Hope and Worry for Reaganomics

By GEORGE J. CHURCH

Interest rates tumble, but the recession subbornly lingers on

Despite the late-summer explosion in the stock market, American business is in a somber and cautious mood as it approaches Labor Day.

Then factory hands and clerks stream back from the beaches and backyards to their lathes and typewriters, and salesmen hit the road again, knowing that their customers will once more be at their desks rather than on the golf links or tennis courts. Everyone, from the executive suite (indeed, the Oval Office) to the grocery checkout, tries to read the early signs to divine what is likely to occur in the months ahead. The chief questions: When is the economic recovery coming, and how strong will it be?

Rarely has the search for omens been as anxious as now, when business is still mired in a slump that has driven unemployment to the highest point in 41 years and bankruptcies to the worst level in half a century. And rarely, if ever, have the signs been so confusing. The forecasters who try to figure out the prospects for jobs, prices, production and incomes are in the position of a motorist approaching a schizoid traffic light that is flashing green, amber and red signals all at once.

Which signal turns out to be the true one will pose a crucial test for Reaganomics, the theory espoused by President Reagan that a combination of deep cuts in taxes and federal spending, tight control of the money supply and a general lessening of Government intervention in the economy will eventually lead to healthy, noninflationary economic growth. By last summer, the President had put most of his program through Congress, and just about then the slump started. But the policy has yet to achieve the promised payoff.

Fortunately, for almost the first time since the beginning of the recession in July 1981, there are some genuinely hopeful signs. The towering interest rates that virtually every economist has identified as the most daunting hurdle to recovery have come tumbling down faster than al most anyone would have dared to predict a few weeks ago. The Federal Reserve Board last week dropped its discount rate, the amount it charges banks and other financial institutions that borrow funds, for the fourth time since July 19. The discount rate now stands at 10%. Mean while, the prime rate that banks charge their most creditworthy business customers has dropped to 13 1/2%, down three points since midsummer and the lowest since September 1980; some other short-term rates have come down even more sharply. The decline is also spreading to interest charges that are of concern to anyone hoping to buy a house or car. Government agencies last week lowered the interest charges on VA-or FHA-backed mortgages to 14%, and the financing subsidiary of Ford Motor Co. dropped the level of new car-purchase loans to an average of about 16%; all are down one point.

Of more concern to Main Street, the annual rate of inflation, as measured by the Consumer Price Index, dropped in July to 7.3%, after two months of renewed flirtation with double digits. For a welcome change, after-tax incomes are now rising faster than prices, about 1 1/2% more rapidly in the most recent twelve months. That means that consumers are slowly acquiring more purchasing power, following two years of stagnation or even decline.

The stock market rally in response to these favorable signs caused some Wall Streeters to talk as if the millennium had suddenly arrived. Said Stephen Weisglass, president of Ladenburg, Thalmann & Co., a brokerage house: "This is the first leg of a great bull market that will take us to an alltime high by 1983, if not sooner." Such euphoria was obviously not shared by most businessmen, but it cannot be entirely dismissed. Stock prices have a respectable, though far from perfect, record as an indicator of future trends in general business, and can also help nudge the economy in the direction they foreshadow. Bull markets on Wall Street make some people feel richer, thus more willing to spend, and they make it easier for companies to raise money by selling new stock issues rather than by borrowing. That is a tendency that would be especially helpful now, when many corporations are sagging under the burden of repaying heavy debts incurred at crushing interest rates.

But for every cheerful sign, there is at least one gloomy one or, more often, one-and-a-half. Every week brings fresh news of falling sales and profits, new factory closings, more layoffs. Some samples from last week: Exxon, the world's biggest industrial corporation, announced that it would permanently close 850 gasoline stations in the Northeast and Midwest, and dismantle part of its giant Bayway refinery in New Jersey to cope with a decline in retail business. Sales of the Big Three automakers in the middle ten days of August fell a striking 35% below those of a year earlier. In Detroit, where determined optimism has always been a kind of religion, the big guessing game last week was whether sales of U.S.-made autos for all 1982 will be merely the lowest since 1961 (5.56 million cars) or drop even below that miserable mark.

Overall, U.S. factories and mines in July operated at 69.5% of capacity, compared with an average of 85.7% in 1979. And in industry after industry executives say that they can see few signs of any rise in orders that would permit a boost in production soon. A typical report, from Lynn Michaelis, chief economist of Weyerhaeuser Co., the giant wood-products firm: "Pulp sales currently are the lowest they have been in 15 years. The paper markets, which had been holding up until now, are showing signs of weakness." Like many other companies, Michaelis adds, Weyerhaeuser is deferring new investment until there are more conclusive signs of an upturn: "Basically, we have no major capital projects slated beyond this quarter."

