Is US Fiscal Policy Sustainable?| Challenges Facing the US Economy

>> Stephen Haber: I imagine we'll have as robust discussion and debate as we had in the last panel. I won't introduce the panelists, but I will introduce the chair of the panel, Dan Kessler. Dan is a dear friend and partner in all kinds of good things, both the Hoover and Sandberg.

Dan is the Keith and Jan Senior Fellow at Hoover Institution and a professor at Sandwich Graduate School of Business and Law School, where he teaches courses on economics, public policy, and the healthcare industry. He has published in leading journals across numerous academic disciplines, including law, economics and political science.

Dan, the floor is yours.
>> Dan Kessler: Thank you very much, Steve, and thank you all for coming. It's lovely to see such a big, big crowd here. So our topic is, is US fiscal policy sustainable? And to get a sense of the best thinking on this topic, I decided last night to type in, Is US Fiscal Fiscal Policy Sustainable To ChatGPT.

And it returned a somewhat lengthy response, which I'm gonna edit in the interest of time. But the first and last sentence was, the sustainability of US Fiscal policy is a complex issue influenced by various factors including government debt, economic growth, interest rates, and political decisions. Policymakers need to balance fiscal stimulus and spending with long-term economic stability and growth.

This is why I'm not too worried about artificial intelligence taking over my job. Based on conversations I've had with our panelists, I think you're gonna get a somewhat more informative response than ChatGPT gave me. I think what they're gonna report is that the essential answer here is no.

And that's the same answer as the CBO, the GAO, the Penn Wharton budget model, and many, many other people. And what I think they're also gonna say is that there are really four choices that we have. First, cut spending, including mandatory entitlement spending. Second, raise taxes. Third, grow our way out of it, and fourth, inflate our way out of it.

Where they will differ, and this is where it's gonna get interesting, is what the mix of these answers should be and how we should achieve them and what we should do if we don't quite succeed. And with that, let me turn to to our fantastic panel. Each of them is gonna offer about five minutes of introductory remarks.

Then like the last one, we'll have a discussion. I'll give them some hardball questions and then we'll open it up to to you all. First, sitting right on my left is Ross Levine. Ross, you've already heard about. So I'm gonna, in the interest of time, not re-introduce him.

He did such a good job here on the last panel. You'll be familiar with what he's gonna say. We also have, excuse me, Valerie Ramey. Valerie is a senior fellow at Hoover. She's a member of the panel of economic advisors for CBO. Valerie is a macroeconomist. She's published a very large number of articles on the sources of business cycles, the effects of monetary and fiscal policy, the impact of volatility on growth, and the effects of climate change on growth.

After Valerie, we have Kevin Warsh. Kevin serves as a Shepherd Family Distinguished Visiting Fellow in Economics at Hoover, and he's a lecturer at the GSB. He's a member of the Group of 30 and the Panel of Economic Advisors of CBO. And finally, on my far left is Hanno Lustig.

Hanno is the Mizuho Financial Group professor of Finance at the Stanford GSB. Between 2019 and 2021, he served on the Allocation Advisory Board of Norway's Central bank, which provides input regarding key areas in economic and finance that pertain to asset allocation. So with that, let me turn it over to our fabulous panelists.

Ross.
>> Ross Levine: Thank you, I'm back. So I think that the US Faces an unprecedented fiscal challenge that threatens our prosperity in the long run. So let me explain with a couple of numbers. If we look at the US Fiscal debt, how much it owes to the private sector as a proportion of GDP, or how much the US Produces, we get and can measure it in different ways, about 100%.

So it means that the US federal government owes to its the people it borrowed from about an entire year's worth of production. But the situation is much worse because the federal government has made promises to people who are going to receive Social Security payments in the future, and it's made promises, very, very large promises to people who are gonna receive Medicare help in the future.

And when you total all those together, the recent report from the treasury, you get a number of these unfunded promises of about $78 trillion. Okay, those unfunded promises are sort of like if you decided you were gonna promise all the family members in your household a car next year, but you had no way to pay for it.

When you include those unfunded promises, when you add that in with the debt, which is not fully appropriate. But to get some scale of things, you get a number that the US federal government owes about 350% of GDP. Those are unprecedented numbers. It's about three, four times bigger than it has ever been before in US history.

But that's not the half of it because not only is the debt level at unprecedented levels, we keep adding to the debt at unprecedented speeds, meaning that the fiscal deficit is extremely large. For example, last year the US government, federal government, spent about $7 trillion. It raised about 5 trillion in revenues and it borrowed the other 2 trillion.

So it's like if you had a gigantic credit card debt and what you did is instead of dealing with that debt, you simply added to it again and again by borrowing more and more. There will be a reckoning to all of this. So this debt, when I mention that it threatens our prosperity, it threatens our prosperity in three ways.

And these three ways have been known since before Adam Smith. It can crowd out private investment, meaning that if the government is borrowing and taking our savings, that means less of that savings is available for private businesses in order to expand, create jobs, and innovate. It also has an effect on economic prosperity because it distorts decision making.

Individuals and businesses, rather than focusing on growing their businesses and becoming more efficient, have to spend a lot of time worrying about those future taxes in the future to pay for the debt. Or the future inflation that's going to be used to diminish the real value of that debt, without which I view simply as another form of taxation.

