[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]


 
                          WHY DEFICITS MATTER

=======================================================================

                                HEARING

                               before the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

            HEARING HELD IN WASHINGTON, DC, JANUARY 23, 2007

                               __________

                            Serial No. 110-2

                               __________

           Printed for the use of the Committee on the Budget


                       Available on the Internet:
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                                 ______

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                        COMMITTEE ON THE BUDGET

             JOHN M. SPRATT, Jr., South Carolina, Chairman
ROSA L. DeLAURO, Connecticut,        PAUL RYAN, Wisconsin,
CHET EDWARDS, Texas                    Ranking Minority Member
LOIS CAPPS, California               J. GRESHAM BARRETT, South Carolina
JIM COOPER, Tennessee                JO BONNER, Alabama
THOMAS H. ALLEN, Maine               SCOTT GARRETT, New Jersey
ALLYSON Y. SCHWARTZ, Pennsylvania    THADDEUS G. McCOTTER, Michigan
MARCY KAPTUR, Ohio                   MARIO DIAZ-BALART, Florida
XAVIER BECERRA, California           JEB HENSARLING, Texas
LLOYD DOGGETT, Texas                 DANIEL E. LUNGREN, California
EARL BLUMENAUER, Oregon              MICHAEL K. SIMPSON, Idaho
MARION BERRY, Arkansas               PATRICK T. McHENRY, North Carolina
ALLEN BOYD, Florida                  CONNIE MACK, Florida
JAMES P. McGOVERN, Massachusetts     K. MICHAEL CONAWAY, Texas
BETTY SUTTON, Ohio                   JOHN CAMPBELL, California
ROBERT E. ANDREWS, New Jersey        PATRICK J. TIBERI, Ohio
ROBERT C. ``BOBBY'' SCOTT, Virginia  JON C. PORTER, Nevada
BOB ETHERIDGE, North Carolina        RODNEY ALEXANDER, Louisiana
DARLENE HOOLEY, Oregon               ADRIAN SMITH, Nebraska
BRIAN BAIRD, Washington
DENNIS MOORE, Kansas
TIMOTHY H. BISHOP, New York

                           Professional Staff

            Thomas S. Kahn, Staff Director and Chief Counsel
                James T. Bates, Minority Chief of Staff



                            C O N T E N T S

                                                                   Page
Hearing held in Washington, DC, January 23, 2007.................     1
Statement of:
    Hon. John M. Spratt, Jr., Chairman, House Committee on the 
      Budget.....................................................     1
    Hon. Paul Ryan, a Representative in Congress from the State 
      of Wisconsin...............................................     2
    David M. Walker, Comptroller General of the United States....     4
    Edward M. Gramlich, Richard B. Fisher Senior Fellow, the 
      Urban Institute............................................    25
    Edwin M. Truman, Senior Fellow, Peterson Institute for 
      International Economics....................................    28
Prepared statement of, additional materials submitted:
    General Walker...............................................    17
        Response to Mr. Scott's question about the value of 
          permanent tax cuts.....................................    55
    Mr. Gramlich.................................................    27
    Mr. Truman...................................................    30
        Responses to questions posed by Hon. Marcy Kaptur, a 
          Representative in Congress from the State of Ohio......    68


                          WHY DEFICITS MATTER

                              ----------                              


                       TUESDAY, JANUARY 23, 2007

                          House of Representatives,
                                   Committee on the Budget,
                                                    Washington, DC.
    The committee met, pursuant to call, at 10:07 a.m., in room 
210, Cannon House Office Building, Hon. John M. Spratt, Jr. 
[chairman of the committee] presiding.
    Present: Representatives Spratt, DeLauro, Edwards, Cooper, 
Allen, Doggett, Boyd, McGovern, Sutton, Andrews, Scott, 
Etheridge, Hooley, Moore, Bishop, Ryan, Bonner, Garrett, 
Barrett, Diaz-Balart, Hensarling, Lungren, McHenry, Campbell, 
Porter, Alexander, Smith, and Tiberi.
    Chairman Spratt. I will call the hearing to order and first 
recognize our witnesses and turn to the ranking member for any 
statement he wishes to make.
    On this day, when we will hear from the President on the 
State of the Union, I am pleased that we will also hear from 
our distinguished witnesses on why deficits matter.
    I wanted to thank our witnesses for today's hearing: The 
Comptroller of the United States, who needs no introduction, he 
has been here plenty of times before and has become a very 
vocal, visible and responsible advocate for fiscal 
responsibility, David Walker, head of the Government 
Accountability Office; Dr. Edward Gramlich, who is the Richard 
B. Fisher Senior Fellow at the Urban Institute, and Dr. Edwin 
M. Truman, who is the Senior Fellow at the Peterson Institute 
For International Economics.
    As I have said, the topic for today is a very pressing and 
pertinent and timely one, and that is, do deficits matter? As 
we begin this 110th Congress, we find ourselves faced with a 
daunting task. Six years ago, the budget was in surplus, the 
surplus by official projections over 10 years to the tune of 
$5.6 trillion. Within 2 years, that surplus was gone, vanished, 
disappeared. Within 2 more years, the deficit reached record 
levels, over $400 billion. Fortunately, the deficit has come 
down a bit from there, but nobody can assume the deficit is on 
a glide path to being balanced or the budget is on a glide path 
to being balanced by any means, and nor should anyone assume 
that the task of bringing it back to balance, putting the 
budget back in surplus is going to be an easy one. It will not 
be.
    In the 1980s and 1990s, we had four different major efforts 
on the budget: Gramm, Rudman and Hollings, the Bush Budget 
Summit in 1990, 1991, the Clinton budget in 1993, and the 
Balanced Budget Act of 1997. It took us all of those budgets to 
finally bring the budget to heel and put it back in surplus.
    So today we will explore with our witnesses do deficits 
matter. Is this something that should be an urgent priority for 
this Congress or is this something that we can put on the back 
burner while we attend to other priorities? If they do matter, 
to what extent are they a problem and what should we do about 
the problem?
    Those are, broadly speaking, the questions we put to our 
witnesses today; and before turning first to General Walker, I 
want to turn to our ranking member, Mr. Ryan, for any statement 
he cares to make.
    Mr. Ryan. I thank the chairman for yielding. I would like 
to make a few opening remarks.
    Number one, I think both members, Republicans and Democrats 
here, share concern about the effects of chronic deficit 
spending. But it is not enough for us to just sit here and rail 
against deficits. We have got to understand the cause of 
today's deficits; and we have got to recognize that deficits 
are a symptom, a symptom of excessive spending that is going to 
get dramatically worse if we don't take the right steps to 
control it.
    First, let's review how we got to this point. I have no 
doubt that we are going to hear later on today that Republicans 
squandered a $5.6 trillion surplus through reckless tax cuts 
and spending. We are going to hear this a lot in the next 
couple of years, I think, but it is important to note that the 
surplus was a projection, was a guess into the future, one that 
did not foresee the bursting of the dot-com bubble, economic 
slowdown and the recession of 2000 and 2001, attacks on 9/11 
and the ensuing war on terror.
    Tax relief was not the problem. Well-timed tax relief not 
only helped buoy the economy out of recession, it also unlocked 
investment, leading to significant job creation, sustained 
economic growth we have seen over the past few years. That 
economic growth results in the key factor in recent deficit 
reduction. In fact, despite an immense set of costly 
challenges, from the war on terror to last year's hurricanes, 
we have had significant progress in reducing short-term 
deficits through pro-growth economic policies and spending 
restraint.
    Last year, the deficit fell to $248 billion, a drop of $114 
billion since January estimates and the lowest deficit in 4 
years. The current deficit is 2 percent of GDP. That is well 
below the average of the past 35 years and is projected to stay 
in that range to the end of the decade under current policies.
    Again, the primary reason for this improvement is double-
digit growth in revenues coming into the Federal Treasury. I 
wish we did a lot more on spending, but we have plenty of 
revenues coming into the Federal Government. Even with 
accelerated tax relief that we have had, revenues for 2006 
reached 18.4 percent of GDP and that is higher than the average 
of the past four decades; and, recently, both CBO and the 
Treasury reported the revenue for the first quarter of the 
fiscal year 2007 was 8.1 percent ahead of the prior year.
    On appropriations, over the past 3 years, we held 
nonsecurity appropriations to less than inflation, higher than 
I would have done it, but we held some limit on that.
    Entitlements, in 2005, for the first time in about a 
decade, we took the first step toward reining in the largest, 
least sustainable portion of our Federal Government, 
entitlement spending, by saving $40 billion over the next 5 
years.
    But while the near-term fiscal outlook is improving, the 
oncoming retirement of the baby boomers--and the first of them 
just turned 60 last year--will bring rapidly swelling demands 
in the budget and in the economy.
    As this committee has been told time and again by experts 
ranging from our witness today, Dave Walker, to Doug Holtz-
Eakin at CBO to Alan Greenspan, the chief threat to our 
Nation's long-term fiscal health is spending, particularly the 
unsustainable growth rates in our Nation's big three 
entitlement programs: Social Security, Medicare and Medicaid. 
These three programs right now consume about 9 percent of our 
economy, 9 percent of GDP. They are going to grow to about 15.5 
percent of GDP by 2030. Without fundamental structural reforms, 
neither the budget nor the economy can sustain projected 
spending for these programs as they are currently structured.
    I just want to close with one quote from our esteemed 
witness, General Walker, who said in an earlier hearing, ``We 
cannot grow our way out of this problem.'' Eliminating earmarks 
will not solve the problem; lightening up fraud, waste and 
abuse will not solve the problem; ending the war or cutting way 
back on defense will not solve the problem; and letting the 
recent tax cuts expire will not solve the problem. We are going 
to have to do much bigger things in Congress. We are going to 
have to have much larger reforms, and all roads lead to 
fundamental restructuring of these entitlement programs if we 
are going to solve the problem.
    Do we want to give our kids and our grandkids a government 
that is literally twice the size of the government we have 
today, that we would literally have to tax about 40 percent of 
our Nation's output in order to just pay for the programs that 
we have today in the future? I don't think we want to do that, 
Mr. Chairman; and I appreciate the chance to have this 
conversation, this dialogue. We have great witnesses today, and 
I look forward to it.
    Thank you.
    Chairman Spratt. Let me remind the gentleman that over the 
last 6 years we have accumulated $3.1 trillion in debt, 
statutory debt. The debt service on that debt will be with us 
for years to come, and that debt service widening--the widening 
wage in the budget is going to make it even harder than ever to 
resolve the entitlements problems. Because if there is one 
entitlement truly entitled mandatory spending it is interest on 
the national debt. We can change the other programs, but 
interest on the national debt is obligatory. And as it grows 
and grows and grows, it crowds out our ability to respond to 
other demands and promises we have made and keep those 
promises.
    But we didn't come here to talk ourselves. We have come 
here to hear what you have to say, General Walker, and what our 
other two witnesses have. The floor is yours. We will make your 
statement a part of the record if you care to summarize it. The 
chart is on the wall, the screens on the wall are yours, too, 
because I am sure you have come armed with charts.
    Before I proceed, let me ask unanimous consent that all 
members be allowed to put their opening statement, if they care 
to file one, in the record at this point.
    General Walker, the floor is yours.

STATEMENT OF DAVID M. WALKER, COMPTROLLER GENERAL OF THE UNITED 
                             STATES

    Mr. Walker. Thank you Chairman Spratt, Ranking Member Ryan, 
members of the House Budget Committee. It is a pleasure to be 
back before you today to talk about why deficits matter.
    I do have a PowerPoint presentation which I am going to 
use. I find that when you are dealing with numbers this big, 
you need to have charts and graphs or else you really can't 
convey the message effectively. You have a copy of my full 
statement which I have also provided for the record.
    Let me first answer the question, do deficits matter? The 
answer is, if you care about--pardon me--if you are concerned 
with stewardship and if you care about the future of our 
country, our children and our grandchildren, the answer is a 
clear yes, they do matter.
    Secondly, today in America we suffer from two maladies: 
nearsightedness or shortsightedness and tunnel vision. The 
analogy from a fiscal standpoint is, the short-term deficits 
aren't our problem. It is where we are headed, and where we are 
headed could swamp the ship of state if we don't get serious 
soon. The simple truth is, we do not face an immediate heart 
attack, but we have been diagnosed with cancer, and we need to 
change behavior, and we need to engage in dramatic and 
fundamental reforms, which I will touch on, in order to save 
our future.
    First slide, please.
    
    
    This represents deficits as a percentage of the economy, 
going back to World War II.
    A couple of comments. First, obviously, our country and our 
way of life was threatened in World War II. We did what it took 
and subsequently were able to pay off most of that debt for a 
variety of reasons.
    In the 1980s, we did have larger deficits as a percentage 
of the GDP than we do today, but we got something for it. We 
bankrupted the Soviet Union, we won the Cold War, and we 
declared a peace dividend. Only time will tell what we get for 
the current deficits.
    Next, please.
    
    
    This represents deficits as a percentage of the economy for 
more recent years, since 1962. The red represents the on-budget 
deficit. The blue represents the off-budget surplus, primarily 
Social Security. The black line represents the unified deficit, 
and I think you can see here that we did run larger deficits as 
a percentage of the economy in the 1980s.
    We then took a number of dramatic steps. We turned deficits 
into surpluses. The trend turned negative. It has gotten better 
in the last several years, but let me reinforce my statement: 
The problem is not the short term. The problem is the long run.
    We should not be having a debate in my opinion, in my 
professional opinion, about whether or not deficits were larger 
in the 1980s. The fact is, when you are flying a plane, driving 
a car, you need to look forward, not in the rear-view mirror, 
and it doesn't really make a difference what the deficits were 
in the 1980s. What matters is where we are now and where are we 
headed and what the consequences to the country and our 
children and grandchildren.
    Next, please.
    
    
    This represents the future of unified surpluses and 
deficits as a share of GDP under two alternative fiscal policy 
simulations. One is CBO baseline extended. You can see, even 
with that, we face large problems in the years that grow.
    The second one, which is the red dotted line, shows 
discretionary spending growing with the economy and all tax 
provisions that are scheduled to expire being extended. Neither 
way sustainable. We are going to have to engage in dramatic and 
fundamental reforms.
    Next, please.
    
    
    In January and February of 2001, I testified before 
numerous committees in the House and the Senate about where we 
stood from a financial and fiscal standpoint. This represented 
GAO's long-range fiscal simulation in January of 2001. It was 
based upon a number of assumptions, some of which proved to be 
valid, some of which did not. Anytime you go out 40-plus years, 
that is a long way to go; and, obviously, the power of 
compounding is such that the further out you go the more 
variance there can be. The bottom line is, based upon this, we 
had fiscal sustainability for 40-plus years; and, at that time, 
we were even on a path to pay down all of the national debt, 
although I know a lot of people were really concerned about 
that. Personally, I was never really concerned about that, but 
some people were.
    Next, please.
    
    
    When it comes up, you will see the next one represents the 
current simulation based upon CBO's baseline extended. That 
represents the current simulation based upon CBO's baseline 
extended; and, just to help, the black line represents revenues 
as a percentage of the economy, only Federal revenues. The bars 
represent spending as a percentage of the economy. So inflation 
is taken out of these numbers.
    When the bar is above the line, that is a deficit. And you 
can see that even under, you know, baseline extended, which 
assumes that all tax cuts will expire, which assumes that 
discretionary spending will only grow by the rate of the 
economy for the first 10 years and assumes a number of other 
things, including that we don't have a long-term fixed AMT, you 
can see we have a large and growing problem in the outyears.
    Next, please.
    
    
    The following simulation assumes that discretionary 
spending grows by the rate of the economy, rather than the rate 
of inflation, and that the expiring tax cuts are made permanent 
and that somehow we do something with AMT such that we are 
basically maintaining about the historical level of taxation as 
compared to the economy. Well, on this, you can see that the 
fastest-growing cost by far is the bottom blue segment, which 
represents interest on the Federal debt. Now, unlike 2001, 
where we had fiscal sustainability for 40-plus years, under 
this, the model blows up in the 2040s.
    Next, please.
    
    
    We are on a path where, even if you exclude interest on the 
Federal debt, which, obviously, you can't, the Federal 
Government is not going to default either on debt held by the 
public or, frankly, debt held by the trust funds. We are not 
going to default on that. We will deliver on that. It 
represents a priority claim on future general revenues.
    But if you exclude interest on the debt, which, obviously, 
we can't, but for lesser purposes Social Security, Medicare and 
Medicaid alone are on a path, well, they will consume the 
entire revenues based on a historical percentage of our 
economy, these three programs alone. That obviously can't be 
allowed to happen.
    Next, please.
    
    
    Now, this is important. In the last 6 years, the total 
liabilities and unfunded commitments of the United States 
government have gone up from $20 trillion--now you have to 
write 12 zeros to the right of that 20; it is really not 
impressive until you write it out--$20 trillion to $50 trillion 
in 6 years, primarily due to Medicare. The Medicare 
prescription drug benefit alone comes with an $8 trillion price 
tag. That $8 trillion price tag is more than the entire 
unfunded obligation of Social Security.
    Mr. Scott. Present value?
    Mr. Walker. Present value.
    Let me help explain this. This takes dedicated payroll tax 
and premium revenues over the next 75 years, estimated benefit 
payments based upon the best estimate assumptions of the 
trustees of Social Security and Medicare--and I used to be one 
from 1990 to 1995. You calculate the difference, and you 
discount it back to current dollar terms at Treasury rates.
    So, in other words, how much money would you have to have 
today invested at Treasury rates in order to deliver on the 
promise with no reforms? This is how much money you would have 
to have. It has gone up almost--well, it has gone up 147 
percent in 6 years.
    Now the next one I think is easier to understand.
    
    
    How can we take $50 trillion and translate that into terms 
that you and I and, you know, people on Main Street can 
understand? First, $50 trillion is 95 percent of the entire net 
worth of every American. $50 trillion is 95 percent of the 
estimated net worth of every American, individual net worth, 
doesn't count corporate retained earnings.
    By the way, it was below--that percentage was below 50 
percent 6 years ago. Last year, the percentage was 91 percent. 
We are on a path to where it will exceed 100 percent within the 
next 2 years.
    $50 trillion is $440,000 per American household. Median 
household income in America is less than $47,000. So, stated 
differently, the typical American household has an implicit 
debt of over nine times our annual income. That is like having 
a mortgage but no house. And while this obligation will end up 
having to be discharged over a number of years, the only asset 
that people have to discharge this obligation is their 
citizenship in the United States of America, which does provide 
unparalleled opportunities, but it obviously is not a tangible 
asset.


    The next chart shows that part of our problem is that, in 
addition to the fiscal issue, we face slowing labor force 
growth. We have an aging society with longer life spans; people 
are wanting to retire earlier. That undercuts our ability to 
continue to grow economically, especially in a knowledge-based 
economy where it is brain power rather than brawn power that 
drives value and where people have an ability and hopefully an 
opportunity to work longer and to continue to contribute to our 
economy, both from the standpoint of the revenue side and to 
reduce the expenditure side over time.
    Next, please.
    
    
    Cash is key. This represents cash flows for the Social 
Security Trust Fund. The Social Security Trust Fund will start 
declining in its surpluses in 2009. Congress will therefore 
start going through withdrawal, because Congress has been 
accustomed and so has the executive branch to being able to 
spend those surpluses. So, starting in 2009, they will start to 
decline. In 2017, they will be G-O-N-E, gone. There will be 
deficits, and we will start having to count on these bonds and 
trust funds which aren't really trust funds, but that is a 
different story. We are already running a negative cash flow in 
Medicare; and, in fact, the Medicare Part A Trust Fund is 
expected to become exhausted in about 2017, 2018.
    Next, please.
    
    
    This is a possible way forward. Number one, we have to 
improve financial reporting, public education and performance 
metrics. You can't solve a problem until people understand that 
we have a problem that needs to be solved and it is prudent to 
solve it sooner rather than later. We need to improve our 
transparency with regard to financial reporting, budgeting and 
other legislative processes, more truth in advertising about 
where we really are.
    Secondly, we need to strengthen budget and legislative 
processes and controls. I am happy to answer questions. We need 
to bring back the controls that we had in the 1990s, and we 
need more than we had in the 1990s because we are in worse 
shape than we were in the early 1990s, and the demographic 
tsunami of entitlement spending is very close to becoming a 
reality.
    The first baby boomer reaches 62 January 1, 2008, less than 
a year from now, will be eligible for early retirement under 
Social Security. They will reach 65 in 2011, will be eligible 
for Medicare. That will begin a surge in spending which could 
swamp the ship of state.
    And last but certainly not least, and I think Mr. Ryan 
touched on some of this, most of the Federal Government's 
policies, programs, functions and activities, whether it is on 
the tax side, whether it is on the spending side, whether it is 
on the organizational structure and management models, are 
based on the 1940s to the 1970s. They get into the base, they 
are assumed to be okay and, in many cases, they are not 
effective, and they are outdated. And even if they are 
reasonably effective and not outdated, they may not be as high 
a priority for the 21st century as they were when they were put 
in place.
    We have got to engage in a fundamental reexamination and 
transformation of the entire Federal Government, entitlement 
programs, spending policies and tax reform. Also, our 
organizational models.
    We published a document in February, 2005. Every Member of 
Congress received one. It is entitled, Reexamining the Base--
pardon me. It is entitled 21st Century Challenges: Reexamining 
the Base of the Federal Government. It gives you an idea of the 
kinds of questions we will have to ask and answer. It will take 
us 20-plus years, but we need to get started now.
    Last two slides.
    
