U.S. Department of the Treasury

(Archived Content)

FROM THE OFFICE OF PUBLIC AFFAIRS

We come together at a moment of remarkable success for the American economy. This success is a reflection of the entrepreneurial drive of Americans, the development and implementation of new technology, and the dynamic and flexible character of the American economy.

But this is not a moment for complacency. Prosperity and credibility are attributes that are rented, not owned. If we as a country - families, businesses and government - are to take maximum advantage of this moment, it is crucial that we understand how we got here, not take our good fortune for granted, and make prudent choices for our economic future.

Today I would like to talk about the contribution that a responsible and disciplined fiscal policy can make to our continued prosperity. Let me divide my remarks into three parts:

• First, the fiscal choices that we have made as a nation over the past 50 years and what we have learned from the resulting economic outcomes.

• Second, how our understanding of the role of fiscal policy in the economy has evolved over time, and the implications for the crucial fiscal choices we face today.

• Third, in light of these observations, the reasons why the elimination of the net national debt held by the public should be the central objective of our nation's fiscal policy.

During the post-war period, the U.S. has made a major fiscal choice every decade or two. Some of those choices were made wisely, some less so.

• After World War II, we chose to redress the expansion of debt that had been used to finance the war and to bring us out of the Great Depression. The ratio of debt to GDP fell dramatically, helping to lay the foundation for the strong growth of the following decades.

• During the late 1960s we chose to finance expanded outlays on both guns and butter partly by relying on budget deficits. These deficits contributed to the over-heating of the economy which, in turn, contributed to rising inflation, higher interest rates, and a long period of slow growth of productivity and real wages starting in the early 1970s.

• In the 1980s we chose to increase defense spending significantly while cutting taxes. As a result, real interest rates increased to record levels, the rate of net investment declined sharply, productivity growth continued to stagnate and the stock of public debt almost quadrupled.

• And in the 1990s, rather than continue with the policies of the 1980s we chose to move strongly in the direction of fiscal discipline. In retrospect, that decision was a crucial building block for the prosperity that we currently enjoy. By adopting budget discipline, we have allowed roughly $2.5 trillion that would otherwise have been absorbed by government borrowing to have been invested in making America's economy more productive.

We again face major choices today, at a time when record economic strength is giving rise to substantial budget surpluses and the reduction of national debt held by the public. The question we face is whether to keep our country on a path toward eliminating publicly held debt, or to devote the bulk of projected surpluses to alternate priorities instead.

The choice we make will be critical to the health of the American economy for many years to come. It can and must therefore be guided by our best understanding of the role of a well-designed fiscal policy.

Over the past 50 years, there has been a sea change in economic thinking about fiscal policy. As an undergraduate in the 1970s, I was taught that expansionary fiscal policy could have important beneficial effects on economic performance by increasing aggregate demand, and that one of the features of a successful economy was the use of budget deficits as a stimulus to economic growth.

This Keynesian idea, that budget deficits could be used to stimulate demand in an economy producing well short of its capacity, still captures a very important truth about certain economies at certain times. It was surely the right prescription for the economy of the 1930s and, indeed, for Japan's economy of today. And it was the right response to the unused economic capacity in the U.S. economy of the late 1950s and early 1960s.

Since my days as an undergraduate, however, experience has shaped our understanding of fiscal policy:

• First, we now place much greater emphasis on the importance of supply factors for long-term growth, and the danger that by crowding out investment, budget deficits can slow productivity growth and lead to a vicious cycle as higher public borrowing leads to higher interest rates, lower investment and economic growth, and still higher budget deficits. And we have come increasingly to appreciate that in an economy close to full capacity, excessive stimulus can increase inflationary pressures, raise risk premiums, and lead to higher interest rates.

• Second, financial markets have become more forward-looking, and more sensitive to changes in the outlook for fiscal policy. As a result, a change in the outlook for the budget is likely to provoke a more aggressive and immediate offsetting response from financial markets. This was powerfully demonstrated by the stimulative impact of deficit reduction in the 1990s, as increased investment demand resulting in a lower cost of capital more than outweighed any demand losses to the economy that resulted from lower government spending.

It bears emphasis that these changes in understanding have not taken place in isolation. Globally, there has been a widespread recognition of the importance of fiscal discipline, the benefits of crowding in the private sector rather than crowding it out, and the important role that confidence can play in ensuring the long-term success of economic policies.

The idea that fiscal discipline would help an economy expand by promoting confidence and crowding the private sector in rather than out, used to be considered theoretical. In that sense our fiscal policies in 1993 had an experimental element. Today the results of that experiment are in: the link between fiscal discipline and higher growth has been demonstrated.

In light of this experience and what we have learned, we need to examine fiscal policy both in terms of what we can afford and in terms of its long-term impact on the economy.

The question of what we can afford based on realistic economic projections has been much discussed. It is imperative that we not embark on any fiscal policy that would endanger Social Security, Medicare, or our capacity to maintain core government functions.

But there is a question beyond affordability, namely: what fiscal policies would contribute best to strong national economic performance in the future? Here, we believe there is a compelling argument for setting, as a medium term goal, the elimination of the net debt held by the public.

Like tax cuts, reducing publicly held debt also delivers substantial direct benefits to the pocket books of American families.

• First, because it reduces the burden of future payments on interest and principal. For every dollar borrowed in the 10-year bond market today, taxpayers will pay a total of $1.61 in interest and principal. That obligation rises to $2.79 for a dollar borrowed with a 30-year bond.

