How Budget Cuts Effect the Economy

WHAT will happen to the already staggering US economy if Congress approves massive reductions in federal spending?

Most economists agree that over the long-term removing the shackles of Washington deficit spending will free the US economy to grow. But they differ over whether a dramatic drop in government outlays could push the economy from its current downturn into a steeper slide.

A "nose-dive school" of analysts sees impending doom if the government cuts proceed. A "good-times group," on the other hand, insists that prudence reaps big and early dividends.

The administration, for its part, is tending toward the nose-dive persuasion - at least when it comes to criticizing Republican plans. Since the the White House released its kinder, gentler, deficit-reduction scheme earlier this month - fewer cuts over a 10-year period than the GOP calls for in seven years - officials have stepped up their attacks on the GOP.

President Clinton and his economic advisers say that if all goes according to Republican plan, by 1996 the government will drastically slash its spending, lower tax revenues, and send the nation into recession.

But that claim is countered by Wall Street good-times thinkers, who welcome the strictest fiscal discipline Washington can offer. If the White House and Congress could agree on balancing the budget within the next seven years, predicts Greg Smith of New York's Prudential Securities, the nation's "fiscal path ... would be very bullish for the financial markets," with industry generating more investment and jobs.

Nose-dive view

But "Wall Street is underestimating the intensity of the slow-down .... The reality is that when the economy decelerates sharply, profits do not go up," says David Levy of the Jerome Levy Economics Institute in New York. "The outlook for 1996 will be dismal if deep budget cuts accompany the second potential threat to economic expansion: global recession."

Eliminating deficit spending within seven years, coupled with tax relief, means dumping federal programs and forgoing government revenues at a time when they may be sorely needed, says Gary Bass, executive director of the left-leaning OMB Watch, an advocacy research group in Washington.

The Joint Economic Committee in Congress has calculated that "for every dollar not spent in the public sector, there is a $1.20 return on that dollar in the private sector," says Paul Merski, a JEC economist. So if the US skids into even slower growth, "reducing deficit spending and lowering taxes will be a boost, it will pull us out faster."

Taking such bold steps to balance the budget removes one standard way to ease tough economic times: a fiscal stimulus in the form of government-jobs programs, business credits and other measures to help generate income by keeping people working, shopping in stores, and paying their bills.

"Fiscal tools just don't work," says John Tottie, an analyst with the Citizens for a Sound Economy Foundation. "The best cure for recession is less government, because less government means more resources are left in the private sector.

"This means more jobs and higher economic growth, since the private sector does not waste money on farm subsidies, foreign aid, and other fiascos," he says.

By removing the option of reaching into its own pockets, government is left with only one alternative: to generate added private-sector spending with lower interest rates.

Rates must go down if a possible coming recession is to be different from the last one that lingered, says Daniel Bachman, an economist with the WEFA forecasting group in Philadelphia.

Lessons from 1991

In 1991, government downsizing - mostly sharp drops in defense outlays - had a ripple effect on the economy. The Federal Reserve Board was widely criticized for not pushing rates down far enough and fast enough to generate growth.

"Of course, Fed action today could moderate a lot of that," says Mr. Bachman, who predicts the nation's central bank will "lower interest rates substantially to ease the burden of less government money going into the economy."

Federal Reserve Chairman Alan Greenspan carries the most weight in the Federal Open Market Committee (FOMC), which decides whether rates go up or down.

Tempering recession in the near term does not appear to be his dominant concern. Last week he endorsed the steepest, speediest budget cuts possible for "subtle, but ultimately substantial" economic benefits. The FOMC meets next on July 5.