Economists Now Find Deficit Isn’t So Bad : Faced With Cuts They Urged, Experts Fear Effect on Economy

Ever since the last recession ended in 1982, the nation’s economists have chorused a single warning: reduce the massive federal deficits, or economic recovery will be jeopardized.

Finally, prodded by the new Gramm-Rudman law, President Reagan has proposed a fiscal 1987 budget that would do just what the economic doctors ordered--slash the deficit by $38 billion next year and balance the budget by 1991.

And what are the nation’s economists saying now? They are warning that the cure may do more harm than the disease.

4% Growth Seen

The Administration insists that the economy can keep growing vigorously even if the stimulus of deficit spending is reduced. It forecasts after-inflation growth of 4% in 1986, a trend that it predicts will continue through the end of the decade. In the Administration’s view, inflation will remain at a moderate 3.5% this year, interest rates will continue to decline slightly and civilian unemployment will slip to 6.7% by the end of the year.

Reagan, in his budget message to Congress, said that the economy is in “one of the most vigorous” expansions in 35 years and gave much of the credit to reduced federal spending, lower taxes and deregulation. “We have put in place policies that reflect our commitment to reduce federal government intrusion in the private sector,” the message said.

In fact, according to Reagan, the economy should remain so robust that a balanced budget can be achieved under the Gramm-Rudman timetable even without further spending cuts after 1987. The growing tax revenues generated by a thriving economy will steadily erode the deficit, the Administration says, until a $1.3-billion surplus materializes in 1991.

For fiscal 1987, which begins Oct. 1, the Reagan budget calls for a $143.6-billion deficit, $38 billion smaller than would be produced by current taxing and spending laws. If Congress fails to adopt the Reagan budget or otherwise to reduce the deficit to the Gramm-Rudman ceiling of $144 billion, the new law mandates across-the-board spending cuts deep enough to reach that ceiling.

Starving Fiscal Engine

However, many economists argue that such drastic austerity measures--whether imposed by Reagan’s proposed budget cuts or by across-the-board cuts under Gramm-Rudman--would starve the fiscal engine that has kept the economy growing for the last three years. Already, they note, the engine is sputtering: Last year’s economic growth was only 2.3%, ominously short of the Administration’s predicted 4%.

“If the economy is growing weakly, we should not subject it to a dose of fiscal restraint, which would only make it weaker,” cautioned Irwin Kellner, chief economist of Manufacturers Hanover Bank in New York. “The time to reduce the deficit was earlier in the cycle when the recovery was stronger.”

Allen Sinai, chief economist at Shearson Lehman Bros., said that the Gramm-Rudman law reminds him of “a cat chasing its own tail. The larger are cuts in the deficit, the weaker is growth. The weaker the growth, the larger the deficit, so the cuts have to be still larger.”

Robert Gough of Data Resources Inc., a forecasting firm in Lexington, Mass., urged Congress to discard the Gramm-Rudman timetable and schedule more gradual deficit cuts. “This red ink took a while to materialize and it will take a while to wipe out,” he said. “You just have to be patient over time.”

Voiding Gramm-Rudman

Indeed, many economists expect Congress to overturn the Gramm-Rudman law and permit deficits substantially larger than the act permits.

“Gramm-Rudman is a hoax,” said Michael K. Evans, head of his own Washington economic consulting firm. “They will never enforce it. If I really thought the government was going to, I’d forecast a recession. But I don’t have that in my forecast.”

However, if Congress persists with Gramm-Rudman, Gough added, the Federal Reserve Board could compensate by loosening its grip on the money supply. The resulting lower interest rates, he said, could provide enough economic stimulus to offset the drag of the shrinking deficit.

Federal Reserve Chairman Paul A. Volcker has shown signs recently of moderating his once militant tight-money stance, which wrung inflation out of the economy in the early 1980s at the cost of record high interest rates and two recessions.

Volcker has cooperated closely with Treasury Secretary James A. Baker III’s strategy for lowering the value of the dollar in international exchange. And he attended a recent London meeting between Baker and the finance ministers of the four other major industrialized nations, which was widely believed to mark the start of a campaign to lower interest rates worldwide.

Some economists, conceding that massive deficits are nearly inevitable for years to come, are beginning to challenge the conventional wisdom that the deficits, which have totaled more than $800 billion over the last four years, must be curtailed if not abolished.

Predictions Prove False

Predictions that the deficits would push the economy into an abyss thus far have proved false. The theory that massive government borrowing would “crowd out” private investment and send interest rates through the roof has not become reality. Instead, foreign investment kept money circulating at a level perfectly normal for the longer-than-average recovery that the economy is enjoying, and a flood of imported goods has satisfied what economist Walter W. Heller characterized as a “consumer binge.”

Now, the prophets of economic doom are concentrating on the possibility that foreign investors will cut back or reverse the rush of foreign investment, which has turned the United States into a debtor nation for the first time since 1914. C. Fred Bergsten, a top Treasury Department official for President Jimmy Carter, warned that the United States under Reagan has accumulated foreign debt “faster than any country in recorded history.”

Bergsten, who heads the Institute for International Economics, warns that the consequence will be an international economic crisis as foreigners lose confidence in the American economy and sell off their U.S. investments. The value of the dollar could fall precipitously and interest rates and inflation could skyrocket, he says--and a global recession could develop.

But, to many economists, this new theory of deficit-driven disaster is no more compelling than the old “crowding out” scenario. Edward M. Bernstein, former research director of the International Monetary Fund, says that foreigners are investing in the United States because this is where they can make a safe and healthy profit.

Foreign Pull-Out Discounted

Fears that foreigners will suddenly sell their U.S. investments are grossly exaggerated, he said. “The huge inflow of capital to the United States was due to a preference on the part of foreigners to have assets here,” he said. If the deficit were going to scare foreign investors out of the United States, he contended, they would have pulled out long ago.

If the record so far does not support the doom-sayers, it does not offer total comfort to the optimists either. The Administration’s persistent predictions that the nation would grow its way out of the deficit also have fallen short year after year.

Now, White House Budget Director James C. Miller III argues that, if Congress will only accept Reagan’s dose of fiscal austerity for next year, economic growth will take care of the rest and rising tax revenues will overtake spending by 1991, the Gramm-Rudman deadline.

But Miller’s projection requires growth of nearly 4% through 1991, a prolonged period of prosperity that practically no economist foresees. When 1991 finally arrives, most analysts think, the budget debate will have the same focus as it does today--a massive and irrepressible federal deficit.