The Whole World : Economy-Size

For months, American economists saw the storm clouds gathering, but in the euphoria of a bullish stock market, the 1986 tax re form and relatively sustained consumer spending, neither the public nor politicians paid much heed. Then came the stock market meltdown. Suddenly, not only the nation but the world’s attention has been focused.

Earlier this year, The Times began surveying 24 leading economists on the state of the U.S. and world economies (please see list of respondents on Page 2). Here are some of the findings:

--They generally agreed that, given economic prospects, stocks were overvalued and the market was being driven by speculative activity. The downturn, therefore, was not surprising. Early this summer Allen Sinai warned that investors were becoming increasingly leery of pouring money into a nation with runaway debts: “This is how investors vote with their feet. That kind of sentiment to me is a very strong signal and a very strong warning for this country for the future if we don’t get our house in order and that involves the twin deficits (budget and trade). “

--Most of the economists felt a day of reckoning for Reaganomics was fast approaching but thought the White House would be able to postpone it until after the 1988 election. “They don’t give a damn about the deficits,” said James Tobin.

--Some economists expected the trade deficit to have showed marked improvement by this time and are disappointed that it has not. Now, indications are that deficit reduction will be a long and painful process. Last month Rudolph G. Penner, director of the Congressional Budget Office until March, 1987, told an audience of congressional staffers: “Every month I have forecast that next month’s trade figures would be better and each month I have had to think up a new excuse why they haven’t been. I have run out of excuses.”

--The dollar will need to decline another 20% to 30% against foreign currencies before the United States regains its competitive place in world markets. “More nearly 30% because we made these stupid mistakes of (the last) five years,” said Rudiger Dornbusch.

--The continuing trade deficit will generate additional pressure for protectionist legislation, and there is near-unanimity that a trade bill like the one now pending in Congress would be an invitation to disaster.

--The Reagan Administration will bequeath a legacy of an additional $1.7 trillion in debt: about $1 trillion of national debt and $700 billion owed to foreigners on the cumulative trade deficit. Penner calls it “fiscal child abuse” because of the burden it places on future generations.

--A recession can be expected sometime between 1988 and 1990. Most of the economists do not not think it will be a severe one, but because of the deficits and our newly developed dependence on foreign funds, the freedom of U.S. institutions to respond will be hampered severely and America will be in uncharted waters.

--Because of the high loads of corporate and consumer debt, even a moderate recession could produce a flood of bankruptcies. Many financial institutions are already in serious trouble. According to Andrew F. Brimmer, “We expect to see a substantial number of savings and loans now technically in default coming down.” And David Gordon said: “The consequences of the triple deficits--federal, trade and overborrowing--will not be resolved through some magnificent, cushioned ‘soft landing.’ I foresee . . . several crash landings over the next five years or so.”

--Yet economists may also be optimists. Over the long run there is a general belief that the U.S. economy will emerge in good shape once it weathers Reaganomics. “Granted the stupidity of the budget policy to begin with,” said Charles L. Schultze, “it makes for a more exciting life. If you look at the amounts involved we will end up with--who the hell knows?--owing net $700 billion abroad, the real interest rate on that, let’s say, is $28 billion a year . . . it’s throwing it away in some sense and it’s bad and I’m all agin’ it but it ain’t a catastrophe.”

What is clear is the development of a new global economic order of national interdependence, with the United States still a fulcrum, albeit of diminished power after the policies of the past six years. The chain of events leading America to its current plight probably began eight years ago, in October, 1979.

During the ‘50s and ‘60s, the United States was the godfather of economic recovery in Europe and Japan. The economic vigor, however, brought about an unexpected shortage of commodities--primarily oil and foodstuffs--in the ‘70s, together with surging inflation. After the 1973 and 1979 oil shocks resulted in a rapid multiplication of the price of oil, America’s major trading partners convinced Federal Reserve Board Chairman Paul A. Volcker that a concerted effort must be made to squeeze the air out of inflation. While this proved a fairly painless process in West Germany and Japan, the central bank discount rate in the United States was pushed up from 6% in 1977 to 13% in 1980, precipitating a worldwide recession that had more repercussions and lasted far longer than envisioned.

In the United States, the new Reagan Administration had its own agenda, to combine a massive increase in defense spending with substantial tax reduction while purportedly balancing the budget. These seemingly contradictory goals were rationalized as attainable under supply-side economics. Supply-siders argued that if the tax burden were reduced, economic activity would be spurred to such a degree that lower tax rates would produce increased revenues, and that expanded supply would result in cost-efficiencies and lower prices that would eliminate the ‘70s stagflation.

