Time For a Tax Hike? Or a Budget Cut?

Pete Peterson, Secretary of Commerce for Nixon, chairman of The Blackstone Group, chairman of the Institute for International Economics and chairman of the Council on Foreign Relations (How’s that for a CV?) has written an article in Foreign Affairs entitled Riding For A Fall, which is adapted from his book Running On Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It.

It’s a pretty damning article. First he lays out all the nasty facts:

* In short, the stunning effectiveness of the U.S. armed forces has come with an equally stunning price tag. For most of U.S. history, going to war was like organizing a large federal jobs program, with most of the work done by inexpensive, quickly trained recruits. Today, it is more like a NASA moon launch, entailing a massive logistical tail supporting a professionally managed and swiftly depreciating body of high-tech physical capital.

The Congressional Budget Office recently recalculated the administration’s projections…The results are eye-opening: total defense outlays over the next decade may cost 18 percent more than the administration’s official projection. Including interest costs, this excess amounts to $1.1 trillion in new spending…Even this number does not reflect the cost of any new military operations abroad, which three of every four Americans believe are “very likely” in “the next few years,”…

* He then goes on list all the unfunded homeland security issues that almost certainly need to be addressed, including: properly equipping first responders, costs to improve health-care capabilities over the next five years for radiation or biowarfare attacks (about $36 billion), reducing the threat posed by cargo containers ($20 billion upfront, plus recurring costs), improving our ability to deal with immigrants of both the legal and illegal variety and safeguarding critical infrastructure.

He concludes that section by saying, “For the first time in the post-World War II era, the United States faces a future in which every major category of federal spending is projected to grow at least as fast as, or faster than, the economy for many years to come.”

He then has this to say about our ongoing budget deficit:

* The United States is now borrowing about $540 billion per year from the rest of the world to pay for the overall deficit funding Americans’ consumption of goods and services and U.S. foreign aid transfers. This unprecedented current account deficit is paid for through direct lending and the net sales of U.S. assets to foreign businesses or persons: everything from stocks and bonds to corporations and real estate. The United States imports roughly $4 billion of foreign capital each day, half of that to cover the current-account deficit and the other half to finance investments abroad.

And then makes these observations:

* If nothing else were to change, borrowing would continue until foreigners accumulated all the U.S. assets they cared to own, at which point a rise in interest rates (choking off investment) and a decline in the dollar (choking off imports and stimulating exports) would gradually close the current-account deficit.

* The next dollar run, should it happen, would likely lead to serious reverberations in the “real” economy, including a loss of consumer and investor confidence, a severe contraction, and ultimately a global recession.

* Virtually none of the policy leaders, financial traders, and economists interviewed by this author believes the U.S. current account deficit is sustainable at current levels for much longer than five more years. Many see a real risk of a crisis. Former Federal Reserve Chairman Paul Volcker says the odds of this happening are around 75 percent within the next five years; former Treasury Secretary Robert Rubin talks of “a day of serious reckoning.” What might trigger such a crisis? Almost anything: an act of terrorism, a bad day on Wall Street, a disappointing employment report, or even a testy remark by a central banker.

*With the substantial fall in the exchange value of the dollar since the beginning of 2002, global investors may be telling markets that a partial readjustment of the U.S. current account deficit is overdue.

Finally, he looks at the coming tidal wave of medical and age related spending as the Baby Boomers reach retirement age. Compounding the problem, our European partners and Japanese bankers are facing the same demographic issues, only worse, due to higher social spending and lower birth rates. In short, they can’t continue to fund our deficits since that money is going to be spent at home. Nor are they likely to be spending more on defense or antiterrorism measures.

He ends with this warning, “Leading nations cannot indefinitely borrow massively from those they intend to lead. As the economist Benjamin Friedman puts it, “World power and influence have historically accrued to creditor countries.” Equally, leading nations cannot subscribe to a foreign policy that has been aptly characterized by historian Niall Ferguson as based on “the Wal-Mart motto: Always low prices.” Global security has never been guaranteed on the cheap–and that is unlikely to change in an age of fanatical passions and hand-held WMD.”

“The United States would greatly benefit from a serious and realistic discussion of the total cost of its long-term security agenda. It is a discussion that would lend welcome urgency to efforts to control the federal deficit, and, in particular, to reform ballooning entitlement programs. It is a discussion that would reconnect the domestic and foreign policy communities by requiring every policymaker to make a tradeoff: ‘How much am I willing to pay in tax hikes or benefit cuts in order to fund my security priorities?’ Most of all, it is a discussion that ordinary Americans would welcome. People know in their personal and family lives that they cannot call for new sacrifices or promise new benefits without carefully considering the consequences. Why, they wonder, should things be any different in national life?”

