Roadblocks to Recovery

By Charles Alexander

Those deep deficits and steep interest rates alarm TIME's economists

A strong recovery from the recession that now grips the U.S. economy will be virtually impossible unless quick action is taken to curb record federal deficits and thus bring down oppressive interest rates. That was the somber verdict of TIME's Board of Economists, which met in New York City last week to review President Reagan's 1983 budget and assess its impact on the economy. The board applauded the dramatic progress that Reagan has made in cooling inflation and restoring incentives for investment, but feared that these gains could be erased by the deficits.

The economists were disappointed, and even a little shocked, by the President's "no retreat" budget message. They particularly questioned his refusal to recommend significant tax increases or to pare, even slightly, spending for Social Security and defense, the two largest budget programs. Taken at face value, Reagan's deficit projections are alarming enough: $91.5 billion in 1983, narrowing to $71.9 billion by 1985. Those figures assume, however, that economic growth will rebound vigorously this summer and that Congress in an election year will make further cutbacks in social programs like food stamps. Both assumptions, TIME's economists agreed, are wishful thinking. The board expected the deficit to rise from $125 billion in 1983 to $150 billion in 1985. If the Government has to borrow those gargantuan sums, interest rates will almost surely remain at towering levels and prevent a robust economic recovery.

Concern about the deficits united the board's Democrats and Republicans, liberals and conservatives. Said Democrat Otto Eckstein, a Harvard professor who was an economic adviser to President Johnson: "Reagan's economic policy is an off-the-wall approach that rejects conventional wisdom. We're running an incredible experiment with these deficits." Conservative Martin Feldstein, president of the National Bureau for Economic Research, observed, "The Administration has put itself in an impossible position." Even Republican Alan Greenspan, a New York consultant and sometime adviser to Reagan, admitted that the outlook was "extraordinarily bleak."

The board members expected that the current recession would worsen. They predicted that unemployment, which was 8.5% in January, will rise to 9.5% by spring, the highest level since World War II. Not only are millions of Americans without paychecks, but millions more are so fearful of being laid off that they are forgoing new autos and appliances and scrimping on clothes. These lost sales lower industrial production and give self-sustaining momentum to the recession.

TIME's economists predicted that the recession should hit bottom in late spring or early summer. By then, many businesses that are now cutting production in order to reduce bulging inventories of unsold goods will have exhausted excessive stock and begun to increase output again. In July a scheduled 10% cut in personal income taxes could give a boost to consumer spending. Recovery, though, will be painfully slow. "We may just have a long, flat bottom with very little growth," said Feldstein, adding wryly, "Only professional economists will know that the recession is over." Even by year's end, according to the board's forecast, unemployment will still hover at 8.7%. Growth in the gross national product is expected to accelerate gradually from 1.8% this year to 3.9% in 1983, a pace that would be only about half as strong as after other postwar recessions. Walter Heller, chief economic adviser to President Kennedy, warned that the economy may stall again within a year or two. Said he: "Under present policies, I don't think we can have a very strong rebound or a long one."

The main threat to growth will be the daunting cost of borrowing money. Said Eckstein: "Interest rates are a big cloud over the economy. We won't have a normal recovery." Though the slump has dampened business demand for credit, the prime rate that banks levy on corporate customers still hovers around 16 1/2%, more than double the interest charge that prevailed in 1977. The high rates are partly the work of the Federal Reserve, which is trying to restrain inflation by reining in the growth of the money supply. Fed Chairman Paul Volcker told Congress last week that he would continue holding the line on money growth. He said that the real cause of high interest rates was growing Government deficits, which are soaking up an ever greater share of the funds available in financial markets. Volcker charged that current fiscal policy is incompatible with the Federal Reserve's goal of maintaining a responsible monetary policy. Said he: "I think we all know that without action [on the deficit] we would be on a collision course."

TIME's economists foresaw no big break in interest rates. Rimmer de Vries, senior vice president at Morgan Guaranty Trust Co. and a new member of TIME's board, predicted that the prime rate would fluctuate narrowly between 14% and 17% for the rest of the year. Said he: "We're in a stalemate. Congress will have to attack the budget deficit."

The news on the economic scene, however, is not uniformly bad. The Federal Reserve's policy, along with the recession, has brought down inflation far more rapidly than expected. The pace of consumer price hikes slowed from 12.4% in 1980 to 8.9% in 1981. TIME's economists forecast that inflation will cool further to 6.5% this year. The progress is partly a result of bumper grain crops and the worldwide oil glut, which have moderated food and energy prices. More important, the slump has prodded many unions, from the Teamsters to the United Auto Workers, to scale back their wage demands. Said Greenspan: "We're looking at a very significant slowing in the inflation rate. There has been a fundamental change in the wage structure of American industry." Eckstein points to a drop in the so-called core inflation rate. This measures the rise in costs of production due to wages and spending for capital equipment. Unlike the consumer price index, it excludes temporary fluctuations in food, energy and housing costs. He forecasts that the core inflation rate will dip from a peak of 9.2% in 1980 to 7.5% this year.