And third, the debt risks triggering a crisis that if markets become uncertain about the willingness and the ability of the federal government to pay its debts, interest rates would soar and this would wreak havoc on the economy and living standards more generally. So there's a saying that it was written a few years ago that said, either the nation must destroy public credit, meaning deal with its public debt, or public credit will destroy the nation.

And this was argued in 1750 by David Hume. And although this view of the debt as something very, very challenging is not new, we have to take action to deal with it now. So how can we address this challenge? So I guess I'll go back to something that Steve Haber mentioned when he started.

He says, any solution that starts with we just have to is almost certainly wrong, okay? We cannot just cut discretionary spending. There's not enough there to cut to deal with the debt problem, the deficit problem. I think it's eliminating everything except defense and promise commitments such as Social Security and Medicare and other promises that would be almost impossible to break would not balance the books.

We cannot just raise taxes. Taxes are already pretty high by historical standards. They would have to be raised to unprecedented levels, which would almost certainly reduce investment, reduce growth, and therefore be counterproductive to dealing with the debt crisis. And we cannot just grow our way out of this problem.

My calculations, and they're back of the envelopes, and they could be wrong by a lot, but I don't think they'll be that wrong. Is that given that the labor force is unlikely to grow very much in the next few decades, that is gonna put a damper on what has historically been a very large source of growth.

Productivity growth, in order to make up for that and in order to make up for the deficit, would have to be about five times faster than it has been in the last 50 years. So going back to the outline that Dan gave, dealing with the debt is probably going to entail a confluence of factors.

I am not going to offer some solutions now cuz my time is up. And I hope the discussion deals with the sophistication of this problem rather than focusing on simplistic answers like we just have to. Thank you.
>> Dan Kessler: Valerie.
>> Valerie Ramey: Well, I'm going to elaborate on Ross comments in two ways.

First of all, to give you an idea of how truly unprecedented the current situation is, I'm going to put it in historical context. And second, I'm gonna talk about how we got into this predicament and how it's going to get much worse. So there is a graph of the history of the United States since its founding up through the 20th century, so it stops right now at 2000.

Several messages come from this graph. First of all, almost all the big increases in the debt to GDP ratio happened during wars. Also, the debt to GDP ratio tended to decrease after wars. Basically, the war would end, spending would end, Congress and administrations would raise taxes and start paying off that debt.

The highest spike was World War II, where we went to 106% debt to GDP ratio. Now there's another increase, as you can see in the 80s and, and that was the Carter Reagan buildup which led to the end of the Cold War in 1989. Therefore, we got the peace dividend and spending went down.

There were also some tax cuts there. At that point in 2000, we're at 34% debt. There was still a worry though, even then of all of these promises we had made about Social Security and Medicare because it was looking like we weren't funding them properly. Now I'm going to come up to the present.

We are at 98% debt to GDP ratio, okay? How did we get here? Part of the reason is the rebirth of Keynesian stimulus. So that had fallen out of fashion for several decades. They used monetary policy, but when the global financial crisis hit, the interest rates went to zero monetary policy didn't have any bullets or very weak ones.

So they decided to spend trillions of dollars to try to stimulate the economy. Now, unlike Europe where after the crises passed they would have fiscal consolidations, raise taxes, cut spending to get the debt back down, the US didn't do that. Same thing happened with COVID, they hit the economy with trillions more dollars, but did not do any specific legislation to try to reduce the debt afterwards.

So there's been a big change. Prior to 2000, Congress would do things to try to keep the debt to GDP ratio low and also to bring it down quickly. You could see that after World War II they brought it down quite quickly. Now the issue is that it's gonna get even worse, all right?

So there are the CBO projections, all right? So why is the path so steep? Well, it's part of the underlying reason that was for the first 24 years of the 21st century, which is we have made all those promises that Ross said to people. Many of whom are retired or in their later working years, saying that Social Security will be this and that Medicare will be that, and that is what is underlying those.

And those projections assume the expiration of the personal income part of the Trump tax cuts. They assume no more crises and no more Keynesian spending. That will, of course, ratchet things up again if that happens. So why do we see this rise? Well, basically, number one, the aging of the population that affects Social Security and Medicare.

And it's all of those promises we meet. Many, many presidents have made Medicare and Social Security even more generous, starting with Nixon. There's also the rising cost of health care, this is over and above the inflation rate. The cost of health care is really affecting the budget because it affects Medicare, Medicaid, and all of the government health programs.

Finally, there's interest payments. In the last several years, this has become more and more important. Why? Well, all that debt that we built up, the 98% of GDP, we have to pay interest on it. So the higher the debt, the more interest payment. And so all that past spending is leading to this required current spending.

Even if we cut Social Security and Medicare, we'd still have the interest payments. Also, interest rates have gone up in the last few years. So of course that means that we're having to pay more. So now interest payments exceed defense spending, they exceed Medicare spending. 20% of our tax revenues go just to interest payments.

So that is the current situation.
>> Dan Kessler: Well, thank you, Valerie. It's a little bit discouraging, but thank you nonetheless, Kevin.
>> Kevin Warsh: So thanks for that setup. Let me give you the bad news, but the good news. So the bad news is our government for most last 20 years, has done its level best to destroy this economy.

