A Weak Recovery (Maybe)

International debts and U.S. deficits concern TIME’S Board of Economists

“This is the first time in my memory when the outlook for the international economy is forcing analysts to scale back their short-term domestic projections here in the United States. The international picture is impinging very seriously on the domestic outlook and creating a clear fear that is beginning to spill over into domestic decision making.”

The speaker was former Presidential Economic Adviser Alan Greenspan, and his remarks aptly summarized the grim concern that pervaded a meeting qf the TIME Board of Economists held in New York City last week to survey the economic outlook for the remainder of 1982 and 1983. Dominating the discussion was the precarious state of the world’s finances and the damage that a loan default by Mexico, Poland or any of a dozen other large borrowers might do to the international banking system. The economists worried about whether those countries could pay their debts, and also what impact their shaky positions might have on growth and inflation in the U.S.

The crisis of confidence that has been building for months in international banking has reached a climax at a time when the U.S. economy is bedeviled by uncertainties. On the plus side, the battle against inflation continues to go well. Price rises, which reached a peak annual rate of 17% in early 1980, now seem safely in the 6% range. Said Walter Heller, chief economic adviser to Presidents John Kennedy and Lyndon Johnson: “We have had a real structural improvement in inflation. We have gone through a watershed.” The TIME board saw prices increasing at 5.3% annually by the end of the year, with inflation at a modest 5.5% by the middle of next year.

The drop in inflation and a sluggish economy have brought some relief to hard-pressed business borrowers, who lately have been going bankrupt in the greatest numbers since the 1930s. But there may not be much additional good news on interest rates for a while (see box). Despite some encouraging signs, TIME’S board members found the economy to be still weak and the recovery to be somewhere in the future. In May, when the board last met, members thought that the Reagan Administration’s July 1 income tax cut would spur consumer spending and push growth to a 3.3% annual rate during the third quarter. In fact, scared consumers have been keeping a tight lid on spending, raising doubts about whether the economy will show any growth next month when the Commerce Department releases its preliminary third-quarter figures for the gross national product.

New Government figures last week showed that the economy remains very weak. Retail sales in August declined nearly 1%, after a revised 1.2% increase in July, and industrial production dropped .5% in August for the tenth decline in the past twelve months.

Although most board members continued to stick to earlier growth forecasts of about 3% during the fourth quarter, all agreed that any such recovery would be vulnerable to the slightest setback. Said Heller: “The strength of the recovery, in a word, will be lousy.” Rimmer de Vries, chief international economist for Morgan Guaranty Trust Co., doubted whether the economy had bottomed out at all. Said he: “I think we have not got to the end yet. I do not think recovery will really come until 1984.”

Although board members were generally relieved that Congress had dented the federal budget deficit a bit by adopting a threeyear, $98.6 billion package of tax increases in mid-August, budgetary red ink remains a key concern. Alice Rivlin, director of the Congressional Budget Office, said that analyses done by her staff show a deficit climbing to $155 billion by next year and staying at about that level until 1985. This compares with an earlier forecast indicating that if no action were taken by Congress, the deficit would increase to more than $230 billion by 1985.

Said Rivlin of Congress’s frustrating battle to pare spending: “The whole struggle has been terribly discouraging. Congress’s tax-increase and spending-cut actions have been considerable, but at the same time, the recovery has been weaker than had been assumed in the spring, and as a result, revenues have tended to be lower. As a consequence, the best that can be said is that the deficit has leveled off from an increase that otherwise would have happened.”

The members agreed that further curbs in spending will be difficult. Rivlin pointed out that in 1985 nearly $700 billion of the projected budget of $910 billion will go for defense, interest payments on the national debt, and pension payments such as Social Security and Medicare. President Reagan has ruled out defense cuts, and spending in the other areas can be reduced only if the Administration overcomes powerful congressional lobbies.

To reduce the deficit to $100 billion by 1985, said Rivlin, would mean cutting more than 25% out of all other Government programs, from space exploration to river dredging. Yet those areas have already sustained deep cuts in budget allocations under the Reagan Administration.

Heller argued that next year’s 10% personal income tax cut should be canceled in order to reduce the deficit and permit more money growth. But Board Member Charles Schultze, former chief economic adviser to President Jimmy Carter, warned that the tax cut may be needed to give a weak economy some help. He explained, “Until you get a better sense of monetary policy and the likely strength of the recovery, Congress ought not to be in any big rush to raise taxes. You just cannot hit too hard on fiscal policy if you are still hitting hard on monetary policy.”

