Smooth Waters Now, but Rapids Ahead

By John Greenwald

ECONOMY & BUSINESS

Budget and trade deficits trouble the second-term outlook

"The President's economic task in the next four years will be as formidable as anything he faced in the last four."

Henry Kaufman's grim predictions have made the Salomon Brothers chief economist Wall Street's leading doomsayer. But his assessment of the economic problems that President Reagan must tackle in his second term is widely shared by economists and business leaders. After a first term in which he presided over historic cuts in taxes and social spending combined with a major military buildup, Reagan now must confront the largest and most menacing budget deficits in U.S. history. Along with them have come woes ranging from an unprecedented international trade gap (an estimated $114 billion) to jitters about interest rates and worries about the continued health of the business recovery.

Impressive economic improvements took place during Reagan's first term. Heading the list is the drop in inflation, from a high of more than 12% in the year before Reagan took office to a current level of about 4.5%. That has been coupled with a booming rebound after the severe 1981-82 recession. Unemployment meanwhile has been holding steady at 7.4%, after reaching a high of 10.6% at the bottom of the recession.

But all that is history. The Administration now must keep the economy humming along. Says Rimmer de Vries, chief international economist of Morgan Guaranty Trust: "The top priority is to make sure the economic expansion continues." The U.S. recovery is about to celebrate its second birthday. Since World War II, the average upturn has lasted about four years, and so it is unlikely that the Reagan Administration will go through its entire second term without another economic dip, perhaps a sizable one.

A sharp drop in the growth of the gross national product, from 8.6% during the first half of 1984 to 2.7% in the third quarter, has already raised fears that the economy may be sliding into a new downturn. Some experts are worried that the U.S. may be heading at least into a so-called growth recession, in which the G.N.P expands too slowly to keep unemployment from rising.

Most economists, however, doubt that a new slump is likely any time soon. The economy does not now show the signs normally visible just before a recession. Business inventories are generally low, consumers are still spending, and corporations continue to invest. Experts think the economy is simply shifting from the torrid pace of this year's first half to a more sustainable growth rate. Says Walter Heller, chairman of the Council of Economic Advisers under Presidents Kennedy and Johnson: "This is a lull, but not a lull that has come to stay." Concurs Alan Greenspan, President Ford's chief economist: "As best I can judge, it's just a pause."

The biggest danger to continued, long-term growth is the gargantuan federal budget deficit, which amounted to $175 billion in the past fiscal year. Data Resources, a major economic forecasting firm, expects the shortfall to reach $227 billion by 1988. "The budget deficit has to be attacked aggressively," says American Motors Chairman Paul Tippett. "That ought to be No. 1 on the Hit Parade." Failure to act, Tippett adds, will either drive interest rates up or force the Government "to float enough paper money to bring back inflation."

The Administration's own estimates, prepared by the Office of Management and Budget, predict that the deficits will total $846 billion over the next four years. That would raise the national debt to $2.2 trillion. When Reagan took office in 1981, it was $750 billion. This year alone, interest payments on the national debt will be $134 billion.

The deficits will have to be financed by huge Government borrowing, which may force interest rates up. While the bench-mark prime rate has slid from 20% to 12% since Reagan took office, including several recent drops, it is likely to go back up again without some action on the deficit. A higher rate would force both consumers and companies to cut back on their investment plans, and could all by itself push the economy into a recession.

Nothing happened during the election campaign to convince business leaders that the Administration is serious about tackling the deficit problem. Says Ford Chairman Philip Caldwell: "We have to control the budget deficit, and at this point there is no clear plan to do it." Concurs Leon Cooperman, chief portfolio strategist for Wall Street's Goldman, Sachs: "Reagan set out four years ago to lift national prestige by raising defense spending, reducing taxes, bringing down the oppressively high rate of inflation and balancing the budget. He has done a great job in accomplishing three of these goals, and has failed miserably on the budget."

Reagan has shown moderate concern about the deficit at best. Observers both inside and outside the White House say the President is so pleased with the economic results of his first term that he does not feel there is any strong need to change the approach. Says one Administration official: "In the President's own mind, the first four years have been as close to perfection as possible." Concurs Charles Schultze, who was chairman of the Council of Economic Advisers under President Carter: "I think he really believes he has found the goose that laid the golden egg." In an interview with TIME last week, Reagan said suggestions of a shift in his policies are "like asking a quarterback who has taken the team from his own ten-yard line down to the opposing team's 20-yard line is he going to change his game plan? No. It's working."