If you were trying to destroy the economy, what would you do? You would spend trillions where you used to spend millions and billions. You'd keep interest rates artificially low so no politician would feel the cost of it, and you'd grow the government deficits at the levels that we set ourselves in.

In spite of our government's best efforts, they have failed to destroy this economy. Bad public policy put us into this mess, good public policy can get us out of this mess. And so I'll give both the good news and bad news version of the story. So first, let me give this a touch more historical perspective than you heard from Valerie and Ross.

The moment in which we're in is probably the biggest inflection point in the conduct of economic policy, probably since 1980. In 1980, we suffered from a similar set of attributes, economic and otherwise. As you'll recall, we couldn't get five helicopters over the Euphrates river to get American hostages out.

College campuses were driven by riots and protesters and the rest taking over university offices. We had inflation that was causing gas lines and a loss of confidence in institutions, all sounding reasonably familiar. And at the same time, we had a decision that our policymakers would have to make.

Are we gonna choose decline or are we going to try a new. A new economic regime which started in the deregulatory part policies of President Carter and continued through the 80s. This is a similar important and consequential choice. The simple answer to the question framing is, is this fiscal situation sustainable?

The answer is no, if you want peace and prosperity. But this wouldn't be the first great power that's chosen some mix of malaise, decay, decline, and said, well, we'll just kind of muddle our way through this. And so that's why it's incumbent upon policymakers to make these choices.

So let me make four points in three minutes. First, the new administration is inheriting a fiscal and monetary policy mess. So on the USS Resolute desk that the new president is inheriting, while I read in the newspapers that everything is swell, I think he's inheriting a bigger mess of problems, not just in economics, but certainly in economics.

We'll confine this discussion to fiscal policy, but the central banker in me feels compelled to say that irresponsible fiscal policy is of a piece with irresponsible monetary policy. The central bank, as Valerie showed during the financial crisis, cut rates to zero and thereby robbed politicians of any view that there would be a cost to this crazy spending.

And the central bank said, hey, not only are rates zero, but you and government should spend a lot more. Well, our political class heard that message from the very credible central bank and said, sure, we will. And they never said take it back. So these two sets of policies are dangerous and they coexist.

And while this discussion isn't largely about inflation, the inflation problems that we have that are the deepest, most regressive tax any politician could come up with, that inflation tax is a sign that something is really amiss. It's not just about failed monetary policy. Inflation comes from a government that spent too much, a central bank that print too much, and as a result, our citizens are living with less as our government's living with more.

We know how to address those, and we must. So that's the first point, which is this is very messy. And I would say over the next four years, the new administration will have to deal with this through some set of measures. I'd be surprised if we can just coast our way through acting in the next four years the way we've last acted in the last four, the set of solutions that were put forward.

I'll just make a brief point on those with some facts and circumstances. Our federal government today is spending 52% more money than the day before COVID 52% more. I don't remember the day before COVID thinking our government is very efficient. It's running some austere set of policies. COVID gave them an excuse to spend 50% more money that we didn't have.

So I know that we hear a lot from people that are critical of different statements from leaders of Doge, Elon Musk and the rest. But what if we went back to spending the day before COVID. That seems to me very reasonable, very possible, and certainly within our political ability.

The rest of the statistics you guys have already heard from Valerie and others, our interest expense today is $3 billion a day. The day before COVID it was a billion. The expectation from the Congressional Budget Office over the next 10 years that our average interest rate that we will spend to pay this growing debt back is 4.1%.

I'll take the over. As we sit here today, interest rates are running up. Inflation risk, premia, cost of government financing a growing economy. Those interest expenses are gonna go higher. And what's worse about the mess the administration's inherited, well, almost every company saw this long period of zero rates and they refinanced, they locked in long term financing.

Well, almost every household did that. They refinanced their 30 year fixed rate mortgage. I can only think of one actor in the United States who decided to borrow at shorter maturities. That's the United States government. That is a deeply irresponsible policy that has left us with this huge burden.

And again, that's why I think the challenge is upon us. Let me just end briefly, not with the refinancing risk which I mentioned, but I'll say a word about an exit plan first. First, I think we can go back to the day before COVID and spending. I think in the President's first budget he's going to need to show to the financial markets and others to what we used to call the bond vigilantes, that there is a new seriousness of purpose on fiscal restraint.

You don't have to solve it in one day, but my view is you should buy some ex ante insurance to tell markets that you take this seriously. And if you do that in your first budget, I think you're probably buying yourself a little bit more room. Second, economic growth.

If this is to be a golden age, we need stronger economic growth, which means more people working more and as we heard at the outset, more productivity. I actually think that is in the realm of the possible. That changed the country in the 80s and 90s. We've had sluggish productivity since.

It can change it again. And then finally, I think we need to go back to a place where, where the Fed and Treasury haven't conflated responsibilities. We at the Fed start buying the debt from our own Treasury Department in the financial crisis and we've effectively never stopped. This is banana republic stuff.

This is not what serious governments do in times of peace and prosperity. So those are few of the plans, and if we get this right, as a final sentence, what we can pull off, which does not have many historical precedents, is an expansionary fiscal contraction. Our government spends less, pass the baton to the private sector who invests more and grows more, and we can get through this.

And markets will give the US the benefit of the doubt because there is no other country that is giving the US a run for its irresponsibility.
>> Dan Kessler: Thank you, Kevin, Hanno?
>> Hanno Lustig: Great, okay, thank you. So I'll use my five minutes to sort of provide some color and context on how we got here.