I am not an economist. On the other hand, his credentials as an economic analyst seem impressive. Outside of the issue of the war in Iraq, the budget defecit seems to me to be the single biggest issue facing the United States. Unfortunately, we’re not facing it. For four years we’ve been spending money like drunken sailors right after making a massive tax cut. We’re looking at a confluence of events that are conspiring to produce what Peterson calls, “a perfect storm”.

If I were budget director, I would try to stabilize then reduce military spending and raise taxes. I’d shoot for a balanced budget in four years and surpluses for the following years. I’d probably close many European bases and reduce the the rest to skeleton staff. Ditto Korea. Ditto Japan. Ditto Turkey. I’d also open Social Security accounts to allow them to be partially (fully?) investable in 401k type plans. I’d do whatever it took.

So what do you think? What should we do? If you were budget director, what would you recommend?

14 thoughts on “Time For a Tax Hike? Or a Budget Cut?”

  1. I don’t think you need to raise taxes. You do, however, need to reduce discretionary spending (pork and things like ag subsidies), increase the retirement age and social security taxes, and get our so-called allies to start taking responsibility. And while I’m doing wishful thinking, you need more accountability on the state level as well. K-12 school funding is out of control ($10K+ per student per year is common). And we need tort reform, and to stop paying health care and education expenses for illegal aliens.

  2. Peterson has been peddling the same anxious theories (accompanied by high-tax, anti-debt nostrums) for years, always predicated on assumptions that borrowing is bad, that annual deficits in government spending are bad, and that raising taxes will not cause more harm than good. It’s difficult to know where to begin to refute these bad ideas, but the short answers are that debt isn’t bad if it finances economic growth, that there isn’t any evidence that running an annual government-spending deficit is harmful, that there’s plenty of room to cut government spending (which, unlike increasing taxes, usually leads to more productive use of the funds thereby freed up), and that spending on defense (a la the Cold War and SDI) can actually be one of the most productive types of government spending — because in the long run it frees economies around the world to be more productive.

    We should be cutting taxes and cutting nondefense spending, by large percentages. National prosperity doesn’t come from careful economic management by government officials. It comes from the productive energies of millions of citizens when the government gets out of the way.

  3. Jon,

    Let me start by saying that I’m sure you know and understand far more about economics than I. Maybe you can help me understand a few things.

    When you say:
    debt isn’t bad if it finances economic growth

    1. How does our paying debt service to Europe, Japan and China finance economic growth here?

    2. Wouldn’t we be better off as citizens if a large portion of our taxes were not being spent on debt interest, which buys nothing, than if were being spent on goods and services? At least then we’re something for our money.

    there isn’t any evidence that running an annual government-spending deficit is harmful

    Wouldn’t that depend on how much debt we’re talking about? Don’t the major economists (i.e. Greenspan, Volker) say we’re carrying too much debt?

    there’s plenty of room to cut government spending

    What, specifically, would you recommend?

    National prosperity doesn’t come from careful economic management by government officials. It comes from the productive energies of millions of citizens when the government gets out of the way.

    I agree with that completely as a general principal. However, haven’t the populace voted for social programs? Medicade, AFDC, etc. Personally, I’d prefer we find ways to make the health care industry (for one) more responsive to the market. It’s clearly not working properly if there are people who can’t afford basic health services. Tort reform would be a damn good start, IMAO. Deregulating healthcare to some degree by allowing RN’s to prescribe basic medices, put in stitches, treat flu, etc. might also help.

    I would also defend my military cuts. There is no reason whatsoever we can’t do a better job prioritizing our security. Why does the US Navy to patrol the entire globe? Why the Europeans take responsibly for the North Sea and the Med? Why not let the Canadian patrol the North Atlantic? Why not let the Aussies & Japanese patrol the eastern pacific? Why do we need to maintain full scale bases all over the globe. Make the Euros provide and pay for their own security. They can certainly afford it. Same with the Japanese and Koreans. Keep only skeleton facilities where there’s a critical necessity. What’s wrong with that?

    My point is, we’re trying to pay for X + 10 amount of goods and services yet only taking in X – 10 dollars each year to the treasury. We need to address that I think.

  4. First I’ll echo Jonathan, I’ve heard this argument a million times, always as a reason to raise taxes (although this won’t “fix” and of these “problems”). The problem is that even if you believe the dire predictions over the last 30 years that disaster is just around the corner, the cure is inevitably much worse than the “disease”.

    First of all, the trade “deficit” is a consequence of other countries subsidizing and protecting what they believe are important home industries with protectionist barriers and cash payments. This is called mercantilism or crony capitalism, and the people who pay for it are the citizens of those countries. Their taxpayers are paying Americans to buy cheaper goods.

