Big budget deficits are bad because they push up interest rates and will perpetuate the recession.
Big budget deficits are good because they add to purchasing power and will help end the recession.
As President Reagan wraps up the fiscal 1984 budget proposal he is scheduled to send to Congress Jan. 31, you can hear it both ways among economists, sometimes both ways from the same economist. The reason is that both propositions are partly true.
The debate in the administration over the upcoming budget may be NEWS ANALYSIS over, but the more fundamental debate in the economic community over the huge deficits likely for the next few years is not.
For some people, the prospective deficits of $200 billion and more are only symptoms of the nation's distress; the deficit is large because the economy is weak, tax revenues are down and social costs are up.
Others, including some members of Congress, regard the likely deficits as causes of the economic problems.
Their belief is that lower deficits would mean lower interest rates and faster economic recovery. They see the federal government borrowing so much to finance the deficit that it is crowding private investment out of the money markets.
No one, least of all the Reagan administration, is offering the old prescription of cutting taxes and spending more--in other words, increasing the deficit--to boost the American economy out of what has become the worst recession in postwar history.
That is true even though most economists still agree that this medicine does work, that deficits do stimulate the economy, and that large, immediate deficit reductions probably would do more harm than good.
But the same economists believe that in the longer run, as the promised recovery proceeds, lower deficits will become an absolute necessity for the health of the economy.
The problem has to do mostly with monetary policy.
Fiscal policy, the combination of tax and spending decisions, has been stimulating the economy. Together, the Reagan administration's tax cuts and defense spending increases have been substantially larger than the nondefense spending cuts. That widened the deficit and made the total demand for goods and services higher than it otherwise would have been.
However, at the same time that fiscal policy was pushing in one direction, monetary policy has been pulling in the other to reduce inflation. And over the last two years, tight money and high interest rates have turned out to to be more powerful than fiscal policy in controlling the level of economic activity.
That is the main reason the $111 billion deficit in fiscal 1982, the largest in history, and the even larger deficit developing this fiscal year, have not helped end the recession.
Charles L. Schultze, chairman of President Carter's Council of Economic Advisers, recently described the interplay of fiscal and monetary policy this way:
"The huge budget deficits, that threaten to continue growing throughout the recovery, will indeed provide some economic stimulus, principally in the consumer goods and defense industries," he told a congressional committee. "But at the same time, the higher interest rates, occasioned as the burgeoning deficits collide with tight money, will retard recovery in the already depressed interest-sensitive industries such as autos, housing, and investment goods.
"Moreover, current expectations that the problem will grow worse over the years ahead help prop up today's long-term interest rates. And finally," Schultze continued, "quite apart from current problems, huge long-term budget deficits tend to give us an economy structurally biased against productivity-improving investment."
His comments echoed those made a few days earlier by four prominent conservative economists at the American Enterprise Institute: Phillip Cagan, William Fellner, Rudolph Penner and Herbert Stein, who was CEA chairman in the Nixon administration.
"Conventional economics tells us that an increase of government expenditures or cut of taxes, raising the deficit, will increase nominal gross national product that is, GNP in current dollars and increase employment," they wrote in a joint article in The AEI Economist.
"Whether this is true today is unclear, because we already have a large deficit and because a deliberate increase of the deficit would heighten uncertainties in financial markets.
"In any case, the rise of nominal GNP is limited today by a monetary policy that aims to get the inflation rate down. In this circumstance, monetary policy would have to offset any stimulus from an increased deficit" or else the inflation rate would not continue to fall.
"Then employment that might be gained from an increase of expenditures or cut of taxes would be offset by a loss of employment in industries mainly affected by high interest rates, such as residential construction," the four economists argued.
Translation: while fiscal policy and deficits were revving up the economy, the Federal Reserve was standing on the monetary brakes.
And a lighter touch on the brakes may end the policy contradiction just as readily as a heavier foot on the gas. That is exactly what the Fed has provided over the last few months. As a result, interest rates are down and the prospects for recovery vastly improved.
Those members of Congress such as Sen. Ernest F. Hollings Jr. (D-S.C.) and Rep. Newt Gingrich (R-Ga.), who urge deficit reduction to spur recovery, say they do not think this somewhat easier monetary policy by itself will do the trick.
"Massive increases in defense spending and a massive loss of revenue all at once have locked the economy into a deep freeze," Hollings maintained. "Business, ready to take advantage of new tax incentives and lower interest rates, has withheld investment for fear of future economic instability. It sees little hope in projected federal deficits of $200 to $250 billion . . . . Business is sitting back, investing in financial paper and mergers and waiting for Congress to thaw the economy with lower deficits."
Hollings said he wants to reduce deficits by up to $200 billion over the next three years while the Federal Reserve provides "an accommodating monetary policy."
Economists agree that in a period of tight money, the larger the deficit, the higher interest rates are likely to be, particularly as measured in so-called real terms, or relative to the expected rate of inflation.
The present CEA chairman, Martin Feldstein, said this effect on interest rates is large enough that unless deficits are reduced, the coming recovery will be lopsided, with interest-rate-sensitive industries, such as housing and autos and those providing investment goods, and those dependent upon export markets, lagging behind other industries providing consumer goods and services.
Feldstein said deficits have raised real interest rates sufficiently to attract more foreign investment funds to the United States and in the process boosted the value of the U.S. dollar relative to a number of other currencies. The increase in the dollar's value has encouraged imports of foreign goods while making exports less competitive, and that has added to U.S. unemployment.
But how important is each of these effects? Feldstein has provided no data showing the size of the negative economic impact of the deficit-related increase in real interest rates, whether through lower investment or a worsened trade picture.
Many economists believe the stimulative effect of the budget deficit is greater than the depressing effects described by Feldstein or pointed out by Hollings and other members of Congress. After all, the higher taxes and spending cuts required to trim the deficit would also reduce the level of economic activity.
Apparently no economist studying the subject ever has found conclusively that even in a period of tight money the drop in real interest rates likely to be associated with a lowering of the deficit would stimulate the economy as much as the drop in the deficit would depress it.
Deficits also affect priorities. Economists of just about every persuasion think more investment would be good, but the national instinct may be the opposite.
The four AEI economists put it this way. "Deficits absorb saving that would otherwise go into private investment and so contribute to the growth of productivity and productive capacity. Thus the decision about the size of deficits is a decision about priorities, like other decisions affecting the federal budget.
"It is a decision that affects how much of the national output goes into private investment, just as other budget decisions affect how much of the national output goes into private consumptions, or defense, or the non-defense functions of government. Like the other budget decisions it should be made by balancing the interest in more private investment against the interest in more private consumption, or in more defense, or in more roads . . . .
"No natural law tells us how much of the national savings should be absorbed in a budget deficit, or how much savings should be augmented by a surplus. That is a decision for society to make, through its political processes," they wrote.