U.S. Debt Scolds Can’t Be Ignored Much Longer

The big lesson of 2009 was that financial panic can be catastrophic for the economy if caused by a bursting housing bubble with an enormously overleveraged financial structure perched on top of it.

That sounds obvious, but the best minds of our economic establishment didn’t see it coming. The unforeseen losses were off the charts: millions of jobs, widespread foreclosures and business failures, plummeting wealth and confidence, and immeasurable human misery.

The reassuring lesson was that policy makers and regulators, the same ones whose inaction exacerbated the crisis, acted aggressively when it hit. Massive intervention by the Federal Reserve, the U.S. Treasury Department and Congress stabilized the reeling financial sector and mitigated damage to the real economy.

We now know something that was far from evident a year ago: 2010 will not be a year in which financial meltdown pushes the economy into a Great Depression. Instead – and this is truly good news – it will be the first year of a long, slow recovery from a remarkably severe recession.

The enormous costs of the crisis are not only lost employment, production and economic opportunities, but also anger and disillusionment. People are angry at officials who failed to protect them and spent their tax trillions avoiding allegedly more terrible outcomes. “It could have been worse” is not a winning political slogan.

Moreover, while average people may realize they were part of the problem – borrowing too much, saving too little and counting on the Tooth Fairy – they also feel betrayed by the financial titans whose reckless greed brought good times to an end.

Clueless Titans

The titans themselves don’t get the anger. “We are so smart and work such killer hours to make the finances function,” they say to themselves. “Why can’t people see that we deserve those bonuses?” The chasm between Wall Street and average folk will not close quickly.

Nor will the budgetary costs of the crisis disappear quickly. The hard-won surpluses of the late 1990s had vanished well before the economy’s crash, as a result of tax cuts, prescription drug benefits, war costs and undisciplined domestic spending.

But budget deficits before the crisis, while inappropriate in a prosperous economy, were of manageable size, and the debt, at low interest rates, not especially burdensome. Budget scolds, like me, warned of looming deficits threatening the economy as federal revenue failed to keep up with the costs of promises to an aging population compounded by rising medical spending. Our warnings were unheeded.

Scary Deficits

The recession slashed federal revenue, while efforts to preserve jobs and mitigate economic suffering ballooned spending. The combination pushed deficits to record levels – way above the percent of gross domestic product of the scary Reagan deficits.

These deficits will recede as the economy recovers, but they won’t disappear, and their legacy is a public debt that drastically reduces our economic flexibility.

Suddenly, the nation’s public debt, which was 37 percent of GDP in 2007, has risen to about 67 percent in 2010 and is projected to continue rising if we don’t change course. The built-in deficits caused by aging and medical spending for seniors are no longer looming far ahead of us. They will affect our crisis-damaged budget within the decade.

If we don’t want a continuous drain on our standard of living and growing vulnerability to the demands of our creditors, especially the Chinese – both of which will undermine our influence in the world – we must stabilize the debt by moving the federal budget back toward balance.

Not So Hard

The biggest economic challenge for 2010 is enacting credible future deficit reduction without derailing the fragile recovery. That isn’t a hard as it sounds, because tax increases or benefit reductions sufficient to stabilize the debt would be phased in slowly and wouldn’t affect the near-term economy.

Increasing the retirement age for Social Security, means- testing benefits of Medicare or adding a national sales or carbon tax would take several years to implement. Enacting such measures in 2010, however, could show our creditors we mean business and help the recovery by avoiding future interest rates increases.

A congressional budget commission could provide a mechanism, but it won’t work unless both political parties have the courage to make the necessary tough decisions and soften their ideological rigidities.

New Rules

The second policy challenge is reforming the financial regulatory system to reduce the chances of another serious crisis. That will require consolidating regulation of financial institutions in one agency with stronger rules so firms can’t shop for the weakest regulator. Capital requirements also must be increased, as financial institutions grow in size and complexity, to discourage too big to fail. Financial rules also need to be modernized to keep up with smart financiers who invent ways around them.

We also need to create a strong agency that protects consumers from predatory practices and to make sure that regulators focus on threats to the whole system, not just on keeping individual institutions from taking excessive risk.

Is our political system up to these challenges? We will learn a lot about that in 2010.