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With Huge U.S. Deficits, Rates Are Now Sure to Rise

Laura D'Andrea Tyson was U.S. President Bill Clinton's chief economic advisor and is now dean of the London Business School. In its World Economic Outlook report to be issued on April 21, the International Monetary Fund calls on the U.S. Federal Reserve to prepare the world for higher interest rates "to avoid financial market disruption both domestically and abroad."

By Laura D'Andrea Tyson

LONDON -- Four years ago, at the beginning of the last American presidential campaign, the U.S. economy was enjoying a nine-year expansion: strong growth, low unemployment and inflation, rising incomes, a soaring stock market, and large federal budget surpluses. At the time, many observers from both left and right accorded the policies of the Clinton administration -- in particular its support for significant deficit reduction -- at least partial credit for the economy's strong performance.

Today, the U.S. economy appears poised for another period of high growth following a spectacular stock market correction, a painful recession and an anemic recovery characterized by persistent job losses, stagnant incomes and ballooning budget deficits.

The economy's performance and future prospects will be big issues in this year's presidential campaign. The Republicans will claim that Bush's economic policies, in particular the two large tax cuts of 2001 and 2003, have triggered renewed economic expansion, while the Democrats will argue that these policies have caused large job losses, rising income inequality and huge budget deficits. The debate is sure to be heated and not very enlightening.

Luckily for those trying to understand what has really happened, a new book, "In an Uncertain World: Tough Choices From Wall Street to Washington" by Robert Rubin, secretary of the Treasury for most of the Clinton presidency, provides a compelling and largely dispassionate analysis of recent U.S. economic history. Another book, "The Roaring Nineties: A New History of the World's Most Prosperous Decade" by Joseph Stiglitz, a chairman of the council of economic advisors during President Clinton's first term, confuses the picture with an analysis that, while occasionally insightful, is marred by inconsistencies and exaggerations. As a central member of the president's economic team during his first term, I have firsthand knowledge of the policymaking process and the different positions of the participants.

Both books devote considerable attention to President Clinton's 1993 economic plan and its impact on the economy. When Clinton's economic team met with him for the first time in early 1993, the federal deficit amounted to nearly 5 percent of GDP, the federal debt was growing much faster than output, and long-term budget projections were deteriorating. There were huge deficits as far as the eye could see, indicating that even if the economy enjoyed a strong recovery -- not judged likely at the time -- deficits would persist, acting as a drag on economic growth. All of us presidential advisors, including Stiglitz, believed that the deficits were not sustainable in the long run and that a serious deficit-reduction program was essential. The president agreed.

Clinton's decision was a politically courageous one. As Rubin argues, this decision, like several others during his eight years in office, exhibited his willingness to exchange short-term political gain for potential -- but unguaranteed -- long-term economic gain. President Bush has shown no such willingness. Contrary to what Stiglitz argues, Clinton understood both the dangers of deficit reduction when the economy was weak (as it was in 1993) and the uncertainties about how deficit reduction would affect interest rates and growth over time as the economy recovered.

Clinton's advisors warned him that reducing the deficit through cutting spending or increasing taxes could slow the economy in the short run. We also predicted that reducing the deficit would reduce long-term interest rates, thereby stimulating investment and growth over time, but cautioned that the links between deficit reduction, long-term interest rates and investment were uncertain both in timing and in size.

Both Rubin and Stiglitz agree that the most heated debates among the president's economic advisors at the time concerned the size and composition of the deficit- reduction package. The larger the package, the greater the sacrifices the president would have to make in his spending plans for education, health and infrastructure and in his plans for a middle-class tax cut. But the smaller the package, the less its likely effects on long-term interest rates and investment.

Along with Stiglitz and Alan Blinder, the other member of the council of economic advisors, I was counted among the deficit doves, counseling a less ambitious deficit-reduction target both because the economy was weak and because of the policy choices that might be necessary to achieve a larger target. But Clinton ultimately opted for a more aggressive target, convinced by Lloyd Bentsen (Treasury secretary from 1993 to 1994), Rubin and Vice President Al Gore that a bold target was necessary to restore investor confidence in the federal government's commitment to fiscal responsibility. They argued that long-term interest rates were likely to fall further and faster as a result of greater confidence.

