That Used to Be Us: How America Fell Behind in the World It Invented and How We Can

by Thomas L. Friedman

  This great loosening was brought about, in part, by a generational shift in the Republican Party. The old guard, the members of the World War II generation, which included Richard Nixon, Gerald Ford, George H. W. Bush, Bob Dole, George Shultz, and Ronald Reagan himself, believed in keeping the deficit under control—by raising taxes if necessary. They were succeeded by a new generation of Republicans, led by Newt Gingrich, Tom DeLay, Dick Armey, Dick Cheney, and George W. Bush. The new generation took as its hero an imaginary version of Reagan, one who, unlike the real fortieth president, believed that deficits don’t matter and opposed raising any taxes at any time under any circumstances, especially for the wealthiest Americans.

  As noted, Bush’s first Treasury secretary, Paul O’Neill, was pushed out after resisting the administration’s decision to enact a $350 billion tax cut in 2003, having enacted a $1.35 trillion tax cut just weeks after entering office in 2001—at a time when the budget was essentially in balance. “I believed we needed the money to facilitate fundamental tax reform and begin working on unfunded liabilities for Social Security and Medicare,” O’Neill said in an interview with The Washington Post (May 1, 2011). The White House, he said, was focused on improving economic growth for the fourth quarter of 2004. “They wanted to make sure economic conditions were great going into the president’s reelection.”

  Looking back on the whole period in an essay in The New York Times (July 31, 2010), David Stockman wrote:

  In 1981, traditional Republicans supported tax cuts, matched by spending cuts, to offset the way inflation was pushing many taxpayers into higher brackets and to spur investment … Through the 1984 election, the old guard earnestly tried to control the deficit, rolling back about 40 percent of the original Reagan tax cuts. But when, in the following years, the Federal Reserve chairman, Paul Volcker, finally crushed inflation, enabling a solid economic rebound, the new tax-cutters not only claimed victory for their supply-side strategy but hooked Republicans for good on the delusion that the economy will outgrow the deficit if plied with enough tax cuts.

  As Stockman explained, this “new cadre of ideological tax-cutters” undermined the Republican Party’s commitment to fiscal prudence and conservatism.

  Republicans gone wild on tax cuts (which they justified by invoking an imaginary version of Reagan), combined with Democrats determined not to cut spending during the first decade of the twenty-first century, along with two wars and the costs of coping with the meltdown of the financial system and the Great Recession: all this created today’s huge deficits and massive total debt.

  But what happened to the discipline of Milton Friedman’s free-currency markets? Why didn’t these lead to a sharp devaluation of the dollar and force the White House and Congress to take the castor oil of tax increases and spending cuts? The reason, argued Stockman, was that a totally unanticipated development got in the way and made us think we were flying: We were able, too easily, to finance our growing budget deficits by borrowing from other countries. The biggest pusher for our debt habit turned out to be China, which proved willing to lend us money on a previously unimaginable scale through the purchase of U.S. Treasury bonds. The Chinese government was eager to do this because of its economic strategy of export-led development. To sustain the country’s growth, which was necessary for the Communist Party to keep its grip on power in the country, China had to sustain and expand its exports in order to create jobs for more and more Chinese. That required keeping those exports affordable for the chief consumer of Chinese-made products, the United States. By buying American dollars, China kept the dollar strong in relation to the yuan, making it possible for American consumers to continue to buy Chinese products in ever larger quantities.

  “What Milton Friedman had failed to anticipate,” said Stockman, “was that there would never be a global free market in currencies—that countries such as Japan and China would manipulate their currencies to support their export growth models, and their export growth models turned out to support our consumption growth model.” The result was a system that allowed the United States to overborrow from China and others and to overconsume, and this in turn allowed China and its neighbors to develop much more rapidly than they would have in the pre-1970 world by generating growth through massive exports, high savings, and low consumption.

  “China and America entered into the perfect symbiotic relationship,” said Stockman. “China needed somewhere safe to park its massive currency purchases and it put [those purchases] into our sovereign debt. We suddenly had someone who would buy our paper at a scale we never had before in history … We were like two drunks leaning on each other without a lamppost.” America got to live beyond its means as a nation for twenty years and build up a combined shortfall in our trade in goods, services, and income of more than $7 trillion. Stockman describes this as “borrowed prosperity on an epic scale.”

  So when Vice President Cheney declared that “Reagan proved deficits don’t matter,” he was speaking economic “nonsense,” said Stockman, “but he was making an empirically accurate observation. It was morally irresponsible, but empirically accurate. Thanks to China, what everyone feared about deficits was no longer true—you could have ‘deficits without tears,’ as a famous French economist said.”

  Of course, that is true only as long as China and others are ready to keep lending, which now seems to be coming into question—and not just for Chinese lenders but also for American ones. If, or rather when, that funding slows or stops, the party will end. And that stop could come very suddenly. At that point the United States will have three unhappy options: raise interest rates sharply to attract capital, thereby triggering an economic downturn; print money to cover the deficit, thereby triggering inflation; or close the gap with a combination of spending cuts and tax increases. Some combination of the three is perhaps the most likely outcome. None is cost-free: all will inflict economic pain on Americans.

