Bombarding Reagan's Budget

By Charles P. Alexander

Wall Street takes a dive as the President's men duel over monster deficits

Ronald Reagan's 1985 budget took a thunderous shelling last week. Day after day, jittery Wall Street investors fired sell orders, hitting stock prices with their heaviest declines since 1982. Testifying in Washington, Federal Reserve Chairman Paul Volcker fired the single most damaging salvo by warning that the deficits envisaged in the budget pose a "clear and present danger," threatening to keep Interest rates high and tip the economy into a new recession. Vote-conscious Congressmen attacked the budget from all angles. And throughout the barrage, Administration officials were hunkering down behind sandbags.

The size of the deficits is staggering. Rudolph Penner, director of the Congressional Budget Office, predicted that if policy is not changed, the flow of red ink will swell from $190 billion this year to $326 billion by 1989. Congressmen of both parties agreed that Reagan's election-year package, calling for modest spending cuts and small revenue increases achieved by closing tax loopholes, would hardly dent the deficit. Said Republican Senator John Heinz of Pennsylvania: "The President's budget is a retreat from last year's budget plan. There is not a lot of leadership." Grumbled Congressman Charles Roemer, a Louisiana Democrat: "Reagan is like a Louisiana bullfrog: all mouth, no guts."

In testimony on Capitol Hill, the President's men acknowledged that the economy was in danger. Chief Economic Adviser Martin Feldstein, known as the Administration's "Dr. Gloom," agreed with Penner's warning that the deficit could reach the $300 billion range by the end of the decade. If that happened, said Feldstein, federal borrowing would be swallowing 75% of American savings and putting powerful upward pressure on interest rates. Even Treasury Secretary Donald Regan, usually an optimist and a critic of Feldstein's dour outlook, admitted that "without proper fiscal and monetary policies, there is a possibility of our slipping back into a recession in the U.S." Unless the Federal Reserve speeds up growth of the U.S. money supply, warned Treasury Under Secretary Beryl Sprinkel, a recession could start this year.

Such talk stunned the stock market, which has been backsliding for a month. On the day of Regan's remark, the Dow Jones industrial average plunged 24.19 points, its biggest one-day drop in more than 15 months. Observed William LeFevre, a market strategist at Purcell, Graham, a New York City investment house: "Wall Street is saying this do-nothing attitude about the deficit can't go on. Investors have lost confidence in the Administration's ability to deal with its fiscal affairs." Since the Dow hit a peak of 1286.64 in early January, the market has tumbled 10% from its high; investors in the more than 5,000 stocks that make up the Wilshire Associates' equity index have become $158 billion poorer.

The market recognizes that the deficit has left the Federal Reserve in a no-win predicament. If the Fed keeps the money supply tight, interest rates will rise as the economy expands and the credit needs of private business collide with heavy Government borrowing. But if the Reserve Board lets the money supply grow fast enough to accommodate the deficit, inflation will probably be rekindled. Volcker has pledged that he will not give up the progress against inflation that the U.S. achieved at the cost of a deep recession. Because of his tough monetary stance and the economic downturn it generated, the increase in the Consumer Price Index dropped from 12.4% in 1980 to 3.8% last year, the lowest level since 1972. But inflation concerns stirred a bit last week when the Government reported a .6% increase in wholesale prices in January, the sharpest rise in 14 months.

The answer to the deficit problem, said Volcker, "is not easier money." The Reserve Board announced that its monetary targets will be slightly stricter this year than in 1983. Its goal for M 1, the basic money supply, which includes mainly currency in circulation and checking accounts, will be 4% to 8%, down from 5% to 9% last year. Said David Jones, chief economist of Wall Street's Aubrey G. Lanston investment firm: "The Fed has thrown down the gauntlet to the Administration, saying, 'We will not monetize the deficit even if this is an election year.' " Volcker's resolve has dashed Wall Street's hopes that interest rates will soon fall.

The stock market's most recent dip started two weeks ago and was triggered in part by the open warfare within the Administration over what to do about the budget. Regan advised members of the Senate Budget Committee to "throw away" the Economic Report of the President, prepared chiefly by Feldstein. The Treasury Secretary was upset about Feldstein's dark view of the deficit and his calls for a tax increase, a step that Regan and President Reagan oppose. A report of Regan's "throw away" comment went over the Dow Jones News Service wire at about 11 a.m. At the time, the Dow Jones industrial average was up 8.17 points. By the 4 p.m. closing bell, the average had sunk 25.02 points, to finish the day down 16.85.

But the Administration's shenanigans had barely begun. White House Chief of Staff James Baker privately berated Feldstein and ordered him to cancel a scheduled appearance over the weekend on ABC's This Week with David Brinkley. The Treasury Secretary denied reports that he had demanded Feldstein be fired, but, Regan admitted, "I urged that differences between us be kept quiet."

Regan, an ex-chairman of the Merrill Lynch investment firm who has bragged of his "35 years of experience in the market," derides Feldstein, who is on leave from Harvard, for being a professor who spent too much time in the library. Last week, after scared stock sellers sided with the prof, Regan tried to dismiss the shake-out as a "natural correction that temporarily interrupts a bull-market upswing."