The upshot of all this is that the unemployment rate in July hit 9.8% of the work force, the highest figure since 1941. Hard times are spreading into Sunbelt areas that once thought they were immune to the recession. In Texas, the unemployment rate was officially estimated at 7.3% in July; Nolan Ward, chairman of the Texas employment commission, thinks that the true rate was 8.4%. In any case, the state fund out of which unemployment benefits, which average $123 a week, are paid is in danger of running dry by year's end. Republican Governor William Clements, who is in the midst of a hard campaign for reelection, has called a special session of the Texas legislature next week, at which he will propose that the state borrow $250 million to $300 million from Washington for two years at 10% interest to continue payments. That is a prospect that Clements, an archconservative, finds abhorrent, but preferable to tapping the state's general revenues or increasing the payments that Texas employers make into the fund.

Nationally, there are no signs that the drop in interest rates has stemmed the tide of bankruptcies among debt-burdened companies. Quite the opposite: Dun & Bradstreet, the credit-reporting authority, counted 572 companies that went bust in the week ending Aug. 19, the highest weekly figure in 50 years. So far this year, bankruptcies total 15,133, a rate that seems likely to push the figure for all 1982 to the highest point since 1932, the worst of all Great Depression years.

What is especially maddening to policymakers and businessmen trying to read this soggy mess of economic tea leaves is that nearly all the signs are ambiguous.

For example, a small rise in the second quarter in total output of goods and services would normally be hailed as a signal that the recession is ending. This time, however, too much of the production wound up in unsold stockpiles of autos, metal and all manner of other goods. The result: new production will now have to be held down until those unwanted inventories are sold off. Even the decline in inflation, though it is the healthiest of all signals for the long run, has negative short-term aspects. While no corporate chief would ever admit it publicly, Wall Streeters insist that some of their confidants among company leaders whisper that they could use a few more months of price rises at a 10% annual rate so that they can pay off their firms' debts with cheap dollars.

Most striking of all, the drop in interest rates and the accompanying surge in the stock market began as a rather surrealistic reflection of black pessimism. The major reason for the first cracks in rates and the market boom was the expectation that business will be so weak in the coming months that it will drive down the demand for loans. The result of that would mean lower interest rates. Thus the market to a large extent has been exuberantly celebrating an expectation of bad business.

Nonetheless, the doings on Wall Street have converted some of the gloomiest economists to at least mild optimism. Morgan Guaranty Trust only a few weeks ago had predicted that "the worst is yet to come." Milton Hudson, the bank's chief domestic economist, now says, "Because of this incredible decline in interest rates, I am suddenly feeling very upbeat." Edward Yardeni, chief economist of E.F. Hutton & Co., startled his colleagues early this year by forecasting a 30% chance that the recession would spiral down into an outright depression. He asserts today that "the recovery mechanism is slowly getting into gear."

It looks, in fact, as if the "invisible hand" of Adam Smith's self-regulating economy may be very belatedly and imperfectly back at work. Though it was the persistence and severity of the recession that brought interest rates down, the drop will now help push business back up. Irwin Kellner, senior vice president of Manufacturers Hanover Trust, the fourth biggest U.S. bank, estimates, for example, that "every drop of 1 percentage point in the mortgage rate adds another 10% to the number of families that can afford to buy a house." Lower rates also should encourage a slow revival of other credit purchases, and help debt-burdened businesses stay out of bankruptcy by reducing the interest payments that are now devouring their profits.

Though they readily admit that the recession has dragged on longer than expected and has probably not ended even yet, nearly all economists expect an upturn of sorts to begin soon. Sam Nakagama of Kidder, Peabody & Co., a New York City brokerage firm, denounces his colleagues and the press for even talking about a recovery when there are no conclusive signs of one. Yet he adds in the next breath that he too expects one to start by year's end.

A major cause for the anticipation of an upturn, apart from the drop in interest rates, is that most consumers have come through the recession in fairly good shape. They have pared down their debts from a high of 14.9% of disposable personal income in May 1979 to a bit less than 13% last June. Personal income, after taxes, rose 2.1% in July, spurred partly by the second stage of the Reagan Administration's tax cuts. Since the gains are no longer being eaten up by inflation, people have the money to buy things if the drop in interest rates, a stock-market surge or any other good omens motivate them to open their wallets.