  The third option, reducing spending while raising taxes and reinvesting in our formula, is, for the sake of the country’s long-term well-being, the only sensible option. Although we have passed the point at which we could correct our fiscal errors in a pain-free manner, the sooner we adopt the third option, the less economic pain we will have to suffer.

  In the meantime, as one member of the president’s deficit commission put it to us: We had better hope that China does not invade Taiwan. “We have a treaty that says we have to defend Taiwan in the event that it is attacked by China,” he said. “The only problem is that we would now have to borrow the money from China to do it.”

  Hey, Big Spender

  Unfortunately, the war on math was not confined to the federal government or the Republican Party. The Democrats waged a war on math of their own, particularly at the state and local levels. While Republicans were not innocent of this behavior, Democrats in particular fell into the habit of granting pay and pension increases to public-employee unions—police, firemen, teachers, and civil servants—which were based on wildly optimistic assumptions about future tax revenues and future market returns for pension funds. These estimates were often extrapolations from the fat years of the 1990s and early 2000s, when the peace dividend and dot-com and credit bubbles encouraged a kind of magical thinking about economic matters.

  Not simply bad math but also politics were involved. Plenty of governors and mayors, many of them Democrats, entered into mutual backscratching arrangements with state and local unions. They granted generous pay and pension increases to the unions, and the unions turned around and made generous campaign contributions to local and state politicians, and to the Democratic Party.

  Unconstrained by market discipline, public employees’ salaries, pensions, and health benefits got out of line with those of the private sector. So, too, did the numbers of employees, as politicians in flush times added political loyalists to the public payrolls. Illinois, New Jersey, New York, and California were the poster children for this phenomenon. The Chicago Tribune editorial page has made a pr
actice of railing against such abuses in its state. Here is a tiny sampler:

  During the decade that ended in fiscal 2008, the Civic Federation says, pension pledges at 10 governmental bodies grew by 68.9 percent. In the same years, the funding of all these pension promises grew by only 26.4 percent … Did you know that Illinois police and firefighters can receive full pension—75 percent of pay—as early as age 50? (March 9, 2010)

  Citizens in Highland Park have done the right thing since this newspaper exposed what occurred in that northern suburb: Park commissioners awarded their executives fat pre-retirement raises and bonuses. Executive Director Ralph Volpe’s salary was $164,204 in 2008, although the district paid him $435,203 that year. That spiked Volpe’s pension by more than $50,000, to $166,332 a year. Since that disclosure, infuriated taxpayers have forced their commissioners who were on the Park Board at the time to resign. (September 19, 2010)

  Often when these retirement deals were cut, the public officials and the union leaders were, in effect, seated on the same side of the negotiating table holding hands. The politicians essentially pledged future tax dollars in return for the cooperation of public sector unions … The Republicans and Democrats who cut these deals were playing with other people’s money. The pols knew they were creating somebody else’s problem. When the devastating costs came due, they would be gone, out of office, retired. (November 28, 2010)

  The Wall Street Journal reported (October 15, 2010) that, at a time when other traditional Democratic donors were limiting their campaign contributions,

  public-sector unions have remained a bulwark for Democrats this fall … according to a Wall Street Journal analysis of Federal Election Commission data. Unions have long bankrolled Democratic campaigns, but some of the biggest public unions are spending more this fall than they did during the prior midtermcampaign cycle in 2006. The National Education Association, the largest U.S. teachers union, has independently spent more than $3.4 million that must be disclosed, including ad buys and direct-mail campaigns, for the key electioneering period from September 1 to October 14. The NEA spent $444,000 during the same stretch in 2006. The American Federation of State, County and Municipal Employees has nearly matched its 2006 midterm outlays. It has spent $2.1 million on electioneering since the beginning of last month, according to FEC filings for two campaign committees associated with the union. That is just shy of the $2.2 million spent for that period in 2006.

  This explains why the Republican governors of Wisconsin and Ohio moved to curb collective-bargaining rights by their state public-employee unions early in 2011. They could achieve two goals at once: save money and hurt one of the Democratic Party’s key funding sources.

  As at the federal level, spending patterns for state and local governments will have to change. John Hood, the president of the John Locke Foundation, a state-policy think tank based in North Carolina, explained it this way in a report he wrote about on this issue, The States in Crisis: “When tax revenues declined precipitously as a result of the 2008 financial crisis, state officials’ optimistic budgeting crashed into cold, hard reality.” The gaps between promised salaries, pensions, and services and tax revenues are now very large indeed. “State tax revenues,” notes Hood, “were 8.4 percent lower in 2009 than in 2008, and a further 3.1 percent lower in 2010.” States such as California, Texas, New Jersey, and Illinois face the prospect of huge deficits, amounting to 25 percent and more of their entire budgets, in the immediate future.

