My expert colleagues write in somber terms. The conservatives – having never heard of the Pentagon – call for cuts in Social Security and Medicare. The lone liberal speaks bravely of new energy taxes and cutting the F-22. The moderate would put the entire "problem" off beyond 2016, further rinsing her own hands by empowering a commission to do the dirty work. All assume the mantle of realism, grimly accepting that without firm action our fate will be "disastrous for taxation, inflation, and growth."

I have, in previous posts and without effect, tried to convey the accounting reality. Namely: it is impossible to frame a meaningful goal for the budget deficit without stating, explicitly, the implications for the private financial balance and the current account. The three concepts are linked. They cannot be disentangled.

To set a long-term goal of budget balance, or any other figure for the federal deficit in relation to GDP, is to set a compatible long-term goal for the sum of the other two. To take the simplest case, budget balance and a balanced private financial sector implies trade balance. A trade deficit and a balanced private financial sector implies a budget deficit. A trade deficit and a private financial surplus – gross savings above gross investment owing to the economic crisis as at present – means a larger budget deficit. There is no way around this.

The Obama goal is said to be for a budget deficit of three percent of GDP by 2016. Let's assume (optimistically) that the current account deficit after a return to high employment is five percent of GDP.

In that case, the administration assumes a return to private net saving of minus two percent – domestic investment exceeding domestic saving by two percent of GDP. Their assumption, in other words, is of a complete recovery of private credit, and even a renewed boom, similar to the late 1990s.

Let's face it: This is not remotely plausible on the current strategic path.

Implication: if you wish to reduce budget deficits, you cannot simply wave a magic wand, whether composed of spending cuts or tax increases. You must set forth an explicit strategy for the recovery of private investment -- for general economic recovery -- and for a reduction of the deficit on current account. Anything else is delusional. In all the previous posts -- excepting Dr. Sawhill's impulse to push this issue off into the long-run future – the delusion is close to the surface.

In the real world, deficits will be larger: either because we run an aggressive public policy to create jobs and restore employment, or because we fail to recover and continue to suffer high unemployment.

In my view we must have growth – not by assumption, but by policy. A growth strategy requires financial reform. Without such reform – which may require building entirely new financial institutions to get credit moving out in the private sector – enduring recovery of private spending is very unlikely.

A growth strategy also requires an aggressive public effort. If the private sector will not create jobs, it is much better to have the public sector create them, than to leave people on the dole. (I'd favor Frankel's energy taxes, and I agree with him on the estate tax -- but not for deficit reduction. The revenues should be more than offset by new public energy-saving investments.)

Finally, what about the current account? None of my expert colleagues is a protectionist – so none of them thinks, I gather, that the goal of budget balance is worth any sacrifice in the holy area of free trade. Very well. If they believe that there is any plausible dollar devaluation that would do the trick, they are also silent on that point. (Wisely so, in my view.)

In the real world, let me gently suggest, there is not much we can do about our current account. It is, exactly, the counterpart of the desire of the rest of the world to hold dollar reserves. It will rise or fall with that desire.

The baseline forecast for the budget deficit should therefore be set, first and foremost, by estimating the scale of that desire, in relation to the US economy at high employment. We can't control this, so we have to live with it – whatever it is.

My expert colleagues ignore that factor, and in doing so they skew the entire discussion toward a deeply unrealistic premise. And so have the Obama budgeteers.

Finally, is it in fact the case that large budget (and current account) deficits, which are in my view inescapable, are disastrous? This is universally stated. It would appear "irresponsible" – and that term is easily thrown around – to argue otherwise.

But what is the evidence? Is it in long-term interest rates, bleakly signaling the inflation of which Professor Calomiris warns? Obviously not. The financial market is plainly unconvinced. Economists who have built their careers arguing for the prescience of markets have a problem with this one.

Professor Calomiris also asserts that there will be an "imminent collapse" in the value of the dollar. These are very strong words. We shall see.

We live in an extremely dangerous time, with the threat of high long-term unemployment, the unraveling of our social fabric still very much at hand. Financial failure has not been cured. Economic recovery is not assured. And our energy and environmental problems haven't yet been addressed at all.

Let's not complicate these pressing and immediate problems by making up impossible budget goals – whose pursuit, in practically every case, would come first and foremost at the expense of the elderly and the poor.

