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The budget deficit and how it grew

By Jonathan Weisman
The Washington Post

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One group, led by Treasury Secretary Paul O'Neill and White House budget director Mitchell Daniels, watched anxiously as the government's 2002 balance sheet swung from a record $313 billion surplus projected when Bush took office to a $157 billion deficit projected that August. How could the president demand fiscal discipline from Congress, they argued, then push expensive reforms of Social Security and the tax code if he continued cutting taxes?

The other side, led by White House economists Lawrence Lindsey and Glenn Hubbard, focused on economic growth, which had slipped from a 5 percent surge in the first three months of 2002 to 1.3 percent in the next quarter. Employment had slid by 235,000 jobs between January and September. Deficits would have little if any effect on the economy, they assured Bush, but if the president wanted to halt the stock market's slide and prop up incomes, he had to cut taxes more.

After weeks of debate, Bush made his choice clear, unveiling a $674 billion tax-reduction package on Jan. 6, 2003, that was larger and bolder than even Hubbard and Lindsey had expected. The proposal locked in Bush's record as a tax cutter. But it also contributed to mounting budget deficits and debt that may prove to be one of Bush's most enduring legacies.

A billion a day

Bush's economic team Group one: Treasury Secretary Paul O'Neill, left, and Budget Director Mitchell Daniels focused on fiscal discipline. Group two: White House economists Lawrence Lindsey, left, and Glenn Hubbard focused on economic growth.

When Bush took office in January 2001, the government was forecasting a $5.6 trillion budget surplus between then and 2011. Instead, it is now expecting to accumulate an extra $3 trillion in debt — including a record $415 billion in the fiscal year that ended Sept. 30.

The government has to borrow an average of more than $1.1 billion a day to pay its bills, and it spends more on interest payments on the federal debt each year — about $159 billion — than it does on education, homeland security, justice and law enforcement, veterans, international aid and space exploration combined.

Without doubt, the fiscal turnaround started with the bursting of the stock-market bubble and was pushed forward by recession, terrorist attacks and corporate scandals not of the president's making. But conservative and liberal budget analysts agree that deficits were increased by the administration's policy choices: tax cuts amid swelling red ink and the costly invasion of Iraq.

The consequences are just coming into view. The White House has ordered draft budgets for 2006 that would cut spending on homeland security, veterans affairs and education, according to White House documents. Some economists — although by no means most — see a reckoning on the horizon, when foreign lenders reject U.S. debt, interest rates rise, and the value of the dollar crashes.

"The [deficit] pressures going forward are too great to allow us to borrow these kinds of moneys on the international market on a sustained basis," said Douglas Holtz-Eakin, a former White House economist who heads the Congressional Budget Office.

Through it all Bush has stood his ground, pushing through four tax cuts in four years totaling $1.9 trillion over a decade, and opposing repeated efforts to roll back any of them.

"We have a deficit challenge in the short and medium term," said Joshua Bolten, the director of the White House Office of Management and Budget. But, he added, "the most important economic responsibility of a president is to make sure the economy is growing and people are working."

From surplus to debt

As of 2001, the White House expected surpluses of nearly $1.3 trillion through 2004. Instead, the government fell into debt by roughly $850 billion. According to the White House budget office, about half of the change can be attributed to factors largely outside the president's control: recession, a weak recovery, the bursting of the stock-market bubble and the unanticipated costs of the 2001 terrorist attacks.

But the other 50 percent is attributable to policy choices.

The four tax cuts account for about 30 percent of the change. The remaining 20 percent was spending, including the cost of the war in Afghanistan and the invasion of Iraq. Since 2001, government spending has risen 23 percent, from $1.86 trillion to $2.29 trillion this year. Defense spending increased 48 percent, while nondefense spending went from $343 billion in 2001 to $436 billion, a 27 percent increase.

Congress has allocated $174 billion so far for the Iraq war alone, with another emergency spending request expected early next year. Among the larger nondefense items Bush signed were a multiyear extension of agriculture subsidies and a prescription-drug benefit for Medicare, the largest expansion of an entitlement program since the 1960s.

The president's first tax cut, at a cost of $1.35 trillion, was passed in June 2001 by a Congress still convinced the government would run a large surplus even without those tax revenues.

More tax cuts

But by 2002, a "dramatic reversal of revenues" was becoming clear, Bolten said. Future policy decisions would be a choice, White House economic advisers believed, between the government's long-term fiscal health and the nation's short-run economic well-being.

Although some members of Bush's economic team advised fiscal restraint that crucial year, their influence waned as the economy staggered. In March 2002, Bush signed further tax reductions worth $42 billion over 10 years. Three months later, Lindsey was counseling Bush to cut taxes again.

O'Neill and Commerce Secretary Donald Evans — the more deficit-conscious members of the economic team — pushed back, arguing the economy was on the mend.

But on Aug. 13, at an economic summit in Waco, Texas, business executives and affluent GOP donors warned that the economy remained in trouble and pushed their own tax-cut ideas.

The political winds shifted decisively against O'Neill and the deficit hawks.

In an Aug. 23 memo detailed by a former economic aide, Bush's economic advisers laid out a menu of tax-cut options, outlining policies of intentionally modest cost.

Four days later, budget director Daniels joined O'Neill in expressing concern that another tax cut would undermine efforts to demand fiscal restraint from Congress, according to staff notes from the time.