• Second, because it helps to put downward pressure on long-term interest rates. Indeed, we estimate that, as a consequence of our new path of fiscal discipline and the resulting reduction in interest rates, a typical American family with a mortgage of $100,000 would save around $2,000 a year on mortgage payments.

The crucial point is that debt reduction can provide these kinds of benefits to American families in a way that will also support the long-term strength of our economy. We do not believe that alternative approaches offer the same prospect.

Some might argue that we should take this opportunity to substantially enlarge the size of government relative to the economy. We believe that large scale spending increases would put in jeopardy the fundamentals of this record period of economic growth.

Since 1993, we have made major progress in shrinking government's share of the American economy: we have reduced the size of the Federal civilian workforce by 377,000, or almost a sixth. At 18.7 percent of GDP, government spending is now lower than it has been in a generation.

At the same time, history has taught that unrealistically low discretionary spending assumptions threaten fiscal discipline in much the same way that unrealistic economic forecasts threaten fiscal discipline. They can lead to fixed commitments that create problems when the lack of realism in the assumptions becomes apparent. The President's budget proposal would sustain core government functions, while keeping the share of government in the economy firmly in check. And it does so on the basis of spending projections that we can realistically expect to achieve.

On the other hand, there are those who advocate very large tax cuts. We believe that a large-scale tax cut would also be profoundly counter-productive with respect to both the macro- and the micro- economic challenges that our economy faces today. Within a framework that recognizes the central importance of debt reduction, there is a strong microeconomic case for making targeted and responsible tax cuts that are designed to meet specific goals such as promoting incentives to save or to work.

But the overarching focus must be on the elimination of the net debt held by the public. Within such a framework, the President's budget provides for a tightening of fiscal policy that we believe is appropriate at a time of economic strength.

Such a strategy represents the best course for our economy for five reasons:

As Chairman Greenspan and others have emphasized, the return on investment is probably greater today than it has been in a very long time, because of the opportunities that new technologies afford. The more we save through debt reduction, the greater will be the level of investment in the productive economy.

In contrast, measures that reduce potential national saving threaten to reduce domestic investment and thereby constrain potential growth. For example, under reasonable assumptions, a tax cut of $1 trillion over 10 years would reduce business investment in equipment and software alone by about $350 billion over the same period.

Today, when our challenges are increasingly on the supply side, with businesses struggling to find workers and to find capacity to expand operations, the priority for policy must be to increase the supply potential of the economy. Policies that boost demand, without increasing supply potential, run the risk of higher interest rates, higher inflation and greater economic instability.

A strategy of eliminating net publicly held debt provides the best prospect for maintaining the expansion, because it better safeguards against the risk that market interest rates will rise sharply in the future in response to unsustainable growth in demand. By contrast, policies that would use the surpluses in ways that substantially promote either public or private consumption raise the risks of economic instability in the future.

At 4.2 percent of GDP in the fourth quarter of 1999, the US current account deficit is now the largest in more than a generation. When a large external imbalance reflects a period of strong growth relative to the rest of the world, and relatively high investment in our productive potential, as it does in the United States today, that imbalance is unlikely to pose an immediate threat to our economic well-being. But, as Secretary Rubin pointed out frequently, a large and growing current account deficit is not something that can be sustained indefinitely. It can also give rise to protectionist pressures, and it distorts the pattern of domestic economic activity.

The best way for the current account deficit to adjust over time is through increased national saving, so that reduced foreign borrowing does not lead to reductions in productive domestic investment. We will significantly enhance the prospect for such a healthy adjustment if we are successful in eliminating the net debt held by the public.

In contrast, policies that promote consumption, that use up the surpluses that are now projected, and that increase domestic demand would run the risk of exacerbating already substantial external imbalances - and the risks that such imbalances can pose.

This is a time of remarkable prosperity. It is equally a time when we face a major challenge, of meeting our obligations to the next generation of retirees. And as the President's budget demonstrates, it is within America's reach to be free of the net debt held by the public by the time the baby boom generation retires in the second decade of this century.

Failure to achieve this goal would mean extra interest payments in future Federal budgets and less space for meeting our Social Security and Medicare obligations to future retirees. It is in that sense that a large-scale tax cut or a large spending increase would deprive us of critical resources needed to meet the challenges ahead. It would pass on the burden of adjustment to future generations, and the longer it is deferred, the more painful the adjustment is likely to be.

We are fortunate in the current strength of the economy and in the current strength of our economic forecasts. The experience of businesses is that they most often fail when a period of strength leads to excessively optimistic plans - and then they grow right out of cash. In the same way, it is essential we recognize the enormous uncertainty surrounding any budget projections that are made today. On more than one occasion, budget projections have swung by literally trillions of dollars within the space of a couple of years. It is therefore essential to avoid making permanent and irrevocable commitments.

Debt reduction as a strategy has the central virtue of preserving our flexibility and leaving us with options, not merely if projections turn out as we hope, but also if they do not. Equally, debt reduction today leaves us room for the automatic stabilizers to provide a counter-cyclical response in the event of future negative shocks.

Let me conclude where I began. We owe our unprecedented economic success to many factors. But this moment of prosperity would not have been possible without the responsible policy of fiscal discipline that we have pursued over the last seven years, and the broader increase in confidence and market credibility that such discipline has helped to promote. Just as such credibility can be won - so too can it be lost. That is why the fiscal choices that we make now will be so consequential, as they have been at similar crucial moments in the past. Thank you.