Forecast: Sunshine on Election Day

By Charles P. Alexander

But TIME'S economists see thunderheads in interest rates and deficits

When Americans go to the polls, they usually think about their pocketbooks. As much as any other issue, the economy can buoy or destroy a President's chances for reelection. TIME'S Board of Economists met last week to gauge how strong an economic engine Ronald Reagan will be riding into November. The board's verdict: if the financial markets can calm down, the immediate outlook is good. The economy, which grew at a surprising 8.8% annual rate in the first quarter, is sure to slow down, but it is not likely to stall. Said Board Member Walter Heller, who served as President Kennedy's chief economic adviser: "There is plenty of steam left in the boiler."

One way to measure the health of the U.S. economy, suggested by the late economist Arthur Okun, is the discomfort index, a sum of the unemployment and inflation rates. In November 1980, that yardstick stood at 20.2% (12.7% inflation and 7.5% unemployment). On Election Day this year, TIME'S economists predict, the discomfort index will be only 12.7% (5.4% inflation and 7.3% unemployment).

Heller warned, however, of several "thunderheads" that could rain on Reagan's re-election effort or generate hailstorms for whoever occupies the White House in 1985. The dangers include rising interest rates, a gargantuan federal deficit, a plunge in the dollar's value, a cutoff of Persian Guff oil supplies, and increasing turmoil in the financial industry as a result of the near collapse of the Continental Illinois Bank and the continuing troubles that major banks are having with loans to Latin American countries.

The Federal Reserve Board has been fairly tight with the money supply, and since March the prime rate that banks charge for commercial loans has edged up from 11% to 12.5%. Said Charles Schultze, who served as President Carter's chief economic adviser: "The Reserve Board is determined to keep the economy within noninflationary speed limits." The economists predicted that the prime rate would move up a bit more in the coming months, to 13% or 13.5%, and then level off. That would be enough, the economists forecast, to moderate growth. The blistering 8.8% rate of rise in the gross national product in the first quarter was something of a fluke, caused in part by a rapid buildup of inventories. By the fourth quarter, G.N.P. growth is expected to slow to a more sustainable 3.5% pace.

The TIME board agreed that the federal deficit, which threatens to top $200 billion annually for the next few years, is a major force pushing up interest rates. As the economy expands, businesses are increasingly competing with the Government for credit. Said Alan Greenspan, who was chairman of the Council of Economic Advisers under President Ford: "There is a growing cynicism in the financial markets about Congress's ability to control the deficit."

Unless strong action is taken against the budget gap, the economy may eventually face a severe credit squeeze. Lawrence Chimerine, a guest at the TIME meeting, who is chairman of Chase Econometrics, forecasting firm in Bala Cynwyd, Pa., predicted that the prime rate could rise to 15% by mid-1985. Said he: "The economy could very well flatten out and maybe even head into recession next year." Heller maintained, however, that if Congress moves against the deficit, the recovery has enough momentum to carry it through 1985 with no downturn.

The brightest part of the forecast is the inflation outlook. The Labor Department reported last week that consumer prices increased at a 5.6% annual rate in April, and TIME'S board predicted that the pace would remain in the 5%-to-6% range through 1985. Among the factors holding down prices are an improvement in worker productivity (see box), the competition that U.S. manufacturers face from cheap imports, and deregulation in industries like trucking and airlines. In addition, most workers have curbed their wage demands as a result of the 1981-82 recession. During the first quarter, average hourly earnings for production workers were rising at an annual rate of 3.4%.

That pace could quicken, though, if organized labor starts trying to make up for the five lean years it has suffered. One dissatisfied union is the United Auto Workers, which will be negotiating new three-year agreements with General Motors and Ford to replace contracts that expire in September. Incensed by the hefty bonuses that the auto executives have been getting, the union, led by its new president, Owen Bieber, is determined to get its share of Detroit's record profits.

