Confusion -- But Hope

By Nancy R. Gibbs

Uncertainty. Volatility. Confusion. Those have become the watchwords of the postcrash economy. For weeks some prognosticators have warned that the stock collapse of Black Monday presaged a recession. Others have argued just as vehemently that the crash was primarily a Wall Street event that will have little impact on the economy. No wonder consumers have been cautious and bewildered and the financial markets have swung wildly between hope and despair.

Last week's upheavals only made the economic outlook fuzzier. One of the strongest stock rallies since the crash suddenly fizzled when the Government announced that the U.S. trade deficit had hit a record $17.6 billion in October, up 25% from September. The news threw the world's currency traders into a frenzy, and the dollar plummeted to its lowest levels against the Japanese yen and the West German mark since the 1940s. The turmoil could not help pushing urgent questions into the minds of every reader of the financial pages: What is going on with the U.S. economy, and what is going to happen in the new year?

To gather the most informed opinion possible on the outlook, TIME last week conducted its own survey of 17 leading forecasters. They were chosen for their reputations and the accuracy of their past predictions. The economists represent academia, the financial community and business, and include several experts from Europe and Japan.

Their views on the U.S. economy for 1988 were far from uniform, but the majority opinion was firm and a bit surprising. Despite the stock crash, the plunging dollar and the scary new trade figures, most of the economists insist that America will muddle along next year with no recession, no significant rise in unemployment or inflation and only a modest increase in interest rates. Their median forecast is for growth in the gross national product, after adjustment for inflation, to slow only slightly, from 3.4% this year to 2.7% in 1988. Asserts Sam Nakagama of the Manhattan-based consulting firm Nakagama & Wallace: "Views are changing radically right now. It appears we are going to have a vigorous economy next year." Agrees Edward Yardeni, chief economist of Prudential-Bache Securities: "Much to everyone's surprise, the economy didn't even flinch from the crash. Clearly, I do not see a recession coming."

The economists acknowledged that consumers have become more subdued since the crash; the Commerce Department reported last week that retail sales in November were up a meager .2% from the previous month. But the forecasters felt confident that other sources of growth besides consumer spending would power the economy in 1988. In particular, the experts were convinced that the falling dollar, by making American products cheaper, will fuel a continuing surge in U.S. exports.

Moreover, Americans will turn increasingly to homemade goods rather than imports. "A larger share of total domestic demand will be satisfied by domestic production," says Saul Hymans, professor of economics at the University of Michigan. To meet the increased demand, U.S. companies will have to boost capacity, and that will give a forceful stimulus to capital goods industries. "Exports and capital spending are two very powerful forces," says Charles Reeder, a former chief economist for Du Pont and now an independent consultant.

Still, consumer spending accounts for about two-thirds of the economy. If retail sales slow down much more sharply than expected, that would overwhelm the benefits of increased exports and capital outlays. For that reason, the economists admitted that there is a significant chance of a recession in 1988 -- perhaps 20%. Some experts doubt the economy could withstand another body blow from Wall Street. Says Economist Gerald Holtham of Credit Suisse First Boston in London: "The only thing that could push the U.S. into a recession is another panic sell-off on the stock market that hits consumer confidence."

Two dissenters in TIME's poll believe a downturn is already on the way. Irwin Kellner, chief economist for Manufacturers Hanover Trust, forecasts that GNP will contract by 1.5% next year. "Consumer spending is weak and likely to weaken further," he says. "Wages have just not kept up with inflation." Johsen Takahashi, of the Mitsubishi Research Institute in Tokyo, predicts a .5% decline for the U.S. economy in 1988: "The stock market will take another plunge next year, as will the dollar." The outlook, he warns, is "very bad."

Last week's trade report would seem to support Takahashi's pessimism. Although exports climbed 3.6% in October, to $21.7 billion, imports jumped 12%, to $39.4 billion. Admitted a top economist in the Reagan Administration: "This wasn't something you want to try to put a happy face on."

