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What If They Actually Balanced The Budget?

News: Analysis & Commentary: THE ECONOMY


It may be the most crucial policy debate of the decade: Will balancing the budget over seven years condemn the economy to chronic weakness and recession? Or will getting the government's finances in order unshackle the economy?

Here's one vote for the optimistic scenario. DRI/McGraw-Hill, the economic consulting subsidiary of BUSINESS WEEK's parent, has assessed the macroeconomic and regional effects of the Republican's budget-balancing blueprint. The result: Some parts of the country will show healthy employment gains while others lose out. But overall, the national economy will grow stronger and more globally competitive. "One of the problems with deficit reduction is fear," says Roger E. Brinner, chief economist at DRI. "But deficit reduction is truly digestible in this economy."

Of course, most budget-cut specifics won't be fleshed out until this fall. Still, the Republican budget resolution offers broad guidance. DRI's model assumes that the GOP will succeed, for example, in slowing annual growth in Medicare spending by $270 billion and Medicaid by $180 billion, and it accepts that overall planned government spending will be reduced by nearly $1 trillion over seven years. It assumes that bond investors will react by driving long-term interest rates to nearly 4% in 2002. It expects a major capital-gains tax cut, and sees the Federal Reserve Board aggressively pursuing a looser monetary policy to offset the fiscal contraction.

As a result, DRI says, real gross domestic product in 1996 would come out 0.3% lower than current projections. But by 2005, real GDP would be about 1% higher, as a restrained government sparks strong investment and higher productivity. A 17% drop in federal spending would put hundreds of thousands of government employees out of work. Yet with the fed funds rate, the rate banks charge each other for overnight money, dropping as low as 3.5%, the stock market booming, and investment spending surging, overall unemployment would hover around a low 6%.

Pie in the sky? Not to Jared E. Hazleton, director of the Center for Business & Economic Analysis at Texas A&M University. He points out that Fort Worth has lost at least 13,000 defense-related jobs over the past five years and that the loss has been largely absorbed by growth in the service sector. Robert D. Reischauer, former Congressional Budget Office director, agrees: "Downsizing the federal no different from IBM and other companies laying off thousands," says Reischauer. "It hurts the communities where these people are let go, but a big, dynamic economy like ours reabsorbs people."

MIXED BAG. Industry, in fact, should gain broadly from deficit reduction. By 2005, according to DRI, capital spending will jump by an extra 6% as businesses load up on computers, machine tools, and other goods. Lower interest rates should also hike car sales by 250,000 units a year by 2005, housing starts should jump by roughly 5% a year from 1997 on, and exports will increase.

The regional impact is less conclusive (map). In a balanced-budget world, the manufacturing belt of the Midwest would gain from strong plant and equipment investment and healthier auto sales. Much of the Southeast and the Gulf Coast would do better than average, too, partly because these regions are less dependent on Medicare and Medicaid expenditures while likely to get a boost from higher exports, says Sara Johnson, chief regional economist at DRI. Florida, of course, would suffer with its large elderly population.

The Northeast is a mixed bag. It produces many high-tech capital goods--a plus. But health care is big business in the New York-to-Boston corridor, and Mitchell L. Moss, director of the Taub Urban Research Center at New York University, expects massive consolidation in the New York and New Jersey hospital business. According to DRI, balancing the budget means 19,500 fewer jobs than otherwise expected in New England and 80,900 less in the Middle Atlantic states in 2002. Much of the Pacific region will suffer because of a high concentration of federal employment.

The fiscal squeeze on most states, meanwhile, could be nothing to sneeze at. By DRI's reckoning, federal aid to the states will be at least $40 billion lower than current projections in 2000--evidence that there is no painless way to eliminate America's chronic budget deficit. Still, it appears that the payoff is worth the risk--if Fed inflation hawks and bond-market vigilantes become convinced that Washington is finally serious about fiscal discipline. In the end, that's the question to be answered: Does Washington have what it takes to get its fiscal house in order?By Christopher Farrell in New York, with Wendy Zellner in Dallas and bureau reports

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