    
    This is not just about numbers. This is about values and 
people. The value that I would give you to focus on is 
stewardship. Stewardship means that leaders have an obligation 
not just to generate positive results today, not just to leave 
things better off when you leave than when you came, but better 
positioned for the future. My generation, the baby boom 
generation, individuals born between 1946 and 1964, are on 
track to be the first generation in the history of this country 
not to discharge its stewardship responsibilities. That is not 
acceptable to me, and I would imagine it is not acceptable to 
you. So it is about values, and it is about people.
    Next and last.
    
    
    These are my three grandchildren. They did not create this 
problem. This is their problem. They will pay the price. They 
will bear the burden if tough choices are not made and not made 
soon. They, obviously, are too young to vote. They have voices, 
but their voices typically are not heard. I am their voice.
    Thank you, Mr. Chairman.
    Chairman Spratt. Thank you very much, General Walker.
    [The prepared statement of David Walker follows:]

   Prepared Statement of David M. Walker, Comptroller General of the 
                             United States

    Chairman Spratt, Mr. Ryan, Members of the Committee: I appreciate 
this invitation to talk with you about why deficits matter--about our 
nation's long-term fiscal outlook and the challenge it presents. Your 
decision to focus on this issue is an important statement about the 
seriousness with which you view this challenge and your commitment to 
begin to address it.
    You all have entitled this hearing ``Why Deficits Matter.'' Let me 
start with a very simple reason: they matter for the world we leave our 
children and grandchildren. As all of you know--and as I will discuss 
in this statement--it is not the short-term deficit that threatens us; 
it is the longterm fiscal outlook. We are on an imprudent and 
unsustainable path. Continuing on our current fiscal path would 
gradually erode, if not suddenly damage, our economy, our standard of 
living, and ultimately even our domestic tranquility and our national 
security. This is a great nation with much to be proud of and much to 
be thankful for. But today we are failing in one of our most important 
stewardship responsibilities--our duty to pass on a country better 
positioned to deal with the challenges of the future than the one we 
were given.
    The picture I will lay out for you today is not a pretty one and 
it's getting worse with the passage of time. But this nation has met 
difficult challenges--including challenges to its very existence--in 
the past and I'm confident that we can do so again.
    The essence of my message today is no surprise to Members of this 
Committee:
     Our current financial condition is worse than is widely 
understood.
     Our current fiscal path is both imprudent and 
unsustainable.
     Improvements in information and processes are needed and 
can help.
     Meeting our long-term fiscal challenge will require (1) 
significant entitlement reform to change the path of those programs; 
(2) reprioritizing, restructuring and constraining other spending 
programs; and (3) more revenues--hopefully through a reformed tax 
system. This will take bipartisan cooperation and compromise.
     The time to act to save our future is now!
    When fiscal year 2006 ended a great deal of attention was paid to 
the fact that at $248 billion ``the deficit'' came in lower than 
originally predicted and lower than in 2005. And just this week press 
reports have noted that--as figure 1 shows--the (unified) deficit as a 
share of the economy is not terribly high.
    This is all true--and it is also misleading. First, a single year's 
unified budget deficit is not the critical issue here. Certainly this 
improvement in the 1-year fiscal picture is better than a worsening in 
that picture, but it did not fundamentally change our long-term fiscal 
outlook. In fact, the U.S. government's total reported liabilities, net 
social insurance commitments, and other fiscal exposures continue to 
grow and now total approximately $50 trillion, representing 
approximately four times the nation's total output, or gross domestic 
product (GDP) in fiscal year 2006, up from about $20 trillion, or two 
times GDP in fiscal year 2000.
    Further, the long-term challenge is fast becoming a short-term one 
as the first of the baby boomers become eligible for early retirement 
under Social Security on January 1, 2008--less than one year--and for 
Medicare benefits in 2011--less than 4 years from now. The budget and 
economic implications of the baby boom generation's retirement have 
already become a factor in the Congressional Budget Office's (CBO) 10-
year baseline projections and will only intensify as the baby boomers 
age. Simply put, our nation is on an imprudent and unsustainable fiscal 
path. Herbert Stein once said that something that is not sustainable 
will stop. That, however, should not give us comfort. It is more 
prudent to change the path than to wait until a crisis occurs.
    And that brings me to my next point. While restraint in the near 
term and efforts to balance the budget over the next 5 years can be 
positive, it is important that actions to achieve this also address the 
long-term fiscal outlook. The real problem is not the near-term 
deficit--it is the long-term fiscal outlook. It is important to look 
beyond year 5 or even year 10. Both the budget and the budget process 
need more transparency about and focus on the long-term implications of 
current and proposed spending and tax policies. In this testimony I 
will suggest a number of things that I believe will help in this area.

   OUR FISCAL AND FINANCIAL CONDITION IS WORSE THAN WIDELY UNDERSTOOD

    A great deal of budget reporting focuses on a single number--the 
unified budget deficit, which was $248 billion in fiscal year 2006. 
This largely cash-based number represents the difference between 
revenues and outlays for the government as a whole. It is an important 
measure since it is indicative of the government's draw on today's 
credit markets--and its claim on today's economy. But it also masks the 
difference between Social Security's cash flows and those for the rest 
of the budget. Therefore we also need to look beneath the unified 
deficit at the on-budget deficit--what I like to call the ``operating 
deficit.'' And, finally, we should be looking at the financial 
statements' report of net operating cost--the accrual-based deficit.
    Social Security currently takes in more tax revenue than it needs 
to pay benefits. This cash surplus is invested in Treasury securities 
and earns interest in the form of additional securities. The difference 
between the on-budget deficit and the unified budget deficit is the 
total surplus in Social Security (cash and interest) and the U.S. 
Postal Service. Excluding consideration of the $185 billion surplus in 
Social Security and a $1 billion surplus in the Postal Service, the on-
budget deficit was $434 billion in 2006. Figure 2 shows graphically how 
the on-budget deficit and the offbudget surplus have related and 
combine to lead to the unified deficit. Since the Social Security trust 
fund invests any receipts not needed to pay benefits in Treasury 
securities, its cash surplus reduces the amount the Treasury must 
borrow from the public. As I will note later, this pattern of cash 
flows is important--and it is projected to come to an end just 10 years 
from now.
    The third number, net operating cost, is the amount by which costs 
exceed revenue and it is reported in the federal government's financial 
statements, which are prepared using generally accepted accounting 
principles.\1\ Costs are recorded on an accrual basis--namely, in the 
period when goods are used or services are performed as opposed to when 
the resulting cash payments are made. However, most revenues, on the 
other hand, are recorded on the modified cash basis--that is, they are 
recorded when collected. The net operating cost can be thought of as 
the accrual deficit. The accrual measure primarily provides more 
information on the longer-term implications of today's policy decisions 
and operations by showing certain costs incurred today but not payable 
for years to come, such as civilian and military pensions and retiree 
health care. In fiscal year 2006 net operating cost was $450 billion.
    All three of these numbers are informative. However, neither 
accrual nor cash measures alone provide a full picture of the 
government's fiscal condition or the cost of government. Used together, 
they present complementary information and provide a more comprehensive 
picture of the government's financial condition today and fiscal 
position over time. For example, the unified budget deficit provides 
information on borrowing needs and current cash flow. The accrual 
deficit provides information on the current cost of government, but it 
does not provide information on how much the government has to borrow 
in the current year to finance government activities. Also, while 
accrual deficits provide more information on the longer-term 
consequences of current government activities, they do not include the 
longer-term cost associated with social insurance programs like Social 
Security and Medicare. In addition, they are not designed to provide 
information about the timing of payments and receipts, which can be 
very important. Therefore, just as investors need income statements, 
statements of cash flow, and balance sheets to understand a business's 
financial condition, both cash and accrual measures are important for 
understanding the government's financial condition.\2\
    Although looking at both the cash and accrual measures provides a 
more complete picture of the government's fiscal stance today and over 
time than looking at either alone, even these together do not tell us 
the full story. For example, as shown in table 1, all three of these 
deficits improved between fiscal year 2005 and fiscal year 2006.\3\ 
This improvement, however, did not result from a change in the 
fundamental drivers of our long-term challenge and did not signal an 
improvement in that outlook. To understand the long-term implications 
of our current path requires more than a single year's snapshot. In 
this regard, the longterm outlook has worsened significantly in the 
last several years. That is why for more than a decade GAO has been 
running simulations to tell this longer-term story.

          THE CURRENT LONGTERM FISCAL OUTLOOK IS UNACCEPTABLE

    As I mentioned, it is not the recent past shown in figure 1--nor 
the outlook for this year--that should concern us. Rather it is the 
picture in figure 3 that should worry us.
    Long-term fiscal simulations by GAO, CBO, and others all show that 
we face large and growing structural deficits driven primarily by 
rising health care costs and known demographic trends. GAO runs 
simulations under two sets of assumptions. One takes the legislatively-
mandated baseline from CBO for the first 10 years and then keeps 
discretionary spending and revenues constant as a share of GDP while 
letting Social Security, Medicare, and Medicaid grow as projected by 
the Trustees and CBO under midrange assumptions.\4\ The other, perhaps 
more realistic, scenario based on the Administration's announced policy 
preferences changes only two things in the first 10 years: 
discretionary spending grows with the economy and all expiring tax 
provisions are extended.\5\ Like the ``Baseline Extended'' scenario, 
after 10 years both revenues and discretionary spending remain constant 
as a share of the economy. As figure 3 shows, deficits spiral out of 
control under either scenario. We will be updating these figures with 
the release of the new CBO baseline later this month, but even with the 
lower deficit in 2006, the long-term picture will remain daunting.
    Looking more closely at each scenario gives a fuller understanding 
of what the impact of continuing these trends would have on what 
government does. And it shows us ``Why Deficits Matter.''
    First, it makes sense to look back to 2001--it is worth 
understanding how much worse the situation has become. As I noted, 
despite some recent improvements in short-term deficits, the long-term 
outlook is moving in the wrong direction.
    Figures 4 and 5 show the composition of spending under our 
``Baseline Extended'' scenario in 2001 and 2006. Even with short-term 
surpluses, we had a long-term problem in 2001, but it was more than 40 
years out. Certainly an economic slowdown and various decisions driven 
by the attacks of 9/11 and the need to respond to natural disasters 
have contributed to the change in outlook. However, these items alone 
do not account for the dramatic worsening. Tax cuts played a major 
role, but the single largest contributor to the deterioration of our 
long-term outlook was the passage of the Medicare prescription drug 
benefit in 2003.
    Figure 5 illustrates today's cold hard truth, that neither slowing 
the growth in discretionary spending nor allowing the tax provisions to 
expire--nor both together--would eliminate the imbalance. This is even 
clearer under the more realistic scenario as shown in figure 6. 
Estimated growth in the major entitlement programs results in an 
unsustainable fiscal future regardless of whether one assumes future 
revenue will be somewhat above historical levels as a share of the 
economy as in the first simulation (fig. 5) or lower as shown in figure 
6.
    Both these simulations remind us ``Why Deficits Matter.'' They 
illustrate that without policy changes on the spending and revenue side 
of the budget, the growth in spending on federal retirement and health 
entitlements will encumber an escalating share of the government's 
resources. A government that in our children's lifetimes does nothing 
more than pay interest on its debt and mail checks to retirees and some 
of their health providers is unacceptable.
    Although Social Security is a major part of the fiscal challenge, 
contrary to popular perception, it is far from our biggest challenge. 
While today Social Security spending exceeds federal spending for 
Medicare and Medicaid, that will change. Over the past several decades, 
health care spending on average has grown much faster than the economy, 
absorbing increasing shares of the nation's resources, and this rapid 
growth is projected to continue. CBO estimates that Medicare and 
Medicaid spending will reach 6.3 percent of GDP in 2016, up from 4.6 
percent this year (2007), while spending for Social Security will only 
reach 4.7 percent of GDP in 2016 up from 4.2 percent this year. For 
this reason and others, rising health care costs pose a fiscal 
challenge not just to the federal budget but also to states, American 
business, and our society as a whole.
    While there is always some uncertainty in long-term projections, 
two things are certain: the population is aging and the baby boom 
generation is nearing retirement age. The aging population and rising 
health care spending will have significant implications not only for 
the budget but also for the economy as a whole. Figure 7 shows the 
total future draw on the economy represented by Social Security, 
Medicare, and Medicaid. Under the 2006 Trustees' intermediate estimates 
and CBO's long-term Medicaid estimates, federal spending for these 
entitlement programs combined will grow to 15.5 percent of GDP in 2030 
from today's 9 percent. This graphic is another illustration of why we 
have to act. I do not believe we are prepared to have programs that 
provide income for us in retirement and pay our doctors absorb this 
much of our children's and grandchildren's economy. It is clear that 
taken together, Social Security, Medicare, and Medicaid under current 
law represent an unsustainable burden on future generations.
    While Social Security, Medicare, and Medicaid dominate the long-
term outlook, they are not the only federal programs or activities that 
bind the future. Part of what we owe the future is leaving enough 
flexibility to meet whatever challenges arise. So beyond dealing with 
the ``big 3,'' we need to look at other policies that limit that 
flexibility--not to eliminate all of them but to at least be aware of 
them and make a conscious decision about them. The federal government 
undertakes a wide range of programs, responsibilities, and activities 
that obligate it to future spending or create an expectation for 
spending and potentially limit long-term budget flexibility. GAO has 
described the range and measurement of such fiscal exposures--from 
explicit liabilities such as environmental cleanup requirements to the 
more implicit obligations presented by life-cycle costs of capital 
acquisition or disaster assistance.
    Figure 8 shows that despite improvement in both the fiscal year 
2006 reported net operating cost and the cash-based budget deficit, the 
U.S. government's major reported liabilities, social insurance 
commitments, and other fiscal exposures continue to grow. They now 
total approximately $50 trillion--about four times the nation's total 
output (GDP) in fiscal year 2006--up from about $20 trillion, or two 
times GDP in fiscal year 2000.
    Clearly, despite recent progress on our short-term deficits, we 
have been moving in the wrong direction in connection with our long-
range imbalance in recent years. Our long-range imbalance is growing 
daily due to continuing deficits, known demographic trends, rising 
health care costs, and compounding interest expense.
    We all know that it is hard to make sense of what ``trillions'' 
means. Figure 9 provides some ways to think about these numbers: if we 
wanted to put aside today enough to cover these promises, it would take 
$170,000 for each and every American or approximately $440,000 per 
American household. Considering that median household income is about 
$46,000, the household burden is about 9.5 times median income.

 PROCESS AND PRESENTATIONAL CHANGES TO INCREASE TRANSPARENCY AND FOCUS 
                   ON LONG-TERM CONSEQUENCES CAN HELP

    Since at its heart the budget challenge is a debate about the 
allocation of limited resources, the budget process can and should play 
a key role in helping to address our long-term fiscal challenge and the 
broader challenge of modernizing government for the 21st century. I 
have said that Washington suffers from myopia and tunnel vision. This 
can be especially true in the budget debate in which we focus on one 
program at a time and the deficit for a single year or possibly the 
costs over 5 years without asking about the bigger picture and whether 
the long term is getting better or worse. We at GAO are in the 
transparency and accountability business. Therefore it should come as 
no surprise that I believe we need to increase the understanding of and 
focus on the long term in our policy and budget debates. To that end--
as I noted earlier--I have been talking with a number of Members of the 
Senate and the House as well as various groups concerned about this 
issue concerning a number of steps that might help. I've attached a 
summary of some of these ideas to this statement. Let me highlight 
several critical elements here.
     The President's budget proposal should again cover 10 
years. This is especially important given that some policies--both 
spending and tax--cost significantly more (or lose significantly more 
revenue) in the second 5 years than in the first. In addition, the 
budget should disclose the impact of major tax or spending proposals on 
the short, medium, and long term.
     The executive branch should also provide information on 
fiscal exposures--both spending programs and tax expenditures--that is, 
the long-term budget costs represented by current individual programs, 
policies, or activities as well as the total.
     The budget process needs to pay more attention to the 
long-term implication of the choices being debated. For example, 
elected representatives should be provided with more explicit 
information on the long-term costs of any major tax or spending 
proposal before it is voted upon. It is sobering to recall that during 
the debate over adding prescription drug coverage to Medicare, a great 
deal of attention was paid to whether the 10-year cost was over or 
under $400 billion. Not widely publicized--and certainly not surfaced 
in the debate--was that the present value of the long-term cost of this 
legislation was about $8 trillion!
    Of course, when you are in a hole, the first thing to do is stop 
digging. I have urged reinstitution of the statutory controls--both 
meaningful caps on discretionary spending and pay-as-you-go (PAYGO) on 
both the tax and spending sides of the ledger--that expired in 2002. 
However given the severity of our current challenge, Congress should 
look beyond the return to PAYGO and discretionary caps. Mandatory 
spending cannot remain on autopilot--it will not be enough simply to 
prevent actions to worsen the outlook. We have suggested that Congress 
might wish to design ``triggers'' for mandatory programs--some measure 
that would prompt action when the spending path increased 
significantly. In addition, Congress may wish to look at rules to 
govern the use of ``emergency supplementals.'' However, as everyone in 
this committee knows, these steps alone will not solve the problem. 
That is why building in more consideration of the long-term impact of 
decisions is necessary.

MEETING THE LONG-TERM FISCAL CHALLENGE REQUIRES ACTION ON THE SPENDING 
    AND TAX SIDES OF THE BUDGET--COOPERATION AND COMPROMISE WILL BE 
                               NECESSARY

    There is no easy way out of the challenge we face. Economic growth 
is essential, but we will not be able to simply grow our way out of the 
problem. The numbers speak loudly: our projected fiscal gap is simply 
too great. To ``grow our way out'' of the current long-term fiscal gap 
would require sustained economic growth far beyond that experienced in 
U.S. economic history since World War II.
    Similarly, those who believe we can solve this problem solely by 
cutting spending or solely raising taxes are not being realistic. While 
the appropriate level of revenues will be part of the debate about our 
fiscal future, making no changes to Social Security, Medicare, 
Medicaid, and other drivers of the long-term fiscal gap would require 
ever-increasing tax levels--something that seems both inappropriate and 
implausible. That is why I have said that substantive reform of Social 
Security and our major health programs remains critical to recapturing 
our future fiscal flexibility. I believe we must start now to reform 
these programs.
    Although the long-term outlook is driven by Social Security and 
health care costs, this does not mean the rest of the budget can be 
exempt from scrutiny. Restructuring and constraint will be necessary 
beyond the major entitlement programs. This effort offers us the chance 
to bring our government and its programs in line with 21st century 
realities.\6\ Many tax expenditures act like entitlement programs, but 
with even less scrutiny. Other programs and activities were designed 
for a very different time.
    Taken together, entitlement reform and reexamination of other 
programs and activities could engender a national discussion about what 
Americans want from their government and how much they are willing to 
pay for those things.
    Finally, given demographic and health care cost trends, the size of 
the spending cuts necessary to hold revenues at today's share of GDP 
seems implausible. It is not realistic to assume we can remain at 18.2 
percent of GDP--we will need more revenues. Obviously we want to 
minimize the tax burden on the American people and we want to remain 
competitive with other industrial nations--but in the end the numbers 
have to add up.
    As I noted, we need to start with real changes in existing 
entitlement programs to change the path of those programs. However, 
reform of the major entitlement programs alone will not be sufficient. 
Reprioritization and constraint will be necessary in other spending 
programs. Finally, we will need more revenues--hopefully through a 
reformed tax system.
    The only way to get this done is through bipartisan cooperation and 
compromise--involving both the Congress and the White House.
    Delay only makes matters worse. GAO's simulations show that if no 
action is taken, balancing the budget in 2040 could require actions as 
large as cutting total federal spending by 60 percent or raising 
federal taxes to two times today's level.

