139

Response to Congressman Horton's Questions

July 24, 1986 Lawrence Chimerine

Questions for Dr. Chimerine

1) James Miller, Director of OMB, was recently quoted as blaming higher deficits partly on lower inflation than originally anticipated. You state (p. 3, (d)) that recent price indexes are understating inflation. Do you agree with Mr. Miller?

2)

Inflation in the recent past has been lower than what the
Administration and most private forecasters have expected-in the
short run, this does hold down tax revenue and increase the deficit
over what would have occurred with higher inflation. However, in
my judgment, this is a rather small factor in the current deficit
problem-much larger causes have been weaker-than-expected
economic growth, and a sharp understatement of expenditures for
agricultural and defense programs.

What do you see as the actual inflation rate now?

As of now inflation is varying considerably by sector-for example,
inflation in the service sector is in the 4.0% to 5.0% range, while
commodity prices are actually falling in many cases. On average,
however, I would put the overall inflation rate for the economy as a
whole as currently in the 2.0% to 3.0% range, and it is likely to rise
somewhat once oil prices stop declining.

If lower interest rates will not encourage consumers to spend more (p. 3), how do you feel this could be accomplished?

The primary factor impacting consumer spending is the growth in
income-as I mentioned in my testimony, personal income in general,
and wages and salaries in particular, are growing very slowly. This
will eventually cause a sharp deceleration in consumer spending,
especially in view of the low saving rate and high debt burdens
currently in place. In my judgment, the only way for consumer
spending to be more vigorous in the period ahead is if income growth
accelerates, which would only take place if manufacturing
employment stabilizes and begins to rise in response to a turnaround
in the trade deficit.

3) What is your basis for saying GNP data is inconsistent with other economic data (p. 3)? Do you suggest any other set of data to more accurately measure total economic output?

4)

My point regarding GNP data is largely that the economy was not as
strong as first-quarter GNP suggests, primarily because the National
Income Accounts indicate a rapid rise in consumer spending, which I
believe is being overstated-in particular, it is inconsistent with
retail sales activity.

You point out negative aspects of the recent fall in oil prices (p. 4, #3). Would an increase in current oil prices, say back to the 1984 levels, have overall positive effects on our economy?

I do not believe that an increase in oil prices back to the levels of
1984 would have an overall positive effect on the economy, though it
would benefit the Southwest. My main point, however, is that the

5)

declines in oil prices will not be a very large stimulant to the
economy, and secondly that there are sizable risks inherent in
further declines in oil prices because they would add to the financial
strains which already exist in the system.

You state that the stock market is really a sign of weakness (p. 5). Could you explain the basis of your conclusion? What would a decline in stock values at this time represent?

In regard to the stock market, other than annecdotal evidence I have
no conclusive evidence to support my view that the stock market has
in fact benefitted from the sluggish economy which now prevails.
Many companies have been purchasing their own stock instead of
using those funds for capital investment-this has helped to help
push up stock prices, but it has held back the real economy.
Furthermore, it seems clear that lower interest rates have had a
favorable effect on the stock market by reducing the return on
alternative investments, and by increasing the current value of
expected future earnings as I mentioned in my testimony, I believe
recent declines in interest rates are at least in part a direct result
of the weak economy.

6) If interest rates continue to slide lower, would you still feel the housing boom has peaked? Would this be true if your recommendation that interest rates be greatly reduced were implemented?

I believe it will take some additional declines in interest rates just
to maintain the current level of housing activity, otherwise housing
will taper off. However, a very sharp decline in rates (such as a
decline in mortgage rates to, say, 8%) could in fact cause housing
activity to remain at peak levels or increase slightly further. It
should be noted that there is only a limited demand for housing
based on population and demographic characteristics, so that lower
and lower interest rates cannot push up housing activity on a
sustained basis.

General Questions

1)

What effect on the economy do you forsee if (economic) conditions remain the same as they are now and Congress cuts Federal spending to reach the $144 billion deficit level?

As I mentioned in my testimony, any effort to cut spending by a
sufficient magnitude to reach the $144 billion Gramm-Rudman
deficit target for FY87, assuming that realistic assumptions were
used in projecting the deficit, would produce an enormously
restrictive policy in the short run, which would exert considerable
additional downward pressure on an already sluggish economy--
complete stagnation or even a mild recession could result.

2) Based on your evaluation of the overall economy at this time, what actions are necessary, in economic terms, to ensure that reaching the $144 billion deficit goal will do damage our government programs and our economy during the next fiscal year?

3)

4)

I believe the only action would be to ignore the $144 billion deficit
target. There is no way to prevent some negative short-term
effects on the economy, as well as to severely damage some existing
programs, if serious efforts to reach the $144 billion deficit target
are in fact made, and if realistic economic assumptions are used in
the process.