But by August, 1981, it was clear to then-Budget Director David A. Stockman that this beautiful scheme was not going to work. At the very time the 1981 tax bill was passed, Irwin L. Kellner recalls Stockman advising the financial community that the budget deficit was not going to fade away as advertised, but instead would reach unprecedented levels of $100 billion or more. “The fiscal markets became extraordinarily concerned,” Kellner said, and interest rates ultimately increased 3% to 5%.

While interest rates elsewhere in the world subsided, the Reagan Administration’s expansionary fiscal policy piggybacked upon the Volcker contractionist monetary policy to keep rates elevated here. Not until October, 1982, did Volcker relent. Then, under the impact of the greatest tax cut and fiscal stimulus in American history, the economy made a rapid recovery. Sinai calculates that in the 1983-1985 period, the tax cuts averaged over 9% of GNP, compared to the 2.3% of GNP for the Kennedy-Johnson Administrations’ tax cuts in the 1960s: “Here we have by a fourfold magnitude the biggest tax cuts in our postwar history and when you combine the tax cuts and the military spending buildup it is without doubt the greatest amount of pump-priming since World War II.” In fact, the worldwide recession helped make the ‘80s a decade of surpluses, the very opposite of the ‘70s shortages. Demand was choked off just when new oil fields were coming into production, when new state-of-the-art, low-cost manufacturing facilities were coming on line in the “nics” (the newly industrialized countries of Korea, Taiwan, Hong Kong and Singapore), and when the agricultural revolution took hold to produce a growing world food surplus.

Latin America, an important U.S. market, withered as commodity prices plummeted at the same time interest rates rose; those nations were left with a huge overhang of debt and no funds to pay for further imports--a loss for both American banks and exporters. With the United States placing a premium on funds to finance the federal deficit, foreign funds flowed into American markets and counteracted what would otherwise have been the competitive “crowding out” effect that government debt would have imposed on private borrowers. The demand for dollars drove up the price. Between 1980 and early 1985, the dollar’s value increased 89% against the West German mark and nearly 18% against the Japanese yen and Canadian dollar.

The dollar’s appreciation, together with high real interest rates (in terms of inflation) placed a heavy burden on American manufacturers competing against foreign goods. By 1985, hourly compensation costs for production workers were $12.82 in the United States, $9.60 in West Germany, $6.45 in Japan, $2.07 in Mexico and $1.44 in Korea. The United States, a high-cost producer, could operate profitably only when prices were also high. In the new world climate, America could not compete. Industries shut down. The Southwest and Midwest oil and agricultural booms of the ‘70s turned to busts.

Surprisingly, American exports maintained their share of stagnant world trade (they were 10.5% in 1980 and 10.7% in 1985) but America’s consumption of world imports, spurred by the high dollar, exploded from 11.8% to 17%. As dollars poured into world markets, depressed stock prices shot up. Real estate and stocks in Japan soared beyond logical measurements. Modest 1,000-square-foot houses sell in Tokyo for $1 million and up, stocks go for 70 to 80 times price-earnings--four times the traditional ratios in the United States. “You can’t put any fundamental values to it,” said Donald Ratajczak.

With prices soaring on foreign exchanges, American stocks looked more and more attractive. Prices were pushed up further in the United States by the exchange of equity for debt fostered by the new tax laws and raider mania. A. Gary Shilling points out that there was a $227-billion reduction of net equity between 1984 and 1986, greater than the total of $218 billion (in 1985 dollars) of new equity issued between 1959 and 1983.

At the beginning of 1987, the new tax law, bringing a shift from real estate and other investments into stocks, provided a further impetus. So did the apparent stabilization of the dollar. The United States currency had by then depreciated 45% against the mark and the yen. Yet while much has been made of this figure, supposedly the way to restore American competitiveness, it is misleading. The currency of our No. 1 trading partner, Canada, has appreciated scarcely at all, and that of our No. 3, Mexico, has continued to fall. There has been only marginal movement of the dollar against the currencies of the nics, where the United States has an ever-growing deficit; and even in Japan, labor costs remain substantially below American costs, while oil and commodity prices denominated in dollars have, in effect, become cheaper.

