The Ripon Forum

A Radical Solution for California's Intractable Woes

Erin Drankoski — Tue, 03 Nov 2009 11:37:00 -0500

"Are you ready to put on your white wigs?" That is a question I have been posing lately to many everyday Californians, as the Golden State considers if a constitutional convention composed of regular folks might hold the solution to California's ongoing political and budgetary woes.

Fiscal Disorder

Cecille Isidro — Mon, 20 Apr 2009 12:08:00 -0400

This past February, four months after the beginning of the fiscal year, Congress passed the last bill needed to fund the government.

But what it finally passed was more than just late -- it was sloppy. Instead of offering separate appropriation bills that could be debated thoughtfully and with undivided attention, Congress lumped them into one, gigantic 225-page “omnibus” bill, and hurriedly passed it on the floor.

Economic Diversification

adminn — Mon, 31 Dec 2007 10:23:00 -0500

Harry Markowitz’s 1952 essay Portfolio Theory broke new ground in developing ways to diversify financial portfolios. By the time he won the Nobel Prize nearly four decades later, countless financial innovations to help spread risk had been introduced, making the risks associated with investing more acceptable -- particularly to the American middle class. Sure the markets are taking a hit now, but those with diversified portfolios are certain to weather this downturn better than those without.

U.S. economic public policy would benefit from a similarly innovative approach to managing risk. The economy is facing growing pains that go deeper than just the current financial market turmoil. Despite progress in bringing down international trade barriers and an impressive period of economic growth, we are facing unprecedented levels of income inequality and a host of new economic risks -- everything from disappearing pension plans to entire industries moving abroad. If the economy turns down as it appears to be doing, these challenges will only become more pronounced. Unfortunately, views on how to deal with this issue are polarized and neither side has a viable strategy for dealing with the more tumultuous side of the modern economy.

There are the rosy eyed optimists who focus on the strengths of the new economy while ignoring the pitfalls. Their interpretation does not fit the facts: the top 20 percent of U.S. households now earn well over 50 percent of all income while the top 5 percent earn close to a third. There have been mass layoffs at the kinds of companies once considered the backbone of the U.S. economy, including Hewlett Packard, Boeing, Procter and Gamble, and Sears. Laid-off workers who find new employment often end up in jobs that pay far less than what they were earning before. Even for families who have health insurance, a serious injury or illness can send them tumbling towards financial hardship. The success of this country was never based on guaranteeing economic outcomes, but we need to acknowledge that many families that play by the rules still run the risk of economic ruin.

On the other side, there are those who have focused on the problem, but too often ignore the critical contributions of economic growth, suggesting stale ideas that are more likely to harm than help the economy. They’ve honed in on free trade and the Bush administration’s tax cuts as the major culprits of economic inequality, turning to the tired favorites of protectionism and repealing the tax cuts for the wealthiest Americans in favor of new targeted tax cuts for the middle class as remedies. Neither will work. The first would diminish the large economic gains available from trade. The Institute for International Economics estimates that globalization has increased the standard of living in the US by $1 trillion a year and that further economic integration could lead to increases of another $500 billion per year. The second approach would worsen both the budget deficit and economic incentives. The outcome would be to undermine the building blocks of a stronger economy.

Instead, the goal should be to ensure that the benefits of a growing economy are spread more fairly. A multi-pronged approach focusing on investment, a more progressive and efficient tax code, and most importantly, economic diversification to create a “hybrid economy” where all workers have access to income from a variety of sources would help insulate them from the swings and potential pitfalls that appear to be a permanent condition of the modern-day economy.

Investments and Tax Reform

Much of the growing income gap can be attributed to higher returns to higher-skilled workers. Thus, one of the most important things we can do is to invest in the education and skills of the U.S. labor force, expanding investments in life-long education -- starting at pre-K and continuing through the working years. However, the payoffs from education will be slow to trickle into the economy, and it is not enough to say that one or two generations from now the gap will close. A more immediate fix is also in order.

Fundamental tax reform can make the tax code both more efficient and progressive. Switching from an income tax to a “progressive consumption tax” for instance, where taxes are levied on consumption through progressive rates, would lead to higher levels of saving -- stimulating economic growth -- while allowing more progressive rates to help those who have not fared so well in the recent economic boom. Also, the $800 billion worth of targeted tax cuts that run throughout the tax system (including everything from the home mortgage interest deduction, to the deductibility of employer-provided healthcare, to tax breaks for vacation homes, fertilizer, and film productions) should be dramatically scaled back.

These tax expenditures are inefficient, regressive, they often pay people to do what they would be doing anyhow, and ironically, they drive up the cost of the goods that we are trying to make more accessible, such as housing and health care.

Reforming the tax base would be a huge step to making the tax code both more fair and helping the economy to prosper. Another interesting proposal by Robert Shiller of Yale University, would index tax brackets and tax rates to income inequality.