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1. I agree with Donald Marron, that most of the greenhouse gas emission permits should be auctioned off, not given away to firms (which would confer windfall profits). This is what President Obama originally proposed last February, but it is not in the congressional climate change legislation.
2. Raise the gas tax.
3. Cut agricultural subsidies to rich farmers and agribusiness, saving money and improving economic efficiency. This is another measure that Obama proposed when he first took office, but that was voted down.
4. Continue to cut expensive weapons systems that the military doesn’t want, but are kept only because the suppliers are in the districts of influential congressmen. President Obama and Secretary Gates amazingly managed to do this with the F22 (the first administration to succeed at such a thing, or even to try, so far as I know).
5. End manned space exploration. We don’t need it. Spend half the money on useful science instead, including research on energy and medicine.
6. Yes, let the Bush tax cuts for the rich expire as under current law. Of course the Bush plan to eliminate the estate tax completely in 2010 and have it bounce back to its 2001 level thereafter is nonsense. Level the taxable threshold out at some reasonable estate size, a few million dollars. High enough to de-legitimize the hysterical stories about inheritors supposedly being forced to sell their small farms or small businesses to pay the tax. (Use some of the revenue in these proposals to fix the AMT once and for all. And to eliminate payroll and income taxes on lower income Americans.)
7. Encourage hospitals to standardize around national best-practice medicine -- to avoid unnecessary tests and procedures -- using tools such as conditioning medical payments.
8. Limit or eliminate the tax-exemption for employer-paid health insurance, at least the cadillac plans (which are very expensive but don’t even pay off in health results).
9. Ideally eliminate the tax deductibility of mortgage interest too. But proposing this would be political suicide. Congress and the public are still virtually unanimous in wanting to tilt the playing field in favor of owner-occupied housing and against rental housing and the rest of the capital stock, notwithstanding that such policies contributed to the housing bubble and crash.
10. To save Social Security, raise the retirement age (just a little), tax higher incomes (just a little), and progressively index benefits for future retirees to price inflation, rather than to wage inflation (just a little).

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A modest proposal in the run up to Copenhagen: President Obama should combine his concern about climate change with his concern about the budget. Earlier this year, the House passed a climate change bill that would create a cap-and-trade system to limit emissions of greenhouse gases. Among other things, the bill would create carbon allowances that are worth almost $1 trillion over the next ten years. But virtually none of that money would be used to reduce the deficit. Instead, the bill would give most of the allowances away (to industries that have the best lobbyists) and spend virtually all of the net revenue that comes from auctioning the remaining allowances. President Obama should denounce this approach and demand instead that any climate change bill achieve significant deficit reduction. For example, he could refuse to sign any cap-and-trade bill unless it auctions a large fraction of the allowances and dedicates the resulting revenues to deficit reduction. Congress could still divvy up some of the allowances among its favored constituents, but a large fraction should be used to help American taxpayers generally. A reasonable approach could easily reduce deficits by $300 to $400 billion over the next ten years, including both the value of the allowances and lower interest payments.

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The Administration will likely propose to reduce the deficit to 3% of GDP by 2016 in its next budget. This goal is a far cry from the older norm of trying to balance the budget and shows how serioulsly out of balance the budget is and how much we have had to compromise our fiscal goals as a result. Can the Administration achieve even this limited goal? I think not. They may find a way to achieve it on paper but if the economy remains as depressed as most economists believe it will over the next 5 years, the big changes in spending or revenues that would be required would not only be politically infeasible but probably economically undesirable as well. It would be better to focus on the longer term (the years after 2016) and on health care spending, Social Security, and taxes in particular. The current health care bill does not do enough to constrain costs, and could be strengthened by, for example, not indexing the thresholds for the excise tax on high end plans and by providing more flexibility and authority to the independent Medicare commission in the Senate bill. Social Security should be reformed by constraining the growth of benefits for the more affluent and by increasing the normal retirement age. Although allowing the Bush tax cuts to expire at the end of 2010 as they are scheduled to do under current law is one way to get more revenue, the entire tax code needs to be simplified and the myriad deductions and preferences (totalling close to $1 trillion a year) need to be pared back. The Administration's proposal to limit such deductions for the top brackets makes enormous sense and should be reconsidered by the Congress. Alternatively, we may need a new value added tax that would partially replace the income tax (on individuals and corporations) and could be earmarked for health care. If it were enacted soon but phased in only after the economy recovered as proposed by Len Burman and by myself and Henry Aaron here, it would reassure financial markets, encourage households to consume now before the tax took effect -- thus helping the recovery along -- and promote more saving over the longer run. We will probably need a bipartisan commission to jump start the process since our political system seems paralyzed by partisanship, but our ability to regain some measure of economic stability may well depend on whether our elected officials can find a way to place the public interest above their own more narrow interests.

