A Case of the Downturn Jitters

By George Russell.

Stepping somberly to the podium in a blue-carpeted Washington briefing room last week, Commerce Secretary Malcolm Baldrige confirmed what many businessmen already knew through painful experience. The pace of U.S. economic growth, Baldrige revealed, took a sharp downturn in the second quarter, as American manufacturers continued to be hurt by a high level of imports. After expanding at a 3.8% annual rate from January to March, the gross national product increased at only a 1.1% pace between April and June, the slowest climb since the recession year of 1982.

Baldrige emphasized that the latest growth figures were only a preliminary estimate and that the economy was bound to improve "in the near future." But outside the Reagan Administration, some of Washington's policymakers were less confident. Fretted Republican Jake Garn of Utah, chairman of the Senate Banking Committee: "There's more than the normal level of uncertainty in the economy." Federal Reserve Chairman Paul Volcker warned that the current expansion is in "growing jeopardy" unless the U.S. can curb its burgeoning trade deficit, which reached a record $148.5 billion last year.

The anemic growth rate put added pressure on Congress as it debated two initiatives that may have a profound impact on the economy: a sweeping reform of the tax system and a plan to reduce the $200 billion-plus federal budget deficit. Some lawmakers fear that tax reform, which may hike Government revenues in the short run, when combined with a federal spending cut could deaden an already weak economy. Said Representative Jack Brooks, a Texas Democrat: "We could be staring a raging recession right in the face."

That view is probably alarmist. Though some economists have begun to talk about the possibility of a recession, most experts expect growth to pick up in the second half of the year. They think that the 65% drop in oil prices since late last year, which has devastated the huge U.S. petroleum industry, will soon begin to stimulate investment by other businesses and increased spending by consumers. The fall in the value of the dollar, a 26% decline against major world currencies since early 1985, is expected to help reduce the trade deficit by making imports more expensive and American goods cheaper abroad. A turnaround in trade has been surprisingly slow in coming, but economists point out that changes in currency values usually affect trading patterns only after a long lag.

Whatever the outlook, no one can deny that the U.S. economy is wheezing at the moment. Industrial production, which grew slowly last year, began to shrink in the second quarter of 1986 (see chart). One main cause of the malaise seems to be companies' reluctance to invest in new plants and equipment. Says Stephen Roach, an economist with the Morgan Stanley investment firm: "Capital spending is in the worst shape for any postwar expansion period." Roach projects that capital investment for all of 1986 will fall by 4.5%, compared with last year. Says he: "Every time such a contraction has taken place, the economy has been either on the brink or in the midst of outright recession."

The current balance of supply and demand hardly makes much capital expansion necessary. Partly because of foreign competition, U.S. factories are operating at less than 80% of their capacity on average. At General Electric, for example, "the need to expand is relatively modest," says Walter Joelson, the . company's chief economist, since spending on plant and equipment back in 1983 and 1984 was relatively high. GE expects to cut its capital outlays by 25% this year, to $1.5 billion.

At the moment, though, the main drag on capital spending may be the uncertain fate of tax reform. Business executives watched nervously last week as a 22-member House-Senate conference committee, led by Democratic Representative Dan Rostenkowski of Illinois and Republican Senator Bob Packwood of Oregon, tried to mesh the tax bills passed by the two houses. The conferees intend to approve a large personal tax cut, lowering the top rate from 50% to perhaps as little as 27%. In theory, the lawmakers want to make the bill "revenue neutral," meaning that it would not add or subtract from current federal tax revenues, but in practice, neither the House nor the Senate versions quite meet that goal, at least not yet.

In any foreseeable case, however, businesses will be socked with a higher net tax burden to make up for personal reductions. Just how much higher is the focus of the current talks. By eliminating loopholes and changing accounting procedures while lowering overall rates, the House bill would raise corporate taxes by $178 billion over five years, while the Senate version calls for a more tolerable increase of $93 billion. Among other things, companies will lose the investment tax credit, a popular and important capital-spending incentive introduced in 1962.

