Even with an economic recovery, the federal deficit will continue to rise in the years ahead and will remain extraordinarily high relative to GNP, total credit available, and net savings, unless new deficit-reducing actions are implemented. The rising deficit trend reflects the fact that the combination of tax cuts and increases in military spending, most of which has yet to come, will far offset cuts in nondefense spending, many of which have already occurred.
While it is true the military buildup follows many years of declining real military spending, it comes on top of continued growth in most of the entitlement programs, so that overall federal spending will continue to grow at a significant rate. At the same time, the revenue base has been eroded by the massive tax cuts enacted in 1981. The president's new budget recognizes the imbalance and offers various proposals to narrow the gap.
However, I believe the risks of an unprecedented pattern of rising deficits during a recovery are so large that additional measures should be adopted in order that projected future deficits decrease by at least $25 billion per year, beginning in fiscal 1985. Reducing future deficits to these levels will require significant spending cuts in all areas. In addition, currently scheduled tax cuts will have to be scaled back, or offsetting tax increases enacted, by amounts exceeding the contingency tax increase suggested by the president, and with an earlier effective date.
Can't future deficits be reduced by faster economic growth, rather than by new spending cuts or tax actions?
Counting on an even more rosy outlook than already assumed is a Catch-22, since these structural deficits will eventually cause relatively high long-term interest rates, which will prevent faster growth from occurring, and may in fact cause another recession. Such pressure on interest rates from growing deficits will come from either the direct effect of rising Treasury borrowings (if the Fed does not fully accommodate them) or from an eventual acceleration of inflation (if they are financed by continued rapid growth in the money supply). There is some evidence to suggest that anticipation of either of these outcomes is already keeping long-term interest rates considerably higher than they would otherwise be.
The problem is that while that portion of the deficits reflecting the weak state of the economy must be maintained, and stimulus from modest additional deficit spending is desirable, deficits that become bigger and bigger are not necessarily more and more stimulative. This is especially true now, because deregulation of financial markets and the more monetarist approach to Federal Reserve policy cause sharper increases in interest rates in response to rising credit demands than in previous years.
Furthermore, the sensitivity of economic activity to interest rates has increased over time, reflecting the floating exchange rate environment and the increased swing in the prices of many financial assets and housing.
Thus, excessive deficits will become self- defeating because the resulting rise in interest rates will probably cause sharp declines in credit-sensitive industries such as housing and autos, reductions in consumer spending in response to declines in net worth and consumer confidence, cutbacks in public works spending by many municipal governments, because they in effect would be priced out of the bond market, and declines in U.S. exports and increased foreign penetration in U.S. markets, reflecting upward presure on the U.S. dollar on foreign exchange markets.
A rebound in interest rates would thus prevent the sustained recovery necessary to reduce unemployment and help correct other economic problems in the United States. Furthermore, a growing U.S. economy is needed to ignite a worldwide economic recovery, to alleviate the external debt problem of many less-developed countries, to stem the tide of increased protectionism, and eventually to reduce the strains on the international financial system.
Won't tax increases cause a depression, as they did in the 1930s?
No, because the portion of the deficits that will be reduced is not caused directly by weakness in the economy, unlike the 1930s. Declining structural deficits of the magnitude suggested above would still leave ample stimulus to bolster the recovery process, and would make room for the increase in private credit demands that would result. Furthermore, deficit-reducing actions would not become effective until the economy is well into its recovery process.
Will there be any tax cut left?
It is certainly true that a significant portion of the 1981 reduction in personal tax rates is already being offset by inflation and increases in excise, Social Security and state and local government taxes. But a significant net tax reduction will remain, even with the additional actions that will be necessary to reduce future deficits, particularly since lower-than-expected inflation has sharply reduced the magnitude of "bracket creep." Furthermore, the key issue is not how large the tax cut is going to be, but how much we can afford in view of the fact that overall federal expenditures will not be declining significantly.
Are people already counting on those future tax cuts?
Currently scheduled tax cuts for future years are providing no direct benefits to the economy, in that they are not affecting spending or saving, or influencing economic activity in any other way, at the present time. Furthermore, most deficit-reducing measures can always be reversed in later years if conditions permit.
Incurring the risks associated with rising deficits during a recovery period also seems unwarranted in view of the weak level of investment, poor productivity trends and the widespread financial strains that characterize the economy, all of which will likely worsen if the federal government continues to absorb most newly available credit and savings.
Furthermore, while some longer-term factors are contributing to the problems of the industrial sector, current problems are primarily the result of the high interest rate/recessionary environment of recent years. Unless these conditions are reversed in the near future, many manufacturing and mining companies may never recover.
The top objective for economic policy should be a sustained period of strong economic growth. This can only be accomplished if policy is geared toward lower interest rates. This will require not only continuation of a more accommodative policy by the Federal Reserve, but also a more balanced approach to fiscal policy that significantly alters the outlook for the federal deficit.