Before the week was over, Regan and Feldstein had managed to patch together a facade of harmony. At a House Appropriations Committee hearing, they sat side by side and contradicted each other on only a point or two. Later, at the end of a Senate session, Democrat William Proxmire of Wisconsin asked Regan why he had said that Feldstein's economic report should be thrown away. "Sorry, Senator," said Regan, "that was last week." The meeting adjourned amid chuckles.

The public truce, though, did little to mask sharp differences between Regan and Feldstein or to ease fears that the Administration's economic policy is awry. Regan's ideas are very close to the President's original supply-side strategy, which was based on a strong reliance on the stimulative power of tax cuts. Regan believes that the growth generated by the President's tax-reduction program will boost Government revenues and take care of part of the deficit. To reduce the budget gap further, Regan argues, Congress must concentrate on slashing spending. He believes a tax hike would stifle growth and wind up enlarging the deficit.

Feldstein, a mainstream conservative economist who never accepted the most radical claims of the supply-side doctrine, joined the Administration in 1982. He was brought on board to re-establish credibility after the Administration's early predictions of supply-side prosperity and balanced budgets went wildly wrong. Philosophically, Feldstein agrees with Reagan and Regan that the spending side of the ledger is the place to reduce the budget deficit. But Feldstein maintains that if spending cannot be cut sufficiently because of defense needs or the growth of social programs, then taxes must be raised. Along with his Administration ally, Budget Director David Stockman, Feldstein urged the President to include a tax hike in the budget, but Regan's no-tax stance won out in the White House debate. Neither the President nor his political advisers wanted to propose tax increases in an election year.

In his testimony before Congress last week, Volcker backed Feldstein's approach to attacking the deficit. Said the Federal Reserve chairman: "If you can not do it on the spending side, you have got to do it on the revenue side." Volcker said that the economy could absorb a tax increase of about $35 billion without danger to the recovery.

A close look at the 1985 budget figures reveals how fruitless the President's efforts to cut Government spending have been. Reagan's reductions in social programs will produce 1985 savings of only $59 billion. By comparison, the budget shows that between 1981, Reagan's first year in office, and 1985, defense spending will rise $114.5 billion and interest on the national debt will increase $47.4 billion, largely because of the deficit.

Administration officials privately concede they will eventually have to compromise with Congress and accept a tax increase, but they fault Feldstein for admitting it publicly. Says a top policymaker: "As a negotiator, Feldstein's a zero. If you want a compromise, you start by insisting on your position and expect the other side to voice its position. But Feldstein lays all our cards on the table face up before the game even starts."

The game got under way last week as a bipartisan group of congressional leaders accepted an invitation to meet with Administration officials and start negotiations to fashion a $100 billion "down payment" deficit-reduction plan. Expectations for quick success were not high, partly because Reagan was far from the fray, at his California ranch. Complained Democratic Senator Donald Riegle of Michigan: "Here they are meeting, and the President is out of town on vacation. Unless he becomes more actively involved in the discussions, there will be a growing perception that the whole effort is not real."

The negotiations began with a two-hour session at Blair House, the elegant building across Pennsylvania Avenue from the White House. The Administration's team included Regan, Stockman and Baker. On the congressional side, two Reaganite stalwarts, Senator Paul Laxalt of Nevada and Congressman Trent Lott of Mississippi, represented the Republicans. The Democrats were House Majority Leader James Wright of Texas and Senator Daniel Inouye of Hawaii.

The Administration offered a $90 billion proposal divided about equally between spending cuts and revenue-raising tax reforms. Expenditure reductions included rollbacks in farm aid, lower Government-employee pay raises and other items already requested in Reagan's new budget. In addition, the proposal listed $25 billion in unspecified savings from cutting Government waste. The Administration's tax proposals were neither far-reaching nor original. They were mostly loophole closings that had already been passed by the House Ways and Means Committee, only to die in the waning days of Congress's last session.

Wright countered with a plan calling for a stretch-out, from five to six years, of most military procurement programs. That, said Wright, would save $100 billion in one grand sweep. He dismissed the White House proposals as a "shopping list of little things that is a waste of time." Wright's stretch-out plan was a politically sly move because it was originally put forward in 1982 by a leading Republican, former President Gerald Ford.

Neither group made any commitments, and no date was set for new talks. All the players were afraid of championing any deficit-cutting steps that might conceivably prove to be political liabilities in the coming campaign. The only thing agreed upon was that Social Security, the biggest nondefense budget item, was off limits. Observed Democratic Congressman Leon Panetta of California: "There's a helluva lot of political paranoia that's in the way of getting something done."

So far, Republicans and Democrats are both resorting to wait-till-next-year tactics. But if the stock market keeps plunging, interest rates start rising, inflation ticks up some more and the economy begins weakening, the President and Congress may have to try another approach. --By Charles P. Alexander. Reported by Bernard Baumohl and David Beckwith/Washington

With reporting by Bernard Baumohl, David Beckwith