Letter From Washington / Bankrupting America: How We Got Here, Why We’ll Stay Here, What It Means

It took less than a decade, a mere blink of an eye in historical terms, for America‟s fiscal fortunes to plunge from surging budget surpluses to soaring debt, from fiscal responsibility to fiscal recklessness.

In 1998, President Clinton and Congress balanced the federal budget for the first time in nearly 30 years. Their achievement reflected the important tax and spending policy changes that they and their predecessors in the 1980s and 1990s had enacted, as well as a roaring economy in the 1990s that generated an unexpected windfall of tax receipts. The surplus of 1998 grew markedly in 1999 and 2000, and the budget remained in the black in 2001. As George W. Bush took office on January 20, 2001, budget officials projected that Washington would generated surpluses over the next decade that could prove large enough to pay off the entire national debt before the first decade of the 21st Century was over. The country faced the happy prospect of less debt, more savings and investment, and a brighter future.

Alas, it would not come to pass. In the ensuing years, President Bush and a Republican-led Congress dramatically cut taxes and boosted spending in an orgy of fiscal recklessness, aided and abetted by a minority of Democrats who neutered Democratic hopes of blocking the GOP agenda. (To justify the recklessness, leading Republicans offered the empty promise that taxcutting would pay for itself – that, in the spirit of “supply side economics,” it would fuel soaring economic growth, which would generate enough federal tax revenues to more than offset the lower tax rates.) Today, Washington is drowning in a sea of ever-rising red ink. Unless President Obama and the new Democratic-led Congress take dramatic action in the coming years, the red ink will grow to once-unimaginable levels, severely jeopardizing the nation‟s economic future – indeed, its position as the world‟s leading economic, military, and diplomatic power.

Washington can fix the problem of soaring budget deficits, for it has done so before. After the deficit soared in the early 1980s (in the aftermath of President Reagan‟s big tax cuts and defense build-up), Presidents Reagan, the first Bush, and Clinton, and the Congresses in place during their administrations, worked doggedly to confront the problem, taking action almost every year through the mid-1990s until the budget reached balance in 1998. Most notably, they raised taxes in 1982 to recapture much of the lost revenue from Reagan‟s 1981 tax cut, they restructured Social Security in 1983, and they enacted major deficit-cutting laws in 1990 and 1993 that raised taxes and cut spending.

But the Washington of 2009 is a far cry from that of a generation ago. Today, elected officials show little resolve to restore fiscal sanity by raising taxes or cutting spending; indeed, they struggle to find politically palatable ways just to offset the costs of their high-priority initiatives and prevent the deficit from growing even larger. Obama and Congress almost certainly will extend most, if not all, of President Bush‟s 2001 and 2003 tax cuts, which would expire at the end of 2010 under current law. They are struggling to enact comprehensive health care reform, which is Obama‟s top domestic priority, largely because lawmakers are reluctant to cut spending or raise taxes enough to fully offset the costs of extending health care coverage to most or all of the 46 million uninsured Americans.

The same political forces that drove Bush and Congress to recklessness earlier this decade are driving their successors. On Capitol Hill, in particular, the committed constituency for deficit cutting has shrunk severely, and the political and economic incentives to pursue it have largely disappeared. These days, lawmakers are loath to raise taxes or cut spending enough to reduce the red ink – or, as noted above, even enough to prevent the deficit problem from growing worse. They won‟t anger special interests that fund their campaigns, nor will they tell average Americans that they must pay more in taxes or receive fewer federal subsidies in order to stop bankrupting the nation. Fiscal insanity under Bush is giving way to fiscal avoidance under Obama.

The problem is not cost-free.  The rising red ink threatens America‟s economy, its predominance as a world power, and its future. Unless Obama and Congress take significant steps to address the problem, Americans will live in a declining nation, with living standards that are lower than they otherwise would be and with fewer resources to serve its people at home and keep the peace abroad. The nation will save less, invest less, and grow less. It will depend more on China and other hostile powers to lend it money, giving those powers more leverage over its economy and foreign policy. Rather than continue to lead, the United States will be forced to retreat, making the world less safe for itself and its allies.

I. How We Got Here

As he assumed office in January 2001, Bush was a lucky man. Washington was flush with cash. White House and congressional budget officials predicted that, under the tax and spending policies in place at the time, the federal government would run budget surpluses of about $5.6 trillion over the ensuing decade (though private experts thought they would be considerably smaller). With those funds, the government could pay off the entire national debt, which then totaled less than $3.5 trillion.i That, in turn, would increase national saving, provide funds to invest for national needs, and strengthen the economy.

During the 2000 campaign for President, neither then-Gov. Bush nor his Democrat opponent, Vice President Al Gore, doubted that the projected surpluses would benefit the economy. They sparred only about what to do with the money. While Bush proposed large across-the-board income tax cuts, Gore preferred smaller, targeted tax incentives for education, for health insurance, for caring for an elderly relative, and for savings. Both vowed to apply unused funds to paying off the debt.

That‟s not what happened. Oh, Bush and Congress cut taxes all right, enacting across-the-board cuts in personal income tax rates that provided much greater financial benefit for those at the top than for other Americans. They cut the top tax rate to 35 percent, from 39.6 percent, created a new 10 percent bracket, boosted incentives for saving, and reduced the tax on large estates.ii  As it turned out, those tax cuts were well-timed. Bush signed them into law on June 7, 2001 and some key provisions took effect in tax year 2001. In March of that year, the economy fell into a relatively mild recession that would last eight months.iii Whether the tax cuts should have been permanent, rather than a temporary boost to consumers that would expire when the economy started growing again, is an entirely different matter.

