January 24, 2006
COMMENTARY
'We Must Change Policy Direction'
By ROBERT E. RUBIN
January 24, 2006; Page A20
As I talk to public and private sector leaders from around the world, I am repeatedly struck by the powerful sense of mission held by the leaders of Asia's emerging market economies. They are making tough decisions to effectively promote competitiveness and growth. The result is large numbers of well-educated workers in low-wage and increasingly market-based environments (especially in China and India), connected to the U.S. by modern transportation and real time communications. This has created a competitive challenge of historic proportions which encompasses manufacturing and virtually all services electronically communicable.
We can meet this challenge and enjoy a bright future. Our economy has great strengths -- most particularly its long history of a true market-based structure, flexibility, relative openness to trade and immigration, and sheer size. These strengths can be especially beneficial when rapid technological development and continued global integration reward economies that are adaptable -- and punish those that are not. However, to reap those rewards, and to avoid the real possibility of great economic difficulty, we must re-establish our own seriousness of purpose about economic policy, and we must change policy direction on many fronts.
Stick With the Status Quo?
Some would argue that our reasonably healthy GDP growth in the last few years -- driven largely by the Federal Reserve Board's accommodative monetary policy and the disposition of consumers to spend based on high housing prices and lower interest rates -- indicates that we can stick with the economic policy status quo. I believe this would be a serious mistake. Median real wages and median family incomes have been roughly stagnant for the past five years -- and many Americans have had falling real incomes. Private sector job growth has been the lowest of any recovery since the '30s. Most importantly, the longer-term underpinnings of our economy are unsound at a time of historic competitive change in the global economy.
Re-establishing seriousness of purpose regarding economic policy and acting to meet the challenges of our era will require our political system to do what it is not doing today: making choices that are very difficult politically, compromising among divergent views in order to reach common ground, and putting aside ideology in favor of facts and analysis. There is almost surely widespread agreement that our future economic well-being is threatened by large current and projected fiscal deficits, huge increases in entitlement costs beginning in the next decade, personal savings rates of approximately zero, public school system inadequacies, and high health care costs. But our political system is failing to mediate differing views on how to address these issues, and failing to make the difficult decisions required. Political leaders in the recent past have taken on critically important economic issues, as President Clinton did on deficit reduction, trade liberalization and global economic crises, and as Ronald Reagan and Tip O'Neill did on Social Security in 1983. The need to do so now is imperative.
To move forward, serious policy advocates from all perspectives should start by agreeing on two basic bedrock principles: that there is no free lunch; and that a strong future requires incurring costs now for benefits later. We should then put everything on the table. Our strategy should have four components:
(1) We should re-establish sound fiscal conditions for the intermediate term (the 10-year federal budget window) and put in place a real plan to get entitlements on a sound footing for the long term. (2) We need a strong public investment program -- paid for, not funded by increased public borrowing -- to promote productivity growth, to help those dislocated by technology and trade, and to equip all citizens to share in our economic well-being and growth. (3) We must pursue an international economic policy that continues global integration, especially multilaterally, and proactively addresses our other international economic interests, including combating global poverty. (4) We should work toward a regulatory regime that meets our needs and sensibly weigh risks and rewards.
Our strategy should reaffirm market-based economics as the most effective organizing principle for economic activity, while recognizing the critical role of government in providing the many requisites for economic success that markets, by their very nature, will not provide.
Broad participation in economic well-being and growth is critical, both as a fundamental value and to realize our economic potential. Enabling all citizens to obtain adequate housing, nutrition, education, health care and much else will best promote productivity. Broad-based participation is also the best antidote to protectionism, and to pressures for undue restrictions on our economic flexibility and immigration. For these same reasons, measures to increase security for the growing number of people dislocated in our rapidly changing economy may well be wise economically. This can be done without creating the rigidities and excessive social benefits that have led to chronically slow growth and high unemployment in Continental Europe.
The seeming inertial tendency of our economy toward less and less broad-based participation is startling and too little discussed. Median real wages, household incomes and family incomes have increased relatively little over the last 30 years, except during the last five years of the '90s. Thus, a study showed that in 1979 it took 44 people with average earnings in the bottom half of the population to equal each person in the top 0.1 of 1%, while in 2001, the last year in that study, that number was 160. Our economy is not working for too many of our people, and that is a problem for all of us.
Turning, then, to the first component of a sound economic strategy -- fiscal conditions and entitlements -- most mainstream forecasters are now predicting a 10-year deficit of $4 trillion to $5 trillion, if the 2001 and 2003 tax cuts are made permanent, and assuming AMT reform. The 2001 and 2003 tax cuts, on the same assumption of permanence, have a 10-year cost of $4 trillion, or 80% of the projected deficit, based on estimates from the Congressional Budget Office. Business Week was quoted as saying that "the deficit morass is due as much to a revenue shortfall as excessive spending." The unexpected increase in tax revenues that occurred last year has been estimated by the CBO as temporary, and in any case would make a relatively small dent even if it were to continue for the whole 10 years. Free lunches are politically appealing, but economically unrealistic.
