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MAY 2006

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United States National Debt Clock 
News and Op/Ed

Redefining Responsibility

How to build a better federal budget.

It is hard not to gloat. On March 16, 2006, the Republican-controlled Congress voted to raise the debt ceiling, this time to nearly $9 trillion. We are presented with the prospect of rivers of red ink spread into the future as far as the eye can see. How many years ago was it that, under Clinton, the federal budget was in surplus? The temptation is certainly there to email our GOP friends and razz them over this dramatic symbol of Republican fiscal irresponsibility. 

But "? if you're so smart?"

If our friends turn the tables on us, however, and ask what we would do about the budget deficit --"if you are so smart?"-- what would we say? If we were the New York Times editorial board, we could whine that "a serious leader would balance spending and taxes in order to govern well", using a type of editorial boilerplate that sounds impressive but says nothing. If we did, my guess would be that our Republican friends would not be impressed, least of all convinced.

When progressives or liberals speak of the current GOP regime's lack of "fiscal responsibility," they hope to score gains with moderate educated voters, even some Republicans. But these relatively sophisticated voters are not going to be impressed unless those leveling the charge of "irresponsibility" are able to explain what they would do differently.

The "big spender" label

Before we make out a successful partisan case against this Administration and Congress on the deficit, we need to recognize that to the average voter, there is some irony in Democrats and liberals using the phrase "big spender" as a political insult. For at least 25 years, the political Right (ironically with the help what the Right likes to call the MSM, the "mainstream media") has been very successful in tying the words "liberal" "Democrat" and "big spender" in the public mind. And, if we are honest, we would have to admit that most of us liberals or progressives do not wish for federal spending to shrink for most domestic programs. So how do successfully make a political issue about rising federal deficits?

The "twin deficits"

The national debt as a percent of gross domestic product (1950-2005) 
The crisis around the federal budget has two aspects. Most obviously, tax revenues are not adequate to fund current spending levels. Thus the government must borrow to bridge the gap, raising the national debt. Much of this debt is now held by foreigners, most notably the central banks of China and Japan. There is a second aspect of the crisis, that is not talked about as often: a second "deficit" if you will. This is the gap between what the government needs to spend to maintain the stock of public assets--our transportation, health and social infrastructure--and the amount we actually spend. This second deficit is visible in our inadequate passenger rail system, decaying inland waterways and flood control systems, overburdened emergency medical facilities and often under-achieving schools. Like the proverbial irresponsible farmer, we are consuming our seed corn. Every year the American Society of Civil Engineers updates their "report card" on American infrastructure. The ASCE rates America's infrastructure a "D" with total unmet 5-year investment needs of $1.6 trillion.

A "Fair and Balanced" Critique of the Bush Record on Deficits

So if a critique of Bush and Co. on deficits is to be persuasive, how should this critique be expressed? The Bush Administration pushed through a series of tax cuts that went far beyond the needs of an economy entering recession after absorbing the shocks of the bursting of the dot-com bubble and 9/11. Instead of speeding tax cuts to those most likely to spend them, the Bush Administration pushed through tax cuts heavily weighted with cuts in tax categories paid overwhelmingly by the rich (capital gains and estate and gift taxes) backloaded in years far into the future. So the Administration maximized the long-term fiscal pain associated with deficits and minimized the immediate stimulus to real spending. "Starve the beast" indeed. 

Meanwhile, Alan Greenspan was abetting the tax cuts by pumping liquidity into the economy like a drunken college student serving his buddies at a kegger. Given the lack of productive avenues of investment, this liquidity could only go into bidding up the value of existing assets, mainly real estate. It also encouraged the wealthy recipients of the lion's share of the tax cuts to put more money into speculative hedge funds that ended up making energy prices far more volatile than necessary. Much of the cash saved by corporate America from declining interest rates and tax cuts was either horded, siphoned off by hedge-fund speculators or spent on new plant construction in China, not the U.S. After billions of dollars of tax cuts and billions of dollars in new private indebtedness (much of it mortgage interest debt at variable rates) the economy has generated few new jobs while median incomes have fallen. The debt-laden economy is now arguably more vulnerable to external shocks while little if nothing has been done to close $1.6 trillion "infrastructure deficit."