The rationale for near-term tax cutting – that government was flush with cash and tax cuts would stimulate a weak economy – gave way to the fiscal insanity of continuous tax cutting that Republican leaders (along with some Democrats) promoted until the end of Bush‟s eight years in office. That is, the President and Congress were not content with the tax cuts of 2001, which surely fulfilled Bush‟s promise of the 2000 campaign. Instead, they launched a policy of endless tax-cutting, along with largely open-ended spending in domestic and defense policy that would turn the sunny projections of early 2001 into ever-more frightening projections of rising budget deficits.

So, after the big tax cuts for individuals in 2001, Bush and Congress followed up with tax cuts for small business in 2002, more sweeping tax cuts for individuals in 2003, and then a big tax cut for corporations in 2004. Year after year, they enacted provisions to ensure that more taxpayers would not be subject to the “alternative minimum tax” (AMT), which would have raised taxes on tens of millions of American families if Congress had not taken action. All of those tax cuts, along with the annual “AMT relief,” added literally trillions of dollars to the projected deficits of future years.

On the spending side, Bush and Congress were irresponsible as well. For decades, Republicans had promised to cut spending and reduce the size and scope of government if they ever controlled the White House and Congress at the same time. They got their chance starting in 2001, but they did quite the opposite. Starting that year, Bush and Congress boosted defense spending, went to war in Afghanistan and Iraq, and spent lavishly on a new area known as “homeland security.” On the domestic side, and to curry favor with senior citizens (who had voted en masse for Democrats ever since President Roosevelt created Social Security in 1935), Bush and his Republican allies in Congress dramatically expanded Medicare, the federal health insurance program for the elderly, by adding prescription drug coverage. But, instead of offsetting the costs, they added an estimated $400 billion to the national debt over 10 years while simultaneously moving up the date of Medicare‟s projected insolvency. Nor would Bush and his allies cut much of anything from other major domestic spending programs.

Remarkably, Bush and Congress kept cutting taxes and boosting spending in a mindless march toward fiscal insanity – first, as projected surpluses failed to materialize; then, as the government began to run deficits that would reach record levels in raw dollars, that would reach troubling levels as a share of the economy (Gross Domestic Product, or GDP), and that were expected to go much, much higher. As Congress cut taxes in 2001, 2002, 2003, 2004, and 2006, Washington ran deficits of $158 billion (2002), $378 billion (2003), $413 billion (2004), $318 billion (2005), $248 billion (2006), $161 billion (2007) and $459 billion (2008). Deficits totaled more than 3 percent of GDP in 2003, 2004, and 2008.

For fiscal 2009 (which ended this past September 30), after huge federal spending to strengthen the nation‟s financial sector and revive the economy after perhaps the worst downturn since the Great Depression, the deficit soared to $1.4 trillion and an astonishing 9.9 percent of GDP. It will likely fall in 2010 – tax receipts will pick up as the economy recovers, and Washington will spend far less to strengthen financial institutions. But it will still be much too high, probably topping $1 trillion.

To be sure, a short-term increase in deficit spending, even one that hits these dizzying heights, is not necessarily bad. Quite the contrary, with the financial sector teetering on the edge of collapse, and with the economy sinking into the worst recession in decades, Washington should have spent whatever was necessary to address the problems. Failure to do so might have proved cataclysmic. In the fourth quarter of 2008, the economy was falling at a rate of over 6 percent a year, household net worth fell by $5 trillion, and the economy lost 1.7 million jobs, marking the largest quarterly decline since the end of World War II.iv Federal Reserve and Treasury spending to bolster financial institutions, and the $787 billion in spending increases and tax cuts that Obama and Congress enacted early this year to stimulate the economy, were short-term measures that would add little to long-term deficits. In fact, the private Center on Budget and Policy Priorities estimated that the $787 billion recovery law would add just 3 percent to long-term deficits.v

Far more troubling are projections of deficits after 2010. Starting in 2011, deficits are expected to average about $1 trillion a year for about five years and then rise to even greater heights in decades to come, according to the nonpartisan Congressional Budget Office (CBO). Under realistic assumptions about current spending and tax policy, CBO projects that deficits will total 7 percent of GDP in 2020, 15 percent in 2035, 22 percent in 2050, and 43 percent in 2080. To put those figures in perspective, consider that the budget was balanced as recently as 2001, the deficit measured 3.2 percent of GDP in 2008, and that (as noted above), after the extraordinary federal measures to strengthen financial institutions and stimulate the economy, the deficit hit 9.9 percent of GDP in 2009. Thus, deficits that seem extraordinary today will become routine if Washington does nothing to avert them.

The main factors behind this frightening long-term scenario are three-fold: (1) soaring health care costs; (2) the coming retirement of “baby boomers” – those born between 1946 and 1964 who are starting to become eligible for key federal programs; and (3) federal revenues that will prove increasingly inadequate to offset the two factors just mentioned. These two factors explain the dramatic growth in Medicare, which provides federal health coverage for the elderly, and Medicaid, which provides health coverage for the poor (but which increasingly funds long-term care for middle-income Americans, such as stays in nursing homes, for seniors who have exhausted their savings). The baby boomers‟ retirement explains the growth of Social Security. These three programs – Medicare, Medicaid, and Social Security – represent “[a]lmost all of the projected growth in federal spending other than interest payments on the national debt” through 2080, the Congressional Budget Office says.vi

Fiscally, Medicare and Medicaid are much more significant than Social Security because health costs are much more significant than the aging of the population. Medicare and Medicaid account for 80 percent of the projected spending increases for the three programs as a whole through 2035 and 90 percent through 2080, according to CBO.vii Also important to the nation‟s fiscal future, of course, is the role of revenues. The higher the revenues, the less policymakers must cut from Medicare, Medicaid, and Social Security to bring the budget closer to balance. Let‟s take a moment to explore each of those issues – Medicare and Medicaid, Social Security, and revenues – in more detail.

