In an Uncertain World (52 page)

The deterioration from a surplus to a deficit is the most accurate way to look at the effect of current fiscal policy. However, analysts often refer to just the projected deficit. So, let me apply the same analysis to the projected deficit of $5.5 trillion over ten years, which averages roughly 4 percent of GDP per annum. This translates into higher long-term interest rates of 1.6 percent (4 percent of GDP x 0.4 percent). With an inflation-adjusted interest rate on the ten-year bond of 3 percent, that's an increase in real interest rates of over 50 percent.

These are serious numbers. But the effects could be far more severe.

If fiscal imprudence continues, at some point markets may become concerned, not just about the projected future demand of the federal government on the available savings pool, but also about the risk of even greater fiscal disarray—with the possibility that the government will rely on inflation rather than fiscal discipline to work out its long-term fiscal problems. Then, the markets may pile on top of the already higher interest rates an unpredictable additional “deficit premium” reflecting those risks. Economists describe this as the risk that deficits could have a “nonlinear” effect on rates. And that could be hugely consequential, and could be even further exacerbated by the impact that an unsound fiscal policy can have on the interest rates foreign creditors require to lend to the United States.

Moreover, interest rate effects are only part of the picture. An unsound long-term fiscal situation can also badly damage business and consumer confidence—as was evident in the few years before the 1992 election. Large structural deficits can also diminish confidence in our economy and currency abroad, impair the ability of the federal government to serve the purposes the American people wish it to serve (including Social Security and Medicare), and undermine our resilience in dealing with future recessions or emergencies. In fact, our ability in 2001 to increase national security spending, and to put into place a stimulus to fight recession without running a serious risk of producing a large increase in interest rates, was the product of a sound inherited fiscal position.

In addition to the proposition that deficits don't affect interest rates, some tax cut proponents also assert that tax cuts will increase private savings, work, and investment activity. This, in a nutshell, was Reagan's theory in the 1980 Republican primary—that is, that tax cuts would pay for themselves through supply-side effects. But the deficit grew instead of diminishing, and by 1992 the federal debt had quadrupled. By the very end of the 1980s, this fiscal morass led to higher interest rates and diminished confidence, which fed the economic difficulties of the late 1980s and early 1990s. Moreover, the evidence that tax rates have significant effects on private savings or work is very thin. Most of the mainstream academic literature suggests that private savings is affected very little, if at all, by interest rates. Thus, reducing taxes would seem unlikely to affect private savings much, despite increasing the after-tax rate of interest. The academic literature also predominantly holds that decisions about how much to work are not significantly affected by marginal tax rates, at least within the ranges of the tax rate debate of the last two decades, with the possible exception of some effect on secondary earners in a family—and that effect on the economy is relatively modest. In fact, the effect of tax cuts on the incentive to work can even be negative, since lower average tax rates enable someone to work less for the same after-tax income. Tax cuts may also affect choices between nontaxable perks (e.g., a larger corner office) and taxable income, but such choices don't significantly affect economic growth. My own experience in setting corporate compensation is that the effect of tax rates on work effort is nonexistent—at least with top tax rates in their current range, as opposed to the rates of 70 percent or higher that we once had.

Tax cut proponents often argue that “dynamic scoring”—that is, budget rules that assume supply-side effects—show that tax cuts pay for themselves. In 2003, the Congressional Budget Office and the Joint Committee on Taxation—both with leadership appointed by the Republican majority—each produced dynamic estimates that refuted these claims. The JCT, examining a version of the 2003 tax cut, concluded that the supply-side effect of the cuts themselves on growth would be slight, and that the overall effect of the cuts plus the deficits they create on growth over the long run would, if anything, be negative. Similarly, the CBO examined the administration budget proposal as a whole and found little effect—and possibly a negative—effect on long-term growth.

Some tax cut proponents argue that the real market for capital is global and that increased demand for capital in the United States can be met by increased inflows from abroad, with relatively little impact on interest rates. It is true that global capital markets will satisfy demand for financing that is not met by U.S. savings, including the demand created by increased deficits. But it is not true that the capital flows into the United States at the same interest rates as would have existed in the United States if we didn't need that capital. And, in fact, the effect long-term fiscal deficits can have on the cost of flows of capital from abroad is one of the great dangers of these deficits. Funding some or all of our large fiscal deficits from abroad means attracting a greater inflow of foreign capital, and that will require paying a higher rate of interest. Moreover, studies clearly show that capital has a substantial home-country bias, making the interest rate increase needed all the greater. Secondly, the United States is such a large factor in capital markets that our excess demand—unlike that of smaller countries—can affect global interest rates. And, most troubling, if foreign capital markets become concerned about our fiscal policy and the soundness of our currency, suppliers of capital are likely to greatly increase the price demanded for use of their capital. This is exactly what happened to many countries during the second half of the twentieth century. And this potential consequence of fiscal ill-discipline could be especially dangerous to the United States under current circumstances, when we are dependent on large inflows of foreign capital to sustain a trade deficit and substantial savings shortfall. Finally, the empirical studies showing that deficits affect interest rates are based on data that reflect all factors, including whatever impact foreign inflows might have.

Because public understanding of these issues is so limited, serious discussion about and proposals to deal with the problem of deficits can easily be misrepresented. For example, in January 2002, Tom Daschle gave a speech arguing that our long-term fiscal situation posed grave dangers and needed to be repaired, without making any specific proposals for doing so. He went on to agree that short-term deficits might make sense when dealing with the currently weak economic conditions. But he was sharply attacked the next day for advocating tax increases during a recession. Daschle had actually done nothing of the sort, but the attack—which was widely and pretty much uncritically reported—took hold. And that deterred others from advancing the arguments Daschle had made.