And I think a key point that hasn't been mentioned yet is that for the past couple of decades, the US has been the world's safe asset supplier. And that's a great position to be in. What does that mean? Well, the great financial crisis of 08 is a good example to illustrate what that means.

As I'm sure most of you remember, Lehman Brothers failed in September of 2008. And what happened is that foreign investors massively started buying treasuries in bulk. That's kind of a remarkable thing because the financial crisis was happening right here, but foreigners fled to the safety of US treasuries.

And in fact they bought 270 billion worth of treasuries in last quarter of 08. And throughout the great financial crisis, they were strong buys. After Congress passed the TARP bill in October of 08, the 10 year treasury yield kept declining, actually another 200 basis points, even though the federal government was about to run deficits in excess of 9% in 2009 of GDP and another 9% in 2010, almost unprecedented peacetime.

So in spite of the massive issuance that was ahead, treasury market was sort of happy to to absorb all of this without forcing yields higher. And that created, I think, a sense of fiscal exuberance in the US, I guess that's part of the exorbitant privilege of being sort of at the center of the international financial system.

In the past, when the treasury had to issue a lot, it could always count on foreign investors to show up. And these investors, they're great investors because they're not particularly price sensitive. They're not just trading off risk and return. They just wanna park their money somewhere that's safe and liquid, and US treasuries were perfect for that.

So that's a great position to be in. And this picks up on something that Valerie mentioned as well. Often the advice US Economists give to foreign policymakers misses the mark a little bit because other countries can't go out and do this. They can't go out and issue a ton of death in global recessions without driving up yields.

But I'm gonna argue that in the US, now we're sort of in what I'd call late stage exorbitant privilege. And the first sign of cracks in the armor was COVID in March 2020. This pattern did not repeat itself. In fact, what happened between March 9th and March 18th when COVID sort of landed on US shores is that yields increased between 60 and 70 basis points at the 10 year maturity, roughly in line with French, German and British yields.

So the US no longer seemed that special, and in fact, foreigners started to sell treasuries. And if you look at the flow of funds, which is a good source for data on this, they sold about 300 billion in the first quarter of 2020. So definitely a very different picture from what we saw in the great financial crisis.

That's some evidence from quantities that maybe we've exhausted, that exorbitant privilege. If you look at prices, you see a similar, similar pattern. It used to be that you could take a treasury and compare it to a foreign bond or a corporate bond or another instrument, and you would always find that treasuries seemed expensive.

That's a measure of this sort of taste appetite of, especially foreign investors, for the safety and liquidity of treasuries. That's no longer the case. So if you for example, nowadays take a German bond, let's say a 10 year bond, add some currency risk hedges and turn it into a do it yourself synthetic treasury, it's no longer true that that synthetic treasury is cheaper than the real thing.

It's actually the other way around. Now the same thing's true when you look at corporate bonds. When you take a triple a corporate bond and add some credit risk insurance to sort of make it look like a Treasury, that thing is no longer cheaper than the real thing, than a Treasury.

That's a pretty important sign that shouldn't be ignored that we've probably exhausted this huge appetite for Treasuries. Demand for treasuries is downward sloping, and as Valerie pointed out, we've dramatically increased supply. And you can sort of construct plumbing explanations for each one of these different patterns. But taken together that suggests that we're in a new world where Treasuries are no longer that special.

And that's gonna complicate all of the issues that my co panelists have talked about. And I think the US Treasury is aware of this because what they did in 2023 is they massively shifted their issuance to the short-end of the yield curve. Because they probably realized that at the long end of the yield curve, that appetite for US treasuries is pretty much gone.

And that's usually a bad sign when governments start to shift their issuance dramatically to the short-term. And it also, of course, creates a lot of interest rate risk that has to be borne by taxpayers, as Kevin pointed out. So I'll stop there.
>> Dan Kessler: Wow, thank you, thank you, Hanno.

Thanks to all of you for really painting a very nice, clear picture of where we're at. Unfortunately. Let me, let me try to get you to think about how to dig our way out of this, okay? And what I'd like to do is start with a question sort of to Ross and Kevin, but anybody can answer.

Which is what are the sorta key political economy aspects that you guys would like to see us start with? And so, I can tell you from the perspective of a health person that the organized interests in healthcare, hospitals, doctors, drug devices, insurance companies, they're all very enthusiastic about the continued deficit financed support of health care.

And as that grows, that becomes harder and harder to get past. If you want to comment on the health business, that's great. If you wanna comment on the financial services business, because I think there too, they've benefited from the cheap money, from the easy money. And have been supportive of this, as Kevin put it, sort of an unfortunate symbiosis between Fed and the Congress.

And maybe just throw out a sort of radical suggestion here, which is that, if you agree with the hypothesis that the fiscal deficit caused expansionary monetary policy. And the expansionary monetary policy caused asset price inflation and asset price inflation caused inequality. Is there a new opportunity here for a coalition of sort of left and right to try to fix this nasty situation we've gotten ourselves into?

So, yeah?
>> Ross Levine: So, you sort of focused initially on the political economy. So I think that there is an opportunity. I wanna focus on three elements. One is the entitlement programs, in particular Medicare and Social Security. Second issue I would talk about is this the relationship between fiscal and monetary policy and financial regulation.

