Rewards Follow If U.S. Ends Deficit, Experts Say : Budget: But they caution that the path to lower interest rates and higher standards of living is long, bumpy and unpredictable.

WASHINGTON —  As political leaders haggle over the details of Congress’ plan to balance the federal budget, there is one detail that virtually all agree on: The nation will be rewarded with a bounty of lower interest rates if the red ink really vanishes.

Getting rid of the deficit ultimately could drive interest rates down by as much as one or even two percentage points, both liberal and conservative economists say. That would provide a windfall to much of society and pave the way for a long-term rise in living standards.

But there’s a hitch. Don’t count on a full payoff anytime soon.

The path to cheaper rates--and all the benefits that come with them--could prove bumpy, unpredictable and highly frustrating for anyone who expects the world to change overnight, experts counsel.

“I suspect that interest rates will fall sharply when the [budget] compromise is announced,” said Stephen S. Roach, an economist at the Morgan Stanley investment firm in New York. “The markets will breathe a sigh of relief and rally sharply. But that rally will be short-lived once they pick up the pieces and look at the program.”

The program now being worked out in House-Senate negotiations would overhaul government spending priorities in an attempt to balance the budget by the year 2002. In the process, it would reshape the U.S. economy and affect the well-being of individuals, households, employers, industries and even states in ways that are only dimly understood.

Indeed, the White House and Congress remain at odds over key issues, including health care and taxes, that could have a huge effect on how individuals experience the shift toward a balanced budget.

Economists disagree, meanwhile, on whether an extraordinary, one-two combination of tighter spending and hefty tax breaks would slow the economy or leave growth little changed as the current economic expansion becomes long in the tooth in 1996 and 1997.

The beguiling promise of lower interest rates, however, is what has captured Congress’ imagination. Analysts say lower rates could provide a cash windfall to Americans at various perches of the wealth ladder: credit card holders and investors, home buyers and mom-and-pop business owners, ordinary borrowers and multinational corporations.

Even the poor, who would lose many government benefits under the separate budget-balancing plans approved by the House and Senate, might be aided by lower rates if they helped keep the economy afloat and bring new jobs.

Just how fast rates would fall remains a mystery, however. Indeed, some scholars look upon today’s budget efforts with a wariness born of past realities.

“If the plan is real, eventually the [interest rate] benefit will be there,” said Harvard University economist Benjamin M. Friedman. For now, he added, “some substantial skepticism is warranted over whether the budget actually will be balanced in seven years.”

Red Ink’s Harm

While it is Republicans who have turned the federal deficit into an economic demon, economists of varying philosophies agree that red ink is harmful to the nation’s health. Budget deficits force the government to borrow huge sums of money, “crowding out” private individuals who must compete for a finite supply of credit. The excess demand for capital drives up its cost, in the form of higher interest rates.

Last year, for example, the government borrowed a mind-boggling $2.2 trillion, according to the Treasury Department, not only to cover the $164-billion deficit for fiscal 1995 but also to accommodate the refinancing of old debt resulting from earlier deficits.

If financing huge deficits drives interest rates up, then slashing deficits would have the opposite effect, or so goes the logic.

To many who advocate a balanced budget, lower interest rates are just the appetizer on a menu of economic gains. The main course comes in the form of a wealthier nation that devotes more of its resources to savings and investment. That is because lower rates make it easier for business to invest in new technology and facilities that boost productivity, the key to rising social prosperity.

Yet waiting for this happy development may prove an exercise in deferred gratification, economists say.

“Let’s not paint this as an incredible transformation of the economy, like you’re going to wake up in 1996 and everything’s going to be beautiful,” said Laurence H. Meyer, an economic forecaster in St. Louis. “You’ve got to go a long way out before you see the sacrifice paying off. I’m not saying it doesn’t happen. But you’re talking about decades.”

For Congress and the White House, the work has only begun. Even if they agree on the broad outlines of a path to balance the budget, this year’s efforts will have to be followed up every year as the budget process grinds on.

