RISING FACTORY PRODUCTIVITY IS GIVING THE EXPANSION ROOM TO RUN
By MAUREEN F. ALLYN CHIEF ECONOMIST Todd May Jr. ASSOCIATE ECONOMIST Vivian Brownstein STAFF ECONOMIST Maureen F. Allyn RESEARCH ASSOCIATES Catherine Comes Haight, Lenore Schiff FORTUNE's forecast is produced by this magazine's economists using our own economic model.

(FORTUNE Magazine) – One of the problems with reassuring paranoiacs, as any psychiatrist will tell you, is that their fears are not always groundless. That's also true in the case of economy watchers, who often seem compelled to find threats lurking around every corner. In FORTUNE'S semiannual 18-month forecast last issue, we acknowledged a number of anxieties but confidently concluded that the long U.S. economic expansion would last at least through 1989. On second thought we're still convinced that the edgy economists who predict a more imminent downturn are simply being, well, paranoid. Unemployment is at a remarkably low 5.3%, but wages have speeded up less than expected. Capacity use is climbing, but remains comfortably below past peaks. The dollar isn't collapsing and isn't about to; in fact, the markets seem to want it to go a bit higher. And the news on productivity, while not the sort of thing to grab headlines, should prove soothing to jangled nerves. FORTUNE does predict slightly better growth in 1989 than the consensus, as measured by the Blue Chip Economic Indicators (see chart, page 26). But most forecasters agree: A slowdown in growth rates is the worst we can expect next year. For those who fear inflation will deal the expansion a lethal blow, the 3.6% rise in nonfarm business productivity in the first quarter should come as unalloyed good news. Productivity is the perfect antidote to inflation. Every gain in productivity squeezes more output from existing resources without adding to costs. Among manufacturers, productivity has been improving smartly for some time. Since the current recovery began, it has risen faster than in any previous postwar expansion. From 1983 to early 1986, year-over-year productivity growth raced ahead at a 5% to 6% clip. In part that reflected the normal rebound that occurs when capacity idled by recession comes back onstream. Downsizing and shutdown of inefficient plants also produced large one-time payoffs. But for the past two years, manufacturing productivity growth has maintained a 2.5% to 3% trot. FORTUNE believes -- and experts agree -- that this very respectable pace looks sustainable. Says Jerome A. Mark, associate commissioner for productivity and technology at the Bureau of Labor Statistics: ''With manufacturing more competitive, encouraging increased output, no one should say productivity growth at recent rates can't go on.'' U.S. industry's current competitive strength is far more than just a mirror image of currency weakness, though the lower dollar helps enormously. In a new study, the Federal Reserve Bank of New York identifies improved quality, high investment levels, increased R&D spending, and industrial restructuring as other key fortifiers of America's industrial muscle. In particular, the report's authors note that from 1980 to 1986, U.S. gross investment per manufacturing employee was, on average, 24% higher than in Japan and 60% higher than in West Germany. The productivity picture in nonmanufacturing -- loosely labeled ''services'' in our chart -- is less bright. Last summer service productivity finally climbed above its previous peak in 1978. But with domestic demand set to slow, nonmanufacturing industries, which derive relatively little benefit from the growing foreign appetite for U.S. products, will do no better than hold on to their gains. You might think that the current burst of computer buying and investing in information networks by American business would help. (For more on the upheaval roiling the U.S. computer industry, see Competition.) Think again. Who hasn't watched an entire office screech to a halt because ''the computer is down'' and otherwise productive humans are left helpless to answer the simplest question? Where is the middle manager who hasn't watched -- and mourned the loss of strategic perspective -- as his chief executive spent hours poring over a 40-page printout of daily operating statistics? In a provocative new Brookings Institution study, Innovation and the Productivity Crisis, Martin N. Baily and Alok K. Chakrabarti explain why computers so often prove the enemies of output. For starters, they rarely reduce a company's white-collar head count. Only humans can ultimately make sense of what these electronic marvels churn out, so the cheaper computer- + generated information becomes, the more you buy and -- as night follows day -- the more people you need to tell you what it all means. Worse still, as Brookings's authors