Wealthier consumers have profited by parking their money in high-yielding interest-bearing securities, and some lines of high-priced goods and services have weathered the recession well. For instance, crowds still line up outside to see Broadway shows, where tickets can cost $40 a seat.

With rare unanimity, however, economists warn that the upturn, whenever it comes, will be painfully slow and gradual. Robert Ortner, chief economist of the U.S. Department of Commerce, ; observes that after past recessions the total output of goods and services on average has jumped 7% in the first year of recovery. "This time it will be less than that," he says. That is putting the case very mildly; many private economists guess that the upswing will be only half as vigorous as it traditionally is. Walter Heller, a member of TIME'S Board of Economists, has compiled a self-mocking list of words that he has used so often to describe the expected recovery that even he is tired of hearing them. Some entries: reluctant, weak, wobbly, fragile and anemic.

One reason for the reluctant, weak, wobbly, fragile and anemic upswing is that interest rates, despite their declines, are still much too high to encourage any big revival in such credit-sensitive industries as housing and autos, which are the ones that traditionally lead a vigorous recovery. Some economists speculate that this time the business upturn will be sparked by the buying of smaller-ticket items: clothing, furniture, even computer games. They see the 1% rise in retail sales in July as a hopeful sign of increased consumer spending.

The slow recovery and the relatively high level of interest rates also mean that it will be a long time before the economy gets much help from new business investment, which is the prime creator of jobs and a major engine of growth. Companies have a lot of idle factories and equipment to put back to work before they can think seriously about any new spending. Moreover, the staggering pile of debts built up during the past few years of inflation, recession and no-growth will need to be decreased before much new borrowing can occur. In the past six years, American manufacturing and other nonfinancial corporations have doubled their total indebtedness to $1.2 trillion, a figure that exceeds the federal debt, and in industry after industry the ratios of assets to borrowing have deteriorated dangerously. The debt load doubtless will crush more companies into bankruptcy even in the early stages of a recovery.

The biggest questions hanging over the economy are longterm. Will the recovery, disappointingly weak though it may be at first, continue beyond a year or so and lead to a sustained period of increasing production, incomes, jobs and living standards? That would belatedly vindicate President Reagan's view that the recession was the bitter price that had to be paid for future healthy growth. Or will the upturn sputter along at half-speed through many months or even years of continued high unemployment, until the economy slips into a new recession? Some liberal economists warn that this may happen, and conservatives by no means dismiss the possibility.

There are grounds, though, for taking a hopeful view. By far the most important of these is the fairly steady, though irregular, drop in the inflation rate from its frightening peaks of 1979-80. During the 1970s, surges of inflation eventually undermined every economic upswing and led to new slumps, which brought about only temporary slowdowns in price rises. But many economists believe that the length and depth of the present recession have wrung inflation out of the economy more thoroughly than the preceding busts.

Says Mickey Levy, vice president for corporate planning of Southeast Banking Corp. in Miami: "Every economic recovery the nation has had since 1949 has been accompanied by an ever increasing rate of inflation. I think that that kind of upward ratcheting will be broken this time around." Walter Heller, a liberal Democrat and sharp critic of Reaganomics, asserts, "I'm an optimist about inflation. I think that at last there has been a lowering of expectations," meaning that people no longer believe prices must rise faster and faster forever. Heller and others cite structural changes in the U.S. economy as another factor behind the high hopes for stable prices. These include: increased foreign competition in industries like autos and steel; deregulation, which has led to more price competition in airlines and trucking; and, of great importance, prospects for renewed growth in productivity, or output per man-hour.

The more a worker produces, the higher his wages can go without forcing an increase in prices. For three years, 1978 through 1980, productivity actually declined; 1981 saw only a small increase. But productivity rose at an annual rate of 2.6% in this year's first quarter, and a further .5% in the second quarter, though it usually drops during recessions. That was partly because employers in this downturn have been more ruthless than in the past about laying off workers rather than keeping them around with little to do. This gives those who remain a particular incentive to protect their jobs by being more efficient. But economists see other reasons why productivity may continue to gain, and faster. Among them: increased skills acquired by the youths and women who flooded into the job market in the 1970s, and greater use of computers by business to plan operations efficiently.

There seems to be growing confidence in the business and financial communities that inflation can be held to about 6% during the next year, and perhaps even reduced below that. Such an accomplishment would permit interest rates to continue declining, thus helping to revive industrial output. Reason: lenders would no longer feel that they had to demand high rates to guard against having their returns eaten up by renewed price boosts. In fact, the drop in inflation seems to have been one reason for the interest-rate slashes that have already occurred.

