Economist Veronique de Rugy on debt debate++

Sean W. Malone Producer and Composer
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On Thursday, Daily Caller multimedia producer, Sean Malone and GWU intern Francesca Nestande visited with economist Veronique de Rugy at George Mason University’s Mercatus Center to film a broad-ranging interview about the current debate over raising the Federal debt ceiling. Although the Obama administration has insisted that failure to raise the amount of money the Federal government is allowed to borrow would result in a nearly immediate default on the payments made on the National Debt, Dr. Veronique de Rugy (Ph.D, University of Paris-Sorbonne) disagrees.

Some of the rhetoric coming from the Democrats in Washington has suggested that the Republicans are playing a dangerous game of “chicken” with the economy by refusing to negotiate or accept tax increases as a part of a deal to raise the debt limit. But according to many Republicans, this debate represents an opportunity to make structural changes in the way government operations are financed.

Both Republicans and Democrats are trying to paint their opponents as irresponsible. The Obama administration, as well as the majority of Democratic Party politicians, claim that unless the debt ceiling is raised, America would almost immediately be forced to default on its debt obligations. But they rely on a number of assumptions, both about the debt itself and about America’s true range of options for making payments. Some economists like de Rugy, a Senior Research Fellow at GMU who studies budget and tax issues, view the administration’s claims as promoting a false choice to the American people.

While some on-camera excerpts of this interview will appear in future multimedia video projects, given the significance and immediacy of the topic, the full interview is worth sharing.

[Note: Portions of this interview have been edited for clarity.]

Sean: Some Americans may not fully understand what the debt-ceiling debate is all about, so first let me ask, what constitutes a default in this case?

VR: Typically a default is when you fail to pay your bondholders the interest that is due, and also the principal that has come due. That’s a default.

Sean: The payments that we’re making on the debt are mostly interest payments, with only a little bit of principal, right?

VR: Yes. Well, a lot of the US debt is short term. […] Every four, four and a half years, you have to either pay the principal or roll it over and borrow more money and maybe roll over some interest and things like this into the new principal. That’s what the US does. It’s like refinancing your mortgage, right?

Sean: In terms of the total debt, what is the difference between intragovernmental debt and the debt that treasury bondholders are owed?

VR: So, you have two parts of what we call the “gross debt.” Roughly nine trillion is debt held by the public. That’s the money that you owe, that you’ve borrowed from foreign and domestic investors.

And then you have intragovernmental debt. It’s an additional four trillion something dollars, and that’s actually the money that the federal government has borrowed against other government trust funds, like Social Security trust fund, the Medicare trust fund. The biggest one is the Social Security trust fund. It has roughly 2.5 trillion dollars. So here’s how it works. Let’s take the Social Security trust fund. Since 1983, when the rules about Social Security were changed, we’ve been collecting more payroll tax than we need in a given year to pay beneficiaries their benefits. The difference of that tax collection goes into the Social Security trust funds. There are two of them.

By law, that money has to be invested in treasuries. So, the trust funds give the cash to treasuries against IOUs. […] Those IOUs and what’s in the trust fund, that’s intragovernmental debt.

Sean: So, what happens if we don’t raise the debt ceiling?

VR: Well, the assumption behind our potential default in two weeks is the fact that first we have to pay all of our bills. Everything. From our bondholders to, you know, our Social Security payment, Medicare, Medicaid, but also defense, and also the subsidy to NPR, the farm subsidies – all of that stuff. And also that there’s nothing that we can do to actually get money elsewhere, right?

So that’s the assumption. The assumption is we’re stuck having to pay all of our bills, and we don’t have cash stashed anywhere. It’s not true.

First, Treasury can actually prioritize and pay our bondholders the interest payments and the principal that’s come due. Also, it will have to pay Social Security because as long as there are assets in the trust funds, these assets have the value of a bond, and I’m assuming that this takes priority over a lot of things.

But, Treasury also collects money.

I mean, it will be able to pay all this with the revenue it collects. Then it will have to prioritize, right? That’s if we assume that some of the payments are not going to be made. The great news is we [can still] pay all of our debt because the US has some assets that it can actually cash and use to pay for things.

For instance, we have non-restricted cash that we can use and make payments with. My colleague, Jason Fichtner and I, we’ve made a very conservative list of all of the assets that we could sell, and it’s roughly 2.4 trillion dollars.

Let me give you one simple example. Why don’t we sell the TARP assets? There’s roughly 170 billion dollars of TARP assets. Let’s sell these to make Medicare and Medicaid payments.