As the gains from economic growth became more (or less) concentrated, tax burdens would be adjusted accordingly.

Economic Diversification

Calls for higher levels of investment and fundamental tax reform are nothing new. The most important contribution in helping workers deal with the risks and inequities of a more competitive economy would come from an updating of the country’s social contract to help broaden the economic streams available to families.

Our current social contract -- consisting mainly of the major health and retirement entitlement programs for the elderly -- focuses on the risks in retirement of outliving ones savings or not having health insurance. But while those were the major risks of decades ago, they are not today. Retirees have become one of the more financially secure cohorts. Meanwhile the insecurity of working families and children has risen. For too many workers their income remains primarily, if not purely, “wage-based”. This is less problematic when wages are growing steadily along with the economy; more so when, like now, wages are at historic lows as a share of GDP. The global economy will continue to put downward pressure on wages in many areas, leaving wage-dependent families vulnerable.

As any financial adviser will tell you, the key to dealing with risk is diversification -- managing risk exposure through multiple investments. In order to increase economic security, we need to diversify personal economic situations just as the titans of Wall Street do their portfolios.

Moving Past Wages -- Mandatory Saving

The first step is to expand capital ownership. Returns to capital have outweighed labor returns in recent years, leaving workers without investment portfolios at a disadvantage. Attempts to increase personal saving levels in the U.S., however, have not been successful. Our patchwork savings policy relies on tax preferences for various forms of saving—from 401(k)s, to IRAs, to targeted saving for education, health, or other tax subsidized activities. The government has spent trillions of dollars trying to encourage people to save, with a dismally low personal saving rate to show for the effort. One reason efforts have not been successful is because our current system of social insurance causes workers to believe they will be cared for in retirement through government programs—never mind that we have no plan for how to actually pay for these promises.

A better approach than providing tax-carrots and unsustainable promises is to rely more on personal responsibility. All workers should be required to save a percentage of their annual earnings to build a pool of personal savings. From an economic perspective, 10 percent might be desirable; realistically, something between 2 and 5 percent is more likely. Workers’ savings would build up and, over time, they would accumulate significant levels of capital with which to generate an alternate income stream. The expansion of asset ownership for many individuals would help smooth out economic fluctuations. Assets could be drawn down during periods where wage income would otherwise be insufficient to meet a family’s needs, such as during a period of unemployment, time off from work, or retirement.

Recognizing how difficult it is to save for families who are barely getting by as it is, individual saving should be supplemented through progressive matches for moderate and lower-income savers. And since minimum wage workers can hardly be expected to live on less than they are already earning, the Earned Income Tax Credit, a government program that is used to augment low worker’s wages while maintaining positive work incentives, should be expanded to a “Super EITC”.

Real Insurance for Real Risk

The social insurance system of the past half-century has focused on supplying benefits for likely occurrences such as routine medical costs in old-age and retirement. What we need in the more turbulent economic environment is real insurance for the many things that are not certain to occur but would be devastating if they did. While millions of people are insured for things like contact lenses purchases, they lack coverage for calamitous unanticipated events -- anything from cancer to Katrina -- that can cause unlucky families to fall off track into financial catastrophe and never find their footing again.

Employers, who have traditionally been in the business of supplying many of these basic insurance benefits, are scaling back because of rising costs. This in fact, gives us the opportunity to update the employer portion of the social contract out of necessity. Moving more towards an individual-based system is likely to improve on the current system which leaves gaping holes in coverage, hides the real costs of these benefits, and creates multiple problems concerning portability, flexibility, and proper targeting of benefits. A new partnership between individuals and government is needed, with workers held responsible for purchasing their own insurance along with sliding-scale subsidies from the government for those who cannot afford the additional costs.

With the recent advances in financial and insurance instruments, the risks of job loss, wage decreases, catastrophic injury or illness, disability, or asset depreciation are all potentially insurable. Vacation insurance is already available. Housing bubble insurance has potential as well. Robert Shiller has developed a real-estate index that allows homeowners to hedge against the risk of the housing market turning down -- or for that matter, renters from the risk of it not. Or we could create estate tax insurance: rather than repealing the estate tax, small business owners and family farms could purchase insurance to cover any estate tax liability their heirs might face down the road. These new financial instruments make hedging against all types of potential loss more manageable. Some of these insurances, such as health and long-term care, should be mandatory and government-subsidized; others such as wage, disability insurance should be highly encouraged through automatic default mechanisms; and still others such as estate tax insurance should be totally voluntary and purchased depending on an individual’s personal needs.

A Well-Targeted Safety Net

But even with a more balanced combination of wage income, capital income, and a mixture of insurances, some workers will inevitably fall on hard times. No level of diversification can eliminate economic risk completely. This new system of risk diversification should be paired with a guaranteed government-financed social safety net to provide minimum levels of income, health care, and retirement payments to the people in greatest need.