And the other is just government spending. So, it strikes me that the quiet in this room after the four of us spoke the depressed quiet in this room after the four of us spoke also gives rise to an opportunity to confront this challenge. And whereas Congress is not always particularly effective at getting things done, when there's something big, it tends to be fairly effective at getting things done, COVID, the crisis.

And I think to the extent that that underlie can be brought to bear on fiscal policy, there's opportunity for compromise. There was in the last Congress coming together on immigration policy. It fell apart for whatever strategic reasons, but it showed that on big issues people can't come together.

And that could happen perhaps on the entitlement programs. Nothing can happen on Medicare and Social Security, I think with one party. And so maybe an opportunity. I think, as Kevin pointed out, bringing spending, for example, back to pre Covid like all things, once we face a budget constraint, there's going to be a lot of disagree.

We may all agree that we need to have a budget constraint of that type. The issue is who is going to give up on what they're getting in order to get there. And this may be an opportunity for compromise to the extent that this is viewed as serious.

I kind of wanna echo and build on something that Kevin mentioned about the central bank. And here they're going to be under tremendous pressure to have continued loose monetary policy if the fiscal situation stays like this. And the other thing, they're going to be under intense pressure to deregulate financial regulations in ways that will expand the economy there.

I think there's an enormous risk in that they can do a lot of research suggests that if they deregulate, this will improve how capital gets allocated. This will expand economic opportunities, this will increase productivity growth. However, if done incorrectly, this could cause the type of bubble and excessive risk taking that we've seen in the past.

So I'll stop there and turn it over.
>> Kevin Warsh: So I'll build up a few of those things first. I'd say the reason why I'm maybe more optimistic than most is the American people actually have this all figured out. They might not have been able to recite the statistics that we did on this panel, but in their gut, they kind of know the country's on the wrong track.

78% of the American people literally say the country's on the wrong track. 75% think they're worse off than they were four years ago. We've had a series of change elections, so incumbent parties have had a hard time winning. So at some level, if you believe what I believe, which is the good common sense of hard working Americans, they figured this all out.

So as is often the case, they're actually leading the political change. They're not being told what to think. So that's why I think they get this as an inflection point. You might think with the stock market as high as it is, we're at full employment historically, they should have come into this last election feeling pretty good about their situation.

But they weren't because I think they kind of get it. So that's point one. Washington will follow where the people are and the people have this figured out. Secondly, inflation, inflation was probably the catalyst to them where they came to the view that those people in Washington don't actually look like they know what they're doing.

Paul Volcker said to me, but he said this commonly, I'm sure I was a young person being sent over to be a governor at the Federal Reserve. I went to go see Chairman Volcker at the request of the ranking Democrat of the Senate Banking Committee, who said that he'd support me if Paul Volcker supported me.

And I asked Paul a bunch of questions about the Fed monetary policy and he sort of cut me off. And he said, I wanna tell you what the job of a central banker is. So I take out my little notepad, my pen, and he said, the first thing you've got to do is get inflation about right.

But the key words about we really don't know how to measure it. We're not exactly sure how our tools work. You wanna get it about right, compare that to the false precision of what's happening in the academy at central banks right now. It's stunning, but the second thing he said I thought was more important than the first.

He said the second most important thing for central bankers and monetary policymakers and all economic policymakers is they gotta make sure they look like they know what they're doing. Well, this gang doesn't look like they know what they're doing. And the American people have that figured out too.

So, I think that inflation and common sense have said to the political class, this is different. And then as a final point, I'd just say this. The American people have figured out that there is a rivalry with an adversary in China that will define the 21st century. And if you think about when Washington and the American people have figured out how to make hard decisions, it's when they think that they're at a seriously important inflection point, what George Shultz used to call a hinge point in history.

And if the G2 rivalry is the rivalry that will define whether the next 30 or 40 years are peaceful and prosperous or poor and dangerous, it's that rivalry. We need to put our own house in order so we can confront that and make sure a cold war doesn't become a hot war.

That's why I think the political economy actually sheds light on this. The only part of it that gives me pause is the intellectual community, as Valerie suggested. A bunch of well meaning academics and policy people have said for the last 25 years there is a free lunch. There's a free lunch in spending, as rates will be so low we'll have secular stagnation and it'll be cheap.

They said there's a free lunch with the Fed cutting interest rates to zero, not just in crises, but for all seasons and all reasons. And there'll be no price to pay. So what we really need isn't actually to convince the American people. We need to convince our peers that are in policymaking circles and academia there's a price to pay and that their priors here need to be corrected.

>> Dan Kessler: Thank you, Hanno, did you have a question then Val?
>> Hanno Lustig: Just real quickly, I wanna follow up on what Kevin mentioned earlier. I think one appealing way for governments dealing with these sorts of fiscal challenges is they resort to what I would call a host of low interest rate policies.

Economists used to call this financial repression, and that could be any number of things. It could be incentivizing your banks to hold more government bonds. It could be having your central bank buy a lot of government bonds. And if you want an example of that, you could look at the Eurozone, you could look at Japan.

Japan's an extreme example of that. And these are sort of appealing for governments because usually the people that are being taxed implicitly don't understand that they're being taxed. So that's the appeal, but they are being taxed. If you're a depositor in Japan, your real rates of return have been very low.

