The White House and the Treasury Department have done a complete turnabout on whether there is a connection between large federal budget deficits and high interest rates.
After spending much of his first term denying any link between deficits and interest rates, President Reagan is expected this week -- possibly as early as his scheduled broadcast tonight -- to begin to argue personally for major spending cuts on precisely those grounds, according to a senior White House official.
The president will argue that reducing the red ink in the budget will lead to lower interest rates, which will weaken the value of the U.S. dollar on foreign exchange markets and ultimately ease the damage being done to American industries by foreign competition. The argument will be addressed specifically to congressional Democrats who are reluctant to reduce spending in some areas, such as Social Security, but who also are advocating protectionist measures to deal with the trade threat, the White House official explained.
Many economists agree that the administration's new argument has merit. In fact, their belief in the validity of the new administration argument is one reason that a large number of them have been persistent critics of the budget and tax policies that produced the large deficits in the first place.
Until recently, however, most administration officials, including former Treasury secretary Donald T. Regan, denied there was any significant link between the deficits and interest rates. A Treasury study, often quoted by Regan, concluded there was no systematic relationship between the two.
Meanwhile, the president and Regan said they regarded the strong U.S. dollar as a sign of economic success, with the strong economic recovery and reduced inflation the envy of the rest of the world.
But the high value of the dollar has begun to have such a serious impact that the U.S. trade deficit is a significant drag on the economy.
In the third quarter of 1984, a surge in imports helped reduce economic growth to a 1.6 percent annual rate, after adjustment for inflation, from the 4 percent-or-greater rate the administration had expected. Last week, the Commerce Department reported that the same thing happened again in the first quarter of this year, with the real gross national product rising at only a 1.3 percent rate.
"At the moment, the economy is not healthy," Regan, now White House chief of staff, said last week. Another recession could occur unless Congress goes along with the compromise package of spending cuts worked out between the president and the Senate Republican leadership, he asserted. "What we feel is happening here is that people are really worried about where we're going with the federal budget," Regan told a group of news executives.
He still maintains there is "no proof" of a link between deficits and interest rates. "What we're saying is we should cut the budget deficit regardless of whether it brings interest rates down or not. If it brings rates down, that's serendipity," he said earlier this month at a press briefing.
The same theme was sounded in a major speech on the economy given the previous week at Princeton University by Secretary of State George P. Shultz, an economist who was director of the Office of Management and Budget and Treasury secretary in the Nixon administration. Shultz explictly linked the large and continuing budget deficits to the strong dollar and the growing trade deficit -- without mentioning that high real interest rates are an integral part of the linkage -- and declared, "These imbalances are interrelated, and they must be corrected if we are to maintain the momentum of our economic success."
Meanwhile, OMB issued a document detailing the budget compromise between Reagan and the Senate Republicans. It enumerated some of the economic accomplishments of the administration, including reduced inflation, and said "continued achievement of these economic gains is threatened by huge federal deficits. This year, Treasury borrowing will absorb 78 percent of net private savings -- putting upward pressure on real interest rates, attracting massive net inflows of foreign capital and contributing to growing problems with exchange rates and the hemorrhaging trade deficit.
"The compromise deficit-reduction plan will dramatically alleviate these pressures and strains in financial markets, manufacturing and agriculture. By reducing the deficit to 2 percent of GNP in 1988, it will release U.S. net savings for private investment and job creation, could help reduce interest rates and bring about a better balance in international exchange markets and trade," OMB said.
"Real" interest rates, which cannot be measured, are actual rates less some expected rate of inflation during the period for which money is being lent. Net private savings are the total savings of households and businesses less the amount required to replace capital assets, such as machines and houses, that wear out.
Some other economic forecasters, including those at the Congressional Budget Office, believe the budget deficit would be considerably higher than 2 percent of GNP in 1988 even if the compromise spending cut plan were passed. The administration is counting on real economic growth remaining close to the 4 percent mark for the next three years while interest rates fall substantially -- thereby slowing the rise in the cost of financing the burgeoning public debt. Analysts at CBO and elsewhere are particularly skeptical about the assumed interest rate decline.
Even if the administration's economic and budget forecasts proved correct, the deficit in fiscal 1988 would be $98 billion. Other analysts, such as Alan Greenspan of Townsend-Greenspan & Co., believe that, even with some substantial spending cuts this year, it will be close to the $200 billion mark. The latest administration deficit estimate for the current year, issued last week, is $213.3 billion.
Whatever the actual level might turn out to be, the OMB description of the budget compromise suggested that it is not realistic to expect many spending cuts beyond those included in the current plan. "With full implementation of the deficit-reduction plan, federal spending will be pared to the bare essentials for both national security and domestic welfare OMB emphasis . After half a century of uncontrolled spending growth, undisciplined expansion of federal activities, rising taxes and ballooning deficits, the nation's fiscal house will at last be in order."
The Reagan administration has not made such a statement before. Always there have been additional, perhaps unspecified, spending cuts and the expectation of strong economic growth to close the budget gap between outlays and receipts.
So far, the shift in the administration's view of the dangers of continued budget deficits is more a change in rhetoric than in policy. Shultz, for instance, was careful to say in his Princeton speech that higher taxes are not needed.
The president remains adamantly opposed to raising taxes, or at least to raising tax rates. Nevertheless, the change in tone being used to describe the deficits -- and the assertion from OMB that federal spending, with one more round of cuts, would be "pared to the bare essentials" -- could be the prelude to President Reagan's "last resort."
The change in tone and in the underlying economic analysis by the administration is so sweeping that, at the least, it could clear the way for a significant policy change as well