Economists Split on Where U.S. Is Headed : Panel Agrees Deficit Is Key Issue but Divides on Chance of Recession
The Los Angeles Times’ panel of distinguished economists reached a standoff this year, equally divided over whether 1989 will be the year that a recession finally halts America’s longest postwar boom.
But the six members of The Times’ Board of Economists who participated in the year-end survey more or less agreed that three key issues will determine 1989’s economic fate. These are whether the Bush Administration and Congress will agree on meaningful steps to lower the budget deficit; the reactions of foreign investors, especially the Japanese, to economic developments here, and whether American consumers, loaded down with record levels of debt, will nevertheless continue to spend beyond their means.
As always, the Federal Reserve Board’s role in setting interest rates, largely in response to these issues, also is considered crucial.
The economists’ forecasts differ so widely mainly because they hinge on predictions of human behavior and the outcome of political maneuvering in Washington, rather than simple number-crunching.
The bright note this year is that the board of economists as a group is somewhat less pessimistic now than a year ago. Jarred by the October, 1987, stock market crash, five out of eight board members last year predicted recession in 1988. But the American economy romped right past the crash, growing by at least 2.6% last year.
Only six economists participated this year because two have been enlisted in the service of the Bush Administration. Michael A. Boskin resigned from the board because he was named chairman of the President’s Council of Economic Advisers. Board member Allan H. Meltzer, a professor of political economy and public policy at Carnegie Mellon University, declined to participate because he is now serving as an adviser to the President’s council.
The three who predict no recession in 1989 are George L. Perry, a senior fellow at the Brookings Institution in Washington; Paul R. Krugman, a professor of economics at the Massachusetts Institute of Technology, and Irwin L. Kellner, chief economist at Manufacturers Hanover in New York.
But those who predict that the expansion will come to an end in what is now its seventh year are Robert Lekachman, professor of economics at Lehman College of the City University of New York and author of “Visions and Nightmares: America After Reagan”; David M. Gordon, economics professor at the New School for Social Research in New York, and A. Gary Shilling, a New York-based economic consultant and author of “The World Has Definitely Changed.”
While the budget deficit has been a big concern in past years, this year the economists agree that it is a pivotal question for the U.S. economy in 1989. One reason is that the budget deficit, and the related U.S. trade deficit, have become key determinants for how foreign investors and foreign central bankers react, driving the dollar down or up, and making foreign capital for investment here plentiful or scarce.
The two economists who believe that Congress and the new President will be able to agree promptly on budgetary steps serious enough to impress the jittery world markets predicted that the economic expansion will continue at least one more year, although the economy will probably grow at a slower rate. One, Krugman, predicted no recession even though he doubts that there will be much progress on the deficit this year.
But the rest, who don’t expect agreement this year on spending cuts or a combination of spending cuts and tax increases predicted a recession.
The recession scenario generally goes like this: A marked failure to do something about the deficit could cause the dollar to drop dramatically against major foreign currencies such as the yen and the West German mark as foreign investors conclude that the U.S. economy isn’t such a good investment and foreign central bankers decide that there is no longer any point to propping up the dollar. The Fed responds by sharply raising interest rates to attract back foreign investors (higher interest rates on investments help compensate investors for a depreciating dollar) and to choke off inflation that may be caused by more expensive imports.
But a big hike in interest rates could easily end the expansion and would be particularly dangerous at a time when both individuals and companies are loaded up with record levels of debt.
Making the situation even more fragile, says Shilling, is that record amounts of both personal and company debt are now subject to fluctuating, variable-rate interest payments. This includes variable-rate mortgages, home equity loans and credit card accounts for individuals, as well as variable-rate borrowing by companies. As a result, Shilling says, any big hike in interest rates would be felt almost immediately throughout the economy, triggering bankruptcies and an abrupt drop-off of consumer spending.
Shilling foresees a recession starting in the first half of 1989, setoff in part by the Fed raising interest rates to choke off a perceived threat of renewed inflation and to make up for an expected loss of confidence in the American economy by foreign investors. “It will be a classic case of the Fed being forced to raise short-term interest rates to recession-precipitating levels,” he says.
Shilling also sees the first strong signs in some time of fear by industry that inflation, currently at a relatively low rate of 4.5% annually as measured by the consumer price index, is about to take off. Companies, he says, are doing the first hedge-buying of inventory--stocking up on supplies in expectation that prices are about to go up--since the 1970s.