So basically, just to recap, the assumption that we’re going to default rests on this idea that all bills have to be paid, and there is no stash of money anywhere that we can tap into to pay these bills once we’re done, when we’ve exhausted all the revenue that the government collects.

Sean: Obviously selling assets like you’ve described would be a one-time thing, so what would we need to do after we sell the TARP and other government assets?

VR: Yes, so I mean, the debt ceiling will have to be raised. There’s no question about it, because there just aren’t any budget proposals out there that actually don’t require for the debt to grow. So that’s like, so the question is really not whether we’re going to raise the debt ceiling or not, because we’re going to raise it at some point, right? The question is when and under which conditions? These are the actual questions.

Sean: Is there a false dichotomy between raising the debt ceiling and instant default?

VR: Yeah, it is a false dichotomy to say that if we don’t raise the debt ceiling, we’re going to go into default. Because it assumes that first, we don’t have the ability to prioritize our payments and, more importantly, that we don’t have other assets that we can use in order to pay all of our bills.

Sean: How long do you think we have, realistically, before we have to raise the debt ceiling?

VR: It’s hard to tell. I’m not, you know, Geithner. I mean, I don’t exactly know how long we can go, but, we may be able to go until the end of the fiscal year. More importantly, what it means, there’s no rush. I mean, we need to be able to get a good deal, you know, lawmakers need to be able to make a good deal out of raising the debt ceiling so that we get off this unsustainable path that we’re on.

Sean: Is the politicians’ debate about the debt ceiling mostly demagoguery?

VR: I think a lot of the debate is demagoguery, but, I mean, this is politics.

So all the options that we have are not easy options. But we’re in a very difficult situation that we’ve put ourselves in, and there’s just, there’s no easy way out.

We’re going to have to do something. But, on the Democrat side, what they want is, they want to be able to do what we’ve done, you know, the last ten years, the last twenty years, the last thirty years — just raise the debt ceiling without any strings attached. Just raise it and just keep on our merry way until we hit the wall and actually default because we really can’t pay our debts. But it doesn’t have to be this way. There is actually really no reason why we should default, you know, in the next two weeks or three weeks, or probably a month, a month and a half.

Sean: I want to talk about your, and Nick Gillespie’s, “19% solution”. You guys have been pretty critical of Paul Ryan. Obviously you can’t be critical of the Obama administration because they haven’t really offered anything.

VR: Yeah, well no, they have offered. I mean, the Obama administration has proposed a budget that doubles the debt held by the public in the next ten years.

So, I mean like, the Obama administration actually proposed a budget in February, and in the next 10 years, debt held by the public will go from, let me think about it […] In the next 10 years it’s going to double from the nine trillion dollars that it’s at right now to something like, I think, eighteen trillion dollars basically. And interest on our debt is going to actually grow by one trillion dollars — the interest on our debt alone.

Yes, so we can look at this budget and say, “Yeah, debt will grow dramatically.” Under Obama’s budget, I think, if I remember correctly, debt held by the public will double in the next 10 years.

Sean: The Obama administration is working off an economic model that is far more Keynesian than you might prefer. But, for example, Paul Krugman certainly believes that the government should be spending even more money to get us out of the recession. What would you say to critics who say that we can’t risk default and we also can’t deal with the budget and deficit problems today because of the financial crisis, because we need to keep spending on social services?

VR: Well, I would say that we’ve tried spending a lot of money to jumpstart the economy, and obviously it hasn’t worked. Except we’ve been saddled with a lot of debt, and I really don’t see why doing more of the thing that hasn’t worked, you know, is a really good idea.

More importantly, I mean, people are really worried about what investors are going to think, and the big worry is that if we don’t raise the debt ceiling, investors are going to freak out and are going to ask higher interest rates by fear of default. Well the academic literature about when there are big shifts in interest rates driven by fear of default [shows that it’s] not when a country is actually trying to put its finance in order, it’s actually when they don’t and they keep actually behaving like a restless teenager and spending and spending and spending.

So, I think continuing on the path we’re on is absolutely irresponsible because it gets us closer to the time when our investors are going to rightfully understand that we’re closer to not being able to pay them back, and as a result, they’re going to fear that the Fed is going to print out a lot of money. They’re going to ask for an inflation premium in the form of higher interest rates, and because the US has so much debt, we’re extremely vulnerable to any big shift in interest rates. So it’s absolutely irresponsible.