               FURTHER DELAY WILL ONLY WORSEN THE OUTLOOK

    For many years those of us who talk about the need to put Social 
Security on a sustainable course and to reform Medicare have talked 
about the benefits of early action. Acting sooner rather than later can 
turn compound interest from an enemy to an ally. Acting sooner rather 
than later permits changes to be phased in more gradually and gives 
those affected time to adjust to the changes. Delay does not avoid 
action--it just makes the steps that have to be taken more dramatic and 
potentially harder.
    Unfortunately, it is getting harder to talk about early action--the 
future is upon us.
    Next year members of the baby boom generation start to leave the 
labor force. Figure 10 shows the impact of demographics on labor force 
growth.
    Reflecting this demographic shift, CBO projects the average annual 
growth rate of real GDP will decline from 3.1 percent in 2008 to 2.6 
percent in the period 2012-2016. This slowing of economic growth will 
come just as spending on Social Security, Medicare and Medicaid will 
begin to accelerate--accounting for 56 percent of all federal spending 
by 2016 compared to 43 percent in 2006.
    As I noted earlier, today Social Security's cash surplus helps 
offset the deficit in the rest of the budget, thus reducing the amount 
Treasury must borrow from the public and increasing budget 
flexibility--but this is about to change.
    Growth in Social Security spending is expected to increase from an 
estimated 4.8 percent in 2008 to 6.5 percent in 2016. The result, as 
shown in figure 11, is that the Social Security surpluses begin a 
permanent decline in 2009. At that time the rest of the budget will 
begin to feel the squeeze since the ability of Social Security 
surpluses to offset deficits in the rest of the budget will begin to 
shrink. In 2017 Social Security will no longer run a cash surplus and 
will begin adding to the deficit. That year Social Security will need 
to redeem the special securities it holds in order to pay benefits. 
Treasury will honor those claims--the United States has never 
defaulted. But there is no free money. The funds to redeem those 
securities will have to come from higher taxes, lower spending on other 
programs, higher borrowing from the public, or a combination of all 
three.
    I spoke before of how big the changes would have to be if we were 
to do nothing until 2040. Of course, we won't get to that point--
something will force action before then. If we act now, we have more 
choices and will have more time to phase-in related changes.

                           CONCLUDING REMARKS

    Chairman Spratt, Mr. Ryan, Members of the Committee--in holding 
this hearing even before the President's Budget is submitted you are 
signaling the importance of considering any proposal within the context 
of the longterm fiscal challenge. This kind of leadership will be 
necessary if progress is to be made.
    I have long believed that the American people can accept difficult 
decisions as long as they understand why such steps are necessary. They 
need to be given the facts about the fiscal outlook: what it is, what 
drives it, and what it will take to address it. As most of you know, I 
have been investing a good deal of time in the Fiscal Wake-Up Tour 
(FWUT) led by the Concord Coalition. Scholars from both the Brookings 
Institution and the Heritage Foundation join with me and Concord in 
laying out the facts and discussing the possible ways forward. In our 
experience, having these people, with quite different policy views on 
how to address our long-range imbalance, agree on the nature, scale, 
and importance of the issue--and on the need to sit down and work 
together--resonates with the audiences. Although the major participants 
have been Concord, GAO, Brookings, and Heritage, others include such 
organizations as the Committee for Economic Development (CED); the 
American Institute of Certified Public Accountants (AICPA); the 
Association of Government Accountants (AGA); the National Association 
of State Auditors, Comptrollers and Treasurers (NASACT); and AARP. The 
FWUT also has received the active support and involvement of community 
leaders, local colleges and universities, the media, the business 
community, and both former and current elected officials. We have been 
to 17 cities to-date. The discussion has been broadcast on public 
television stations in Atlanta and Philadelphia. Earlier this month OMB 
Director Portman and former Senator Glenn joined us at an event at the 
John Glenn School of Public Affairs at Ohio State University in 
Columbus, Ohio.
    The specific policy choices made to address this fiscal challenge 
are the purview of elected officials. The policy debate will reflect 
differing views of the role of government and differing priorities for 
our country. What the FWUT can do--and what I will continue to do--is 
lay out the facts, debunk various myths, and prepare the way for tough 
choices by elected officials. The American people know--or sense--that 
there is something wrong; that these deficits are a problem. If they 
understand that there truly is no magic bullet--if they understand that
     we cannot grow our way out of this problem;
     eliminating earmarks will not solve the problem;
     wiping out fraud, waste, and abuse will not solve the 
problem;
     ending the war or cutting way back on defense will not 
solve the problem;
     restraining discretionary spending will not solve the 
problem; and
     letting the recent tax cuts expire will not solve this 
problem;
    then the American people can engage with you in a discussion about 
what government should do and how.
    People ask me how I think this can happen. I know that some Members 
believe a carefully structured commission will be necessary to prepare 
a package while others feel strongly that elected officials should take 
up the task of developing that package. Whatever the vehicle, success 
will require the active and open-minded involvement of both parties in 
and both houses of the Congress and of the President. With that it 
should be possible to develop a package which accomplishes at least 
three things: (1) a comprehensive solution to the Social Security 
imbalance--one that is not preprogrammed to require us to have to come 
back again, (2) Round I of comprehensive tax reform, and (3) Round I of 
Health Care Reform.
    This is a great nation. We have faced many challenges in the past 
and we have met them. It is a mistake to underestimate the commitment 
of the American people to their children and grandchildren; to 
underestimate their willingness and ability to hear the truth and 
support the decisions necessary to deal with this challenge. We owe it 
to our country, to our children and to our grandchildren to address 
this fiscal imbalance. The world will present them with new 
challenges--we need not bequeath them this burden too. The time for 
action is now.
    Mr. Chairman, Mr. Ryan, Members of the Committee, let me repeat my 
appreciation for your commitment and concern in this matter. We at GAO 
stand ready to assist you in this important endeavor.

APPENDIX I: IDEAS FOR IMPROVING THE TRANSPARENCY OF LONG-TERM COSTS AND 

      the attention paid to these costs before decisions are made
Supplemental Reporting in the President's Annual Budget Submission
     Produce an annual Statement of Fiscal Exposures, including 
a concise list and description of exposures, cost estimates where 
possible, and an assessment of methodologies and data used to produce 
such cost estimates.
     Increase the transparency of tax expenditures by including 
them in the annual Fiscal Exposures Statement and, where possible, also 
showing them along with spending and credit programs in the same policy 
area.
     Provide information on the impact of major tax or spending 
proposals on short-term, mid-term, and long-term fiscal exposures and 
on the path of surplus/deficit and debt as percent of gross domestic 
product (GDP) over 10-year and longer-term horizons (and assuming no 
sunset if sunset is part of the proposal).
     Cover 10 years in the budget.
     Consider requiring the President to include in his annual 
budget submission a long-term fiscal goal (e.g., balance, surplus, or 
deficit as percent of GDP).
Additional Executive Branch Reports
     Prepare and publish a Summary Annual Report or Citizen's 
Summary that summarizes, in a clear, concise, plain English, and 
transparent manner, key financial and performance information included 
in the Consolidated Financial Report.
     Prepare and publish a report on long-range fiscal 
sustainability every 2 to 4 years.
Additional Cost Information on Proposals before Adoption
     Require improved disclosure--at the time proposals are 
debated but before they are adopted--of the long-term costs of 
individual mandatory spending and tax proposals over a certain size and 
for which costs will ramp up over time.
GAO Reports
     An annual report or reports by GAO including comments on 
the Consolidated Financial Statement (CFS), results of the latest long-
term fiscal simulations, comments on the adequacy of information 
regarding long-term cost implications of existing and proposed policies 
in the previous year as well as any other significant financial and 
fiscal issues.
Other Areas in Which GAO Has Suggested That Congress Might Consider 
        Changing the Budget Treatment
     Use accrual budgeting for the following areas where cash 
basis obligations do not adequately represent the government's 
commitment:
     employee pension programs (pre-Federal Employee Retirement 
System employees);
     retiree health programs; and
     federal insurance programs, such as the Pension Benefit 
Guaranty Corporation and crop insurance.
     Explore techniques for expanding accrual budgeting to
     environmental cleanup and
     social insurance--could consider deferring recognition of 
social insurance receipts until they are used to make payments in the 
future (this was suggested in GAO's accrual budgeting report as an idea 
to explore, possibly with a commission designed to explore budget 
concepts).

                                ENDNOTES

    \1\ The Financial Report of the United States Government, 2006 can 
be found at www.fms.treas.gov/fr/index.html.
    \2\ GAO is responsible for auditing the financial statements 
included in the Financial Report, but we have been unable to express an 
opinion on them for 10 years because the federal government could not 
demonstrate the reliability of significant portions of the financial 
statements, especially in connection with the Department of Defense. 
Accordingly, amounts taken from the Financial Report may not be 
reliable.
    \3\ The decline in both the cash and accrual deficits in 2006 was 
primarily driven by an increase in federal revenue by almost 12 
percent. In addition, the decline in the accrual deficit relative to 
the cash deficit was primarily due to a decrease in accrual-based 
expenses resulting from changes in assumptions that are the basis for 
actuarial estimates for certain accrued long-term liabilities. For a 
discussion of how the accrual and cash deficits relate to each other 
see GAO, Understanding Similarities and Differences between Accrual and 
Cash Deficits, GAO-07-117SP (Washington, D.C.: December 2006) and 
Understanding Similarities and Differences between Accrual and Cash 
Deficits, Update for Fiscal Year 2006, GAO-07-341SP (Washington, D.C. 
January 2006).
    \4\ Social Security and Medicare spending is based on the May 2006 
Trustees' intermediate projections. Medicaid spending is based on CBO's 
December 2005 long-term projections under midrange assumptions.
    \5\ Additional information about the GAO model, its assumptions, 
data, and charts can be found at http://www.gao.gov/special.pubs/
longterm/.
    \6\ GAO, 21st Century Challenges: Reexamining the Base of the 
Federal Government, GAO-05-325SP (Washington, D.C.: February 2005) and 
Suggested Areas for Oversight for the 110th Congress, GAO-07-235R 
(Washington, D.C.: Nov. 17, 2006).

    Chairman Spratt. Now I am going to propose something, if it 
agrees with your schedule. I would like to call the other two 
witnesses forward and put questions to you as a panel, if that 
is agreeable with everybody.
    Mr. Walker. That would be fine, Mr. Chairman.
    Chairman Spratt. Dr. Gramlich and Dr. Truman, if you would 
come forward and take your seats beside General Walker. While 
you are sitting down, I will introduce you further.
    Dr. Gramlich has had a long and distinguished career as an 
economist. He was a professor at the University of Michigan for 
much of his career, he served as a governor on the Federal 
Reserve Board from 1997 to 2005, and he was Acting Director of 
the Congressional Budget Office from 1986 to 1987.
    Dr. Truman is the Senior Fellow at the Peterson Institute 
for International Economics, has been since 2001. He was the 
Assistant Secretary for International Affairs and Treasury from 
1998 to 2001; and before that for a number of years he directed 
the Division of International Finance, for more than two 
decades apparently. We are proud and pleased to have you, and 
we look forward to your testimony.
    Chairman Spratt. Dr. Gramlich, let's begin with yours, if 
that is agreeable with you.

   STATEMENT OF EDWARD M. GRAMLICH, RICHARD B. FISHER SENIOR 
                  FELLOW, THE URBAN INSTITUTE

    Mr. Gramlich. Thank you, Mr. Chairman and committee 
members.
    I have submitted a statement, and I am just going to 
briefly summarize it.
    Chairman Spratt. Dr. Gramlich, your statement and Dr. 
Truman's statement will both be made part of the record, so you 
can summarize it as you wish.
    Mr. Gramlich. I am going to just refer to one chart that 
you see there.
    Before I get into my statement, let me say one thing. We 
were asked to talk about deficits and why they mattered, and 
much of my testimony involved current deficits and why they 
mattered. But I would strongly endorse what David Walker has 
just told you, that the real problem is not so much the short 
run. Short run has some difficulties, as we will talk about, 
but the real problem is the long run. And so I am going to 
start with the short run and talk about some of the issues 
there, and then I am not going to say much about the long run, 
because I can't do it any better than David Walker already has, 
and then talk about the policy issues.
    Now, David used the cancer analogy, and I am going to be a 
little bit less dramatic on this. The analogy I used was--it is 
borrowed from Charles Schultze, who is a former budget director 
and Chair of the Council on Economic Advisors. He asked at one 
time whether budget deficits could be likened to a pussycat, 
that is not a problem; to a wolf at the door huffing and 
puffing and threatening to blow the house down; or to termites 
in the basement.
    The pussycat argument is basically that private savers will 
offset the deficit and make it no problem from a standpoint of 
national saving, and you can see the chart there. The top line 
is the national saving rate of the United States, and the 
bottom line is the budget contribution to that national saving.
    And you see particularly in the last 20 years that the two 
are highly correlated. That is when the budget went into 
surplus in the late 1990s, national saving went up, but before 
that it had gone down, and after that it has gone down. In 
other words, private savers have really not offset the behavior 
of the Federal budget, and so the deficit is not a pussycat. It 
does have real economic effect.
    The wolf at the door argument hinges on two aspects. One 
is, it is possible that the Fed would in effect--use an 
economist word here--monetize the deficits and let inflation 
get out of control. Well, the Fed doesn't have to do that. 
There are ways to conduct monetary policy without doing that, 
and the Fed has been very firm in its resolve the past few 
decades to keep prices stable. It has done that. It can 
continue to do that. So I don't think that is a realistic 
worry. It could be in some countries, but not here, not in the 
United States.
    The other part of the wolf argument is that bondholders 
would begin charging higher interest rates on long-term 
interest rates on this debt, and that really hasn't happened 
either. That is one of the things that we used to worry about 
at the Fed, exactly why long-term interest rates were so low. 
Chairman Greenspan at one point called it a conundrum. This 
sent many bond traders to their dictionaries to find out what a 
conundrum was; and, once they found out, yeah, they agreed, 
yeah, it is a conundrum that long-term interest rates have not 
gone up. I will come back to that in a second.
    The argument I find most convincing, and it corresponds 
with David's message here, is that the termites in the basement 
argument, that you can see from the chart that if we have 
deficits they really do lower national saving. When national 
saving goes down, one of two things must happen--this is 
mathematics--either domestic investment would go down, and I 
think most of you would agree, that would be a bad thing. That 
would weaken the country's economy in the long run. Or we 
borrow the difference. Investment stays up, but our saving has 
gone down, and so we have to come up with the fund somewhere, 
so we borrow it from abroad.
    This is what Mr. Truman is going to talk about, and I am 
just going to raise three questions about it. I won't go into 
that in great detail.
    One question you want to ask is, while we have been able to 
borrow the difference between investment and saving, for how 
long? How long can we do this? These are international lenders, 
and they may get cold feet at some point, and then if we can't 
keep on borrowing, then our investment will have to go down.
    The second question that you could ask--and, again, Dr. 
Truman will address this--is what happens if this borrowing 
unwinds? You could have--the history of international finance 
has been that, very often, these periods are ugly, that 
currency rates change abruptly in a short period of time, and 
that causes lots of dislocation, and that is an issue, too.
    And the third question I would ask is, why do we put 
ourselves in this position? All we have to do is run 
responsible fiscal policy. We can keep our national saving at a 
higher rate, we don't have this decline that we see there 
recently, and isn't that a more stable and sensible and sound 
way to manage our economy.
    So my fundamental argument about deficits in the short run 
would be that we are just--this is not good risk management. We 
are just putting the economy of the country at risk in a way 
that we don't have to do.
    Now, things get much worse in the long run, and you have 
already seen David Walker's charts and so forth, and you know 
it is driven by entitlement spending, the demographics. I would 
just make one further point about that.
    Right now, we have roughly 3.3 workers per retiree; and by 
2030 we are going to have two workers per retiree. How are 
these workers in 2030--and these are our kids and grandkids--
going to support us if we are still lucky enough to be alive in 
2030? Well, they are going to need more capital. That is the 
way they are going to support us. And the only way they get 
more capital is by saving more; and so this is a very bad time, 
I would put, for national saving to drop as it has.
    The last point, one simple thing, I am going to try to be 
nonpolitical about this. Should we fix the deficit on the tax 
or expenditure side? In the long run, it is obvious. We really 
have to do something about the growth of entitlement spending. 
In the short run, I would say it is not so obvious. We could 
fix it on either side, and I know it is a huge political issue 
for all of you, but I would just make the simple point as an 
economist that the problem here is the deficits. These are what 
ought to be fixed.
    If your belief is that America needs lower tax rates, fine, 
great, congratulations, but you have to cut spending. If your 
belief is that in some areas America needs more spending, fine, 
great, congratulations, but you have to be willing to pay the 
taxes to cover that spending.
    Thank you, Mr. Chairman.
    Chairman Spratt. Thank you, Dr. Gramlich.
    [The prepared statement of Edward M. Gramlich follows:]

  Prepared Statement of Edward M. Gramlich, Richard B. Fisher Senior 
                      Fellow, the Urban Institute

    Thank you, Mr. Chairman and committee members, for soliciting my 
testimony on the federal budget deficit problem. It is indeed a 
problem, as I will try to argue.
    Arguments about budget deficits have gotten into the political 
domain, and it is probably no surprise that controversy has grown up 
about deficits--just how bad are they? To try to illustrate the exact 
nature of the problem, I will paraphrase Charles Schultze, the 
Brookings scholar and former budget director. Some years ago Schultze 
asked whether deficits could be likened to a pussycat, a wolf at the 
door (huffing and puffing to blow the house down), or to termites in 
the basement. Answering this question is critical in knowing whether 
deficits are a problem and why.
    The pussycat argument holds that deficits are not a problem because 
private savers offset them. As deficits rise, the argument goes, 
perceptive citizens foresee that future tax payments will be higher, or 
transfer payments less, and will save more to cover their future costs. 
This view can be contradicted by personal experience--how many families 
do each of you know who save more when federal deficits rise? But if 
this reasoning is not convincing, refer to the attached chart, which 
compares the BEA concept of national saving with federal budget 
surpluses (+) or deficits (-). Over nearly a fifty-year period the two 
track very well. This indicates that as federal deficits rise, private 
saving changes little, and national saving falls. In other words, 
private saving does not offset the deficits.
    The argument for the wolf at the door, huffing and puffing to blow 
the house down, takes almost a completely opposite position. This time 
the argument is that high federal deficits will either put pressure on 
the Fed to create money to finance the deficits, hence causing 
inflation, or worry lenders into charging higher interest rates to 
finance the deficits. The US has run large deficits for some years and 
neither has happened. For nearly three decades the Federal Reserve has 
been determined to keep inflation low and stable, it has been perfectly 
free to do that (financing as much of the deficit as it deems wise), 
and it has done just that. Deficits have come and gone, but the Fed has 
been able to keep inflation on track.
    As for bondholders, there has been speculation that they would 
insist on higher long-term bond rates as deficits rose, but this really 
hasn't happened either. Long-term rates are well-behaved right now--
indeed, former Fed Chairman Greenspan referred to their low levels as a 
conundrum--and most reasonable forecasts expect them to remain so in 
the near future. We could worry that high deficits will cause high 
interest rates, but that would be, well, crying wolf.
    So we are left with the termite argument, the one I favor. As the 
chart shows, deficits do lower national saving--of that there seems 
little doubt. When national saving declines, it is a mathematical 
truism that one of two things must happen:
    a) domestic investment in capital equipment must decline, lowering 
America's long-term rate of productivity improvement;
    b) domestic investment will not decline but the country will borrow 
the difference, in the form of higher current account deficits in the 
balance of payments.
    This choice is not an assertion, it is true by definition. I could 
show a new set of charts here, but most of you know what happened. So 
far domestic investment has held up well, and the nation has made up 
the difference between saving and investment by borrowing from 
foreigners.
    I think most of you would accept the fact that if the deficit-
induced decline in national saving were to erode domestic investment, 
that would be a bad thing. It is a competitive world out there and our 
nation has to invest in new equipment, keep new techniques coming on-
stream, and maintain its economic strength. The harder part of the 
argument is on the foreign side--if foreigners persist in lending us 
whatever we need to keep investment high, why worry?
    My colleague, Ted Truman, will address this issue in depth, but let 
me make one simple point. How do we know that foreigners will keep on 
lending to us? And at a more basic level, why should the United States 
put itself at the mercy of foreign lenders? One would think we should 
manage our affairs to keep national saving as high as we think it 
should be, from an optimizing standpoint. If foreigners lend to us, our 
own investment will be that much higher. If not, we are protected 
against a decline in investment by our own national saving. The basic 
problem with letting national saving fall is that the country becomes 
vulnerable.
    There is also an important time dimension to the budget problem, 
stressed by Chairman Bernanke in his testimony to the Senate a few days 
ago. Soon the large baby boom cohort in the United States will hit 
retirement ages, and when that happens, projected entitlement spending 
rises rapidly. The Social Security trust fund contributes a cash 
surplus to the budget now, but that cash surplus will be gone in a 
little more than a decade and ultimately will become a big cash 
deficit. Simultaneously, health care spending is likely to be rising 
rapidly. The time to take matters under control, to get our deficits 
down and national saving up, is now.
    Looking at this issue another way, presently the nation has a 
little more than three workers per retiree. In 2030 there will be about 
two workers per retiree. If those workers are to support the rising 
number of retirees, they will need more capital. They can only get 
capital through higher national saving. That is exactly what we should 
be doing today--saving at higher rates. Instead we have let the budget 
deficits erode national saving.
    So this is the argument, Mr. Chairman. Deficits are not like a 
pussycat, with no effect. Nor are they likely to huff and puff and blow 
our house down. But they do either erode investment, or force the 
nation to borrow the difference, and in that way they do eat away at 
the foundation. Moreover, demographics is going to make the deficit 
problem much worse in the future than now. The time to act to get 
deficits under control is now.
    Politics is never far away from such discussions, so I can hardly 
campaign against deficits without commenting on whether they should be 
changed on the tax or expenditure side. Basically, as a macroeconomist, 
I don't think it matters much. It is often argued that it is necessary 
to keep tax rates low. In truth, the US has probably never had a better 
macroeconomic decade than the 1990s, following tax increases at the 
beginning of the decade. There have been other eras when good 
performance followed tax cuts. When national tax rates get very high, 
there is a theoretical argument against letting them increase further, 
but at present moderate rates I do not think it matters much whether 
the budget adjustment is made on the tax or expenditure side of the 
ledger.
    Putting this challenge differently, some politicians may like to 
keep taxes lower. Fine, no problem, but these same politicians must 
then commit to keep spending lower, making the necessary cutbacks in 
spending. Some politicians may like a larger and more expansive 
government. Fine, no problem, but these politicians must then be 
willing to assess higher taxes. Deficits can be fixed on one side of 
the budget or the other, but from a long-term economic management point 
of view, they should be fixed.