Lekachman, another predictor of recession, owns up to having forecast a downturn every year for the past four years. But he maintains that “the chances are about 2 to 1 that by the fourth quarter of 1989, we’ll see the recession.” He predicts that the main cause will be Japanese investors and Japan’s central bank, responding to what they view as a weak U.S. President and a political “mess” in Washington’s approach to the deficit. Lekachman notes that the United States depends on a massive influx of foreign capital and says he detects signs that the Japanese are increasingly willing to throw their weight around on the global economic scene.
If the Japanese lose confidence in Bush’s ability to reduce the deficit, they may well reduce their buying at U.S. Treasury auctions, which in turn could sharply push up U.S. interest rates. “This will be the classic trigger for a recession,” he says.
Gordon foresees a particularly deep recession. “It’s going to be pretty nasty because of the mountainous levels of personal and corporate debt,” he says.
But Kellner, a member of The Times’ board who last year predicted a recession, this year thinks the economy will squeak by with another reprieve. Kellner thinks that despite the political problems, the Bush Administration will win an agreement this year with legislators on a plan to eliminate the deficit over four years. This, he maintains, would be enough to satisfy foreign investors and Japanese and European governments and allow the Fed to ease up on its current tight-money policy.
In addition, Kellner predicts a slackening of consumer spending sufficient to keep inflation in check but not severe enough to induce a recession. Of the six economists, Kellner alone expects consumer spending to slow significantly without a sharp jolt of higher interest rates first.
Economic forecasters consider consumer spending extremely important to their calculations since it makes up about two-thirds of the nation’s economic activity. (Slightly under half of this goes for items bought in stores, the rest goes for rent, health care, transportation and other services.)
Kellner believes that consumers are getting exhausted from years of increased spending and are about to cut back. With employment high, he says, “There is no pent-up demand for big ticket items people delayed buying because they were out of work.”
He also notes that prices of expensive consumer items have risen faster than most peoples’ incomes. “Given that the cost of big-ticket items has gone up faster than incomes, people have bought about all they’re going to buy,” he asserts. As evidence, he cites the fact that consumer spending, adjusted for inflation, was lower this fall than it was two years earlier.
The rest of The Times panel, however, doubts that consumers are likely to begin acting so rationally. Some say that during the past eight years, encouraged by the economic boom and the Republican Administration’s supply side economics, the habit of spending much and saving little has become ingrained. “Ronald Reagan . . . really has gone a long distance to reinforce the American attitude of spend today, pay tomorrow,” says Lekachman.
Shilling, too, sees no signs of consumer spending slowing down. He notes that the stock market crash didn’t shock consumers into spending less. “The consumer just isn’t giving up,” he said. “People are way overextended. They’re borrowing to pay their bills. People don’t want to give up on the American dream of ever-increasing purchasing power.”
‘Economy Pretty Healthy’
Early indications that 1988 Christmas buying was relatively strong seem to give credit to those who see no falloff of consumer spending. One fear is that continued strong consumer demand will add to inflationary pressures, forcing the Fed to continue raising interest rates.
But Perry, although he foresees little change in consumer spending levels this year, says he isn’t particularly worried. “I think the economy is pretty healthy,” he states, adding that he thinks a recession in 1989 is unlikely. “People have predicted it every year, and every year they’ve been wrong,” he says.
He believes that the economy is slowing a bit and that the gross national product--a measure of all goods and services produced in the economy--will continue to grow at an acceptably low rate of about 3% in 1989. Perry doubts that foreigners will become so concerned about the U.S. economic situation that they will begin dumping dollars. And he said that any substantial improvement in the budget deficit would be met by a decline in interest rates.
He gives the Fed credit for keeping growth rates and inflation in check. “The Fed is doing what it traditionally has done, to lean against the wind,” Perry says. “It sees an expansion that is still pretty vigorous, and it’s letting interest rates rise to take a little steam out.”
Krugman, while not completely ruling out the possibility of recession in 1989, sees a greater risk of an overheating economy. “The fundamentals are that we still have very strong domestic demand and a weak dollar,” he says. He believes that the Fed will continue to nudge up interest rates, even enough to send some highly leveraged companies into bankruptcy. But because demand is so strong, he doesn’t predict a full-fledged recession. Because with the wave of corporate takeovers and leveraged buyouts companies are heavily indebted, “what we have is a strange economy--you could have a lot of bankrupt companies working at (full) capacity.”