We are about to witness a great flip-flop. An administration guilty of wild flights of unwarranted optimism in its earlier economic forecasts is about to hit the streets with a forecast so cautious that it is likely to be too pessimistic.
The earlier forecasts went awry largely because they were inconsistent with the anti-inflationary monetary policy so explicitly described in the first Reagan budget. There was no way that the economy could grow vigorously while the Federal Reserve System was squeezing inflation out of the economy by slowing the growth of the money supply. As things turned out, the shift to monetary restraint in 1981 was even more abrupt than the administration had advocated.
The new economic forecast may go awry because it is inconsistent with the much looser monetary policy followed since last summer. This accusation of inconsistency cannot be made with the same assurance as earlier accusations, because we no longer know what monetary strategy is being followed. Earlier, a self-confident administration promulgated monetary growth rates with great precision for five years into the future. Now all that we know is that the old monetarty policy has been at least temporarily abandoned. We do not know what has taken its place.
But presuming that we shall remain for some time in the "go" phase of an old-fashioned stop-go policy, the vigor of the coming recovery may surprise a lot of forecasters, including those in the administration. If this happens, we shall see that the deficit is considerably lower than in the dismal predictions of the administration, the Congressional Budget Office and the group of ex-Cabinet officers, businessmen and academics who recently urged dramatic corrective actions in the form of large tax increases and spending cuts.
If this scenario actually unfolds--and it may not if the Fed suddenly reverses gears--we shall hear more and more that deficit-reducing actions are not as important as they seemed earlier. It will be a popular argument: who wants to endure the pain of spending cuts and tax increases if it is not really necessary?
Though popular, the argument will be about as wrong as an argument can be. With growth more vigorous than expected, the need to reduce the deficit becomes even more urgent. In a typical economic recovery the federal deficit falls rapidly. As the federal government absorbs less saving from the private sector, more is left over for the inventory, housing and other types of investment that occur during the expansion phase of a business cycle. In this recovery, even if vigorous, the deficit will fall very slowly given current policy. Real interest rates will rise more rapidly than usual, and the recovery will consist of an unhealthy mix of production--heavy on consumption but with less capital formation than desirable.
Some suggest that interest rates will rise so fast that the recovery will be aborted. I think that unlikely, but it cannot be ruled out. The more important point is that, if it continues, it will be the wrong kind of recovery--one that does not sufficiently improve our prospects for long-run economic growth.
The severity of the deficit problem is not really reflected by anyone's forecast of the actual deficit in 1984, 1985 or any other year. Those deficit forecasts mainly reflect the forecaster's optimism or pessimism regarding the strength of the economic recovery. The real deficit problem is reflected by the fact that even if the unemployment rate magically fell to 5 percent, we would still have a deficit above $50 billion by 1985 when an unemployment rate that low would warrant running a large surplus. In other words, we cannot grow ourselves out of this problem. It will remain regardless of the speed of the recovery.
The American people are now demanding more government spending than can be financed by current tax laws. Either their demand for programs will have to be dampened or they will have to pay for them up front with higher taxes. Let us hope that our politicians are courageous enough to tell them that.