How do you foresee the new tax bill affecting FY87 revenues? The economy in FY87?
It is difficult to make a good estimate about how the next new tax
bill will effect FY87 revenues until the final provisions are
determined. It will depend heavily upon the effects of those various
provisions. However, both the Senate and the House bills would have
raised revenues somewhat in FY87. With respect to the economy, I
believe that the tax reform bill that will likely emerge will have a
modest negative impact on the economy later this year and in 1987,
reflecting the likelihood that it will hit already weak investment and
construction very hard. In addition, because the changes in the tax
code will be so large, there may be a fairly long period during which
commitments may be delayed as the new law is being assessed.
Finally, many of the winners of tax reform are likely to increase
their expenditures gradually over time, while many of the losers will
cut back more quickly.

Do you believe that increasing revenues would be an appropriate way of reducing the budget deficit?

I see no acceptable way of achieving even a modest downward trend
in the Federal budget deficit in the years ahead without at least
some modest increase in revenues, especially if the reluctance of
Congress and the Administration toward cutting entitlement
programs remains in place. In my view, many of the other domestic
programs have already been cut enough or even too much, and it
appears that further cuts in the defense budget will be difficult to
achieve. Thus, some revenue increases will be necessary.

What form of revenue enhancement would most effectively reduce the deficit without hurting the economy?

In my judgment, I believe that the added revenues that must be
raised should come from income taxes and should be done in a way
that will not make the tax structure even less regressive than we
have already done during the last several years. The ideal way to
accomplish this would be to combine deficit reduction with tax
reform, so that tax rates are set at such a level so that some
incremental revenues will be produced during the years ahead.

D)

What, in your judgment, is the appropriate mix of spending cuts and revenue increases for bringing down the deficit to levels which are sanctioned by Gramm-Rudman?

I believe that on a long-term basis, at least one-third of any deficit
reductions will have to come on the revenue side, even if we strive
for a target of a $100 billion budget deficit by 1991.. If in fact a
balanced budget by 1991 remains the goal, as much as one-half or
more of future changes will have to be on the revenue side.

Today's New York Times reports that the economy grew last quarter at an annual rate of 1.1%. What specific steps would you suggest to stimulate the economy, thereby increasing revenues, but avoiding inflation?

As I mentioned in my testimony, economic policy is limited at this
point in terms of providing additional stimulus to the economy. In
particular, I would advise against tax cuts or spending increases
because these would further widen the deficit in the short term, and
make our long-term problems even more severe. Thus, I think the
appropriate roles of both fiscal and monetary policy in the short
term would be to avoid making the economic situation worse-I think
the way to accomplish this is by cutting interest rates further and by
limiting the amount of deficit reduction in the short term. The
easing of monetary policy is necessary because without even lower
interest rates, the economy might slacken off further.

143

RESPONSES OF JOSEPH W. DUNCAN TO QUESTIONS SUBMITTED BY MR. HORTON

For Mr. Horton

1. Q. As you know, Gramm-Rudman calls for a deficit in FY 87 not to exceed $144 billion. What effect on the economy do you foresee if conditions remain the same as they are now and Congress cuts federal spending to reach the $144 billion deficit level?

2.

3.

A. My economic forecast assumes that Congress cuts special spending to reach the $144 billion deficit level. I do not see any negative effects on economic health if the Gramm-Rudman-Hollings target is met. However, failure to approach the Gramm-Rudman-Hollings target for fiscal 1987 could be detrimental to long term expectations concerning the ability of the United States to brings its fiscal condition under control.

Q. Based on your evaluation of the overall economy at this time, what actions are necessary, in economic terms, to ensure that reaching the $144 billion deficit goal will not do damage to our government programs and our economy during the next fiscal year?

A. Across-the-board cuts would be harmful to government programs because those cuts would be undertaken regardless of current social and economic priorities. The best procedure to achieve the $144 billion deficit target is to implement selective cuts in programs which are viewed as nonessential. Further, the Defense Department's substantial available budget authority allows for defense cuts in strategic weapons acquisitioned wihtout dramatically altering the nation's strategic position. Further, Congress should reevaluate the proposition that government programs should not be touched. The formula for cost of living increases minus one or two percentage points would make a major contribution to bringing the fiscal policy into line.

Q. How do you foresee the new tax bill affecting:

a) Fiscal Year 1987 revenues?

b) the economy in FY 87?

A. My assumptions concerning the new tax bill are identified in my testimony. Under my assumptions, fiscal 1987 revenues would be reduced and the economy would be stimulated.