Medicare and Medicaid

Today, Medicare and Medicaid account for 20 percent of federal spending and measure 5 percent of GDP. If the current trend of soaring health care costs continues, these two programs will occupy a whopping 20 percent of GDP by 2050, says Office of Management and Budget Director Peter Orszag.viii Currently, total federal spending measures 22 percent of GDP. That means that unless the United States plans to have a much bigger government in the coming decades as a share of GDP – and there‟s no reason to believe Americans would welcome that – Medicare and Medicaid will virtually take over the budget.

The answer lies not in restructuring Medicare and Medicaid in isolation, but in reforming the nation‟s health care system. That‟s because “[t]he main driver of the high growth of projected expenditures for Medicare and Medicaid is the continued high growth in health care costs systemwide, not features unique to those two programs,” leading budget and health care experts wrote last year. For the last 30 years, they continued, “per beneficiary spending in Medicaid and Medicaid has grown at rates nearly identical to those for the health care system as a whole.”ix So, the same soaring health care costs that are fueling Medicare and Medicaid‟s rapid growth are making it harder for employers to offer health insurance to employees, for employees to pay rising monthly premiums, and for the self-employed and unemployed to get coverage at all. The problem demands system-wide change, not changes to federal programs that will not address the underlying trends.

Social Security

Social Security, probably the most popular federal program, faces a far less immediate, and far more manageable, sets of challenges. The Social Security Trust Fund has been accumulating surpluses since the early 1980s, the government has been using the surpluses to help fund its other operations, and the trust fund has collected $2.4 trillion in IOUs (in the form of Treasury securities) in return. Under current trends, and presuming Congress does not change the program in the interim, that will change in 2016 when Social Security‟s expenses will exceed its tax revenues.x But, by cashing in its IOUs, the program can pay its required benefits to recipients all the way to 2037. Even after that, the program will be able to pay three-fourths of scheduled benefits. Policymakers would have to raise taxes, cut benefits, or a combination of both to make up the difference.

Revenues

For more than half a century, federal revenues have been remarkably stable as a share of GDP.

Since the early 1950s – through the Korea Conflict and Vietnam War; through President Johnson‟s Great Society and President Reagan‟s effort to shrink government; through Republican or Democratic control of the White House or Congress – revenues have ranged from 17 to 20 percent of GDP, occasionally falling to 16 or rising to 21 percent, even as those levels proved increasingly inadequate to cover the cost of spending programs. Through their elected representatives, Americans have made clear that they do not want federal taxes to grow beyond a certain level. The more that Americans continue to insist on that limit, the more that policymakers will have to take dramatic action on the spending side to restore fiscal sanity – first, by addressing rising health care costs; second, by restructuring Social Security; and third, by cutting elsewhere from defense or other domestic programs.

II. Why We’ll Stay Here

Now what?

To be sure, the goal of balancing the budget, even of reducing the deficit significantly, is politically difficult to achieve. It will force policymakers to raise taxes and cut spending to bring revenues and spending more in line. That will anger constituencies that will pay more in taxes or receive less in benefits. But the problem is hardly insurmountable. Today‟s tax and spending levels were not handed down from the heavens, nor have the tax and spending programs that comprise the budget existed from time immemorial. What lawmakers have given, they can take away.

They have done so before.

For most of the nation‟s history – from its founding until the 1930s – the federal government generally ran a budget deficit for one of two reasons: either the economy was in recession (which reduced revenues from taxes and other sources) or the nation was at war (forcing the government to spend money for troops and firepower). Once the economy recovered or the war ended, the government would run budget surpluses to pay off the debt that had accumulated during the earlier period of deficits.

Since then, Washington has run deficits far more often. Franklin Roosevelt‟s New Deal of the 1930s, Lyndon Johnson‟s Great Society of the 1960s, and significant initiatives by every other post-World War II president greatly expanded the size and scope of government. Meanwhile, the ascendance of Keynesian economics provided the intellectual justification for deficit spending as a tool for economic growth. Consequently, Washington has balanced its books only 12 times since World War II.

For much of that period, policymakers generally kept deficits at economically manageable levels.

Then, in the early 1980s, the deficit exploded in size, both in raw dollars and as a percentage of GDP. Congress enacted President Reagan‟s big tax cuts and his defense build-up, but not the requisite domestic spending cuts to offset the costs of these two expensive initiatives. A deficit that totaled just under $80 billion and 2.6 percent of GDP in 1981 (the year Reagan took office) zoomed to $208 billion and 6 percent of GDP two years later. It hovered around $200 billion for a few years, settled at about $150 billion for a few years after that, and climbed again in the late 1980s and early 1990s, approaching $300 billion as President Clinton took office in 1993.

To its credit, Washington responded. Presidents Reagan, Bush, and Clinton worked with their respective Congresses to chip away at the problem. After 1981, Reagan worked with lawmakers of both parties in almost every year of the 1980s to raise some taxes and cut some spending. Then, Presidents Bush and Clinton took over, working with Congress to finish the job and balance the budget by 1998. The key legislative steps along the way were a big deficit-reduction package of tax increases and spending cuts in 1990, another such package in 1993, and a smaller package in 1997.