And it's extremely hard to accumulate wealth when you're a depositor in Japan. So it's a very regressive tax in some sense, and I think that is one potential scenario for the US, is to keep going down this path of having more low rate policies being implemented. And when you look at sort of the types of reforms that financial regulators have implemented in the US over the past decade, they always favor financial intermediaries holding more treasuries, right?

Because they're not risky. But then things happen like interest rates go up dramatically and banks who hold long dated treasuries have, and mortgage backed securities get into serious trouble.
>> Dan Kessler: Valerie, do you have a comment?
>> Valerie Ramey: Yeah, I just wanted to circle around to your question about health care.

And I really think that there's something there. So as you know, we already indicated that that's a big part of the projected increase in the debt is all of this government health care spending. But it's really part of a bigger problem, which is the entire US health care system.

So we spend 18% of our GDP on, on the health care system, way above every other country. And the question if we can do something to sort of unleash free market forces that had lead to so much innovation in other areas of the economy. But have trouble doing that because of all of the byzantine rules in the health care system and the non competitive market behavior.

Then you could not only reduce that path of health care spending by the government, but you could also increase growth in the US economy because then you could reallocate resources to the other sectors. So if we can figure out how to do that, that would be a win win both in reducing the numerator and the debt to GDP ratio and raising the growth of the denominator.

>> Dan Kessler: Couldn't agree more. Actually Valerie, let me come back to you with a question about history.
>> Valerie Ramey: Okay.
>> Dan Kessler: So, when we started we were talking about, well, there's gonna be some mix of these four things. And we were talking yesterday and you said, actually we have an example from history about how the US dealt with very high debt to GDP ratios post war, post World War II.

And, so what happened there?
>> Valerie Ramey: Okay.
>> Dan Kessler: I mean, what was the mix that we used?
>> Valerie Ramey: So as a lead up, a number of prominent economists before were saying that we grew our way out of debt, that big peak at the end of World War II. Well, subsequent studies have found that that's not quite right.

So for example, in a recent Brookings discussion, I calculated just for the three years after World War II, the debt to GDP ratio went down 28%. Now how did they do that so quickly in three years? Well, part of it is they eliminated the deficit and ran small surpluses.

And so the debt level actually went down by 8%, but GDP went down by 8% because we came down from those highs of World War II. So those canceled each other. So then how did the debt to GDP ratio go down so much? Inflation prices went up 28% because all those price controls during World War II were lifted and all of those savings bonds that they told everybody to buy were in what we call nominal terms.

So then suddenly you inflated away the value of 28% of the debt. Now recent paper by Larry Ball and his co author then also look at things through 1974, which was the trough in those graphs that I showed you. And what they found was it was a combination of not having deficits most of the time or having small deficits, having surpluses sometime, but also that they distorted the interest rate to make it artificially low.

How did that happen? Well initially it was because the Federal Reserve was pressured to keep interest rates at zero until finally they complained and we had the Treasury Federal reserve accord in 1951. But then there's something that also distorted the interest rates that Larry Ball and his co author talk about, which is that there was surprise inflation.

So that the real interest rates people were earning in the 70s and the 80s were actually negative, which helped the federal government lower that debt to GDP ratio. So it was inflation and not running big deficits that did it. We didn't, growth was part of it, but was the minor part of it.

>> Dan Kessler: Thanks, that's very helpful. Hanno, let me direct a question sort of to you about what happens if we don't really succeed. Are we gonna look like something like Japan? A whole lost generation due to flawed monetary and fiscal policy, I mean, or is that overblown? Is that just not gonna happen?

>> Hanno Lustig: Well, let me give you a sort of a two pronged answer. So first if you look for a historical analogy, I'd say look at the UK before the First World War the UK was the world's safe fastest supplier. And then during the interbellum they really were in very narrow fiscal straits, and the US kind of took over the baton from the UK as being sort of the the world's safe hat supplier.

The dollar became the reserve currency. So what happened in the UK? Well, it's kind of sobering actually if you look at it, they were in serious fiscal trouble. As you probably know, the UK in the First World War had borrowed a lot from the US intergovernmental loans and it was actually forced to default and it is still in default on these loans.

It formally defaulted on these loans in 1934, I think. There was actually also some restructuring of a major war bond. A 5% coupon bond was sort of turned into a 3.5% coupon bond. So they were really in fiscal straits and in very narrow fiscal straits. And if you sort of look at measures of this convenience yield that I mentioned earlier.

So before the First World War, gilts were more expensive than other bonds, which should sound familiar, that used to be the case with US treasuries until recently. So, in fact, Hamilton expressed frustration when he was Secretary of the treasury at the fact that the UK was able to borrow a lot more at lower yields than the US in its infancy.

That pattern completely flipped. So after the Second World War, the British were always forced to borrow at higher interest rates, and their fiscal capacity, I'd say, was dramatically reduced. So that's kind of a warning that when you exhaust the privilege, that can be a rude awakening. Japan, as you mentioned, and I'll keep this brief and feel free to cut me off when I'm going over time.

Japan is sort of at the leading edge of this demographic transition that causes all this trouble, right? Because Japan, the government there, has made all these promises to the older generation that it's reluctant to default on. And so what Japan has done, I think, is massive financial repression through the Bank of Japan.

