In an Uncertain World (51 page)

My response was that you might as well give the credit to Herbert Hoover, though I do think in other respects, such as trade and some aspects of deregulation, the Reagan administration made meaningful contributions. George H. W. Bush's administration also had important, constructive initiatives, in trade and—though not often cited by supply-side conservatives—the tax increases and new budget rules he put in place in 1990. These measures were a useful step toward reestablishing fiscal discipline, although far short of what was needed to stem the tide, with the result that actual and projected deficits were at very high levels—and growing—by the end of his administration.

By 2002, conservatives had a different argument: the collapse in stock prices that had followed the eighteen-year bull market showed that the 1990s hadn't really been that healthy an economic period after all. In fact, the 1990s were years of extraordinarily favorable and sound economic conditions, but extended good times almost always produce imbalances that lead to a period of adjustment. Of course, the view that some adjustment was probably inevitable still left an important debate about what policies would best serve to minimize the duration and severity of that adjustment and best position us for the long term. I felt that our policy choices during this difficult period of adjustment did neither.

In 1994, the Democrats lost control of Congress. After the election, conservatives took the political offensive, pushing for big new tax cuts to be paid for with deep reductions in Medicare and other programs. These proposed spending cuts, which were highly unpopular, faded away after the government shutdowns in 1995. However, the tax cut proposals remained—which showed how unwilling the proponents of tax cuts usually are to take the political heat for actually cutting specific programs in a way commensurate with the reduction in tax revenues. Because specific proposals to cut the budget step on toes, conservatives often advocated ameliorating the effects of their tax cuts through “dynamic scoring”—revising the projected cost of a tax cut downward on the basis of the supply-side theory that tax cuts would create enough additional growth to pay for themselves, partially or entirely.

In the 1996 campaign, Bob Dole argued for an across-the-board reduction in rates that would have cost $548 billion over six years; President Clinton responded with the position that any tax cut should be much more modest. In earlier decades, demands for balanced budgets tended to come from Republicans, while Democratic Keynesians argued that deficits should be disregarded. The Reagan administration began to change this traditional alignment, with its supply-side approach to tax cuts. And during the Clinton presidency these roles were reversed: it was Democrats who wanted to hew to the path of fiscal responsibility and many Republicans who seemed relatively indifferent to fiscal effects, so long as the money went to reducing taxes.

As the deficits diminished and a surplus emerged during Clinton's second term, the debate evolved again. Conservatives now argued for “giving back” the large projected surpluses to taxpayers in the form of a tax cut. It seemed that other uses of the surplus better reflected the preferences of the American people and we felt that continued fiscal discipline—in this case, beginning to pay down the debt of the federal government—would best promote economic growth. What's more, Social Security and Medicare were facing huge deficits once the baby-boom generation began to retire in significant numbers. We couldn't literally prepay these future obligations out of general revenues, but if the government had paid off its debt and was in a sound fiscal condition when those enormous bills began coming due, the country would be much better positioned to deal with them.

All of this argued against massive tax cuts. But dealing with the surplus left the Democrats in a tricky situation politically. Most voters don't even understand the difference between the government's annual deficit and its accumulated debt. So it was almost impossible to explain, in a way that people would relate to, why entitlement obligations we faced decades down the road meant that a government that was running a surplus should use the money to pay down its long-term debt instead of refunding it to taxpayers. Preserving the surplus as savings and using that to pay down debt would contribute to lower interest rates, greater job creation, and higher standards of living. But the reasons this was true were complicated. To better bring home to people the advantages of saving the surplus, the administration in 1998 reframed the issue as “Saving Social Security First.” The idea was to offset the political appeal of giving back the surplus in the form of a tax cut and remind the public that if the surplus was their money, the debt was their debt as well, and to connect saving the surplus with a purpose that was easy to explain. That argument worked to hold the line against massive tax cuts for a couple of years more.

In January 2001, the nonpartisan Congressional Budget Office projected a ten-year federal government surplus of $5.6 trillion. Because of certain long-established methodological practices that are widely viewed as unrealistic—for example, assuming that expiring tax credits, such as the research and development tax credit, won't be renewed—that number was probably overstated. By September 2003, after two rounds of tax cuts, Goldman Sachs, using more realistic assumptions, estimated a ten-year
deficit
of $5.5 trillion. That's a swing of $11.1 trillion, but adjusting for certain methodological inconsistencies, the better number to use is a $9 trillion deterioration from surplus to deficit. (Obviously, ten-year projections are extremely unreliable, but the risk of actual results being worse than these projections seems, if anything, to be greater than the chance of them being better—these projections all assume healthy growth rates, which might be undermined by these very deficits.)

Though many factors contributed, the tax cuts of June 2001 and May 2003 were central to this reversal. The CBO estimated that the first tax cut would cost $1.7 trillion, including debt service (the interest that the federal government will have to pay on debt that would have been retired absent the tax cut), but those figures assumed that the tax cuts will actually “sunset,” or expire, when scheduled to do so. Independent analysts suggested the cost would be higher, exceeding $2 trillion with debt service, if the tax cuts were instead made permanent. The second tax cut was officially estimated to cost $550 billion with debt service, again assuming the tax cuts would expire. If, instead, the tax cuts are made permanent, as proponents argued they should be, the cost would exceed $1 trillion over a ten-year period, with debt service. The combined tax cuts, then, represented roughly a third of the total deterioration of $9 trillion, and roughly two thirds of the $5.5 trillion deficit estimated by Goldman Sachs.

