05/19/97 HOW GROWTH COULD END THE BUDGET WARS

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HOW GROWTH COULD END THE BUDGET WARS

Which came first, the strong economy or the shrinking deficit? Has the damming of Washington's flood of red ink spurred today's startlingly healthy growth? Or is it growth that's making the once daunting job of balancing the budget seem as easy as boiling water?
Inside the Beltway, President Clinton and the GOP leaders of Congress are too busy divvying up the spoils of the booming economy--an unexpected $225 billion in extra tax revenues over the next five years--to worry about such philosophical questions. The extra cash, added to the Congressional Budget Office's forecasts in the wake of April's unanticipated $45 billion surge in tax payments, let White House and congressional budget negotiators add extra spending and avoid some of the most politically painful cuts they had contemplated. That should provide the lubricant that Clinton and Senate Majority Leader Trent Lott (R-Miss.) need to get their bipartisan budget pact ratified by Congress.
REVENUE GIFT. While the politicians nail down the final details, economists are focusing on how growth and the dwindling deficit are supporting each other. Clinton's 1993 budget cuts, which reduced projected red ink by more than $400 billion over five years, sparked a major drop in interest rates that helped boost investment in all the equipment and systems that brought forth the New Age economy of technological innovation and rising productivity. In turn, faster growth and income gains have brought the budget closer to balance. CBO's revenue gift of $225 billion over the next five years makes up the single largest chunk of savings in the new budget deal. ''It's the economy that's balancing the budget,'' says Bruce E. Steinberg, chief economist at Merrill Lynch & Co.
The new budget deal should keep the synergy going. With less borrowing by the Treasury Dept., interest rates could fall by one full point over the next 12 months, pushing the 10-year Treasury note to 5.7%, according to DRI/McGraw-Hill. The cash no longer needed for debt service will boost the nation's stock of productive capital by $200 billion or so over the next five years, yielding close to $70 billion in extra economic output. These payoffs don't take into account the kick that Republicans predict will come when the top rate on capital gains is shaved by as much as 8 points from its current 28%.
A vanishing deficit also makes it easier for the Federal Reserve to keep monetary policy on an even keel. The huge deficits of the past have kept long-term interest rates high and created stimulus that the Fed had to offset by pushing up short-term rates. But in an era of no fiscal stimulus and low inflation, the Fed may be able to keep short-term interest rates around 4% to 4.5%, predicts Joel L. Naroff, chief bank economist for First Union Corp.
Is this a return to the 4%-plus annual growth nirvana of the '60s? Washington's official economists don't think so. The White House projects that the economy can only grow at a mere 2.3% rate over the long term, and Janet L. Yellen, chair of Clinton's Council of Economic Advisers, says that ''we would be reluctant to revise that up'' without lasting evidence that productivity will continue to increase quickly. CBO does plan to raise its estimate of the economy's growth potential, but will add only 0.1 or 0.2 percentage points to its current forecast of 2.1%. That will essentially bring CBO's forecast in line with the White House view.
Still, even small increases can make the future brighter. Faster growth would improve the odds for keeping the budget balanced so that the deficit doesn't zoom back into the stratosphere after 2002. And a strong economy can start to solve the looming entitlement crisis of the 21st century by making it easier to pay for pensions and medical care for retiring baby boomers. If the 0.2 percent growth hike CBO projects shows up in real wages, government actuaries say the projected 75-year deficit in Social Security will shrink by 10%--a downpayment, at least, on fixing the retirement system. Medicare, too, will fare better if wages grow, though even optimistic economic forecasts don't have the economy expanding as rapidly as health-care spending.
JUSTIFICATION. The downside of all the good news? The growth payoff lets Washington avoid tough choices. While politicians talk about the need to slow entitlement growth, budget negotiators used CBO's surprise revenue to back away from plans to cap future federal spending on Medicaid and slow down cost-of-living increases for Social Security. The budget deal now creates two new entitlements--$17 billion for federal health insurance for children of the working poor and $35 billion in tax breaks for lower- and middle-class college students. These programs may be worthy and popular. But if they follow the path of most entitlements, they'll prove more costly than expected, complicating future budget problems.
For fiscal conservatives, new programs and deferrals of tough choices suggest that politicians are again shying away from meaningful cutbacks. ''The permanent structure of government will be bigger,'' fumes Senator Phil Gramm (R-Tex.). But if the economy is growing as fast as--or faster than--the budget, that may not strike most Americans as a bad deal.
By Mike McNamee, with Dean Foust, in Washington

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