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Washington is in denial, but pretense is not policy, and this will be revealed with the passage of time. We are on an obviously unsustainable path that will prove disastrous for taxation, inflation, and growth. What should we do? Tax rates should not rise, as they are already high enough; instead, spending and spending promises should fall dramatically, and the most important part of that decline has to be in promised healthcare and retirement benefits in the future. Of course, Congress is in the process of doing precisely the opposite. Our country is pretending not to be able to do arithmetic, but arithmetic, like gravity, has a way of asserting itself when it is ignored. Over the next ten years, the deficit-producing policies currently pursued by the Obama Administration will add more than $10 trillion of debt, and much more than that amount will be added in the following decade. For the moment, the politicians of both parties have conspired to do nothing to prevent the imminent collapse of the value of the dollar, dramatic rises in spending, inflation and taxation, and the anemic growth that are likely to characterize the next decade of American economic history. When the inevitable becomes tangible, budgetary hypocrisy will be shown for what it is, and politicians that know how to channel the public's outrage will be given a chance to right the ship of state. Until then, we will be forced to listen to politicians telling us that two plus two does not equal four. It is going to be a very rough ride.

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When framing the 2010 budget, one would hope that the Obama Administration brings to the task a greater sense of economic realism than that which has characterized its economic policy making decisions to date. In particular, one would hope that it recognizes how ineffectual its fiscal stimulus package has been and how very weak the present US economic recovery is likely to be. This is especially the case when one recalls how, when presenting its fiscal stimulus package earlier this year, the Administration assured us that with the fiscal stimulus unemployment would peak at around 8 ¼ percent, rather than anywhere near its present 10 1/4 percent level.

On scoring the 2009 fiscal stimulus package, the Congressional Budget Office estimated that even were there to be a full economic recovery, the US budget deficit would remain in the region of 4-6 percent of GDP by 2019. The CBO also estimated that over the next decade the US would experience the largest ever peace-time increase in it public debt. Recognizing how optimistic the CBO’s underlying economic assumptions were, including its supposing a relatively robust economic recovery and its not making allowance for increased public health care spending, one would think that long-run US fiscal sustainability will require a medium-term reduction in the US primary budget deficit of at least 3 ½ percentage points of GDP.

In formulating the 2010 budget, the Administration will be confronted with a basic dilemma. Fiscal sustainability will require some combination of deep expenditure cuts and tax revenue enhancements. Yet the present fragile state of the US economy would argue against an early start to budget consolidation. Indeed, it may very well still require a second fiscal stimulus package.

The appropriate way for the Administration to thread the budget needle would be to maintain near term fiscal support to the economy but to couple this near term support with credible policy commitments to medium term spending cuts and revenue enhancements. In the latter respect, the Administration should consider making serious commitments as to how to rein in entitlement spending on the Social Security, Medicare, and Medicaid programs. It should also consider substantive steps at limiting tax deductions on mortgage borrowing and on corporate debt, higher energy taxes, a federal consumption tax, and measures to ensure better tax compliance.

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Legislatively, the Administration faces several major complications, including rising numbers of people subject to the alternative minimum tax, a pledge not to tax more people earning over $250,000, and probably an incomplete “doctors’ fix” in figuring out what rates Medicare will pay doctors. Perhaps one of the biggest hurdles in a budget dominated by health cost growth will be promises made to various interest groups to buy their support in health reform and the reluctance of Congress to go back into this arena. Of course, the more that government sits on pledges to spend almost all increased revenues on health care and retirement (and interest) only, the harder it is for it to stay out of those arenas.

But the Administration has to do something to prove that it is credible about rising debt-to-GDP levels. Contrary to much debate, getting the long-term budget in order does not require avoiding stimulus in bad times; it only means reasonable reductions in those levels in good times.

My guess is that the Administration will look for some ways to act indirectly without explicitly saying that it is overriding its past positions. It might turn to the use of “triggers,” a proposal that Rudy Penner and I made several years ago and which is starting to see several reincarnations (some less practical than others) recently. It might try to turn some power over to a Commission. Whether that is a serious proposition depends a lot on how it is structured, empowered and supported. And it might be willing to engage in broader “Social Security” reform, by which I mean efforts to increase employment, revenues, and saving through longer work lives and additional private saving for retirement. While this last item would only have modest short-term effects on the deficit, if done wisely, it would gain the Administration some credibility.

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