At least until now, Reagan has gone along with Treasury Secretary Donald Regan and supply-side economists, who hold that a combination of strong growth and new spending cuts will eliminate the deficit by the end of the 1980s. They argue that 4% annual G.N.P. increases plus a slowdown in the expansion of Government outlays are all that is needed to balance the budget.

That outlook, however, is not shared by everyone in the Reagan Administration. A group that includes Chief of Staff James Baker and Budget Director David Stockman wants a more vigorous attack on the deficit. One senior Administration official calls the supply-side scenario "wildly optimistic." The aide says it is based on unrealistic projections "that would make this recovery longer and stronger than most postwar cycles."

Those advisers want to continue pushing for spending cuts, but are willing to accept tax increases as a last resort. Said one policymaker: "We would like to have as little tax increase as possible, as few defense cuts as possible and as many domestic spending cuts as are feasible." Their goal is to get the deficit down to something in the $30 billion to $40 billion range by 1989. The President, though, may not accept any tax hikes. As recently as last weekend the President told an Arkansas campaign rally that taxes would be raised in his second term "over my dead body."

One expert who believes that Reagan will nonetheless agree to raise revenues to narrow the budget gap is Martin Feldstein, who returned to Harvard in July after two years as chairman of Reagan's Council of Economic Advisers. "The budget deficit is the remaining issue on the President's original agenda," says Feldstein, "and he will work to bring it down. He will make cuts on the spending side, but in the end he will compromise and we will see additional tax revenues as well."

Feldstein expects the increases to come from a tax-reform program the Treasury Department will present to the White House next month. The President told TIME last week: "We are looking at a tax reform. Is it possible that we can even make the tax system provide more incentives?" While details are sketchy, Secretary Regan has already said that he favors replacing the present graduated income tax with some kind of flat tax, one that would reduce the differences between the highest and lowest tax brackets. The goal of the new program is to simplify the tax system and eliminate the loopholes through which billions of dollars now escape taxation. While many deductions would be dropped, overall tax rates would come down sharply. At present, they range from 11% to 50%. The rates under plans that have already been introduced in Congress by both Republicans and Democrats would start as low as 6% and climb to 34%.

As now envisaged, the Administration's flat tax would simplify the tax system but would not raise any new revenues. Feldstein, though, believes that Congress will alter the proposal to allow the new tax to collect more money, in order to help close the deficit. Reagan, predicts the former CEA chief, would accept such changes.

Taxes and the deficit are certain to be controversial political issues next year. New York Representative Barber Conable, who is retiring from Congress after being the ranking Republican on the House Ways and Means Committee, believes it would be best to separate deficit cutting from tax reform and to deal with the deficit first. Says he: "People expect that whatever is billed as tax reform will bring about a reduction in what they pay. But that isn't easy to do if you're starting at the bottom of a $170 billion hole." Martin Anderson, a former Reagan adviser, believes the Administration will press for constitutional amendments that would limit Government spending, require a balanced budget, and empower the President to veto specific budget items. Says Anderson: "The President is talking about a fundamental change in economic strategy, and he will push it."

Reagan has another big deficit to worry about in a second term: the trade deficit, which is a painful side effect of the federal budget deficit and the strong dollar. High interest rates caused by Government borrowing encourage foreigners to invest their money in the U.S. This in turn drives up the value of American currency, which makes imports enticingly cheap and creates bargains for Americans traveling abroad. But a rising dollar can be devastating to U.S. firms selling in foreign markets, since it pushes up the price of everything from General Electric jet engines to Caterpillar tractors. Since Reagan took office, the dollar has increased in value by 60% against the major world currencies. If the dollar remains high, says M.I.T. Economist Lester Thurow, "American industry will be run out of business, and the President will face enormous pressures for protection."

While it espouses free trade, the Administration already has granted requests for restrictions on such imports as motorcycles, cars and steel. Nor is it just older industries that are protesting. "Most hightech companies have been very hard hit," says C. Norman Winningstad, chairman of Floating Point Systems, an Oregon computer company. Allen Paulson, the chairman of Savannah's Gulfstream Aerospace, is blunt about the strong dollar's impact: "Somebody has to put an end to this insanity."

