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January 25, 2013

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This should be the president’s overwhelming top priority: deal with the looming debt. By George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer, and John B. Taylor.


Sometimes a few facts tell important stories. The American economy is full of facts that tell stories that you really don’t want, but need, to hear.

Did you know that annual spending by the federal government now exceeds the 2007 level by about $1 trillion? With a slow economy, revenues are little changed. The result is an unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3 trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion in 2012. The four-year increase in borrowing amounts to $55,000 per U.S. household.

The amount of debt is one thing. The burden of interest payments is another. The Treasury now has a preponderance of its debt issued in very short-term durations, to take advantage of low short-term interest rates. It must frequently refinance this debt, which, when added to the current deficit, means the Treasury had to raise $4 trillion in 2012 alone. So the debt burden will explode when interest rates go up.

The government has to get the money to finance its spending by taxing or borrowing. While it might be tempting to conclude that we can just tax upper-income people, did you know that the U.S. income tax system is already very progressive? The top 1 percent pay 37 percent of all income taxes, and 50 percent pay none.

Did you know that during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens’ and institutions’ purchases and sales amounted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II.

The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself. It determines the interest rate by declaring what it will pay on reserve balances at the Fed without regard for the supply and demand of money. By replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended economic consequences.

Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process? To pay for quantitative easing—the purchase of government debt, mortgage-backed securities, etc.—the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have exploded to $1.5 trillion from $8 billion in September 2008.

The Fed now pays 0.25 percent interest on reserves it holds. So the Fed is paying the banks almost $4 billion a year. If interest rates rise to 2 percent, and the Federal Reserve raises the rate it pays on reserves correspondingly, the payment rises to $30 billion a year. Would Congress appropriate that kind of money to give—not lend—to banks?

The Fed’s policy of keeping interest rates so low for so long means that the real rate (after accounting for inflation) is negative, thereby cutting significantly the real income of those who have saved for retirement over their lifetime.

The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government. And the Fed’s Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury’s traditional debt management.

The U.S. income tax system is already very progressive. The top 1 percent of earners pay 37 percent of all income taxes.

This large expansion of reserves creates two-sided risks. If it is not unwound, the reserves could pour into the economy, causing inflation. In that event, the Fed will have effectively turned the government debt and mortgage-backed securities it purchased into money that will have an explosive impact. If reserves are unwound too quickly, banks may find it hard to adjust and pull back on loans. Unwinding would be hard to manage now, but it will become ever harder the more the balance sheet rises.

The issue is not merely how much we spend, but how wisely, how effectively. Did you know that the federal government had forty-six separate job-training programs? Yet a forty-seventh for green jobs was added, and the success rate was so poor that the Department of Labor inspector general said it should be shut down. We need to get much better results from current programs, serving a more carefully targeted set of people with more effective programs that increase their opportunities.

Did you know that funding for federal regulatory agencies and their employment levels are at all-time highs? In 2010, the number of Federal Register pages devoted to proposed new rules broke its all-time record for the second consecutive year. It’s up by 25 percent compared to 2008. These regulations alone will impose large costs and create heightened uncertainty for business and especially small business.

This is all bad enough, but where we are headed is even worse.

President Obama’s budget called for raising the federal debt-to-GDP ratio to 80.4 percent in two years, about double its level at the end of 2008. Under this budget, the debt expands rapidly to $18.8 trillion from $10.8 trillion in ten years. The interest costs alone will reach $743 billion a year, more than we currently spend on Social Security, Medicare, or national defense, even under the benign assumption of no inflationary increase or adverse bond-market reaction. For every percentage-point increase in interest rates above this projection, interest costs rise by more than $100 billion, more than current spending on veterans’ health and the National Institutes of Health combined.

Worse, the unfunded long-run liabilities of Social Security, Medicare, and Medicaid add tens of trillions of dollars to the debt, mostly because of rising real benefits per beneficiary. Before long, all the government will be able to do is finance the debt and pay pension and medical benefits. This spending will crowd out all other necessary government functions.

What does this spending-and-debt mean in the long run if it is not controlled? One result will be ever-higher income and payroll taxes on all taxpayers that will reach over 80 percent at the top and 70 percent for many middle-income working couples.

Did you know that the federal government used the bankruptcy of two auto companies to transfer money that belonged to debt holders such as pension funds and paid it to friendly labor unions? This greatly increased uncertainty about creditor rights under bankruptcy law.