Along with the Presidents in office at the time, key to these achievements were the deficit “hawks” on Capitol Hill. They included Bob Dole, the Senate Republican leader and future presidential candidate known with the biting wit and rough edges; Pete Domenici, his chainsmoking Republican colleague who spoke in clipped phrases and, with his earnest eyes and creased face, seemed to carry the weight of the world on his shoulders; Leon Panetta, a stocky, bespectacled House Democrat from Monterey, CA, with an explosive laugh and considerable charm; and Dan Rostenkowski, a large, proud, old-fashioned, back-slapping House Democrat from Chicago.

Anyone who knows the history of deficit-cutting efforts of the 1980s and 1990s might have expected America‟s more recent Presidents and Congresses to survey the fiscal landscape and respond as their predecessors had done. But, today‟s Washington is a far different place than the town of deficit cutting a generation ago. At first blush, today‟s elected officials seem to care little about their reckless, relentless, and purposeful bankrupting of America. But the reality is more complicated.

Political and economic developments over the last 20 years have made deficit cutting a far more challenging exercise for policymakers. The problem is at least three-fold: (1) “moderate” members of both political parties (e.g., Dole, Domenici, Panetta, and Rostenkowski), who have led deficit-reduction efforts over the years, are becoming an endangered species in Washington; (2) elected officials have learned over the years that not only will they receive little political credit for reducing the deficit, they will engender scorn for the tax increases and spending cuts they enact; and (3) officials also learned that while the deficit is a serious problem, it lacks the immediacy of, say, a terrorist attack around which to rally public support for action.

Each of these factors is worth a closer look.

The fall of the moderates

Moderates are, well, moderate – in both style and outlook. They understand that “governing is the art of the possible.” To build bipartisan majorities for legislative action, compromise is necessary; to get some of what you want, you have to give your adversaries some of what they want. That‟s particularly true during periods, such as the 1980s and most of the 1990s, in which the two parties share control of government, enabling either to block the legislative ambitions of the other.

In those deficit-conscious years, moderates spoke of “shared sacrifice,” of “putting everything on the table” for examination – from taxes to defense and domestic programs. Moderates served as party leaders and as chairs and ranking members of key committees, so they were wellpositioned to translate their bipartisan predispositions into action. They pushed for legislation to reduce the deficit, they lobbied their colleagues to provide the votes, and they took their case to the media, appearing on TV and radio and penning op-eds for America‟s most influential newspapers.

That‟s not to say that, in those years, Democratic moderates did not have their differences with their Republican counterparts. Quite the contrary, they had real disagreements that were rooted in their parties‟ competing philosophies. Democrats of that deficit-conscious era were always more inclined to raise taxes, to cut defense, and to oppose cuts in domestic programs – indeed, to expand domestic programs if they could. Republicans were always more predisposed to cut domestic spending, to protect defense, and to oppose tax increases. But when it came to reducing the red ink, what they all wanted, Democrat and Republican alike, was to make progress rather than merely advocate for their parties‟ positions. So, moderate Republicans would vote for tax increases as long as moderate Democrats would vote to cut domestic spending, and vice versa.  And throughout the „80s and „90s, that‟s what they did – first controlling the deficit and then balancing the budget.

And now?

Bob Dole has retired. So have Pete Domenici and Leon Panetta and Dan Rostenkowski. Their departures from Congress, however, are part of a large and more ominous trend. Due to developments in campaign finance, to the reshaping of congressional districts, and to other changes in American politics, moderate members of Congress are going the way of the dinosaur. In both parties, they have shrunk in size and influence; they serve in fewer numbers and in fewer key positions (e.g., as committee and subcommittee chairs and ranking minority members). On Capitol Hill, the parties are now ruled by their ideological wings – left-wing Democrats and right-wing Republicans.

Left-wing Democrats want to expand the size and scope of the federal government to provide universal health coverage, address global warming, improve elementary and secondary education, re-regulate the financial system, and, generally, build on the New Deal and Great Society. Put simply, they want to spend more money. Right-wing Republicans want to empower states, localities, and individuals to make their own choices about health care, education, and other needs. They want people to keep more of their money rather than send it to Washington. Put simply, they want to cut taxes. Neither left-wing Democrats nor right-wing Republicans want to compromise their basic principles to advance legislation. For each side, “it‟s my way or the highway.”

That, of course, is precisely the opposite of what‟s needed for serious deficit cutting. To achieve that goal, Congress needs to return to its more bipartisan past, with all sides putting their favored programs on the table – for Democrats, domestic spending; for Republicans, taxes. Until both parties decide that compromise in the interest of deficit cutting is more important than ideological purity, policymakers will make little progress. (To be sure, an all-Democratic government in Washington, which is what we have today, could enact a Democrat-only plan for deficit cutting. That, in fact, is what occurred in 1993, when President Clinton worked with a Democrat-run Congress to enact a plan that received only Democratic votes. But Democrats these days don‟t seem any more inclined to reduce the deficit on their own than the two parties seem inclined to work together.)

The absence of political credit

Americans have long had a fiscal split personality. On one hand, they strongly support the idea of a balanced budget.  On the other, they strongly oppose the steps needed to achieve that goal – controlling health care costs, restructuring Social Security, and raising taxes (not just on the rich but on tens of millions of Americans in the middle). Those who push these steps and others to help move the budget from deficit to surplus often get little praise from their constituents. In fact, if history is any guide, they will likelier nourish contempt for the spending cuts or tax increases they support.

