The Great Deficit Dilemma

By Christopher Byron

Another flood of red ink dismays economists, bankers and consumers alike

The irony is all too obvious: Ronald Reagan, who built a political career, in large part, out of making lacerating attacks on Democrats for runaway spending and ballooning federal deficits, now finds himself presiding over an economic policy that threatens to produce the biggest run-up of federal debt in American history.

During the 31 years between 1950 and Reagan's Inauguration last January, the federal deficit swelled by about $430 billion. Yet in the four years of this Administration the national debt may well increase by an incredible $400 billion more. Including so-called off-budget expenditures, such as federal-loan-guarantee programs for farmers, students and small businessmen, the Administration's real credit needs by 1984 will be a towering $1.4 trillion. The question that now hangs like a shroud over Reaganomics is whether the economy can endure such huge deficits and borrowing requirements.

Quarrels about the effects of deficit spending by Government are as old as modern economics itself. Since the 1930s, followers of Britain's John Maynard Keynes have argued that deficit spending during recessions is not only justified but is often the only way to end periodic slumps in the business cycle. Experts generally agree that it was the huge deficit spending of World War II that finally got the U.S. out of the Great Depression.

Keynes, however, did not believe that deficits were necessary in periods of economic expansion. Nonetheless, the U.S. has run a deficit in both good and bad economic times for 20 out of the last 21 years. Conservative economists, and even some liberal ones, have long warned that inflation or recession, or perhaps both at once, would inevitably result from such free-spending policies.

Liberals and conservatives are joining forces now to warn of the dangers of the deficits. Walter Heller, a Democrat who was chief economic adviser to both John Kennedy and Lyndon Johnson, argues that the Administration's deficit spree might induce such tight money that it would abort any recovery. Heller wants to shrink the deficit mainly by raising taxes in 1983, a step that could batter the economy even lower. Some conservative economists predict that the result of the red ink will be higher interest rates. Says Burton Malkiel, an adviser to Gerald Ford and now dean of the Yale School of Organization and Management: "You have a $100 billion deficit running smack against a tight rein that the Federal Reserve has held on the money supply. That will push up interest rates."

Attempts last week by Administration officials to play down the importance of deficits sounded both forced and weak. Reagan spokesmen, for example, have been saying that the deficit is not so important because the new tax cuts will increase the savings rate and thus enlarge the amount of money available for borrowing. They point out that both Japan and West Germany run higher deficits than the U.S. in relation to the size of their economies, yet that is not a serious problem for these two countries because their level of savings is more than twice that of the U.S. Said Treasury Secretary Donald Regan last week: "By 1984 we'll have an additional $250 billion in the savings pool. That is way more than enough to handle the increased deficit."

Many private-sector economists dispute this view. Michael Evans, who runs an economic consulting service in Washington, notes that Americans traditionally do increase their savings right after a tax cut. There are already some signs that this happened after the 5% tax reduction last October, and it is likely to occur again when the rate drops another 10% on July 1 this year and a final 10% next year. After a brief increase in savings, Evans points out, consumers have usually "adjusted their spending habits gradually upward," and the savings rate drops down to its previous level. Thus the Government probably cannot count on a significant, long-term increase in the savings rate to offset the rising deficit.

In his State of the Union message, President Reagan contended that there were too many "imponderables" to have much faith in any deficit projections. He is right about that. Past deficit predictions have almost always been wrong, usually because they were badly underestimated. Jimmy Carter originally predicted that the 1981 deficit would be $15.8 billion. It was actually $57.9 billion. Thus, if past performance is any guide, the Reagan estimates are probably too low. Many experts are already saying that the Administration's outlook for $98.6 billion in red ink during 1982 is too optimistic. Alice Rivlin, director of the Congressional Budget Office, predicted last week that the figure is more likely to be $109 billion.

Other arguments by top Administration officials in defense of deficits simply add to the confusion and doubt. Testifying before the Senate Government Affairs Committee last week, Budget Director David Stockman attempted to wave away the disruptive threat of projected Administration deficits by arguing that they will constitute a smaller proportion of a larger economy than before. The claim is a very weak reed to lean on. During Jimmy Carter's peak deficit year of 1980, the red ink reached $59.5 billion, or 2.3% of the nation's $2.6 trillion gross national product. By contrast, the CBO's projected Reagan deficit of $109 billion for fiscal 1982 will be at least 3.6% of the G.N.P., or within .3 of a percentage point of the previous biggest deficit year in the nation's peacetime history, 1976, when Gerald Ford ran a deficit of $66.4 billion.