Sean: According to a recent article by economist Robert Higgs, one of the main reasons we haven’t seen inflation in spite of the huge expansion of the monetary base (M0) is that very little of it has actually made it in to the money supply. Do you think the Fed is capable of counteracting inflation in the long term?

VR: Not at this level. Probably not at this level.

First, let me say, there’s a case to be made that there is already inflation. I mean, we’ve seen pretty noticeable increases in the price of food and other items.

But, the reason why we haven’t seen as much as we’d expect to see considering the expansion of the monetary base is because the economy is just not doing great. Firms, as well as investors and entrepreneurs and people are sitting on their cash. They’re not consuming. They’re saving.

They’re sitting on their cash, and as soon as they start actually to feel that the economy is doing better, they’re going to release this cash into the economy, and then that’s when, you know, trouble starts. When you look at the yield curve, which is basically the projection of what investors think the long term path of inflation is going to be, taking under consideration all the policies that are in place, I mean, you have no doubt that everyone is expecting pretty important inflation. And if you want actually to see firms acting on it, you know one of the biggest bond holders, PIMCO, has actually moved away from long term debt into short term debt because to prevent against this, to hedge against this long term fear of inflation.

Sean: Going back to Obama’s policies, and those advocated by economists like Krugman, or Brad DeLong, etc., is there any way to spend our way out of the recession?

VR: I mean, wasn’t that the idea behind the stimulus act of 2009? But we haven’t seen any of these effects. Remember what the promises were, right? I mean, the threat was if we don’t spend 789 billion dollars, unemployment is going to go past 8.8%. And, we’ve spent the money, and yet, you know, unemployment rate is actually past the 8.8%, hovered around 10% for a while, now it’s to 9.1%. So, those promises have not panned out.

Maybe more importantly, the reason why government spending can’t jumpstart an economy is because it’s making the assumption like that morphine can actually fix a broken arm. Imagine your arm is broken, like our economy, and you inject morphine. For sure, the pain will go away while you’re getting these shots of morphine, and the people who get the stimulus money or get a stimulus job, of course they feel better. Of course you see this little blip in GDP, especially considering how government spending is [included] in GDP.

But the problem is like when the shots of morphine go away, your arm is still broken, or worse. Maybe it’s fixed in the wrong place, and you will be left with pain forever. It’s the same with government spending. Once the government spending [ends], these jobs will go away, and we’re saddled with gigantic amounts of debt. This is why this does not work.

But then there’s another argument that’s more subtle and somewhat interesting. Always what I see is there’s this theory, right, that if you spend on big, you know, building construction, road construction, infrastructure, then you will inject a lot of money into the economy. But those stimulus [packages] are never designed this way. So the latest stimulus package, only 3% of the whole spending actually went to shovel-ready projects.

Sean: President Obama joked that some of the shovel ready projects weren’t as “shovel ready” as he had hoped.

VR: But it’s not really funny when you just actually made that promise to Americans and spent 789 billion dollars of our tax dollars on that, especially at a time when we all feel pretty poor.

Sean: Do you think that there is a comparison that can be made between household spending and government spending?

VR: Yeah, absolutely. Well, actually, I think about it all the time with the debt ceiling debate. That is, right now, lawmakers are telling you, “We need to pay all of our debts, and there’s no way we’re letting go of any of the assets we have.” Whereas households know that this is not the way it works.

When you’re coming to a crunch, when you’ve spent way too much money, first you need is to trim down your spending. You need to prioritize. Make sure you pay your mortgage. All the things that would have actually dramatic consequences on your credit score; that’s what you pay first, and then you see what you can actually postpone, or just not consume any more. And, what we do is like, we actually tap into our savings. That’s what we do.

That’s not what the government is actually talking about doing right now. They say we cannot use our cash. We have to pay absolutely everything, and not prioritize; and by the way, we’re going to continue on our merry way to spend and spend and spend, and we put ourselves in the situation that got us in this mess in the first place.

Sean: Irrespective of politics or what pundits would describe as “politically feasible”, what would be a legitimately effective solution to get us out of our debt situation?

VR: Right now, lawmakers have to find a way to put us on a different path before they can commit to actually borrowing even more money.

So, the good thing is that we have assets they can use to actually pay our bills as tax revenue dries out. And, so we can wait and design a good plan. And I think, rather than do and focus on a one-time spending cuts, which are very unlikely, by the way, to be actual spending cuts, if history is our guide.

Sean: Talk about that a little bit.

VR: So first they wanted a hundred billion dollars [in early 2011]. Republican wanted a hundred billion dollars. And then it went to 61 billion. And then they ended up getting, what, 33, is that what? And then it turned out it just really wasn’t cuts at all.

