Wall Street Votes for Lower Deficit

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IRWIN L. KELLNER <i> is chief economist at Manufacturers Hanover in New York</i>

The American people get to vote for President once every four years. For the financial markets, however, every day is Election Day. By buying and selling various financial instruments such as stocks, bonds and the dollar, market participants constantly render their collective judgments on anything and everything they believe will affect their portfolios. Although the number of buyers and sellers always match up, prices will move higher or lower, depending on who is more anxious to make the transaction--the buyer or the seller.

In the months and weeks prior to this year’s presidential election, stocks, bonds and the dollar all rose. However, by plummeting after George Bush was elected the nation’s 41st President, these markets sent a message to the President-elect: “Read our lips--and look at our sell orders. We’re worried about how you will deal with the country’s economic problems.” The stock market’s decline in particular was significant: In the past it has usually risen immediately after the election of a Republican as President.

What’s bothering the markets, apparently, is the budget deficit and how it will be dealt with by a President who may have painted himself into a corner by simultaneously promising to spend more on defense, education and the environment; leave Social Security untouched; reduce capital gains taxes, and propose no new taxes.


To be sure, budget deficits are nothing new. In the postwar era, Washington has avoided annual red ink only eight times; the last budget surplus was in 1969. Even the fact that the deficit is much larger than it used to be is old news, since it has been in 12-digit ($100 billion or larger) territory every year beginning with 1982. What’s more, the deficit has already begun to decline, both in actual dollars and as a percent of gross national product. The deficit as a share of GNP has shrunk from nearly 5.5% to little more than 3% in only two years.

However, even as the deficits of the past two years have shrunk as a percent of GNP, the accumulated debt (the result of the deficits of years past) has continued to rise. In nominal dollars, the government’s outstanding debt has nearly tripled since Ronald Reagan took office, rising from $914.3 billion in 1980 to more than $2.6 trillion today.

Relative to the size of the economy, this massive dose of red ink has lifted Washington’s debt to 55% today from 34% in 1981, the highest since 1961. While it has been higher (it reached 127% of GNP right after World War II), there are several key differences today that you should be aware of.

For one thing, interest rates are much higher today than they were in the 1960s or the 1940s. The average rate that the government pays to service its debt today is 8.85%, compared to about 3% in 1961 and less than 1% in 1946. What is more, a greater share of government spending is going to service its debt. Today’s share of 14% is now back to its postwar high, reached 40 years ago. The government has to pay ever-larger sums of money to holders of Treasury bills, notes and bonds. Indeed, in fiscal year 1988, the government’s interest expense was as large as its budget deficit.

Some would ask: Why worry--it’s money we owe to ourselves? My answer: That is increasingly untrue. Today, foreigners own 12% of Washington’s outstanding debt, compared with 4.5% in 1970. This means that an increasing chunk of the interest that Washington pays to service its debt is going overseas, and is not being recycled into our domestic economy.

With this in mind, I would like to add my words to the chorus of suggestions as to how the deficit can be done away with. We should first make every effort to cut spending, since the true burden of government on the economy is on the spending side. Having said this, you should remember that there is one uncontrollable expense that must be allowed for and that is interest. Given enough time and willpower, the government can cut (or hold the line on) any other expenditure--but it must meet its debt-service payments or face default.

It seems to me that the President-elect is on the right track when he calls for a freeze in overall government spending after adjusting for inflation. If implemented with only the interest expense exception, it would produce a budget deficit of $60 billion in 1993, half as large as present projections by the Congressional Budget Office.


Besides reducing the government’s burden on the economy, cutting spending growth is important politically as well. For years, politicians have embraced the “buy now, pay later” budget system as a way of getting elected, while the American people have encouraged this by constantly demanding more from Washington than they are willing to pay for in the form of taxes. Freezing non-interest spending would enable the incoming President and the Congress to convince the American people that everyone is “sacrificing” uniformly for the common good.

You will notice that I said a paragraph ago that this approach would still leave us with a deficit by 1993. Financial considerations demand quicker results. There simply won’t be enough money to finance the resulting mountain of debt--neither from the United States, nor from abroad--without a sharp rise in interest rates. To eliminate the deficit in, say, four years, the Administration will have to supplement its spending “freeze” with enhanced revenues.

Starting with the notion that virtually no one wants to see personal or corporate tax rates rise, increased revenues can be generated through the imposition of a number of what might euphemistically be called “user fees.” A tax on imported oil, a value-added tax and an increase in so-called “sin taxes” on alcohol and tobacco could produce enough revenue to close the gap and produce a budget surplus by 1992.

Read our lips, Mr. Bush--eliminate the deficit.