How Long Will It Last?

By John Greenwald

Hardly anyone bothers to deny it. After a record eight years of peacetime economic expansion, the most widely predicted recession in recent U.S. history is finally at hand. No longer confined to the beaten-down Northeast, the slump has brought hard times for many Americans, ranging from Boston bankers to Atlanta autoworkers to California aerospace engineers. The big questions now: How far will the economy slide into misery, and how long will the slump last?

The tidings will probably be grim at least until the middle of next year, according to the consensus of a panel of five leading economists who gathered in Manhattan this month for a TIME economic forum. "We have a moderate, potentially severe recession on our hands," said Allen Sinai, chief economist for the Boston Co. Economic Advisers. "The economy is showing signs of caving in, almost falling off a cliff, as so often is the case once a full-fledged recession begins." If the conditions seem particularly bleak, he noted, "that is because we are in the heart of the slide."

The U.S. gross national product will shrink at an annual rate of 2.5%, after adjusting for inflation, in the fourth quarter, and show smaller declines in the first half of next year, according to TIME's panel. (The economy grew at an anemic 1.4% rate in the July-September quarter.) The downturn would meet the official definition of a recession, which is at least two straight quarters of falling GNP. The panel said the U.S. appeared likely to resume slow growth by mid-1991 as the Federal Reserve Board lowers interest rates to stimulate business activity. That scenario would amount to a far milder recession than the severe 1981-82 downturn, which lasted 16 months.

But that is if everything goes well, which is no sure thing. The economists in the TIME forum warned that the U.S. faces a minefield of unprecedented risks that could worsen the recession and prolong it through next year and beyond. Chief among them is the threat of a drawn-out war in the Persian Gulf. That could push the price of oil, which closed at $25.92 per bbl. last week, well past the $41.40-per-bbl. peak that it hit in October. Another serious threat is the possibility of a crisis in the U.S. banking system, which is awash in bad loans and increasingly reluctant to lend more money. L. William Seidman, chairman of the Federal Deposit Insurance Corporation, told Congress last week that 1991 is likely to bring the failure of 180 banks with total assets of $70 billion. That would reduce the FDIC fund, which insures bank deposits, from an already weak $9 billion to $4 billion by the end of next year. Seidman urged lawmakers to levy a special $25 billion assessment on banks and raise their insurance premiums to rescue the fund.

The U.S. economy is also especially vulnerable to shock waves from overseas. A panic in Japan's superheated real estate market would shake Japanese lenders and help trigger a global slump. So could the chaos that would ensue if the Soviet Union's restive republics plunge that country into civil war.

The Federal Reserve last week sent the clearest signal yet that it has become deeply worried about the slumping economy. In an eagerly awaited move, the Fed cut the so-called discount rate it charges for loans to banks a half- point, to 6 1/2%. The reduction, which was the first change in the discount rate since February 1989, was meant to encourage balky banks to lower their lending rates to consumers and companies. But most major banks refused to budge. Only First National of Chicago, the 13th largest U.S. bank, cut its prime rate a half-point, to 9 1/2%.

Economists in TIME's round table generally viewed the recession as the latest and most painful reaction to the 1980s borrowing binge. They noted that the U.S. has been plagued for the past two years by what Sinai called "subpar, anemic, punky and kind of crummy business activity" as debt- ridden consumers and companies cut back their spending. Iraq's invasion of Kuwait in August provided the final push. "We were headed toward a cul-de-sac in which the economy was going nowhere," said David Hale, chief economist for Kemper Financial Services. "What we have had is a deep shock to confidence on top of a sluggish economy."

The jolt caused consumers to snap shut their wallets and purses just as the peak spending season arrived. In a November poll of consumer attitudes, the Conference Board found Americans to be less optimistic about the economy than at any other time since 1982. The gloomy mood translated into a drop of 0.1% in retail sales during November, compared with the previous month. "This is not a temporary response to temporary events," said Donald Ratajczak, director of the economic forecasting center at Georgia State University. "It is, rather, a call by consumers that they feel their earning potential is weaker."

For many people, the pain has been building for years. When adjusted for inflation, the median weekly income of U.S. families has stagnated since 1988. The government reported last week that Americans' real disposable income showed no growth in November. Declining home values have deepened the ache by reducing people's wealth and thus their willingness to go shopping. Real consumer spending dipped 0.2% in November, despite the start of the Christmas buying rush.

Companies had been slashing their payrolls to become more competitive even before the latest round of consumer retrenchment. The pace of layoffs quickened in November when the economy lost 267,000 jobs and sent the unemployment rate to 5.9%, up from 5.7% the previous month. Since June, nearly 700,000 Americans have been added to the jobless rolls. While past recessions were heavily concentrated in blue-collar industries, few sectors or regions have been spared this time. Manhattan's Citicorp, which laid off 3,600 employees this year, said last week that it plans to dismiss another 4,400 by the end of 1992. Citicorp, the largest U.S. banking company, said it may lose as much as $400 million in the current quarter, largely because of a $340 million addition to its reserves against bad loans.

TIME's panel of economists predicted that unemployment would climb to nearly 7% by late next year as U.S. industry continues to dismiss workers to keep profits from plunging into a free fall. Caught between huge debts and tough * foreign competition, companies in the Standard & Poor's index of 500 stocks saw their earnings drop 3.7% in 1989. They will fall another 2.2% this year, Sinai predicts. "More important than the decline in consumer confidence is the decline in business confidence," said Gail Fosler, chief economist for the Conference Board, a business-research group. "That decline is palpably and immediately translated into what we see going on in the production sector." She warned that companies could trigger "a very serious recession" if they cut payrolls too much in their zeal to keep overhead and inventories lean.