Consider:

In early 1985, after weeks of private discussions, Senate Republicans mounted a major deficitcutting effort. President Reagan had swept to an overwhelming re-election in late 1984, and Republicans believed that he could sell the necessity of deficit cutting to the American people. So, Republicans proposed a bold plan of spending cuts, including a provision to freeze cost-ofliving adjustments for Social Security. Democrats, still smarting from Reagan‟s landslide, saw a political opportunity and pounced, lambasting Republicans for trying to “destroy” Social Security. Feeling the political heat, Reagan disavowed the plan (which his budget director, David Stockman, had privately helped to craft), leaving Senate Republicans twisting in the wind. A year later in the 1986 mid-term elections, Republicans lost eight of nine close Senate races and, with them, control of the Senate. Electoral experts later said the politics of Social Security was the most important reason why.

Or consider:

In 1993, President Clinton worked with a Democrat-led Congress to enact a five-year, $500 billion plan to cut projected deficits. Not a single Republican lawmaker would vote for it. While cutting spending and raising income taxes on the top 1.2 percent of Americans, the plan raised the federal gas tax by 4.3 cents per gallon. A year later in the mid-term elections, Republicans ran against the all-Democratic government, labeling Clinton an old-fashioned tax-and-spend Democrat who, despite his campaign promises to cut taxes for middle class voters, could not wait to raise them instead. Republicans swept to an overwhelming victory, picking up 54 seats in the House and eight in the Senate and taking control of both chambers simultaneously for the first time in 40 years.

The political lesson of these and a host of other incidents from the last 30 years is clear: Beware the wrath of the voters, for they will not countenance efforts, successful or otherwise, to balance the budget. Every elected official with even a superficial knowledge of this history would be wary. In a sense, you can‟t blame them. The voters have spoken, and woe to those who ignore what they have said.

The end of economic fear

When the deficit exploded in size in the early 1980s, experts predicted dire consequences. Unless Washington acted, they said, we would see soaring inflation, skyrocketing interest rates, perhaps even economic collapse. And then – nothing. The economy bounced back strongly from the deep recession of 1981-82, growing robustly through the 1980s. Then, after a relatively shallow recession in the early 1990s, it surged again, growing even more robustly in the 1990s. Nor did the return of deficits seem to matter after the turn of the century. After another relatively shallow recession in 2001, the economy grew strongly from late 2001 until the current recession. No one could demonstrably tie large deficits to the onset of economic problems.

Gradually, Washington came to learn what was, in political terms, an unfortunate lesson: The nation could live with large deficits. They would not necessarily jolt the economy in the short term, though they surely would weaken it over time. As Charles Schultz, the former budget director to President Johnson and top economic advisor to President Carter, had famously put it, the deficit was less the “wolf at the door” than “termites in the basement.” It would not blow down America‟s economic house. Rather, it would eat away at that house, weakening the foundation from within.

Politically speaking, “termites in the basement” are far less likely to spur action in Washington than a “wolf at the door.” With their eyes focused squarely on their re-election campaigns – and with a re-election campaign these days for virtually any member of Congress beginning almost the moment that his or her previous one ends – lawmakers react almost exclusively to short-term stimuli. They have far less political incentive to worry about the problems of future generations. They have, in turn, far greater incentive to worry about the wrath from their constituents after they vote to raise taxes or cut spending. Absent a short-term economic crisis that growing deficits might produce and that might leave lawmakers with no choice but to act (as described in Section III, below), elected officials have far more reason to ignore the rising red ink than to address it.

Where does that leave us?

Here‟s where we are:

Washington lacks a nucleus of moderates who are philosophically predisposed to craft a deficitcutting plan, today‟s lawmakers fear the political consequences of taking action, and they do not fear the economic consequences of failing to do so. At the same time, these lawmakers know the American people largely support the notion of a balanced budget and blame their elected representatives for generating so much red ink. So, lawmakers try to have it both ways, promising to balance the budget while rejecting the steps needed to achieve that goal.

Consider this year‟s budget debate. It began in earnest the week of February 22 when Obama held a “fiscal summit” at the White House to draw attention to the spiraling deficit, outlined his economic and budget plans in a speech before a joint session of Congress, and released A New Era of Responsibility, his 134-page budget blueprint. His budget was designed to provide the resources needed to pursue the key elements of the domestic agenda on which he campaigned – reforming health care, addressing global warming, and improving education – while also making a down payment on deficit reduction. It promised to reduce total projected deficits from 2010 to 2019 by $2 trillion, while still leaving annual deficits in the $600 billion to $700 billion range for most of that period.

Predictably, the reaction on Capitol Hill was two-fold. First, lawmakers of both parties complained that the President had not addressed the deficit problem aggressively enough. Second, lawmakers of both parties raised objections to virtually every major proposal within the budget to save money. That is, lawmakers tried to have it both ways – to pretend they were committed to the goal of deficit cutting, and to oppose the particular tax increases and spending cuts that would anger their constituents.

For instance, while praising Obama‟s budget, Senator Kent Conrad and Representative John Spratt, who chair the Senate and House Budget Committees, respectively, vowed to strengthen it in order to reduce future deficits more quickly. Nevertheless, Conrad was among the farm-state lawmakers who objected to Obama‟s proposal to save $10 billion over 10 years by cutting federal payments to farms with sales above $500,000 a year. You might think that farms with such sales (and the farmers who own them) would not need welfare payments from Uncle Sam, but farm-state lawmakers disagree. Conrad also complained about an Obama proposal to save $48 billion over 10 years by streamlining the federal student loan program, eliminating the role of banks as financial intermediaries, because he had one of those intermediaries in his home state of North Dakota.

