Playing for Time

By GEORGE J. CHURCH

In his budget, Reagan tries to make the deficit a post-election issue

"The threat of indefinitely prolonged high budget deficits . . . raises the specter of sharply higher interest rates, choked-off investment, renewed recession and rising unemployment."

--Ronald Reagan in his budget message

The most dyspeptically partisan Democrat could hardly have put the warning more bluntly. But Congress and the nation searched in vain through the budget message for fiscal 1985 for any reply to the obvious next question: What does the President propose to do to ward off the dangers he so starkly portrayed? Not until his separate economic message the next day did Reagan give an explicit answer: "We must wait until after this year's election" to make any sweeping moves.

"Bold, vigorous fiscal policy action to break the momentum of entrenched spending programs . . . [is] essential to the nation's future economic health," Reagan trumpeted in the budget document. Eventually, that is: for next year he is proposing only minor changes that, by his own figuring, would reduce nonmilitary spending by $4.6 billion, a mere .7% less than what outlays would be if all programs were left on automatic pilot.

That would be dwarfed by another huge increase in the Pentagon budget: Reagan is requesting a 13% (after inflation) rise in spending authorization, to $305 billion (see following story). "To those who say we must raise taxes, I say wait," the President declared. He did couple his less-than-clarion call with a pledge to "go forward with a historic reform" that would "simplify the entire tax code." But the Treasury will not recommend such an overhaul to him until December, a month after the election. For now, he is pro posing small loophole-closing changes that would add a mere $7.9 billion to revenues next year. Reagan promptly muddied the waters further by calling his own deficit forecasts "unacceptable" and inviting congressional leaders, including the opposition Democrats, to help him reduce them. His aides declared "everything," including defense and taxes, to be open for discussion.

Then the President met with congressional Republicans and urged them to assail the Democrats as the high-tax party. Democrats, for their part, agreed reluctantly to join a budget-cutting conference while gloomily predicting that Reagan was trying to inveigle them into giving a bipartisan blessing to gargantuan deficits, or set them up as scapegoats, or both. As a kind of grace note to the babble, one of the President's top economic advisers, Treasury Secretary Donald Regan, derided the analysis of another, Council of Economic Advisers Chairman Martin Feldstein, as ivory-tower dreaming. Said Regan, once chief of the giant securities firm Merrill Lynch, about the CEA report prepared by Feldstein, who is a Harvard professor on leave: "I have 35 years of experience in the market. The CEA has none . . . Experience in the marketplace is a lot more valuable than time spent in the library" (see box).

Out of all the confusion emerged these bottom-line figures for fiscal 1985, which starts Oct. 1:

> Spending would rise to $925.5 billion, up 8.4% from the $853.8 billion now expected in the current fiscal year. Besides the defense boost, there would be major increases in outlays for Social Security and Medicare; for income security, where a sharp rise in federal retirement benefits more than offsets declines in unemployment compensation and food and nutrition assistance; for "international affairs," partly because of more military and economic aid to Central America, and for interest on the national debt, which would swell by 7.3%, to $116.1 billion.

> Revenues, pumped up by the economic recovery, would increase to $745.1 billion. Though that would be an impressive 11.2% jump over the $670.1 billion expected in fiscal 1984, the rise in dollars would be just slightly more than the increase in outlays.

> The deficit, in consequence, would decline only from $183.7 billion this fiscal year to $180.4 billion in 1985. Worse, it would be almost unchanged for the following two fiscal years: $177.1 billion in 1986, $180.5 billion in 1987. Only after that would it drop, and then just to $152 billion in 1988 and $123.4 billion in 1989.

"Out-year" deficit forecasts are, of course, pure guesses, and Presidents rarely have been prescient about predicting red ink, even for the next year or two. That, however, is hardly a comforting thought: Reagan's figures appear more likely to be too low than too high. Office of Management and Budget Director David Stockman conceded last week that the fiscal 1985 deficit "could easily be more than $200 billion" if Congress rejects Reagan's proposals for spending cuts and tax changes and the Administration is a bit off on some of its calculations. Estimates leaking from the non-partisan Congressional Budget Office put the deficit as high as $216 billion in 1986 and $248 billion in 1987, basically because the CBO foresees less future growth in production, more inflation and higher interest rates than the Administration predicts.