The most obvious way to do this, again, comes from updating the current social insurance system. Many of the government’s unaffordable programs such as Social Security and Medicare will have to be reformed regardless of other changes. Given the choice between cutting benefits for everyone and cutting benefits for those who need them least, the choice is clear. Transforming the current system of social insurance away from a universal program to a strong safety net would save needed resources while putting the government in the more appropriate role of the insurer of last resort.

While there is sure to be resistance to transforming the current social insurance system from a universal program to a more targeted means-tested system, it has to be acknowledged that the existing system is already on the decline: there are many types of risks that are not covered, the universal system diverts hundreds of billions of dollars to recipients who do not need them, creating a perverse subsidy from poor to rich, and the major government programs that constitute social insurance are unsustainable. Shifting some resources away from the most well-off in society to help give economic security to those who need it is most appropriate in this time of growing income inequality.

Nothing Comes for Free

Revamping the social contract to increase economic security will not come without a cost. Upper-middle-class earners and the well-off would be required to pay for more of their own benefits by shouldering the costs of the new savings and insurance mandates. Government programs would be scaled back for those who don’t need the help so that resources could be diverted to those who do. The elimination of many current regressive tax breaks could easily generate $200 billion a year. And another $200 billion could be saved by scaling back benefits that go to well-off citizens in programs ranging from agriculture subsidies to Social Security to Medicare.

The need to rethink the United States’ social contract provides us with the opportunity to give it a much-needed facelift. A new system consisting of a diversified economic portfolio of wage supports, mandated saving, new insurances targeted at real risk, and a strong safety net will both help to counter negative trends in income inequality and provide a new level of individual economic security. Last century’s social programs were aimed at helping retirees; this century’s should be aimed at increasing the opportunity and security of workers and their families.

Bloomberg Tackles Poverty

Cecille Isidro — Sat, 30 Jun 2007 11:40:00 -0400

Even for public servants with the best of intentions, the seeming intractability of poverty in America can be awfully discouraging. Its causes are complex and past efforts have met with limited success. Until Hurricane Katrina hit land, poverty had been absent from the public agenda for so long that there was little consensus among policymakers in how to respond. Not only was the toolbox of effective antipoverty proposals empty but partisan gamesmanship often seems to block innovative, good faith efforts to address it.

Yet persistent, concentrated, and intergenerational poverty remains a scourge upon our prosperous society, an enduring challenge for policymakers of all persuasions. One of the more remarkable efforts to meet this challenge is being led by New York City Mayor Michael Bloomberg, who has decided to make tackling poverty one of the core priorities of his second term. With Democrat Charlie Rangel looking on, Mayor Bloomberg announced this past December one of the most innovative anti-poverty efforts to emerge in recent years. While it is too early to predict the ultimate fate of this effort, it has already unleashed an unprecedented public-private partnership that just might create a model for future anti-poverty initiatives across the country.

Rather than identifying amorphous targets or unattainable goals, Mayor Bloomberg committed himself to remaking the toolbox. And he pledged $150 million a year to do so, some of it to be raised in the private sector. Much of the money will be used to try and test out new approaches. At the center of the effort is a newly-formed city office, called the Center for Economic Opportunity (CEO), which is designed to operate as a combination of a philanthropic foundation and a venture capital fund. This office will be charged with seeding innovation by supporting a range of experimental programs. But in addition to investing in R&D, the CEO will be in charge of evaluating the results, so programs that demonstrate success in reducing poverty can be built upon and those that don’t can be shut down. This results and evidence-based approach is gaining momentum in other areas of government, increasingly influencing budget decisions at the federal and state level, but the funding of policy innovation, especially in anti-poverty program at the local level, is breaking new ground.

Emblematic of the search for innovation is the decision to implement and test one of the more remarkable anti-poverty tools developed in recent years -- conditional cash transfers. Piloted in demonstrations throughout the world but largely untried in the U.S., conditional cash transfer programs (CCTs) provide money directly to recipients when they meet specific criteria. It’s an incentive program that makes the social contract explicit. Families are rewarded for their actions, so they may qualify for a transfer when they complete a training program or make sure their children go to school and get vaccinated. The idea behind CCTs is to replace the traditional welfare model of donations of aid with one that allows recipients to invest in their future. It has already been proven to work in other places. One widely studied program in Mexico, one replicated internationally in over 20 countries, has been credited with improved health outcomes that have been linked to improved educational outcomes in young children and a reduction in poverty at the family level.