  At the heart of the states’ fiscal problems, explains Hood,

  lies the fact that government pension plans do not function the way most private retirement plans do. Americans with jobs in the private sector are likely most familiar with “defined contribution” retirement programs—like 401(k) accounts—which involve a set contribution (generally some percentage of one’s pay). This contribution, made over the course of a person’s working years, is channeled into a savings account that accrues interest; upon retirement, that account begins to pay out benefits … Such a retirement plan cannot be underfunded, since it pays out in benefits only what one contributes over the course of one’s working life. Most government pension plans, by contrast, are “defined benefit” programs. These plans, as the name suggests, guarantee a particular annual benefit to each retiree (generally based on the income he earned while he was working, the number of years he worked, and some cost-of-living adjustment). Instead of disbursing payments based on the amount of money collected over time in a savings account, defined-benefit programs work backwards: They first determine the benefits they will provide, and then try to calculate how to collect enough money to meet those obligations.

  The accuracy of the calculation depends on the accuracy of the predictions about how well the stock or bond market will do over time. “If a defined-benefit plan promises excessively generous payouts, or fails to collect enough money to meet its financial pledges to retirees,” said Hood, “the result will be a massive accumulation of debt as large numbers of workers begin to retire.”

  According to a recent report from the Pew Center on the States, which Hood cited, state governments

  face an unfunded liability of $1 trillion for retirement benefits promised to public employees. This figure, which remains the most accurate available assessment of the problem, is based on FY 2008 data—that is, before the financial markets and economy really tanked. More recent estimates, calculated by Northwestern University economist Joshua Rauh and his colleagues, have suggested a figure closer to $3 trillion in unfunded state liabilities (the shortfall in city pensions totaled an additional $574 billion).

  To be sure, there are many reasons states and cities find themselves in fiscal crises these days—not just overspending and under-taxing in good times but also runaway health-care costs from federal mandates that the states cannot finance anymore—but there is no question that the overly generous contracts of public-service workers in the last decade belong on that list. Union members in the private sector know that their employers can go broke at any time, which does temper their demands. Public-sector union workers, by contrast, work for city and state monopolies that can never go out of business, and the workers get to play a role in electing the officials who can grant them increases in pay and benefits. To their credit, many public-service employees have been willing to absorb cutbacks as long as the sacrifice has been shared.

  In sum, national, state, and local economic and fiscal policies over the last two decades added up to a bipartisan flight from prudence, common sense, and reality that has created an enormous challenge for the United States. If you were a trustee running a private pension fund and you had made the assumptions that state and local Democrats made—about the returns their investments would yield forever—you would have been fired by now. If you were a trustee running a private pension fund and had made the assumptions that national Republicans made—that deficits don’t matter if they are the result of tax cuts—you would have been institutionalized by now.

  Unfortunately, people holding those views have dominated American political life for at least the last twenty years, one offering an economics based on wishful math, the other an economics based on no math at all. Now the only solution to the problem they jointly created is a prolonged and far from painless period of adjustment to reality.

  “When you look at the data on things like spending and deficits and the debt-ceiling limit, you will see that starting in the 1980s we lost our way,” said David Walker, the former U.S. comptroller general, a debt expert, and the author of Comeback America: Turning the Country Around and Restoring Fiscal Responsibility. “Then we temporarily regained our senses starting in the early 1990s under President Bush 41 and again under President Clinton.” These two presidents, one a Republican and one a Democrat, added Walker, did three things in common: “One, they supported the imposition of tough statutory budget controls that kept government from making more promises, when it had already made more promises than it could keep; in addition, they each i
mposed tough but realistic discretionary spending caps that included defense and security spending. Two, they did not expand entitlement programs, which is arguably the most imprudent thing you can do.” And third, Walker added, both Bush 41 and Clinton “broke campaign promises in connection with taxes when they saw the reality of our fiscal situation. So we had one Republican and one Democrat who each batted a thousand. Then Bush 43 came along and totally struck out.” President George W. Bush, noted Walker, let the statutory budget controls expire at the end of 2002, he expanded entitlements—with Medicare prescription drugs—“and he never broke his campaign promise to cut taxes. Obama so far is the same thing, but he can still change course.”

  One way or another, we are all going to have to pay for this. The only questions left are these, framed by the Washington Post business columnist Steven Pearlstein (February 22, 2011):

  Will the pain come in the form of prolonged high unemployment? Or wage and salary cuts? Or reduction in the value of homes and financial assets? Or loss of ownership of American companies? Or price inflation? Or higher taxes? Or reductions in government services and benefits? The right answer, of course, is “all of the above.” The hole we dug for ourselves was so deep and so wide that we’ll need all of them to get us out of it. The central political, economic and social challenge of the next decade will be to decide how we are going to apportion the adjustment among these various channels, and among the various classes and sectors and regions of the country, without tanking the economy or breaking the bonds that hold our society and our democracy together.