A Forecast of Glad Tidings

By John Greenwald

TIME'S Board of Economists rejects recession fears and sees growth in 1985

For the U.S. economy, the best Christmas gift would be the promise of further solid growth next year. And that is precisely what TIME'S Board of Economists offered last week when it met to assess the business outlook for 1985. In a spirited session that also examined the impact of sweeping tax reform and budget-cut plans, board members unanimously predicted that the economy will retain its forward momentum and avoid a recession in the year ahead. Said Alan Greenspan, a New York consultant who chaired the Council of Economic Advisers under President Ford: "There is no credible evidence that we are on the edge of a significant cracking of the system."

The board's optimistic forecast, made in the face of a slowdown that chopped third-quarter growth to an annual rate of just 1.9%, noted the absence of such traditional preslump signals as climbing inflation and badly shaken consumer confidence. On the contrary, prices continue to hold steady and shoppers have been in a fairly good mood. The Commerce Department reported last week that November retail sales were up 1.8%. That early Christmas-season gain, the healthiest monthly increase since April, helped allay retailers' fears that holiday buying would be weak. Other key indicators showed that November industrial production grew .4%, the first gain in three months, while stocks of unsold goods remain lean.

TIME'S economists predicted that the gross national product will expand 2% this quarter, down from the 4% they foresaw last September, and then grow a healthy 3% to 4% in 1985. That increase would be typical for the third year of an economic recovery. Board members predicted that the pickup will trim unemployment from the 7.2% rate it unexpectedly fell to in November to 7% by mid-1985. They look for joblessness to remain stuck at that relatively high level through 1986.

The board blamed the large, unforeseen drop in third-quarter growth on a runaway trade deficit that swelled during the period at a record annual rate of $150 billion. That gap, which measures how much more Americans have been importing than exporting, drained substantial purchasing power out of the U.S. economy and funneled it to manufacturers in Japan and other foreign countries. Without the damage wrought by the shortfall, the G.N.P. would have increased a robust 5.7% during the third quarter.

The trade gap greatly worsened what would otherwise have been a normal slowing after a period of rapid expansion. Such pauses for breath frequently aroused fears of a slump during the economic recoveries that occurred in the 1960s and '70s. Recalled Walter Heller, a University of Minnesota economist and the chief economic adviser to Presidents John Kennedy and Lyndon Johnson: "I remember Kennedy being terribly worried in 1962 that there would be a recession, and on the basis of very much the same kind of thing we are looking at here. We assured him that that would not be the case, and, thank goodness, we were right."

The trade deficit, though, will continue to inflict economic damage for at least months to come. The loss of business to foreign firms has helped slash the profits of U.S. companies to about 6% below their level of a year ago. That has crimped the firms' ability to expand and create new jobs. "Even high-tech companies cannot sell anything abroad," said Lester Thurow, an M.I.T. economist. Board members warned that a further sharp erosion of profits would be among the clearest signs that a recession was about to start.

Both the tumbling earnings and the trade gap that caused them reflect the almost incredible strength of the U.S. dollar. The high-flying currency, which has steadily broken and rebroken records over the past three years, makes foreign goods bargains while pricing many U.S. products out of overseas markets. "For the first time that I remember," said Greenspan, "the exchange rate has been the dominant short-term economic variable in the U.S. economy."

The dollar is being kept aloft by another deficit--the federal budget shortfall that is forcing the Government to issue lOUs at the staggering rate of some $200 billion a year. That unprecedented borrowing props up interest rates and sucks in money from all over the world. The foreign capital thus maintains the dollar's strength while helping finance the chasm between federal taxing and spending that has developed since 1981.

The cash influx is turning the U.S. into a debtor nation. By next spring it will join such countries as Brazil and Argentina in owing more to the rest of the world than it is lending to foreign borrowers. The U.S. has not been in such a position since World War I.

Nonetheless, one of the linchpins of the TIME board's forecast is the view that the run-up in the dollar's value is finally coming to an end. That should narrow the trade deficit if it turns out to be correct. Economists have predicted a weaker dollar before, but this time they insist their prediction is more likely to come true. Said Rimmer de Vries, chief international economist for Morgan Guaranty Trust: "The dollar hasn't really moved anywhere since September. It has fallen and then risen, and I don't think it is going to go anywhere for a while." Board members expect the currency to hover at its current level until early next year, and then start slowly down.

The economists base that outlook largely on recent actions of the Federal Reserve Board. It has been pumping out more money in order to lower interest rates, buoy the recovery and slow speculation in the dollar. Since September, the prime rate has dropped from 13% to 11 1/4%. De Vries suggested that further declines may be needed. Said he: "Shouldn't interest rates be a couple of percentage points lower than they are today?" The cheaper money, he argued, would further pep up the U.S. economy and help lagging nations in Europe and around the world.

