Making It Work

By Charles Alexander

COVER STORY

Despite choppy waters, the President holds steady on Reaganomics

"Can anyone here say that if we can't do it, someone down the road can do it? And if no one does it, what happens to the country? All of us here know the economy would face an eventual collapse. I know it's a hell of a challenge, but ask yourselves: If not us, who? If not now, when?"

With those stern words last week, Ronald Reagan ordered his Cabinet to find new ways of cutting as much as $15 billion out of next year's budget and a stunning $74 billion in 1983 and 1984. And with those demands, the President opened Chapter 2 in the history of Reaganomics, the Administration's bold plan to alter fundamentally the policy directions of the past half-century and to put the U.S. back on a course of steady, noninflationary growth after years of stagnation and inflation.

When Reagan left Washington in August for a monthlong vacation at his California ranch, he had just wrapped up Chapter 1 and had every reason to feel satisfied, even a bit smug. No President since Franklin D. Roosevelt had done so much so quickly to change the basic path of the American economy. Though critics had confidently predicted that Congress would never go along with his daring "supply-side" strategy of large budget cuts and deep tax reductions, Reagan had pushed his programs through the House and Senate virtually intact.

But back in the White House last week, the President had to face the sobering reality that his job of overhauling the U.S. economy has barely begun. Even before the program's first tax cut was to go into effect, on Oct. 1, doubts about Reaganomics were proliferating, notably on Wall Street and among Congressmen, aided and abetted by some economists and editorial pundits.

Despite the disquiet--even near panic in some sectors--the economy overall is doing surprisingly well in a number of ways. Near record interest rates have hampered growth, but most experts do not foresee anything like a major drop in the economy. To the contrary, after a period of sluggishness, industrial production is expected to rebound sharply. TIME's Board of Economists,* which met last week in New York City, predicted that by the second half of 1982 business would be growing at a robust 4% annual pace. Alice Rivlin, the director of the Congressional Budget Office and a guest participant at the meeting, reported that her office is assuming a 4% annual economic expansion in the years 1983 and 1984. Said she: "We are quite optimistic about the outlook for the economy."

What matters most to most Americans, as polls have shown in recent years, is inflation--and inflation is coming down. TIME'S economists noted that price increases have slowed from 17.3% in the first quarter of 1980 to 10.8% during the past three months. It is not so far Reagan policy as much as his good luck that is responsible, but the economists now expect that inflation will fall even further next year, to 7.5%, and that will in good measure be to the credit of his policies, with a lot of help from the Federal Reserve Board.

Why, then, the sudden outburst of postsummer anxiety, even before Reaganomics has a chance to show what it can do? Nearsightedness in a word. And a fear that, in the long run, Reagan cannot deliver what he has promised. Or, put another way, a mix of present pain and future lack of faith. A sizable part of the President's problem stems from the fact that the most vigorous critics of Reaganomics are focused on the short run: Congressmen worried about re-election next year, brokers buying and selling stocks minute by minute, businessmen who need loans.

But neither Reaganomics nor any plan for restoring business stability can be expected to work like an economic Valium tablet and provide instant relief. "It took us 20 years to get into this mess," says Getty Oil Co. Chairman Sidney Petersen. "We are not going to get out of it in the next 20 months." Adds James Howell, chief economist for the First National Bank of Boston: "Wall Streeters remind me of a mother on her daughter's wedding night. They just need to be a lot calmer, and we'll get through this."

For now, though, attention is focused on current troubles rather than on latent--and later--possibilities. Millions of families cannot afford loans for new homes or automobiles. Thousands of small businesses are going bankrupt. Says Dwayne Walls, 49, a home remodeler in Chapel Hill, N.C., who is stuck with ten unsold houses because of towering mortgage rates: "I really don't see any end to 20% money. The bankers just keep telling me to hang on, but I'm just one little itty-bitty speck in this whole thing. I don't understand what's going on."

Those high interest rates have paralyzed American financial markets. Stock prices have fallen to their lowest level in 15 months, and corporate bond values are reaching record depths. Says David Jones, chief economist for the Wall Street securities firm of Aubrey G. Lanston & Co.: "The feeling in the market is horrible. Prices just keep falling. It's utter frustration. Hopelessness."

