by Bill Bradley
Financing Our Debt
Meanwhile, of course, we need to finance our federal debt. Without foreign lenders, that will be difficult to accomplish. Our largest creditor is China, which holds $1.426 trillion in U.S. debt. Many argue that China would never precipitate a financial crisis by selling U.S. Treasury bonds, because such action would mean a drop in the value of the dollar and thus of their remaining dollar investments. They argue also that panic selling of U.S. Treasury debt would hurt the U.S. economy, which in turn would mean reduced exports from China to the United States and thus increased unemployment in China. And then there is the question of where China would put its $3.2 trillion in foreign currency reserves. It seems unlikely that they would buy more yen and give the currency of Japan, their Asian rival, the status of a major reserve currency. The euro is also an unlikely repository. Who knows whether, ten years from now, it will even exist? Currencies such as the Swiss franc or the Singapore dollar or the Norwegian krone don’t have enough circulation to be a meaningful alternative for the Chinese. But nations aren’t always rational. Our vulnerability is real.
It’s wise to remember that those who control the purse strings often control much more. An example: In 1956, the British, French, and Israelis invaded Egypt in an attempt to take over the Suez Canal. At the time, the United States was the world’s dominant economy. President Eisenhower was outraged and ordered the U.S. Treasury to start selling the British pound short, thereby putting unbearable downward pressure on that already sinking currency. His administration also prevented the British from drawing down their quota from the International Monetary Fund, further fueling speculation in the pound. Britain got the message and announced its withdrawal within a month.9 The prospect that China will exert similar pressure on us is not a probability, but it is a possibility. By threatening to sell off our debt or excluding our companies from its market, they might try to influence our actions with regard to Japan, Taiwan, or the South China Sea. Whatever the precipitating event, the faster China’s economy grows and the more dollar reserves it accumulates, the more powerful could be such coercive action. Clearly, China is fed up with our failure to deal with our long-term fiscal imbalances. It fears inflation down the road and a depreciating dollar. These concerns make it highly unlikely that China will be at the front of the line to purchase much of the $3.5 trillion in maturing Treasury debt that we have to refinance over the next two years. In January 2011, the Chinese Central Bank ceased to require Chinese companies that earn dollars to return those dollars to the central bank in exchange for yuan; they can now use their dollar earnings any way they want. With fewer dollars at the central bank, the Chinese will be able to say, when we ask them to buy a lot more Treasury bonds, “Sorry, we don’t have the dollars to buy more than we already are buying. They’re in the coffers of Chinese companies, which, as is the case in your country, we don’t control.”
Whereas it might be more difficult to count on the Chinese for our government-debt financing, Chinese capital could lay the groundwork for America’s next wave of economic growth. If we can control our long-term structural budget deficit, we will need less Chinese investment in Treasury bonds. The Chinese will continue to amass dollars as Americans continue to buy Chinese exports. They could use these surpluses to buy the reconstruction bonds issued by the U.S. government to fund the entire $1.2 trillion in infrastructure investment so critical to the recovery of the U.S. economy. Such action would be a tremendous vote of confidence in our bilateral relationship. We could then use the transportation trust fund for the less high-priority but needed infrastructure improvements. Persuading China not only to fund major infrastructure projects in the United States but also to bring more Chinese companies here to hire Americans (as opposed to simply purchasing American companies) should be another national priority. Japanese investments in the United States since the 1980s have led to the current employment of nearly seven hundred thousand Americans at U.S. affiliates of Japanese companies.10 More Chinese investment that creates new jobs could provide a win/win way out of our current capital imbalance with China. The British made major investments in the United States in the nineteenth century; it was a good deal for them and a good deal for us. There is no reason, once we act with fiscal prudence, for China not to follow suit in the twenty-first.
Since 1944, when the Bretton Woods monetary system was established, the dollar has been the world’s principal reserve currency, which means that many governments hold it as part of their foreign-exchange reserves. Indeed, the dollar represents over 60 percent of the world’s foreign-exchange reserves, with the euro next, at 26 percent. For us, the advantage is that the United States can execute international transactions in dollars rather than having to pay the transaction costs of going from one currency to another. With the world’s governments holding dollars, it is also easier for the United States to finance its budget deficit. Trillions of dollars need to go someplace. Given the flexibility and perceived advantage the United States has because of its reserve-currency status, China, Russia, and the Gulf Cooperation Council want to replace the dollar with a new reserve system, such as a basket of currencies or special drawing rights issued by the IMF. As a step in that direction, China, Russia, South Africa, Brazil, and India have established lines of credit among themselves in their local currencies. These countries represent a combined GDP approaching that of the United States and more than one third larger in real terms—that is, adjusted for our higher cost of living. Moreover, most of them have a higher growth rate than ours, so they will only become more important over time.