Alas, for all the optimistic signs, the prospects for sustained growth with lower inflation are far from assured. They are, in fact, surrounded by so many dangers and uncertainties that some economists rate them as only a long shot. Much will depend on the policies of the Federal Reserve Board, which controls the U.S. money supply. With the strong support of Ronald Reagan, Chairman Paul Volcker has permitted only slow monetary growth. That policy has undoubtedly been the most effective part of the war on inflation, but it has also played a major role in jacking up interest rates and deepening, if not starting the recession. Now, with price boosts moderating, the board has been easing up. The Federal Reserve, which publishes some major decisions only a month after they are made, disclosed last week that its Federal Open Market Committee voted in July to let the money supply grow at an annual rate of 5% in the current quarter, vs. 3% earlier.

In a rare on-the-record interview, J. Charles Partee, one of the seven governors of the usually secretive Fed, told TIME Correspondent Gary Lee last week that the board hopes to continue promoting more declines in interest rates and a beginning of economic recovery. He called attention to Chairman Volcker's testimony to Congress last month, when he said that the board might even permit money-supply growth to exceed the 5 1/2% upper end of the target range for a while, if it remains convinced that inflation is under control. If business starts raising prices to fatten its profit margins, says Partee, and "if one started to see wage contracts being reopened with wages rising, if one started to see the possibility of another oil shortage, the Federal Reserve would be very concerned." The implication of Partee's remarks is that the board believes that only a moderate recovery can keep price increases down. Moreover, the Federal Reserve seems ready to crack down on the money supply again to prevent a business boom that might accelerate inflation.

Partee also voiced concern about the level of Government borrowing that will be needed to finance the gargantuan budget deficits that the U.S. is likely to run in the next few years. His worries are shared by experts of every shade of academic and political opinion. They all warn that the U.S. cannot enjoy sustained growth unless the looming deficits are reduced sharply, and soon.

Gary Wenglowski, chief economist for Goldman, Sachs & Co., sketches two scenarios to illustrate what is likely to happen if the deficits continue to mount. The first is essentially stagnation. According to this script, the Federal Reserve, ever fearful of renewed inflation if it pumps too much money into the economy, refuses to let the supply grow rapidly enough to accommodate the deficits. Government borrowing collides with demand for funds by business and consumers. The result: interest rates move back up and inflation perhaps stays moderate, but the economy sputters along for years with low growth and high unemployment.

Even if the Federal Reserve violates Volcker's commitment to tight monetary policy and pours out enough money to meet the borrowing demands of both Government and business, says Wenglowski, the eventual outcome could be, if anything, worse than the stagnation scenario. Interest rates would stay down temporarily, and production might grow rapidly and unemployment drop for a while. But then inflation would reignite, and sooner or later the Federal Reserve would have to crack down again to choke off the miniboom. That scenario would in effect mark a return to the dismal and overlapping inflation-recession cycles of the '70s.

On the deficit front, too, there are grounds for a little optimism. Passage of the threeyear, nearly $100 billion tax increase two weeks ago reassured Wall Street that the problem would at least be addressed. By lobbying all out for the bill, Reagan proved that he has moved away from the supply-side zealots, whose views of lower taxes as an economic cure-all had dominated the early months of the Administration. The President's tendency now is toward a far more traditional Republican philosophy that stresses holding down deficits. Congress showed commendable courage as well in raising taxes at the start of an election campaign.

The tax bill, though, is only the first, and probably the smallest, of the steps that have to be taken. Even after its passage, the nonpartisan Congressional Budget Office estimates that deficits will run around $150 billion in each of the next three fiscal years, dwarfing the record $110 billion now expected for the financial year that ends Sept. 30. The Administration, of course, calculates much lower figures, but it is assuming passage of spending cuts that Congress has not yet enacted.

Fundamentally, the problem is that the reductions in spending programs that Reagan has pushed through Congress so far have come nowhere near offsetting the income tax cuts that he got the legislators to enact in 1981. That is true even though most of the major reductions that can be hacked out of so-called nondefense discretionary programs, in which Congress decides every year how much to appropriate, have already been made.

Future spending slashes will have to come out of defense and the entitlement programs that guarantee benefits to people who meet certain standards, whatever those benefits may cost. Examples are Medicare, Medicaid and, above all, Social Security. Says Alice Rivlin, director of the Congressional Budget Office: "Any significant lowering of the deficit has got to include slowing of the defense increases, entitlement cuts including retirement programs [i.e., Social Security] and probably more taxes, all of those things. It is not a choice. You have to do them all."