One major impediment to serious discussion of our fiscal morass in the political arena is that it immediately raises the question of whether the country now needs to raise taxes to deal with the deficit. My view is that dealing with the fiscal deterioration that current policy has led to will inevitably mean shared sacrifice, as it did in 1993, and will involve both spending and tax measures. But whatever the components of the eventual solution, the President and congressional leaders of both parties should get together—sooner rather than later—to deal with what has become a serious threat to our future well-being.

Despite the difficulties Daschle and others encountered in trying to raise the deficit issue, the prevailing tone of the debate began to shift in 2003. The media perspectives shifted, influenced in part by the Gale-Orszag paper as well as more frequent comments by other prominent economic analysts, by the ballooning current deficits, and by the sharply increased long-term deficit projections. In this changing climate, the administration moved to acknowledge that long-term deficits do, in fact, affect interest rates. Under new leadership, President Bush's Council of Economic Advisers accepted this point in an on-line
Wall Street Journal
article. But the tax cut proponents then argued that even if deficits did matter, the projected amounts were “manageable.” In making this case, however, they used estimates much lower than those used by mainstream analysts, and they did not acknowledge the potential for severe nonlinear effects, the immense entitlement costs on the horizon, or the potentially powerful adverse non-interest-rate effects of deficits on growth.

Robert Reischauer, a former head of the CBO and one of the wisest and most practical budget experts I know, thinks that those who run our political system may well be unwilling to repair our long-term fiscal mess until we reach what he considers an inevitable day of reckoning. When that crisis arrives, we will either have to make the decision to increase revenues substantially—at what may well be an inopportune time—or face severe and prolonged economic tribulations. Then the American people will look back with dismay at what happened. Unfortunately, no one who is now concerned about deficits has yet found a way to explain these future costs in a way that has political resonance in the shorter term, while these most serious problems are being created and can still be prevented. Leaving aside debates about whether deficits matter and about whether the supply-side effects are real, tax cuts and spending increases often seem attractive in the short term to politicians—and voters—who either don't focus on the long term or perhaps, in some cases, recognize the potential problems but feel that they will fall on somebody else's watch.

   

AS THIS DEBATE WAS evolving, my role in it evolved as well. I was still in touch with a number of Democrat senators and House members and, just as important, their staffs. In Washington, businesspeople tend to congregate around the elected official. But very often, if you want to be effective—either in knowing what's going on or in actually getting something done—you're well advised to develop a relationship with the right staff people as well. A good example is Mark Patterson, at that time staff director for Tom Daschle's Democratic Leadership Committee, whom I got to know when he worked for Pat Moynihan. Mark is the kind of staff member who understands substantive issues, can read the politics of the Senate, and has a lot of good-humored insight into what's likely to happen on the floor and in the various committees. It was through Mark and other congressional staff members that I started to get a sense of how I might be useful again in the debate over Bush's 2001 tax cut proposal. When the Democrats controlled the White House, the administration had a series of policy positions that were a regular part of the public debate. Democrats in Congress could decide where they wanted to be on economic issues in relation to where the administration was. Most often, the Democrats on Capitol Hill, whether accepting or critical of our positions, used us as a resource for both policy and politics.

Now, all of a sudden, the Democrats didn't have any of the support structure of a Democratic administration—the fixed star from which to navigate, if they chose, along with the resources, data, and expertise of the cabinet departments and the White House. For example, on tax issues, legislators from the party that controls the White House have at their disposal both the substantive analysis of professional economists at Treasury and the talking points that communications people at Treasury and the White House tailor to different constituencies and different states. They have people they can call on who are deeply involved in economic issues and are thinking about them from the same general perspective. If you're a U.S. senator, there are always plenty of professional economists at your disposal. What you may lack are people who not only understand economic issues but have also lived in your world and have faced the same kinds of policy choices and political realities you have to face every day.

Once the Republicans retook the White House, the Democrats on Capitol Hill began to realize that the Clinton people had been a useful resource, and they seemed to miss having us. Alan Greenspan was seen by most as supporting Republicans on the tax cut issue when he testified before the Senate Budget Committee on January 25, 2001—though in that same testimony, he stated his concerns about not encroaching upon the Social Security surpluses and warned that a tax cut should not be so large as to plunge the government back into deficit. The Democrats needed people with significant economic policy-making credentials and political experience to support them in developing their positions and to validate those positions.

I remember one Democratic congressman saying to me, “Our members are ready to go out and fight on the tax cut. But many of them don't fully understand this substantively. They want to have a comfort level with the issues.” It's an important point: if you're a member, you're constantly being asked what you think about a vast range of complicated subjects. Even legislators who are very diligent and dedicated can't be experts on more than a few issues. The leadership and other members who are deeply involved may give you material to help you understand an issue or answer questions from the press. But legislators don't want to take a position and realize six weeks or six months later that they were wrong. The bipartisan Concord Coalition played an important role in meeting these needs on fiscal matters, providing analysis of fiscal conditions and the dangers of large long-term deficits, as well as the reassurance that comes from the support of well-respected figures. Among those associated with the organization who opposed fiscally unsound tax cuts were former Senators Bob Kerrey, Sam Nunn, and Warren Rudman, former Federal Reserve chairman Paul Volcker, and former Commerce Secretary Pete Peterson. They held press conferences and their work was widely circulated on the Hill during hotly contested struggles over tax cuts.