Good Cause for Optimism on 1987

Lawrence R. Klein received the 1980 Nobel Prize for economics. He is a professor of economics at Wharton School, University of Pennsylvania, and was a founder of Wharton Econometric Forecasting Associates.

Last winter, it was widely expected that the triple dip in oil prices, interest rates and the value of the dollar would be so beneficial for the economy that we would be seeing better performance in 1986 than in 1985, perhaps much better.

Now there is disappointment with the economy's response and fear among some respected commentators that we could slide into recession. My own conclusion is that there are many positive effects from the triple dip, that they outweigh the negatives, and that there are additional benefits to come.

It is not yet clear how the U.S. economy overall has turned out this year. Growth of inflation-adjusted gross national product in the first quarter of 1986 was quite substantial at 3.8%. The second quarter was quite poor, with growth at only 0.6%, while the preliminary estimate for the third quarter is the mediocre rate of 2.4%.

With the final quarter projected at about 3%, the yearly average should come to about 2.6%. This is neither bad nor good. It is certainly not recessionary. But neither is it what might have been expected as a result of the triple dip in oil prices, interest rates and the value of the dollar.

In one sense, it is just a matter of timing. Next year's growth should be stronger; the only poor result for GNP in 1986 has been the disappointing spring quarter.

But why has it taken so long to reap benefits from the improved economic environment? And why is the outlook for improvement in 1987 rather than a slide into recession?

Hard Times in the Farm Belt

The oil price drop hurt some areas of the economy while it helped others. Texas, Oklahoma, Louisiana and Alaska understandably had localized recessions. The gains were realized by energy users in both the consumer and producer sectors of the national economy. Automobile sales and use have benefited. Inflation has been held in check, with national measures of price changes dropping for part of the year.

Prices for agricultural and other primary commodities have been depressed, although they have not seriously fallen like oil prices. This has generated hard times in the Farm Belt.

But deterioration in 1987 is likely to be mitigated or even reversed amid a tendency for oil prices to stabilize or firm and for agricultural support payments to help farmers.

Another effect of the oil price decline can be seen in our international trade statistics. While we have not yet had any improvement in our total trade balance, measured in current dollars, the figures would have been much worse without lower oil prices.

During the January-August period last year, we spent $33.3 billion on imports of petroleum and related products. The corresponding figure for 1986 was only $26.2 billion. There clearly have been great savings in what we spend on imported oil.

But oil demand is somewhat sensitive to price. During the January-August period of 1985, we imported 1.2 billion barrels of crude and related products. This figure rose to 1.5 billion barrels in the like 1986 period. In real terms--that is, adjusted for price changes--our petroleum balance deteriorated. This has been a setback for real GNP. Had there been a tax on imports, we could have had better domestic production, a better federal budget picture and a better national economy.

The drop in interest rates has been beneficial for economic activity that is sensitive to rates--consumer purchases of cars and other durables, residential construction and servicing of debt. Now that we are a large debtor nation in the world economy, we gain when interest rates fall. Ordinarily, we should expect lower interest rates to stimulate business investment, a lagging sector in this phase of the recovery. The drop in rates was not enough to overcome the effect of excessive expansion in 1983-84, commercial overbuilding in some areas and uncertainties raised while tax reform was debated. Eventually, investment will pick up again, creating yet another reason to be optimistic about 1987 and beyond.

The J-Curve Effect

The depreciation of the dollar was fully expected to result in what is known as the J-curve effect: Trade balances get worse before they get better. While the price paid for imports may rise quickly because of the dollar's fall, the volume of exports and imports may respond more slowly.

This J-curve effect has taken place systematically in the past. There are good reasons to believe that the worst is over.

It was evident from the beginning of the process of dollar depreciation that the decline would have to be much greater than what we have already seen--and effective across a much broader range of currencies. Further decline in the dollar is now taking place, and that is a reason for expecting improvement in the trade account during 1987.

Both West Germany and Japan feel the effect of the dollar dip. Their real net export positions have worsened (although that is not reflected in current dollars), and as a result they are looking to stimulate their own domestic economies. This should help us in the near future.

The triple dip of oil prices, interest rates and the dollar has not been as ineffective as many people believe.

For some time before the triple dip became apparent, the Wharton Forecast was for a mild 1986 recession in the United States. That fit nicely with our time-honored business cycle chronology. It would have caused a worldwide slowdown, since the United States accounts for about one-quarter of total production. But the occurrence of the triple dip led the Wharton Forecasters to shift during 1985 from recession to slowdown to moderate (that is, 3%) growth, thus ironing out the expected recession. I believe that the recession forecast was realistic until the dips became apparent and also that the dips were largely responsible for our being in a no-recession, mediocre-growth phase now.

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