Certainly Wall Street was not happy. After soaring 136 points during the first three days of the week, the Dow Jones industrial average fell 47 points on Thursday, when the trade figures were released, then recovered a bit on Friday to close at 1867.04, up 100.30 for the week. Economists were encouraged that the record deficit did not send the stock market into a free fall; they remembered well that a less bleak trade report and a drop in the dollar helped trigger the Black Monday crash. The reason for the milder market reaction this time was that investors were no longer afraid that the Administration and the Federal Reserve will try to defend the dollar with higher interest rates.

Experts have been surprised for months now that the long fall of the dollar, which has declined by 40% against the major currencies since early 1985, has not produced a turnaround in the trade balance. According to economic theory, a cheaper dollar makes U.S. products less expensive to foreigners and thus eventually boosts demand for American exports. Conversely, a weak dollar makes foreign goods more costly in the U.S. and dampens Americans' enthusiasm for imports. That, in fact, is what has happened: this year exports have increased, and the growth of imports has slowed sharply. The problem is that with the dollar continuing to drop precipitously, the cost of the imports is going up much faster than their volume, and the trade deficit is going through the roof.

Only if the dollar's descent slows down will the U.S. at last enjoy an improvement in the trade deficit. Most of the economists surveyed said the dollar would indeed become more stable. Their median forecast has the dollar drifting down only 2.3% next year against the yen and 1.8% against the mark. At the same time, they predicted, the trade deficit will fall nearly 15%, from a record $175 billion this year to about $150 billion in 1988.

To a large extent, the fate of the dollar -- and the entire U.S. economy -- is in the hands of Chairman Alan Greenspan and the other governors of the Federal Reserve Board. As always, Greenspan faces some hard choices. If he raises interest rates to prop up the dollar, he risks stifling economic activity and triggering a recession. But if he allows the money supply to grow too quickly, and interest rates drop, the dollar could go into a further nose dive, and inflation would take off.

So Greenspan is moving very cautiously. In the immediate aftermath of the crash, he rushed to reassure the markets by pumping money into the economy. But since then the Fed has returned to a more conservative monetary stance, and interest rates have started to creep up again. The economists foresee a long-term continuation of that trend, with the prime rate that banks charge for commercial loans hitting 9.5% at the end of 1988, compared with 8.75% now.

Some of the forecasters fear the consequences of an upward drift in interest rates. "If the Fed continues on its present course," says John Rutledge, president of the Claremont Economics Institute in California, "then I think that's a danger. The Fed will have to print substantial money next year to keep the economy out of a recession." But in an election year, when the Administration would plainly prefer a loose monetary policy to pump up economic growth, Greenspan could be accused of playing politics at the expense of prudence. Declares Kellner of Manufacturers Hanover: "The financial markets won't let Greenspan grease the skids for the politicians in 1988. Only if a recession began might the Fed be able to do something. But then that would be already after the fact."

Howard Wachtel, professor of economics at American University, is worried that if the trade deficit does not show some signs of improvement soon, the dollar might tumble further. That could force the Federal Reserve to raise interest rates to stabilize the U.S. currency, whatever the toll on economic growth. Admits a top Administration official: "There has never been a trade deficit of this magnitude that has not been corrected by a recession."

Many of the economists are optimistic, however, that the trade gap can be substantially reduced without an economic downturn. They expect increased growth abroad to boost demand for U.S. exports. One especially encouraging sign: Japan's economy grew at an annual rate of 8.4% in the quarter ending in September, thanks in part to a $38 billion government program to stimulate the economy that passed the parliament last spring. Roger Brinner, chief economist of the forecasting firm Data Resources, predicts that even West Germany will spur its economy and increase imports from the U.S. Says he: "The stimulus in Europe will not be because they are being kind to us. It's entirely because they see that their own economies are in very dire need of support. Otherwise they end up having a genuine recession."