To implement and evaluate this approach in New York City, Mayor Bloomberg formed a public-private partnership in March of this year. The first of its kind in the U.S., Opportunity NYC is a $50 million effort that has raised support from a number of foundations, including the Rockefeller Foundation, the Open Society Institute, AIG, and Starr Foundation. Designed with input by MDRC, a leading national evaluation and research firm, the Opportunity NYC program will include a sample of approximately 5,000 families throughout the city -- half of which will be part of a control group. The incentive-based strategies of the program will focus not on developing new social services, but on increasing participation in certain existing programs and taking actions that have already been proven to reduce poverty among children and families now and in the long run. Participants may receive $50 to $300 for meeting specified targets or completing a conditional activity, and families may be eligible to augment their income $3,000 to $5,000 per year depending on the activities and family size. Initially, incentives will focus on the areas of education, health, and work, but poverty advocates are already identifying promising areas to expand the effort.

Another set of early investments will focus increasing the financial capacity of lower-income households. A first-of-its-kind Office of Financial Empowerment is being formed to ensure that families have access to information that can maximize their financial health and minimize the likelihood that they will be subject to predatory schemes. This will include coordinated information campaigns to publicize the availability of tax credits and public benefits which can families get and save financial resources. The idea is to provide and coordinate access to asset building activities, such as basic bank accounts, financial literacy help, and matched savings account programs.

An additional plank of the effort is designed to help families with young child enter and stay in the work force. Recognizing that child care costs often impede labor force attachment, the Mayor has taken up an earlier proposal of his Democrat-led City Council to create a local child care tax credit that could help offset these costs and make work pay. The proposed credit, still pending before the council and state legislature, would target families with children three years old and young which have household incomes less than $30,000. It is estimated that this proposal would cost the city $42 million a year and benefit almost 50,000 families.

This initial round of investments is ambitious in both its scale and breadth -- a testament to a driven, second-term mayor committed to forging new ground in some difficult terrain. And yet, Mayor Bloomberg is not alone in his decision to focus on combating poverty or in his search for new, effective ways to confront it. Across the country, mayors are increasingly turning their attention to these issues. Los Angeles Mayor Antonio Villaraigosa recently convened a task force of mayors to develop a forward-thinking anti-poverty action plan. The mayors acknowledged that reductions in poverty are unlikely to come from expanding subsidies and entitlement programs, but from revising the way we use public resources to create a lifelong ladder of learning and opportunity. Specifically, Villaraigosa has called for a revitalizing system of work skills and training, an expanded EITC to make work pay, and the provision of children’s savings accounts to provide a platform to build assets over a lifetime and learn the basics of financial education.

Like Bloomberg, these mayors recognize that there are no quick fixes. This current crop of politicians may be long gone before we realize what works, making these efforts all the more laudable. But they have launched a necessary first step, which is an active search for policy interventions that can work over the long term.

Navigating America's China Challenge

Cecille Isidro — Thu, 17 Nov 2005 00:00:00 -0500

When he served as Deputy Secretary of the Treasury, Harvard President Lawrence Summers frequently stitched into his opening remarks an excessively hubris-laden assessment of American power. At one such speech, he asserted that the "world has never seen a nation such as the United States that possesses such unrivaled economic might...that the world has never seen a country such as the United States of America that had such a degree of global military power and global reach that a serious rival can not even be imagined."

Summers believed that a more integrated and efficient Europe as well as a rapidly growing China would become high impact players in the future but that neither would rival the U.S. on any serious front for a very long period. Today, just a short six years after Summers' triumphalist commentary, America's current account balance has rocketed from roughly 2.5% of GDP to nearly 7%, or roughly $700 billion a year or about $3,000 per capita, with the fastest growing and most significant part of that imbalance associated with China specifically and Asia more broadly. In contrast, China now possesses nearly $800 billion in currency reserves, has overtaken the United States as the largest trading partner of key American allies Japan and South Korea, is spawning free-trade agreements with global stakeholders at a faster clip than the U.S., has more than 2 million individuals with wealth greater than $40 million each, and is preparing Beijing to show itself off to the world in the 2008 Olympics.

In addition, China is pouring great sums into a modernized and enlarged military force. To give a sense of scale, this newly empowered China has three provinces each larger than the entire population of Germany. The Chinese economy has grown 9% per annum since 1978. Its export growth the last two years has been a hurricane force 35% annually. Equally remarkable, while America is grappling with terrorism-induced security costs and the perception of military overextension, foreign direct investment into China the past two years has surged to 26% annually.

When China was a poor nation, mismanaged under the command economy edicts of Communist leadership, China was largely contained both by the challenges of maintaining internal stability and by an often vicious struggle with the former Soviet Union--at that time a convenient geopolitical assist to U.S. interests.

But today, China--while still managed by nominal Communist leadership--nonetheless is a rapidly developing market economy (or semi-market economy given the fact that non-market decisions still govern a significant portion of China's business sector). The Chinese are well on their way to becoming a richer nation--and one of the most serious and consequential questions facing America and the West is whether China will play by Western rules and abide by the international institutional arrangements that Europe, Japan and the U.S. have established--or, on the other hand, will seek to upend global affairs, refashion global arrangements to better suit its preferences, challenge U.S. hegemony not only in Asia but globally, and as part of its design--attempt to end its decades-old Civil War and forcefully compel Taiwan to submit to Beijing's control.