If more countries use dollars only to trade with the United States, gradually the dollar will play less of a role in world commerce. It won’t happen tomorrow, but it could happen sooner than you expect. Our economy will reel from the effects of losing our reserve currency status. The government will have to pay higher interest rates to attract the necessary capital for its bonds—or higher taxes to reduce the deficit and therefore our borrowing and exchange-rate costs. There will be less demand for dollars, and the dollar’s value will drop. Our imports will then be more expensive. Shortages could develop, as the United States could no longer pay for imports of goods and services with its own paper currency. And we will be unable to replace the imports with domestic production, because we have sent our manufacturing jobs offshore. We’ll be just like any other country that consumes more than it produces and borrows more than it saves: We will have to accept a lower standard of living.
Federal and State Budgets
The state of our economy is similar to a turnaround situation in the private sector. When a company is in distress, the CEO decides what to cut, what to consolidate, what to do about pricing, how much additional capital to request, and what to set as the executive team’s priorities going forward. He tells all participants that for two years all employees, including himself, will have to tighten their belts and make sure that any expenditure promotes future growth. He lays out a plan and executes it. Today a similar program has to take place in the public sector.
Projecting budget deficits beyond a year or two is difficult. They are subject to assumptions about economic growth and interest rates. Manipulate those assumptions and a deficit projection can be practically anything you’d like it to be. For example, a growth rate 1 percent lower than the projected rate will increase the budget deficit by $40 billion per year, because of lower tax revenues and higher unemployment outlays.11 In a Wall Street Journal opinion piece in June 2011, former Federal Reserve governor Lawrence B. Lindsey warned that if interest rates on government debt return to their levels of the last two decades (5.7 percent per annum, on average), they will add $420 billion in interest costs in 2014 alone. These two unknowns—growth rate and interest rates—make predicting precise budget deficits similar to shooting blindfolded at a moving target. If you try—because Congress now formulates a ten-year budget—to project growth and interest rates a decade out, you enter the realm of fantasy. Inaccurate projections often
lead to government policy that exacerbates either inflation by spending too much or recession by spending too little.
Politics will determine whether our long-term structural deficit can be successfully addressed. The structural deficit is the trajectory of spending over current revenues with no changes in law, and it differs from the cyclical deficit, which comes from higher unemployment with its mushrooming unemployment benefits and lower tax revenues. The structural deficit hangs over our future prospects like a dark cloud over the Kansas prairie. Medicare is the starkest example of a federal program with a large structural deficit. That’s why actions need to be taken today that will have an effect beginning three to five years from now, when the economy will presumably have recovered. If interest rates remain lower than inflation, the deficit could be reduced over time; the cost of borrowing would be less, and we could repay our loans with the increased taxes arising from inflation. But negative interest rates take a long time to have a substantial effect. Then there are the people who argue for “a little inflation” as the way out of our debt problem, but if the Federal Reserve miscalculates, “a little inflation” becomes much more and the American people pay the cruelest tax of all.
If you want to reduce the deficit without inflation, you have only four areas that will yield significant savings: Social Security, health care (Medicaid/Medicare), defense, and taxes. Cato Institute senior fellow Michael Tanner points out, in Bankrupt: Entitlements and the Federal Budget, that if no changes are made in law and if revenues return to their historical level of 18 percent of GDP, by 2050 the big three entitlement programs will consume all the revenue the federal government raises in taxes. In a much closer time frame, by 2015 defense, entitlements and interest on the federal debt will consume 76 percent of the budget.12 And even after President Obama’s healthcare bill fully takes effect, unfunded Medicare liabilities—according to Medicare’s trustees report for 2010—will be $28.7 trillion.13 If we are to pay for such already scheduled spending only with income taxes, then corporate and individual tax rates must dramatically increase; the Congressional Budget Office reports that the top marginal tax rate would have to go from 35 to 88 percent and the 25-percent rate for middle-income workers would have to reach 63 percent.14 Clearly, the answer doesn’t lie in income tax increases alone. Entitlement benefits must also be trimmed, and our national defense must accede to our economic limitations. We should first identify the spending cuts and then increase taxes to pay for the rest of the needed deficit reduction, and pass both the cuts and the taxes in one integrated package, with no loopholes or earmarks or other gifts to members of the Washington club and their clients.
Fifty-five percent of all federal spending is a transfer of money from one group of people to another. For example, we tax workers and send the money to the elderly through Social Security and Medicare, and we tax companies to pay for unemployment compensation. When politicians are unwilling to cut back on these kinds of transfers, what remains to be cut are the government programs that underpin our society: Schools deteriorate; judges and teachers remain underpaid; talented civil servants go elsewhere; needed infrastructure is postponed. An unwillingness to cut the transfers or to close tax loopholes or to raise taxes leads to a country that increasingly will fall apart.
When you consider that state governments, too, have diminished revenue and have made enormous commitments in health care and pensions, you see the full dimensions of the problem. Take the example of courts: Already in some states misdemeanors are ignored. In fourteen states, courts have reduced their hours in session. The courts have been slashed, even as the prison population is growing. The Economist recently pointed out that in California, because of budgetary restraints, a typical lawsuit may soon have to wait five years for a trial. The effects of rationed justice abound. As the Economist put it,
The recession left a vast legacy of foreclosures, personal and business bankruptcies, debt-collection and credit-card disputes. In Florida in 2009, according to the Washington Economics Group, the backlog in civil courts is costing the state some $9.8 billion in GDP a year, a staggering achievement for a court system that costs just $1.2 billion in its entirety. To make up the funding shortfall, courts are imposing higher filing fees on litigants. . . .
