Risks In Every Direction

By GEORGE J. CHURCH

Let a bad economic situation fester too long, and eventually there are no good policy choices. That was a favorite saying of the late Arthur Burns when he piloted the Federal Reserve Board through the inflation-ridden 1970s, and it applies with equal force to the dilemmas facing Government policymakers in the wake of the stock market's Crash of '87. A babble of conflicting voices warns of peril in almost any course the economic managers might take to reduce the budget and trade deficits and force the country to live within its means. And those warnings cannot be lightly dismissed. There are in fact risks, magnified by years of drift, in any conceivable action on taxes, spending, interest rates, money supply and the U.S. dollar.

No help for it: the greatest risk of all would be to confirm investors' fears that U.S. economic policy will remain paralyzed by indecision and partisan bickering. That might bring on a still worse crash, a world financial crisis and a shattering global recession. Moreover, there does seem to be a way out. In outline: Start now a program to cut the budget deficit steadily and substantially through a mixture of spending cuts and, yes, tax increases. Cushion the blow to the American economy -- and there will be some blow -- by easing Federal Reserve monetary policy and allowing interest rates to come down. Meanwhile seek the cooperation of foreign nations to ease their own interest rates and stimulate their home economies -- and perhaps let the exchange value of the U.S. dollar gradually nudge lower. It will not be an easy policy to carry out, since it calls for a degree of coordination in meshing intricate moves that policymakers rarely achieve. But it might work, and it is difficult to see what else would.

Washington seems to be groping toward some such policy, though as yet timidly and uncertainly. At a so-called domestic summit last week, bipartisan congressional leaders and top advisers to Ronald Reagan began discussing tax increases and spending cuts that would reduce the budget deficit in the current fiscal year by at least $23 billion, more if possible. The President, who before Black Monday had strongly resisted calls for such a conference, got the sessions going by meeting with the legislators and issued a statement urging them "to put aside partisan rivalries and work together for our nation's future." Said Pennsylvania Democrat William Gray: "The atmosphere is charged to get something done."

The first sessions seemed devoted to a cautious feeling out of positions. But by week's end the group had made enough progress to continue meeting over the weekend, and some participants felt a breakthrough was near. They were discussing, among other things, a partial freeze on federal spending for the next two years; there was no word on what tax action might be pending. It seemed clear, though, that the summiteers were unlikely to go beyond a $23 billion deficit reduction in the current fiscal year and indeed were having trouble going that far. Said a participant: "Getting over $20 billion is difficult. The last $3 billion is a bitch."

The sessions at least appeared to be free of the partisan wrangling that erupted on the House floor. There, Speaker Jim Wright rammed through a $14.4 billion deficit-reduction bill by a single vote, 206 to 205. The plan features $12 billion worth of tax increases, including a three-year extension of the 3% telephone excise tax, a shrinking of tax benefits for corporate takeovers, and limits on the amounts of home loans that are eligible for interest deductions ($1 million on mortgages and $100,000 for home-equity loans). "Treacherous!" exclaimed Texas Republican Richard Armey. "This is a bait-and-switch tactic. They baited the President into a summit and then switched on him." The Democrats in fact are likely to use this package of tax increases as a lever to pry concessions out of the White House at the domestic summit. Though Reagan has withdrawn his frequent pledges to veto anything resembling a tax increase, he has made no secret of his reluctance to go any further than he absolutely must to get a deficit-reduction package.

Yet even as the summiteers began meeting, a strange alliance of economists grumbled that the policymakers were taking exactly the wrong tack. That might have been expected from supply-siders, who are opposed to just about any tax increase at any time in the belief that it depresses economic activity. What was surprising was that they were joined by some orthodox Keynesian economists, who ordinarily are at ideological swords' points with the supply- side school.

The anti-action case: the aftershock of the stock-market quake might tip the U.S. into a recession next year. And that is the wrong time to slash away at the deficit; tax boosts and cuts in Government spending would deepen any slump, because they would reduce the amount of money in consumers' hands. Some worriers go so far as to raise the ghost of Herbert Hoover, who slashed federal spending and persuaded Congress to raise income tax rates sharply in the wake of the 1929 Crash. Says University of Tennessee Economist Paul Davidson: "Cutting the deficit at this particular time would be the worst thing we could do. It would be Hooverism all over again. If the budget cuts proceed, we could slip into another Great Depression."