China has had a problematic few centuries--but it's back. Some used to joke that America fought the Cold War and Japan won. Now it seems that America is fighting the Global War on Terror, and China is winning. It has become an oasis of stability and high growth during a period of security crisis in the U.S. and Europe.

Managing China's rapidly growing pretensions as both a regional and global power is fraught with danger. Transitions such as this often don't go well--as they didn't when Western powers tried to contain the rise of Germany and Japan in the early part of the 20th century--and sewed instead seeds of national resentment.

In China's case, the potential historic grievances and national "chip-on-the-shoulder" attitudes about Western colonial exploitation run far more deep than what Germany or Japan experienced. Thus, historical metaphors should give us some reason to move cautiously and carefully with China and to make sure that we do all that is possible to avoid repeating mistakes that were made in the past. Isolating China has huge costs--but so too does robust embrace. Maintaining balance while incrementally integrating China with the rest of the global system should be among the highest priorities of the U.S.

China is a conundrum in America's future, and there are opposing currents within both American political parties as to the course the nation should go vis-a-vis China. Republicans are divided into several camps. One of these is the Kissinger/Scowcroft realist camp that believes that America must try to deeply embed China in global institutions and manage its emergence as a great power with an unsentimental calculation of economic and military interests that avoids front-on conflict and yields mutual prosperity. Others believe that deep economic integration between China and the U.S.--and fashioning China as a massive example of global middle class development may lay the groundwork for democratic self-determination. Then there is a neoconservative-inspired group led by the likes of William Kristol, Richard Perle, and Frank Gaffney who view such economic development ties between China and the U.S. as appeasement of anti-democratic Communist theology and enrichment of a likely foe and peer competitor against American interests. This wing of the Republican establishment sees collision with China as a near certainty and that America must marshal its resources to prepare for a global struggle against China and its pretensions.

In Democratic circles there is also a deep divide with, on one side, a neoliberal wing of pro-business Democratic Leadership Council types favoring robust economic engagement with China, while on the other, a group that elevates the importance of China subscribing to global norms of human rights protections and democratic choice over economic factors. It is more than ironic that in some causes, House Minority Leader Nancy Pelosi who has chided China on human rights abuses might find herself morally and politically aligned with Senator Sam Brownback or Senator John Kyl who think that America and the West should not reward what they have called a "thug regime" that oppresses its people and seethes at democratic practice and genuine civil society.

Given these realities, what might a roster of policy prescriptions for America look like that take into account both China's potential as a possible menace and threat to American interests--but also the possibility that China may evolve into a nation that does the world great good and which may generate significant wealth and new possibilities for the U.S. Already, for example, China has been a powerhouse in lifting more people out of dollar-a-day poverty than any other nation. China has put a man into outer space and is proving to be an important source for a new generation of original scientific technological innovation.

America's great success with China--which started with Nixon's brave trip there in 1971 and Kissinger's diplomatic genius--is that China's 1.2 billion people have become increasingly integrated into a global system of governance and accountability. This has happened rapidly--and the question is whether China can change at a fast enough pace to adapt to modern global norms--or whether the system will erode or collapse if China fails to make the necessary transitions. China used to be isolated. In the view of this author, we can't go back without a disastrous global convulsion. Alternatively, if we fail to manage our relations with China adequately, the world will pay a heavy price.

So, what to do?

First, we must recognize that America's love-hate, engage-disengage relationship with China is a problem. China is a major nation of consequence--so important to the future welfare of the U.S. and the world that it cannot be cut off completely, not without destroying much of America's economy. That does not require appeasement of Chinese misbehavior or tolerance of reckless objectives. It means that our nations will long be working out deals--and like the former Soviet Union--the smartest way to steady an important relationship is to move that relationship away from binary, on-off, all eggs-in-one-basket politics. We must build deep broad, complex networks of government and civil society interaction. We need robust institutional and people-to-people exchanges, multilateral efforts across all sectors of society. Why? Because if relations get explosive or testy in one sector of the relationship, there are other stabilizers built into the system--and diplomacy can continue to attempt to get most aspects of the relationship right. This can be called a "Shock Absorber" strategy.

This is a relationship characterized by an ascending Chinese "national ego" and a defensive, wary American ego. America needs to rid itself from unhelpful Cold War analogies that could make our experience during the Cold War with the Soviet Union--which had radically different ambitions and pretensions than modern day China--a self-fulfilled "unwanted reality in our future with China." China and the U.S. need to negotiate the terms of China's emergence--and part of America's acquiescence to that rise should be tied to obligations from China for responsible regional and global stewardship. China's key role in forcing North Korea to negotiate about its nuclear weapons program is heartening and should build confidence that China is committed to global stability.