Gloomy executives are unlikely to start more factories humming anytime soon. The government said last week that companies plan to increase their spending on buildings and equipment by just 0.4% in 1991, the smallest increase in five years. But companies may decide to spend even less if the economy becomes weaker.

The panelists foresee a slowing of inflation, which climbed to what would be nearly 10% on an annual basis in August and September, if the gulf crisis can be resolved without a lengthy war. Unlike the oil shocks of the 1970s, the latest price hikes have not threatened to work their way into wage settlements -- largely because of the weak economy. "We have already had our maximum inflationary impact from the oil shock, unless there is another one," Ratajczak said. The government buttressed the point last week when it reported that the Consumer Price Index for November rose a moderate 0.3%, or 3.7% on an annual basis. The TIME group predicts that the CPI will climb at an annual rate of 7.2% in the fourth quarter and slow to 3.8% by late next year.

The panel expects falling inflation to set the stage for a turnaround. As price increases slow, they contend, Federal Reserve chairman Alan Greenspan will continue to permit interest rates to drop. The average fixed rate for home mortgages has already dipped to 9.6%, from roughly 10.25% last summer. A general drop in interest rates would have a double-barreled benefit. Besides stimulating business at home, lower rates would tend to reduce the foreign- exchange value of the dollar, thereby spurring U.S. exports.

Yet tumbling interest rates will have little impact if banks fail to ease the credit crunch that has frustrated borrowers for most of the year. Beset by tough new regulations and saddled with hastily made loans that went sour in the 1980s, many lenders remain wary of granting credit to any but their best- * heeled customers. Said Ratajczak: "Regulators told the banks, 'Make no bad loans.' But the banks heard, 'Make no loans.' " Lenders have been just as reluctant to cut their rates for business borrowers. As a result, the prime rate that most major banks charge corporations has been stuck since January at 10%. "Banks are protecting their profit margins like crazy," said Carol Leisenring, chief economist for Core-States Financial, a Philadelphia-based bank-holding company. "That is not surprising, given the situation the banking industry is in."

The TIME group warns that the banking industry's weakness could prolong the economic downturn. Leisenring points out that the FDIC has placed more than 1,000 of the nation's 12,700 commercial banks on its watch list of troubled lenders, because of a mountain of bad real-estate loans and other debt problems. "That is roughly four times the number on the list when we entered the last recession," Leisenring said. "We don't usually go into a recession with these kinds of loan problems and stresses in the financial system." As a consequence, she said, the U.S. "will not get the traditional kick from construction activity" that normally helps lead an economic recovery.

Some major banks are barely hanging on. Creditors of Bank of New England Corp. offered last week to swap $600 million of bonds for stock in a move that would infuse the firm with desperately needed capital. The neighboring Bank of Boston Corp., which lost $255 million in the third quarter, said it expects to report another substantial loss in the fourth.

The shortage of funds could grow more acute as Japan and Germany throttle back their foreign investments. Beset by a yearlong slide in prices on the Tokyo Stock Exchange, Japan's giant banks and financial institutions have sharply reduced their lending overseas. While Japan was a net buyer of $25 billion of U.S. securities and other assets in 1989, Japanese investors will be net sellers of about $30 billion of U.S. holdings in 1990. Said Hale: "Japan is no longer a source of global asset inflation and global credit expansion. It is now a source of restraint." At the same time, a unified Germany may invest as much as $1 trillion over the next decade to rebuild its eastern region. That will severely crimp the amount of German funds available for foreign lending.

A cash squeeze could help tip much of the world into a recession. Britain, Canada and Australia are in a slump, while the economies of most European ! countries outside Germany appear to be faltering, according to the TIME group. "I see the international economy slowing down," Fosler said, "which is going to be an added burden over the next two years." Such a slide could erode U.S. exports, one of the economy's few remaining sources of strength. The government said last week that the U.S. trade deficit widened in October to $11.6 billion, the largest gap in nearly three years, as rising oil prices pushed up the country's bill for imports.

At home, the Bush Administration seems powerless to pull the U.S. out of the recession. While Ronald Reagan's tax cuts and $2 trillion military buildup helped end the last slump, the resulting federal deficit makes new tax reductions or spending increases politically and economically impossible. Even after the October budget deal between the White House and Congress, the federal deficit could swell to $300 billion in fiscal 1991 when the savings and loan bailout and the projected $30 billion U.S. cost of Operation Desert Shield are factored in. At the same time, some $25 billion of income tax increases and higher levies on tobacco, alcoholic beverages and luxury items will hit the economy in 1991 as a result of the budget agreement.

While deficit cutting is good long-term policy, the immediate effect is likely to be more pain. "We are raising taxes in the teeth of a recession," Ratajczak noted. "I am not sure that many people would call that a useful idea." Added Fosler: "The budget agreement was very much like spraying shrapnel. It was sort of an AK-47, as opposed to a target rifle, in terms of its impact on the economy. Lots of sectors are going to be paying higher fees and costs for public services."

For now, Americans must scramble to cope with hard times and keep up their hopes that the recession turns out to be no worse than a moderate one. Yet the downturn could have a silver lining if it forces Americans to confront the legacy of 1980s-style borrowing and spending, which threatens to stifle growth for years to come. "We simply cannot go on doing business as usual in so intensely competitive a world," Sinai said. "This downturn may be a catalyst that will wake up the nation." If the recession does help inspire the U.S. to face its long-term economic problems, hard times could help achieve what eight years of debt-fueled prosperity could not.

CHART: NOT AVAILABLE

CREDIT: TIME Chart by Steve Hart

CAPTION: IN HARM'S WAY

The median forecasts of five economists suggest that the economy will rebound by mid-1991, assuming that the U.S. avoids a protracted war in the Persian Gulf.

With reporting by Bernard Baumohl/New York