So we’ve been down that road before. I mean, we’ve been down that road before too when they say, “Okay, we’ll make a deal,” and they say that there will be like two trillion dollars cuts and one trillion dollars tax revenue. And what you end up getting is the tax revenue increase, but then the spending cuts never take place. Very often those spending cuts are fake spending cuts.

Basically they agree to not grow spending as fast as it was supposed to grow. These are not actual cuts. More importantly, cutting even Medicare here and there is not actually changing the path we’re on which is driven by the gigantic explosion in Medicare, Medicaid, and Social Security spending; driven by Baby Boomers starting to retire.

Sean: In the current budget discussions, they just want to make across the board cuts. There’s no prioritizing, no cutting of whole programs.

VR: Well, I mean, you see it all the time when there’s all these talks about how if only we could get rid of waste, fraud, and abuse, then we would be fine, right?

First, fraud, waste, and abuse defined the way lawmakers are thinking about it is just not getting us out of this mess.

But more importantly, they’re not thinking about fraud, waste, and abuse the way I think about it, which is, you know, that waste is basically when the federal government does all the stuff that it shouldn’t be doing because the either the private sector should be doing it: funding museums, NPR — or because the states could do it: education, roads.

This is not the role of the federal government. This is waste, but they don’t want to think this way. They don’t want to actually have a conversation about what is the role of the federal government, and should the federal government even be involved in funding all that stuff.

Sean: Walk me through this; what would you prioritize, and how would you get us out of this debt crisis?

VR: So part of the deal, I think, rather than have these fake, one-time cuts — let’s even imagine that it’s a good deal, it’s still a one time cut.

Rather than this, what I would like them to do is put in place fundamental, institutional reforms. Block grant Medicaid. Put spending caps, put budget rules that actually really bite. Things that lawmakers can’t go around. You know, maybe a spending cap constitutional amendment so it binds future Congresses. A lot of these budget fixes usually don’t bind the hands of future Congresses. I mean, I think at this point that would be more productive than a one-time cut, which are not likely to be cuts anyway.

Sean: Please talk a little bit more about the 19% idea… Really the question that I want to ask is: Why can’t we just tax more to generate enough revenue to cover current (and future) government expenditures?

VR: So, in that piece called “The 19% Solution” with Nick Gillespie in Reason Magazine, one of the things that we actually wanted to bring to people’s attention is that unlike regular families, the federal government seems to be completely disconnected from the fact that it shouldn’t be spending more than it actually makes.

We used the title “The 19% Solution” because 19% as a share of GDP is the upper limit of what the federal government can realistically collect in tax revenue. And the reason why we said this — and by the way I actually think this is even a little, you know, optimistic on our front — the federal government has […] really never been able to collect more than 19% on a sustainable basis for more than a few years. Whether marginal tax rates were high, whether marginal tax rates were low, whether they were, you know, smack in the middle, it just can’t collect more money.

Sean: Why do you think that is, by the way, because one obvious response to that statement is: “Well, European countries collect more than 19% of GDP in taxes all the time.”

VR: But I mean, it’s very different. It’s an easy thing to say, “Well, if we had a completely different tax code, we could do it, right?” That’s completely changing the debate, right?

There are two reasons [why, under the current tax code, we can’t do it].

First, the more you tax people, the more likely they are to either work less or hide their revenue, or just do a lot of things and engage in a lot of activity that is actually not going to bring about more revenue in spite of having higher marginal rates.

The second very important reason, I think, is because fundamentally, what lawmakers are in the business of is buying votes.

So while they may be willing to increase marginal tax rates, what they do when interest groups come to their office and whine about the increase in rates is to say, “Well, okay. We’ll exempt your industry.” Or, you know, if you have three children or two children, what we’ll do is we’ll carve the tax base. So while you have increase in marginal rates, basically the tax base that this rate is applied on shrink and then you don’t collect as much revenue. I think these two things together explain why we can’t raise more money.

Sean: And your solution was fairly simple… don’t spend over 19%.

VR: Yeah, we need to kind of bring back this idea that the government should only be spending reasonably what it collects, right?

I mean, it just doesn’t seem crazy to most American families, but for some reason, there’s this gigantic fiscal imbalance [within the government] that doesn’t seem to bother anyone.