Engage, engage, engage. America's distraction in the Middle East while China prospered has given powerful incentives to China to continue to try and maintain our distraction there--most likely in covert ways. While America organized much of the world to assist in our Global War on Terror, China went on a charm offensive and filled the vacuum of our absence with seductive and powerful diplomacy. China is now competing with America in Asia not in a head-to-head way but through brilliant multilateral initiatives such as the East Asia Summit/East Asia Community proposals it has pushed and other multilateral efforts in security and economic arenas. This "new multilateralism" by China is competing with America's penchant for bilateral deals between itself and other countries like Japan, Australia, and South Korea. While America is party to other multilateral efforts in the region--it relies on bilateral arrangements and has not strongly pushed multilateral institutions. The recent Six-Party Talks are one exception, but America's commitment to that process has also been frequently marked by inconsistency and ambivalence. So, America needs to be consistently engaged in Asia broadly and not leave vacuums for China to fill, which it will--not because it's a dangerous nation, but because any ascendant powerful regional power would do the same.

America needs to decrease economic dependency on China--but not too fast. China and the U.S. are playing a game of Russian roulette where both players know that at some point one or the other will pull a trigger that undermines the health of both. America is far too dependent on China for its economic livelihood. China, likewise, is exploiting America's binge appetite to grow its economy in structurally unsound ways. China must move some of its productive capacity to domestic consumption. America must stop blaming China for its current account deficit and cut consumption. In the long run, America can do this by modifying its tax structure to reward saving and investment and tax consumption. China, on the other hand, needs its people, who are saving at a rate of 50% of income, to trust their future enough to spend. China could move forward in creating greater health care provision, pension tools, and other sophisticated investment and financial instruments so that Chinese released cash to bolster domestic consumption.

The toughest item to deal with will be Taiwan, where preservation of the status quo is in the interests of the U.S.--but which powerful forces in Taiwan are trying to undo. Taiwan has geographic problems that America must be honest about. China, meanwhile, must feel that an unacceptable price will be paid not only by the punitive actions of U.S. forces but by relations with others in the region and around the world if it attacks and seeks to reunify Taiwan by force. America needs to continue to give Taiwan the wherewithal to keep China guessing about the high price that invasion would entail. At the same time, America can not countenance Taiwan hijacking the Pentagon or the helm of U.S. foreign policy to guarantee its sovereignty if Taiwan declares independence. America does not recognize Taiwanese independence--and this delicate balance must be maintained lest other major goals come apart.

Revaluation of the yuan against the dollar is important, but needs to be pursued in steps. Quick adjustments can be painful and create vast unintended consequences as they did after the yen-dollar revaluation in the 1985 Plaza Accord. A summit should be called by the President of the U.S. that does not hammer China for its economic success--but which makes clear the importance of "sustainable growth" on both sides of this key relationship. And China's currency should float up with the strength of its economy, but needs to be moved to full floating status in stages, perhaps by implementing higher ranges of float every two years for the next eight years. That will help prevent shocks from quick currency shifts.

The resource area is one of the most critical given Chinese energy demands as well as the fact that it has one-third the renewable water sources that is the average global norm. China is currently engaged in buying long-term oil contracts and futures. America needs to be doing the same--just to make sure that America does not take for granted the privileged role it has from most oil exporters today and find that tomorrow China has legal control of a significant share of global oil output.

There are many other aspects to a full policy roadmap for engaging China in the future. Such an exercise would be valuable within thoughtful Republican circles so as to prevent myopic interests and ad hoc policy formulations to erode the foundation for a long-term balanced strategy with China. The most important thing America can do is to work to show China the benefits of responsible behavior and rather than seeing its multilateralism, though mostly anchored in Beijing, as a threat, applaud it. Support China's aspirations for greatness--as long as these aspirations don't upend the global system. Applaud the lift of so many out of poverty in China as long as China can "sustain" this growth economically and environmentally.

If there is misbehavior or aggression, America should respond and not be timid in responding to Chinese aggression--but thus far, China is proving to be a worthy competitor with a vision of its stake in the world. The question is whether there can be competing versions of globalization as well as global and regional institutions--anchored respectively in Beijing and Washington.

Dealing with the Deficit

Cecille Isidro — Mon, 01 Aug 2005 00:00:00 -0400

With structural budget deficits stretching indefinitely into the future, the mounting national debt and few meaningful budget rules left in place, the chances of the deficit disappearing on its own are about as likely as finding a quick fix for health care. It is no wonder fiscal conservatives are in such a state of despair. Despite numerous warnings from the Congressional Budget Office, the Government Accountability Office, the Federal Reserve and the International Monetary Fund, the past four years have seen a solid deterioration in the nation's fiscal state of affairs. If nothing is done, it may well be financial markets that force action upon us. This is a far inferior alternative to the types of bipartisan budget deals that have led us out of budget messes in the past.