Indeed, Reagan's rosy economic forecast seems quite inconsistent with his own warnings about the dire effects of high deficits. The budget assumes that the output of goods and services will rise a steady 4% a year from 1985 through 1988 and 3.8% in 1989. Unemployment is expected to drop fairly regularly to 5.7% by the end of the decade. The Government announced last Friday that the jobless rate fell again in January, to 8%, from 8.2% in December, continuing the fastest slide in more than 30 years. Some other budget forecasts: consumer prices will go up only in a moderate range of 3.5% to 4.7% a year for the rest of the 1980s, and the key short-term interest rate on Treasury bills will fall from an average of 8.6% in 1983 to 5% by decade's end. But Feldstein is openly concerned that if deficits really go as high as Reagan predicts, parts of this happy prophecy may not come true. Says he: "These deficits do keep the level of real interest rates high, and consequently we have less business investment than would otherwise have been the case."

For the moment, however, the White House made one thing plain: it was thinking less of economics last week than of the President's just launched re-election drive. As a political issue, says Nevada Senator Paul Laxalt, chairman of Reagan's campaign committee, deficits are "a yawner. We, as Republicans, have talked about deficits and balanced budgets since the days of [Franklin D.] Roosevelt, and the people simply haven't listened, because they can't relate to those huge numbers."

Indeed, a slam-bang attack on deficits now might lose some votes. Tax increases are as repugnant to many voters as they are to Reagan. Proposals for a drastic cut in spending would anger those voters whose benefits might be reduced, and would be impossible to ram through Congress in an election year anyway. Cutting the deficit, says Stockman candidly, "is really a political question, and we will look to the electorate for the answer."

But if the electorate is to give the answer that Reagan wants, it must at the least be assured that the President is not ignoring his own warnings. To that end, Reagan is adopting a three-part strategy. Its elements: pledge a broad-scale attack on deficits early in a second term; meanwhile, summon congressional leaders to help him rewrite his just completed budget proposals and make a modest "down payment" to reduce the deficit in this election year; get set to assail the Demo-crats for blocking progress if there is no down payment.

Thus in his economic message Reagan proclaimed, almost confoundingly, that the deficits he had forecast the day before "are totally unacceptable to me" and insisted that "we cannot delay until 1985" making at least a start on stemming the red ink. He repeated the call he had voiced in his State of the Union speech for a conference between Administration officials and Republican and Democratic congressional leaders, with the aim of agreeing on "less contentious" spending cuts and loophole-closing tax reforms that might trim $100 billion off the deficit over the next three years. Simultaneously, the President journeyed to Capitol Hill and told a meeting of Republican legislators, "We must make it clear they [the Democrats] don't want to cut spending. They want to raise taxes."

The Democrats did their best to achieve the difficult feat of matching the White House in political posturing. Ohio Senator Howard Metzenbaum displayed an "American Excess" credit card he proposed to issue to Reagan as the buy-now, pay-later spender of all time. Hitting the same theme, House Budget Committee Chairman James Jones ridiculed Reagan for saying, in effect, "Don't give me the bill; send it to my children." Nonetheless, the Democrats could not refuse to participate in talks on deficit reduction. "We've got them in a box," exulted one of Reagan's senior advisers just before House Majority Leader James Wright of Texas phoned the White House to propose an organizational meeting of a joint Administration-congressional panel that will be held Wednesday. Seeking to put Reagan in a box, Wright publicly proposed to double the deficit-cutting package to $200 billion over three years. Said the poker-playing Texan:

"We'll call you and raise you $100 billion."

Whether the conference can in fact achieve anything beyond political bluffing is in serious doubt. The kind of spending cuts and tax changes Reagan has in mind presumably were foreshadowed by those he proposed in the budget. Once again he is recommending spending reductions, though this time very small, in such old targets as food stamps, welfare and job training. Those are exactly the reductions Democrats find most objectionable. On the revenue side, Reagan's principal proposal is to raise $3.9 billion by taxing workers on any contributions in excess of $175 a month that their companies make to family medical insurance plans.

