America's Fiscal Constitution (58 page)

2007–2013: Years when deficits exceeded debt service = 7 (recession, war, medical services and extension of tax cuts)

O
N THE
P
RECIPICE

Upon taking office in 2001 George W. Bush pledged to reduce total debt by $2 trillion and create a $1 trillion contingency reserve. Paying down the debt would allow the nation some flexibility in the event of an economic emergency. His initial goals were consistent with the proud traditions of his party, including the debt reduction following the end of World War I and the Civil War. By 2007, even excluding the cost of two wars, the original Bush fiscal plan was in shambles.

Republicans incurred trillions of dollars of debt to lower tax rates and raise base military spending apart from war. Ultimately that debt would have to be repaid, with interest. Republicans could not realistically expect that future debt service would somehow be borne by the 70 percent of households with 10 percent of the nation’s wealth rather than the 5 percent of households with 80 percent of the wealth.
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The War on Terror entailed a sustained investment in the capacity to detect and respond to potential attacks by groups operating anywhere in the world. The United States could not continue to forever fund its antiterrorism efforts with debt.

Leaders of the new Democratic majority in the House in 2007 faced a stark political dilemma. They took pride in contrasting the Clinton administration’s balanced budgets with the red ink of the Bush administration, but congressional Democrats could only balance the budget by slashing federal spending. They were not prepared to cross that bridge.

The new House leadership initially vowed that any tax cut or spending increase would have to be accompanied by corresponding spending cuts or new revenues. The Senate, however, did not offset a loss of revenues when passing legislation that limited the application of the Alternative Minimum Tax. Only a relatively small group of traditional fiscal conservatives—largely “Blue Dog” Democrats from Republican-leaning districts—opposed final House passage of that debt-financed tax cut in 2007.

Most Democrats were also unwilling to insist that new taxes be levied to pay for the wars in Iraq and Afghanistan. The Democratic congressional majority tried to condition war funding on a timetable for withdrawal, but dropped that requirement following a veto by President Bush. The pace of debt-financed wartime spending continued to accelerate as the administration deployed more ground forces as part of a new strategy to reduce violence against Iraqi civilians and thereby stabilize the country’s government.

The American Fiscal Tradition allowed for the use of debt in response to severe economic downturns. The need to preserve debt capacity for economic emergencies provided a strong justification for otherwise limiting the use of debt. Downturns are, of course, difficult to forecast. The significance of the ominous clouds that began to appear in 2007 became visible to most experts only in hindsight. Total mortgage debt grew from $6.7 trillion in 2000 to $14.6 trillion in 2008. Total consumer debt rose from 100 percent of annual national income in 2000 to about 140 percent in 2008.
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Then, in 2007, the number of homeowners who missed mortgage payments soared, and some mortgage lenders failed.

As the decline in the housing market began to slow overall economic growth, the Federal Reserve slashed interest rates in the final months of 2007. The White House and Congress also sought to bolster the economy. In early 2008 the Bush administration joined House Speaker Nancy Pelosi and Minority Leader John Boehner in support of a plan for the federal government to borrow $168 billion and distribute it to Americans as “tax rebates.”
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It would have been more difficult to maintain the fiction of this “tax rebate” if members of Congress had been required to vote separately to authorize additional debt for that purpose. Generations of prior federal
leaders would have ridiculed the idea of borrowing money to distribute cash to Americans during a war. Wisely enough, Americans saved the borrowed dollars rather than following the president’s recommendation that they spend them.
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The risks posed by large pools of mortgage debt and related synthetic debt became clearer when two enormous financial institutions, Freddie Mac and Fannie Mae, became insolvent in the summer of 2008. The erosion of one of the old pillars of the American Fiscal Tradition—clear accounting—contributed to that crisis. For years the federal government had eschewed traditional limits on debt by allowing Freddie Mac and Fannie Mae to foster the perception of a federal guaranty, though Congress had never voted to guarantee their debt. The potential bankruptcy of Freddie Mac and Fannie Mae threatened the survival of banks, insurers, and pension funds that held their debt. In August 2008 the federal government guaranteed the debt of Freddie Mac and Fannie Mae and put both institutions into receivership.

That episode illustrated the risk of dependence on foreign creditors. Even before Congress acted on the guaranty, Treasury Secretary Hank Paulson had to reassure the Chinese government that the United States would stand behind the debts of its two large mortgage lenders. Russian officials tried to convince their Chinese counterparts to begin liquidating bonds issued by Fannie Mae and Freddie Mac as a means of forcing federal assumption of this debt.

B
ORROWING TO
P
REVENT
D
EPRESSION

Wall Street’s financial giant Lehman Brothers filed for bankruptcy protection on September 9, 2008. Immediately afterward the world’s oldest money market fund became illiquid. If depositors withdrew funds from financial institutions, the credit system of the United States and much of the world would be destroyed.

Much has already been written on the Great Recession of 2008, the world’s narrow escape from a global depression. Three lessons from that experience highlight the peril of the current federal debt crisis. First, arcane accounting disguised the size of the debt. Second, creditworthy financial institutions borrowed excessively in pursuit of growth. Third
,
the danger of high debt became apparent only suddenly, when buyers of mortgage debt disappeared. Creditors loaned freely to the world’s largest banks
when it was inconceivable that they would be unable to repay; that lending ended abruptly when the inconceivable became a real possibility.

Federal Reserve Chairman Ben Bernanke, a student of the Great Depression, concluded later that “we came very close in October 2008 to Depression 2.0.”
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Bernanke’s Federal Reserve functioned as a lender of last resort, and its powerful status as a virtual fourth branch of government—another feature of the nation’s unwritten constitution—helped it to preserve the continuity of federal policies when leadership of the executive branch changed hands after the November 2008 election.