Until they know what the tax bill will contain, many firms are unwilling to move. Richard Rahn, chief economist of the U.S. Chamber of Commerce, cites an informal survey of his organization's members, in which 42% of respondents said they were postponing expansion plans because of impending tax reform. Some companies are trying to ignore what Congress is doing, however. Says James Stover, chairman of Cleveland's Eaton, a manufacturer of auto components and military equipment: "We're making investments where we need new plant to become more cost effective. We do not invest from a tax-incentive view. That would be the tail wagging the dog."

Several members of Congress, including Senate Majority Leader Robert Dole of Kansas, have argued that a primary cause of low U.S. capital spending and sluggish growth is high interest rates. But that thesis was challenged last week by the Federal Reserve, which since March has already reduced the discount rate that it charges on loans to member banks from 7 1/2% to 6%. Fed Chairman Volcker, chewing occasionally on his trademark cigar, told the Senate Banking Committee that further decreases in the discount rate would not necessarily perk up the economy. Said Volcker: "Our domestic demand is quite strong already."

The problem is that much of this demand is being filled by foreign manufacturers. Volcker warned that the trade deficit cannot be erased by the decline in the dollar alone. He called upon the governments of Western Europe and Japan to stimulate additional growth in their countries, which would increase the demand for U.S. exports.

One serious constraint on any further Volcker efforts to spur the U.S. economy is the federal budget deficit. Heavy Government borrowing keeps interest rates higher than they otherwise would be, and if Volcker tried to force rates down too low in the face of the deficit, he would rekindle inflation. Indeed, Government figures released last week showed that inflation is still around. The consumer price index rose at an annual rate of 5.7% in June, the largest monthly increase since November. Even so, the increase in consumer prices for the entire year is projected at a mere 2% or less.

Congress had expected the budget deficit to decline from last year's record of $212 billion, but new estimates show that it could increase to $220 billion in 1986. A major factor in the anticipated hike: sluggish growth has cut tax revenue. Next week the Administration will release its semiannual budget projections, and the report will undoubtedly forecast a drop in the deficit during 1987. But that prediction will be based on the assumption that the growth rate will rise to 4.5% next year, higher than most economists envision.

Efforts to curb the budget shortfall suffered a blow last month when the Supreme Court overturned a central provision of the Gramm-Rudman-Holli ngs law, which mandates chopping the federal deficit in stages to zero by 1991. The legislation provided that if Congress and the President could not agree on the needed cuts, the U.S. Comptroller General could order automatic across- the-board reductions in accordance with the law's targets (the 1987 deficit goal: $144 billion). The Supreme Court ruled that it would be an unconstitutional violation of the principle of separation of powers if the Comptroller General, who can be removed by Congress, were allowed to carry out spending cuts, which is the prerogative of the Executive Branch. Last week Gramm-Rudman's backers were working on an amendment that would guarantee the automatic cutting procedure by putting it under the auspices of the director of the White House's Office of Management and Budget.

There is a possibility that tax reform may have a one-shot effect on federal revenue in 1987. Reason: many tax loopholes for individuals under the old law might be closed as of Jan. 1, 1987, while reduced income tax rates may not take full effect until June. The issue is still up in the air, however. This tax-revenue hike, coupled with severe government spending cuts of the kind mandated by Gramm-Rudman, might run the risk of stunting the economy's growth next year, especially in light of the projected increase in the 1986 deficit. But that is a risk that some members of Congress are apparently willing to take. Senator Phil Gramm, a Texas Republican and a drafter of the Gramm-Rudman law, argues that cutting the deficit, however painful in the short run, is vital to long-term growth. Says he: "You've got to go to Valley Forge before you go to Yorktown."

The trip will undoubtedly be treacherous. During the coming weeks, Congress will have to keep a close eye on the state of the economy as it fashions its new fiscal policy. In particular, the lawmakers will want to be careful to avoid boosting business taxes to the extent that they depress investment. The danger of reducing Government spending too drastically is much less immediate. So far, Congress has not been able to cut the deficit at all, much less slice it enough to endanger the economy.

With reporting by Laurence I. Barrett and Jay Branegan/Washington