Wall Street's main concern is the bulging federal deficit, which s $55.6 billion this year and rising. Government borrowing weighs heavily on credit markets already strained by brisk demand for business loans, including the huge sums to finance megabuck corporate mergers like that between Du Pont and Conoco. The Administration has predicted that the deficit will shrink to $42.5 billion in 1982, and disappear altogether by 1984. But those targets are fast slipping away. The Congressional Budget Office forecast last week that the deficit would be $65 billion in 1982 and would total an extra $50 billion in 1984. As the Federal Reserve continues to restrict the growth of the money supply in its fight to bring down inflation, such unrelenting credit demand from the Government is bound to keep interest rates high or force them even higher. As if to underline the deficit problem, the Senate will open debate as early as next week on a bill to raise the nation's debt ceiling beyond the $1 trillion mark, a figure whose symbolism, as well as size, is certain to catch headlines everywhere.

Concern about the deficit, interest rates and the slumping stock market was enough to persuade Reagan last week to try new versions on some parts of his economic program. During a 75-min. meeting on his first morning in the Oval Office after the Labor Day weekend, Budget Director David Stockman told the President that broad new cuts in federal spending would have to be made soon if Reagan were to have any chance of fulfilling his promise to erase the federal deficit by 1984 and restore business confidence. Said Stockman: "Wall Street is skeptical because they have seen a decade of broken promises. We have to make believers of them." The President agreed: "We've got to hold down the budget deficit and stay on target."

After the meeting, the White House announced that the President would soon propose major new cuts in federal spending. To emphasize his determination to balance the budget, Reagan has tentatively decided to trim $13 billion from his once sacrosanct defense spending goals over the next three years. His only alternative would be a politically risky move to reduce Social Security benefits. Defense, Social Security and interest on the national debt make up about 60% of the budget, and other programs have already been slashed to barebone levels, prompting street demonstrations by labor unions and other angry groups. Without rollbacks in Social Security or military spending, said Alice Rivlin last week as she testified before the House on the budget outlook, "you would simply have to close down the rest of the Government."

Any new cuts in federal spending, however, will face a difficult time in a Congress that is becoming increasingly uneasy about Reaganomics. Said Senate Majority Leader Howard Baker last week: "Already Senators are saying to me, 'What the hell difference does it make? If we cut another $10 billion to $15 billion, the financial community will just come back and ask for another $15 billion cut."

During the month the President was in California, legislators returned to their home districts, where many of them heard loud complaints about the level of interest rates. Said House Republican Leader Robert Michel of Illinois: "We can't live with a 20% prime. Something has got to give in the next 90 days." Added California Republican John H. Rousselot, a strong Reagan backer: "On a crisis scale of one to ten, I'd say we're about seven and climbing."

The President himself sowed many of the seeds of the current disillusionment by his boundless campaign promises and early, far too rosy economic predictions. Rather than adopting a Churchillian posture and admitting that it would take sacrifice and patience by all Americans to set the economy right, Reagan has steadily underplayed the pain involved. During last year's presidential campaign, he pledged that strong growth, less unemployment, lower inflation and a restoration of American military might were all just over his supply-side horizon.

Once the new Administration was in office, the happy talk continued. When the supply-side Reaganauts were preparing to unveil their economic plan last February, they used imaginative new computer models to project what would happen when their tax cuts took effect. The results were absurdly Pollyannaish. Growth in 1982 was going to surge to 7%, while inflation would fall to 6.5%.

Businessmen and economists immediately scoffed at the idea that the problems of sluggish growth and high inflation could be solved that quickly. Charles Schultze, former chief economic adviser to President Carter, called the Administration numbers "wishful thinking." Murray Weidenbaum, Reagan's top economist, and other officials eventually persuaded the Administration to tone down its projections. Yet even then, Reagan's aides, apparently counting on pure psychology to do the job, steadfastly insisted that high interest rates would fall sharply once Congress passed its proposals for budget cuts and tax reductions.

The reality of the new Administration's economic program, of course, turned out to be far different from Reagan's campaign speeches and his Government's early projections. Though industrial production and investment were somewhat higher than most economists expected in view of the high cost of borrowing money, the specter of those larger-than-expected budget deficits soon began to cast a shadow over the whole Reagan program. Says Donald Miller, vice chairman of the Continental Illinois Corp.: "Supplyside economics has been oversold, and people have come to expect too much." Adds Conservative Economist Martin Feldstein, president of the National Bureau of Economic Research: "I think the Administration hurt itself by a series of unbelievable statements, starting with those optimistic forecasts about growth of the economy."