Should the efforts succeed, economists typically foresee a decline in interest rates of one to two percentage points. The Congressional Budget Office, for example, calculated that rates would fall 1.5 percentage points. Still, the estimates vary. A July study by the DRI-McGraw Hill forecasting firm found that a balanced budget could knock 2.7 percentage points off fixed-rate mortgages within seven years, and 1.7 points off variable-rate home loans.

The question of when rates would fall is more disputed than whether or even by how much.

“It all depends on people’s perception of whether the package is credible, whether it’s permanent or whether it will be changed around 10 million times,” said Mickey D. Levy, chief financial economist with NationsBank in New York. “If financial markets find the plan absolutely believable from Day One, it could all move right away.”

Skepticism about interest rates arises from Congress’ ill-fated bids to control spending in the past. It was in the 1980s, after all, that the phrase “rosy scenario” became a cliche in budget debates, reflecting the view that upbeat forecasts about the deficit inevitably proved disappointing. As the deficit soared past the $200-billion mark, it became a major issue--but high-profile efforts to conquer it fell short.

Not only did the 1985 legislation known as Gramm-Rudman-Hollings fail to meet its deficit-reduction targets, but the Supreme Court also ruled that its mechanism for keeping lawmakers on the task--automatic, across-the-board spending cuts--was unconstitutional. Two years later, a revised version of the law met with no more success.

In contrast, today’s budget plans are universally regarded as tougher than their 1980s ancestors, particularly in their controversial proposals to control health care spending.

Nevertheless, some economists scold Congress for the size and nature of proposed tax cuts. Especially worrisome is the proposed $500-per-child tax credit, which would cost a boatload of money without rewarding economically productive behavior. Moreover, GOP leaders would push back much of the spending cuts’ pain to the end of the seven-year period, even as the tax breaks kicked in rapidly.

“You get your sweet first, then you take your sour,” said Donald Ratajczak, an economic forecaster at Georgia State University. He wondered whether Congress would have the stomach for the sour after enjoying the sweet.

Skeptics also wonder whether Congress could muster the will to continue with spending cutbacks if the national mood shifted and the deficit faded as a public concern.

“If we all believed deep in our gut that the next three elected Congresses would abide by the budget cuts of this Congress, then interest rates could go down 1 to 1.5 percentage points,” Ratajczak said. “But people doubt it.”

Wall Street’s Verdict

In the event of a budget deal between the President and Congress, the Federal Reserve may provide an early reality check. Most observers believe that a credible deal would help persuade the Fed to ease short-term interest rates, to offset any drag on the economy from spending cuts.

However, the ultimate verdict on credibility will come not from the Fed, which directly controls only short-term interest rates, but from the financial markets, which determine whether long-term rates rise or fall. And Wall Street investors are keenly aware of past missteps on the path to a balanced budget.

“I’d say the skepticism is pretty universal,” said Douglas J. Schindewolf, a money market economist with the Smith Barney investment firm. “I understand it, and I’m not surprised by it. But at the same time, you have to recognize that the skepticism isn’t overpowering.”

In fact, the unworried behavior of interest rates this year is evidence for the view that budget history may not repeat itself this time around. Long-term rates have fallen about 2 percentage points since late last year, reflecting a lack of anxiety over inflation and, many believe, a growing confidence that there will be a meaningful budget deal.

Not that anyone can assign a particular amount of credit for the drop in rates to expectations on the budget.

“I’d say that’s part of it, but it’s not all of it,” said Kyle A. Permut, a managing director with the Oppenheimer & Co. investment firm. “You’ve got a great inflationary environment.”

What’s more, Congress in the 1990s has already displayed a bit more fiscal discipline than its recent predecessors. For example, spending caps for domestic discretionary programs (which excludes mandatory programs, such as Social Security) have been met.

“History suggests another disappointment,” said Donald H. Straszheim, chief economist at the Merrill Lynch investment firm. Yet he wrote in a recent analysis that U.S. fiscal policy is really going to change: “This time it’s different.”