Nor is the Administration very convincing when it argues that the deficits will prove somehow less disruptive than earlier ones because they will be caused by tax cuts instead of increased Government spending. That distinction actually means little since the impact of the deficits will be the same: they will soak up capital that could otherwise be used for productive, job-creating investment. Says Otto Eckstein, chairman of Data Resources Inc., an economics consulting firm: "In the situation that we have now, deficits do not necessarily mean inflation. But they do mean loss of capital formation and productivity. That is the kind of thing this Administration does not want to face up to. They are living in a dream world. If this continues, you might as well hold the funeral for industrial progress now."

The first danger that deficits pose to the economy is that they drive up the cost of borrowing money, making it impossible for some firms even to obtain funds. Since it has the best credit rating of any borrower in the market, the Federal Government, in effect, has first call on the money available. Only then can corporations or individuals look for cash. The more the Government takes, the less will be available for the private sector. Financiers along Wall Street are now saying that federal credit demands are crowding out private ones.

The second danger of deficits is that the Federal Reserve will attempt to keep credit available by increasing the money supply. The result would be still more inflation. "As a general rule, deficits are by their very nature harmful," says Alan Greenspan, former chief economic adviser to Gerald Ford and now an unofficial adviser to the White House. "Deficits either pre-empt credit available to nongovernmental borrowers or, to prevent that from happening, the Federal Reserve winds up pumping more money into the economy, which causes inflation to rise."

Bankers and moneymen are deeply worried by the prospect of a steady flood of gargantuan federal credit demands. Says David Jones, an economist with the New York-based Government securities firm of Aubrey G. Lanston & Co.: "The Administration is doing too much, too fast, by imposing this superdeficit on top of the monetary restrictions needed to wind down a decade and a half of inflation." Adds Philip Hummer, a partner in the Chicago securities firm of Wayne Hummer & Co.: "The financial community gets very emotional about these high deficits. It is absolutely wrong to say that they do not matter. The trend is the most important element of all, and the deficit trend right now is terrible." Financiers showed their pessimism about the economy's future by pushing up the interest rate on 30-year U.S. Treasury bonds last week to a record 14.56%. In late November the rate was only 12.75%.

Normally, interest rates ease back during periods of economic slowdown, as credit demands by businesses and individuals decline. But except for a brief period late last year, rates have not declined much at all, and now they are headed up again. Several major banks last week raised the benchmark prime lending rate another .75%, to 16.5%. The jumps have been extremely discouraging for the Administration, since a downward trend in rates is necessary to spur the business investment boom that Reaganomics needs. The latest interest rate increases have also renewed worries in Western European countries that their costs of borrowing will start climbing once again, forcing their economies still deeper into a slump.

The greatest harm done by high deficits, however, cannot be put into an economist's computer. This is the psychological impact on the battle against inflation. The average American consumer may not be well versed in the fine points of economic theory, but he is worried about anyone, whether it be an indi vidual family or the Government, who spends more than he earns. Said David R. Johnson, president of the Wyoming Bancorporation: "To continue to run the country at these big deficits is disastrous.

It's no different than a family living beyond its income. In my business, we must balance our budget. It's no different for the country." The sheer size of the projected deficits has many Americans concerned. Said Edward Boss, vice president of Chicago's Continental Illinois Bank:

"The consumer is worried about any figure as large as $100 billion." When businessmen, investors or consumers see such towering deficit figures, they tend to believe that inflation will be going higher. That slows down investment and pushes up prices even more, as everyone tries to protect himself from the coming storm.

The Reagan Administration and the Federal Reserve have in the past year made good progress in bringing down inflation. While prices roared ahead at an annual rate of 18.2% during the first quarter of 1980, the consumer price index has increased by only 5.3% in the past three months, and in December the annual rate of rise was 4.9%. The battle against inflation, however, could still be lost if the Administration proves unwilling to take the steps necessary to keep deficits under

-- By Christopher Byron. Reported by Patricia Delaney/ Chicago and Frederick Ungeheuer/New York

With reporting by Patricia Delaney, Frederick Ungeheuer

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