    Chairman Spratt. Dr. Truman, we would be happy to hear from 
you now.

STATEMENT OF EDWIN M. TRUMAN, SENIOR FELLOW, PETERSON INSTITUTE 
                  FOR INTERNATIONAL ECONOMICS

    Mr. Truman. Thank you, Chairman Spratt, Mr. Ryan, members 
of the committee.
    It is a pleasure to appear before you today as a pinch-
hitter for Fred Bergsten, who is the Director of the Peterson 
Institute for International Economics. Fred was called out of 
town on a family emergency. He regrets he cannot participate in 
your hearing on this important topic.
    I worked closely with him on preparation of his testimony. 
The words are his, but I fully share the thinking. These oral 
remarks are my own responsibility.
    Fred was asked in particular, as Ed Gramlich just 
indicated, to address the international dimensions on why U.S. 
budget deficits matter. Should we be concerned that foreigners 
now own more than 50 percent of U.S. Treasury debt that is in 
private hands? Should we be concerned that foreigners own about 
15 percent of the value of U.S. long-term securities? We have 
tables in the testimony documenting all this. Should we be 
concerned that at the end of 2005, the latest comprehensive 
data available, our net debt to foreigners was 22 percent of 
our GDP and our gross debt to foreigners was $13.6 trillion, 
equal to almost 110 percent of our GDP?
    The answer is not entirely straightforward. On the one 
hand--as a two-handed economist, we do not need to worry about 
foreign holdings of U.S. Treasury securities per se. Because of 
the size and liquidity of our capital markets, the form in 
which foreigners hold claims on the United States is of 
marginal importance. Who they are is also relatively 
unimportant, whether they are private holders or official 
holders. However, what is important is that foreigners as a 
group continue to hold existing claims on the United States in 
some form and continue to add to their holdings at a rate of 
about $2 trillion a year to cover both our current account 
deficits and our capital outflows.
    Our overall dependence on foreign financing is one of the 
major reasons why we should adopt a national policy objective 
of restoring the modest budget surpluses that were in place as 
recently as 1998 to 2001, preferably by the end of this decade, 
and excluding off-budget financing. If we do not put our house 
in order, as the phrase goes, the performance of the U.S. 
economy is vulnerable to an abrupt cessation of foreign capital 
inflows.
    This is the one point I think in terms of your hearings 
where there is some difference between the sort of longer-term 
view that you have heard from David and Ned, which is certainly 
correct, but, in the short run, we may not have as long as we 
think we have, and that has to do with the vulnerability to 
foreign financing.
    As evidence of that vulnerability, note that over the past 
5 years we have only been able to attract the foreign financing 
to cover our current account deficits at progressively lower 
exchange rates--in other words, by selling U.S. assets each 
year at lower prices.
    The cost is also rising in other dimensions. Our gross 
income payments to foreigners are now more than 4\1/2\ percent 
of GDP, compared with less than 2\1/2\ percent 3 years ago. 
Even with today's low interest rates, that figure is rising at 
about a half a percentage point a year.
    In addition, we require--and this was Ned's point--a net 
inflow of saving from abroad to cover more than \3/4\ of our 
net domestic investment, investment that is critical to 
boosting the productivity of our economy as baby boomers 
retire. Thus, because of our dependence on foreign financing, 
the U.S. economy faces the risk of what is called a hard 
landing, not only in the form of a lower dollar, which is 
essentially inevitable, but in the form of higher interest 
rates, lower investments and a weaker economy.
    Moreover, if we fail promptly to put our house in order, 
domestic residents may also lose confidence in our policies and 
seek to move their investments abroad. Their holdings of U.S. 
financial assets are three times those of foreigners.
    Our current account deficit has been widening steadily for 
15 years with only one recession-related narrowing in 2001. The 
deficit may be in the process of leveling out, but the prudent 
policy is to anticipate that the current account deficit will 
be cut in half, to about 3\1/2\ percent of GDP, by the end of 
the decade. Not sure, but that would be the prudent assumption, 
in my judgment.
    If this process is to proceed smoothly, if we are to avoid 
a hard landing for our economy, which could happen even during 
this Congress, we should reduce our reliance on foreign 
savings. We should do so not by erecting barriers to foreign 
trade or to capital inflows but by boosting national savings. 
The only policy tool that we can expect with confidence to 
deliver such an increase in national savings is a comparable 
improvement in the Federal budget position.
    Thank you. I look forward to your questions.
    [The prepared statement of Edwin Truman follows:]

 Prepared Statement of Edwin M. Truman, Ph.D., Senior Fellow, Peterson 
                 Institute for International Economics

                               THE ISSUE

    Foreigners account for about $2.2 trillion, or a little over half, 
of the outstanding total of $4.3 trillion of US Treasury securities 
held by the public. Official institutions, mainly central banks, 
account for about 60 percent of this total. In addition, foreigners as 
a whole probably hold close to $1 trillion, or about 15 percent, of US 
government agency securities. The data are in Tables 1-4,* prepared by 
our colleague Doug Dowson at our Peterson Institute for International 
Economics.
---------------------------------------------------------------------------
    *Editor's Note: Tables begin on page 35.
---------------------------------------------------------------------------
    These totals and ratios have risen rapidly over the past twenty 
years. From 1985 to 2005, foreigners acquired almost 75 percent of the 
overall increase in outstanding Treasuries. From 1995 to 2005, domestic 
holdings actually fell while foreign holdings grew by twice the 
aggregate increase. Since 2001, foreign purchases of Treasuries have 
accounted for most of the rise in the total outstanding.\1\
    These data raise the obvious question of whether the United States 
in general, and the US Government in particular, have become 
excessively dependent on foreigners to finance our domestic economy and 
indeed our federal budget. The ultimate concern is whether these 
holders, or perhaps some subset of them such as foreign governmental 
institutions, might precipitate a financial crisis by rapidly selling 
off large amounts of Treasuries for economic or even political reasons.

                     FOREIGN HOLDINGS OF TREASURIES

    The answer to these questions is two-fold. First, we do not need to 
worry very much about foreign holdings of US Treasury securities per 
se. The US capital markets are so large and so liquid, and the Treasury 
market is a sufficiently modest component of it, that foreign shifts 
from Treasuries to other dollar investments could readily be 
accommodated by a reallocation of the portfolios of other investors. We 
should worry even less about the risk of liquidation of Treasuries by 
foreign official institutions, including the largest holders in Japan 
and China, who are the least likely sources of disruption of our 
financial markets in view of their responsibilities for financial 
stability and their institutional aversion to being blamed for any 
disruption of the world economy--and, unfortunately, due to the desire 
of many of these countries to maintain undervalued exchange rates to 
bolster even further their international competitiveness.\2\
    It would in fact be a mistake to overemphasize the 50 percent share 
of foreign holders of US Treasuries. The reason is that Treasury long-
term debt accounts for less than 10 percent of the total stock of 
outstanding long-term US securities (Table 3). The addition of USG 
agency securities, of which foreigners hold about 15 percent, leaves 
their holdings of all governmental paper at about 20 percent of the 
overall capital market. Hence there is plenty of room for reallocation 
of investment portfolios by different groups of investors among 
different asset classes. If foreigners decided to shift their holdings 
of Treasuries to US agencies or corporate bonds (or bank deposits or 
some other assets), as they in fact seem to be doing (at least from 
short-term Treasury bills) in recent years, other investors would be 
attracted by the reduction in prices of Treasuries to make switches in 
the opposite direction. There might be some alteration in the relative 
prices of the different US assets, with a modest increase in the cost 
of financing the federal debt, but major disruptions would be highly 
unlikely.
    When seen in this larger context of the entire US capital market, 
foreign holdings are more on the order of 15 percent. This is 
considerably less than their share of 50 percent in the Treasury market 
by itself. Foreigners hold only about 10 percent of US equities and 
about 20 percent of corporate bonds.
    This conclusion receives strong empirical support from the 
experience of the last few years. Foreign holdings of Treasuries fell 
in 2000-01 but the exchange rate of the dollar continued to rise 
throughout that period. Conversely, foreign holdings of Treasuries rose 
sharply in 2003-04 while the dollar was declining steadily and 
substantially. There is simply no clear relationship between changes in 
foreign holdings of Treasuries and the value of our currency.\3\

            TOTAL FOREIGN CAPITAL FLOWS TO THE UNITED STATES

    Second, however, we do need to worry considerably about total 
foreign holdings of dollar assets and, in particular, the extent to 
which our economy has become dependent on new capital inflows to 
finance both our external and internal deficits because those inflows 
could slow abruptly or even totally dry up at virtually any time. 
Because of the direct impact of the federal budget position on total 
national saving, and thus on our current account imbalance with the 
rest of the world, I believe that this US dependence on foreign funding 
is one of the major reasons we should adopt a national policy objective 
of restoring the modest federal budget surpluses that were in place as 
recently as 1998-2001.
    At the margin, the role of foreigners in financing the US economy 
is much more salient than suggested by the averages cited above: they 
accounted for virtually the entire increase in the total holdings of 
all US long-term securities, including equities and corporate bonds, 
from 2000 to June 2005 (the latest date for which comprehensive data 
are available, see Table 3). It is true that this period is distorted 
by the sharp fall in equity prices after early 2000 and our ratio of 
dependence on foreign investors is considerably lower--though still 
close to 50 percent--if different base periods are chosen. But the 
United States has clearly become reliant on external funding for a very 
large proportion of the investment needed to fuel our domestic economy 
and we need to carefully consider the implications thereof in setting 
national economic policy.
    These financial flows are a manifestation of the very large and 
rapidly growing deficits in the US merchandise trade and current 
account balances with the rest of the world. Those deficits hit $850-
875 billion in 2006, about 7 percent of GDP. They have increased by an 
average of $100 billion annually over the past four years (and by an 
annual average of over $80 billion for the past nine years). Funding 
those deficits requires the United States to attract $3-4 billion of 
foreign money (including direct investment as well as financial 
capital) every working day. As a result, our net foreign debt had 
climbed to $2.7 billion at the end of 2005. In addition, the United 
States exports capital (including direct investment as well as 
portfolio capital) in the range of $500 billion to $1 trillion every 
year, which must also be offset by capital inflows.\4\
    Hence we must attract $7-8 billion of foreign capital every working 
day to avoid significant changes in prices, mainly of interest rates 
and exchange rates but also of equities and housing, throughout the US 
economy. Any substantial diminution of the total inflow of new foreign 
investment into the United States from this required total would have 
jarring effects on our financial markets and thus on our economy. The 
exchange rate of the dollar would fall, interest rates would rise, 
equity prices would almost certainly decline and the weakening of the 
housing market would be exacerbated. The scale of these shocks would 
depend largely on whether the reduction in foreign inflows took place 
quickly, producing a ``hard landing,'' or more gradually over a period 
of several years (as actually occurred in 2002-03 and again, albeit 
sporadically, in 2004 and 2006). With the US economy now at full 
employment, however, unlike in 2002-03 when considerable slack existed 
as we recovered from the recession of 2001, a rapid and sizable fall of 
the dollar could generate substantial inflationary pressure and push US 
interest rates up sharply, perhaps even into double digits, possibly 
triggering a severe recession.\5\
    It would not matter whether the reduced inflow took place via the 
market for Treasury securities or for other asset classes. Nor would it 
matter whether the reduction came from foreign official institutions 
or, much more likely, private investors. What would count, perhaps 
severely, would be the cutback (or, in the extreme case, the drying up 
or reversal) of total foreign demand for additional dollar assets. The 
huge inflows of foreign capital in recent years have held down US 
interest rates and supported our economic expansion, thus obviating for 
a time the ``crowding out'' of private investment and growth that would 
otherwise have occurred as a result of the large budget deficits, but 
they have done so at considerable long-term cost to the economy (in 
terms of future debt service payments to foreigners) and with 
substantial ongoing risk to our stability and prosperity.
    Thus it would not require a liquidation of foreign holdings of 
Treasuries, or any other class of dollar financial assets, to cause 
considerable problems for the US economy. Such liquidations, from the 
current total of such holdings of more than $10 trillion, would 
obviously make the situation worse. But we have become so dependent on 
additional inflows of very large amounts of foreign funds that any 
significant setback therein would have substantial consequences for our 
economy.
    Some observers believe that the United States has not yet reached 
the point where there is serious risk of a large falloff in new foreign 
investment in the dollar.\6\ It is true that the ratio of US foreign 
debt to GDP is only about 20 percent, which is modest by historical 
standards. But it is also true that we are on an unsustainable 
trajectory: my colleague Michael Mussa, the former chief economist of 
the IMF for ten years and a member of the Council of Economic Advisers 
under President Reagan, notes that continuation of the external 
deficits at current levels, let alone any further increases, would 
carry that ratio to at least 50 percent within the next few years and 
ultimately to 100-120 percent. This would be exceedingly dangerous 
terrain for an advanced industrial country, let alone the supposed 
steward of the world's key currency.\7\
    Some observers also downplay the risk of any significant falloff in 
new foreign investments in the dollar on the grounds that ``there is no 
place else to put the money.'' That view has proved repeatedly to be 
wrong in the past as indicated by the sharp falls in the dollar that 
have occurred about once per decade over the last 35 years, notably by 
more than 20 percent in 1971-73, about the same amount in 1978-79, more 
than 30 per cent (and about 50 percent against the DM and yen) in 1985-
87 and (to its record lows) in 1994-95.
    Currently and in the future, however, that view is even more 
incorrect because of the systemic change represented by the creation of 
the euro. The dollar was the world's dominant currency for most of the 
past century for a simple reason: it had no real competition. No other 
currency was based on an economy that was anywhere near the size of the 
United States nor was able to support financial markets of the breadth, 
depth and resiliency of ours. The euro, however, is based on an economy 
that is almost as large and that in fact features considerably larger 
levels of international trade and monetary reserves. Hence it presents, 
for the first time, a true alternative to the dollar and an alternative 
locus for footloose international investment that might previously have 
come into dollar assets.\8\
    Indeed, euro-denominated bonds have attracted more international 
investment than dollar-denominated bonds for the past two years. The US 
financial market (at $48 trillion) is still considerably larger than 
the financial market of the Eurozone ($27 trillion) but now accounts 
for only one third of the global total and the Eurozone market is 
growing twice as fast. The periodic diversifications by foreign central 
banks of their reserve holdings out of dollars are primarily into euros 
and reflect this new international financial reality (though all these 
shifts have been handled in a way that avoids market disruption, 
supporting the conclusion suggested above that foreign official 
institutions are highly unlikely to destabilize markets).\9\

                          THE POLICY RESPONSE

    The only effective response to this potentially severe threat to US 
economic stability and prosperity is to substantially reduce the 
external deficit in our trade and current account balances.\10\ The 
goal should be to cut that deficit at least in half, to about 3-3\1/2\ 
percent of GDP (at which level external funding might well be 
sustainable) rather than the 7 percent or so at present.
    This will require a series of changes in economic policy in the 
United States and other major countries. One essential part of the 
package is to reduce the gap between saving and investment in the 
United States by a like amount of 3-4 percent of GDP, most or all of 
which should be accomplished by increasing national saving since 
reducing investment would weaken both our growth prospects and 
continued improvements in US productivity. The chief policy tool that 
we can deploy with some confidence to promote achievement of this 
objective is a shift in the budget position of the federal government 
over the next several years from today's deficits of 2-3 percent of GDP 
to modest surpluses a la 1998-2001.\11\
    It must be noted that there is no automatic link between the US 
budget and current account deficits. The external imbalance in fact 
soared anew during the late 1990s while the budget was moving into 
surplus (because domestic investment was running at postwar highs and 
continuing declines in private saving offset much of the reduction in 
public dissaving). In theory, there could be some offset to increases 
in public saving achieved by budget improvement via reduced private 
saving (though the two have tended to move in similar rather than 
opposite directions in the United States in recent decades).
    The deficits were much more closely related throughout most of the 
1980s, however, when both reached their previous record highs and 
required substantial adjustment. The external deficits would probably 
be much larger today had the budget not improved so dramatically during 
the 1990s. The tax cuts and rapid spending increases of the early years 
of this decade clearly worsened our external position, by further 
reducing national saving, and played central roles in pushing it to 
today's precarious levels. Indeed, less expansionary fiscal policy in 
recent years would have reduced the need for tightening of monetary 
policy by the Federal Reserve and produced a weaker dollar that would 
have strengthened our current account. Budget correction would almost 
surely promote external adjustment under current circumstances, perhaps 
by around one half of the improvement in the budget itself.\12\
    Trade policy is not the topic of this hearing but I would note, 
before closing, that the creation of new US barriers to imports of 
goods or capital would be an ineffectual and wholly inappropriate 
response to our trade and current account deficits. As indicated 
throughout my statement, these large imbalances are a macroeconomic 
problem that require macroeconomic (including exchange rate) remedies. 
It would be particularly counterproductive to discourage inflows of 
direct investment or any other forms of foreign capital, which we must 
continue to attract as long as we run current account deficits, as 
might well be the result of some of the current proposals for 
``reforming'' the Committee on Foreign Investment in the United States 
(CFIUS) and US policy in that area more broadly.\13\
    I believe there are strong reasons to convert the current, and 
especially prospective, US budget deficits into modest surpluses 
without appealing to these international aspects of the issue. But the 
vulnerability of the US economy to large and prolonged reductions in 
foreign capital inflows, especially if they occur abruptly, surely 
counsel that we ``put our house in order'' as promptly as possible. I 
am delighted that the Committee is assessing these issues as part of 
its deliberations on the fiscal situation and hope they will help 
persuade you to adopt an aggressive stance to sharply improve the 
prospects over the coming budget cycle.

                                ENDNOTES

    \1\ Estimates of these longer trends are presented in Philip D. 
Winters, ``Growth in Foreign Holdings of US Debt,'' Congressional 
Research Service, November 13, 2006.
    \2\ One possible caveat is that rumors of sizable liquidations by 
foreign official holders could spook the markets and trigger a run on 
the dollar. Such rumors concerning Kuwait were in fact widely cited as 
a factor in the sharp fall of the dollar in late 1978, the closest the 
United States has ever come to experiencing a ``hard landing.'' Similar 
rumors in more recent periods, however, have been largely shrugged off 
by the markets.
    \3\ On this issue see especially Edwin M. Truman and Anna Wong, The 
Case for An International Reserve Diversification Standard, Working 
Paper 06-2, Washington, Institute for International Economics, May 
2006.
    \4\ This large US capital outflow reminds us that Americans, at 
least as much as foreigners, could trigger a run on the dollar that 
would have the consequences described later.
    \5\ Martin Neil Baily, ``Persistent Dollar Swings and the US 
Economy,'' in C. Fred Bergsten and John Williamson, eds., Dollar 
Overvaluation and the World Economy, Washington, Institute for 
International Economics, February 2003.
    \6\ See Richard N. Cooper, ``Living with Global Imbalances: A 
Contrarian View,'' Washington, Institute for International Economics, 
November 2005.
    \7\ See Michael Mussa in ``Sustaining Global Growth While Reducing 
External Imbalances,'' in C. Fred Bergsten and the Institute for 
International Economics, The United States and the World Economy: 
Foreign Economic Policy for the Next Decade, Washington, January 2005. 
See also William R. Cline, The United States as a Debtor Nation, 
Washington, Institute for International Economics, September 2005.
    \8\ See C. Fred Bergsten, ``The Euro and the Dollar: Toward a 
'Finance G-2'?'' in Adam S. Posen, editor, The Euro at Five: Ready for 
a Global Role? Washington, Institute for International Economics, April 
2005, especially pp. 30-35.
    \9\ See Truman and Wong, The Case for an International Reserve 
Diversification Standard, Working Paper 06-2, Washington, Institute for 
International Economics, May 2006.
    \10\ These imbalances also add substantially to the difficulties of 
maintaining an open trade policy in the United States. See C. Fred 
Bergsten, ``A New Foreign Economic Policy for the United States,'' in 
C. Fred Bergsten and the Institute for International Economics, The 
United States and the World Economy: Foreign Economic Policy for the 
Next Decade, Washington, Institute for International Economics, January 
2005.
    \11\ Detailed scenarios for doing so can be found in Cline, The 
United States as a Debtor Nation, Chapter 4, and Mussa, ``Sustaining 
Global Growth While Reducing External Imbalances,'' especially pp. 193-
196. It would of course be highly desirable to increase US private 
saving as well. This may happen spontaneously, at least to a limited 
extent, from the decline in the housing market and the rise in interest 
rates more generally but, unfortunately, there are no policy tools that 
can confidently be deployed to do so.
    \12\ There is a wide range of estimates of this relationship but 
they tend to cluster around 50 percent. The main outlier is the Federal 
Reserve, whose much lower estimates are explained and criticized in 
Cline, The United States as a Debtor Nation.
    \13\ Edward M. Graham and David M. Marchick, US National Security 
and Foreign Direct Investment, Washington, Institute for International 
Economics, May 2006.

