5 Experts Explain How to Solve the Budget Deficit
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5 Experts Explain How to Solve the Budget Deficit

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If current policies remain in place, the Congressional Budget Office (CBO) estimates the U.S. budget deficit for 2011 will be close to $1.5 trillion, or 9.8 percent of GDP. While CBO "benchmark" projections see a short-term, gradual decline in deficits as the economic recovery continues, long-term deficits loom large with ballooning entitlement outlays stemming from an aging population and rising health care costs.

Most economists fear that large budget deficits and growing debt poses a considerable threat to U.S. global economic competitiveness. Maya MacGuineas of the New America Foundation suggests the government needs a dramatic shift from a consumption-oriented budget to one centered on investment, including R&D and human capital.

The Peterson Institute's C. Fred Bergsten says an "early correction" is necessary to prevent investment-killing interest rate hikes and an inflationary dollar. CFR's Sebastian Mallaby says ongoing deficits may reduce the willingness of major investors to buy and hold U.S. Treasuries, pushing up interest rates and threatening the dollar's reserve currency status. Daniel Mitchell of the Cato Institute asserts the best way to control red ink is to cap the rise of federal spending and allow revenue growth from the economic recovery to "catch up." The Economist's Greg Ip advocates a "medium-term plan" that includes a reform of the tax system and, possibly, raising the retirement age.

Maya MacGuineas, President, Committee for a Responsible Federal Budget

The United States is on an unsustainable fiscal path, and changes will be made, whether on our own terms or because we are forced to by markets. But dealing with our deficits and debt needs to be more than just an exercise in getting the numbers to add up (which will be hard enough).

A balanced, multi-year fiscal consolidation plan needs to be a central part of a strategy to enhance U.S. growth and competitiveness. If we fail to reduce our borrowing needs, at some point there will be upward pressure on interest rates, increasing the cost of capital as well as the interest payments owed by the government, dampening investment, and harming economic growth. This could come on gradually or in the form of a full-blown fiscal crisis.

But dealing with the debt is only the first step. At the same time we need to ensure that we dramatically shift our budget from a consumption-oriented budget to an investment-based budget. This will mean spending more on certain areas of public investment, from research and development to investment in human capital, and less--much less--on many of our major entitlement programs such as Social Security and Medicare, for those who do not need them.

Moreover, our tax code needs to be overhauled and updated for the modern economy. Revenues will have to go up to deal with the deficit, but it is thus more important than ever to be careful to do as little damage to the economy as possible. The tax base should be reconsidered, rates should be reduced when possible, and issues such as the mobility of capital must be taken into account. Consumption taxes could help promote savings; a carbon tax could help lead to improved energy policies; and reforming tax expenditures could greatly improve the efficiency, complexity, and fairness of our tax code.

Overwhelming? Somewhat. But if we use the need to deal with our fiscal situation as an excuse to make some long-overdue changes, our economy could benefit tremendously.

C. Fred Bergsten, Director, Peterson Institute for International Economics

Early and effective correction of the budget deficit is critical to the global competitiveness of the U.S. economy. This is because there are only two possible financial consequences of our continuing to run deficits of more than $1 trillion annually as now projected for the next decade or more. One is sky-high interest rates that would crowd out private investment. The other is huge borrowing from the rest of the world that would push the exchange rate of the dollar so high as to price U.S. products out of international markets. Either outcome would severely undermine U.S. global competitiveness.

The saving rate of the U.S. private sector, despite modest recovery from its rock-bottom lows prior to the recent crisis, is far too meager to finance enough investment to grow U.S. productivity and economic output at an acceptable rate. Government deficits anywhere near current levels tap such a large share of this pool of funds that they starve the capital needs of productive enterprise.

The traditional "escape value" from this dilemma, facilitated by the central international role of the dollar, is for the United States to borrow abroad. We can do so in only two ways, however: by offering interest rates so high that they will also stultify domestic investment or, more likely, by letting the dollar climb to levels that are substantially overvalued in terms of U.S. trade competitiveness. Every rise of a mere 4 percent in the trade-weighted average of the dollar in fact reduces the U.S. current account balance by $20 to $25 billion, after a lag of two years, cutting economic growth and destroying 100,000 to 150,000 jobs in an economy already suffering from high unemployment. Partly as a result of persistent budget deficits, the dollar has been overvalued by at least 10 percent--and frequently by much more--over the past forty years. As a result, U.S. competitiveness and the entire U.S. economy have been severely undermined. In addition, the United States has become by far the world's largest debtor country, and its external balance is on a wholly unsustainable trajectory.

The trade and budget deficits are not "twins" in any mechanistic sense. The latter inherently promotes the former, however, as we have observed over these last four decades. Elimination of the fiscal imbalance, and preferably the maintenance of a modest surplus over the course of the business cycle to produce an adequate level of overall national saving, is imperative to avoid further severe deterioration of the international economic position of the United States.

Sebastian Mallaby, Director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations

The United States is running an unsustainable budget deficit. The International Monetary Fund calculates that it will come to 10.8 percent of GDP in 2011, worse than the 8 percent projected for the group of advanced G20 countries and far worse than the 2.5 percent projected for the emerging G20 countries. The future doesn't look much better. The IMF calculates that the gap between the current budget path and a sustainable budget path is larger for the United States between now and 2016 than for any other country bar Japan.

Deficits for a few years don't matter. The United States can borrow easily to cover its budget gap thanks to the dollar's status as the leading reserve currency. But sustained deficits do matter. They add to the stock of national debt, driving up the cost of interest payments and draining the government of resources. When cumulative deficits drive national debt to around 90 percent of GDP, a country's growth rate starts to suffer. On current projections, the United States will hit that level within a decade.

