Still Stuck in the Slush

By Christopher Byron

The new year will start in recession, but growth should pick up later

For millions of Americans it will be a bleak Christmas and a grim New Year, and not until many months into 1982 will people begin to see the first glimmerings of the supply-side economic prosperity that Ronald Reagan promised would be the hallmark of his Administration. Such was the sobering conclusion of TIME'S Board of Economists last week as it met in New York to survey the year now ending and the economic outlook for the one soon to begin.

After eleven months in office, the President has reversed the trend toward steady increases in taxes and spending by the Federal Governmment and placed the U.S. on a path designed to lead the economy toward steady long-term growth. Yet, as the TIME economists made clear, the Administration at year's end finds itself increasingly entangled in a web of economic difficulties. Some of these are due to the recession that is now gathering force with alarming swiftness, but many are being caused, in effect, by the Administration's policy miscalculations and sheer wishful thinking. In either case, the result has been to limit Reagan's ability to push ahead with his program.

Having promised to boost defense spending, cut taxes, protect Social Security and balance the federal budget by 1984, the President now faces the increasing likelihood of winding up his last year in office with the biggest budget deficit in the nation's history. Both Republicans and Democrats on TIME'S board agreed that to avoid such a fate and the economic repercussions of so large a deficit, the President has no choice but to begin rethinking, and soon, many of his past promises. Summed up Walter Heller, chief economic adviser to President John Kennedy: "The Administration is now down to what the White House itself admits are 'some fairly unpleasant alternatives.' "

Normally, periods of economic contraction call for stimulative measures such as cuts in taxes or increases in Government spending to get business going again. But the looming federal deficit is forcing the Administration to begin thinking instead of tax increases and further budget cuts. Said Alice Rivlin, director of the Congressional Budget Office and a guest at last week's meeting: "The lead time on both tax and spending changes is necessarily very long for the Congress, so any serious effort to solve the fiscal 1983 and 1984 deficit problems would have to start right away. But to do that in the middle of a recession that is not yet showing any signs of getting better is a very serious problem."

The immediate difficulty is the business slump itself, and signs of the worsening economy continue to multiply. Already suffering through one of its worst years in decades, the auto industry last week received still more bad news. New figures showed that sales by the Big Three automakers during the first ten days of December were nearly 28% lower than year-earlier levels, which were already extraordinarily depressed. On an average day early this month, fewer than 14,000 cars were sold throughout the U.S., the slowest pace since 1959, when the U.S. population was 177 million, compared with more than 226 million today.

Far more alarming, TIME'S board stressed that the developing downturn is no longer confined largely to housing and autos, but has now spilled over into so-called feeder industries like steel, machine tools, building supplies and, through them, into the national economy as a whole. Figures released last week by the Federal Reserve Board showed that industrial production dropped by 2.1% in November, the fourth monthly decline in a row. That was the largest one-month slump since May of 1980, and was a clear signal that worse difficulties are still to come. Meanwhile, the Fed also reported that the nation's factories operated at a mere 74.9% of capacity during the month, a decline of 2 percentage points from the October level and of 4.4 percentage points from the rate of one year ago.

One of the developments most worrisome to TIME'S board concerned the steadily swelling inventories of unsold goods. Commerce Department data released during the week showed business stockpiles increasing by nearly 1% during October, while sales of finished goods fell by 2.3%.

Bulging inventories frighten economists because the stockpiles have the unavoidable effect of creating a vicious circle of economic decline. As unsold goods build up, businessmen are forced to pare back production and lay off workers, and this in turn drives up unemployment, which currently stands at 8.4% of the labor force. As jobless lines lengthen, consumer spending shrinks, and this in turn causes inventories of unsold goods to grow even more. Said Alan Greenspan of the Townsend-Greenspan economic consulting firm: "Involuntary inventory accumulation by business will be an absolutely critical piece of evidence in gauging the severity of the recession in 1982. The more rapidly that inventories grow now, the steeper will be the plunge, but the sooner the slide will be over."

TIME'S board proved uncharacteristically wary of predicting precisely just how steep or long-lasting the recession will eventually turn out to be. From the crisis in Poland to the future course of interest rates, the weeks and months ahead are a minefield of uncertainties. Any one of several factors could play havoc with even the most carefully devised economic forecast.

