in fostering faster economic growth, this would lead to new demands for higher wages and still more inflation. He argued that only the slow business expansion of the past two years has kept pay increases low. Said he: "If the economy is even moderately stimulated and nothing is done to change inflation expectations, I think we could see tremendous pressure on the wage side. We really have to do something in the next year or two, or we will find that we are in a much worse situation."

All the members of the TIME board agreed that carving $50 billion out of Government spending will be difficult. Almost half of the projected 1982 budget, or some $340 billion, goes to so-called entitlement programs like Social Security and the railroad retirement fund, which make payments to individuals that are mandated by law. Another $260 billion is slated for national defense and interest on the federal debt. Reagan has pledged to increase defense spending, and reportedly will propose cuts of no more than $20 billion in the popular entitlement benefits. This means that the President will have to trim about $30 billion from the remaining $160 billion in the budget, which is largely made up of social and public works programs. Schultze called such a slash of almost 20% "highly improbable."

Schultze was surprised at Reagan's apparent decision not to press for changes in the way entitlement programs are "indexed," or adjusted to compensate for the impact of inflation. Many Government benefits, including Social Security payments and civil service pensions, rise automatically in tandem with the Consumer Price Index. Schultze said that during the past three years, the CPI had overstated the rise in the cost of living by more than 5% because it gives too much weight to rising home prices and mortgage rates. Before leaving office, the Carter Administration proposed using a more accurate cost of living index. If that alternative measuring stick had been used for increasing Government payments during the past three years, federal expenditures in fiscal 1982 would be $13 billion lower.

Congress would have to be uncommonly cooperative for the budget cuts to be adopted. Said Pechman:

"The kinds of expenditures that Reagan wants chopped all have important political constituencies. It will be a hell of a battle on Capitol Hill." He noted, for example, that some of the reductions in Social Security benefits that Reagan is expected to propose were first recommended by President Carter and rejected by Congress two years ago. One example: the plan to eliminate benefits to college age students who are children of a retired, dis abled or dead Social Security beneficiary was never even considered by a congressional committee. Last year, despite the general public sentiment in favor of spending reductions, Congress passed less than one-third of the $16 billion in total budget cuts and revenue increases that Carter requested.

Some board members, though, felt that the more conservative Congress elected in November could make many of the changes the President will request. Said M.I.T. Professor Lester Thurow: "Reagan may get a lot more of these budget cuts than you would believe based on past experience." Thurow, who was a presidential campaign adviser to George McGovern in 1972, maintained that even liberal Democrats had a reason for supporting the cuts. Said he: "Many Democrats are inclined to let Reagan have what he wants. Then, if the economy is still in a mess in the election years of 1982 and 1984, he'll have to assume all the blame. The phrase is, 'Give him rope to hang himself.' "

Even so, most of the TIME economists doubt that the budget can be trimmed nearly enough to make room for the sweeping 30% slash in personal income tax rates over three years that Reagan envisions. They believe that cuts should be much more heavily weighted toward business to encourage investment in new equipment and thereby boost the supply of goods and services generated by the economy. Most of the money from personal tax reductions, they argue, would be quickly spent rather than saved and invested. Said Thurow:

"Reagan's program runs the risk of overstimulating the economy and fanning inflation. The country really needs supply-side economics, but this just isn't supply-side economics." The board members had several alternative ideas about how to change the tax laws to stimulate savings and investment. Thurow suggested that capital gains taxes be indexed. Under current law, profits from the sale of stock, for example, are taxed even if those gains are merely the result of inflation. Thurow, however, would limit this new tax protection to productive investments like stocks and bonds, rather than ventures like gold, paintings or rare stamps. He also asserted that if the Government were really serious about encouraging saving, it would impose a levy on consumption like the national sales taxes that are common in Western Europe. Feldstein recommended that Congress focus on tax relief for middle-and high-income taxpayers, who have the greatest ability to save. In particular, he would lower the maximum rate on interest and dividend income from 70% to 50%. He believes that if that rate were lowered, upper-income taxpayers would invest more of their money and switch a great deal of cash from unproductive tax shelters like real estate into stocks and bonds, which provide funds for industrial growth.

Though the TIME economists quibbled about the precise tax changes or the types of budget cuts that are best for spurring the economy and productivity, there was no disagreement about the need to take action. Said Thurow: "This is not a crisis. It is a disaster. If you imagine the productivity trends continuing for a decade the way they have gone for the last four years, that's just a national disaster. We really are facing what England faced just after 1900 when we passed them in terms of per capita income." President Reagan this week will make another attempt to convince the American public that the U.S. economic situation demands daring and drastic measures, when he unveils the specifics of his budget reductions and other proposals in his first speech to Congress. If he fails to show the people and members of Congress that action must be taken, the economic malaise of the past few years could worsen rather quickly. Said Greenspan: "Time is of the essence; this is a very serious period. We may have a small window of opportunity to resolve this problem perhaps a year. More than at any time I can remember, the outlook depends on the success or failure of economic policy." By Charles P. Alexander

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