The Fed is adding to the uncertainty of current policy. Quantitative easing as a policy tool is very hard to manage. Traders speculate about whether and when the Fed will intervene next. The Fed can intervene without limit in any credit market—not only mortgage-backed securities but also securities backed by automobile loans or student loans. This raises questions about why an independent agency of government should have this power.

When businesses and households confront large-scale uncertainty, they tend to wait for more clarity before making major commitments to spend, invest, and hire. Right now, they confront a mountain of regulatory uncertainty and potential sharp increases in taxes and declines in spending. Are you surprised that so much cash is waiting on the sidelines?

What’s at stake?

We cannot count on problems elsewhere in the world to make Treasury securities a safe haven forever. We risk eventually losing the privilege and great benefit of lower interest rates from the dollar’s role as the global reserve currency. In short, we risk passing an economic, fiscal, and financial point of no return.

Suppose you were offered the job of treasury secretary. Would you accept? You would confront problems that are so daunting even Alexander Hamilton would have trouble preserving the full faith and credit of the United States. Our first treasury secretary famously argued that one of a nation’s greatest assets is its ability to issue debt, especially in a crisis. We needed to honor our Revolutionary War debt, he said, because the debt, “foreign and domestic, was the price of liberty.”

History has reconfirmed Hamilton’s wisdom. As historian John Steele Gordon has written, our nation’s ability to issue debt helped preserve the Union in the 1860s and defeat totalitarian governments in the 1940s. Today, government officials are issuing debt to finance pet projects and pay off interest groups—not to support some vital, let alone existential, national purpose.

The problems are close to unmanageable now. If we stay on the current path, they will wind up being completely unmanageable, culminating in an unwelcome explosion and crisis.

The fixes are blindingly obvious. Economic theory, empirical studies, and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation, and education reform. The need is clear. Why wait for disaster? The future is now.


George P. Shultz is the Thomas W. and Susan B. Ford Distinguished Fellow at the Hoover Institution. He was sworn in on July 16, 1982, as the sixtieth US secretary of state and served until January 20, 1989. In January 1989, he rejoined Stanford University as the Jack Steele Parker Professor of International Economics at the Graduate School of Business and as a distinguished fellow at the Hoover Institution.


Michael J. Boskin is a senior fellow at the Hoover Institution and the T. M. Friedman Professor of Economics at Stanford University. He is also a research associate at the National Bureau of Economic Research. In addition, he advises governments and businesses globally. Among other posts, he served as chairman of the President's Council of Economic Advisers from 1989 to 1993.

His research papers are available at the Hoover Institution Archives.


John F. Cogan is the Leonard and Shirley Ely Senior Fellow at the Hoover Institution and a professor in the Public Policy Program at Stanford University, where he has had a continuing appointment since 1980.

Cogan is an expert in domestic policy. His current research is focused on US budget and fiscal policy, social security, and health care. He has published widely in professional journals in both economics and political science. His most recent book, Healthy, Wealthy, and Wise: Five Steps to a Better Health Care System (Hoover Institution Press, 2011), coauthored with Glenn Hubbard and Daniel Kessler, recommends federal policy changes to improve US health-care markets.


Allan Meltzer is a distinguished visiting fellow at the Hoover Institution and the Allan H. Meltzer University Professor of Political Economy at the Tepper School of Business at Carnegie Mellon University. His teaching and research interests include the history of US monetary policy, size of government, macroeconomics, and the relation of money to inflation and unemployment in open and closed economies. Professor Meltzer has served as a consultant on economic policy for the US Congress, US Treasury, the Federal Reserve, the World Bank, and the US and foreign governments and was chair of the International Financial Institution Advisory Commission. He was founder and chairman of the Shadow Open Market Committee from 1973 to 2000 and was an honorary adviser to the Bank of Japan. He is the author of many books and papers in the field of economics.


John B. Taylor is the George P. Shultz Senior Fellow in Economics at the Hoover Institution and the Mary and Robert Raymond Professor of Economics at Stanford University. He was previously the director of the Stanford Institute for Economic Policy Research and was founding director of Stanford's Introductory Economics Center. He has a long and distinguished record of public service. Among other roles, he served as a member of the President’s Council of Economic Advisors from 1989 to 1991 and as Under Secretary of the Treasury for International Affairs from 2001 to 2005.


Reprinted by permission of the Wall Street Journal. © 2012 Dow Jones & Co. All rights reserved.