                                                                                         TABLE 1.--MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES
                                                                                         [In billions of dollars; Holdings\1\ at end of period]
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                June     June
                           Country                              2005     2005      July     Aug      Sept     Oct      Nov      Dec      Jan      Feb      Mar      Apr      May      Jun      Jul      Aug      Sep      Oct      Nov
                                                                (V)      (VI)      2005     2005     2005     2005     2005     2005     2006     2006     2006     2006     2006     2006     2006     2006     2006     2006     2006
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Japan.......................................................    681.2     667.1    669.4    670      672.8    667      667.9    670      653.4    656.4    639      639.4    636.8    636.2    636.3    645      639.6    639.6    637.4
China, Mainland.............................................    243.3     298      296.4    302.1    306.3    301.7    303.9    310      313.9    317.2    317.4    319.2    322.3    325.4    330.4    339.2    342.4    345      346.5
United Kingdom\2\...........................................    140.8      58.8     73.2     87.2     95.8    100.3    135.5    146      157.2    162.3    179.1    166.8    175      201.5    190.3    200.8    207.8    207.5    223.5
Oil Exporters\3\............................................     57.2      68.5     64.1     65.2     66.1     75.4     79.3     78.2     89.4     96.2     98       99.1    102.6    101.5    103.1    107.2    104.4     97.9     97.1
Korea.......................................................     59.4      63       62.6     62.4     64.1     63.7     68.8     69       71.2     72.8     72.4     70.9     68.8     68.9     68.4     66.7     69       69       67.7
Taiwan......................................................     71.3      67.8     68.8     68.4     68.9     68.9     68.3     68.1     68.7     68.9     68.9     68.9     67.5     67.1     66.7     65.6     65       64.5     63.2
Carib Bnkng Ctrs\4\.........................................     66.9      70.9     65.2     67.4     68.3     75       81.2     77.2     64       52.9     60.5     60.1     58.2     60.2     68.7     63.7     51.4     56.3     63.6
Germany.....................................................     61.2      44.1     44.8     47.9     46.4     47.3     48.6     49.9     48       47.9     46.4     46.7     47.2     48.7     50.3     51.9     52.9     52.7     52.1
Hong Kong...................................................     48.7      44.5     44.7     43.6     44.4     44       42.8     40.3     44.6     44.9     46.6     49.4     48.4     48.8     48.9     50.6     49.6     50.6     51
Canada......................................................     43.8      18.5     21.4     23       22.4     26.3     28.5     27.9     29.6     33.3     34.7     36.8     40.8     41.2     42.3     49.1     49.6     49.5     47.8
Brazil......................................................     20.9      22.1     24.5     25       27.5     27.1     28.8     28.7     30.1     33.3     31.4     30.8     32.9     33.4     31.7     43.2     45       46.4     51.1
Mexico......................................................     31.9      29       32       32.9     32.1     34.9     36.6     35       36.5     37.6     40.1     41.9     43.4     45.7     45.7     39.9     39.9     40       38.2
Luxembourg..................................................     43.5      38.8     36.9     38.2     37.6     36.7     36.6     35.6     35.2     36.2     36.6     37.5     38.5     37.4     38       37       37.3     38.1     39.1
Singapore...................................................     29.9      34.4     34.1     34.2     33.9     33.9     33.4     33       32.9     33.5     33.1     36.7     35.7     34.6     34.3     34       33.3     30.5     30.3
France......................................................     19.2      23.2     26.4     28.5     28.5     30       31.3     30.9     32       34.9     34.7     30.1     30.7     29.2     25.6     26.9     21       30       33.7
Switzerland.................................................     39.5      34.9     32.3     32.9     32       32.6     30.7     30.8     30.4     31.2     30.9     31.1     30.5     30.6     31       30.9     29.8     29.7     28.4
Ireland.....................................................     15.6      22.2     23.1     18.9     19.1     22.1     23       19.7     21.1     19.3     19.6     17.7     19       20       19.8     21.3     20.8     21.9     21
Turkey......................................................     13.8      15.3     16.6     15.5     14.6     15.7     18.5     17.4     18.9     21.6     21       21.6     21.5     19.1     21.8     23.3     22.9     21.5     22.7
Netherlands.................................................     13.3      19.1     19.6     18.7     18.2     19.1     16.9     15.7     15.7     15       15.3     15.4     15.4     17       16       14.4     15.8     17.6     18.2
Sweden......................................................     19.4      16.9     16.4     16.8     16.8     16.7     17.1     16.3     17.4     17.1     17.9     18       18.1     18.2     18.3     18.3     17.8     16.9     16.7
Belgium.....................................................     15.9      15.4     15.6     15.8     15.7     15.4     15.6     17       16.7     17.2     17.1     17.4     17.5     17       18.4     17.8     17.1     16.6     16.3
Thailand....................................................     12.9      16.3     15.6     15.7     14.8     16.2     16.2     16.1     17       17.9     17.5     15.6     15.5     15.8     15.8     16.4     16.3     16.1     16.5
Israel......................................................      9.5      10.9     10.5     11.4     11.8     11.9     10.8     12.5     12.5     12.4     12.3     13.4     13.4     11.4     10.4     10.2     13.1     15.2     15.6
Italy.......................................................     14.4      13.1     14.4     14.9     14.2     15.1     16.5     15.4     15       14.3     13.7     13.9     14.2     15.4     14.9     15       14.5     14.7     16.8
Poland......................................................     11.4      12.4     12.2     12.1     12.9     13.2     13.4     13.7     11.3     12.4     12.2     12.3     13.3     11.4     12.8     13.7     13.1     14.4     14.2
All Other...................................................    186.5     152.3    158.3    157      144.5    154      163.8    159.4    163.2    166.6    161.7    150.8    138.5    132.5    139.9    144.8    142.7    160.4    170.3
                                                             ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
      Grand Total...........................................   1971.3    1877.5   1899.2   1925.9   1929.6   1964.3   2034     2033.9   2045.9   2073.2   2078.2   2061.6   2065.7   2088.1   2099.9   2146.8   2132.1   2162.5   2199
                                                             ===========================================================================================================================================================================
Of which:                                                     .......  ........
    For. Official...........................................   1236.6    1258.6   1261.9   1267.8   1256.7   1267.1   1291.8   1284.7   1299.7   1317.9   1310     1303.1   1286.8   1272.1   1281.6   1302.1   1299.2   1316.8   1325.5
    Treasury Bills..........................................    204.9     204.9    203.2    205.4    195.4    199.8    214.9    201.9    210.5    216      215.5    197.5    195.1    185.1    186.3    190      179.4    178.5    186.2
    T-Bonds & Notes.........................................   1031.7    1053.7   1058.7   1062.4   1061.3   1067.3   1077     1082.8   1089.2   1101.9   1094.6   1105.6   1091.7   1087     1095.2   1112.1   1119.8   1138.3   1139.3
                                                             ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Total Marketable Outstanding................................   4012.6    4012.6   4059.1   4087.6   4066.1   4112.5   4166.5   4165.8   4176.3   4259.5   4321.7   4264.5   4250.5   4235.1   4261.3   4325.3   4283.8   4318.6   4361.4
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Department of the Treasury/Federal Reserve Board, January 17, 2007.

\1\ Estimated foreign holdings of U.S. Treasury marketable and non-marketable bills, bonds, and notes reported under the Treasury International Capital (TIC) reporting system are based on annual Surveys of Foreign Holdings of U.S.
  Securities and on monthly data.
\2\ United Kingdom includes Channel Islands and Isle of Man.
\3\ Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria.
\4\ Caribbean Banking Centers include Bahamas, Bermuda, Cayman Islands, Netherlands Antilles and Panama.


                             TABLE 2.--MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES
              [Share of total outstanding including bills (percent); Holdings\1\ at end of period]
----------------------------------------------------------------------------------------------------------------
                                            Q2      Q2
                 Country                   2005    2005     Q3      Q4      Q1      Q2      Q3      Oct     Nov
                                            (V)    (VI)    2005    2005    2006    2006    2006    2006    2006
----------------------------------------------------------------------------------------------------------------
Japan...................................    17.9    17.5    17.4    16.9    15.5    15.8    15.7    15.5    15.3
China, Mainland.........................     6.4     7.8     7.9     7.8     7.7     8.1     8.4     8.4     8.3
United Kingdom\2\.......................     3.7     1.5     2.5     3.7     4.4     5.0     5.1     5.0     5.4
Oil Exporters\3\........................     1.5     1.8     1.7     2.0     2.4     2.5     2.6     2.4     2.3
Korea...................................     1.6     1.7     1.7     1.7     1.8     1.7     1.7     1.7     1.6
Taiwan..................................     1.9     1.8     1.8     1.7     1.7     1.7     1.6     1.6     1.5
Carib Bnkng Ctrs\4\.....................     1.8     1.9     1.8     1.9     1.5     1.5     1.3     1.4     1.5
Germany.................................     1.6     1.2     1.2     1.3     1.1     1.2     1.3     1.3     1.2
Hong Kong...............................     1.3     1.2     1.1     1.0     1.1     1.2     1.2     1.2     1.2
Canada..................................     1.2     0.5     0.6     0.7     0.8     1.0     1.2     1.2     1.1
Brazil..................................     0.5     0.6     0.7     0.7     0.8     0.8     1.1     1.1     1.2
Mexico..................................     0.8     0.8     0.8     0.9     1.0     1.1     1.0     1.0     0.9
Luxembourg..............................     1.1     1.0     1.0     0.9     0.9     0.9     0.9     0.9     0.9
Singapore...............................     0.8     0.9     0.9     0.8     0.8     0.9     0.8     0.7     0.7
France..................................     0.5     0.6     0.7     0.8     0.8     0.7     0.5     0.7     0.8
Switzerland.............................     1.0     0.9     0.8     0.8     0.8     0.8     0.7     0.7     0.7
Ireland.................................     0.4     0.6     0.5     0.5     0.5     0.5     0.5     0.5     0.5
Turkey..................................     0.4     0.4     0.4     0.4     0.5     0.5     0.6     0.5     0.5
Netherlands.............................     0.3     0.5     0.5     0.4     0.4     0.4     0.4     0.4     0.4
Sweden..................................     0.5     0.4     0.4     0.4     0.4     0.5     0.4     0.4     0.4
Belgium.................................     0.4     0.4     0.4     0.4     0.4     0.4     0.4     0.4     0.4
Thailand................................     0.3     0.4     0.4     0.4     0.4     0.4     0.4     0.4     0.4
Israel..................................     0.2     0.3     0.3     0.3     0.3     0.3     0.3     0.4     0.4
Italy...................................     0.4     0.3     0.4     0.4     0.3     0.4     0.4     0.4     0.4
Poland..................................     0.3     0.3     0.3     0.3     0.3     0.3     0.3     0.3     0.3
All Other...............................     4.9     4.0     3.7     4.0     3.9     3.3     3.5     3.9     4.1
                                         -----------------------------------------------------------------------
      Grand Total.......................    51.8    49.4    49.9    51.2    50.5    51.8    52.3    52.3    52.7
                                         =======================================================================
Of which:
    For. Official.......................    32.5    33.1    32.5    32.4    31.8    31.6    31.9    31.9    31.7
    Treasury Bills......................     5.4     5.4     5.1     5.1     5.2     4.6     4.4     4.3     4.5
    T-Bonds & Notes.....................    27.1    27.7    27.5    27.3    26.6    27.0    27.5    27.6    27.3
----------------------------------------------------------------------------------------------------------------
Department of the Treasury/Federal Reserve Board, January 17, 2007.

\1\ Estimated foreign holdings of U.S. Treasury marketable and non-marketable bills, bonds, and notes reported
  under the Treasury International Capital (TIC) reporting system are based on annual Surveys of Foreign
  Holdings of U.S. Securities and on monthly data. The total debt outstanding excludes debt held by the U.S.
  Treasury and other federal agencies and trust funds and holdings by the Federal Reserve Banks.
\2\ United Kingdom includes Channel Islands and Isle of Man.
\3\ Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia,
  the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria.
\4\ Caribbean Banking Centers include Bahamas, Bermuda, Cayman Islands, Netherlands Antilles and Panama.


                TABLE 3.--VALUE OF FOREIGN-OWNED U.S. LONG-TERM SECURITIES AND SHARE OF THE TOTAL
         [Outstanding, by asset class, as of selected survey dates; Billions of dollars except as noted]
----------------------------------------------------------------------------------------------------------------
                                            Dec.     Dec.     Dec.     Mar.     June     June     June     June
            Type of security                1984     1989     1994     2000     2002     2003     2004     2005
----------------------------------------------------------------------------------------------------------------
Equity:
    Total outstanding\1\................    2,131    4,638    7,767   24,703   17,904   17,941   20,779   22,041
    Foreign-owned.......................      105      275      398    1,709    1,395    1,564    1,930    2,144
    Percent foreign-owned...............      4.9      5.9      5.1      6.9      7.8      8.7      9.3      9.7
Marketable U.S. Treasury:
    Total outstanding\2\................      873    1,515    2,392    2,508    2,230    2,451    2,809    3,093
    Foreign-owned.......................      118      333      464      884      908    1,116    1,426    1,599
    Percent foreign-owned...............     13.5       22     19.4     35.2     40.7     45.5     50.8     51.7
U.S. government agency:
    Total outstanding\3\................      507    1,167    1,982    3,575    4,830    5,199    5,527    5,591
    Foreign-owned.......................       13       48      107      261      492      586      619      791
    Percent.............................      2.6      4.1      5.4      7.3     10.2     11.3     11.2     14.1
Corporate and other debt:
    Total outstanding\4\................    1,305    2,599    3,556    5,713    7,205    7,852    8,384    8,858
    Foreign-owned.......................       32      191      276      703    1,130    1,236    1,455    1,729
    Percent foreign-owned...............      2.5      7.3      7.8     12.3     15.7     15.7     17.6     19.5
Total U.S. long-term securities:
    Total outstanding...................    4,682    9,904   15,700   36,583   32,169   33,443   37,499   39,583
    Foreign-owned.......................      268      847    1,244    3,558    3,926    4,503    5,431    6,262
    Percent foreign-owned...............      5.7      8.6      7.9      9.7     12.2     13.5     14.5     15.8
----------------------------------------------------------------------------------------------------------------
\1\ Source: Federal Reserve Statistical Release Z.1, Flow of Funds Accounts of the United States, Table L213,
  row 1, minus: Table L213, row 3, plus Table L214, row 1, plus Table L206, row 1.
\2\ Source: Bureau of the Public Debt Table 1 Summary of Public Debt Summary of Treasury Securities Outstanding,
  Total marketable held by the public less Bills.
\3\ Source: Federal Reserve Statistical Release Z.1, Flow of Funds Accounts of the United States, Table L210,
  row 1, less the amount of this figure determined by staff research to represent short-term securities
  (approximately $587 billion as of June 30, 2005). U.S. government agency securities include all securities
  issued by federally sponsored agencies and corporations, as well as all securities guaranteed by the
  Government National Mortgage Association (GNMA).
\4\ Source: Federal Reserve Statistical Release Z.1, Flow of Funds Accounts of the United States, Table L212,
  row 1, less Table L212, row 3, plus Table L211, row 1, less Table L211, row 3.


 TABLE 4.--VALUE OF FOREIGN HOLDINGS OF U.S. SECURITIES, BY MAJOR INVESTING COUNTRY AND TYPE OF SECURITY, AS OF
                                                  JUNE 30, 2005
                                              [Billions of dollars]
----------------------------------------------------------------------------------------------------------------
                                                                  Treas.  Agency LT debt   Corp. LT debt
                     Country                       Total  Equity    LT   --------------------------------   ST
                                                                   debt     ABS    Other    ABS    Other   debt
----------------------------------------------------------------------------------------------------------------
Japan...........................................   1,091     178     572      54      86      37      66     100
United Kingdom..................................     560     260      45      12      11      71     144      16
China, P.R......................................     527       3     277      56     116       7      29      40
Luxembourg......................................     460     151      30      13      21      36     172      37
Cayman Islands..................................     430     152      30      32      10      77     103      26
Belgium.........................................     335      18      13       1      50      38     210       5
Canada..........................................     308     221      14       *       4      18      37      13
Netherlands.....................................     262     161      17      12       6      22      36       8
Switzerland.....................................     238     129      29       4       7      29      26      15
Bermuda.........................................     202      59      24      16      12      22      48      20
Country unknown.................................     196       2       *       *       *       1     192       1
Rest of world...................................   2,254     811     546      63     203      96     214     322
                                                 ---------------------------------------------------------------
      Total.....................................   6,864   2,144   1,599     264     527     453   1,276     602
                                                 ===============================================================
Of which: Holdings of official foreign             1,938     177   1,054      63     261      17      44     322
 institutions...................................
----------------------------------------------------------------------------------------------------------------
* Greater than zero but less than $500 million.

\1\ Asset-backed securities. Agency ABS are backed primarily by home mortgages; corporate ABS are backed by a
  wide variety of assets, such as car loans, credit card receivables, home and commercial mortgages, and student
  loans.

Asset-backed securities (ABS) are securities backed by pools of assets, such as pools of residential home
  mortgages, which give the security owners claims against the cash flows generated by the underlying assets.
  Unlike most other debt securities, these securities often repay both principal and interest on a regular
  basis, thus reducing the principal outstanding with each payment cycle. However, some classes of ABS replace
  repaid principal with additional assets for a set period of time, thus holding the total principal outstanding
  constant.

