The Deficit and Economic Performance L.R. Klein The public have been conditioned to accept a large federal deficit as an ordinary part of the economic landscape. At first, the prospect of a $100 billion deficit and subsequently a $200 billion deficit was contemplated with great horror and fear. The unwillingness of policy makers to do anything about this enormous gap and the apparent economic recovery have led people to accept the present deficit numbers as something that they can accept, however reluctantly. Since the deficit is a simple arithmetic balance between receipts and expenditures it is clear that the only way to change the situation is to increase revenues or decrease expenditures or have some combination of both; it is as easy as that. Of course, receipts or expenditures may change automatically, as a consequence of overall economic performance, but it is surely wishful thinking to expect that the deficit will simply wither away without our doing something about it. When the deficit is in the neighborhood of $200 billion, we recognize and applaud great achievement if it could be brought to the neighborhood of $100 billion, but this would be a poor target that can only be accepted in a state of despair. Will the deficit cause harm to the economy, perhaps even choking off the recovery that many are relying upon to bring the deficit down? There are two senses in which the existence of a large deficit brings harm to the economy. In the first place, the deficit is a "bottom-line" on the books of the federal government establishment. A good bottom-line near zero indicates that the establishment is being run efficiently, much as a private company's bottom 30-228 0-84--7 line is used as an indicator of efficiency in the private sector. By forcing adherence to overall budget balance in department after department, the chief executive can monitor economic efficiency, for this is the executive's only accounting measure of how well the management job is being done in the federal establishment. We are now witnessing the worst imbalance in our peacetime history, and there is a painful lack of response to the prevailing inefficiency in the federal government bureaucracy. Budgets are for the management of enterprise in either the public or private sectors and the failure to adhere to budgetary discipline, allowing the imbalance to soar, must be laid at the foot of the administration. It is The second source of economic harm of the deficit is its possible "crowding out" of private investment activity in the present recovery. more than one year since the recovery began, and private investment has not been crowded out, it is still recovering briskly and expected to continue; therefore, we lack concrete evidence that the existence of the large imbalances does indeed crowd out private investment threaten the choking off of the present recovery. Nevertheless, we still have the future to contend with; the recovery has not yet run its full course, especially the course that would be normal for business cycle experience, which is what we should rightfully expect. The crowding out scenario runs as follows: Large credit demands by the federal government for the purposes of deficit financing absorbs large amounts (some $200 billion) of funds from the money market. In order to induce lenders to part with this sum, with due allowance for risk in an environment where default has become a fact of life, high interest rates must be paid. This will drive up the cost of capital to investors, who will then retrench and send the economy into a relapse. - The Wharton Forecast does not accept this scenario. It fully recognizes the huge borrowing requirements of the federal government now, as well as from the very beginning of the present admnistration's fiscal/monetary program and projects a sources and uses statement of funds flows that permit the recovery to continue with only moderate increases in interest rates and a steady revival of capital spending. The latter is absolutely necessary for confirmation of the second stage of recovery. The first stage having just been completed. There are three factors that enable the economy to absorb the large credit demands of the federal government: (i) large increments in gross national private savings, providing corporate liquidity, especially through retained earnings and capital consumption allowances. (ii) monetary accommodation by the Federal Reserve System (iii) an inflow of foreign capital. All three items can be seen in the statistical summary of the sources and uses statement as projected in the latest Wharton Forecast. Gross Saving.. Gross Private Saving. Billions of Current Dollars, SAAR 419.3 452.2 690.3 508.9 531.1 553.4 575.1 583.9 02.3 612.0 -05.7 440.2 542.1 604.7 91.5 55.2 -10.6 Gov Surplus or Deficit.. -114.-133.2 Federal State and Local...... Cap Grants Recd by...... 0.0 0.0 -133.1 -129.3 -119.3 -111.5.07.2 -126.5 -129.2 -111.5 521.5 571.1 659.0 726.3 125.4 116.4 136.3 158.5 46.4 58.6 33.6 36.5 -13.5 -24.6 50.- 68.5 -8.3-12.J -!.! 29.7 115.3 ∙130.9-115.3 -121.6 -10-132.6 -175.2 -181.J 31.2 51.7 59.6 59.8 0.0 Gross Investment. Gross Private Domestic. 0.0 0.0 567.1 581.8 596.2 607.0 573.0 593.7 616.1 631.3 647.6 557.8 -52.0 -.9.2 -49.0 -49.9 -51. -50.8 -6.0 -5.0 0.0 0.0 406.2 +37.1 532.9 599.2 414.5 471.3 583.6 649.8 -8.3 -34.2 -50.3 -50.6 0.0 -7.0 0.4 -3.4 -9.3 -5.5 Corporate savings are moving up smartly now because overall profits are strong in this environment of wage moderation. In the recession, this figure declined. Now we look for increments of $12 billion this year and $25 billion next year, before leveling off in 1985. Simultaneously, capital recovery comes alive as a result of the favorable rates of capital write-off, that were introduced in the tax legislation of 1981. We expect to find an increment of $20 billion this year, $28 billion next year, and $30 billion in 1985. This source of funds begins to take over when the increment in undistributed profits begins to falter. The federal deficit is but one component of national savings. It is inadequate to analyze the capital market situation in terms of this item alone; the whole savings picture must be pieced together. People tend to look primarily at personal savings flows. These are important but pitifully small in this country, and we make up for this deficiency by providing corporate cash flow on a large scale. We would like to see households spend now, case, in any in order to stimulate aggregate demand. Thre is also some increment in the state/local surplus, which helps a bit in 1983. The Wharton Forecast factors in moderate growth in money aggregates permitted by the overall policy of the Federal Reserve System. On a yearly basis, we are looking for M1 and M2 growth within their stated bands. This is prudent accommodation. For the near term, we see no reason why the monetary authorities would want to jeopardize our national recovery; it is crucial to the whole world recovery movement, and all our partners are depending on it. Moreover, a monetary squeeze that would generate higher rates would place such an excrutiating burden on heavily indebted countries that it would put the whole world monetary system in a state of panic, and I am sure that our authorities do not want to make this mistake a second time. Finally, there has been a large flow of foreign funds into the United States, an increase of some $26 billion are estimated to have crossed our shores (net) in 1983. Wharton projects an increment of $16 billion in 1984 before the total stops growing significantly. Some of these funds come in search of high interest rates, but a great deal come in search of a safe haven, to earn potential profits in business ventures, and to set up production on our land in order to forestall movements towards protectionism. This is the Wharton picture of the near term. We are looking for real gains in business investment of more than 9 percent in 1984 and 7 percent in 1985. These contribute to continuing overall (estimated) cyclical recovery rates of 5.9 percent (year-over-year) in 1984 and 3.7 percent in 1985. The economy can move forward despite the ludicrous deficit figures. It is an unhealthy situation inspired by the excesive tax cuts of 1981-83 and the large scale spending programs. Again it has been a simple matter of Apart from the obvious techniques of raising taxes and cutting spending we can seek policies that attempt to achieve a better fiscal/ monetary mix, stimulate activity and affect the revenue/expenditure balance. Prudent tax increases and expenditure cuts can do some good, but they do restrain economic activity and thus make only limited contributions to deficit reduction. It used to be the case, some five t ten years ago that stimulative policies (scenarios) applied to the Wharton Model generated high employment activities and quickly brought the federal budget towards balance. The fiscal structure has been so severely changed since 1981 that the Model no longer has that resiliency. Policies that aim to bring the economy to about 6 percent unemployment by 1986 reduce the deficit from its present level of about $200 |