Bill Clinton was in a teasing mood during an Oval Office meeting last August. The White House had won a tense congressional battle to pass its $496 billion deficit-reduction bill, and long-term interest rates were falling sharply. But the reward for fiscal discipline -- an economic rebound predicted by advisers Robert Rubin and Laura D'Andrea Tyson -- had yet to materialize. "OK, guys," Clinton needled the pair, "where is it?"
Since that day, of course, the economy has responded. Economic growth accelerated to a rate of more than 4 percent in the second half of last year, and the White House declared 1993 a victory for Clintonomics. But last week's economic news was punctuated by a new batch of question marks. Major retailers such as Wal-Mart and Sears reported modest sales gains during January, a month when the nation was battered by the Los Angeles earthquake and winter storms. The U.S. Labor Department reported that payrolls expanded by a disappointing 62,000 jobs in January -- the smallest gain in five months -- even though the unemployment rate, as measured by a new survey method, fell to 6.7 percent from 7 percent in December.
And then, in an end-of-the-week announcement that startled financial markets, Federal Reserve Board Chairman Alan Greenspan said the nation's central bank had decided to push up short-term interest rates for the first time in five years. Greenspan believes that raising the Fed's target for the influential federal funds rate, from 3 percent to 3.25 percent, will dampen inflationary expectations as the economy expands this year. But Greenspan's timing stunned many economists, who said that Washington's recent deficit cutting had helped cool inflationary pressures and reduced the need for an early increase in interest rates.
This week, as Clinton submits his second budget to Congress, the fiscal ferment in Washington will intensify. Budget hawks on Capitol Hill plan to resume their campaign for a balanced-budget amendment. They are also expected to seek deep new spending cuts. Last year Republican Representative John Kasich of Ohio and Democrat Tim Penny of Minnesota were narrowly defeated in their attempt to further slash federal outlays. The White House has other priorities. Clinton's budget for fiscal 1995 will project a deficit of roughly $178 billion -- a dramatic improvement over the $230 billion shortfall that administration economists predicted just one year ago. Clinton will propose freezing or cutting budgets at 10 of 14 cabinet agencies and eliminating perhaps 115 separate federal programs. But he wants to redeploy the savings to federal "investments," such as Head Start and worker training, rather than pressing for deeper deficit reduction. Says White House economic adviser Gene Sperling: "This isn't about beating your chest to see who can cut spending the most. It's about improving the economy."
Good news. The danger is that Washington's ideological clamor will drown out a quiet economic truth: Last year's budget package changed fiscal policy significantly, and the economy is already responding. In its widely watched annual economic forecast, the Congressional Budget Office said last month that the federal deficit came in at $255 billion last year -- fully $55 billion less than the agency predicted just one year ago -- and will continue shrinking gradually until 1996. The yield on a 10-year Treasury note averaged just 5.9 percent in 1993, compared with the 6.7 percent forecast by CBO one year ago, and consumer inflation moderated to 2.7 percent, down from the 3 percent that CBO had predicted.
This new forecast for deficits and interest rates will continue to send ripples throughout the rest of the economy. To illustrate the impact of shrinking deficits on economic performance, U.S. News asked the WEFA Group, a Pennsylvania-based forecasting firm, to simulate the effects of additional deficit reduction. WEFA did not assume that Congress would enact new taxes or bigger spending cuts, but it did assume that inflation will remain at about 2.5 percent annually for the next four years instead of rising above 3 percent as the economy expands. Lower inflation would help shrink federal deficits because, even though it restrains the growth of tax revenues, it produces even bigger savings in government outlays on pensions, medical care and other programs. And while a sustained inflation rate of just 2.5 percent would have been unthinkable only a decade ago, the new fiscal restraint in Washington, coupled with rampant cost cutting in corporate America, has altered inflationary expectations significantly. CBO, for example, now predicts that inflation will remain at 3 percent or less through 1995, while economist Allen Sinai of Lehman Brothers Global Economics forecasts inflation at 2.5 percent this year and 2.8 percent next year.
Payoff. The WEFA simulation shows dramatic payoffs from that sort of price restraint. With low inflation curbing federal outlays, the budget deficit shrinks to $110.5 billion in 1997, almost 14 percent less than it would be if inflation rebounded. The reduction in federal credit demands releases funds for business investment and consumer borrowing, triggering a growth spurt that adds $26.1 billion to national economic output by 1997 and leaving gross domestic product 0.5 percentage points higher than it would have been with bigger federal deficits. Consumers get an extra $17.3 billion of disposable income from an expanding economy, auto sales climb an extra 150,000 units to reach almost 10.5 million because of higher incomes and lower financing costs, and employers create an additional 380,000 jobs by 1997.
This economic chain reaction shouldn't surprise anyone who followed a financial phenomenon called crowding out during the 1980s. The federal debt load, which more than tripled to $3.2 trillion between 1980 and 1990, put a squeeze on the nation's credit markets. Competition for scarce capital forced interest rates to artificially high levels, and this in turn depressed business investment. But if federal borrowing really does decelerate during the 1990s, Washington would put a much smaller drain on the nation's pool of savings. In the WEFA simulation, business investment rises smartly as the economy expands, yet long-term interest rates inch up only modestly, to 6.8 percent, compared with 7.2 percent under a more pessimistic deficit scenario. Says Harvard University economist Benjamin Friedman: "The whole point of deficit reduction is to undo crowding out. And today we're seeing real progress."
Washington's fiscal restraint makes this economic cycle virtually unique in the memories of many economists. The expansion that started in 1991 is proceeding "with no help at all from the federal government sector," says Lehman Brothers' Sinai. He adds: "No other business expansion in modern economic history has been so characterized."
The degree of this federal retrenchment is spelled out in the CBO's latest budget report. In his congressional testimony last month, CBO Director Robert Reischauer delivered a remarkable piece of arithmetic: Excluding Medicare and Medicaid, every single category of federal spending is now either shrinking or stable in relation to the size of the U.S. economy. It is the first time in at least a generation that virtually all of the federal government is contracting as a share of gross domestic product.
What might happen if spending on Medicare and Medicaid began to slow down, too? WEFA simulated the economic outlook if inflation in medical services decelerated to less than 5 percent annually, instead of the 5 percent to 6 percent increases it has posted in recent years. Again, the economic impact is startling. The federal deficit shrinks to $112.2 billion, or about 12 percent less than it would be if health care costs resumed rising. With a smaller federal drain on the private savings pool, long-term interest rates edge up to just 6.9 percent, compared with 7.2 percent if federal borrowing were greater. Consumers' disposable income surges by $18.5 billion, car