Nonetheless, the consensus outlook shows the economy continuing to decline into early next year, and then picking up at about midyear. Preliminary Government figures released last week showed business declining at a steep annual rate of 5.4% in the fourth quarter. TIME'S board predicted that the pace of the slump will slow to 2.2% during the first three months of 1982. Then, by the second quarter of the year, the plunge should have leveled off, with no more than about 0.2% of decline in G.N.P. In the second half of the year, the economy is expected to snap back and grow at an average annual rate of 4.4%.

Board Member Greenspan warned, however, that the developing downturn could prove to be deeper and longer than expected if capital outlays by business begin to shrivel in the months ahead. So far, most spending plans by businessmen on new plants and equipment have not been shelved or scrapped, and companies are generally pushing ahead with investment programs. Yet Greenspan feared that any dramatic new shock to the economy, such as an unexpected bankruptcy of a major European bank, triggered by a Polish default on its loans, could easily lead to widespread cancellations of business spending plans. But Robert Triffin, an international monetary expert, doubted that if Poland renounced its foreign debts, such action would lead to a collapse in banking around the world.

The unemployment picture next year looks grim. In most economic downturns, joblessness continues to grow even after the economy starts to recover, and TIME'S board sees the pattern being repeated once again in 1982. By year's end, the board expects unemployment to stand at 8.3% of the labor force after peaking at 9% during the second quarter of 1982. Such a jobless rate would match that of the 1973-75 slump as the worst in the postwar era.

The bright spot in the forecast was the board's encouraging outlook for inflation. From a peacetime record annual rate of 18.2% in the first quarter of 1980, the level of consumer price rise has slowed fairly steadily in recent months. The board expects that inflation for 1981 as a whole will be 9.6%. During the first half of next year, the pace of price increases will continue dropping, perhaps to a low of 6.8%, but in the second half of 1982, when the economy starts to pick up speed, the rate of inflation may also go up. The board projects that consumer prices will be growing at a 7.5% rate by the end of next year. If that projection for next year turns out to be correct, it would mean that 1982 will have the lowest annual rate of inflation since 1977.

The great unknown hanging over the economy next year is the level of interest rates. The skyrocketing cost of money this year took the steam out of the economy and caused the recession. The business downturn is now reducing the cost of money, but the question is whether rates will start climbing back to their past heights when economic activity picks up after the middle of the year. Says Alan Greenspan: "The real economic issue is where does the second half of next year go, and the second half goes where interest rates go."

Most board members believed that interest levels are not likely to fall much further. Currently, the prime commercial lending rate that banks charge their most credit-worthy customers stands at 15.75%. The board forecasts that it will still be a high 13.75% in mid-1982. After that, TIME'S economists expect rates to begin inching up, reaching at least 14.5% by the beginning of 1983. Anything much higher than that would have a very damaging effect on next year's projected economic rebound.

The level of interest rates will depend, in part, on the size of the federal deficit. Since he assumed office in January, Reagan has seen the combined effects of a slumping economy and towering interest rates wreck his Administration's deficit forecasts. As the economy weakened and unemployment rose, tax receipts fell off, while outlays for such things as welfare and unemployment benefits climbed. Meanwhile, high interest rates ballooned the carrying cost of the federal deficit, with the result that interest charges alone now account for 10% of the budget.

Though the Administration predicted in September that its fiscal 1982 budget would contain a deficit of just $43.1 billion, the Congressional Budget Office said during the same month that the red ink would more probably total at least $65 billion or perhaps even higher. More recently, the Office of Management and Budget has conceded that the deficit for the year could top $109 billion.

The biggest budget problems, though, are still to come. During 1982, the President's phased 25% three-year income tax cut package will cost the Treasury upwards of $27 billion in lost revenue. At the same time, the Administration's defense spending buildup will boost the Pentagon's fiscal 1981 outlays by 27%, to $200 billion, further swelling Government expenditures. By fiscal 1984, OMB projections put the deficit at a towering $162 billion, and rising.

Regaining control over the budget now looms as the most difficult challenge facing the Administration. Rightly or wrongly, large deficits have come to be viewed by Americans as fiscally irresponsible. Reagan and other Republicans for years have ceaselessly hammered home the message that deficits are the key cause of inflation, even though many of them are now saying that they do not really matter all that much.