The credibility problem of Reaganomics is based, in part, on its origins. In a sense, it was born one evening in December 1974, in the Two Continents restaurant in Washington, D.C. Three men were sipping drinks: Arthur Laffer, a young economist with an early-Beatles haircut who was considered a maverick by many of his colleagues; Jude Wanniski, an editorial writer for the Wall Street Journal; and Richard Cheney, a White House aide under President Ford.

Laffer argued that the fundamental problem with the American economy was that federal tax rates had got so high that they were beginning to discourage work and investment, and were thus holding down the supply of goods in the economy. Because the demand for goods raced ahead of their supply, inflation had become a chronic problem.

If tax rates were slashed, Laffer said, the result would be a boom in work, saving and investment. The "supply side" of the economy would be so stimulated that before long the Government would gain more revenue than it lost through cutting taxes. To illustrate his point, as legend now has it, Laffer sketched a crude diagram on a cocktail napkin on the table.* It showed that if taxes went too high, the Government would take in less revenue because people would be working less. That first Laffer curve landed in a wastebasket, but it was destined to become one of the most controversial concepts in recent economic theory.

Wanniski became Laffer's most avid apostle and spread the gospel of tax cutting with all the fervor of a circuit-riding preacher. An important early convert was Jack Kemp, a New York Congressman and former quarterback with the Buffalo Bills. In 1977 Kemp, together with Senator William Roth Jr. of Delaware, introduced a bill in Congress to reduce personal income taxes by almost 33% over three years.

AIthough the plan was defeated in Congress, the Kemp-Roth bill gained a loyal supporter: Ronald Reagan. As the 1980 presidential campaign began, the tax-cut proposal was the centerpiece of his economic policy. But when Reagan wrapped up the Republican nomination, the G.O.P.'s mainstream economists flocked to his fold, and the influence of Laffer, Wanniski and Kemp waned as old-line conservatives began having an impact. Among the most prominent: Alan Greenspan, Gerald Ford's chief economic adviser; George Shultz, Treasury Secretary under Richard Nixon; and Arthur Burns, former Federal Reserve Board chairman. Some of those non-Administration advisers met with Reagan last week to discuss the new budget cuts.

The traditional economists gradually began to shift Reagan's program away from the original supply-side doctrine. Laffer assumed that large tax cuts would not be inflationary because they would stimulate enough business to compensate for the lost revenues by significantly increasing the Government's total tax take. But Reagan's more conservative advisers convinced him that tax cuts--and the inevitable, initially huge budget deficits--would fuel inflation unless accompanied by measures to restrain demand. Thus Reaganomics now includes not only a supply-side tax reduction but also calls for less Government spending and strict control over the growth of money.

Although the Democrats had no alternative economic program to offer--and have yet to produce one--they immediately pounced on the problems that they saw as inherent in Reaganomics. They charged that the Administration was papering over the fundamental conflict between the President's main goals--stimulating the economy by cutting taxes and slowing down inflation through tight money--resulting in high interest rates and sluggish growth. Compounding the difficulty was Reagan's proposal for a large and simultaneous increase in defense spending.

As the critics pointed out, Reagan's big tax reductions were bound to swell the size of the deficit, at least in the short run. But the Federal Reserve, which controls the growth of money, has not let credit grow faster to pay for those deficits, so the Government's borrowing demands are pushing up interest rates. The result is the current staggering levels, which threaten to choke off the private investment boom that the tax cut is supposed to bring about. Says Oklahoma Democrat Jim Jones, chairman of the House Budget Committee: "My fear is that the program now put in place by the Administration is the equivalent of stepping hard on the gas at the same time as you slam on the brakes. The result will sound spectacular--until either the brakes fail or the engine blows. It is a gamble of titanic proportions."

Traditional Keynesian economists were the sharpest critics. Said John Kenneth Galbraith, a professor emeritus at Harvard: "The Administration has promised vigorous expansion through supply-side incentives in combination with monetary policy that works through high interest rates and a powerful contraction of the economy. This contradiction can only be resolved by divine intervention--a task for the Moral Majority." Adds Walter Heller, who was President Kennedy's chief economist: "Only an ostrich could have missed the contradictions in Reaganomics."

