In spite of the administration's current inability to agree on a politically realistic request for defense spending we predict that the administration and Congress will get together in 1985 to design a deficit reduction package that is acceptable to both parties. But the real challenge for those who negotiate will be to design a plan that will reduce the deficit while sustaining economic growth. The crucial ingredients for a successful outcome will be the timing and reliability of the deficit reduction.
There is no question that deficit reduction is absolutely essential for the long-term health of the economy. But the way we go about the reduction has important short-term consequences because of two initial countervailing effects of a reduction in the deficit.
A direct effect of deficit reduction is actually contractionary. Reduced government spending means less demand for the goods bought by the government and by the recipients of government transfers. And higher taxes mean less spending by consumers and businesses that pay those higher taxes.
To offset the direct contractionary effect of the reduced spending by government and consumers, there must be increases in other types of spending -- investment and exports. Fortunately, there is an automatic tendency for a decline in the deficit to stimulate investment and exports -- but only, and this is important, after a significant delay. The reduced government borrowing causes a decline in the real interest rate and therefore in the level of the dollar. The lower interest rate leads to more investment and the lower dollar causes exports to rise and imports to fall.
But experience shows that there are delays of about a year between the time when the interest rate falls and the time when a substantial rise in investment occurs. Similarly, there are lags of about a year between the fall in the dollar and the time when net exports rise to their new level.
These delays mean that offsetting the contractionary effects of a 1986 budget decline will require a fall in the real interest rate and in the dollar in 1985. But what will cause such a significant decline during the coming year? The real interest rate and the dollar are likely to fall significantly only if financial investors become convinced that there will be a substantial decline in the government's borrowing needs in the future years.
The key, then, to sustaining the expansion in 1986 and beyond is convincing financial investors in 1985 that government borrowing will decline significantly in the years ahead. That can only be achieved by legislating a predictable and reliable series of future deficit reductions. A one-step-at-a-time, piecemeal approach is not good enough.
There can be no guarantee that the very large projected deficits can be reduced and eventually eliminated without causing a temporary economic downturn at some point in the process. But the best way to reduce the risk that a downturn would result from a mismatch of timing is to enact as soon as possible legislation that implies a steady and substantial reduction in future deficits.
What happens in the next few weeks will be of critical importance for Ronald Reagan's economic record. The election suggests that he convinced the voters that Congress, and not the administration, has been the culprit in creating the deficit, which voters consider the biggest economic problem facing us today. But that apparent lack of culpability could easily be overturned if the administration does not now cooperate with congressional leaders to work out a reasonable and reliable deficit reduction program.
Some consistent signals are coming out of the closed-door debates within the White House. The administration will propose to Congress at the beginning of February a plan to reduce the deficit in a series of steps between now and 1988. The plan will call for budget reductions that will reduce the deficit to 4 percent of GNP in 1986, 3 percent in 1987, and 2 percent in 1988.
But we have significant reservations about the specifics of the administration's plan. Their proposals are relying entirely on a narrow range of spending reductions that are unrealistic and unacceptable to Congress. An acceptable compromise will require a broader range of spending cuts, including a greater reduction in the growth of defense spending and a slowdown in the growth of middle class entitlements such as Social Security. In addition, to be reliable, the eventual compromise will have to include additional tax revenue as well as reductions in outlays.
The budget that the administration submits to Congress is of course only the beginning of the negotiation process that we believe will eventually produce a workable compromise. But the sooner Congress and the administration reach an agreement, the more likely it is that the current economic expansion can be sustained.