Three proposals

So how do we correct Bush's mistakes and address both deficits at once? Recently policy proposals have been circulated that would apparently close the "infrastructure deficit" while not increasing the federal budget deficit. In simplified terms, these proposals are to:

  • Account for Federal infrastructure spending in a capital budget separate from the budget for general spending (a concept proposed by many over the last few years, including by banker Felix Rohatyn and Nobel-laureate Joseph Stiglitz); 
  • Raise money at the state level through special bond issues to be used for infrastructure projects (for example the $222 billion 10-year public works program for California proposed by Governor Schwarzenegger;
  • Create a new National Investment Corporation (NIC) to guarantee the borrowing by states for the building of infrastructure proposed by Felix Rohatyn and former Republican Senator Warren Rudman

The three proposals are useful in pushing the debate forward and each has its merits. However, none by themselves will be adequate to break the U.S. out of its current policy bind. And each has hidden dangers that must be kept in mind in formulating an effective approach to cure the "twin deficits."

The basic "capital account" proposal is on the surface a sensible idea. Why should federal spending on building assets that will strengthen the economy for years ahead be treated the same as federal spending on paper clips or salaries that will be spent in one year and leave nothing behind? Although it makes sense that spending and taxes balance in any year if the spending is for paper clips or salaries, it might not make much sense to worry about borrowing to build a new high-speed rail network if the network will make the U.S. economy perform better in the long run. This method of accounting is not radical. It is how all private businesses account for their operations. Private businesses "run deficits" for years, using the proceeds of stock and bond offerings to build plants, distribution centers and other assets that are "capitalized," i.e. credited to the balance sheet as an asset, not subtracted from current income as an expense.

The specific Schwarzenegger and Rohatyn/Rudman proposals also have their merits. In today's credit markets there is a great deal investment capital seeking quality borrowers willing to take long-term credit than there is borrower demand for investor funds. States might take advantage of what specialists call the "flat yield curve" by issuing 10-, 15- or even 50-year bonds at low interest rates to pay for infrastructure improvements. And if these could be coordinated and guaranteed through a federal NIC, a great deal of money could be raised for these projects without raising the general federal budget deficit.

The weakness of these proposals is that all three rely on the global money markets and the investment banking houses that are the gatekeepers to accessing capital in those markets. In particular, those in other states wishing to imitate the Governator's infrastructure plan should weigh carefully the risks of increasing borrowing at the state level, without Federal coordination or support. States and municipalities are in a weak position in that they have no constitutional power to regulate or influence the value of the money they will have to repay. The U.S. Congress, on the other hand, has the unique power, expressed in Article I, Section 8 of the Federal Constitution to "regulate the value" of the nation's money and to take all actions "necessary and proper" to exercise that power. The NIC proposal is better than "Ahnold's" for the reason that there are clear advantages to financing a major infrastructure program using the resources of the federal government. But impact the Rohatyn-linked plans will be limited by the fact that they are fundamentally little more than accounting gimmicks. Changing the way spending is accounted or offering a federal guarantee for state borrowing might be useful but provides no assurance that the massive borrowing necessary can be accomplished on favorable terms, given the current structure of the global capital markets. Essentially all three proposals put the investment banking community, with their characteristic policy prejudices unchallenged and intact, in charge of the program.

Meanwhile, Senators Voinovich (R-OH) Carper (D-DE) and Clinton (D-NY) have co-sponsored the National Infrastructure Improvement Act of 2006. It takes up a recommendation from the ASCE's Report Card that a government panel evaluate the nation's infrastructure and recommend actions. So the legislative context exists to put the issue of infrastructure in front of the voters in this fall's mid-term elections. But what should the panel recommend?

Revive the Reconstruction Finance Corporation

At this point, intelligent readers may be asking why in evaluating the Rohatyn/Rudman and Schwarzenegger proposals, I have dwelled on the influence of the investment banking community. Am I simply biased? Isn't it inevitable that any reorganization of federal borrowing for infrastructure would entail dependence on the investment banks who dominate the Treasury bond market? And what's wrong with that?

To begin to answer these questions, we should consider the experience of Franklin Delano Roosevelt's New Deal. Contrary to what some believe, FDR did not originate one of the most important institutions of the New Deal, the Reconstruction Finance Corporation. The RFC was created in 1932 during the administration of Republican Herbert Hoover. The crucial point of difference, however, is how the two presidents used the RFC.