Yet even some leading conservative economists predicted that the Reagan program would soon run into trouble. Said Robert Lucas, professor of economics at the University of Chicago: "This Administration has committed itself to a whole series of tax cuts, and it's going to be hard as hell for them to reverse course. They have locked themselves into some very tough arithmetic, especially since they have been overoptimistic about the benefits of the tax cuts."

TIME's Board of Economists agreed at its meeting last week that American business faces some difficult times in the next few months. But once beyond these choppy waters, the prospects for the economy in terms of growth and reducing inflation are markedly brighter. However, there will undoubtedly be stress in the short term:

Growth. After expanding at an annual pace of 8.6% in the first three months of the year, U.S. production of goods and services fell at a 2.4% annual rate during the second quarter. TIME's economists expect little or no growth for the rest of the year. From 1982 on, business activity is expected to be stronger.

Inflation. The board optimistically projects that price rises will fall from the 10.8% annual rate of the past three months to about 8% at the end of the year. A bumper crop harvest will hold down food costs, and the continuing ample supply of oil improves the energy outlook. Said James McKie, a University of Texas energy expert: "I think the prospect is for level or somewhat declining prices for oil unless there is some major supply disruption." Otto Eckstein, chairman of Data Resources, a business consulting firm, estimated that oil prices, after being adjusted for inflation, will fall by 3% annually for the next two years. Finally, the board members expect that Federal Reserve Chairman Paul Volcker will maintain monetary discipline to guard against any new burst of inflation.

Interest Rates. Volcker's tough policy will keep the cost of borrowing money high. The TIME board predicts that the prime rate for business loans will edge down slowly from the current 20 1/2% to 17 3/4% by the end of the year. But intense upward pressure on rates will come from strong federal borrowing. The economists agree with the Congressional Budget Office that without new budget cuts, the deficit will reach about $65 billion next year, some $23 billion more than the White House has predicted. Said Joseph Pechman, director of economic studies at the Brookings Institution in Washington: "The financial markets are telling us that the Administration deficit forecasts are pie in the sky."

The board recognized that continued high interest rates will be necessary, for a while at least, to curb inflation. Said Schultze: "We cannot cure inflation painlessly."

That pain is already intense for businesses dependent upon the easy availability of low-cost loans. Auto sales this year are running 30% below the same period in 1978. Home construction for the year is expected to plummet to its lowest level since 1946. "The housing recession is now 34 months old and counting," says Jack Carlson, chief economist for the National Association of Realtors. "We've never had one that long before."

So far this year, 11,076 companies, most of them small, have gone bankrupt. That is 42% more than during the same period in 1980. Most big companies have been able to handle their cash flow problems. The balance sheets, though, are getting tighter and tighter. Warns William Silber, a New York University professor of finance: "With interest rates at these levels, there could be major bankruptcies within months."

One familiar company in danger is Pan American World Airways, which has lost $217.6 million in the first half of this year. In a desperate attempt to raise cash, the company last year sold its Manhattan headquarters for $400 million, and in August it got an additional $500 million for its profitable chain of 97 Intercontinental Hotels. In another attempt to stay aloft, Pan Am last week slashed its domestic fares by up to 68%. The move may be futile, though, because other airlines quickly followed Pan Am, setting off a new price war in the skies.

Many savings and loan associations, which have always been the mainstay of home financing, are also hurting. To keep their deposits, these thrift institutions must pay as much as 16% interest, though many of the old mortgages on their books earn them less than 10%. As a result, an estimated 85% of all S and Ls are losing money. Administration officials are confident that most of the S and Ls have large enough capital reserves to tide them over until rates fall. But some financial experts are not so sure. Says the president of one of the largest U.S. commercial banks: "It could be a major setback to Reaganomics if a bloody disaster of failing S and Ls were allowed to happen. We are on the verge of that now, and it could so hurt confidence that everything accomplished by Reaganomics to date could be wiped out."

Last week the West Side Federal Savings and Loan in New York City and the Washington Savings and Loan in Miami were acquired by National Steel Corp.'s financial subsidiary. The Government played matchmaker by paying National Steel subsidies--currently around $9 million a month--until its new partners return a profit.