observe, managers in the vanguard of the computer revolution rarely have understood the technology well ''and were often at the mercy of technical staffs who were not tuned to the larger goals of their companies.'' SUCCESS STORIES in using computers productively do exist, of course. Telecommunications, commercial banking, and some sectors of transportation have all done well. But they are the exception, not the rule. To jack up white-collar productivity another notch and take advantage of the coming revolution in networking technology, managers must think even harder about how to target computer use toward furthering their companies' critical objectives. If they do, breakthroughs in service productivity are definitely possible. Within the 18-month horizon of FORTUNE'S forecast, however, manufacturing productivity will have to carry the ball. We expect it to do so with style, grace, and speed enough to elude the tacklers. The fiercest of these remains the risk that the economy might yet overheat. Over the past year demand has been so buoyant that, despite higher productivity, total industry operating rates have risen more than 2.5 points, hitting 82.9% in May. That's the highest level of capacity use since March 1980, when a credit crunch was propelling the economy into recession. Sounds ominous -- unless you also recall that capacity utilization during the last economic upturn first hit 82.8% way back in June 1977. Yet the economy carried on at close to that rate or higher for 34 months. Similarly, industry was running at 82.7% of capacity by March 1972, a full 20 months before expansion tumbled into recession. At the peak, rates soared to 88.6%, almost six points above where we are today. Admittedly, a few key industries, such as paper, chemicals, and textiles, are much closer to running out of room than the broad numbers suggest. But that bad news is old news. The good news is that since December, factory operating rates among all three have retreated convincingly. The troubling trio have also announced sizable capital spending plans, which should make it easier for them to increase output in line with more slowly rising demand. Overall, American industry's utilization rate will rise a bit more in coming months, largely because durable-goods makers will pump out more trucks, < machinery, and, yes, computers -- many of them for export. But factories producing durable goods are operating at only 81.6% of capacity, and more output won't strain them. AND WHAT OF everyone's other ogre, a sudden collapse in the dollar? Even without a clear answer to the question presently distracting easily distractible currency traders -- what do central bankers want? -- here, too, the latest news is good. As quick as you can revise a trade statistic, sentiment on the U.S. dollar has shifted from bearish to bullish. Gone for the moment is the fear of a dollar hard-landing that could force the Fed to raise interest rates. Meanwhile, risks to the economy of a strong upward move in the dollar are very low. First, the dollar isn't likely to rise far. Improve though it may, America's current account deficit -- lately running at a $160 billion annual rate -- will continue to spew lots of additional dollars into the international system. That very abundance in turn ensures a fairly tight lid on the greenback's price. Far from being harmful, a modest rise in the dollar eases pressure on interest rates and inflation, without in any way endangering the vital U.S. export drive. Tomorrow or next week is sure to give rise to a new crowd of potential economy bashers. One day one of them will do more than slow things down. So it makes sense to stay wary. Still, you've got to be at least a little paranoid to spy a killer in the current bunch. And when the consensus calls for a year and a half more of growth to add to the 68 months we've already had, surely at least half a smile is in order.

BOX: OVERVIEW -- Growth at a slower rate is the worst we can expect through 1989. -- Mismanagement of computers is retarding white-collar productivity. -- Industry operating rates will stay below previous peaks. -- Give two cheers for a somewhat stronger dollar.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: STEPPING ON THE GAS Productivity is on an upswing in factories like this Mazda USA plant in Flat Rock, Michigan. But services are stalling. DESCRIPTION: Productivity growth in manufacturing and services from 1983 through first half of 1988 with estimated forecast for last half of 1988 and all of 1989.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: DOWN FROM THE PEAK FORTUNE and the Blue Chip consensus agree: GNP growth will slow in 1989 but the economy won't slide into recession. DESCRIPTION: Percentage change in real GNP growth from 1983 through 1987 with projections for 1988 through 1989.