Last year's budget deficit was $412 billion. The Congressional Budget Office projects we will borrow another $1.6 trillion over the rest of the decade. That's before any money is set aside for further operations in Iraq and Afghanistan, reforming Social Security, fixing the Alternative Minimum Tax, or extending any of the expiring tax cuts. Even this far from rosy scenario depends on our borrowing all the surpluses from the Social Security system, and using that additional $1.3 trillion of intra-governmental borrowing to mask the true size of the deficits.

Meanwhile, the nation's largest entitlement programs are clearly on an unsustainable track. The first Baby Boomer will retire in three short years, and quickly, we will transition from a nation where the largest generation is in the midst of its most productive years, to one where the Boomers are on the receiving end of our national entitlement programs -- greatly increasing their costs. Though Social Security reform is on the national agenda, Congress has been more focused on debating whether the system faces a crisis than discussing how to actually fix it. The program is over-promised to the tune of $11 trillion. Congress has known about the problem of years, and every year we wait to make changes, the harder the problem becomes. Given that Social Security is by far the easiest of the under-funded entitlement programs to fix, this does not bode well for a fruitful discussion on Medicare.

If changes are not made to the nation's largest entitlements, we are left with two choices: squeeze out virtually all other areas of the budget or allow the government to grow to an unprecedented peacetime size of 25 to 30 percent of GDP. Neither scenario is one we should be proud to pass along to the next generation.

Furthermore, as Gene Steuerle of the Urban Institute has pointed out, we are losing control of the budget as we pre-allocate more and more of the nation's resources. Just as we could not have predicted the major needs of today 50 years ago, it is difficult to anticipate what those needs will be 50 years from now. Yet because of our intergenerational, consumption-oriented, pay-as-you-go entitlement programs, it will be far harder to meet new needs since so much of the budget has already been promised away.

Finally, while seniors are by far the strongest voting block, it is hard to make the case that our current resource allocation of $8 per senior for every $1 on children makes sense. And that ratio will be changing to further favor seniors just at the time when due to the new hyper-competitive global environment we should be investing far more in the next generation of workers.

Turning a Blind Eye

The political class has not yet woken up to the seriousness of these tremendous challenges. Perhaps we are a victim of our past successes. Politicians may hope for a replay of the 1990s, when strong economic growth and a booming stock market helped pull the U.S. budget out of what looked to be a permanent deficit spiral. But many levers were used to generate those budget surpluses: multiple rounds of tax increases, considerable spending constraint, the emergence of the peace dividend, and budget rules that would have prohibited enactment of the tax cut and prescription drug legislation that we have seen in recent years. Moreover, sitting on the precipice of such a large demographic shift, the bar for success is now much higher than it was a decade ago.

It is hopeful that the administration has acknowledged that deficits do matter and, accordingly, has promised to cut the deficit in half before the end of the decade. However, the commitment is unconvincing given the number of executive branch priorities omitted from the President's budget.

Furthermore, the goal is insufficient even if it were realistic. At the bare minimum, sound fiscal policy would involve balancing the budget over the business cycle, running deficits during a downturn and surpluses during periods of economic strength, which is a far more aggressive target than the course the President has laid out. Secondly, the goal should not include the Social Security surpluses, which not long ago, members of both political parties were committed to saving. Finally, in preparation for the upcoming demographic shift, we should have been running large budget surpluses over the entirety of the past decade. Fiscal policy would then have involved a shift between smaller and larger surpluses depending on economic conditions, with the additional savings helping to prepare us for the Baby Boom's retirement. Instead, the budget that Congress just passed, while bold in its willingness to scale back some entitlement spending, actually enlarged the deficit beyond what it would have been if no budget had been passed!

A Financial Market Crisis?

The broader and more troubling question has become not when will Congress come up with a realistic budget deal, but instead, will it be a financial market meltdown that finally forces our hand? While the scenario may seem far-fetched -- fiscally driven market crises occur in developing markets and regions, not the home of the global benchmark security -- a spiraling chain of events is not out of the question. The United States is now highly dependent on lenders from abroad to finance our massive levels of borrowing. About half of outstanding Treasury bonds are owned by foreign lenders. Particularly troubling is that the composition of lenders has shifted away from private investors seeking out the highest returns, to foreign central bands attempting to prop up their currencies vis-a-vis the dollar. This leaves the United States in the odd situation of being the single strongest superpower and at the same time, the single largest debtor and thus, surprisingly dependent on other nations.

A mini wake-up call occurred when the South Korean central bank let it be known that they were considering shifting part of their reserves to currencies other than the U.S. dollar, leading to a temporary stomach-lurching decline in the dollar. It is easy to envision a more permanent scenario where concern over America's fiscal position would lead to a selling off of dollars, stocks and bonds, rising interest rates, the bursting of the housing market bubble, and a slowdown in not just our economy, but the world's economy.