    Chairman Spratt. Thank you very much, all of you, for your 
testimony.
    General Walker, let me go back to one of your charts. I 
have forgotten one which--and they all, I think, have this 
underlying problem. I think we can solve Social Security. It 
requires that we come together, put everything on the table, 
bring everybody to the table. We have got a model for that, 
1983. It worked. We made Social Security solvent for the next 
60 years, in effect; and we can do that again.
    Medicare is the conundrum. It is the big, difficult 
problem. And the underlying reason for that, the major reason, 
is that the cost of medical care is going up at 2\1/2\ percent 
to 3 percent over and above the CPI, the rate of inflation in 
our economy, every year. As you compound that, you see the 
problems, the outyears looking just impossibly enormous, as you 
have just shown on your table. Would you agree that the real 
resolution of Medicare's problem is a subset of the resolution 
of the whole problem of the cost of healthcare delivery in the 
country?
    Mr. Walker. Yes, I would. Healthcare represents the single 
largest fiscal challenge of the Federal Government. Healthcare 
represents the single largest, arguably, domestic policy 
challenge in the United States; and the two big drivers to the 
Federal long-range fiscal imbalance are demographics and 
healthcare cost. As you can see from the numbers that I have 
put up, that Medicare is in five times plus worse shape than 
Social Security, just Medicare alone. That doesn't count 
Medicaid or civilian and military, you know, healthcare.
    Chairman Spratt. Healthcare entitlements, TRICARE, 
Medicaid, Medicare, all of them are afflicted with this 
problem.
    Mr. Walker. Correct. And, ultimately, I believe that we are 
going to have to engage in comprehensive reform of our entire 
healthcare system in installments over a number of years.
    Chairman Spratt. Dr. Gramlich, Dr. Truman, do you care to 
comment on that?
    Mr. Gramlich. I would certainly agree. I was Chair of the 
Social Security Advisory Council in the mid-1990s, and the 
first thing you said, can we fix Social Security, yes, I firmly 
believe we can, and there are many ways to do it, and they are 
not that painful.
    But the health programs, you throw up your hands at. 
Because, number one, the dollars are much more and the ethical 
issues are much worse. With Social Security, you are only 
talking money. Somebody gets a little bit more or a little bit 
less. We can deal with those kinds of questions. But, with 
Medicare, you start talking about denying treatments for this 
and that sort of thing, and you just take the whole discussion 
to a new level, and that becomes much harder for anybody to 
think about and also much harder to think about politically.
    Chairman Spratt. Dr. Truman, we were all raised on 
Samuelson in Economics 101; and we were taught by Paul 
Samuelson that we owed the debt to ourselves, so not to worry. 
It is fundamentally different today. Are you concerned about 
that? And when do we hit the wall? When do we reach the limit 
of foreigners' willingness to keep purchasing dollar-
denominated assets?
    Mr. Truman. Well, the honest answer to that question is, we 
don't know when we hit the wall.
    I was joking with Ned Gramlich yesterday that, when I was 
still at the Federal Reserve, we presented a presentation to 
the Board and FOMC, suggesting that the current account deficit 
was on an unsustainable trajectory. That was in 1996. We are 
now in 2007. I still believe we are on an unsustainable 
trajectory, but it is true that there is no assurance about 
when they are going to hit a wall.
    What is true is that the costs are going up, and the risks 
of--because the debt is larger today, the risks are, in my 
view, larger. Therefore, to pick up a phrase that Ned used in 
another context, prudent risk management would say you should 
start addressing those risks so that when the inevitable change 
in the availability of foreign savings comes about--and it may 
well be starting now because it looks like the current account 
is about leveled out--then you are replacing the savings that 
we have been sucking in from abroad by savings at home.
    The alternative, the arithmetic that Ned had in his chart, 
the alternative is is that investment will go down. Investment 
goes down, growth goes down, and then solving some of these 
other problems, right, generating the revenues that are 
necessary to--and the income that is necessary to generate the 
programs will be that much more difficult.
    So I don't predict the end of the world, if I might put it 
that way, but I think the risk--right--the probability 
statement is non-zero that we could have a messy period over 
the next 3 or 4 years, and that is the sense in which in some 
sense--and that is driven by confidence in our policies, what 
is done here and the sense in which we have gotten our hands 
around some of these longer-term problems. Because our 
financial markets have a way of bringing home, bringing back to 
today the problems that we see on these charts out there 20 
years from now.
    But, as always, it doesn't happen instantaneously, and no 
set of economists can tell you what has happened, but we have 
had several periods of very abrupt and painful dislocative 
movements of the dollar and associated movements in interest 
rates in the last 30 years, and I think you can't rule out 
another one.
    Chairman Spratt. Mr. Walker.
    Mr. Walker. We have three financial deficits that are of 
concern and somewhat interrelated. We have a budget deficit, 
which we have talked about. We have a balance of payments 
deficit, and we have a savings deficit. There is absolutely no 
question that we are on an imprudent and unsustainable fiscal 
path. There is absolutely no question that our risk will 
increase over time. Nobody knows for sure when and if we will 
hit the wall and how bad it will be, but it is fundamentally 
imprudent to continue on our current path.
    Chairman Spratt. Thank you all for your testimony.
    Mr. Ryan.
    Mr. Ryan. I thank the Chairman for yielding.
    Mr. Walker, I love it when you come and give these 
presentations that are extremely helpful and very valuable.
    You know, our big problem is we don't seem to be able to 
come together for a fundamental entitlement reform, and I blame 
politics as a big reason for that, both sides. You know, we do 
seem unwilling to come together, bite the bullet, even though 
we know it might cost us politically, and actually 
fundamentally fix these things and change these things.
    I am not going to ask you to give us political solutions. 
That is not your job. But what can we do in the form of metrics 
to improve our understanding and appreciation for the situation 
that we are in?
    I think the chairman is right--he is not right when he said 
that we were all raised on Samuelson. Many of us may have 
studied him, but some of us were raised on Friedman. But he is 
right in saying that Social Security is pretty easy to fix. 
Social Security is a containable problem within itself.
    The healthcare stuff is all--they are manifestations of the 
healthcare situation we have. So a much, much bigger obstacle 
to tackle.
    The question that I want to ask you is in the context of 
this: We can fix these entitlement programs easily if we wanted 
to. We could just raise FICA taxes, and we could just raise the 
payroll tax to 25 percent and pretty much probably fix the 
problem.
    The problem is we have two economic threats. We have the 
entitlement threat, which is a fiscal meltdown, but we also 
have globalization. We have competitiveness. We have the threat 
that confronts our standard of living with a new kind of sense 
of competition we have never seen before that confronts us in 
the 21st century, and so we--at least many of us believe we 
need to think about our international competitiveness and the 
competitiveness of our workers as we figure out how to fix 
these entitlement problems. So that is why many of us don't 
want to just tax our way out of this problem. Because we know, 
if we will do so, we will lose our prosperity and just 
eviscerate our standard of living.
    So how do we better measure this stuff? What metrics can we 
use to give policymakers and the public a better appreciation 
for the real mix that we are in and to do so within the context 
of realizing we have to keep an eye on our international 
competitiveness so that we can enjoy good jobs at good wages so 
we can enjoy a higher standard of living?
    Mr. Walker. I think additional transparency in metrics are 
very, very important in order not only to help the Congress 
understand what needs to be done and to help manage the way 
forward but to help the American people understand where we 
are, where we are headed, the need for tough choices, the 
prudence of doing it sooner rather than later so that, frankly, 
they will reward members who have the courage to think about 
our future, rather than penalizing them and not returning them 
to office.
    Mr. Ryan. That is exactly the question I am trying to ask. 
How can you shift----
    Mr. Walker. Two ways. Two ways. Number one, I and others 
have been involved since September of 2005 in something called 
the Fiscal Wake-Up Tour, where myself from the government as 
well as the Concord Coalition, the Heritage Foundation, the 
Brookings Institution and a variety of other groups, including 
AICPA, AGA, AARP, Committee for Economic Development, have been 
going to various cities around the country--we have been to 15 
already; we average about one a month--to state the facts and 
speak the truth about where we are, where we are headed, the 
need for action, the consequence of inaction.
    I use a number of the graphics that I have showed you 
there. The American people are pretty smart. They get it. They 
get it pretty quickly. So that is one thing we are doing. We 
are doing it to try to prepare the way, to till the ground so 
that people can end up making tough choices.
    I might note Diane Rogers, who is on this Committee's 
staff, has been a participant in some of those past Fiscal 
Wake-Up Tour events.
    The second thing that is, in addition to congressional 
testimony, one of the things I am going to be sending to every 
Member of Congress, probably on Groundhog Day, February 2--
which is my dad's birthday, I might add----
    Mr. Ryan. It is my daughter's birthday.
    Mr. Walker. There you go. It is my dad's birthday. On 
Groundhog Day I plan to send to every Member of Congress a 
concise, plain English summary of key financial and fiscal 
facts. I think it is important that Members have a foundation, 
a level playing field as to the past, the present and where we 
are headed in the future in order to help them understand this.
    In the end, I would respectfully suggest that when you talk 
about after we improve transparency, after we impose budget 
controls, we are going to have to do three things: Number one, 
dramatically and fundamentally reform entitlement programs, and 
we are going to have to get the most money out of that. Number 
two, re-engineer, restructure, reprioritize and constrain other 
spending. We are going to have to get money out of that. And, 
thirdly, engage in comprehensive tax reform in ways that will 
generate additional revenues. We are going to have to get some 
money out of that.
    And I would respectfully suggest, you want to try to 
minimize tax burdens in order to maximize economic growth, 
maximize disposable income and maximize our competitive 
advantages compared to other countries. At the same time, in 
the final analysis, you have got to have enough revenues to pay 
your current bills and deliver on your future promises. We are 
short today. We are going to get a lot shorter in the future.
    Mr. Ryan. So you are saying minimize tax burdens to 
maximize growth and output, meaning entitlement reform. Focus 
on reforming the actual entitlement programs themselves more 
than just going down the road of just raising taxes is 
basically----
    Mr. Walker. Well, you are not going to solve your problem 
without serious adverse consequences merely by raising 
revenues. But, again, I don't know anybody who is talking about 
that.
    Again, you are going to have to do all three. Entitlement 
reform and probably get the most money out of that with regard 
to gap spending, restructuring, prioritization, constraint, and 
then tax reform with additional revenues. You are going to have 
to do all three. That is probably relative weighting.
    And round one I would respectfully suggest is as follows: 
Social Security reform, you don't want to do what was done in 
1983. You don't want to be preprogrammed to have to come back. 
There is no need to preprogram to have to come back.
    Number two, round one of healthcare reform and, number two, 
round one of tax reform. Those three would represent a 
significant down payment, a significant credibility enhancement 
on behalf of the public and a significant confidence builder on 
behalf of the Congress.
    Mr. Ryan. Since we are so demographically driven, since our 
systems are a pay-as-you-go system to a full-funded system with 
respect to our entitlements?
    Mr. Walker. Well, obviously, it depends on how you would go 
about achieving that; and one of the concerns would be is that, 
to the extent you have a funded system where the money does not 
belong to individuals, then history shows that it might get 
spent on other things. Let's keep in mind that last year there 
was a $185 billion Social Security surplus, and we spent every 
dime of that Social Security surplus, and we have been doing it 
for years.
    Mr. Ryan. So if you go to a full-funded system, it has got 
to have property rights to protect the government from taking 
it away from people?
    Mr. Walker. Well--or at least put it in a real trust fund 
with real fiduciary responsibilities and liability. That has 
been discussed before.
    For example, I have been involved in conversations over the 
years where there was a possibility of creating a separate 
account within, like the Federal Thrift Savings Plan, that 
would be invested in passive investments, index funds that 
could end up, you know, actually walling off the money so the 
money would not be spent. Now, depending on how much you are 
talking about, it could grow to a very sizable sum. But history 
has shown that, without some type of constraints, that the 
money is likely to get spent.
    Mr. Ryan. Thank you.
    Chairman Spratt. Mr. Gramlich, would you like to add 
something to that?
    Mr. Gramlich. Yes, I do. These programs are hard because 
they are social insurance programs, and you can't--you know, it 
is great to talk about entitlement reform, and we need it. But 
it is a little bit of a buzzword, you know; and I think at some 
point we have to get specific about what we mean.
    Now, first off, we played this out a couple of years ago. 
There are serious risks in going to just making everything into 
individual accounts because there are social risks here, 
especially you can see it in the medical programs, that some 
people, just through the difficulties of health, are going to 
need a lot of money. So I am not sure the private solution does 
things.
    The other thing I tell you is, on your point about metrics, 
Congressman, it has always seemed to me that the real problem 
is that people don't get this information in the form of trade-
offs. For example, having been through Social Security, I think 
one of the most intriguing ideas about how to resolve that is 
to have the retirement age grow slowly with life expectancy. I 
mean, you know, when people are living longer and longer and 
longer and they are on the Social Security system, it just 
becomes unaffordable at some point; and if we had the 
retirement age grow as life expectancy grows and every person 
would work a constant share of their adult life and be retired 
a constant share of their adult life----
    Well, as you know, you are all politicians, and you know 
that raising the retirement age is not popular. And I heard 
some polls on that last fall. Do you want to raise the 
retirement age in Social Security? And everybody said, no, we 
don't.
    Well, that is not the question I would put. The question 
is, do you want to raise the retirement age or do something 
else, like pay 10 percent more taxes or do this or that? These 
questions can't be given to people in the form of takeaways. 
They have to be given to people in the form of tradeoffs. Do 
you want to do this or that? Neither one is going to be 
pleasant, and you have got to make the judgment.
    I have always felt that that is the problem, more than the 
metrics. I think people in a vague sense do know what David is 
talking about. They do know that the population is aging. They 
do know that there are going to be fewer people to support 
their retiree population. They do know that the cost of 
healthcare is rising. We all see that in our daily life. What 
they don't know is what the trade-off is. And I think the 
information that should go to people is that, do you want to 
work longer or do you want to pay more taxes, you know, that 
kind of thing.
    Chairman Spratt. Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman.
    Thank you, each one of the witnesses, for your wisdom. We 
need it.
    You know, Congress is undergoing mandatory ethics training 
right now, but we have a too narrow definition of ethics. I 
think according to your testimony, particularly Mr. Walker's, 
since this is a values question, how we handle these budget 
deficits may be the ultimate ethics question. Because we are 
robbing our children and grandchildren today the way we are 
conducting business in this country.
    The key to me is diagnosis. If we believe on this committee 
in a bipartisan basis that it is cancer, as Mr. Walker said, 
and not a bad cold, as some people would like to suggest, then 
the treatment options become more agreeable. It is never fun to 
undergo radiation or chemotherapy, but if you have got cancer, 
that can be your salvation. So I want to work on the diagnosis.
    You all agree that deficits do matter. I think it is a 
problem sometimes, though, getting us to realize the 
implications of that. For example, Mr. Walker mentioned how 
every penny of the Social Security surplus has been spent. In 
my opinion, one reason that happens is because we only report 
the net deficit number, which allows us to hide the gross 
borrowing figure and the fact that we do make off with the 
Social Security surplus every year.
    The President has held a couple of press conferences 
bragging about how small the net deficit is, but he has always 
omitted the gross borrowing numbers and so much of that money, 
185 million, was borrowed from Social Security and spent on 
other things not related to Social Security.
    Another way of measuring the deficit is to use what 
businesses across America use, which is the accrual deficit 
number or net operating costs. The President has never 
mentioned that deficit either. Precious few people in Congress 
have mentioned it, but that says that the deficit is 450 
billion or 760 billion, not in the 200 billion range. And that 
is a number that Rotarians across America and Lions Club 
members, Civic Club members can relate to because that is the 
way they are required to measure their business. They cannot 
pretend back home in Main Street, America that pension and 
health care liabilities are not liabilities. Only the Federal 
Government is able to do that.
    As you know, business was required to account for pension 
and health care liabilities back in 1992, State and local 
governments have had to do it in recent years. The Federal 
Government is the last holdout. So I am worried that this 
committee operates in an air of unreality.
    You mentioned the Medicare drug bill, $7.9 trillion present 
value liability added to our books, and one of the reasons we 
were able to vote on it is because the Budget Committee under 
prior leadership pretended under our little budget window that 
if the bill came in under 400 billion it was okay for us to 
vote on. That was, as Bruce Bartlett, a Reagan economist, has 
said, possibly the worst bill ever passed in American history 
because it is one of the least funded bills ever passed.
    So I am worried that this committee sometimes 
unintentionally under old rules contributes to the air of 
unreality. And the two primary airs of unreality are not only 
hiding the fact that we are stealing the Social Security 
surplus but also the fact that according to the chief actuary 
of Social Security, Social Security isn't even a promise, it is 
a scheduled benefit. Beneficiaries, even though in all of our 
speeches we say it is a sacred commitment, untouchable, as an 
accounting matter it is completely discretionary with the 
Federal Government.
    So those are the issues I am concerned about. Let's focus 
on diagnosis. Then the treatment options will seem a lot more 
palatable. Any comment?
    Mr. Walker. Yes. First, let's talk a little bit about 
metrics. For fiscal 2006 there are three annual deficit 
numbers. The first is a unified budget deficit, $248 billion. 
The second is the on-budget deficit, $434 billion. The third is 
the net operating cost accrual, $450 billion. But of that 450 
there was a significant actuarial gain, so but for the number 
dealing with the VA the number would have been much higher.
    With regard to pensions and health care, the Federal 
Government is already ahead of the private sector on accounting 
for employer-sponsored pension and health care costs. We book 
the entire unfunded liability for pension, accrued pension and 
health cost for civilian and military employees, and that is on 
the books.
    However, the Federal Government is not where it needs to be 
with regard to accounting for social insurance programs. I do 
not believe for a variety of reasons which I won't go into here 
that you want to book a liability for the $40 trillion that I 
put up. I don't think it is appropriate, I think it is 
misleading, and we shouldn't do it.
    However, I do believe that we ought to have more 
transparency with regard to fiscal sustainability and 
generational equity and I do believe there is an additional 
liability that ought to be booked. Do any of you realize that 
the bonds that are in the Social Security and Medicare Trust 
Funds are not deemed to be a liability of the United States 
Government. You will not find it on the financial statements of 
the U.S. Government. That is wrong, in my view.
    We took the people's money, we spent the people's money, we 
replaced it with a bond that is guaranteed by the full faith 
and credit of the United States as to principal and interest. 
It is in the so-called trust fund, which isn't really a trust 
fund. We will honor that commitment. Whether or not we will 
honor things beyond that is a different question but we will 
honor that, and I think that needs to be changed. So we do need 
to change our financial reporting and quite frankly the other 
thing you need to do on the budget, I would respectfully 
suggest that you need to disclose the discounted present value 
dollar cost of any major spending and tax proposals before you 
vote because there is a lot of gamesmanship that goes on to 
where the costs explode beyond the 5 or 10-year horizon and 
that is just when our wave comes in. That is when the wave 
crest is beyond that 10-year horizon.
    We are shooting ourselves by doing that.
    Chairman Spratt. Mr. Barrett.
    Mr. Barrett. Thank you, Mr. Chairman. General, I love to 
hear your testimony. It is a breath of fresh air. It is a true 
wake-up call. I have got a couple of questions, one for you, 
then one for all three of you gentlemen. You talked about 
working together for fresh air and sunshine with a lot of 
different organizations throughout America to let people know 
exactly what is going on. When it comes to the problem of 
entitlements if there's 435 Members of Congress, there's 435 
different ways to handle how we need to go forward, whether 
they are spending caps, whether it is reconciliation 
legislation or whatever.
    Is there anything that you are doing right now, and if not 
I would encourage you to get these groups together, General, 
whether they be conservative, moderate, liberal, doesn't 
matter, and work a road map. Are you doing anything like that 
right now to give us a road map and in doing that are you 
thinking about major wholesale changes, and I think that might 
be wrong because I think I heard you mention several times 
doing it in kind of a step fashion.
    Second question to all three of you gentlemen, we talk 
about national savings, we talk about Social Security, one of 
the pieces that they have talked about is a personal retirement 
account that has an individual's name on it that is money just 
for them. This is not a novel idea. But my question to you is 
doesn't it make sense to proceed with something like that but 
start it in the first year of someone's life, whether it is 
incentivize or give them or whatever, I don't know. We are 
missing 18 years of productivity and sometimes more if they go 
into the higher ed market or something like that to encourage 
national savings that you can add, take tax breaks out for 
something like that. Just throw those two out to you.
    Mr. Walker. First, the organizations that are involved in 
the Fiscal Wake-Up Tour agree that our financial condition is 
worse than advertised, they agree that we face large and 
growing structural deficits to the known demographic trends in 
rising health care costs and that tough choices are required, 
the sooner the better.
    They generally agree that you are going to have to look at 
all the elements that I have talked about, although there are 
disagreements between the individual groups about how much of 
the gap should be closed through entitlement reform versus 
spending constraint versus tax policy, tax reform and 
additional revenues.
    My personal view is that I think this Congress needs to 
seriously consider whether or not you form a credible, capable 
and bipartisan commission to do three things. Number one, come 
up with a comprehensive reform to Social Security. I could 
write it in 3 minutes and exceed the expectation of every 
generation of Americans. Number two, round one of tax reform; 
and number three, round one of health care reform. I also think 
that you might need to think about some budget and additional 
transparency things if they don't get acted on before that.
    Congressman Wolf and Senator Voinovich have such a bill 
that they have just introduced in this Congress. That is a way, 
it may not be the way. There are other bills that are emerging. 
I know that Senator Domenici and Senator Feinstein have 
introduced a bill. There are other Members such as Senator 
Conrad and Senator Gregg that would prefer to do something that 
is not a commission, would prefer that something be created 
that is only Members.
    You are going to have to have a package that is credible, 
that you can focus on in order to make the tough choices, in my 
view. I think we can help there. I know I can help there and 
would be happy to do it.
    With regard to the last issue, individual accounts. I would 
respectfully suggest that, and we should not look at things in 
isolation. Let's take retirement income security. Social 
Security is the foundation of retirement income security in 
America. It is the only thing that is nearly universal. In the 
private pension system only about 50 percent of full-time 
workers have a pension plan. And most of those are in defined 
contribution plans, individual accounts.
    The savings rate in America for individuals, negative in 
2005. The last year that happened, 1933. Wasn't a good year for 
America. All right. I would respectfully suggest that you need 
to think seriously about reforming Social Security, making it 
solvent, sustainable and secure as a defined benefit program 
with potentially a supplemental individual account on top for a 
lot of different reasons as a way to try to enhance personal 
savings, as a way to provide a pre-retirement death benefit, as 
a way to help finance long-term care and a variety of other 
things. We need to start looking comprehensively.
    Mr. Gramlich. Yes, Congressman. I will just talk about the 
last issue, the individual accounts. I actually agree with I 
think what you are thinking and what David just said. I do 
think we need--I do think it would be a good idea to have 
accounts on top of Social Security. Indeed, I recommended that 
10 years ago when I worked on Social Security.
    But there is a pitfall and we have got to be very careful 
about this. From an economic standpoint the problem is low 
national saving, and so if we get in the position of having to 
give away too many tax advantages to get people to save; if for 
example to get me to save a dollar you have got to give away a 
dollar from the budget, then national saving hasn't improved.
    We have got to focus on the sum of government and private 
saving. If private savers are going to respond to tax 
incentives, that is great and it might be a good idea, but we 
have actually had a lot of saving incentives in the tax system 
over the past 25 years and still the private saving rate has 
gone down.
    So we have to be very careful about this and not give 
people tax inducements to save when they are not going to 
increase their saving because if we do that then national 
saving goes the wrong way.
    Chairman Spratt. Mr. Allen.
    Mr. Allen. Thank you, Mr. Chairman. Thank you all for being 
here. These challenges are so great. One thing is absolutely 
obvious to me, we cannot solve them except on a bipartisan 
basis. They are simply not subject to resolution by one party 
or the other. And I think that where Mr. Ryan was saying we 
can't just tax our way out of these problems, I agree with 
that. We also can't just reduce spending on these entitlement 
programs and get out of the problem that way.
    I do think that probably no place in the Congress reflects 
the debate over these issues better than the debates we have 
had in this committee over the last few years and there are 
some things like sometimes I think we are stuck in the 1980's 
debate about the role of government all across the range here 
and I wanted to bring up one point. The President did--this is 
from a Wall Street--I am sorry, a Washington Post summary of 
one issue and it begins: President Bush wrote in a Wall Street 
Journal op-ed 2 weeks ago that, quote, it is also a fact that 
our tax cuts have fueled robust economic growth and record 
revenues. And the Post says: The claim about fueling record 
revenue is flat wrong.
    And they go on to discuss studies by Greg Mankiw, well 
known to the administration, by the Congressional Budget Office 
and by the Treasury, which basically make the point that tax 
cuts generate only--in terms of additional revenue, tax cuts 
generate only a fraction, a relatively small fraction, though 
of course it is debatable, of the loss in revenue. So the tax 
cuts cause the deficits to go up in a significant way, in fact 
citing the Treasury study, the Post says that those who did 
that study concluded that economic--let me go back to another 
point here. Since the Federal Government collects about 18 
percent of gross domestic product and taxes enlarging GDP by .7 
percent, which is what they say would be the impact of making 
the Bush tax cuts permanent, would result in an extra tax 
revenue equivalent to 0.13 percent of GDP. That would offset 
less than a tenth of the revenue that would be lost because of 
the tax cuts.
    It seems to me that we have got to get a balance here in 
terms of how we think about additional taxes to deal with this 
unprecedented pressure on our entitlement programs and how we 
deal with reform itself. So my question to you is since tax 
cuts increase the deficit and since you have said, Mr. Walker, 
let's start with you, that there needs to be some tax reform 
which goes to added revenue, what do you suggest? I mean how do 
you best keep economic growth continuing and still generate 
added revenues to deal with these entitlement programs? What 
would you recommend?
    Mr. Walker. First, there is a lot of misinformation and 
disinformation in this area. A few key points. Not all tax cuts 
stimulate the economy. Very few tax cuts pay for themselves. 
The only studies that I have seen where tax cuts potentially 
pay for themselves are dramatic reductions in marginal tax 
rates and significant reductions in tariffs. There is a 
difference between whether or not you generate more revenues 
and whether or not you generate as much revenues as otherwise 
you would have had if you didn't have the tax cut. Merely due 
to inflation we are going to generate more revenues. I mean you 
can see that with AMT. We don't index the AMT and more and more 
people are subject to that if you don't end up doing something 
about it.
    There are several things we need to do. One, we need to 
focus on the tax gap, it is $345 billion. We need additional 
information returns, we need additional withholding. We also 
need to engage in more fundamental tax reform to simplify the 
Tax Code that would broaden the base and try to keep rates as 
low as possible but broaden the base in order to facilitate 
compliance and enforcement among other things.
    We need to put tax preferences on the table. They need to 
be subject to periodic review and reexamination. We forego $700 
to $800 billion a year in revenue due to tax preferences. It is 
backdoor spending. It is not on the budget, it is not in the 
appropriations process, not in the financial statements. Needs 
to be on the radar screen, needs to be reviewed just like 
spending. Ultimately I think we are going to need to think 
about moving towards a consumption-based type of tax.
    Mr. Gramlich. A couple of points, Congressman. First off, I 
would agree with both you and David that in general tax cuts 
don't pay for themselves. The other thing, if you think about 
it, in the short run tax cuts do stimulate output in spending 
some, but spending increases do as well. And I don't think 
there is, and the evidence I know of would not suggest a huge 
difference.
    On your broader question of how can we possibly do it, 
well, it may not be that hard. In the 1990s, not that long ago, 
we had a period where we actually had government surpluses. If 
you remember my chart there, government surpluses were high, 
national saving was high, and that was one of the better 
decades ever in American history. So it is not necessary to run 
deficits to have a good economy.
    In the very recent history we have shown that you can have 
a very fine economic outcome with government surpluses and high 
national saving.
    Chairman Spratt. Mr. Bonner.
    Mr. Bonner. Thank you, Mr. Chairman. Mr. Walker, I am going 
to try to break from the mold of the previous question which 
took 4 minutes and 30 seconds, only to give you about 30 
seconds to respond. I would like for you to talk a little bit 
more about your most recent answer to Mr. Allen and that is 
your views on a consumption tax.
    Mr. Walker. Well, I am not a Ph.D. Economist but I do a lot 
of reading and you do have two Ph.D. Economists here. But I 
think what I do know is several things. Income and wealth in 
the United States are distributed fundamentally differently 
today than they were in the early 1900s when our income tax 
system came into place.
    Secondly, the world economy is fundamentally different than 
it was in the early 1900s; and thirdly, that one of the things 
that we need to do is that we need to encourage real savings in 
order to stimulate investment, in order to enhance R&D, in 
order to improve productivity, in order to stimulate additional 
economic growth and further grow our standard of living. All 
right.
    And most research that I have read would say that while you 
will probably never move away from an income tax in toto, but 
to the extent that we can do more consumption-based taxation, 
it is better for economic growth, it is a better chance for us 
to have more savings and generate all of those positive aspects 
that I just talked about.
    The last thing, quite frankly, a lot of the special savings 
incentives don't work. They don't really generate real 
additional savings broadly, and I think when I talked before 
about potentially an additional individual account on top of 
Social Security, I was talking about mandatory savings.
    Mr. Bonner. Would either of those two gentlemen?
    Mr. Gramlich. First off, I was talking about mandatory 
saving on top of Social Security as well. On your point, 
Congressman, I think most economists if you catch them in a 
classroom talking to undergrads, they would probably argue that 
if you could start over a consumption tax system would be 
better than an income tax; that you would in effect tax people 
on how much they take out of the system, not on how much they 
put into it.
    I think most people in their heart of hearts would prefer 
that. But economists have worried about this issue for years 
and years and it is incredibly hard to get from one tax system 
to another, raising hundreds of issues. So I think a lot of 
people who even in their heart are consumption tax advocates 
have just gotten ground down by the problems in transitioning 
from one system to another.
    In the particular case I think you have to be very careful 
of these hybrid situations because right now the tax system is 
giving saving incentives but it also gives you full write-off 
on your borrowing so I can borrow on my house, claim the 
interest deduction, and save tax free. And so the government 
loses and I may not save any more. So you have got to be very 
careful of these hybrid systems.
    If we go all the way to a consumption tax that would be 
great, but it is very difficult to do, I think maybe even 
harder than solving Medicare. So I just give you those words of 
caution.
    Mr. Truman. Two points here. One is I think the crucial 
point, and this builds on what Ned Gramlich just said, is 
whether a consumption tax would be more efficient in terms of 
raising a given amount of revenue especially given the 
transitional problems. That is a very complicated issue, 
especially in the transition area. The second point, just to 
emphasize again but put a slightly different way, there is--the 
reason why the academic and his undergraduate classroom favors 
consumption taxes is because you say you are taxing consumption 
but you are not taxing savings, and savings adds to investment 
and that helps. But the problem is if it is easier to save but 
you only have a target to save X, right, you will still save X.
    And so by not taxing the savings there is no assurance that 
you will increase savings. That is the lesson of all the 
gimmicks that we have used through the tax system and other 
things to increase savings, not to, to go back to the earlier 
question, not that we don't save too little, not that I don't 
think it is a good idea to teach our children or grandchildren 
how to save. My grandchildren have one piggy bank for savings 
and one for spending, I think that is a terrific idea. But 
don't fool yourself that you can make it up because this is the 
difference between what we economists call income and 
substitution effects. And the net may be no more savings for 
the economy as a whole, and if you are interested in generating 
savings for investment in order to support when you get down to 
two workers per retired person, you need a bigger capital stock 
in order to support those people.
    Chairman Spratt. Allen Boyd.
    Mr. Boyd. Thank you very much, Mr. Chairman. This is like 
my second or third hearing and I tell you what, I am intrigued 
by the subject that we are doing here and really enjoying it. I 
was thinking this morning we went yesterday from a first grade 
lesson in budgeting that we went through to something today 
that is as complex as how do we solve the long-term budgeting 
problems of our country.
    My question, I am going to be very brief, Mr. Walker, I 
think that you answered a question a few moments ago to Tom 
Allen about which tax cuts pay for themselves. And I wanted you 
to clarify. I thought I understood you to say that dramatic 
cuts in marginal tax rates and also you mentioned tariffs. 
Would you restate that and elaborate?
    Mr. Walker. The research that I have seen, but my 
colleagues here on the panel may want to jump in, is the two 
that potentially could pay for themselves would be dramatic 
reductions in marginal tax rates like what happened when JFK 
was President. You are talking about huge reductions in 
marginal tax rate, not several percentage points, and dramatic 
reductions in tariffs, which promotes additional trade and 
economic growth.
    Mr. Boyd. So the presumption would be you have to have a 
very large marginal national tax rate to start with to get a 
dramatic cut.
    Mr. Walker. That doesn't mean there is not some positive 
economic stimulus. There is a difference between paying for 
themselves and being stimulative. That is my key point. As Dr. 
Gramlich said, additional spending can stimulate economic 
growth at a price. Tax cuts can stimulate economic growth at a 
price as well. What is going on right now is we have a national 
credit card with no credit limit and we are charging it and our 
kids are going to have to pay off the bill with compounded 
interest costs.
    Mr. Boyd. I think I understand.
    Mr. Gramlich. Just to elaborate on one point. The starting 
point matters in this business because if you have a situation 
let's say 90 percent marginal tax rates, which we have had in 
this country, and you cut it to 80 percent, you know, you may 
well get a big increase in effort and tax revenue and so forth. 
If you go from 36 to 34, you know, that is a different issue.
    Mr. Boyd. I understand. The next question, if I could, Mr. 
Walker. In terms of this discussion about our economy and the 
budget problems that exist, the long-term issues related to 
deficits, the mandatory spending programs, the crisis that 
faces us 10 or 12 years down the road, at what point in time do 
the national, international markets begin to react to that 
gloomy crisis. Would you be willing to expound on that?
    Mr. Walker. Only God knows. In all seriousness. I mean----
    Mr. Boyd. But it happens at some point in time.
    Mr. Walker. In my view there is no question that ultimately 
we will pay a price. The question is what will that price be. 
One could argue that we will have a gradual erosion over time 
rather than a sudden catastrophic event. A gradual, continual 
erosion in the value of the dollar, a gradual increase in 
interest rates over time, a gradual drag on economic growth, on 
standard of living and a variety of other issues. That is a 
possible scenario, rather than a catastrophic event, a 
precipitous decline in the dollar, a dramatic increase in 
interest rates.
    But the bottom line is as we know we are on an 
unsustainable path so we ought to do something about it.
    Mr. Truman. I think that is the point. You have had several 
occasions in our history, right, where the movements in the 
exchange value of the dollar, in the early 70s, the late 70s, 
and the late 1980's have triggered very unpleasant periods in 
our economy, maybe not a full-fledged hard landing but in the 
late 80s, for example, we had a period of very low growth and 
part of that was that we were cutting ourselves off from 
foreign savings, right, and domestic savings wasn't picking up 
and so we damped investment, and it was a period in which GDP 
growth was low, we ultimately had a recession but that had more 
to do with oil prices.
    So you can easily go through that period as David Walker 
was just saying, that makes things no big crisis, though in 
1987, just to remind you, in 1987 the dollar was falling, 
right, and we, I say we because I was then part of the 
government, we begged the foreigners to come help us and they 
said we are not going to help you until you have a budget 
summit which will put on the table a credible commitment to cut 
the budget deficit. I think it was all of $76 billion, but the 
point is there was a sense at that point that that issue--with 
the weak dollar following the stock market crash in October 
1987--came right into this hearing room in a very painful, 
painful, painful way and it was all against the background of 
very slow growth. Very slow growth means that these 10 percent 
rates of increase in revenues aren't going to be there.
    I think no one can say when. The question is how long do 
you want to take the risk that it is not going to be; another 
decade or not.
    Mr. Boyd. Thank you very much. Mr. Chairman, thank you.
    Chairman Spratt. Mr. Garrett.
    Mr. Garrett. Thank you, Mr. Chairman. I thank the panel as 
well. We will start off with I appreciate one of the opening 
comments that you made with regard to your wake-up tour that 
you are traveling around the country about. I just learned of 
that yesterday. I would invite you all to come to my home State 
which is the great State of New Jersey where we may need the 
wake-up.
    Our State is going through equally difficult budgetary 
times. Where other States saw revenue increases and be able to 
cut their taxes, New Jersey is in dire straits right now 
financially. We were supposed to have a budget forum recently 
to try to solve those problems and instead they dealt with 
other social issues as well so we are on the same cusp in our 
State.
    We have taken a different tact in the State of New Jersey. 
Whereas Congress has in the past several years cut taxes to try 
to stimulate the economy and that sort of thing, New Jersey has 
gone the other direction and has actually raised taxes. The 
result is what you see right now and the dilemma that we face 
and, as Ronald Reagan used to say, people vote with their feet, 
and last year 60,000 people voted with their feet and saw a 
decline in our population. I welcome you to come and educate 
our State.
    I commend the General's comment. At the opening comment he 
made two statements. One is we should be looking forward in 
this committee and not in the rear view mirror. We can debate 
all day long as to what the problems were but we need to look 
forward and I appreciate your last slide with the grandkids as 
to who it is all about.
    This Congress passed last session the increase in the 
benefits for Medicare and it is true, and correct me if I am 
wrong, that people that are receiving that benefit today are 
not the people who are paying for it nor is this generation 
really paying for it, it is your grandkids and other grandkids 
who will be paying for the beneficiaries today.
    So I go to my first question is the structural reform that 
you mentioned, how do we get to the structural reform, and ask 
for the comments in this sense as far as entitlement reform 
based upon two comments you all made. One is to minimize the 
tax burden, this was the answer to Mr. Ryan's question, to 
minimize the tax burden is to increase economic growth; so is 
the converse true, to increase the tax burden to decrease 
economic growth.
    And also in light of Mr. Gramlich's comment, a better tax 
system would be not putting a tax you put on the system but a 
tax you take out of the system. Since I may not have enough 
time on this I will ask my last question now and you can answer 
these, and that is going to the Social Security and the whole 
issue of tradeoffs. Mr. Gramlich, you said we need more 
transparency and more of a show to show the tradeoffs to 
people. Can we do anything with regard to the information that 
recipients get every year in our Social Security packets or 
statement on your birthday every year as to show the people 
what the tradeoffs really are. This is what my investment today 
is in Social Security, but show them really what their 
tradeoffs are in the future as far as the alternatives they 
could have gotten had they been in other markets.
    Thank you, gentlemen.
    Mr. Walker. I will touch on a couple. First, bad news flows 
downhill. We are talking about the Federal fiscal challenge 
today. State and local governments have their own fiscal 
challenges. And for those that are interested in having a 
Fiscal Wake-Up Tour come to your State, Bob Bixby, who is 
executive director of the Concord Coalition, is the point 
person. He is the one that schedules the different visits. And 
we have not been to New Jersey yet.
    Secondly, my point on taxes is you want to try to minimize 
tax burdens in order to maximize economic growth, maximize 
disposal income, and maximize our competitive advantages. But, 
in the end, if you don't want to mortgage the future of our 
kids and our grandkids and if you want to mitigate the risk of 
the imprudent and unsustainable path that we are on, you have 
got to have a situation where ultimately we are going to 
generate enough revenue to pay our current bills and deliver on 
our future promises. So we need to recognize that we can't have 
it all.
    Mr. Gramlich. Just a quickie on your very last idea to make 
what are known as the PEB statement, personal earning and 
benefit, even more complicated by putting in these tradeoffs, I 
don't think people would understand it. I would rather have the 
PEB statements go out just as they are now but have the fiscal 
wake-up tour go around and explain the issue because it is--
there are too many options. You can't put in something about 
the retirement age or something about this or something about 
that and have people have any clue what they are getting. I 
think it would just confuse people. And I would rather have it 
done with a little instruction and then focus groups and that 
kind of thing. I think you get farther that way.
    Chairman Spratt. Mr. Scott.
    Mr. Scott. Thank you, Mr. Chairman. Several people have 
mentioned this commission idea. The only problem with the 
commission is that suggests a one-time fix and then it is 
solved. Like Social Security, you had a commission and solved 
it for 5, 10, 15, maybe 20 years. But if you have the one-time 
fix, the following year you can just mess it up all over again. 
We had this thing pretty much on the right track in 2000 and 
all of a sudden it got messed up.
    Unless you have some people willing to continually make the 
tough choices, you are not going to get very far with a one-
time commission.
    The Social Security question, let me, Mr. Walker, ask you a 
question. You have--on your long-term fiscal exposures you had 
Social Security benefits at 3.8 in 2000 and 6.4 in 2006. Does 
that mean we could have fixed it with 3.8 in 2000?
    Mr. Walker. Yes and no.
    Mr. Scott. For 75 years.
    Mr. Walker. Yes, but the next year we would have had a 
deficit. And the reason being is because of known demographic 
trends. What is happening right now, in the short term we have 
surpluses, so every year that passes we drop a surplus year and 
we add on to the end of 75 years an increasing deficit year. 
And that is why it is important that we recognize that reality 
and that the next time there is a commission we try to do 
something to try to assure sustainability beyond that.
    Mr. Scott. Could we have paid 75 years with 3.8?
    Mr. Walker. We could have, but we wouldn't have solved the 
problem.
    Mr. Scott. Now 75 years is going to cost 6.4.
    Mr. Walker. It goes up about $600 billion a year.
    Mr. Gramlich. Congressman, could I interrupt? There is a 
way to deal with this, and we got it in our dealing with Social 
Security. When you have groups come together the wrong question 
is to make the system sustainable for 75 years because, as 
David said, 1 year passes and all of a sudden it is out of 
balance.
    The right way to do it is to make it sustainable for 75 
years and have no change in what is known as the trust fund 
ratio in the last 10 years because that is the ratio of assets 
to spending, basically, and if that ratio is stable then you 
can presume that as we go forward it won't change in the 11th 
year, the 12th year.
    Mr. Scott. If you fixed it, the next year you would have a 
different 75 years. But if you could fix it to 75 years, that 
gives you 75 years starting off now to fix it for the next 75 
years. Maybe another program or something. But we could have 
fixed 75 years for $3.8 trillion.
    Mr. Walker. Correct. Importantly----
    Mr. Scott. It gets worse as you go forward. Now we had a 
surplus of 5.5. How much--what is the present value of making 
the tax cuts permanent?
    Mr. Walker. I will be happy to provide it for the record.
    [The information follows:]

