U.S. Economy Wavers While Forecasters Fudge

Pity the poor economic forecaster. Every year since the 1981-82 recession, the consensus forecast consistently underestimated the strength of the U.S. recovery, or worse, wrongly predicated a recession. Finally, in 1986, economists across the land screwed up their courage to forecast booming growth. As if on cue, the economy stagnated, and the forecasters are once again suffused with gloom.

Economists might be forgiven their lapses--except perhaps by clients who pay so well for false certitudes--because the underlying facts warrant confusion. There are good reasons to expect the economy to strengthen markedly over the next six months or so. There are also almost equally good reasons to anticipate a stupendous collapse.

The best news, perhaps, is that the American recovery, already one of the longest in peacetime history, is still underway. Employment is growing; unemployment figures continue to show a downward trend, slipping under 7% for the first time in years. The disappointing 1.1% annual growth rate in the second quarter looks like more of an accomplishment when measured against the sharp downturn in Japan (-2%) and the near-collapse in Germany (-6.5%) during the same period.

There’s good reason, too, to expect better news on the manufacturing front, which has been the major drag on the rest of the economy as oil companies, automobile companies and manufacturers of consumer durables--washing machines, refrigerators and the like--slashed budgets for new plant and equipment. Business investment is a basic economic driver, adding steam to basic industries like steel and rubber. More modern factories raise productivity and help America compete overseas.

The reasons for the cuts in oil company spending are obvious. But the capital spending slowdown in the rest of the manufacturing sector was truly unexpected. With the sharp fall in the dollar, most companies had expected a quick reduction in imports--a cheaper dollar raises the cost of foreign goods--and a boom in domestically manufactured goods. Instead, Japanese and German companies held their prices and took a beating on profits, suffering their own mini-recessions in order to keep their American market shares.

The good news now is that foreign manufacturers can’t hold the price line much longer. A number of analysts, in fact, think an abrupt turn in trade flows may be already underway, but has yet to show up in the official statistics. One straw in the wind is the feverish activity by Japanese companies as they move factories to the United States, making everything from automobiles and refrigerators to television sets and computer disc drives.

If the trade numbers do turn, business investment could recover smartly. Investment should also get a boost once the details of the tax bill are settled--any tax bill, just to remove the uncertainty. The Congressional Budget Office, for instance, no admirer of the Reagan Administration’s typically rosy forecasts, is predicting just that--growth and moderate inflation.

For connoisseurs of pessimism, however, there is truly dreadful news in the two sectors that have been propping up the economy for at least the last decade--agriculture and finance. For a long time, America has been the Saudi Arabia of food. It is not entirely coincidental that American wheat prices tripled at about the same time as Arabian oil prices, nor that world food supplies have moved into glut the way oil stocks have. Market forces and price mechanisms do work, however imperfectly.

There is no way out for the American farmer now. Feed grain supplies at the end of the year will be four times higher than two years ago, even with a 15% cut in output. The tight grain markets of the late 1970s impelled vast new production all across the world, from India to Argentina. Plenty of American farmers--and not just little farmers--will have to go bankrupt and quit before agriculture can return to profitability.

The agricultural collapse is becoming increasingly difficult to muffle. The Farm Credit System--a patchwork of federal land banks and farmer cooperatives--has some $66 billion in paper floating in the secondary financial markets, about $5 billion of it in bad loans. Band-Aid congressional legislation has been deferring a reckoning, but the longer the bad debts are allowed to mount, the taller and more vulnerable the whole haystack becomes.

Exuberant farm lending is only one of the last decade’s banking follies that are straining the big commercial banks; real estate, developing countries and oil-patch lending are the others. But so far, except for critical cases like Bank of America, falling interest rates have masked their weaknesses.

The rates commercial banks pay on deposits always fall much faster than the rates they charge on loans, particularly to consumers. So banks have recently enjoyed huge lending spreads--as much as 10% or more. The profits on consumer loans have kept reported bank earnings high, even as they book huge commercial lending losses. But interest rates are stabilizing, and the windfall consumer lending spreads will now be narrowing, exposing bank balance sheets in all their fragility, naked and shivering before the world.

Falling interest rates have also propped up Wall Street earnings by generating huge paper profits on the fixed-rate bond portfolios held by the investment banks and brokerage houses. (The value of a bond that pays 10% interest for 10 years will increase sharply if the rates on comparable bonds dropped to 5%.)

But behind their portfolio profits, the Wall Street houses may be in even worse shape than the commercial banks. Their staple business of buying and selling stocks and bonds for their customers at high fees has long since dried up and gone away. The lion’s share of Wall Street investing is now the province of big institutions, like corporate pension funds, outfits willing to pay brokers only what their services are worth, which is not so much.

In order to keep earnings high, investment banks have been concentrating on megadollar mergers and acquisitions. But the days of cherry-picking undervalued companies are over. The prices of the most recent big acquisitions have been very high; and to induce their customers to play, the Wall Street houses have been investing their own scarce capital in ever larger amounts. The result is that they are loaded up on very high-risk paper, making the brokerages at least as vulnerable to a downturn as the shaky commercial banks.

There is little to choose between the probabilities of the two scenarios. Optimists will expect the trade deficit and company profits to turn around by the end of the year, funding the debt on corporate balance sheets and keeping the economy on a solid course. Pessimists will run for the storm cellar. The economics profession will clear its collective throat and fudge its forecasts--the rest of us can only keep our fingers crossed.