In the past three weeks, the value of U.S. currency has fallen a bit. Since mid-October the dollar has lost 5% of its value against major foreign currencies. The dollar is now worth less than three West German marks for the first time in nearly two months. Analysts attribute the slide largely to a decline in U.S. interest rates. Some economists, including Britain's Stephen Marris, warn that the Reagan Administration should be worried about a precipitous fall in the value of the dollar. In a world of freely floating exchange rates, the dollar could drop just as far during the second Reagan term as it rose in the first. A sharp and quick fall in the dollar would cause U.S. inflation to shoot up because the cost of imports would rise.

Some new economic policymakers may be coming into office to tackle the problems of the second Reagan term. The policy group remained remarkably stable during the first term. Treasury Secretary Regan, Budget Director Stockman and Federal Reserve Chairman Paul Volcker have all served since the beginning of the Administration. The only economic policy group in turmoil has been the Council of Economic Advisers. There have been two council chairmen in four years, Murray Weidenbaum of Washington University in St. Louis and Feldstein, and the post has been unoccupied since July. The council, though, has been reduced in power and importance under Reagan, who distrusts economists. Indeed, he tends to be his own chief economist.

The most important shift could be the appointment of a new Federal Reserve chairman. Volcker was originally named by Carter, but was reappointed in June 1983 by Reagan. At the time, it was believed that Volcker would leave in 1985, even though his term as chairman runs until 1987, so that the President could appoint his own person to that key position. If Volcker does go, a possible successor might be Preston Martin, the Reagan-appointed Vice Chairman of the Federal Reserve. The Reagan Administration has criticized the Federal Reserve for not allowing the money supply to grow faster, thus keeping interest rates high, and it is expected to look for someone who would be more accommodating than Volcker.

Budget Director Stockman may also leave. He has already served longer than most in his demanding job. Stockman is expected, though, to remain in office at least until next year's budget takes effect a year from now.

Treasury Secretary Regan is likely to stay at his post for the second term. The former chairman of Merrill Lynch clearly enjoys the job and has a comfortable working relationship with both the President and the powerful White House staff.

Reagan is expected to name a new chairman of the Council of Economic Advisers shortly. A frequently named candidate is Jack Albertine, a strong Reagan supporter and president of the American Business Conference, a lobbying organization for medium-size companies. His appointment would break the tradition of giving the job to a well-known economist.

One of the Administration's strongest allies as it tries to keep the economy expanding during the second term will be the business community. Reagan enjoys the enthusiastic backing of America's corporate leaders. "I would say that business has never been more supportive of a President since I have been able to read and write," says Felix Rohatyn, 56, a Democrat and senior partner of the investment banking firm of Lazard Freres & Co. David Coffin, chairman of Dexter Corp., a Connecticut manufacturer of everything from adhesives to tea-bag paper, agrees: "Reagan is No. 1. You know where he comes from because he has a proven record of action over the last four years. President Reagan is good for business--it's that simple."

Many businessmen and women worked hard for Reagan's reelection. Among them was PepsiCo Chairman Donald Kendall, a leader of Business Groups for Reagan-Bush '84, and co-chairman of a drive to get out the vote. Says he: "I've written letters to nearly all of corporate America, to medium and large companies, to chambers of commerce, and we set up regional committees and state chairmen."

Rhonda Morris, president of her own construction firm in Austin, regularly set her alarm for 5 a.m. during the campaign to get an early start on sending out election material. "That was the only way I could do my job and do the Reagan stuff at the same time," she says. As voter-registration chairman for the National Association of Home Builders, Morris contacted nearly 1,000 company presidents to persuade them to distribute boxes of voter-registration cards. In Chicago, George Fisk joined the Reagan re-election drive after retiring in September as senior vice president of Container Corp. of America. Says he: "What better thing could I do? I could hardly look at myself in the mirror if he didn't win and I hadn't worked for him."

The deficit now seems to stand as the primary barrier to a new era of strong economic growth. If the deficit can be controlled, the second Reagan Administration could leave a record of economic success that would eclipse the triumphs of the first term. --By John Greenwald. Reported by Christopher Redman/Washington and Adam Zagorin/New York

With reporting by Christopher Redman, Adam Zagorin