In 1991, the year the Reagan administration plans to balance the federal budget, the budget deficit, if it remains,will have come of age -- it will be 21.
At that time, the United States will have run a consecutive budget deficit since 1970, when the government went from a $3 billion surplus to $2.8 billion in the red.
Since 1970, the government has accumulated $1.3 trillion in deficits for which it has had to borrow by selling government securities. The interest alone on that debt has become the fastest growing part of the federal budget and is expected this year to be about $200 billion.
The effect on the economy has been profound, according to economists. The deficits have been blamed for the sustained increase in interest rates, the high value of the dollar, the erosion of manufacturing's competitive edge and the decline of agricultural exports.
However, the deficits have also served as an engine for growth, albeit lopsided at times. Annual deficits of $150 billion plus during nearly all of the fiscal years since President Reagan took office have contributed to a strong post-Vietnam war recovery. Since the economy has never experienced long stretches of large deficits, economists have had a difficult time coming up with accurate forecasts during these years.
Enter the Gramm-Rudman-Hollings Act, designed to eliminate the deficit by 1991. Wiping out the deficit is expected to lead to lower interest rates and in the long run promote more economic growth. However, in the short run many economists say that a reduction in the deficit may sharply slow economic growth. If the deficits had been cut earlier in the current recovery when economic growth was stronger, dangers to the economy would have been less, economists said.
Whatever happens depends on whether Congress and the administration will be able to make the budget cuts that until now they have shied away from and whether the act will pass judicial muster, because some critics claim it is unconstitutional.
Expectations that the federal budget deficits will be reduced in the next several years led to the boom in the bond and stock markets, with some long-term interest rates falling by nearly a full percentage point in the last two months to reach their lowest levels since 1979. In some places, the interest rate on 30-year-fixed mortgages has dropped to almost 11 percent. Long-term government bond yields are close to 9.5 percent.
The strength in the stock market produced by expectations of lower future budget deficits and lower interest rates will add to household wealth, encourage consumer spending and make it easier for businesses to invest because their costs of obtaining money will be lower, economists have said.
In addition to the short-term boost in spending provided by higher stock prices and lower interest rates, the economy's growth potential will be increased by higher investment, economists said.
Lower interest rates would also help the dollar continue its decline on foreign exchange markets, which began last February. A drop in interest rates makes U.S. assets less attractive as investments and, therefore, reduces the demand for dollars, leading to a fall in the dollar's value. The decline is expected to help reduce record U.S. trade deficits over time by making U.S. goods less expensive overseas.
Some economists are concerned that a lower deficit would reduce government and private sector spending in the economy, contributing to slower economic growth or even a recession. Government spending for goods and services is a major component of the nation's output of goods and services.
Additionally, to reduce the deficit the government is expected to pay less to recipients of certain types of federal benefits, who would therefore have less to spend. Finally, if the deficit is reduced through higher taxes, those paying the taxes would have less to spend, further reducing the economy's power, economists said.
"Government spending also will be less stimulative in 1986, although the legality of Gramm-Rudman is under dispute," according to a report by Bankers Trust Co. "At the least, Congress will not increase the federal deficit. Longer term, however, the federal spending juggernaut probably has not been derailed. The latest farm bill, for example, contains enough dollars to fill all the silos in America. It is testimony to the fact that no Congress and no administration can rebuff the pleas of a distressed and powerful lobby."
However, many economists expect that the Federal Reserve may offset the short-term slowdowns resulting from deficit reduction by easing monetary policy. Then short-term interest rates would drop; bank lending rates would fall, and many business borrowers would find their operating costs falling and their profits rising.
Declining interest rates also would reduce the large interest bill owed by developing nations on their foreign debt.
Under Gramm-Rudman-Hollings, declining deficit targets are set that would lead to a balanced budget by 1991. If deficits exceed those targets, spending cuts would be made automaticly. Many major programs, such as Social Security, would be exeempt and others would be cut only up to certain limits.
The new law's requirements are expected to be triggered this year with expected federal budget deficits at least $30 billion higher than the legislation's target of $171.9 billion. The gap is expected to result from weaker economic growth than expected and underestimation of the cost of the recently passed farm bill, economists said.
In fiscal 1987 the target is $144 billion, compared with current estimates of a deficit exceeding $200 billion. If the fiscal 1987 gap is about $60 billion, some defense and nondefense programs would have to be cut by one-third to one-half, and perhaps even more under the automatic spending cut provisions of Gramm-Rudman-Hollings.
Wharton Econometrics, in an analysis of the new legislation, said that output will be reduced and inflation and interest rates will be lower. "The reduction in government spending causes a direct reduction in aggregate demand and thus a reduction in gross national product ," Wharton said in a recent report.
However, benefits from lower government spending will be downward pressure on prices "or at worst, help to restrain other forces that would push prices higher. This helps to lower inflation premiums present in interest rates," according to the study.
Additionally, lower deficits reduce government borrowing demands from what they would be without the Gramm-Rudman-Hollings law. "This reduced demand for funds lowers the upward pressure on interest rates that occurs as the economy expands," Wharton said.
"Although the passage of GRH reduces interest rates causing investment spending -- both business and residential -- to expand, the net effect on output is negative," Wharton said. "The pickup in interest-sensitive spending is unlikely to equal the decline in government spending."
However, whether all of this occurs depends on the implementation of the Gramm-Rudman measure. Many economists said that merely mandating reductions in the deficit doesn't mean it will happen. For example, many economists said that the inability of the Congress and administration to agree on approprations for fiscal 1986 before leaving for the Christmas recess is an example of the government's refusal to make tough choices.