The Democrats are certain to demand a much smaller increase in military spending commitments than Reagan is proposing, and some sort of general tax increase, at least on higher incomes. Reagan knows that Congress will never approve all his military spending requests, but since the strengthening of American defense muscle is one of his prime election boasts, the size of the cutback he might agree to is highly questionable. His plan to stick the Democrats with a "high tax" label during the campaign indicates that he will hang tough on that subject as well. For all that, there is a feeling on Capitol Hill that political and economic reality might in the end push Reagan and congressional leaders to come up with some sort of agreement. Says Democratic Senator Joseph Biden of Delaware: "Sure, the down-payment idea is a political move. But some things that start off as political moves end up having consequences far beyond what was originally envisioned." Whether any package would be large enough to make a significant dent in the deficits is another question entirely. What is altogether too clear, at least in the judgment of most economists, is what will happen if the deficits are not curbed. The effects are hardly visible yet. If anything, deficits are spurring the powerful rise in production and employment by putting more spending money into the pockets of businessmen and consumers. But that is what usually happens in the early stages of recovery from a deep recession, like the one the U.S. suffered through in 1981-82. The extra money initially puts idle plant and laid-off workers back into productive action.

The pinch comes when the economy operates closer to full capacity. Businesses that have been financing needed investment out of retained profits and consumers who have been paying for purchases out of rising incomes increasingly borrow to keep up their spending. So long as there are idle resources, the Federal Reserve can safely create enough new money to meet all borrowing demands, but once the slack is mostly gone, doing so would set off a new round of inflation; the Fed probably would limit the funds it supplies to the banking system. Then business and consumer demands for funds collide with the voracious appetite of Government for loans to cover the budget deficits. Those businessmen and consumers who can still get loans pay high interest rates. In one sense, something of the sort is happening already. As Reagan incessantly points out, the keystone bank prime rate has dropped from 21 1/2% in December 1980 to 11% today. But economists generally consider the "real" interest rate--that is, the gap between interest and inflation rates--to be a truer measure of the burden on borrowers. And at 11%, the prime is more than seven points above the current inflation rate, one of the highest spreads ever.

As a kind of foretaste of the potential effects, economists point to the startling rise in the U.S. trade deficit (excess of imports over exports), which soared to $69.4 billion last year, almost two-thirds higher than the previous record in 1982. The connection between budget and trade deficits is indirect but undisputed. Budget deficits keep real interest rates high, and that prompts foreigners to pour money into purchases of interest-yielding U.S. securities. But first they must exchange francs, marks, lire or yen for dollars. The demand for dollars artificially raises the exchange value of the U.S. currency: the Council of Economic Advisers calculated last week that the dollar is now priced 32% above its true worth.

Finally, the overvaluation of the dollar distorts the prices of U.S. imports and exports. Americans need fewer dollars to buy, say, French wines; Frenchmen must pay more francs to buy U.S. computers. Domestically, some economists expect continued high deficits to cause not an abrupt crisis but a withering away of gains in production, incomes and jobs.

Says Rudolph Penner, director of the Congressional Budget Office: "The process we are facing now is gradual erosion of our economic health. It's not a dramatic event. You won't wake up one morning and say, 'The recovery is aborted.' It's an enervating process."

Similar worries are troubling the pro-Reagan stock market.

The Dow Jones industrial average fell 17 points last Friday, accentuating a decline that has now brought it down 90 points since Jan. 6. Said Edward Yardeni, chief economist of Prudential-Bache Securities: "One of the primary concerns confronting investors as they look ahead to 1984 and 1985 is the size of the federal deficit, and the possibility that it could push interest rates higher and put an end to the recovery." To those who cannot yet see any troublesome effects from all the red ink, the stock market and economists generally give the same answer that Reagan is using to calm deficit jitters: wait till next year.

With reporting by Bernard Baumohl, David Beckwith