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Should we worry about the deficit?


On February 20 The New York Times startled its readers with the front-page headline, "Economists Now Detect Falling Trend in Deficit.' After years of passing along gloomy projections about $200 billion deficits "as far as the eye can see,' as David Stockman once put it, the Times was now predicting that the deficit would fall by $20 billion a year--even without the benefit of Gramm-Rudman. With inflation down and employment up, cuts that had already been made in federal spending meant that the deficit was not going to be nearly as great as once projected. One particularly good sign was that interest rates were down; lower interest rates meant that payments on the $1.6 trillion national debt might drop by as must as $16 billion through fiscal year 1987.

On the following day, The Washington Post was telling a different story. "Volcker Questions Deficit Projections' read the headline. Appearing before the Senate Banking Committee, Paul Volcker, chairman of the Federal Reserve, had called the optimistic calculations "very fragile.' The deficit was not "last year's problem,' he warned. "It is very much with us.'

Then came a maybe-yes/maybe-no story in The Wall Street Journal under the headline, "Deficit Projections Raise Hope and Doubt.' On the one hand, Gramm-Rudman's "show of deficit-cutting resolve' had provided a boost to the financial markets and triggered a decline in interest rates. On the other hand, President Reagan's pledge to raise defense spending 8 percent after inflation hand't been taken into account by the optimists.

Who's right? In one sense, all three papers are wrong: ephemeral projections based on today's favorable economic conditions aren't nearly as significant as the headlines suggest. But the big news is that the deficit does indeed seem to be coming down--thanks in large part to a factor so obvious that it's been overlooked.

Could'a been worse

Just how out of control was the deficit? Consider: if the federal budget had remained on the trajectory mapped out by the policies adopted in 1981, we would now be facing a deficit approaching $400 billion or 9 percent of Gross National Product--nearly double the current deficit. By fiscal year 1991 the deficit would have been climbing to well over $500 billion--and still growing. Before the 1980s, peacetime deficits had never risen above 3 percent of GNP, except briefly in fiscal years 1975 and 1976, in the aftermath of a recession and a decade of rapid expansion of spending on domestic programs. With the resumption of economic growth after 1976, the deficit declined rapidly, falling to well under 2 percent in FY 1979. (In discussing the deficit over a long period of time, percent of GNP is more revealing than aggregate dollars, since a $200 billion deficit is only half as significant in our current $4 trillion economy as it would have been in the $2 trillion economy of a decade ago.)

In the 1980s, of course, we also have had a recession, followed by a resumption of growth, but the deficit has not proved similarly obliging, remaining stubbornly above 5 percent of GNP for the past four years. The widely accepted explanation is the imbalance of taxing and spending policies introduced by the 1981 tax bill and accelerated defense buildup. This imbalance turned out to be so great that it far outweighed the effects of economic recovery. The recovery in the late 1970s, in contrast, went hand-in-hand with growing fiscal stability: spending for domestic programs did not rise significantly over the latter half of the decade; defense spending had begun a moderate climb in FY 1979, after falling throughout the decade (but like domestic spending it was the same percent of GNP in FY 1981 as in FY 1976); and taxes had risen by more than 2 percent of GNP from the average of the previous decade. More important for the fiscal outlook at the end of the decade, taxes were on a path of continued increase, since they were not then indexed for inflaction (as they are now) and high inflation rates produced "bracket creep.'

The balance between taxes and spending disappeared in the early 1980s. Domestic spending dropped, but not by nearly as must as tax revenues, while defense spending and interest payments rapidly rose. Also, the economy plunged into a much deeper recession than anyone had anticipated. The result: out-of-control deficits.

While this part of the story is familiar to us all, the ensuing preoccupation with finger-pointing has obscured the denouement. Had Congress not gone into action, we would now be facing a self-feeding deficit of twice its current size. Instead, over the past four budget cycles Congress has managed to achieve substantial savings--enough to reduce the FY 1986 deficit by more than $160 billion (4 percent of GNP) from what it otherwise would have been and to reduce projected future deficits by far more. If Congress had not slowed down the planned defense buildup, initiated tax increases, and made further domestic program cuts in the years after FY 1982 (the year the deficit really took off), we would be in one hell of a mess. In essence, Congress has been running very hard down an upescalator, seemingly just to stay in place. But, as a result, the deficit will go down.

The hard running will yield more evident dividends in the future because the longer-term effects of the deficit "savings' (the phrase is odd, but there's really no better one) are proportionately much larger than their short-term effects. This is particularly true for defense, where increases in budget authority had already been scaled back before big additional cuts this fiscal year. This year's defense outlays are already more than $30 billion less than what was called for in the buildup as planned in 1981, but these savings will amount to more than $100 billion annually by the end of the decade, even if defense budget authority is allowed to grow in real terms (adjusted for inflation) by as much as 3 percent per year--the upper limit currently being discussed in Congress. Similarly, past years' adjustments in entitlement programs, especially Social Security and Medicare, and this fiscal year's appropriation actions for discretionary programs--which together account for the bulk of the additional deficit savings realized since FY 1982 from domestic programs--are yielding deficit savings that will increase relative to GNP each year. Finally, because of the deficit reduction effects over the past four years, considerably less new, compounding debt is being added to existing debt each year than would otherwise be the case, and this, in turn, brings savings on interest payments.