Now that the Reagan Administration has presented its version of the budget, Congress will take over and actually set the spending limits. Alice Rivlin, director of the Congressional Budget Office and a guest at last week's meeting, pointed out that the lawmakers confront "a very new and different situation that budgeters have never been in before." Past budgets have contained projections that deficits would cease within two to four years. Reason: inflation would boost Americans into higher tax brackets and thus increase revenues faster than spending. The Reagan tax-cut bill passed by Congress last summer changed that pattern. It not only slashed current rates, but also called for indexing, which will automatically adjust brackets to keep taxpayers from paying a higher percentage of their income simply because of inflation. As a result, unless Congress comes up with more budget cuts or new revenues, the annual deficit will top $200 billion by 1985.

Charles Schultze, chief economic adviser to President Carter, feared that with so enormous a deficit Congress would lose its enthusiasm for budget cutting. Said he: "The danger is that once the job looks too big, you give up. If you're faced with cutting a $60 billion deficit to $30 billion, that's one thing. But what do you do with a $200 billion deficit?"

Greenspan, in contrast, saw a positive side to the budget dilemma. In the past, he said, the lawmakers always believed that inflation would raise revenues and create a surplus within a few years. They used this "fiscal dividend" from inflation as a justification for launching costly new spending programs. As a result, the budget never came into balance, but took up an ever larger portion of U.S. income. Federal social programs alone account for 12% of the American G.N.P., up from 8% in 1960. Now that indexing has eliminated taxation through inflation, Greenspan argued, Congress may finally be forced to halt the growth of Government.

Cutting the spending level will not be easy, but it will be impossible without looking at outlays for defense and Social Security. These two programs consume 52% of the budget, while interest on the burgeoning national debt absorbs another 13%. The economists called Reagan's plan to take all cuts from the remaining third of the budget unworkable. Said Schultze: "What he's asking for is a dismantling of the modern Federal Government, except for defense and transfer payments like Social Security. It would mean that, after adjustment for inflation, education programs would be cut by 50% beween 1981 and 1985, social services by 40%, training and job programs by about 70%, and on down the line."

Rather than take such draconian action, Congress is more likely to search for new sources of revenue. Reagan has proposed to lop $27.5 billion off the 1983 deficit by closing a few business tax loopholes and taking various "management initiatives," but TIME's board considered that estimate fanciful. For example, the President said that $8.4 billion could come from faster leasing of oil drilling rights in U.S. coastal waters. Observed James McKie, an economics professor at the University of Texas: "That projection of revenue from offshore leasing shows an excessive degree of optimism."

McKie and the other board members argued that Congress has little choice but to increase taxes significantly. The board did not suggest, however, that Reagan's program of income tax relief for individuals and businesses be completely dismantled. Those cuts are powerful incentives for Americans to work harder, save more and make the investments that are needed to bolster sagging U.S. productivity.

Instead, the economists generally favored tax increases that would discourage consumption rather than investment. One possibility that had support from the board would be coupling decontrol of natural gas prices with a tax on the windfall profits the industry would reap. The price hike would cut consumption of an important fuel, and the tax could net the Treasury perhaps $20 billion in 1983. Greenspan suggested that Congress might look seriously at the Value Added Tax (VAT), a kind of national sales tax that is used by most Western European countries.

No board member suggested that scrapping Reaganomics altogether and starting over would be a good remedy for the current economic problems. For 20 years the U.S. has suffered from stop-go policies. As soon as unemployment started to climb, the battle against inflation ended. Then when prices began to jump, policy was reversed again. Said Feldstein: "The greatest danger is that we panic and undo all the gains we have achieved in reducing inflation and easing the burden of excessive federal spending."

TIME's Board of Economists generally agreed that while most of the goals of Reaganomics are sound, the execution has been faulty. Said De Vries: "Reaganomics was intended to provide incentives and productivity gains. But the policy is increasingly thought of in terms of high interest rates and unemployment. That's not right. That's not what Reaganomics was meant to be." It is not the general thrust of the President's program that the economists question, but rather his inflexible stance against any changes in spending priorities or new taxes of any description. With some compromises and repairs, Reaganomics could still be a powerful engine of economic growth in the years ahead. --By Charles Alexander

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