What the Bank of Japan has done over the past decade and a half is it's basically bought almost all of the bonds that the Japanese government has issued. What does that mean? Well, essentially what it means is that the Japanese government, if you sort of consolidate the Bank of Japan and the treasury, is not really borrowing in the bond market.

What they're doing is they're borrowing through the central bank by having the central bank issue reserves, IOUs that are held by financial intermediaries. And you do that, you borrow at a policy rate, a short term policy rate, not at a market determined interest rate. So that's one thing.

They're borrowing at artificially low rates. And then they turn around and through the Japanese pension fund, they actually make a bunch of risky investments. So in a way, what Japan is trying to do is they're trying to run a Norwegian style sovereign wealth fund, but with borrowed money.

And you're probably thinking, can you do that? Well, not if you let the market work, right? So the problem here is of course, that the rate at which the Japanese government is borrowing is not reflective of the risks it's taking on its asset side. And implicitly what you're doing there is, as I mentioned earlier, you're taxing the Japanese depositors.

The ratio of deposits to GDP in Japan is 200%. The model median Japanese household saves in deposits for various historical reasons that I probably don't wanna get into. And so they're being taxed dramatically. So that's a very costly form of financial repression and extreme form, but I think it's an interesting template to study for where the US might go.

>> Dan Kessler: Kevin and Ross, do you guys have any concluding remarks before I open it up?
>> Kevin Warsh: Sure.
>> Dan Kessler: Please.
>> Kevin Warsh: I was triggered by that last set of comments. So Inflate, Devalue and Repress is the standard economic textbook about what great empires do when they find themselves at this perilous moment.

And it would be deeply destructive to the ethos of the country, deeply destructive to our economy. Do the most harm to the least well off among us, as was spoken about on that prior panel. But wait, there's more. It would also make the world more dangerous. After England, the United Kingdom passed the baton of leadership to us, the world, though it might not always seem it, since World War II was somewhat more peaceful and prosperous than in all of human history.

From 1946 until the present, the US led an economic commons in the world and a security commons. If the rest of the world thinks we don't know how to run a banking system, remember 2008, we don't really believe in federalism and liberty. Remember the COVID crisis? We don't really know what we're doing to ensure stability.

The world will no longer be that impressed with our economic or our national security might, and the world will become considerably more dangerous. I don't know who will stand into that void to show respect for the rule of law, for sovereign borders. So, a bunch of academics can well think well, if we just had inflation at 3% instead of 2%, we could just sort of, through some financial engineering, make this all right.

We just tell the banks that they're really arms of the government, they're too big to fail and they'll buy bonds no one else will. This is a muddled middle ground that not only does real harm to what has made the country stronger, but it's also been the beacon for global security.

So I think it's a very dangerous recipe.
>> Dan Kessler: Thank you, thanks, with that, let me open it up to you folks. If folks have questions, please just come on down to the microphones and I'll take them in groups of three, just like we did last time. Sir, go ahead, please.

>> Speaker 7: Yeah, question for Kevin. You're solution was to return spending to where it was back in 2019. If understand that correctly, are you saying we should reduce Social Security, Medicare and defense back to 2019 levels?
>> Kevin Warsh: Well, the good news is I'm a has been central banker and good central bankers stay out of the sort of political choices.

Now, central banks in more recent times haven't been quite as good about that. They have been calling for spending when times are tough and have somehow lost their voice in other times. So they've been asymmetric. I'll stay out of the business, but I would say that for the incoming administration, going back to a 2019 baseline for discretionary funding won't solve the problem, but I think it'll buy us a lot of time.

I think it'll show a demonstration of credibility that this government is serious about taking the waste, fraud and abuse and the excess spending that we did for a short period of a crisis, and we decided to turn that into a permanent welfare state. There is no reason why the government needs to be spending 52% more today.

So I would start at discretionary, and I would build some confidence that we know how to do it. That does have an effect on macroeconomic statistics. We've got to pass the baton from government spending, which has a multiplier of every dollar we spend, in my view, tends to be worth less than a dollar to the economy cuz we don't spend it very well.

Pass that baton back to the private sector where they tend to spend it a lot better. So I would surely begin with discretionary spending and think about 2019 as a baseline. And in some sense some of the work coming out of that Department of Government Efficiency led by Elon Musk is, I think, an attempt to do that.

And it does seem to have more support at least in the Republican Party, than arguments that had made before to bring the government back down to size. So that's where I begin.
>> Dan Kessler: Thank you. Let me take the three folks we have up here and then I'll pass it back to you all.

Sir, go ahead, please.
>> Speaker 8: So, first of all, thank you very much for a very sobering discussion. The question that I have is really trying to reconcile some numbers that are in my head. One of the gentlemen stated that we are the highest tax rates. And I find it hard to reconcile with what I thought were my facts, which was the corporate tax is down to 22%.

And that was lowered after 2019 tax reduction by Trump, which contributed to $1.8 trillion of increased deficit, which I didn't see reflected in the slide that Valerie showed. Also, we're at the lower rate since the 1970s in terms of individual taxes. So I kind of have a hard time understanding how do these numbers relate to the statement that we're the highest tax rates in the recent history.