Sustained U.S. deficits may also create doubts about the U.S. commitment to repay creditors. The more the U.S. government owes, the more tempting it is to reduce the value of those obligations via inflation or a depreciating dollar. The fear that U.S. officials will succumb to these temptations, justified or not, may dampen investors' willingness to hold U.S. Treasuries, threatening the dollar's reserve currency status. At some unpredictable point, investor jitters could spark a rush for the exit, driving U.S. interest rates up and causing the dollar to fall sharply.

How pressing is this risk? CFR's Center for Geoeconomic Studies tracks the foreign-exchange reserves held by BRIC central banks (PDF); the data show that faith in the dollar may already be waning. China, for example, held 70 percent of its reserves in dollars in 2005, but the share has since fallen to 63 percent. Another CFR chartbook underscores the importance of foreign governments' confidence in the dollar (PDF). More than a third of U.S. government debt is in the hands of foreign official investors. If they were to sell even a small share of their stake, the United States would be in trouble.

Daniel Mitchell, Senior Fellow, Cato Institute

Competitiveness, like beauty, is in the eye of the beholder. But there's presumably widespread agreement that it is good for a nation to have a prosperous and dynamic economy that generates above-average income and growth.

Government impacts competitiveness in many ways, including monetary policy, trade policy, and regulatory policy. Moreover, the presence of sound institutions, such as property rights and the rule of law, is critical for an economy to have a good foundation.

Fiscal policy also is an important part of the mix. Excessive government spending can slow growth by diverting labor and capital from more productive uses. Punitive tax rates can hinder prosperity by discouraging work, saving, investment, and entrepreneurship. And large budget deficits can undermine competitivenesss by "crowding out" private capital and building negative expectations of future tax increases.

In extreme cases, high budget deficits can destabilize entire economies, either because a government resorts to the printing press to finance deficits or because investors lose faith in a government's ability to service debt, thus leading to a sovereign debt crisis.

The United States hopefully is not close to becoming either Argentina or Greece, but the trend in recent years is not very encouraging. The burden of government spending has exploded, which, combined with temporarily low tax receipts because of a weak economy, has pushed annual red ink above $1 trillion per year.

The good news is that the deficit situation will get a bit better in coming years. Even modest growth rates will cause revenues to climb (that's the kind of tax increase nobody opposes). Indeed, revenues will soon be above their long-run average, as a share of economic output.

The bad news is that we'll still have too much red ink because the federal government's budget is about twice as big as it was when Bill Clinton left office. Even more worrisome, government borrowing actually will begin to increase again by the end of the decade because of demographic changes such as retiring baby boomers.

The best way to control this red ink while also boosting competitiveness is to cap the growth of government spending. If revenues increase by an average of 7 percent each year (as the president's budget projects, even without tax increases), then we can reduce deficits by making sure spending grows by less than 7 percent annually.

Given the enormous size of the budget deficit, this doesn't solve the problem overnight. If spending was allowed to grow 2 percent each year, the budget wouldn't be balanced until 2021. But it would be a big step on the road to fiscal recovery.

To turn a phrase upside down, this makes a necessity out of virtue. Spending restraint is good for growth since it leaves a greater share of resources in the productive sector of the economy. And since this also happens to be the best way of letting revenue catch up to spending, it also solves the deficit issue.

Greg Ip, U.S. Economics Editor, The Economist

Textbook economics tells us that government deficits eat up scarce savings, pushing up interest rates and the dollar. That discourages private investment and exports, a lethal combination for our productivity and competitiveness. The textbook does not apply to our current circumstance: Today's deficit is occurring against a backdrop of deeply depressed private demand, which is evident from the fact that interest rates are so low. This argues against too rapid a cut in the deficit, because the Federal Reserve can't compensate for fiscal austerity through lower interest rates.

At some point, though, the recovery will be more firmly established. If we still haven't put the deficit on a firm downward path by then, interest rates will rise, reflecting not just competition for savings but compensation to investors who fear we'll escape our debts via default or inflation. That interest rate penalty will add to the cost of capital of every business in the United States. A medium-term plan to reduce the deficit will help keep both interest rates and the dollar low, speeding the reorientation of the American economy from borrowing and consumption to saving and exports.

A medium-term plan to reduce the deficit will help keep both interest rates and the dollar low, speeding the reorientation of the American economy from borrowing and consumption to saving and exports.

There are no painless ways to reduce the deficit: Spending will have to drop and taxes will have to rise. But it can be done in ways that make the economy more productive. On spending, for example, gradually raising the retirement age to sixty-seven then indexing it to life expectancy will reduce future liabilities for both Social Security and (somewhat less) for Medicare, while at the same time expanding the supply of labor by encouraging Americans to work longer.

Taxes can be raised via reform that makes the entire system less of a burden to growth. Relative to other countries, America taxes income too much and consumption too little. This can be corrected either through a broad-based consumption tax or, more narrowly, by raising the gasoline tax. This would both not only raise revenue and cut carbon emissions, it would do more to make alternative energy viable than our current preference for subsidies and mandates. Rather than raise marginal tax rates, which discourages work and saving, better to eliminate distortionary exemptions such as for mortgage interest which tilts investment toward housing.

This post originally appeared at the Council on Foreign Relations.

Related Links:
Nightmare:  Suddenly the Deficit Sounds Very Familiar (Business Insider) 
A Complete Guide to Obama's Plan to Cut the Deficit (Business Insider)
14 Facts About the Federal Deficit That Will Blow Your Mind (Business Insider)
Deficit Logic That Will Make Your Head Explode (Business Insider) 
Deficit Panel Co-Chairmen Endorse Obama Plan (Business Insider)