De Vries, who recently returned from a visit to Argentina, noted that the U.S. rebound has become "a very, very significant factor" in pulling Brazil, Mexico and Venezuela out of their debt quagmire. Said he: "In the absence of shocks like major recessions or sky-high interest rates, the Third World debt crisis should work itself out during the remainder of this decade." He added that the biggest trouble spots at present are the Andean states of Peru and Chile, whose economies remain in the doldrums.

TIME'S economists agreed that any fall in the dollar's value will test just how much U.S. inflation really has been subdued in recent years. Reason: the flood of attractively priced imports has been a powerful ally of Washington's drive to keep living costs in check. Martin Feldstein, who resigned in July as chairman of the Council of Economic Advisers, estimated that the strong dollar has knocked a full percentage point off U.S. inflation. For 1985, board members expect the Consumer Price Index to climb at a moderate 4.6% pace.

Though critical of some parts of the Treasury Department's income tax reform plan, the economists generally endorsed that highly controversial document. "My overall assessment is favorable," said Feldstein. "I think that there is much of value in the proposal." He applauded the drop in the top tax rate for individuals from 50% to 35%, and savings incentives the increased deductibility of contributions to Individual Retirement Accounts. But Feldstein opposed the attempt to bar consumers from deducting property taxes on their primary homes and mortgage interest on their secondary ones. If enacted, he said, such measures would cause a drop in housing values that could wipe out many people's residential investments.

Feldstein was unhappy with the tax plan's treatment of business. While it would slash the top corporate rate from 46% to 33%, the Treasury proposal would eliminate the investment tax credit that helps business finance new equipment. In addition, it would halt accelerated business write-offs, a tax break that the Reagan Administration pushed through in 1981. Said Feldstein: "The proposed reforms of business taxation are misguided. The effect would be to clobber plant and equipment investments."

Alice Rivlin, director of economic studies for the Brookings Institution, called the Treasury's program "an economists' kind of reform" that is triggering a clash between competing tax philosophies. On one side, she said, are most economists, who believe that the tax system should not be used to influence what people and companies do with their money. On the other side are politicians who advocate tax incentives to encourage such activities as home ownership, the purchase of health insurance and charitable giving. Rivlin conceded, though, that this neat separation can break down. Said she: "We economists realize the importance of things like charitable donations and say, 'O.K., we've got to leave them as deductions.' " Even so, the Treasury plan sharply reduces the amount of gifts to charity that can be written off.

The Treasury's package was carefully crafted to avoid any overall tax increase, but TIME'S economists think that new tax legislation should raise additional revenues in order to reduce the budget deficit. The proposal now increases taxes on business, while lowering them for consumers. Feldstein maintained that the reduced individual rates would make any future tax hikes easier to take. Said he: "I wouldn't mind paying more taxes if my top tax rate could be reduced to 35% or 40%."

Board members were far less taken with the Reagan Administration's plan to attack the budget deficit by hacking another $237 billion mainly out of nondefense spending by 1988. Said Charles Schultze, a Brookings Institution senior fellow: "Many of those cuts are unconscionable. Freezing Government spending on food stamps, aid to the elderly poor, and welfare recipients while Social Security gets off scot-free is atrocious." Concurred Heller: "An awful lot of it is a case of 'Hit 'em again! Harder!' "

Given the political unpalatability of the budget cuts and Reagan's outspoken resistance to tax increases, TIME'S economists warned that a stalemate could very well develop next year over efforts to deal with the deficit. Congress would show greater willingness to cut spending, Schultze said, "if you could somehow get the President to take the heat for a tax increase as well."

He predicted that without any presidential change of heart, the dickering between the Administration and Congress over current budget proposals is likely to yield only "another down payment on the deficit, and one that isn't going to be terribly large." Schultze added, "This leads me to believe that you will really get major action on the deficit only if there is a crisis like a sharp upsurge in interest rates or some other forcing event."

Even worse than such a crisis would be the long-term consequences of doing little or nothing about the deficit. That would add some $800 billion to the national debt by 1988. "That is the worst of all worlds," said Schultze. "That is the slow poison."

Heller traced some of the toxin's likely effects. For one thing, he noted, each year of a $200 billion deficit adds about $20 billion to U.S. interest payments, which now total $140 billion. Simply keeping up with those rapidly rising borrowing costs will require either tax hikes or ever deeper cuts in Government programs. For another, "the bigger the lOUs that we pile up to foreign creditors, the greater the tribute that future generations will have to pay to service those debts that are fattening today's standard of living." Finally, the mushrooming deficit crowds out productive private investments by keeping interest rates high.

TIME'S economists said that Reagan can avoid such nasty consequences if he seizes the opportunity to act boldly. Said Rivlin: "Whether we really get tax reform or a workable budget-reduction package seems to me to come back to whether the President is serious. My sense is that he could have them if he acted quickly and argued strongly." Added Thurow: "If Reagan wants to exercise a conservative mandate within limits, I think he will be able to do it simply because the Democrats don't have an agenda." Regardless of their feelings about Reagan's policies, the board members agree that any solution to the budget deficit is largely in presidential hands. --By John Greenwald