    When the corporations in the these countries sell us goods they receive dollars. They can’t spend those dollars in their home countries directly, they have to exchange them for their own currency. If they lose money in that exchange (like now) then they have the option of investing those dollars in America, getting the best return on their money that they can.

    This is a good thing: Foreigners investing their excess capital in America instead of in their home countries. Where do you think the financing for all of those Japanese and German auto plants in America came from? Excess tarde surplus dollars. Toyota, Nissan, BMW, etc. saw a better return on that capital in America than in their home countries. They used their profits to employ Americans instead of Japanese or German citizens. Is that bad?

    “1. How does our paying debt service to Europe, Japan and China finance economic growth here?”

    Why do you care who lends Americans money? Do you think Americans are more benevolent investors than the Japanese? Based on what?

    The big myth here is the whole idea that creditors hold ultimate power over borrowers. That’s a socilist, depression era superstition. Creditors are in a precarious situation any time they lend or invest their money. There is always the chance they will lose it all. Debtors actually hold a position of power in many of these situations (just look at Argentina’s negotiations with it’s creditors!) because all they have to lose is money that they didn’t have in the first place.

    The moral of the story is that creditors don’t have leverage to control the lives of debtors in the way that many people think. Japanese, Chinese, European investors want to get the best return on their money possible, just like Americans. If they don’t get it they will eventually bail out, just like Americans. No difference. Most conspiracy theories in this vein assume that the nefarious foreign creditors are willing lose money big time in order to mess with America’s finacial health. That’s just dumb.

    Last point since I’m running out of time: The trade “deficit” and the budget defict have no relation to each other. America had a sizable trade deficit even when the budget was supposedly in surplus.

    I don’t want to go as far as to make the blanket statement that deficits don’t matter, becasue at some level they start to. But where the people who always get all upset about the budget deficit usually get off track is beleiveing that even a small (in comaparison to GDP or world debt markets) budget deficit has large effects on interest rates. In reality interest rates are probably a total of about 2% higher than they otherwise would be if we had no national debt at at all. The increase due to the current budget deficit is probably in the range of about 0.1%-0.2%.

    Then there is the whole falacy that low interest rates are the holy grail of economic prosperity. They are not. Real interest rates were much higher in the 1980’s and the economy was booming. The investment attracted by those high interest rates fueled the growth of the 1990’s.

    Some many subjects so little time. I’d love to continue this later.

  5. The dollar bill printing machine went on at the same time worldwide trade exchanges accelerated.
    As long as there is a nominal increase the dollar should be ok. The day we have a contraction of the exchanges…

    As most of you claim to be clever economists or ideologues can you give me an idea of how to quantify the “advantage” the US has over the last 15 years compare to any country in the world thanks to these almost never reimbursed(so far) 0% loan to the US treasury.

  6. Here are a few things that can be done to drastically improve things outside of crashing the budget and raising taxes:

    1. Expand loser pays rules for torts.
    The amount of extortion that goes on in lawsuits that are brought and settled for less than the lawyer fees would have cost to get the case thrown out is astounding. The amount of defensive, money wasting actions that such legal extortion causes is criminal. Why is the doctor ordering so many tests? He doesn’t want to end up in court so he gold plates the treatment.

    2. Fire any government manager that resists automation and efficiency reforms.
    The reason that the private sector has shed so many jobs and government hasn’t over the past few decades is that the private sector is judged on profitability while government managers are judged by their peers by their head count. If you automate, create more flexible workplaces, and improve efficiency, an awful lot of “necessary” expenditures don’t turn out to be necessary.

    3. Offer significant rewards for finding better ways to do things in government
    If somebody comes up with a billion dollar savings plan, I’ve got no problem giving him 10% of savings as they are realized and without cap (though with a time limit). There’s a lot of creativity and good sense in the government workforce that needs incentivization.

  7. IIRC, it is an accounting axiom that the current account deficit and the budget deficit are related. They do not go in lockstep because not all of the borrowing that the US economy does is governmental. As anyone who knows someone who bought a home or has credit card debt, this borrowing must come from foreign savings also.

    Peterson HAS been peddling scare stories for a long time. And so was the Economist magazine in the 1990s. They were calling the “Internet Bubble” and the US Stock market bubble in 1994-5, as other obervers were declaring the end of the business cycle and permanent prosperity. My point: sometimes scare stories turn out to be true.

    Unsustainable trends will eventually assert themselves. When they do, there will be great pressure on everyone in the world economy. As has been pointed out, if I owe the bank $200,000 on my house, that is my problem. But if the US owes Japan and Europe $5 trillion, that is THEIR problem too, as we can simply repay them in inflated dollars.