Take 2011: The government is scheduled to spend 3.8 trillion dollars while only collecting 2.2 trillion dollars. And by the way, I’m always like stunned to see people say, “Oh yeah, but we can’t touch our savings. Let’s just borrow more, borrow more.” You know, it makes no sense. The way this city [Washington, DC] thinks, and the pundits that inhabit it, it’s just completely off. It is so disconnected from the way American families think about this stuff. It’s just crazy.

Sean: So, are some Republicans’ plans to cap the budget realistic?

VR: Well, but we need to cap it at a much lower level, right?

Sean: You don’t think Paul Ryan’s, or any of those budgets, go nearly far enough in capping spending.

VR: No, absolutely not. More importantly, everything ought to be on the table. Defense spending, the Social Security, Medicare, Medicaid spending needs to be on the table. Non-defense spending. Everything ought to be on the table.

But, I mean, […] I’m in favor of capping spending. The problem is that I don’t know how in this system, that capping spending alone is actually going to address the problem that we have, because we have these autopilot programs that are like marching towards this gigantic spending explosion, and it’s going to put so much tension on the programs. The expectation is that these lawmakers are going to be like, “Oh yeah, we can respect these caps”, but if history is our guide, when those caps become inconvenient, they just repeal them or let them expire.

I mean, we’ve seen this with the Republicans in the 90’s and in 2002. So they’re just going to repeal them, and this is why we need to actually fundamentally change the way these programs are spending money. I think it is really key, in the debt ceiling debate, as well as in any budget debate, to make people understand that the way lawmakers are thinking is just completely nuts.

It’s like, we can’t cut any spending, we can’t touch our savings, and we assume that investors are going to be totally fine letting us do all that crazy stuff without every responding.

Sean: Do you think that our AAA bond rating is in danger?

VR: So here’s what the S&P bond rating threat was. It was like, “We don’t believe you’re going to default right now, however, the pressure put on the US system by this explosion of Social Security, Medicare, Medicaid spending is actually putting you in a very precarious situation, and we think that, you know, starting in the next two years there is a chance that you’re going to lose your rating.”

That’s really the message that was sent.

Sean: And do you think that we could stave that off?

VR: I don’t see — I mean, obviously raising the ceiling is not necessarily my preferred option — but I don’t see how we can get away with it. I don’t necessarily have a problem with raising the debt ceiling in the short term if we actually do it in exchange for a fundamental change in the way we’re going to be spending money in the future.

But raising the debt ceiling without making these fundamental changes is crazy. And, as I said, the academic literature is actually pretty clear that investors freak out, not when you actually try to put your house in order financially, but when you actually continue on the same crazy path, right?

Sean: Do you see any hope for making a deal that is actually valuable or can function as intended?

VR: The hope I see is in the dramatic situation we find ourselves in. We can keep saying, “We’re not going to do it. We’re not going to do it.” There’s just a moment when we won’t have any choices.

We’re going to have to actually really rethink what we want from these programs and I think we’re going to have to come to terms with this idea that it’s not because you’re 65 and American that you’re entitled to some government payment for your healthcare or for your retirement. In fact it’s not even beneficial to you because government spending always comes with gigantic strings attached. I think we’re going to actually refocus on the original intent of these programs, which is actually taking [care] of the people who are really poor and who really can’t take care of themselves.

Certainly we’re a society that’s rich enough that we can take care of these people in spite of all the inefficiency that comes with government run programs.

But we don’t have any choice. People, I mean, lawmakers will drag their feet, but there’s a moment when they’re going to realize we don’t want to end up in the situation that Greece is in […] and I’m not saying we’re going to be Greece tomorrow, but you know, when things start to go bad, they go bad really quickly, and we don’t want to be in a situation where there’s just really no good options.

Sean: Do you think there’s a chance that we would end up in Greece’s position? In Greece, and in France where you’re from even, people are taking to the streets because the government has cut their benefits…

VR: When in America, we have the Tea Party actually complaining about the fact that the government is too big?

Sean: Sure. Do you think this Tea Party mentality is enough so that America won’t go down Greece’s path?

VR: I hope, but, you know how Greece and France and all these countries became what they are is because a majority of people started [collecting benefits] from the government, right?

And, I’m afraid the more we create, you know, government programs that most people benefit from [but don’t pay into], it makes it harder and harder and harder to actually find people who are not benefitting from government and are willing to change things.

So, I hope that America will always be different, but I can see a path where we’re just going to become more like Europe. I think we have already gone down that path in the last 10 years. I mean the Republicans have been just awful, and they’ve been gigantic spenders, and obviously, you know, President Obama is just President Bush on steroids. So, I’m worried.

Sean: Thank you so much for your time this morning.