In this age of multinational companies and global production, “Made in Japan” and “Made in the USA” labels lose much of their meaning anyway. Multinationals produce components wherever it is most cost-effective. Not a single “American” car is without foreign parts. The European Ford Escort, theoretically German because it is assembled there, is in fact an amalgam of components produced in 15 nations on three continents.

Once established, production is not likely moved from one nation to another unless it becomes clear that exchange rates have changed on a permanent basis. And in some once-competitive industries, American producers no longer exist after the 1981-82 shakeout. In others, such as the manufacture of VCRs, there never were any, only a horrendous $580-million miscalculation by RCA to produce video disc players instead.

The October stock market meltdown began as a rational, thumbs-down appraisal of American economic and political sectors, of a President who refused to acknowledge economic realities and of so many would-be Presidents who tiptoe around the issues. With a 5% to 6% inflation rate looming and higher interest rates promising to put an end to the now-plodding economic recovery, any prudent investor might transfer money from stocks paying 2% to 3% dividends to bonds offering 9% to 10% returns.

Certainly the Wall Street meltdown will impel Americans to take a harder look at their economy. “There isn’t much understanding on the part of the public as to what the choices are,” said Penner. “There is still a belief that there are painless ways out of this, by cutting the other guy’s bill down and raising the other guy’s taxes. And we don’t seem to have the political leadership. You can’t really expect the public to know all the details of the budget, but they should have leaders willing to educate them.” On the other hand, with Sinai estimating that by 1990 U.S. annual interest payments on the twin deficits will total $235 billion, it would not be surprising if Americans followed Penner’s admonition to his congressional listeners: “You may prefer to go directly to the bar.”

Participants in The Times’ Economic Study The following economists participated in this survey of the United States and global economies. Evaluations in the article are the author’s, unless specifically attributed to a participant. MICHAEL J. BOSKIN, director, Center for Economic Policy Research, Stanford University. ANDREW F. BRIMMER, president, Brimmer & Co., Inc., Washington; member, Federal Reserve Board, 1966-1974. RICHARD N. COOPER, Martin C. Boas professor of international economics, Harvard University; under secretary for economic affairs, Department of State, 1977-1981. RUDIGER DORNBUSCH, Ford International professor of economics, MIT. ROBERT EISNER, William R. Kenan professor of economics, Northwestern University; president, American Economics Assn. MILTON FRIEDMAN, senior fellow, Hoover Institute, Stanford University; nobel laureate, 1976. DAVID GORDON, professor of economics, New School of Social Research, New York. WALTER W. HELLER (deceased), professor emeritus of economics, University of Minnesota; chairman, President’s Council of Economic Advisers, 1961-1964. RANDALL HINSHAW, professor emeritus of economics, Claremont Graduate School, Claremont; director, Bologna-Claremont (biennial) International Monetary Conference. IRWIN L. KELLNER, chief economist, Manufacturers Hanover Trust Co., New York. LAWRENCE R. KLEIN, chairman, Wharton Econometric Forecasting Assoc., Inc., University of Pennsylvania; nobel laureate, 1980. ROBERT LEKACHMAN, professor of economics, Lehman College, City University of New York. WILLIAM A. NISKANEN JR., chairman, Cato Institute, Washington; member, President’s Council of Economic Advisers, 1981-1985. WILLIAM D. NORDHAUS, member, President’s Council of Economic Advisers, 1977-1979; provost, Yale University. RUDOLPH G. PENNER, director, Congressional Budget Office, 1983-(March) 1987. DONALD RATAJCZAK, director, Economic Forecasting Center, Georgia State University. UWE E. REINHARDT, James Madison Professor of Political Economy, Woodrow Wilson School, Princeton University. ALICE M. RIVLIN, director, Congressional Budget Office, 1975-1983. CHARLES L. SCHULTZE, director, Bureau of the Budget, 1965-1967; chairman, President’s Council of Economic Advisers, 1977-1981. A. GARY SHILLING, president, A. Gary Shilling & Co., Inc., New York. ALLEN SINAI, chief economist and managing director, Shearson-Lehman Bros., Inc., New York. HERBERT STEIN, chairman, President’s Council of Economic Advisers, 1972-1974. JAMES TOBIN, Sterling professor of economics, Yale University; member, President’s Council of Economic Advisers, 1961-1962; nobel laureate, 1981. MURRAY L. WEIDENBAUM, director, Center for the Study of American Business, Washington University, St. Louis; chairman, President’s Council of Economic Advisers, 1981-1982.