Tax increases have so far been the major source of deficit savings. (More than half of the revenue loss embodied by the 1981 tax cut will ultimately be offset.) But by the end of the decade, the defense and interest savings will be about equally as important. Domestic program cuts initiated subsequent to FY 1982, when the deficit explosion began, are considerably less important than the other components of savings. However, in combination with the administration-initiated domestic cuts from FY 1982, these later domestic cuts are projected to result in a 20 percent decline in domestic program spending relative to GNP.

We may go on indefinitely debating the question of who was more responsible, Congress or the administration, for getting us into the deficit hole. On the one hand, the administration did serve up some wildly unrealistic economic and budget forecasts--predicated on immediate, strong, and sustained economic growth--in 1981, but on the other hand, Congress swallowed them (and, in a manner of speaking, asked for more by expanding the administration's proposed tax cut). On the one hand, Congress did refuse to cut domestic spending by as much as the president requested in 1981, but on the other hand, even if Congress had granted his full request the subsequent deficits would have been only marginally smaller. And so on. On the administration's side, it must be acknowledged that the 1981 budget proposals were attempting to address some real concerns: defense spending had shrunk to feed domestic programs through most of the 1970s and taxes had risen higher than seemed tolerable to many people. On Congress's side, it must be acknowledged that the political situation in 1981 did not favor the telling of painful truths to the public: it's very hard to sell "fiscal responsibility' when "voodoo economics' is going like hotcakes.

But if blame for creating the problem is hard to fix, credit for solving it is not. For all the president's grave talk about a spendthrift Congress, his actual budget proposals since 1981 attest to how little he cares about the deficit. He has remained intransigent on the subjects of defense spending and taxes and has wished away the bulk of the deficit with overly optimistic economic assumptions and politically unrealistic cuts in domestic programs. In fact, even if all of the president's post-1981 domestic cuts had been accepted by Congress, the Congressional Budget Office's (CBO) estimates indicate that none of his proposed budgets for fiscal years 1983 to 1986 would have reduced the deficit at the end of five years by even one half.

The exhausting political pulling and hauling over the budget in Congress during the past four years takes on new meaning in this light. Far from indulging in empty posturing, Congress has been engaged in an extremely difficult--and so far very responsible--political struggle (among themselves and with the president) that has produced considerable success against highly unfavorable odds. As an institution, Congress is simply not well-constituted--indeed, was never intended--to develop its own detailed design for something as complex as fiscal policy and the federal budget. The appropriate role of Congress in fiscal matters is to respond to and modify an overall plan from the executive branch. The legislative branch is particularly ill-adapted to exercise the initiative for such politically controversial and painful actions as have been necessary to bring the deficit under control, especially with the House and Senate under different party leadership. Nevertheless, Congress--most notably, the Senate Republican leadership--has taken on this thankless task, consistently rejecting the president's budgetary euphorics, insisting on meaningful action against deficits, and forcing substantial compromise to this end on the president.

Where does this leave us? While the actions taken by Congress over the past four years have set the stage for a dramatic decline in the deficit, they by no means guarantee it. The economy must also cooperate. The CBO projections assume strong, sustained economic growth over the next five years, with increases in real GNP averaging well in excess of 3 percent per year, far more than either last year or the past five years. They also assume substantially declining interest rates, a moderately declining unemployment rate and a relatively stable rate of inflation. When the CBO released its findings in February, these assumptions were--as usual--significantly less optimistic than the administration's assumptions were. But they were more optimistic than the prevailing consensus of private forecasters. The key thing to remember is that such forecasts always involve considerable guesswork.

Although the deficit is now a far tamer beast than the one unleashed in 1981, there is still an imbalance between taxes and spending. This imbalance sustains a historically high debt-to-GNP ratio, leaves us too dependent on foreign capital and vulnerable to international competition, and generally serves to depress future increases in our standard of living. For all Congress has managed to accomplish in the past four years, still more legislative action is needed to reduce the remaining structural deficit. Accompanied by a continued easing of monetary policy, such action would help us to either realize CBO's optimistic projections for the economy or limit the increase in the deficit should the economy ultimately fall short of CBO's expectations. The good news is that the amount of additional budget cutting and/or tax increases needed to bring the deficit down to a comfortable level is only about one-fourth as much as has already been achieved. Relative to the CBO baseline, another 1 to 2 percent of GNP by the end of the decade would be adequate.

So far, this year's budget debate has followed the course of the previous four: the president has served up a proposed budget that both the House and Senate have almost unanimously rejected as entailing too little deficit savings and relying too much on deep domestic program cuts. But, politically, times have changed. On the one hand, just as in a marathon race, the last few miles are likely to be far more difficult than all the earlier ones, simply because the politically easy steps have already been taken. And political energies may flag as the public, the president, and Congress read articles like this proclaiming our success in reducing the deficit. On the other hand, Gramm-Rudman calls for a balanced budget by the end of the decade and holds a gun to the head of Congress and the president by providing for automatic spending cuts to achieve the balance, absent agreement on some other approach. No one knows whether Gramm-Rudman will survive constitutional challenges or, if it does, whether Congress or the president would ultimately be willing to pull the trigger and put in motion automatic cuts far larger and more politically painful than those recently implemented. But Congress's record of the last five years suggests that at least one branch of government takes the deficit much more seriously than most of us have recognized.
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Author:Palmer, John
Publication:Washington Monthly
Date:May 1, 1986
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