Economic Picture Looks Brighter

George L. Perry is a senior fellow at the Brookings Institution research organization in Washington

In this season for economic forecasts, the outlook for expansion in my own crystal ball is looking rosier. Gross national product rose a disappointing 2.2% between the fourth quarters of 1985 and 1986. Over the four quarters of 1987, I expect growth to pick up to 3.5% to 4%. Industrial production should rise even more as the GNP gains are concentrated in the cyclical goods-producing areas of the economy.

This forecast of faster output gains stems mainly from my expectation that the foreign trade and business investment sectors of the economy will improve strongly. In both cases, this will represent a turnaround from the recent past. The foreign trade deficit--the difference between our exports and imports--has widened every year since 1982, cutting into the GNP advance. And, as the inroads of foreign competition discouraged domestic producers from expanding and upgrading facilities, business investment in new plant and equipment has been lackluster, adding a further damper to total GNP growth.

The real trade balance finally showed signs of improving in the fourth quarter of last year. Although this balance between exports and imports moves erratically, and one quarter hardly establishes a new trend, I believe the improvement will continue during 1987.

The main reason for expecting this improvement is the sharply lower exchange rate of the dollar, which has made U.S. goods more cost-competitive in world trade. The dollar is now below 1980 levels against the Japanese yen and West German mark. Because of trends not captured in these exchange rate comparisons, this may not be enough to restore trade balance, but it should start moving us in that direction.

Export Orders on Rise

The more competitive dollar has already raised sales and profit margins in basic export industries such as lumber, chemicals and paper, and U.S. capital goods makers are now seeing strong export orders as well.

There will also be gains for producers that can now recapture domestic markets they had been losing to imports, or at least keep imports' inroads from growing.

I expect real exports will rise about 10% while real imports change little over this period.

The difference between the two--the foreign trade balance--will thus improve and add about 1% to real GNP over the course of the year. It has been subtracting more than 1% from GNP over the past two years, so the swing will be dramatic.

To be sure, business investment spending, the other sector in which I anticipate the start of renewed strength, will be hurt by important changes in the tax law.

Lower tax rates for business, with a maximum corporate rate of 34% rather than the previous 46%, are in themselves a stimulus to business investment.

However, other changes in the tax law reduce investment incentives and, with their revenue effects more than offsetting the effects of rate reductions, leave prospective corporate tax liabilities higher by about $25 billion a year.

Consistent with its objective of providing a level playing field for all forms of investment, the new tax law reduces the tax shelter incentives and over-generous depreciation allowances on structures that had helped fuel office and commercial construction.

It also raises the effective cost of investing in business equipment by eliminating the investment tax credit. The investment tax credit, however, was repealed retroactive to the start of 1986, so the effects of its repeal should have already shown up in equipment spending last year. On balance, the net near-term effect of tax reform on total business investment in 1987 is likely to be moderately negative.

But offsetting these tax effects are some economic fundamentals that are growing more favorable to business investment spending. The rising stock market is one positive factor since it reduces the cost of capital to firms.

Demand Should Improve

More important, 1987 should also see improvements on the demand side, starting with the improved sales at firms that are affected by foreign competition. Improving sales and profit margins will, in turn, encourage higher levels of investment by these same firms, which will generate stronger sales for capital goods manufacturers.

Recent increases in new orders for non-defense capital goods strongly support this view. Commercial and office construction are two areas of business investment that will be hurt by tax reform, but not enough to offset the emerging strength in spending for machinery and equipment.

Because the strength in business investment depends to a large extent on improved competitiveness and a declining trade deficit, the entire GNP outlook is tied closely to the foreign trade sector.

Thus, one should allow a larger margin for error than usual around the forecast because of uncertainties about both the response of trade to the dollar's decline and about the strength of expansion in foreign economies--an important determinant of U.S. exports.

When Treasury Secretary James A. Baker III leans on the Germans and Japanese to stimulate their economies, he is not just sticking his nose into their business, he is looking after the U.S. expansion as well.

What of prices for 1987?

The underlying rate of inflation in the United States--a concept that disregards the volatile price swings of such goods as energy and food--has slowed to about 3.5% to 4%, and is unlikely to accelerate in 1987. We are not looking at so strong an economy that it would overheat labor and product markets and lead to a resurgence of demand inflation.

However, the consumer price index will rise faster than this for two main reasons. First, oil prices will be up for the first time since the early 1980s, though not dramatically. Second, import prices will be up as a result of the lower dollar, and their increase will spread to some U.S.-produced goods that compete with them.

Thus, the bad news for 1987 is that the consumer price index, which rose only 1.1% between December, 1985, and December, 1986, will rise by more than 4% this year.

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