The economists expect that the automakers will agree to a big wage pact to avoid a strike. Said Greenspan: "The companies will do reasonably well if they come out giving only a 20% increase, including benefits, over three years." Heller suggested that the Government might try to restrain the unions and hold down car prices by threatening early removal of the quotas on Japanese auto imports, which are now scheduled to last at least through next March.

Another threat to the inflation outlook is the danger that the Iran-Iraq war will shut off the Persian Gulf oil tap. The daily flow of 7 million to 8 million bbl. a day from the gulf amounts to 20% of the free world's oil consumption, and a major disruption would drive up crude prices, as countries scrambled to boost imports from such producers as Mexico and Venezuela. Fortunately, the U.S. could help moderate the price hike by dipping into its 400 million-bbl. strategic reserve.

Perhaps the most serious peril on the price front is the fate of the dollar. For several years, high American interest rates have encouraged foreigners to convert their money into dollars for investment in the U.S. Since 1980, the value of the dollar has risen about 50% against an average of ten major currencies. As a result, imports have become cheaper, and the U.S. is running a record trade deficit that puts downward pressure on the dollar. A steep plunge could kindle U.S. inflation by boosting the price of imports. Warned TIME Board Member Lester Thurow, an economics professor at the Massachusetts Institute of Technology: "You could get a dollar shock that could push the inflation rate close to the double-digit level a year from now." Rimmer de Vries, chief international economist for New York City's Morgan Guaranty Trust, said that the dollar may stay strong for a while longer, but acknowledged that the financial markets fear a big drop in the U.S. currency.

A panicky flight of foreign capital from the U.S. could lift American interest rates. High on the list of victims would be the 15 Latin American countries that are some $335 billion in debt. Brazil, which owes $96 billion, has an extra $750 million added on to its annual interest bill each time the U.S. prime and other international lending rates rise by a percentage point. De Vries suggested that the banks, together with the International Monetary Fund, should consider setting up a revolving loan pool to be used by Latin American and other countries to cope with escalating interest rates. To do the job, the credit line would have to be in the $10 billion to $20 billion range. Thurow argued that the banks should have to shoulder more of the cost of the questionable loans they have made to Latin America. Said he: "There are some real losses out there that nobody wants to take, and you are going to have to spread them out somehow among bank shareholders, the taxpayers of the creditor countries and the peoples of the debtor nations."

The Latin countries resent being asked to tighten their belts when Congress has been so slow to tackle the U.S. budget deficit. The House has passed a modest plan to lower spending and raise taxes by $182 billion over three years, while the Senate has approved an even less ambitious reduction package that adds up to $142 billion through 1987. Such efforts will still leave the annual deficit in the unacceptable $200 billion range.

Alice Rivlin, former director of the Congressional Budget Office who now heads economic studies at Washington's Brookings Institution, reported that her organization would soon release a plan to begin immediate steps that would balance the budget by 1989. It would carve nearly $50 billion out of domestic spending, partly by imposing a one-year freeze on cost of living adjustments in all federal benefit programs except those aimed at the poor. The proposal would also slash defense spending by almost $50 billion, mainly by canceling a number of weapons systems, chiefly the B-1 bomber and the MX missile.

Even after these cuts, said Rivlin, annual tax revenues would have to be raised by about $100 billion to balance the budget. She favors a tax reform of the type proposed by Senator Bill Bradley of New Jersey and Representative Richard Gephardt of Missouri. Their plan, which would eliminate many loopholes, could raise revenue and also lower tax rates. Said Rivlin: "I am fairly optimistic that Congress, realizing it needs a lot of revenue, will go for a major reform."

She admitted that the tax change "will be terribly hard to do and take presidential leadership." The window of opportunity will come early in 1985, when Congress and the White House are not yet worried about the next election. Said Greenspan: "If we cannot deal with the budget problem in the first six months of the next presidential term, the odds of a solution will dwindle rapidly." The job of reducing deficits and maintaining growth is certain to be one of the biggest tasks facing whoever sits in the Oval Office come January. --By Charles P. Alexander