While it is true that the Asian central banks have a strong interest in not letting the dollar drop to avoid taking a big loss on their existing holdings, it is little comfort that this co-dependent relationship could ultimately produce two sets of losers. Japan, India and Russia have all recently made rumblings about diversifying their reserve currencies, and when they speak, U.S. Treasury officials must now listen.

Another unsettling scenario is that private rating agencies, such as Moody's and Standard & Poor's, downgrade the United States' debt based on our high levels of borrowing and unfunded liabilities, much as they did Canada's in the mid-1990s when their fiscal policies were deemed overly reckless. A downgrade would surely cause bondholders to dump their debt, leading to an abrupt jump in interest rates and potentially setting off an unwelcome economic spiral.

No one knows if any of these scenarios will materialize. Certainly, no one knows when. Clearly, however, this is one of those times when we would rather not find out if the crisis predictions are accurate. Even if there is no financial crisis, or it is closer to a blip than a meltdown, ongoing budget deficits drain the economy of investment capital, lead to lower standards of living in the future and squeeze out other areas of the budget as interest payments mount. In short, deficits are a reflection of our spending more than we can afford and forcing our children to pay the bill.

The best scenario to stave off any potential crises and the right one in terms of generational responsibility is to take preemptive action rather than waiting until action is forced upon us. The gap between revenues and spending is large enough that a few tweaks here and there will not come close to doing the trick: a real budget deal is called for.

A Grand Fiscal Bargain

Any effective deal will have to be bipartisan to give both parties political cover on the tough choices that will inevitably be involved. Moreover, a bipartisan and balanced compromise has a far better chance of sticking, even if power in the House, Senate or White House changes hands. In order to reassure forward-looking financial markets, the deal will have to address both the short- and long-term challenges.

While it is hard to picture what sort of deal could come out of this highly polarized and partisan environment, the numbers paint a pretty compelling picture of where to begin. Federal revenues have ranged from about 17.5 percent to 21 percent of GDP over the past few decades. Today they stand at a 46-year low of 16.3 percent. Meanwhile, federal spending has been in the range of 18.4 percent to 22.9 percent over the past 20 years. On its current path, spending is expected to grow to between 25 and 30 percent. Even for those who don't worry about the inefficiencies caused by taxation at current levels, such exorbitant growth is cause for concern.

One possibility would be a grand fiscal bargain: Raise taxes in the short-run and rein in entitlement spending in the long-run so that both are more in line with historical norms. Such a balanced approach has a far better chance of success than any of the alternatives. Neither party will particularly relish the plan because both will have to give something up. But real budget deals are never easy.

First, let's take taxes. Initially, there was concern that surpluses would grow so large they would consume all the outstanding debt, prompting calls for tax cuts. Then, as the economy stalled, the case for fiscal stimulus made sense. (Though using both arguments to justify the same tax package was a bit of a stretch.)

The subsequent rounds of tax cuts, however, from a fiscal perspective were inexcusable. With the looming costs of the Baby Boom around the corner, we should have been using the government's excess funds to pre-fund the major retirement and health care programs. Moreover, once the budget surpluses vanished, the tax cuts merely exploded the deficit further. Republicans had their chance to reduce the size of government, but chose not to. Accordingly, neither the argument that the tax cuts were part of a plan to scale back government or increase economic efficiency holds. Either the President's tax cuts could be repealed, or a new revenue stream -- such as a progressive consumption tax or environmental and energy taxes -- could be added. But given the current budget picture, taxes will have to go up.

Meanwhile, Democrats must give up on the notion that entitlement programs cannot be changed, updated, or cut. We have greatly over-promised this area of the budget and have no plan for how to pay for all these promises. What did we do with Medicare, the most challenging of the problems? We expanded it by adding the prescription drug plan with virtually no regard for the tremendous long-term costs.

Entitlement programs will have to be reduced. The most sensible way to do so is to progressively scale back benefits for those who do not need them. The President's plan to reduce promised Social Security benefits for wealthier retirees, for instance, while protecting those who depend on the program, makes an awful lot of sense. Same goes for means-testing health care benefits, through reduced benefits or higher premiums for the well-off elderly. The other option of course is to employ across-the-board benefit reductions, which would do great damage to the recipients who truly depend on these programs. But surprisingly it is Democrats who tend to object to redesigning these programs in a way that would make them more progressive, fearing that it would undermine their political support. The argument that we should dole out generous middle-class benefits in order to buy political support, particularly when the cot falls squarely on the backs of workers, many of whom are less well-off, is not only excessively inefficient and costly: it is not in keeping with what progressives should stand for.

Both parties have put politics in front of principles, and this will have to change. In order to directly confront the country's major fiscal challenges, both the eras of big government conservatism and anti-progressive progressivism will have to come to an end. If we are not willing to enter into some kind of grand fiscal bargain where everything is on the table, and both parties are willing to give up something, more than likely, financial markers will end up forcing our hand.