Forecasters agree that U.S. exports will be the main engine for whatever growth is achieved in 1988. "The export industries appear to be out of the woods," says Thomas Swanstrom, chief economist for Sears. David Hale, the chief economist for Kemper Financial Services in Chicago, predicts that exports of manufactured goods could jump 15% to 20% next year, at the expense of America's trading partners. "We are going to increase our market share," he says, "largely by cannibalizing the foreigners'."

The increased competitiveness of American firms in overseas markets comes not only from the cheaper dollar but from a dramatic streamlining of U.S. industry over the past five years. Companies have closed down outmoded factories, and are squeezing more output from those that survive. As a result, America's manufacturing productivity has risen faster than West Germany's and nearly matched Japan's increase during the past two years.

That boost in productivity will help U.S. companies to curb costs and keep prices under control. "We're going to have productivity-led growth," says Yardeni of Prudential-Bache. "And that doesn't necessarily push inflation rates higher." Among the economists polled, the median forecast for next year's increase in the Consumer Price Index was 4.6%, virtually the same as the 4.3% rise currently projected for 1987.

A minority of the economists, though, were concerned about the outlook for inflation. Kemper's Hale is worried that in its rush to downsize, corporate America may have set the stage for capacity shortages that could create bottlenecks and drive up prices. Says he: "We have now had five years of underinvestment in manufacturing. The new lean and mean strategy may simply represent a form of corporate anorexia."

Another threat is a shortage of labor, which could push wages higher. In October the unemployment rate fell to 5.9%, the lowest level this decade. Notes Kathryn Eickhoff, former staff economist of the Office of Management and Budget and now a private consultant: "We are approaching a full-employment economy for both labor and capacity in industry. This is the type of combination that usually leads to price increases."

Finally, the declining dollar could rekindle inflation, even as it revitalizes U.S. companies. As the cost of imports rises, domestic manufacturers could see that as an opportunity to boost their prices as well. For that reason, the inflation fighters at the Federal Reserve may try to prevent the dollar from falling too fast.

One of the essential steps toward keeping inflation in check -- and correcting the trade imbalance -- is a substantial reduction in the federal budget deficit. Years of excessive Government spending have put upward pressure on prices and helped overstimulate demand for imports. Many of the economists in the survey saw the recent budget compromise fashioned by Congress and the White House, which is intended to trim $30 billion from the deficit next year, as woefully inadequate. "The 1987 budget had a lot of phony stuff in it that will come back to haunt us in 1988," warns Jerry Jordan, chief economist at First Interstate Bancorp in Los Angeles. "This will produce a rising trend in the budget deficits."

Most of the forecasters predicted that the budget gap will grow from $148 billion in fiscal 1987 to somewhere between $160 billion and $175 billion next year. With an election year coming up, the chances for major spending cuts or tax increases are slim. Says Swiss Economist Christoph Koellreuter, who heads the Forecasting Institute at the University of Basel: "For political reasons, the U.S. is unlikely to do what it should do."

Delay, though, could be costly. Warns Nakagama: "You might have another stock-market crash next spring if the Government doesn't do enough on the budget side. After all, if you are running at full employment, then what the hell are you doing with a $150 billion deficit?"

The difficulty in cutting the budget shows that it will not be easy -- or painless -- for the U.S. to resolve its economic problems. Even if the country avoids a recession in the near future, it faces a long period of slower than normal growth, which will be necessary to bring down the trade deficit. The decline in the dollar will help, but only by curbing the rise in the U.S. standard of living. If Americans cannot lower their expectations now, they face faster inflation and a truly nasty recession somewhere down the road.

CHART: TEXT NOT AVAILABLE

CREDIT: TIME Charts by Cynthia Davis

CAPTION: Median forecasts of 17 economists surveyed by TIME

DESCRIPTION: Forecasts for various economic indicators - 1987 and 1988.

With reporting by Bernard Baumohl/New York and Rosemary Byrnes/New York