"Is this enough?"

Amid those divisions, the economic team gathered in the Oval Office on Oct. 4. Lindsey pushed a 50 percent reduction in the taxation of capital gains and dividends and an expansion of savings limits on 401(k) plans and individual retirement accounts, at a cost of $27.3 billion a year. The Congressional Budget Office had just increased its deficit forecast to $157 billion, but Hubbard assured the president that a shortfall that size would not significantly raise interest rates.

"The president's body language was 'Is this enough?' " said one participant, who spoke on the condition of anonymity for fear of angering other members of the team.

The package languished until after the 2002 midterm election, with Bush convinced it could not pass unless Republicans gained control of the Senate. When they did, the policy-makers swung into high gear. At a meeting Nov. 12, a consensus formed on accelerating income-tax rate cuts, eliminating taxes on half of all dividends and passing a one-year tax write-off for new business investment. Days later, at a meeting with the vice president, O'Neill "tipped his hand," said an administration participant in the session, and warned that the government was careening "toward a fiscal crisis." But by then, the Treasury secretary was virtually alone. On Dec. 6, he was fired.

A Dec. 28 memo from Lindsey's deputy, Keith Hennessey, cautioned Bush that his advisers were divided over whether he should cut the top two income-tax rates or limit the cuts to lower-income and middle-class taxpayers. Daniels warned that cuts to the top tax rate would prompt a new round of accusations that the administration favors the rich.

But on Jan. 6, when Bush unveiled the package, he held nothing back, calling for even steeper dividend tax cuts than his staff envisioned, and income-tax rate cuts for all income levels. Economic aides said the president made the decision himself, subordinating fiscal concerns to philosophy: If it was wrong to "double-tax" dividends, then that tax should be eliminated, not merely reduced. If some taxpayers deserved lower income-tax rates, all of them did.

Congress gave Bush his income-tax cuts and slashed dividends and capital-gains taxes. Lawmakers trimmed the cost of the proposal to $350 billion, but only by declaring that its most politically popular provisions would expire in 2005. As expected, Congress overwhelmingly voted to extend those expiring provisions, at an additional cost of $146 billion.

Foreign reliance

To finance its deficits, the Treasury has increasingly looked to investors overseas, especially foreign governments, to buy U.S. Treasury bonds. But recent economic data suggest foreign buyers may be losing interest, afraid that a sudden drop in the value of the dollar will upend portfolios swollen with U.S. currency.

According to a Treasury Department report released this month, net foreign purchases of U.S. bonds fell 45 percent in July, to $22.4 billion, while purchases by foreign central banks plummeted 76 percent, to $4 billion — the lowest levels in a about a year.

Sung Won Sohn, chief economist at Wells Fargo Bank, warned clients recently that foreign governments are already cutting back, leaving the Treasury dependent on unreliable bond traders.

"The U.S. will rely increasingly on less stable sources of funding and pay higher interest rates," he said. "It is a fait accompli that the dollar will depreciate further. The dollar depreciation will lead to higher inflation and interest rates, hurting the economy."

That downturn follows a record influx of foreign lending to the United States that accelerated from $19.2 billion in 2001 to $279 billion in 2003.

Foreign governments lent the Treasury $3.5 billion in 2001 and $7.1 billion in 2002. Last year, the figure soared fifteenfold, to $109 billion. Japanese reserves of U.S. Treasuries climbed from $317 billion when Bush came to office to $695 billion in July. During the president's term, China surpassed Britain as the United States' second-largest foreign lender, with its holdings more than tripling.

The situation may put Washington in a bind.

If foreign investors stop buying Treasury bonds and turn away in a herd-minded rush, interest rates would shoot up to try to attract those buyers back so the government can pay its bills. The value of the dollar would drop. Heavily indebted U.S. consumers, facing rising interest rates and soaring prices for imports, would cut spending. Economies in Europe and Japan would not be able to pick up the slack.

The result? "Global recession," predicted John Williamson, a senior fellow at the Institute for International Economics.

Concerns exaggerated?

Treasury economists say such concerns are exaggerated, arguing that the U.S. economy is large enough to absorb much more borrowing. Compared with the overall economy, total outstanding U.S. debt is about 35 percent of gross domestic product, said Randy Quarles, assistant Treasury secretary for international affairs. Japan's debt, by comparison, is roughly 100 percent of GDP.

"We're not going to tell you that we don't want to see smaller deficits," said Timothy Bitsberger, acting assistant Treasury secretary for financial markets. "But we see nothing in the market to suggest we're having trouble funding our deficit."

Bush has shown no sign of worry, either. Since the 2003 tax cut passed, he has beaten back repeated Democratic efforts to roll back some tax cuts to pay for the war in Iraq. Earlier this year, he rebuffed demands by some moderate Republicans to offset the cost of future tax cuts with spending reductions or tax-loophole closures. His 2005 budget proposal included $1.4 trillion in additional tax-cut costs, including new savings accounts that would eliminate taxes on capital gains, dividends and interest for almost all Americans.

In July, when GOP leaders moved to extend expiring tax cuts for just two years to hold down the cost, the president quashed the deal, demanding a five-year extension at a cost of $146 billion. He signed the bill last week.

Copyright © 2004 The Seattle Times Company

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