As businessmen suffer more and more from the sky-high interest rates, pressure will build for Federal Reserve Chairman Volcker to ease up on the monetary brakes. Although monetary responsibility is supposed to be one of the keystones of Reaganomics, the Administration has hinted on several occasions in the past few weeks that it might consider a somewhat looser credit policy. Treasury Secretary Donald Regan first mentioned this possibility in an interview last month. At a California fund raiser, the President said that high interest rates were "hurting us in what we are trying to do." In an interview with FORTUNE magazine, the President called for "some loosening" of the money supply, while admitting that "we can't dictate to the Fed."

Among Reagan's advisers, battle lines are already being drawn between the monetarists, who back Volcker's tough stance, and the supply-siders, who are afraid that tight money will not give the tax cuts a chance to work their magic. If they in fact change policy, it may be from very tight to merely tight. Says a White House aide: "There is an attitude by some of the supply-siders within the Administration that the monetarists have until the end of the year. Then we may have to jawbone the Fed."

But forcing the Federal Reserve to adopt a looser money policy might be an extremely shortsighted strategy. As Reagan Adviser Greenspan warns: "If the Fed eased, it would reignite inflationary expectations." Though interest rates would come down for a while with a program of easy credit, they would then probably rise quickly once again because financiers would be anticipating still higher inflation and demand still more interest. In the end, rates could well go higher than they are now.

As has happened so often before, the Federal Reserve is caught in a no-win situation. It will have to continue to battle inflation by keeping money tight, while fighting off critics who say that such a policy is plunging business into a recession. In the view of a number of economists, it would be unfortunate if the Federal Reserve Board were to change course now, just when its policies are beginning to help make a definite dent in inflation. Reagan told his Cabinet last week that he shares that view. "I want to see the Fed continue monetary restraint and be the fourth leg of our economic program."

Tough money management and high interest rates have also bolstered the value of the dollar abroad. Many Europeans and Japanese have converted their money into American currency to take advantage of attractive investments in the U.S. Since January the dollar has risen by as much as 36% against other major currencies. That in turn has helped hold down U.S. inflation by making imports cheaper, though American exporters are having a harder time selling their wares abroad.

European moneymen recognize that Reaganomics is a risky strategy. But they believe the President has turned the U.S. economy in the right direction and admire his boldness. Says Giorgio La Malfa, Italy's Budget Minister: "Supplyside theory is an important new departure, which deserves to be fully tried." Even in West Germany, where Chancellor Helmut Schmidt has been strongly complaining about high U.S. interest rates, there is much admiration for Reagan. Says a top official in the West German Economics Ministry: "Reaganomics has reminded the West that by strong decisive leadership, it is possible to change perceptions of economic policy among the public."

Perhaps the most promising sign that Reaganomics may be working is the slowdown in wage demands. Since wages make up a major portion of the cost of any product, a decline in the pace of salary increases should slow down the rate of price rises. Average hourly earnings were jumping at a pace of almost 11 % during the last quarter of 1980, but in the past three months the rate of increase was about 7%. If this trend continues, it could be the key to a reduction in inflation and interest levels.

Most immediately, though, the future of Reaganomics will be determined by how Congress reacts to the second round of Reagan budget cuts. Quick approval could go a long way toward convincing Wall Street skeptics that the Administration will stick with its policy and not retreat at the first sign of resistance.

This second congressional battle of the budget promises to be tough. It could, in fact, crack the solid Republican support that Reagan enjoyed this summer. Conservative hawks might balk at reductions in projected military spending. Other Republicans might flinch at deeper cuts in already lean social programs. Observes Democratic Congressman Morris Udall of Arizona: "There are 20 or 30 liberal Republicans in the House who are embarrassed with their constituencies. They can't go on [supporting Reagan] forever."

The Democrats last week were naturally blaming the Republicans and Reaganomics for all of the financial troubles. Said House Speaker Tip O'Neill: "They left here completely happy last month; they got exactly what they wanted. Now the onus is on them."