This, however, is a minority view, rebutted by an even more broadly based coalition. For example, in hearings before the House Banking Committee last week, economists ranging from the very conservative Martin Feldstein to the very liberal John Kenneth Galbraith wrangled about the size and composition of deficit cuts but not at all about their necessity. In this view, the U.S. has about come to the end of its ability to cover giant budget and trade deficits by borrowing from foreign investors. The stock-market crash served as a warning of what would happen if the foreign capital is ever withdrawn; thus the nation must reduce its dependence on overseas borrowing for the long-term health of the economy, at whatever cost in immediate pain. Says Barry Bosworth of the Brookings Institution: "Risk of a recession is unavoidable. But a failure to act is even worse. We cannot live with this deficit in the long run." Harvard Economist Lawrence Summers agrees: "Doing nothing about the deficit would definitely bring about an eventual recession."

To these economists, the warnings about Hooverism are vastly overstated anyway. Nobody, they point out, is talking of anything remotely so drastic as the approximate doubling of income tax rates that Hoover engineered in 1932. Alice Rivlin, former head of the Congressional Budget Office, observes that $23 billion "is not a lot in a $1 trillion budget." Indeed, the bigger question is whether $23 billion would be enough to make much difference. A cut of that size is already automatically mandated by the Gramm-Rudman Act, which calls for a slash in most types of spending by Nov. 20 if Congress and the President cannot agree on a substitute package. It would be better if the reduction could be made by mutual agreement -- as a sign that the Government is still able to govern, if for no other reason -- but many economists would like to see a considerably larger reduction. There is no consensus about just how deep the first-year slash can safely go; $30 billion to $40 billion might be a midpoint figure. But, given the summiteers' troubles in reaching even the $23 billion minimum goal, that debate is academic.

In any case, to most economists the exact amount of deficit cuts is less important than two other considerations:

1) They must be real reductions that give some promise of accelerating through 1989, rather than a collection of one-shot gimmicks. Says Feldstein, who once headed Reagan's Council of Economic Advisers: "We have to arrange it so that there will be progressively larger reductions in deficits in later years."

2) The package ought to include some significant tax increases as well as spending cuts. Says Herbert Stein, who was President Nixon's chief economic adviser: "That is necessary to show that the Reagan Administration is sufficiently concerned with the economic problem to be willing to give up one of its favorite ideas," sarcastically characterized by Stein as the "sinfulness of taxation."

But deficit cutting, however desirable or even indispensable, is not enough. Says Walter Joelson, chief economist of General Electric: "If there is no change in monetary policy, and you still have a deficit reduction, then it won't work. The economy would weaken." In other words, tax increases and spending cuts might not in themselves bring about a serious recession, but a combination of those moves and a tight-money, high-interest-rate policy very well might.

Consequently, economists almost unanimously urge that deficit reduction be accompanied by a willingness on the part of the Federal Reserve to increase the U.S. money supply rapidly enough to allow a drop in interest rates. In fact, Summers, Bosworth and many others argue that the deficit must be cut in large part precisely to make an easier-money policy possible. Their reasoning: the only way the U.S. can finance enormous deficits without ruinous inflation is by attracting foreign lenders. But to lure overseas capital, the Fed has been compelled to keep interest rates relatively high. In turn, the high rates, by crimping the borrowing power of consumers and businesses, threaten to tip the U.S. into recession regardless of what else happens. (They also tend to pull money out of the stock market into bonds; rising interest rates and the fear of further increases are widely believed to have helped trigger the Black Monday collapse in stock prices.) But the same chain reaction can work in reverse. Reduce the deficit, and there is less need for foreign borrowing; the Fed can then safely let up on money supply and allow interest rates to come down. That should either ward off recession or soften its bite if a slump begins anyway.

There are some signs that the Fed is shifting in this direction. On the morning after Black Monday, Chairman Alan Greenspan reversed policy to announce that the Federal Reserve Board would make as much money available as might be necessary to avoid a financial crisis, and since then interest rates have come down. But how much further can the Fed go? Its position is endlessly complicated by the precarious state of the U.S. dollar, and that introduces still another tricky calculation into the policy equation.

