Rates may climb 100 basis points if budget killed, Treasury says.

WASHINGTON - The Treasury Department is projecting that interest rates on government securities could jump by 100 basis points, provoking other economic reverberations, if the Senate defeats President Clinton's $500 billion budget plan this month.

An analysis by the department's economic policy office, released by Treasury Secretary Lloyd Bentsen on Sunday, predicts both "substantial disruption of the financial markets in the short run" and "severe damage to the American economy in the medium and long run" should the plan fail.

The Clinton administration and Senate Democratic leaders have been drafting a compromise amendment to help make passage of the plan easier in the Senate Finance Committee and the full Senate by increasing its ratio of spending cuts to tax increases.

But with no Republican support for the plan, and Democrats commanding only slim margins in the committee and on the floor, the voting is expected to be very close.

While Bentsen and Clinton have been warning about the possible consequences for interest rates should the plan go down, the analysis by one of the administration's three top forecasting units is the first to attempt to quantify the precise impact that the failure, would have on the credit markets.

Wall Street economists said the analysis' predictions are plausible, though probably overstated, because they assume that the failure of the Clinton plan would mean the end of spending discipline in Congress.

The Treasury analysis asserts that a "return to the high-deficit uncontrolled budget policies of the past decade" after defeat of the plan not only would cause a sizable increase in Treasury rates, but would force consumer, business, and mortgage interest rates up "by at least as much."

Loss of control over the $300 billion deficit also would reignite fears of inflation and restrictive monetary policy, the analysis says.

"The Federal Reserve will come under pressure to offset the return to excessively loose fiscal policy," said Alicia H. Munnell, the Treasury's assistant secretary for economic policy, in a memorandum appended to the analysis.

The resulting turmoil in the bond market would, in turn, cause a sharp decline in the stock market as well, the analysis says. "Historically, a sharp rise in rates has driven down the Dow Jones industrial average," Munnell said.

The interest rate rise and more restrictive Fed policies, while "outweighing the short-run expansionary effect of less deficit reduction," in the long run would slow the rate of productivity growth and output, Munnell said.

"The reversal of interest rate declines depresses investment and consumption, and reduces production and employment," the analysis says. The result would be a $50 billion drop in the gross domestic product and a 170,000 increase in joblessness by 1998, it says.

Higher interest costs also would add $45 billion to the annual deficit by 1998, the analysis says. Overall, the deficit would increase by $138 billion annually in five years if the budget plan were killed, it says.

Wall Street economists generally agreed that defeat of the deficit reduction plan would be negative for the market, though some disagreed with the magnitude of the interest rate increase predicted by the administration.

"If there's increased government spending because of defeat of the program, then yes, interest rates will go up and go up quite dramatically," said Samuel Kahan, economist with Fuji Securities.

But Kahan said more likely the loss of the plan would result in a rate increase of about 50 basis points, because Congress is more conservative than Clinton on spending matters and simply would not let the lid come off spending.

Lawrence Chimerine of DRI/McGraw-Hill Inc., agreed with Kahan that the defeat of the Clinton plan probably would push long-term rates up about 50 basis points, and in any case, by no more than 100 basis points. But unlike Kahan, he said he agreed with the administration that the plan probably would not be replaced with any significant spending discipline.

"If the Clinton plan goes down, it will be very hard to pass an alternative," he said.

Chimerine noted that the bond market has actually been disappointed that the Clinton plan did not go far enough to control spending.

"The bond market looks at the Clinton plan as meaningful deficit reduction and a significant drag on the economy, but that doesn't mean it solves the problem," said Chimerine. "The market would do even better if it saw a bolder program, particularly one that does something about entitlements."

Entitlements, at $767 billion the government's largest and fastest-growing category of spending, were only nicked by the budget plan.

Chimerine was not optimistic, however, that Senate leaders would improve the mix of entitlement cuts to tax increases in their negotiations with conservative Democrats. "The changes they're talking about are just a few billion dollars here and there," he said.

The Treasury, meanwhile, insists that its estimates are conservative, if anything. "They assign a moderate value to the interest rate spike that is likely to follow a failure of the deficit reduction effort," the analysis says.

"They use what Treasury staff regard as the most probable assessment of the channel from interest rates to GDP," the analysis says. "They do not assume very strong links between deficit reduction and long-run potential output growth."

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