The farm proposals in particular, and the opposition to them, were part of a larger pattern. To reduce the deficit and also finance his major initiatives, Obama proposed to force the most wellto-do Americans and large corporate interests to pay more in taxes or receive fewer subsidies. With dubious logic and a paucity of evidence, opponents complained that these proposals would mainly hurt average Americans or small businesses and would have a devastating impact on certain sectors of the economy. Lawmakers raised objections to many of Obama‟s major proposals, putting their fate in serious doubt.

For instance, Obama proposed to save $638 billion over 10 years by reinstating the 36 and 39.6 percent tax brackets of the Clinton era, reinstating limits on personal exemptions and itemized deductions from that era, and raising capital gains and dividends taxes – all for those earning more than $250,000 a year. Critics charged, disingenuously, that the higher tax rates would mainly raise taxes on the owners of small business, thus costing jobs on “Main Streets” across America.

Obama also proposed to save $318 billion over 10 years by limiting the value of itemized deductions for the wealthiest Americans to 28 percent for those in higher tax brackets – the 33 and 35 percent brackets of current law, and the 36 and 39.6 percent brackets if Congress enacts Obama‟s plan to raise income tax rates. Critics predicted the proposal would decimate the bottom line of charitable institutions by reducing the tax benefit for charitable giving – never mind that the nonpartisan Tax Policy Center estimated that, under Obama’s proposal, charitable giving would fall by less than two percent.

In fact, while they were chastising Obama for insufficient deficit cutting, lawmakers were pushing steps that would actually make the deficit larger. In late 2009, for instance, Congress was expected to debate a proposal to reduce the tax on estates that pass from one generation to the next upon an individual‟s death. Although couples now pay the tax only on estates of over $7 million, and only one in every 500 estates now pay any such tax, lawmakers will consider whether to raise that exemption to $10 million.xi

Lawmakers also will likely consider this fall whether to give senior citizens a one-time boost in Social Security benefits – for no justifiable reason. Social Security recipients receive yearly costof-living adjustments (COLA) in their benefits to offset inflation. With living costs falling rather than rising of late, senior citizens will not receive a COLA boost for 2010 (and perhaps 2011). That will likely make the elderly unhappy – and making this politically potent group unhappy is something that lawmakers always want to avoid. So, many lawmakers want to give a one-time boost in Social Security benefits for tens of millions of elderly Americans. More red ink is a price that lawmakers will readily pay in order to inoculate themselves against the wrath of seniors.

III. What It Means

America‟s leaders are recklessly bankrupting the federal government and, by extension, the nation at large, creating a sea of red ink that will pass from this generation to the next and well beyond. Unless they take action to at least reduce sea levels, lowering year-to-year deficits to an economically manageable size, the red ink will weaken America‟s economy, increase its dependence on foreign lenders (some of which are the central banks of hostile foreign governments), reduce its flexibility to act at home and abroad, and threaten America‟s role as the world‟s pre-eminent economic and military power.

The budget deficits create at least distinct, though inter-related, problems – economic, global, and governmental.

The economic problem

Think of a nation as you would a farmer. The farmer can set aside profits from his current harvest to buy the seeds to plant for a future harvest. Or that farmer can spend all of his profits today, leaving himself nothing for the next planting and, by extension, no future harvest to enjoy.

Of late, the United States has been acting like an irresponsible farmer, spending all too much today and not saving for the future.

National saving has two components – public (that is, governmental) saving and private (that is, personal and corporate) saving. All else being equal, the more the United States saves as a nation, the more it has to invest in plant and equipment, in education and training, and in the other priorities that will strengthen its economy by raising productivity and, in turn, the living standards of average Americans.

Americans used to save quite a bit, but private saving rates have plummeted in recent years. Private saving hovered around 10 percent of GDP from about 1950 to the late 1980s, at which point it began to fall. What fueled the drop, in particular, was the fall in personal saving. Over the last decade, personal saving fell below 2 percent of GDP and, by 2005, fell to almost 0. That is, American households were spending, on average, everything they earned, saving nothing for the future. (The current recession, and the very real threat that it could have turned into a second Great Depression, apparently has provided a financial wake-up call to Americans. Since mid2008, they have begun to save significantly more, with personal saving reaching nearly 6 percent of GDP at one point this spring.xii Whether that portends a long-term change in Americans‟ behavior, one that outlasts the inevitable onset of economic recovery in the coming months, is anyone‟s guess.)

As personal saving fell, policymakers tried various ways to boost it.  Since the early 1980s, they have created an assortment of tax-preferred savings instruments, such as traditional individual retirement accounts (IRAs) and so-called Roth IRAs. But if there‟s one thing that policymakers have learned from the experience, it‟s this: they do not know how to convince or incentivize Americans to save more. Saving behavior reflects cultural norms and, until very recently, the nation‟s spend-happy culture has convinced Americans to enjoy what they have now, rather than save for the future.

On the other hand, policymakers have a sure-fire way to boost overall national saving – and that‟s to reduce the federal budget deficit. Unfortunately, while private saving was plummeting over the last decade, Washington was running record-breaking deficits (as it continues to do). Thus, saving suffered a double whammy, leaving few domestic funds for investment. Under these circumstances, one of two things will happen: (1) investment will fall or (2) foreigners, viewing the United States as an attractive place to invest (with a stable political system and a nice rate of return), will provide the funds for investment to continue. It‟s the latter that took place.

In recent years, the United States has grown highly dependent on borrowing from foreign investors and governments, including U.S. Treasury borrowing to finance budget deficits. Today, foreign creditors, such as China‟s central bank, own nearly half of U.S. federal debt that‟s held by the public. Foreign investment in the United States is better than no investment at all. In the public sector, it helps finance budget deficits. In the private sector, it provides the capital to build the plant and equipment through which businesses become more productive, fueling higher living standards in America. But foreign investment comes with a cost. The returns on that investment flow overseas to the lenders and that, in turn, means the United States benefits less when foreigners are funding its investments than when the nation is funding them itself with its own saving.

