Henry A. Kaufman, Wall Street's best-known economist, said yesterday that a $50 billion to $60 billion reduction in the federal budget deficit over the next 12 months would trigger a bond market rally and permit the Federal Reserve Board to run an easier monetary policy that presumably would lead to lower interest rates.
Kaufman, chief economist for the investment banking firm Salomon Brothers Inc., also said that economic growth in the United States would run in the 4 to 5 percent range this year -- after a sharp slowdown in the final half of 1984 -- and that inflation would remain low.
Kaufman's upbeat appraisal of the impact of a $50 billion deficit trim supported the first step of a plan by Senate Republicans to halve the anticipated $200 billion-a-year shortfall over the next three years.
Federal Reserve Chairman Paul A. Volcker endorsed the plan to trim at least $50 billion from the deficit for fiscal 1986 (which begins Oct. 1) after a breakfast meeting with Senate Republican leaders Tuesday. Volcker said a $50 billion cut was a "minimum threshold" to ensure lower interest rates but said the program should provide for continuing deficit cuts in future years.
Kaufman's optimistic assessment of the 1985 economy and of the beneficial effects of a $50 billion budget cut came in a question period that followed a gloomy speech to the National Press Club in which he said that long-term effects of excessive business and government borrowing, weak credit quality and the deregulation of financial institutions pose a threat to "the preservation of a democratic economic society."
He said it is imperative that the the two-year-old recovery in the United States be preserved to buy the time needed to take steps to slow down the growth of debt, improve the quality of outstanding debt and strengthen the supervision and regulation of the financial system.
"Another recession any time soon would arrest the feeble recovery in Europe and in the developing world. This, in turn, would enhance the risk of further credit quality deterioration, large debt write-offs and a frail domestic and international financial system that would deepen the economic slowdown."
A prolonged expansion, on the other hand, "would allow institutions to gradually write off old poor risks, while other marginal borrowers would have the opportunity to rehabilitate themselves," Kaufman said. He said the increasing use of short-term debt and floating interest charges on loans weaken the financial integrity of borrowers. Unlike dividend payments to shareholders, which can be curtailed or canceled in bad times, debt payments must continue.
Short-term debt must continually be refinanced, and floating rate debt adds to a borrower's obligations when rates are rising. Banks shift the interest rate risk to the borrowers, but create potential repayment risks in the process. Rising rates do not by themselves threaten bank profitability; profits are determined by the number of loans made. That encourages growth of debt and weakening of credit standards.
But borrowers -- be they corporations with floating rate bank loans or consumers with floating rate mortgages -- do not perceive the risks they are taking, Kaufman said.
He decried the current drive to deregulate banks and other financial institutions. The institutions are unique in society, entrusted with taking in savings and temporary funds and making prudent loans, and they have both public and private responsibilities, he said.
But deregulation encourages risk-taking, and there is a lack of penalties for institutions that take too many risks, he said. The type of market discipline that permits some businesses to fail cannot be permitted among big financial institutions -- or even among big debtors if they threaten the institutions' health -- because of the massive repercussions on the entire society, he said.