Whether Reagan and Congress can summon the will to make such supremely difficult choices is problematic. Reagan has rebuffed all suggestions for slower defense spending increases, to the dismay of some in his own Administration. In an inter view with the Associated Press that was released as his resignation be came effective last week, Murray Weidenbaum, former chairman of the Council of Economic Advisers, charged that increases in military spending have fully offset all Reagan's cuts in civilian programs. Said Weidenbaum: "On balance, we really haven't cut the budget. When you add that [defense spending] to the big tax cuts, you get such horrendous deficits." While the Administration considers higher defense outlays to be sacred, Democrats controlling the House regard Social Security as equally untouchable.

No guidance on how, or even whether, these tough problems will be faced is likely to emerge for the next several weeks. With the tax bill passed, the White House has made it clear that there will be no further Administration economic policy actions beyond a few vetoes of appropriations bills that provide for more spending than the President wants. From now until Nov. 2, both parties will be preoccupied with the congressional and gubernatorial election campaigns that begin in earnest after Labor Day.

The state of the economy will be a major issue in many campaigns, and the predominant one in some. Until recently, Democrats had expected to score heavily by assailing Reaganomics for producing disastrous unemployment and interest-rate levels, and many Republicans had been running scared. That is still true in certain areas. In California, Democratic Governor Jerry Brown is telling voters that electing him U.S. Senator will "send a message that we're tired of deficits, we're tired of interest rates, we're tired of tax breaks for the few." In Oregon, which is plagued by an 11.4% unemployment rate, Republican Governor Victor Atiyeh has openly criticized Reagan for initially proposing a budget "so out of balance" that it "shocked" his strongest supporters, including Atiyeh.

Nationally, however, the drop in interest rates and the surge on Wall Street have made the political signals quite as confusing as the economic ones. Republicans are suddenly feeling much more cheerful. Says one top White House aide: "Now we are in a position to go out and argue hope. Here is our line for the fall: We are seeing the initial signs that the recovery might be worth the wait."

At least one prominent Democrat admits that this line might indeed lessen the large gains in congressional representation that his party had hoped to win. Says Tony Coelho, chairman of the Democratic Congressional Campaign Committee: "Now there is a psychological uplift to those who are not unemployed or facing bankruptcy. If the psychology of fear is reversed, then people will listen to the Republican message. We will still pick up seats, but not as many." Most estimates, including Coelho's, cluster around a Democratic gain often to 15 seats in the House, not particularly impressive for the opposition party in a mid-term election.

The Senate seems likely to stay under Republican control. All politicians, however, admit that the public mood is hard to read. Few citizens have yet to see any improvement in their own lives because of the drop in inflation and interest rates, and they are all too aware of high unemployment and rising bankruptcies. But they differ widely on how much to blame Reagan and his party, if at all. Brenda Pace, who lost her $300-a-week job as a supervisor at Hudson's department store in Detroit, delivers a two-word verdict on Reaganomics: "It stinks."

However, Donna Nowak, who is seeking advice from her lawyer about how to file for the bankruptcy of her framing and print shop in nearby Royal Oak, has "mixed feelings" about the President's policy. Says she: "Sometimes I think it's terrible, but other times I think it's doing a lot of good because it's forcing us to take a lot of the fat out of business." Paul Kampka, a mailman in Warren, Mich., reports that the people to whom he delivers letters "are mad, real mad." Then he adds: "Personally, I think Reagan is right. I hate to say it, but he is getting rid of a lot of the deadbeats." In many areas of the country, there seems to be a strong impression that a certain amount of waste has grown into social programs over the years and that they could be pruned back without inflicting serious hardship.

The President himself was in an ebullient mood last week. "That's wonderful!" he exclaimed when White House Chief of Staff James Baker phoned him at his ranch in California with news of the latest Federal Reserve cut in the discount rate. In two fund-raising speeches in Los Angeles, Reagan ran through a litany of hopeful signs about interest rates, inflation, savings and personal income that he no doubt will repeat endlessly on behalf of the candidates for whom he campaigns.

But outside the halls, crowds of protesters carried signs proclaiming that his program favored the rich.

There are indeed some indications that the economy may be breaking out of the inflation-recession cycle. But the upturn so long awaited has not yet arrived and before it can strengthen into a sustained advance, many hard decisions, especially concerning the budget, must be made. These may involve more pain, but the alternative is a return to the failed and unacceptable economic poli cies of the past.

-- By George J. Church. Reported by Gisela Bolte/ Washington and Frederick Ungeheuer/New York

With reporting by Gisela Bolte, Frederick Ungeheue

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