 General Walker's Response to Mr. Scott's Question About the Value of 
                           Permanent Tax Cuts

    CBO's January 2007 outlook shows the cumulative difference--not 
present value--between assuming the 2001 and 2003 tax cuts expire and 
making them permanent to be $1.9 trillion over the period 2008 to 2017. 
This estimate does not include extending the 2006 AMT adjustment into 
the future. If the higher AMT exemption amount is extended then the 
cumulative difference of these changes would rise to $2.8 trillion over 
the 10 year period. Under CBO's baseline in which the tax cuts and the 
increased AMT exemption are allowed to expire, revenues reach 20.1 
percent of GDP in 2017. In contrast, if the tax cuts are made permanent 
and the 2006 exemption is continued, revenues would be about 18 percent 
of GDP in that year.
    Calculating the present value of the tax cuts over a longer period 
of time is more difficult because it is less obvious what the reference 
point should be.\1\ Because of inflation, bracket creep, and the 
alternative minimum tax, current tax policies if left in place would 
result in revenue as a share of GDP approaching 24 percent by 2050. It 
does not seem reasonable however to use this as the point of 
comparison--in the years since the end of World War II Congress and the 
President have taken actions to keep the overall tax burden within a 
relatively narrow range around an average of about 18 percent of GDP. 
Any analysis of the present value of any tax cuts would need to make an 
assumption about the level of future taxes to use as a comparison.
---------------------------------------------------------------------------
    \1\ A 2004 paper by Brian Jenn and Donald Marron when they were 
economists at the Joint Economic Committee noted the problems in 
comparing the cost of extending the tax cuts to ``current law'' when 
current law--as noted above--would project taxes as a share of GDP at 
levels exceeding the post-World War II average by more than 5 
percentage points. (See ``The Long-Run `Cost' of Tax Cuts'' by Brian H. 
Jenn and Donald B. Marron, in taxanalysts July 20, 2004)