For Hoover, the RFC was used to "restore investor confidence." Before FDR reformed it, the RFC lent money to banks and, to a much lesser extent, railroads. These private institutions did not use the money to invest in new plant and equipment or put the unemployed to work. This money was used to shore up balance sheets and prevent the further deterioration in the value of stocks and bonds already issued, and loans already made, by these institutions. Thus, if the RFC served any purpose at all it essentially bailed out investors. Its lending was essentially sterile; no new assets were created and nobody was put back to work. 

During FDR's famous "hundred days", the RFC's authorization for borrowing from the Treasury was increased dramatically, and it was given vast new powers. Under Roosevelt, the RFC quickly became the nerve center for the most creative aspects of the New Deal. Led by banker Jesse H. Jones and lawyer, Thomas G. "Tommy the Cork" Corcoran (a protégé of Felix Frankfurter), the RFC helped finance a major infrastructure program, capitalizing the Tennessee Valley Authority, funding dam and waterway projects in the West, and underwriting the building of government assets through the Works Progress Administration and the Public Works Administration. It funded the government's de-monetization of gold (an important plank in the New Deal's effort to combat deflation) and served as the chief means of reorganizing the banks. It provided crucial financial support for rural electrification efforts. The RFC founded Fannie Mae as the centerpiece of its policy of spreading home ownership through government-insured mortgages. In the 1940's, the RFC played a central role in financing the industrial expansion necessary to support the war effort.

The key aspect of the RFC experience is that it points out the importance of creating institutions with broad public mandate that can be the catalyst for new capital formation, outside the overriding influence of private bankers and their policy preferences. As in the 1930's, today's private bankers are obsessed with maintaining "investor confidence" in the value of the paper (stocks and bonds) their institutions previously issued and the extraordinary profits they earn from making a market for this paper in their trading operations. Its not that these bankers oppose expanding government infrastructure spending per se, but they tend to subordinate this to their prime goal: keeping capital markets orderly and under private control. This strong bias to defend the paper value of existing investments and loans and maintain the autonomy of private markets can conflict with need to gather swiftly the material resources needed to meet the economy's needs for current and future investment.

The Role of an RFC Today

So how do we tackle the twin deficits of today? We need an institution that can lead the effort necessary to close the $1.6 trillion investment gap in infrastructure (if anything a conservative number) while not compromising the ability of government to finance its existing spending priorities (now mainly national defense, homeland security and entitlement programs). The way to do this is to charter a new Reconstruction Finance Corporation with the authority to borrow the necessary funds directly from the U.S. treasury at guaranteed low interest rates. These direct borrowings by the RFC, like the RFC borrowings from the Treasury during the New Deal, would not be counted as government spending in budget calculations and need not be financed by a special issue of government bonds. Rather they would be direct obligations of one government agency to another, not borrowings from private investors. This is precisely what was done by the RFC in the 1930's and 1940's. The original RFC had the authority to borrow from both from private bond markets and the government, but borrowed the lion's share of the $50 billion dollars it lent in its 25-year life directly from the U.S. Treasury. Just so there is no mistake, every penny of taxpayers' dollars so borrowed by the RFC were paid back to the Treasury with interest.

A new RFC would immediately begin compiling a list of priority infrastructure projects and provide the institutional framework for assembling the management and technical resources necessary to begin construction on an immediate basis. Of particular importance would be redeploying the assets idled by the impending shutdown by GM and Ford of much of their and their parts suppliers' capacity. This capacity, which includes a heavy share of the nation's existing machine tool capabilities, could easily be redeployed in producing the goods necessary to rebuild our nation's rail system and expanding electricity production using environmentally-friendly 21st century generating technology.

Redefining "Fiscal Responsibility"

In conclusion, the term "fiscal responsibility" needs to be redefined. It is no longer enough to say it is "fiscally responsible" to raise taxes and cut spending and leave our real needs to be addressed later. A new concept of "fiscal responsibility" must be nurtured that encourages us to build the productive assets today that will uniquely enable our children and grandchildren to continue to enjoy the "blessings of liberty" and the level of prosperity generations have come to expect from the "American Dream."

Rick Pasquier is a lawyer in Philadelphia and has co-led several "Issues Summits" since 2001 for the Lower Merion Narberth Democratic Committee.