Now the liberals are also warning about the size of deficits. One critic was Board Member Joseph Pechman, director of economic studies for the Brookings Institution in Washington, D.C. He said that a failure by Reagan to submit a January budget message containing a convincing and credible program for paring back the deficits for both fiscal 1983 and 1984 would rekindle inflationary expectations all over again and send interest rates leaping anew. Said he: "If the Administration doesn't get ahold of the budget or puts out numbers that everybody can easily put holes in, I think that we are in for quite a of trouble. Interest rates will remain high and will abort the recovery."

Board conservatives like Martin Feldstein, a Harvard professor of economics and president of the National Bureau of Economic Research, continued to emphasize that the most fruitful way to close the budget gap is to keep cutting to reduce spending. Said he: "I am continually struck by the fact that in 1960 only 9% of the nation's gross national product was spent by the Government on nondefense items, while by 1980 the figure had climbed to 17%. Just cutting back to the 1970 share, or 13%, would save roughly $160 billion in 1984."

On the other hand, Alice Rivlin argued that there simply is not all that much left in the federal budget to cut unless the President begins to look at previously untouchable spending programs. Said she: "To balance the fiscal 1984 budget, you would have to reduce Government spending from 23% of G.N.P to 19%. If you leave out defense spending, interest on the debt and entitlement programs such as Social Security and Civil Service retirement, you wind up having to cut everything else in the budget by more than 75%. That would mean practically closing down the Government." Added Charles Schultze, chief economic adviser to Jimmy Carter: "If you refuse to look at entitlements, defense or new taxes, you have a real problem."

Instead of relying almost exclusively on spending cuts, Heller, Pechman and Schultze all proposed lists of revenue raising measures designed to shrink the 1984 deficit sharply. Each urged the Administration to postpone the third stage of the Reagan tax-cut package, which is scheduled to reduce federal income taxes by another 10% when it takes effect in July 1983. This, they said, would automatically reduce the fiscal 1984 deficit by approximately $30 billion. Such action was ruled out by Reagan at his press conference last week when he stressed that he intended to stand by his income tax package as enacted.

The idea of postponing the income tax cut brought demurrals from several more conservative board members. Energy Economist James McKie of the University of Texas protested, only half in jest, that as a lifelong member of the middle class he had been counting heavily on the tax cut as being the first such action in years to benefit him directly. Now, said McKie, he supposed he had been right in suspecting all along that it was too good to be true and that something would transpire to snatch away the benefit before he could enjoy it.

The board's Democrats also urged the Administration to adopt some additional revenue-raising measures. Pechman argued, for example, that doubling the federal excise tax on alcohol, gasoline and tobacco would bring in another $13 billion, and that enacting a windfall tax on decontrolled natural gas could result in anywhere from $10 billion to $20 billion more Government revenue.

In addition, Pechman offered a laundry list of tax reforms that he urged the Administration to make in order to raise the badly needed money. He argued that perhaps $6 billion could be collected simply by eliminating the deductibility of interest on consumer loans, and $3 billion to $4 billion by removing the tax-exempt status now granted to interest payments received by holders of state and local industrial development and revenue bonds. Unlike tax-exempt municipal bonds, which are usually issued to finance such projects as sewer systems and schools, industrial revenue bonds are often sold to help private developers finance urban redevelopment projects and sometimes even suburban shopping malls.

Such measures would be difficult to get through Congress during a recession, but some changes are essential to get the budget back in rein. Rivlin said that although Congress was exhausted by this year's efforts to cut spending, there is now a firm recognition that action is necessary. Said she: "A sufficient portion of the Congress realizes that the budget crunch is very serious and that several drastic things will have to be done, both on the tax side and on the spending side."

In late January or early February, Reagan will present to Congress his budget for the 1983 fiscal year. In preparing those spending proposals, the President will have to face some difficult, but inescapable, choices. It is going to be impossible for the Administration to keep its old campaign promises of increasing defense spending, reducing taxes and protecting entitlement programs, without running up dangerous and damaging deficits. Some compromises between past rhetoric and present reality are inevitable.

If the President does not sharply reduce the size of the budget deficits either by delaying the income tax cut, raising other taxes or sharply cutting federal spending, interest rates next year are likely to jump back to the levels that caused this year's recession. The result would then be another year of little or no economic growth. But if the federal budget can be brought under control, there is the prospect of a sound business expansion next year. The recovery of the American economy during the second half of 1982, and beyond, will largely depend on the budget decisions that Reagan will soon take.

--By Christopher Byron

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