Perhaps the most critical unknown in the domestic economy remains the future cost and availability of money. Under Federal Reserve Chairman Paul Volcker, the U.S. for the past three years has pursued a policy of slowing money growth in an effort to curb inflation. But tighter money has collided head-on with strong demands for credit from both business and Government. The result: interest rates have gone to the highest sustained levels in more than 100 years.

As a result of the weak economy, the demand for short-term credit has begun to slacken, and the cost of such borrowing has started to slide. To prevent interest rates from spurting back up again as the economy recovers, TIME’S board felt, the Federal Reserve should allow the money supply to begin modestly “overshooting” its annual growth target of 5.5%. Said John Paulus, chief economist for the Mor gan Stanley investment banking firm and a guest at last week’s session: “Current monetary targets are basically consistent with no growth in the economy at all. The question is: What is more important, the need to have positive growth in 1983, or the need for the Fed to protect its anti-inflation credibility? I think that the Fed will muddle through and judiciously overshoot the 1983 money-growth target by up to one percentage point.”

The Federal Reserve can now permit credit to grow a little faster because Volcker has established good credentials in the fight against inflation. But there are already rumors in financial circles that Volcker would like to return to private banking when his term as Federal Reserve chairman expires next August. In private banking, Volcker could easily earn as much as ten times the $60,663 annual salary he gets at the Federal Reserve. But if he leaves, monetary policy would again be in doubt. Said Paulus: “If he is not reappointed, then the Fed will have to re-establish its credibility all over again.”

Hanging over the U.S. economic outlook is the tenuous situation in world banking. Since 1974, lending to the cash-squeezed nations of the developing world has climbed to more than $540 billion. That debt burden was heavy, but bearable as long as the global economy was growing even modestly. But the world slump has put those countries in a very difficult situation. Commodity prices, the main source of income for most Third World countries, have collapsed, imperiling the ability of these nations to meet even their interest payments, let alone repay the loans.

Morgan Guaranty’s De Vries, who had just attended a somber gathering of international bankers at the annual conference of the International Monetary Fund in Toronto, reported that the mood of the IMF and banks was distinctly against “bailing out” the debtor countries on easy terms. Indeed, De Vries was afraid that nervous bankers might now overreact to the danger of default and begin withdrawing from international lending. That, he warned, could make defaults all but unavoidable.

Nonetheless, De Vries predicted a “very significant slowdown in international lending.” He foresees a sharp cutback in the rate of increase in such lending, which could wind up trimming new loans to overseas borrowers by as much as 50%. Said he: “International lending is not going to be the same as it has been in the past.”

He anticipates a tense, three-way tug of war developing among private bankers, debtor countries and international institutions like the International Monetary Fund. The bankers want payment on their loans, the developing countries are not anxious to take austerity measures to pay their debts, and international institutions are reluctant to lend still more money to the poor countries except on tough terms. The result of the three-sided struggle could lead to more political unrest in some Third World countries.

Greenspan was afraid that domestic politics might eventually compel an economically struggling borrower to default on all its loans, encouraging other countries to follow suit. That, in turn, would confront Western finance officials with a cruel choice. On the one hand, the lenders could wipe the worthless loans off their books and invite a worldwide financial contraction because of dwindling monetary reserves. On the other hand, central banks could attempt to avoid such a massive depression by buying up the defaulted loans. That would keep the international financial system functioning, but it would also cause a wild new burst of inflation, since the U.S. Federal Reserve would have to pay for those loans with dollars, thereby dramatically increasing the money supply around the world. Greenspan argued that the recent run-up in the price of gold, which has jumped about $100 per oz. in the past four weeks to reach $441.50, is a result of fears that such an inflationary bailout of banks may be inevitable.

Although no board member saw either doomsday case as the most likely possibility, the TIME group believed that the international credit crisis would cause continued troubles for both the Third World and the U.S. Said Greenspan: “There will be a slowdown in lending, very considerable difficulties in developing countries to achieve their growth targets, and probably significant political problems for some countries.” In the U.S., the debt troubles could mean less bank lending and slightly higher interest rates. The world banking crisis would thus be one additional trouble for an American economy struggling to pull out of a long, steep recession. —By Christopher Byron