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The proponents of supply-side theory who assert that tax cuts will wholly -- or even significantly -- pay for themselves (through increased growth and federal tax revenues), appear to be no more accurate now than they were in the '90s. Then, they argued that tax increases included in our plan to address fiscal deficits were likely to lead to massive job loss, but what followed instead was the longest economic expansion in our history. Moreover, while 10-year fiscal deficit projections are inevitably unreliable, these forecasts could just as readily turn out to be low as to be high. What actually happens will always involve factors cutting both ways -- the unexpected costs for Katrina and unbudgeted costs for Iraq and Afghanistan are already projected to exceed the unexpected tax revenues.
Furthermore, by the middle of the next decade, the rate of growth of entitlement spending will increase at a very rapid pace because of increases in baby boomer retirements, with Medicare being several times as great a fiscal problem as Social Security. The effects of these fiscal conditions are exacerbated because they occur, uniquely in the U.S. amongst the developed nations, in combination with a very low personal savings rates, high levels of personal debt and enormous current account deficits (currently in excess of 6% of GDP, and caused at least in part by our fiscal deficits).
Virtually all mainstream economists take the view that sustained long-term deficits will crowd out private investment, increase interest rates, reduce productivity and reduce growth. And the far greater danger is that these various imbalances could at some point lead to fear of fiscal disarray and concern about our currency, causing sharply higher interest rates in our bond markets and the risk of a sharp exchange-rate decline. Also, very importantly, the evidence of the early '90s strongly suggests that sustained deficits can undermine business and consumer confidence. The adverse impact on interest and currency rates has not yet occurred, partly because business has had relatively low levels of demand for capital -- but most importantly because of vast capital inflows from abroad (until recently, predominantly from central banks supporting the dollar to subsidize their exports). This is not indefinitely sustainable; at some point, which could be near in time or still some years out, continued imbalances, increasing fiscal debt levels and ever-greater overweighting of dollar holdings abroad are highly likely to lead to loss of confidence, and trouble.
The fiscal and entitlement holes are now so deep that measures adequate to address them would be exceedingly difficult politically, deterring elected officials from unilaterally proposing them. And, even more importantly, the proposals themselves would likely be so sharply attacked as to become politically toxic. Thus, I believe that the most realistic way forward is for the president to bring together the leaders of both parties and both houses to make these decisions with joint political responsibility. Everything should be on the table, including cost discipline, progress toward entitlement reform, and judgment as to the revenues needed to close current deficits and provide the functions the American people expect of government. These include public investment in education, basic research, infrastructure and other requisites for a successful economy as well as national security and the entitlement costs of an aging population. Finding the balance that best promotes economic growth in this context could well call for revenue increases as well as spending discipline, as evidenced by the '90s, when a mixture of spending cuts and targeted tax increases was followed by years of strong growth, powerful job creation and rising incomes. Moreover, any revenue-increasing measures should reduce, not exacerbate, our growing income gap.
Vested Interests, Constrained Options
As to public investment and other public programs, too often vested interests have constrained our options, with an adverse impact on our competitiveness we can no longer afford. In public education, we should consider teacher performance metrics, modifying the tenure system, different types of charter schools and much else. In basic research, the Internet was invented in federal programs, and that dynamic commitment should be revived, including focus on energy alternatives, energy conservation and global warming, which could lead to new job-creating industries. And we must move energetically forward in rebuilding our infrastructure, equipping the poor to join the economic mainstream (with great potential for reducing social costs and increasing productivity), and reforming our health-care system.
As to global integration, while trade liberalization is still the right path, we must deal with the problem that those who support trade too often don't support a powerful domestic agenda for productivity and helping the dislocated, while those who support such initiatives tend to be less likely to support trade liberalization.
Finally, regulation should provide constraints where markets fail to reflect externalities, but those constraints must be based on risk/reward calculations. Thus, effective environmental protection should be recognized as a long-term economic imperative as well as a value in itself, but restraint should be proportionate to the benefits, however difficult measuring those benefits often is. Similarly, further tort reform could strike a better balance between providing the ability to obtain redress and generating costs that impede competitiveness. More generally, our objective should not be to eliminate all risks, but rather to reduce risk to optimal risk/reward levels.
None of this is easy, but our economy could well be at a critical juncture for the longer term. To realize our bright future and to minimize the risk of serious difficulty, we urgently need our own sense of mission to meet the challenges facing our economy.
Mr. Rubin, U.S. Treasury Secretary from 1995 to 1999, is a director of Citigroup.
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