>> Dan Kessler: Thank you.
>> Speaker 8: Additionally, I'm not a big tax person, but I do believe that the problem needs to be attacked from multiple facets, and tax is one facet that I didn't hear stated very much in the panel.
>> Speaker 9: Thank you. I was actually wondering if we're gonna get people to reduce spending.

It seems to me that we need to educate voters more cuz it seems to me not since probably like Ross Perot in 1992 has anyone cared at all about this stuff or known anything about it. We need someone holding up charts and pointing to things because I think politicians will respond to pressure from voters.

And so I guess I wanted to ask, how do you think that we can sway the public, educate the public so they actually know about the stuff you guys are talking about and understand it on a basic level.
>> Ross Levine: Thank you, ma'am.
>> Speaker 10: I just wonder if you foresee an actual tipping point where some catastrophic event would happen, affecting the economy, I hate to say it, by something like a failure of a treasury auction or something like that.

>> Dan Kessler: Thank you, okay, would any of you like to respond to any of those three? Valerie and then Hanno.
>> Valerie Ramey: I'll talk about taxes.
>> Dan Kessler: Please.
>> Valerie Ramey: Part of the increase in the debt to GDP ratio has been tax cuts, starting with, I mean this is what was different after 2000.

Because remember, Reagan had tax cuts at the same time he built up defense spending and that's when we saw it go up. But then the spending went down with the fall of the Berlin Wall. But then also remember both parties, Bush Senior and Clinton also raised taxes. And that was part of the mix in terms of the corporate taxes have gone down, some other taxes have gone up like Medicare and those sorts of things.

If you go back farther, you're right, we're not at all time high tax as a percent of GDP, but for say the 21st century, we are right there in the average.
>> Dan Kessler: Thanks, Hanno, did you have a comment?
>> Hanno Lustig: Yeah, I'd like to address the point about educating voters.

I think that's a great point. And actually, so when I talk to my family and friends in Europe, that's always the first thing they mention is that when they follow the presidential campaign. There was almost no mention when there's a new proposal, well, how are we gonna pay for it?

Whereas if you follow an election in Europe, and I think that's probably true in the rest of the world, that's always the first thing, like the moderator of debate will ask how are you gonna pay for this? That somehow just doesn't come up in the US, and I think that's partly because of this exorbitant privilege that I've talked about.

But yes, we need to make sure we educate voters. And I have to say in that sense, I feel like when I'm sort of just reading the newspaper on a daily basis, I don't feel like journalists here do a great job at that. They typically don't bring up these fiscal issues and they perpetuate this myth that we could just keep rolling over deficits and there's no sense of urgency.

So I think that that might help if we get journalists to do more of that, talk more about that, actually.
>> Dan Kessler: That and MBA instructors of economics, right? Of which you all are, have been a part. Well, I think we are out of time actually, so thank you very much.

Sir, do you have a question? Go ahead. We have time for one more, please.
>> Speaker 11: You mentioned deflate, revalue, suppress, and the USA will be less impressive in the world stage, which makes the world stage a little more dangerous. You alluded to a vacuum and some countries might step into that vacuum of power globally.

Can you just look in your crystal ball and say what possible countries or institutions might step into that vacuum. That'd be fun to know.
>> Kevin Warsh: It's always the last question that gets. We almost got out of this okay. So I don't know. I would say over the course of, again, I use 1980 as this fulcrum point in US history.

And I think that there are some parallels till now, we don't know who is going to seize power. We don't know who's going to do that. But I think we do know that when the US retreats from playing its leadership role, that adversaries decide that they're going to try to seize it.

The adversaries can be terrorists in the Middle East, they can be great powers pushing borders around. So we never have a great sense of that. But I would say over the course of the pre-1980 period, our allies weren't sure they could trust us. And our adverse were pretty sure they didn't fear us.

If we go back over the course of period of more recent years, did our allies trust us and think we would be there for them on national security grounds or were they less certain? Did our enemies fear us? As we think about wars that have built up over the years, we need to put ourselves economically in a position so that we are putting our best foot forward.

So this is the economy that's the envy of the world. So we're standing up for first principles. We never do everything perfectly. But that economic growth then gives a gusher of revenue such that we can build up our national security deterrence. I think it was Eisenhower who said the only thing more expensive than a first rate army is a second rate army because the world gets more dangerous.

I don't think we're breaking news here to suggest that the G2 rivalry, the rivalry between the US and its allies and China and its allies is the formidable fight. The great power competition that will define whether the 21st century is one of peace and prosperity or not. And so we wanna do everything we can in economics to make sure that adversaries around the world, they might not like us, but they respect us.

They might not run their economy the way we run it, but they think we actually more or less know what we're doing. So that's why this can all sound like bean counting, budget math. But I actually think it's much more consequential than that. And if we can leave this period of the next year or two with an economy that's stronger, then I think almost by definition, our deterrence against adversaries of the US and its allies will be a little bit more cautious.

They'll stand back a little bit more, and they'll ask themselves, does the US have the strength and the will to defend what it believes, or is it too weak by those standards? And that's where I think a new economic and security commons like the one that George Shultz helped preside over and lead over in the post war era is incumbent upon this group.

And so, with that final word, I'll turn it back to our moderator.
>> Dan Kessler: Thank you. And thanks to all of you for a wonderful, if a bit sobering presentation. And thank you. Thank you for great questions and for being here.