Bernanke asked the Treasury to borrow in order to help fund the commercial banking system. In a televised address on September 14, 2008, President Bush told Americans that “without immediate action by Congress . . . America could slip into a financial panic” endangering “our entire economy.”
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Senator John McCain, the Republican presidential nominee, suspended his campaign to attend a White House meeting with President Bush, congressional leaders, and the Democratic presidential nominee, Senator Barack Obama. They urged Congress to move quickly to help prevent a financial collapse.

The idea of federal borrowing to support big banks was difficult to sell to the American public. Taxpayers understood quite well the fact that many federal officials had been reluctant to acknowledge since 2000: federal debt—at least amounts that were not monetized—would have to be repaid by someone, namely American taxpayers. On October 3, after an initial defeat in the House that was followed by a market crash, Congress reluctantly appropriated $680 billion for the Troubled Asset Relief Program, which made loans and equity investments to financial institutions and the auto industry.
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Though borrowing on this scale and speed had not occurred since World War II, the use of debt for relief from depression was consistent with the American Fiscal Tradition. Bernanke told Congress on October 20, 2008, that while additional deficit spending could “burden future generations and constrain future policy options,” it seemed “appropriate in light of the downturn.”
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Never before, however, had borrowing during a downturn begun with a level of debt already so high in relation to national income.

Senators Obama and McCain had both pledged during the campaign to stimulate the economy with plans that required over $100 billion in debt. After Obama’s election, as economic activity continued to fall faster
than at any time since the Great Depression, most economists urged even greater debt-financed stimulus.
⁹

The new president noted the reality of large inherited debts. He explained to the Congressional Democratic Caucus that debt had doubled since 2000 and was “wrapped in a big bow waiting for me as I stepped into the Oval Office.”
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The Congressional Budget Office forecasted a deficit of $1.2 trillion for fiscal year 2009, which was three and a half months underway when President Obama took office.
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In fact, tax revenues were falling faster than predicted. The deficit in the federal funds budget for fiscal year 2009, which ended on June 30, 2009, turned out to be $1.54 trillion, a larger percentage of national income than at any time except during World War II.
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President Obama urged Congress to raise spending and reduce taxes in order to compensate for an estimated trillion dollar contraction of national income. In February Congress passed the $787 billion American Recovery and Reinvestment Act of 2009. It consisted primarily of tax cuts and spending for infrastructure and unemployment relief spread over several fiscal years.
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Up to that point in early 2009, the Bush and Obama administrations’ responses to the downturn had followed precedents set by the Hoover and Roosevelt administrations. They, along with the Federal Reserve, tried to avoid the mistake of doing too little too late, as in 1929–1933. However, the budget for fiscal year 2010 failed to create a clear line between extraordinary spending for recovery-related efforts and some normal level of spending. The Obama administration’s proposed budget for that year, which Congress largely adopted, increased formula-based spending by 14.9 percent and other federal spending by 13.8 percent. The White House estimated that level of spending would require additional debt of $1.1 billion in the unified budget.
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As in the prior fiscal year, tax revenues during the year turned out to be lower than expected, and borrowing was higher than initially forecasted.

By the summer of 2009 the economy began growing again, though from a much lower level of private sector employment than before the Great Recession.
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Debt-financed federal spending and tax cuts had placed a floor under economic activity. In the twenty-four months between October 1, 2008, and September 30, 2010, the federal funds budget consisted of $5.37 trillion in spending, $2.42 billion in tax revenues, and almost $3
trillion in new debt, the equivalent of approximately $20,000 of debt for every employed citizen and $30,000 per household.
¹⁶

Senator Kent Conrad, the Senate’s budget expert and a harsh critic of chronic deficit spending, warned the president that the deficit resulted from an imbalance between tax and spending policies that predated the recession. Obama replied that he would be willing to make hard decisions to reduce the deficit even if it meant he would be “a one-term president.”
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In January 2010 the Senate defeated a bill, advocated by Conrad, to appoint a bipartisan commission that would make specific recommendations on actions to close the budget deficit. The Senate vote on the measure was 46 in favor and 54 opposed; 6 Republicans who had sponsored the bill voted against it. Obama used an executive order to appoint a commission with a similar purpose.

Republican congressional leaders criticized annual deficits, but did not propose to balance the budget through any combination of spending cuts and tax increases. Republican activist Grover Norquist considered opposition to higher taxes to be his party’s “brand” and likened Republicans who voted for any tax increase to “rat heads in a Coke bottle. . . . They damage the brand for everyone else.”
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M
EDICAL
S
PENDING

Greater access to medical insurance had become a goal that embodied the values of the Democratic Party. The debate over health care during the 2008 campaign focused far more on the expansion of medical coverage than on how to pay for existing Medicare. Most Americans believed it made no sense that a person just a few months younger than those who were eligible for Medicare could face death or financial ruin because of a serious medical condition, while Medicare beneficiaries received some of the finest medical care in the world. There was, of course, a straightforward—though politically awkward—reason for this situation: it was difficult to expand coverage when the federal government lacked sufficient revenues to pay for existing Medicare. Politicians in both parties tended to sidestep this inconvenient truth, which posed the inconvenient question of how they intended to pare down Medicare or increase taxes to fill the funding gap.

No public figure can match the president’s power to frame an issue for public debate, but even a president must clearly define and repeat any goal in order to move public opinion. President Obama had the opportunity to
explain the goals of paying for Medicare or paying for coverage of workers too young for Medicare. The administration recognized the challenge posed by debt-financed Medicare. White House Budget Director Peter Orszag had warned for years of that problem.