Massive Deficit Reduction Has Perils, Analysts Warn

The U.S. economy has grown without interruption over the last 7 1/2 years, despite record-setting federal deficits. So why is it so important to cut the deficit right now?

The answer, many economists sheepishly admit, is that it isn’t. Deficits do matter, but not for the Chicken Little “sky-is-falling” reasons most Americans have been hearing for the last decade. In fact, as long as the national debt does not grow much faster than the economy itself, the United States probably does not face any day of reckoning for its profligate ways.

Nor are the politicians being candid about the real reason they recently have convened high level budget negotiations between Congress and the White House. The political reality of the Gramm-Rudman deficit reduction law, which would require huge funding cuts this fall that could drive the country into an election-year recession, has more to do with the current budget negotiations than any pieties about the health of the economy.

If the issue were only economic, it might be far simpler. The annual federal deficit, at $152 billion last year, has been shrinking for several years in response largely to higher tax revenues from an expanding work force and a sharp retrenchment in the once-exploding Pentagon budget. From a peak of 6.2% of the U.S. economic output (the gross national product, or GNP) in 1983, the federal deficit has fallen to less than 3%.

That’s still high, but the gap between spending and revenues is no longer so wide that it threatens to push the government’s borrowing costs uncontrollably upward.

Moreover, the total federal debt owed to foreign and domestic lenders has stabilized. “As a percentage of GNP, it has been falling in recent years and now stands at about 40%,” writes Martin Anderson, a conservative economist at the Hoover Institute in Palo Alto who once served as an adviser to former President Ronald Reagan. “That is lower than at any time from 1945 to 1965. It was not a serious problem then,” he contends, “and it is not a serious problem now.”

“All in all,” concludes Charles Schultze, a leading mainstream Democratic economist at the Brookings Institution here, “the wolf is not likely to appear at the door.”

There is, however, one real risk to the economy if the current budget talks fail. The Gramm-Rudman law--tattered symbol of the government’s promise to some day balance the budget--sets a deficit target of $64 billion for the next fiscal year.

Gramm-Rudman, by mandating automatic spending cuts equally divided between defense and domestic programs for failure to meet its targets, was accepted by Congress and the White House in 1985 as a desperate bid to force themselves into reducing the deficit more rationally.

But in large part because of the temporarily soaring cash needs of the savings and loan industry salvage operation, the gap between spending and revenues is expected to widen next year to as much as $175 billion to $200 billion. Trying to achieve the goal demanded by Gramm-Rudman would require the government to slash the deficit suddenly by such a massive amount that the jolt almost certainly would throw the economy into recession.

As a result, Washington’s strongest motive for cutting the deficit is not so much to improve the economy as to prevent a painful political backlash. The popular Gramm-Rudman law, already revised once in 1987, needs to be gutted again to avoid Draconian automatic spending cuts in October--just before this fall’s election. Congress and the White House can justify doing so only by providing themselves enough cover to argue that they are making at least a credible dent in the deficit.

In short, the main reason to try to narrow the budget gap this year is to avoid having to slash it even further.

That paradox is just starting to sink in here. Today, even the toughest budget hawks want to pull back from the brink.

Letting the Gramm-Rudman time bomb go off, one of its co-authors, Sen. Ernest F. Hollings (D-S.C.), now admits, would be like detonating “a nuclear explosion” in the middle of a bustling American city. “If we allow that to happen,” he says, “nobody ought to get reelected in November.”

To get themselves off the hook, Administration officials and lawmakers have been talking about a substantially smaller deficit reduction package of spending cuts and tax increases that might add up to as much as $50 billion for the fiscal year that begins on Oct. 1.

Any package much larger than that, acknowledges Rep. Leon E. Panetta (D-Carmel Valley), chairman of the House Budget Committee and a longtime advocate of far-reaching budget changes, “could end up doing more harm than good.”

Even cutting the deficit by $50 billion, if done honestly through spending cuts and tax increases that would continue to narrow the budget gap over the long term, would mark an unprecedented accomplishment after years of political stalemate.

Yet it would also require President Bush to abandon openly his “read-my-lips, no-new-taxes” pledge, a change that would strip Republicans of a popular campaign position.

Nervous White House officials are looking to the Federal Reserve to help make such a bitter pill easier to swallow. They hope that the central bank, with its powerful sway over U.S. interest rates, will push rates down and pump more money into the economy in return for the White House and Congress agreeing to shrink the budget gap.

Most mainstream economists think that is exactly what the central bankers would do.

“To the extent lower interest rates would . . . keep up the pace of economic expansion after a deficit agreement, I’m sure the Fed would go along with that,” said Lyle Gramley, a former Fed governor who is now chief economist at the Mortgage Bankers Assn. “But that is not something (Chairman Alan) Greenspan can promise in advance because of the risk that circumstances might change in an unexpected direction.”

Fed officials, however, make an important distinction between an active monetary policy and a more reactive one. They argue that the Fed’s chief task is to fight inflation. As a result, several top officials argue, the central bank should ease credit only after long-term rates fall of their own weight in the bond market without any help from the central bank.

If Congress passes a deficit-cutting package that is credible “in a sense that the markets believe it is for real,” the Fed chairman told a House Banking, Finance and Urban Affairs subcommittee recently, “I have no doubt . . . real interest rates will indeed fall.”

But what’s a credible package? That depends on whom you listen to.

Mainstream economists argue that almost any combination of spending cuts and tax increases would be desirable because it would help reduce the federal government’s drain on world savings. Although cutting the deficit might crimp consumption in the short run, they argue, it would free more funds for private investment to strengthen the long-term outlook for the economy.

“In short,” says Schultze, “the nation would consume less and save more, and the higher saving would lead to some combination of more domestic investment and less borrowing from abroad.”

Conservative analysts, however, take a much more skeptical view of any deficit agreement that significantly boosts taxes. To most of them, it is far more important to keep government spending under control than simply to wipe out the federal deficit.

“Higher taxes will only make it easier for Congress to spend more money and would weaken the economy. That means they won’t make as much of a dent in the deficit as they claim,” contends Larry Kudlow, chief economist at Bear Stearns & Co., a Wall Street investment firm.

“You have to look carefully at any deficit agreement,” adds Kudlow, who briefly served under David A. Stockman, who headed the White House Office of Management and Budget in the Reagan Administration. “If it focuses on keeping tax rates low and controlling spending, then that will be bullish. But if it raises taxes too much, investors will flee the markets.”