Even criminal cases are not immune. Some crimes, like domestic violence, have increased with the rotten economy. In Georgia, where court funds have fallen by 25% in the last two years, criminal cases now routinely take more than a year to come to trial. This means that jails are full of the innocent alongside the guilty. Their incarceration adds costs far greater than the alleged savings in the court system. Above all, it causes gross injustice.15
I was heartened to hear about Kasim Reed, the mayor of Atlanta, who (like many mayors and governors) inherited an unsustainable pension system that accounted for 20 percent of the city’s budget. In nine years, from 2001 to 2009, the unfunded pension liabilities had quintupled to $1.5 billion. Mayor Reed called the union and political leaders in and pointed out that unless they agreed to reductions in pensions the whole system would go bankrupt and no one would have any pension at all. In addition, services would be cut and city workers would be laid off. The city council passed a measure that guaranteed $270 million in pension savings over ten years.16
We need more of that kind of candor. Governors in many statehouses have arrived at a moment of truth: No budget gimmick or sleight-of-hand accounting can save them. Selling a few public assets, doing a few one-time fixes, and then passing the buck on to the next governor no longer works. With all the pension and healthcare promises, the situation has gotten out of control. City halls will no longer benefit from the deep pockets of fiscally compromised statehouses. The money will begin to dry up, and the mayors will have to break the news to their citizens and admit that they, too, have borrowed to near bankruptcy. They, too, will have to make the cuts or increase the taxes needed to right their ship. The truth is that state and local governments will probably have to do both.
A balanced approach will generate support—if only grudging support. No one wants to have a favorite government program cut back or pay more taxes, but if the alternative is bankruptcy, compromise just might be possible. I cannot emphasize enough the requirement of balance: asking something from everyone. Democrats want the rich to bear the burden; Republicans want to ask primarily the poor to sacrifice. Both political parties champion the middle class and neither asks anything significant of it in this crisis. A true solution cannot give the middle class a pass.
In the early 1980s, Social Security was in danger of going bankrupt. A bipartisan commission composed of respected politicians and economists was asked to recommend measures that would make Social Security secure; the Congress would then vote on those recommendations. As a first-term U.S. senator, I held over a dozen special Social Security meetings in New Jersey to get people’s sense of what should happen, given the imperative for some kind of action. At each meeting, I had a professor from the state university explain the exact situation. I then put the options on a blackboard and asked the audience to choose the ones they preferred. The common political wisdom was that the seniors would want tax increases for people paying into the system but not benefit cuts; that workers would want benefit cuts for the elderly and not tax increases for themselves; and that neither the old nor the young would want the retirement age raised. To my surprise I discovered that seniors knew that to save the Social Security system just by increasing taxes would hit their children too hard. They volunteered to take some benefit cuts so the tax increases wouldn’t have to be so large. Workers knew that just cutting benefits would hurt their parents, and therefore they accepted some increased taxes. And both groups agreed to raise the retirement age to sixty-seven, if it was done not immediately but over the next several decades. The bipartisan commission recommended all three measures—benefit cuts, tax increases, and raising the retirement age—and the Congress adopted them. The solution asked something of everyone. That’s what has to h
appen today, in the negotiations over our larger budget. And it will happen, if the public has anything to say about it.
The Battle over Taxes
Today our politicians tend to score political points by pleasing their most extreme supporters. In last August’s Republican presidential debate, one candidate was asked whether he would accept a measure requiring $4 of spending cuts for every $1 of new taxes. He said, “No.” How about $10 in cuts for every $1 of tax increase? Again, the answer was no. Finally, the questioner asked all eight candidates, “Is there any ratio of cuts to taxes that you would accept?” and the answer was still no. The exchange revealed an ideological rigidity that endangers America. In a system that requires compromise to advance the public interest, it’s difficult to move the country forward if compromise is ruled out. Apparently what was most important to those Republican candidates was the next election, not the economic health of their country.
As we saw in the federal debt-limit confrontation last summer, many Republican senators and representatives seem ready to let the country default on its debt rather than raise taxes. To give you an idea of how radical the views of these latter-day Republicans are, consider Ronald Reagan. He was known by his political base as the president who cut taxes by reducing the top marginal rate in 1981 from 70 percent to 50 percent and in 1986 from 50 percent to 28 percent. What is acknowledged by only a few Republicans, and just as rarely reported by the press, is that in 1982 he presided over the largest peacetime tax increase in American history, which replaced nearly one third of the revenue lost in the 1981 tax cut, and he followed this in 1984 with another large tax increase. He did this by closing a substantial number of tax loopholes—those special exclusions, credits, and deductions that benefit only selected taxpayers. In today’s budget debates, the radical Republicans reject loophole closings because they increase taxes on someone. (Actually, closing loopholes doesn’t “increase” taxes—it just makes sure that someone who owes taxes doesn’t get out of paying them.) By taking this rigid “no tax” position, they forfeit their claim to the legacy of Ronald Reagan.