Rather than deciding where to trim the budget next, the Republican leadership last week first tried to float the idea of giving the President authority to impound funds appropriated by Congress. That would undercut the Budget Act of 1974, which was passed after President Nixon repeatedly used impoundment to control the flow of federal spending in defiance of congressional wishes. Not surprisingly, Democrats were cool to the idea, saying that the proposal was just a copout for the Republicans.

Rather than slash the budget any further, some Democrats would prefer to roll back part of the tax cuts already passed. Colorado Democrat Gary Hart introduced a bill in the Senate last week that would postpone any personal tax cuts until the budget is balanced.

Despite the loud congressional protests and the worries along Wall Street, the President's program so far appears to retain generally broad public support. A Gallup poll released last week showed that Reagan's approval rating of about 60% has not slipped during this summer's economic slowdown. Interviews by TIME correspondents around the U.S. last week also showed the public's willingness to sacrifice in order to get the economy on the path to steady, noninflationary growth.

More and more people seem to recognize that exorcising inflation can be neither instant nor painless. Says Paul Sullivan, who owns a sportswear manufacturing firm in Methuen, Mass.: "The steps that the President is taking are necessary. It may be tough now, but we can weather it." Says James Graham, a high school teacher in North Little Rock, Ark.: "People are going to have to bite the bullet now, or there isn't going to be any bullet to bite in ten years."

This attitude can even be found among some of the people who are most directly affected by tight money. Says David Brown, a homebuilder in Englewood, N.J.: "I do not want to see my business destroyed, but I'm willing to bear the interim pain if it will help the economy in the long run. We're bleeding. But I think that high interest rates are necessary to slow down inflation."

Corporate executives generally remain as convinced as ever that future prosperity is worth some hardship now. Says Robert Noyce, vice chairman of Intel, a semiconductor manufacturer: "We're somewhat concerned about the transitory period of tight money, but it's part of the medicine we have to take to get the economy to improve." Adds Goff Smith, chairman of Amsted Industries, a Chicago-based equipment supplier: "It's going to hurt a little, but we ought to be glad for a little suffering if it brings the inflation rate down."

To critics who counsel the abrupt abandonment of Reaganomics, some economists suggest a look at the alternatives. Says Walter Hoadley, former chief economist for the Bank of America and now a resident scholar at the Hoover Institution in Stanford, Calif.: "If the Administration backs away from its program under pressure, then the picture gets much worse. Inflation will take over America. Then there goes the dollar, interest rates, everything."

The seven members of TIME'S Board of Economists generally agreed that Reaganomics can work--that the program can curb inflation and revive business growth--if it is given enough time and if Congress implements the full program. Greenspan warned that the policy will not really be in place until lawmakers pass the President's second round of budget cuts. Feldstein said that inflation would not be tamed unless monetary policy remained strict and consistent for several years. Liberal economists on the board were concerned about the social cost of the program; Heller, for one, argued that the policy will place an unfair burden on the poor, who are dependent on federal assistance programs. But the board's liberals also conceded that Reaganomics will hold down Government spending and thus have a chance to stem inflation.

And that, as any economist is sure to agree, would be quite a feat. For nearly two decades, repeated and abrupt changes in economic policy were a major cause of erratic growth and persistent inflation. Administrations from Lyndon Johnson to Jimmy Carter adopted anti-inflationary programs, but these proved to be either ineffectual or too brief to achieve significant returns. Result: chronic stagflation.

Reaganomics is clearly not the painless quick fix that the President promised during his campaign and the early weeks of the Administration. The program will take time, and it will not be easy. Reagan admitted as much last week during his talk to the Cabinet about further budget cuts. Said he: "Some people are frustrated because we don't see instant recovery. We can't be stampeded now by frustration or fear. We have to stay on a steady long-term course." Reaganomics can work, its namesake was saying, if the American public--and politicians--are patient enough to let it work.--By Charles Alexander. Reported by David Beckwith /Washington, with other U.S. bureaus

* The board members: Otto Eckstein, Martin Feldstein, Alan Greenspan, Walter Heller, James McKie, Joseph Pechman, Charles Schultze. * Actually, the cocktail napkin's role in the story may be apocryphal. Laffer cannot remember drawing on it, and Cheney also does not recall it. Other supply-siders say that Wanniski dreamed up the story to add some pizazz to a dry subject. But Laffer now draws the curve on napkins and autographs them for admirers.

With reporting by David Beckwith/Washington

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