All that U.S. borrowing from abroad leads to the next problem.

The global problem

“The borrower is a slave to the lender,” Benjamin Franklin cautioned, “and the debtor to the creditor.” If so, America‟s situation is particularly dicey, for it is tapping problematic foreign sources for funds, prompting questions about the nation‟s flexibility to act in its own interest on the world stage.

Let‟s play things out by way of anecdote. Let‟s presume, as seems likely, that the United States continues to borrow huge sums from China for the foreseeable future to finance its budget deficits. Now, let‟s presume that China and the United States get tangled in a dispute over the fate of Taiwan. Theoretically, China could threaten to reduce its purchases of U.S. debt or even dump some of its holdings, forcing the United States to look elsewhere for other borrowers to fill the gap. To find them, the nation might have to raise the rate of return on those investments – i.e., the interest rate – quickly and perhaps quite significantly. That would raise rates not just on Treasury securities but on virtually all forms of borrowing, from mortgage loans to car loans to bank loans. If the Chinese moved aggressively enough, the United States could face a flight away from the dollar, causing a run on the currency that leads to soaring interest rates and inflation.

A fantasy? Perhaps. Skeptics note that China would hurt itself economically by trying to hurt the United States. Holding so many dollars already, China presumably would avoid steps that would reduce their value. Thus, skeptics say, the relationship between these two nations is far more complicated than Franklin‟s notion of the borrower as slave to the lender. In essence, the world‟s lone superpower and its emerging global competitor are co-dependent – positioned in what Lawrence Summers, now Obama‟s top economic advisor, once called a “balance of financial terror,” with each enjoying leverage over the other and, in that way, ensuring that the lending and borrowing will continue.xiii

Having said that, China and America‟s other major foreign creditors, which include Japan, Russia, and the Gulf States, could find other legitimate reasons to reduce their purchase of Treasury securities. They may simply have what they consider an abundance of dollars, prompting them to diversify their portfolios as any responsible investor would, and they may also be attracted to other instruments that pay higher rates of return. Or they may fear that the United States will help itself while explicitly hurting its investors, such as by inflating its currency to reduce the economic burden of its debt. That would hurt investors by making their returns less valuable over time. That explains why top U.S. officials have been reassuring the Chinese and others that the United States will not resort to that step and that, to ensure that America retains its Triple A rating on world markets, the nation will soon take serious steps to reduce its long-run deficits.

All of this begs a simple question: Why should the world‟s lone superpower, one with a huge agenda at home and abroad and that needs a sturdy fiscal foundation to achieve it, put itself in this position in the first place?  As former Congressional Budget Office Director Edward M. Gramlich asked the House Budget Committee in 2007, “How do we know that foreigners will keep on lending to us?  And at a more basic level, why should the United States put itself at the mercy of foreign lenders?”xiv

While the red ink weakens the U.S. economy and increases its vulnerability, it hurts the nation in a more practical way: It starves policymakers of the resources needed to defend the nation, invest in its people, and otherwise perform the necessary tasks of a well-functioning government. It is there to which we now turn.

The government problem

Elected officials of both parties come to Washington to do things – to use the power of the federal government to reach domestic or foreign goals. To be sure, they differ in what they hope to accomplish, with Republicans more focused on strengthening defense and giving tax breaks to corporations, and Democrats more inclined to expand domestic programs and give tax breaks to low- and moderate-income Americans. But, make no mistake: candidates for Congress may complain about the size of government, but they are more than happy to tap its power once they assume office.

What today‟s policymakers of both parties seem not to realize is that the rising tide of red ink threatens them equally. The more that the red ink mounts, the fewer resources they will have to pursue their goals. Unless they take bold action to greatly reduce the deficit to economically manageable levels, they will face year-to-year pressure to not spend public funds, to not allocate more tax breaks. Government will gradually lose its capacity to respond to new challenges at home and abroad.

In 2009, Washington allocated about $200 billion, or 6 percent of its budget, to pay interest on the national debt. Presuming current tax and spending programs continue and Washington runs deficits of a magnitude described earlier, that figure will grow to about $900 billion, or 18 percent of the budget, by 2019.xv That‟s nearly a fifth of the public purse that will go to pay debt, rather than invest in things that will make the nation stronger. The more that share of the budget grows, the less will be available to defend the nation, invest in research, improve health care and education, and protect the environment.

Theoretically, a deficit-riddled Washington will have two choices in the years ahead. It can (1) address the budget deficit by significantly raising taxes and reducing spending, as it did in the 1980s and 1990s, or (2) ignore the problem. As a practical matter, it cannot wholeheartedly do the latter. At some point, America‟s foreign creditors will grow wary of continuing to lend to the United States at current rates, or the public will demand a return to fiscal sanity. Policymakers, however, will try to take a minimalist approach, fearing the wrath of voters for enacting tax increases and spending cuts that will anger key constituencies.

In the end, policymakers will find themselves in a kind of holding pattern – on the spending side, unable to expand government significantly to meet emerging needs while unwilling to cut existing programs significantly; on the tax side, unable to allocate significant new tax breaks to achieve social ends while unwilling to raise taxes significantly beyond the levels that have historically prompted popular tax revolts. In essence, all sides will put government on automatic pilot, with current programs protected but new directions out of reach.

