Return to red ink: Deficits seen as a threat to economy

Concern grows that a loss of 'fiscal discipline' could push up interest rates.

Twenty months ago the nation was looking at a budget surplus of $313 billion for 2002. Now the government is forecasting a deficit of $157 billion – and more red ink for years ahead.

Federal Reserve Chairman Alan Greenspan warned Congress about that shift last Thursday. "Returning to a fiscal climate of continuous large deficits would risk returning to an era of high interest rates, low levels of investment, and slower growth of productivity," he testified.

During a campaign fundraiser in Davenport, Iowa, Monday, President Bush issued his own call for fiscal discipline.

Many economists also worry about the economic impact of sizable deficits on the economy - at least in the long run.

"If you lose control of the budget, long-term interest rates go up, and that could impede the economy," says Allen Sinai of Decision Economics in New York.

It's true that, at the moment, interest rates on Treasury debts are the lowest in 40 years. "I can scarcely argue that deficits are pressuring interest rates," Mr. Greenspan said. Moreover, the deficit is relatively small. It is about 1.5 percent of gross domestic product, the nation's output of goods and services, versus 5 or 6 percent in the Reagan years.

Nonetheless, investors could become concerned that the renewed deficits are a sign of fiscal irresponsibility. Foreigners could refrain from buying so many American stocks and bonds, eventually pushing up interest rates more than they would climb with a balanced budget.

In the short run, few economists are bothered much by today's deficit. To many it is welcome because it has a stimulative impact on the economy at a time when the recovery from recession is weak.

Stimulant effect

New spending on defense, unemployment insurance, Medicaid, and welfare may help keep consumers spending.

Indeed, Sen. Ted Kennedy (D) of Massachusetts introduced legislation last week to further extend unemployment insurance, with the stated goal of both helping the jobless and boosting the economy.

At the same time, Democrats nowadays harp on the idea of "fiscal responsibility" about as much as Republicans.

Talking about budget discipline, some Democrats call for freezing the remainder of the $1.3 trillion Bush tax cut to improve the long-term budget picture, better the outlook for Social Security, and save money for their favorite causes.

Most of the not-yet-in-effect tax cuts would benefit the nation's wealthy households by trimming their marginal income tax rates and by reducing, and over time ending, taxes on estates.

Democrats also propose federal payments to states hit by the economic slowdown and falling revenues. Many states are cutting jobs and spending to balance budgets.

In contrast, the Bush administration wants the tax cuts pushed ahead and made permanent. It has not taken a position on unemployment insurance or financial help to the states.

There has been speculation that President Bush would seek additional tax cuts. Bush would bill these as an attempt to pep up the economy by helping investors provide capital for the growth of business.

These would help, but "not a lot," says Sinai, who was at the president's forum in Waco, Texas, on the economy last month.

Discretionary spending debate

Greenspan opposed freezing the remainder of the Bush tax cut, saying only $500 billion would be saved. But Peter Orszag, an economist at the Brookings Institution in Washington, maintains its much more than that, since Greenspan's calculation assumes that the entire tax cut will expire in 2010, an unlikely event.

The Republican central bank chief suggested renewing 12-year-old budget control measures set to expire at the end of this month as a partial way of restoring a balanced budget. He refused to get into details as to what measures would help.

But Mr. Sinai assumes Greenspan wants federal spending, other than for the "war on terrorism." shrunk more. Between 1990 and 1998, "discretionary" spending by Washington fell from more than 10 percent of GDP to less than 6 percent.

Richard Kogan, a drafter of the Budget Enforcement Act of 1990 praised by Greenspan for disciplining congressional spending, sees the current budget deficits as having helped avoid a deeper recession. Now a budget analyst at the Center on Budget and Policy Priorities in Washington, he would like the federal government to give an extra $40 billion to $50 billion to the states.

"Every penny would be spent," he says.

The big picture

Economists, as usual, have a range of views on the economy.

Sinai thinks that the robust 4 percent growth rate in the current quarter could slip back to 2.5 to 2.75 percent as car sales fade. By contrast, Susan Hickok, chief economist of Prudential Economics, predicts that output in this second half will rise at a 4.9 percent annual rate.

Almost all economists now figure the Fed won't drop interest rates further when its policymakers meet again next week. Five presidents of regional Fed branches have hinted that by indicating they expect the economy to pick up in coming months.

One uncertain factor is the possibility of an American strike on Iraq. Extra military spending could lift the economy. But if the war causes oil prices to rise dramatically, it could depress activity.

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