Several contradictory imperatives are at work. Generally speaking, exchange rates for major currencies ought to be held steady so that goods and capital can flow from one nation to another with minimal uncertainty. But it was widely thought that a once badly overvalued dollar had to come down to ease the U.S. trade deficit. A cheaper dollar makes imports more expensive to American buyers and U.S. exports less costly to foreigners. At the same time, a falling dollar makes it more difficult for the U.S. to attract foreign lenders; they are not eager to buy dollar-denominated securities that shrink in value against their own currencies. The upshot: in 1985 the U.S. and other major nations agreed to let the dollar sink, and for a while it fell drastically. But last February, believing the decline had gone far enough, the six biggest trading nations negotiated the Louvre accord (named after the palace that houses both the museum and the French Finance Ministry), under which they try to keep currency fluctuations in a narrow range.

Many American experts now believe that was a serious mistake. The dollar, its real value undermined by budget and trade deficits, has continued to attract more sellers than buyers. Central banks have spent something like $90 billion this year buying greenbacks to prop up the price. Worse, the Federal Reserve was forced into the high-interest-rate policy that proved to be poison to world stock markets. And still the Louvre values could not be sustained. ( Last week the dollar fell to new lows against the West German mark and Japanese yen; foreign governments seemed willing to buy only enough U.S. currency to cushion, not stop, the decline.

U.S. economists generally believe any attempt to restore the Louvre values would push the Federal Reserve back into a dangerous high-interest-rate policy and would be bound to fail anyway. "Willy-nilly the dollar is going to fall in the next two to three years," says Charles Schultze, who headed the Council of Economic Advisers under Jimmy Carter. Feldstein figures that the dollar would have to drop 30% in five years to reach a sustainable value and adds that if natural market forces were left to work unhindered, most of that decline would occur in the next twelve months.

Free-marketeers like Feldstein would just as soon let that happen and get it over with. Says Herbert Stein: "The dollar should be allowed to decline as far and as fast as it will." But that course runs a gigantic risk: a free- falling dollar could easily touch off a panic flight of foreign capital from the U.S. That is about the last thing anyone wants, since it could trigger a worldwide financial collapse. It would be much better to renegotiate the Louvre accord to allow a gentle, managed decline in the dollar. As part of such an agreement, foreign nations would have to lower their interest rates, so that they would not bid against the U.S. for international capital during the period when the U.S. is slowly weaning itself from dependence on foreign borrowing. That course is necessary for other reasons: Japan, West Germany and possibly other exporting countries would need to stimulate their own economies to take up the slack if a lower American trade deficit reduced their sales to the U.S. Rimmer de Vries, chief international economist of Morgan Guaranty Trust, puts the case for such international cooperation succinctly: "A global economy needs global management."

Can the U.S. win such global cooperation? Prospects seem to be improving slightly. Last week, for example, French Finance Minister Edouard Balladur called for a meeting of the seven largest financial powers as soon as possible to stem turmoil on world financial markets. That represents a reversal of the previous French position and indicates a willingness to revise the Louvre agreement.

Foreign leaders, however, attach one enormous condition, and it brings economic arguments full circle. They will not risk overstimulating their economies and inducing a new round of inflation for the sake of enabling America to continue living beyond its means. They will insist on a meaningful slash in the American budget deficit. The fear of inflation is particularly strong in West Germany, which was still raising interest rates shortly before Black Monday, to the intense displeasure of the U.S. German Finance Minister Gerhard Stoltenberg last week hinted at what would be required to get Bonn to change course. Said he: "What we need most are political decisions in the U.S., strong efforts and agreements to make substantial cuts in the budget deficit." Other officials add that the Germans will insist on hard evidence that this is being done before taking any action to accommodate the U.S. on interest rates.

So all discussions of economic strategy keep coming back to that U.S. deficit. Reducing it is not without risk; to contain that risk will require an exquisitely delicate balancing act between U.S. fiscal and monetary policy and a never before achieved fine tuning of international cooperation. Even then some danger will remain, but it will simply have to be accepted. The deficit is just not sustainable much longer. If it does not give, something else will -- and the stock market has made it all too plain what that something else will be.

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CREDIT: TIME Chart by Cynthia Davis

CAPTION: WHERE TO CUT

DESCRIPTION: Five suggested areas for budget cuts.

With reporting by Bernard Baumohl/New York and Rosemary Byrnes/Washington