by Robert Rubin
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.
The deterioration from a surplus to a deficit is the most accurate way to look at the effect of current fiscal policy. Howe
ver, 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 di
d 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.