The tax cuts also helped to undermine the fragile political consensus around fiscal discipline that came out of the 1990s. The natural inertial tendency in Washington is toward passing more immediately gratifying tax cuts or spending increases, rather than what is best for the long term. A large tax cut, especially one that benefited higher-income taxpayers so much, made it hard to argue for discipline in other areas and thereby worked to unravel the reluctant sense of obligation to maintain sound fiscal policy. The federal debt, which would have fallen from one third of GDP to zero well within ten years under earlier fiscal estimates, instead was estimated two years later in that Goldman Sachs study to increase to more than 50 percent of GDP by the end of the ten years. Moreover, the numbers of baby boomers retiring will increase rapidly in the years ahead, raising Medicare and Social Security costs and making prospects as the years go on even worse.

Do Deficits Matter?
With this as a background, the Great Fiscal Debate now moved to the question of whether these projected deficits mattered. This is clearly the heart of the issue. The proponents of tax cuts had to argue that they didn't matter—or at least didn't matter much—because large tax cuts and a sound fiscal position could not be reconciled. And tax cut advocates, including President George W. Bush's CEA chairman, Glenn Hubbard, pointed to me as the symbol of the position that deficits have a significant effect on interest rates and therefore on economic activity, job creation, and growth. The
Wall Street Journal
editorial page dismissed the theory that deficits affect interest rates as “Rubinomics.”

Flattered as I was, at first I didn't think this position could possibly get traction. But it was loudly trumpeted, and the countervailing view wasn't. As a result, what seemed to me arrant nonsense came to be treated as a serious point of view. One tax cut proponent testifying beside me at a congressional hearing went so far as to say that nothing in the literature supported the concern about fiscal conditions affecting interest rates.

Nothing in the literature? The first thing you learn in Introductory Economics is that supply and demand determine price. It's curious to me that people whose basic credo is that markets explain everything don't think that an important factor in the supply and demand for debt financing—the federal government's fiscal position—has any effect on interest rates. Put another way, it's an even more obvious point: when the government borrows, the pool of savings available for private purposes shrinks and the price of capital—expressed as the interest rate—rises. If the Treasury ceases borrowing and instead begins paying down some of its outstanding $3.8 trillion debt, the savings pool available to the private sector increases and interest rates go down. A study by Robert Cumby at Georgetown University and two of his colleagues, completed sometime after that hearing, found a strong correlation between bond market interest rates and expectations about future fiscal conditions. The Cumby paper overcame a serious problem with previous papers that had examined only the relationship between interest rates and current fiscal conditions. Focusing instead on the relationship between interest rates and expected future conditions makes sense: a buyer of a five- or ten-year bond should logically be influenced primarily by expectations about interest rates and bond prices over the life of the asset.

But Cumby's paper didn't get much public visibility. Then Bill Gale and Peter Orszag of the Brookings Institution prepared a fifty-five-page paper with analysis and conclusions similar to Cumby's. It cited other well-established economists in support of the impact of projected fiscal conditions on interest rates—including Martin Feldstein of Harvard, who has also long been a major voice supporting a moderate version of supply-side tax theory. Gale and Orszag went one critical step further and actively briefed the media and members of Congress and their staffs. As a result, their work received widespread attention and contributed meaningfully to the growing concern about our fiscal mess. This exemplifies an important point often deeply frustrating to serious policy analysts outside government, whose work seldom has any significant effect on the policy process. Having a significant influence ordinarily requires not only an important piece of work but also a savvy sense of how to get attention in the media, Congress, and elsewhere in official Washington.

Interest rates are affected by many factors, which makes isolating the impact of fiscal conditions more difficult. Also, though fundamentals win out over time, at any given moment the psychology of the market may be at variance with the fundamentals. For example, when the economy and private demand for capital are sluggish, markets may focus very little on unsound long-term fiscal conditions and interest rates may remain low, as happened in 2002 and the first half of 2003. (Although even during this weak period the historically large spread between higher long-term interest rates and the lower short-term rates the Fed controls suggests that the deficits might have been having some effect.)

But whatever the effects may be when the economy is weak, once economic conditions are again healthy, the private demand for capital will increase. Then markets will at some point focus on long-term fiscal conditions, and that increase in private demand will then collide with the government demand for financing to fund its budget deficits. Virtually all mainstream economists agree that there is no fiscal free lunch. Though no one can predict when, interest rates will react strongly to expectations of substantial long-term deficits and the effect of those deficits on the demand to borrow.

Let me put numbers on these concepts, to show how powerfully adverse the effects on our economy could be. When used to look at the effects of tax cuts, the Federal Reserve Board model projects that for each increase in the deficit of 1 percent of GDP, long-term interest rates will increase by 0.5 percent to 0.7 percent. Some analysts use lower estimates of that relationship, so, for purposes of this calculation, I assume that if the deficit increases by 1 percent of GDP, long-term interest rates will increase by 0.4 percent.

The $9 trillion deterioration in the Federal government's fiscal position over ten years that I mentioned previously is an average annual deterioration of 7 percent of GDP per year. That is, the swing from the previously projected surplus to the now projected deficit averages 7 percent of GDP per annum. Since each 1 percent of GDP will increase interest rates by 0.4 percent, a change of 7 percent of GDP per year will increase interest rates by 2.8 percent (0.4 percent x 7).

With ten-year long-term bonds at roughly 4½ percent, that is an increase in interest rates of more than 60 percent. However, the situation is actually substantially worse. A key interest rate for most economists is the market rate of the ten-year bond adjusted for inflation, which is called the “real” interest rate. With today's ten-year rate of 4½ percent and an inflation rate of 1½ percent, that means real interest rates are 3 percent (that is to say, the interest rate is 3 percent over and above the inflation rate). Using that figure, the 2.8 percent increase in interest rates that I've just described amounts to over 90 percent of real interest rates.