In a thinly veiled attack on Rubin, Stiglitz states in his book that the confidence effect is the refuge of those who cannot find better arguments, allowing the "businessman turned politician" to go unchallenged in policy advice. In contrast, Rubin argues in his book that the effect of the Clinton deficit-reduction plan on business and consumer confidence may have been even more important than its direct effect on interest rates. Like Stiglitz, I questioned the confidence argument in 1993, and I still haven't found evidence to validate it.

Despite their disagreements during the Clinton years, Stiglitz and Rubin are united in their criticisms of the economic policies of the Bush administration -- criticisms that I wholeheartedly share. Both believe that the large budget surpluses projected at the end of the 1990s should have been used to pay off the debt of the federal government and so prepare for borrowing needs that will arise when the baby boom generation begins to retire in significant numbers. They identify the 2001 and 2003 Bush tax cuts as the major factor behind the unprecedented reversal in the nation's fiscal fortunes -- from a projected 10-year surplus of more than $5.6 trillion in early 2001 to a projected 10-year deficit of more than $5 trillion today, according to several independent analysts. They question both the Keynesian and the supply-side logic of these tax cuts, arguing that they do not deliver much "bang for the buck" in stimulating demand in the short term and do not act as an incentive on saving and investment in the long term.

Indeed, as Rubin points out, the congressional budget office and the joint committee on taxation -- both with leadership appointed by the congressional Republican majority -- recently concluded that the Bush tax cuts, including the deficits that they have created, are likely to reduce rather than increase the economy's growth over the next decade. Stiglitz is more outspoken than Rubin about the distributional consequences of the Bush tax cuts, while Rubin devotes more attention to the possible negative effects of fiscal disarray on market confidence. But both believe that the long-run fiscal outlook is bleak and could trigger a sharp fall in the dollar and a spike in interest rates if foreigners lose confidence in U.S. economic policies. Stiglitz may believe that the Clinton administration took deficit reduction too far in the 1990s, but, like Rubin, he is convinced that the Bush administration has taken deficit creation to new and unsustainable heights.

Apparently Paul O'Neill, who served as Bush's Treasury secretary until he was asked to resign in late 2002, agrees with this assessment. According to Ron Suskind's recent book, "The Price of Loyalty," O'Neill repeatedly warned Bush that the country was moving toward a fiscal crisis. But O'Neill's warnings were dismissed by Vice President Dick Cheney, who argued that "Reagan proved deficits don't matter." O'Neill paid for his unwanted advice with his job.

But under realistic assumptions, large budget deficits -- more than 5 percent of GDP, excluding the Social Security and Medicare trust funds -- are projected every year through the next decade, right up to the time when the first baby boomers begin to retire. Future budgetary imbalances will be so large that the risk of severe adverse consequences -- including a sharp loss in investor confidence in U.S. economic policies, a sell-off of U.S. securities, a precipitous decline in the dollar, a sharp rise in interest rates and a rapid contraction in economic growth -- must be taken seriously. And even if these risks do not materialize, large budget deficits will require a combination of lower private investment and greater indebtedness to the rest of the world. Either way, Americans' claims on the nation's future output and their future living standards will be reduced as a result of Bush's budgetary profligacy.

Meanwhile, Bush takes no responsibility for the fiscal mess he has created. His most recent budget calls for making his tax cuts permanent -- which would amount to more than three times the cost of making the Social Security system solvent over the next 75 years. He promises to halve the deficit as a percentage of GDP by sharp reductions in federal spending on everything but defense and homeland security. But his proposals are neither politically realistic nor economically sound.

Nonetheless, his calls for spending cuts with continued tax relief that disproportionately benefit the wealthy reveal the Republican goal that has guided his administration from the start: to starve the federal government of the revenues necessary to fund social programs that benefit middle and lower-income families.

Bush has undermined the fragile political consensus behind fiscal responsibility that emerged in the 1990s and is willing to threaten the nation -- with adverse spillover effects around the globe -- to realize this ideological objective.

(c) 2004, Prospect/Global Viewpoint. Distributed by Tribune Media Services International.

For immediate release (Distributed 4/20/04)