In the late 1980s, while Washington was struggling with the budget deficits of that era, I wrote the following words for National Journal magazine:

[T]he deficit has become an all-consuming problem of perhaps unprecedented proportions. It establishes limits, if not strait-jackets, for policy makers in the White House, Congress and the private sector. It shapes the day-to-day lives of lawmakers. It sets the strategies of lobbyists, and it limits their aspirations.

The deficit culture that has grown up around this problem has a distinct, undeniable tone: tentative, defensive, penurious, frustrated, gloomy. Issues that were once tackled with gusto are sidestepped, put off for another day or handed off to others. Supporters of existing programs withhold ideas for improving them for fear that negotiations could lead to cuts. Time is spent protecting the status quo.xvi

The past is prologue, for that seems to describe where Washington is headed. Welcome back to the future.

IV. A Final Thought

“A foolish consistency,” Ralph Waldo Emerson wrote, “is the hobgoblin of little minds, adored by little statesmen and philosophers and divines.” When it comes to the deficit, America‟s leaders strive at all costs to avoid derision by Emerson‟s disciples. They display no consistency of belief – foolish or otherwise. For one thing, they promise to reduce the deficit but reject the major steps needed to do so. For another, when serving in the congressional minority, they chastise the majority party for generating huge deficits and assert that they would do better. When they return to power, however, they downplay the problem of deficits and focus on their higher legislative priorities.

The GOP record of late is particularly shameless. From 2001 to 2006, Republicans controlled the White House and Congress, and they enacted the policies that turned record surpluses into record deficits and created the frightening fiscal future that the nation now faces. As deficits soared, they pushed tax cut after tax cut into law and promised that it would all power an economy of soaring growth – so much growth, in fact, that it would generate a surfeit of revenues that would reduce the very deficits that their policies were creating. “Free lunch-ism” had become the economic orthodoxy of the Republican Party. Now out of power, Republicans complain that Obama and a Democratic Congress are on track to add trillions of dollars to the national debt. Never mind that Republicans crafted the policies that have put the federal government on the path to do just that.

Democrats, of course, complained bitterly during those years of Republican rule as the GOP‟s policy of tax cuts uber alles plunged the nation into a sea of red ink. Democrats promised to do better once they regained the levers of power, to restore fiscal sanity to an out-of-control federal government. Well, now it‟s their turn. They control the White House and Congress. But deficit cutting ranks low on the scale of Democratic priorities. Although Democrats are quite right not to pursue it while the economy remains weak, they show little interest to pursue it even when the economy recovers.

Politically, who can blame them? As discussed above, the elected official who votes for tax increases and spending cuts to address the problem will receive few accolades for public spiritedness. In fact, such fiscal responsibility could cost the lawmaker his or her seat. Nor, dayto-day, do the fiscal “termites in the basement” provide the political impetus for serious deficit cutting. Until the fiscal “wolf” appears on America‟s doorstep in the form of an economic or political crisis of some kind, the nation faces a future of economic deterioration, governmental paralysis, and possible global retreat.

It is not a pretty picture.

Lawrence J. Haas, former Communications Director to Vice President Al Gore, writes widely about foreign and domestic affairs.  With this “Letter from Washington,” he is inaugurating a quarterly feature for the Henry Jackson Society.

i The total refers to “debt held by the public,” which does not include the debt held by federal government accounts and which economists generally believe is the best measure of the government‟s debt burden.

ii Tempalski, Jerry, “Revenue Effects of Major Tax Bills,” OTA Working Paper 81, Office of Tax Analysis, Department of the Treasury, September 2006.

iii “It‟s Official: 2001 recession only lasted eight months,” USA Today, July 17, 2003.

iv Orszag, Peter, Director of the Office of Management and Budget, “New Foundation for Growth,” a speech before the Council on Foreign Relations, New York, July 22, 2009.

v See, for instance, Cox, Kris and Van de Water, Paul N., “Economic Recovery Act Would Add Little to Long-Run Fiscal Problem,” Center on Budget and Policy Priorities, January 16, 2009.

vi Congressional Budget Office, “The Long-Term Budget Outlook,” June 2009, first page of “Summary.”

vii Ibid.

viii Orszag has made that point on numerous occasions, such as at his confirmation hearings early this year and, more recently, in “New Foundation for Growth,” his July 22 speech in New York before the Council on Foreign Relations. The Congressional Budget Office predicts these programs will rise somewhat less quickly but still measure over 17 percent of GDP by 2080. See Congressional Budget Office, “The Long-Term Budget Outlook,” June 2009.

ix Aaron, Henry J.; Greenstein, Robert, et. al., “A Balanced Approach to Restoring Fiscal Discipline,” June 2008.

x The 2009 Annual Report of the Board of Trustees of the Federal Old Age and Survivors Insurance and Federal Disability Insurance Trust Funds.

xi The figures in this paragraph come from Huang, Chye-Ching; Brunet, Gillian; and Marr, Chuck, “Reports Calling for Estate Tax Repeal Seriously Flawed,” Center on Budget and Policy Priorities,” July 7, 2009.

xii The figures in this paragraph come from the Bureau of Economic Analysis, which is a branch of the U.S. Department of Commerce.

xiii Summers, Lawrence H., “The United States and the Global Adjustment Process,” Speech at the Third Annual Stavros S. Niarchos Lecture, Institute for International Economics, Washington, D.C., March 23, 2004.

xiv Gramlich, Edward M., “Testimony Before the U.S. House Budget Committee, January 23, 2007.

xv The estimates for 2019 come from calculations from the Center on Budget and Policy Priorities.

xvi Haas, Lawrence J., “The Deficit Culture, National Journal, June 4, 1988.