    But that is the trap that we are setting for ourselves. A massive inflation, and the end of the dollar as the reliable, reserve currency for the world, are possible results. What would a massive inflation do to our economy? Just remember your Milton Friedman and the relationship between political stability and inflation (in Argentina, Weimar Germany, Nationalist China) and even our own modest bout of inflation in the goodold 1970s. The risks referred to by Volcker et al are certainly there.

    As for what to cut, let’s all admit that this President and Congress has been disastrous on the spending side of the ledger. The new ag subsidies and the Medicare benefit were porky. And let’s see what happens on the huge transportation pork bill winding its way through Congress.

    First advice: when you are in a hole, stop digging.

    Second, Bush has continued and expanded the Clinton “competitive government” proposals, which compare what private sector service providers can do versus their government counterparts. It has acted as a brake on govt costs and has also led to more outsourcing to the private sector. Continue this.

    Third, the discretionary accounts have been squeezed mightily over the past 15 years, but every Federal manager has a “waste bank” that s/he dare not tap until the situation is dire. Take the money away and you will get more Federal employees coming up with ideas to save $$. EG, take a look at how much money the Feds raise through the Treasury markets: trillions of dollars in financing using like 15 people. The same guys (Bureau of Public Debt?? I forget) also run the Treasury sales to the public — the old timey $50 savings bond. They use something like 800 people in Sen Byrd’s state of West Virginia to raise $3 billion through the labor intensivebond program. Common sense tells us to end the bond program and use the T-market for it all.

    The General Services Administration operates a fleet of vehicles. Privatizing this as a business would yield $2.9 billion in one-time income and tax revenue thereafter. EVERY agency has its little pocket of inefficiency thatit dare not offer up TOO soon. You may need when Congress REALLY cuts to the bone. So go ahead Congress– cut. (note: I was Congressional staffer for 10 years and it’d be nice if there was some institutional incentive for Congress to reduce spending rather than piling it into their own district. Maybe some wiser soul knows how.)

    One more point about shifting resources out of government. Bush’s Social Security privatization proposals will, over time, shift investments from (fake) Treasury bonds to (real) investments in the private economy. These hopes are why I am supporting a second Bush term — not the huge increases in spending and backsliding on free trade.

  8. Mike suggests:
    “Make the Euros provide and pay for their own security. They can certainly afford it.”

    But i don’t know how one would “make” France or Germany do such a thing. And if, say, Japan and Australia did not do a good job of policing the Pacific, what happens to the piracy rate going by Malaysia and Indonesia?

    Yup, we got rich as a nation riding on the security that the British navy gave our trading ships. And now others are doing the same on the back of our navy. But i think we are the ones with the most to lose, so accepting the cost is the less bad alternative.

    Matya no baka

  9. Matya, I’m not so sure. I agree that the US benefitted greatly as a trading nation from the Pax Britanicca imposed by the Royal Navy.

    But consider this. The EU nations have a larger population and larger combined GNP than the US. As long as the US continues to coddle them they can continue to play the part of the irresponsible, self-indulgent, defiant child. Removing their safety blanket will force them to grow up. They will be forced to take the security of their region far more seriously. It’s far more likely they will realize that they’re better off allied with the US than in opposition.

    Australia and Japan are completely capable of patrolling the eastern Pacific and putting down piracy. Coddling them only infantalizes them. I’d rather have strong partners than weak dependents.

  10. Michael, sure they have a larger population and combined GNP, but we have a more efficient economy and better demographics. Coddling is not something we want to do. But how long would the transition period be, between when we pare back the navy and Europe grows up and smells the coffee? When not picking up their part of the burden hurts us more than it does them, and they are struggling to deal with pensions?

    Maybe finally moving significant numbers of ground troops out of Europe will get that process started. That would be a nice result.

    Matya no baka

  11. Maty sez:

    “Yup, we got rich as a nation riding on the security that the British navy gave our trading ships. And now others are doing the same on the back of our navy. But i think we are the ones with the most to lose, so accepting the cost is the less bad alternative.”

    Unfortunately that’s just not true. We have provided our own protection since 1813 when we created a permanent Med squadron to deal with the barbary pirates. Other than that it was “at your own risk.” If you were providing protection to another country at that time it was as the colonial ruler of that country or its patron. It really is time for us to not provide the sea protection for other countries that are well enough developed to provide it themselves. After WWII we did the protecting because we were the only game in town and provided cover for Europe and Japan to redevelop. They have redeveloped and it is time to leave.

  12. Also:

    There really is no threat except terrorism for Europe. In the Pacific all the countries have to deal with China and our pulling out of Japan and Korea may encourage them to seek bilateral treaties spelling out how they will deal with the China threat with no US there. Its not like the US is leaving. The Pacific will still be an area of intense crutiny for the US.

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