    Mr. Scott. It was 12 trillion a couple of years ago. Does 
that sound about right?
    Mr. Walker. I can tell you this, as I showed, even if you 
don't make the tax cuts permanent, you are still going to have 
to do more. But that is obviously a big number.
    Mr. Scott. A couple of years ago make the tax cuts 
permanent was equivalent to the present value of the Social 
Security Trust Fund 75-year deficit and the Medicare Trust Fund 
75-year deficit.
    Mr. Walker. Not the Medicare; no way it could have been 
that big. We were in the hole $15 to $20 trillion on Medicare 
Parts A and B before Medicare prescription drug was passed. And 
so it wouldn't have been the combination of both Social 
Security and Medicare. It did exceed Social Security, there is 
no question about that.
    Mr. Scott. The top 1 percent we are going to get out of 
making the tax cuts permanent was in the same order of 
magnitude as the Social Security 75-year trust fund.
    Mr. Walker. By itself, right.
    Mr. Scott. Let me just get in one more question. The trade 
deficit and the capital deficit, we have a capital deficit now. 
What does the trade deficit do to that, the combination?
    Mr. Truman. We have actually, as was put in the 2006 
Council of Economic Advisors report, we have a surplus on 
capital because the surplus is coming in to pay for our trade 
deficit. The problem is that the trade deficit represents the 
fact that we are adding currently to our consumption at a 
higher rate than we are adding to our production. And so we 
send IOUs abroad in order to finance our current consumption. 
So we are not sending the IOUs internally, as we said before, 
we are sending them abroad. Ultimately at a minimum we are 
going do continue to pay interest on those IOUs and so that 
goes up just like the interest on the debt here and we will 
have to at a minimum probably have to stop piling up those IOUs 
because they will exhaust the appetite for those and ultimately 
conceivably we will have to pay off some of those IOUs. So we 
have to pay the interest all along, we have to reduce the rate 
at which we are piling up IOUs and we may have to pay them off 
and that means you have to bring down the current account 
deficit in order to attract that and bring up the trade balance 
in the process. I hope that is clear.
    Chairman Spratt. Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman. I am certainly 
happy to hear from all of our panelists on this subject, on why 
deficits matter, although I am not sure it is much of a subject 
of debate within this committee. I am hopeful that you can all 
return and in the future we can have a hearing entitled while 
spiraling unfunded obligations and entitlement spending 
matters, which I believe is, from the testimony I hear, clearly 
a place where this committee needs to put some focus.
    General Walker, I don't have the slide number here but I am 
looking at one of your handouts, Composition of Spending as a 
Share of GDP Under Baseline Extended, August 2006. If I am 
interpreting this correctly, under these base assumptions all 
the tax relief that many believe is the root of all evil 
expire. We do not have an AMT patch, and yet by 2040 we still 
have apparently spending as a percentage of GDP go from roughly 
18, 19 percent of the economy to roughly 30 percent. I am just 
eyeballing it.
    Mr. Walker. It goes from about 20 percent, a little over 20 
percent of the economy to about 30 percent.
    Mr. Hensarling. From roughly 20 to 30, which would suggest 
on kind of back of cocktail napkin math I believe the average 
family of four in the U.S. pays roughly $20,000 combined in 
Federal taxes. That would seem to suggest an increase of 50 
percent in their tax burden to balance the budget by 2040. So 
in inflation adjusted terms might their tax burden go up to 
30,000 a year?
    Mr. Walker. If you saw that solely through tax increases, 
which I don't know anybody who is proposing that, and if you 
waited until 2040 to do it, then you would have to increase tax 
burdens by about 50 percent, but then again you have to keep in 
mind that is only at that point in time. If you look out 
further from there we have still got a long range problem so 
that wouldn't solve it. Similar to the 1983 Social Security, we 
solved it for 75 but we didn't solve it long term for the 
reasons Ed Gramlich talked about.
    Mr. Hensarling. But for those who do not wish to engage in 
a bipartisan dialogue on reform of entitlement spending, if you 
take away again the Bush tax relief, ultimately then you would 
be looking at what I believe many would view as an 
unconscionable tax increase upon American families and our 
economy.
    General Walker, speaking of tax relief, I think I heard you 
say that from your perspective in order for tax cuts to quote, 
unquote, pay for themselves I think you have said only 
significant decreases in marginal rates and significant 
decreases in tariffs would meet that criteria. But recently we 
had a rather dramatic decrease in the tax gains cap rate, and 
if I did my homework correctly, we have doubled our capital 
gains realizations from 269 billion in 2002 to 539 billion in 
2005, which has led to a 45 percent increase in tax revenue 
from these realizations.
    Would cap gains be part or not part, if properly designed, 
part of a tax relief package that might pay for itself?
    Mr. Walker. Well, first I would say that I don't think you 
can look at the capital gains in isolation, I think you have to 
look at what has happened in the capital markets during that 
period of time, what has happened to real estate prices, stock 
and bond prices and things of that nature. One of the things 
that happened to us in the late 1990s is we assumed that--or 
the early part of this millennium, we assumed that the past was 
prologue and gains turned into losses and they were carried 
forward. The others may have a comment.
    Mr. Gramlich. Just on that, I don't know what the answer is 
but you have to be careful of these realizations because it 
could be the bigger number, the 500 was just pulling money out 
of some other year. That is the problem with these capital 
gains realizations. You have large accrued gains and then the 
question is when you realize them, and if you realize them this 
year, you may not realize them next year. So you have to 
consider all years in that kind of calculation.
    I don't know how it would come out, but I do know that 
these are tricky calculations for capital gains.
    Mr. Hensarling. In the less than 20 seconds I have left, 
just to make sure I understand what I heard earlier, General 
Walker, I think I heard you say something along the lines we 
cannot grow our way out of this problem and perhaps we can't 
tax our way out of our problem. Is it fair to say that in your 
opinion the most important fiscal reform we could undertake is 
trying to find some bipartisan reform to the growth curves and 
entitlement spending?
    Mr. Walker. There is no question that is number one. By the 
way, with regard to your question and Mr. Scott's question, of 
the two commissions that are on the table right now, I am sure 
many others will be, one is a one-time commission that has a 
broad scope. That is the Wolf-Voinovich commission, that 
includes a broad scope, and is a one-time group. The Domenici 
and Feinstein commission deals solely with entitlements, so it 
is narrow scope--but it is permanent, or long term.
    Chairman Spratt. Mr. Etheridge.
    Mr. Etheridge. Thank you, Mr. Chairman. Let me thank you 
for the opportunity to participate in this and thank you three 
gentlemen. Someone said earlier and I think it is true, all of 
us get an education here and I wish more citizens could see it, 
hear it and be a part of it.
    I believe, Mr. Walker, you said earlier we have a budget 
deficit, balance payments deficit, and a savings deficit. I 
think we can probably agree on that. Let me ask one other 
question and maybe all three of you maybe want to comment on 
this because usually what happens when we start talking, even 
when we get together jointly, is we want to fix the narrow 
piece that we have been involved in and don't want to pay 
attention to the broader issue.
    Reminds me of a family that wants to buy a new car, looks 
at their revenue and can't figure out how they can buy it but 
they are going to decide to do it, find a dealer who will let 
them have it for the lowest amount of money they can get, 
whether they own the car at the end of the day or not, and are 
ultimately headed toward a cliff. They will have neither the 
car nor the home nor anything else if they don't deal with it.
    So let me ask you on one other issue, we haven't talked 
about this but I think it does have an impact on the overall 
piece, what the value of the U.S. dollar was in terms of the 
international markets, say in 2000. We had a strong dollar. All 
of a sudden we have seen that dollar go down in value 
dramatically. I don't know how much it has gone down but it has 
gone down substantially, whatever the dollar is today versus 
whatever it was in 2000, which is on the American consumer a 
tax any way you cut it. And tie that, if you will, to the 
questions or the issue as relates to investment, because when 
we own the debt, those dollars that the Federal Government was 
paying for the debt that was turned over in our economy today 
is turned over in the economies of other countries so we are 
sending the dollar overseas to increase their investment for 
the products we are going to buy and how that helps hit the 
wall sooner.
    Mr. Truman. I can't go to 2000, but from the peak of the 
dollar, which was in February of 2002 to today in real terms, 
adjusting for inflation rates on the broadest average that the 
Federal Reserve computes, the dollar is down 15 percent. It is 
down a lot more against the Euro and other currencies like that 
but it is down a lot less against the Chinese yuan. So the 
dollar is down 15 percent.
    The second question: is that a tax on American consumers? 
The answer to that question is yes. But it is probably in the 
category of an inevitable tax on American consumers in the sort 
of death and taxes type of thing because you need to have a 
lower dollar in order to stimulate us to import less and for 
the rest of the world to buy more of our exports. And it is the 
one way that we close, one, not the only way that we close this 
current account deficit and stop having to send IOUs abroad, as 
I said to Mr. Scott, IOUs abroad that we have to pay interest 
on.
    And we economists say there is a terms of trade loss in 
that because in fact we are now paying more for a given level 
of imports, sending more bushels of wheat abroad for every 
Lexus that we are importing. So that actually acts like a tax, 
but it is a necessary part of how the process works of 
correcting the current account deficit, and what this hearing 
is about is to make sure that as that process of squeezing that 
comes on, we actually can generate through the principle 
reason--we have the savings to replace the savings that we have 
been importing from abroad. And that is where these questions 
about raising taxes and going into entitlements and other 
mechanisms come into play.
    Mr. Walker. I would just say that arguably the way that we 
have felt the pain so far is decline in the dollar rather than 
an increase in long-term borrowing cost. We do have 
competition. The U.S. is still a global currency. We are not 
the only one in town anymore.
    Mr. Etheridge. Thank you.
    Chairman Spratt. Mr. Alexander.
    Mr. Alexander. Thank you, Mr. Chairman. General Walker, 
this sheet here is almost black but I believe it says major 
fiscal exposures of 50 trillion. What does that mean?
    Mr. Walker. What it means is it includes total explicit 
liabilities, which would include debt held by the public, 
military and civilian pensions, the unfunded obligations there, 
and Social Security and Medicare. It doesn't include 
everything. It doesn't include Medicaid, it doesn't include a 
variety of other things. So it is selected fiscal exposures. 
And the numbers down below with regard to Social Security and 
Medicare are the discounted present value dollar difference 
between dedicated revenues and likely expenditures based on the 
Trustees' best estimates.
    Mr. Alexander. The reason I ask is the members of the Blue 
Dog Coalition have signs posted outside most of their offices 
around and their numbers don't come anywhere close to this.
    Mr. Walker. Those signs are too low. Those signs are too 
low. That is part of our problem. We have got the wrong 
metrics. We are focusing on debt held by the public, all right, 
which is a small subset of this. It is basically a down payment 
of this number. And so we need to change how we keep score.
    Another example is if you are heading for a cliff and you 
slow the car down to half speed by the time you hit the cliff 
that ain't going to get the job done. We need to change our 
metrics and measurements.
    Mr. Alexander. In another illustration earlier I think I 
saw two lines running parallel to each other, national savings 
versus individual savings. When an individual saves something, 
it is something tangible. Explain national savings.
    Mr. Gramlich. National saving is the amount that we--that 
we reserve from production for growing investment, basically. 
And so when an individual saves, that money goes in a bank and 
can be used to finance corporate investment. If the government 
comes along and runs a deficit then a lot of the individual's 
money gets used up in paying for the deficit. And so the 
national saving would then go down. So that is why you have to 
worry about what the government is doing.
    What we want to do is have both individuals save a lot and 
have the government not be detracting from the individual 
saving by mopping up their saving just to finance a deficit. 
You want to have that saving rooted all the way back to 
corporate investment.
    Mr. Alexander. Thank you. Thank you, Mr. Chairman.
    Chairman Spratt. Thank you, Mr. Alexander. Mr. McGovern is 
not here. Mr. Smith is not here. Mr. Doggett.
    Mr. Doggett. Thank you very much. Thank you for the 
testimony you all have provided. Mr. Walker, if I understand 
your testimony, while we cannot rely exclusively on increased 
revenues to address these problems, there is no way we can 
solve these problems without a substantial increase in tax 
revenue over the long haul.
    Mr. Walker. Over the long haul I don't believe you are 
going to be able to solve the problem with taxes at 18.2 
percent of GDP. I do think you want to keep it down as much as 
you can for the reasons I have articulated, but I don't think--
politically I don't think you can solve the problem at 18.2 
percent of GDP.
    Mr. Doggett. You have indicated we have a shortfall of 
revenues today and we will have a much greater shortfall in the 
future if we continue on the present course.
    Mr. Walker. Correct.
    Mr. Doggett. And that you have seen very few tax cuts that 
pay for themselves.
    Mr. Walker. That is the authoritative literature.
    Mr. Doggett. Would you take a look back at page 5 of your 
charts where you talk about the baseline that you presented to 
this committee in January of 2001.
    Mr. Walker. I am familiar with it, yes.
    Mr. Doggett. At that time did it appear that the spending 
and even entitlements were sustainable at the current revenue?
    Mr. Walker. Based upon the assumptions that existed at that 
point in time, some of which proved not to be valid, yes. I 
mean the assumption then, if you will note, there is no 
interest cost because the assumption then was we were going to 
pay off all the debt. We actually were going to have savings 
that we were going to invest.
    Mr. Doggett. I remember the testimony to the Ways and Means 
where he was concerned we were going to pay off too much debt.
    Mr. Walker. So really some of the assumptions may have 
changed. The situation we find ourselves in today is largely 
the result of policy decisions that have been made in the last 
6 years. Largely but not solely.
    Mr. Doggett. That is right.
    Mr. Walker. For example, back in January of 2001 I 
testified about fiscal risk. The highest risk thing I said that 
Congress could do was increase entitlements. Guess what, that 
is what Congress did, called Medicare part D.
    Mr. Doggett. The prescription drug program, and you have 
outlined the cost for that. And there has also been a reduction 
in revenues over that time, too, hasn't there?
    Mr. Walker. The combination of several things, changes in 
assumptions, number one; there has also been an increase in 
entitlements, there has been a significant increase in spending 
as compared to historical levels, not all of which is defense 
and homeland security, for a significant part is; and thirdly, 
tax cuts.
    Mr. Doggett. You mentioned health care as perhaps the 
greatest public policy challenge that we face in the country 
today. Health care is responsible for a significant number of 
personal bankruptcies being taken across the country. As we 
look at how to address this looming crisis that you have 
described don't we also have to consider the crises that 
individual families are faced with health care and address 
those deficits in health care and education as well?
    Mr. Walker. Health care is the number one fiscal challenge 
for the Federal and State governments; number two, it is the 
number one competitiveness challenge for American business; and 
number three, it is a growing challenge for American families. 
Let me just tell you if there is one thing that can bankrupt 
America, it is health care. We need dramatic and fundamental 
reforms in phases over time and I am happy to talk about that 
some other time if you want.
    Mr. Doggett. It could bankrupt our country or it could 
continue to bankrupt more and more families in the country if 
we don't find a way to address it.
    Mr. Walker. It would have an adverse affect on many 
players.
    Mr. Doggett. I thank you for your testimony.
    Chairman Spratt. Mr. Moore.
    Mr. Moore. General Walker, I was at the White House with 
the Blue Dog leadership and the new Dem leadership about a 
month ago and had a chance to meet with the President, and when 
it was my turn the speak for 2 minutes I said, Mr. President, I 
have seven and a half grandchildren and we have mortgaged the 
future of our children and grandchildren. So I very much 
appreciate the slide with your three grandchildren because I 
think that is what all of us on this committee and Congress 
should be looking at because they are our future and we have 
done horrible things to their future. We need to change the way 
we are doing business. And I said to the President this should 
not be about Democrats and Republicans, we are all in this 
together as are future generations in our country.
    I mentioned Blue Dogs. What should be the number instead of 
$8.9 trillion national debt, what should be the number on the 
Blue Dog sign right now?
    Mr. Walker. $440,000 per household.
    Mr. Moore. What does that come to in terms of trillions of 
dollars?
    Mr. Walker. $50 trillion.
    Mr. Moore. Just in round numbers, right?
    Mr. Walker. In round numbers. That is big enough. We can 
round off at $50 trillion.
    Mr. Moore. I understand, I really truly do understand, and 
I mentioned this shouldn't be partisan at all and I have heard 
from the other side and I am not trying to point fingers here 
but it gets frustrating when you hear that tax cuts kind of pay 
for themselves, and we have heard some difference this morning, 
and I understand we need to look at the whole big picture here 
if we are really going to make a difference here. It is about 
entitlements certainly. That is the big one that you have 
identified and others have identified. It is about spending, 
and we have got to look at that, and we have also got to look 
at tax cuts because I believe all tax cuts aren't created equal 
and they don't all pay for themselves. Some do, but some don't.
    But what--what change in metrics, if any, I mean do you 
have any suggestions, and I heard you mention too that health 
care is the big, the big thing in the picture out here. Can you 
give us just--I know you don't have time to go into a lot of 
detail. I have got 3 minutes left. Can you give us just a 
summary of some of the ideas you have for reforming health care 
to make it better for us in the future?
    Mr. Walker. Well, first, I think you need to reconsider the 
Part D benefit.
    Mr. Moore. Yes, sir.
    Mr. Walker. Number two, we need to move the national 
practice standards, which would help us to control cost, 
improve consistency and reduce litigation.
    Number three, we need to expand case management approaches 
within the Federal healthcare programs.
    I mean, those are just a few examples, but since this is 
the Budget Committee, let me suggest that some of the things 
that need to be considered--we need to go back to PAYGO rules 
on both sides of the ledger. We need discretionary spending 
caps. We need mandatory reconsideration triggers when certain 
mandatory spending programs get to a certain size of the 
budget. We need to have more transparency and mandatory 
reconsideration triggers on tax preferences and tax 
expenditures as well. And whether you have a commission or not, 
you have got to have better transparency and strong budget 
controls in place to make sure you don't slip back and undo the 
good things that ultimately, hopefully, will get done.
    Mr. Moore. Well, I will pledge to the two members of the 
minority now that are on the other side here that are here that 
I really appreciate what you all have said. I have had private 
conversations with the ranking member about some of these 
items; and I, again, just hope we can come together and put 
aside some of the rhetoric and really work together to address 
some of these. Because that is what needs to happen not for us 
but for the American people and our country in the future.
    One more question that is kind of a tag-along, I guess, is 
China right now, I understand, holds over half a trillion 
dollars, over $500 billion of our debt. What would be--and I 
understand--I have read some of the materials that have been 
provided that say it is probably not going to happen. What 
would be the result, though, if China and some others who hold 
our debt decided they didn't want to hold our debt anymore? 
What would be the impact on our country?
    Mr. Truman. Going on the principle of comparative 
advantage, I think the first question is, if they sell 
treasuries and they buy equities, right, in the United States, 
the answer is nothing. Maybe the price of the treasuries goes 
down and the price of equities goes up.
    Mr. Moore. My question is, if they decide they didn't want 
to be involved----
    Mr. Truman. If they sell their holdings and they buy Euro 
dollars, Euro assets, denomination in Euros or yen or whatever 
you want to think in, then what you have is a--you could have, 
as you said, as you stipulated, not likely--these are 
sophisticated financial people, they don't want to shoot 
themselves in the foot--but you could have, if there was a 
widespread tendency for foreigners--or domestic residents, for 
that matter--to say, I have too much dollar assets because the 
United States government--people and government can't get their 
hands around the problems that Mr. Walker--General Walker--
described, then you could have a sharp fall in the dollar, and 
that surely would shrink the current account deficit, and it 
surely would reduce the availability of savings from abroad, 
and that surely would put interest rates up, and whether our 
friends at the Federal Reserve could manage that without a 
recession is something you could bet on. I mean, one would hope 
so, but, at a minimum, you would have--as we did in the late 
1980s, you would have sharply lower growth for a sustained 
period of time.
    Mr. Moore. Thank you.
    One last comment, I just want to thank you for the good 
work you are doing in educating the American people and the 
Congress about what all this means to the future of our 
country. Thank you.
    Chairman Spratt. Mr. Andrews.
    Mr. Andrews. Thank you, Mr. Chairman. I thank the 
witnesses.
    Dr. Gramlich, on the second page of your testimony, you say 
there has been speculation that bondholders would insist on 
higher long-term bond rates as deficit grows, but this hasn't 
really happened. Long-term rates are well behaved right now, 
and most reasonable forecasts expect them to remain so in the 
near future. We could worry that high deficits will cause high 
interest rates, but that would be crying wolf.
    I am not crying wolf, but I fear the wolf. I do. And one of 
the reasons that I do is inherent in General Walker's 
testimony. I look at his graph on page 4. If I read it 
correctly, he says that under the most likely policy scenario 
that we are presently on, by 2010 we would be running a deficit 
of 4 percent of GDP, give or take; by 2015, it would be about 5 
percent of GDP, give or take, trending up to 7 percent in 2020 
and 10 percent in 2025.
    Here is my question for all three on the panel: If General 
Walker's assumptions are correct and that is the path that we 
are on, do you think that we would reach a point where the wolf 
would visit the door and we would be punished in terms of 
higher interest rates, number one.
    And, number two, if that is a scenario that we should be 
concerned about, what level of remedy do we need to achieve now 
to forestall or postpone that? In other words, how much deficit 
reduction in the short run is enough to mitigate the 
probability we would face that wolf at the door?
    Dr. Gramlich, do you want to----
    Mr. Gramlich. Yes, Congressman. I brought up the wolf, so I 
probably ought to deal with it.
    I think what you are seeing--this is the conundrum. You 
know, given all these things--I mean, the international 
financial traders have seen David's charts. They know these 
numbers, but yet they are still not charging very high interest 
rates, and it is puzzling. I think the reason is, to be honest, 
that there is still a reservoir of faith in the American 
economy, in American politicians that, by the time this 
happens, the problem will be fixed. So, in some sense, the 
committee--there is almost nobody left here, but the committee 
could view this as a challenge--I mean, that you want to prove 
the bond traders right.
    Mr. Andrews. My question is, what do we need to do to 
retain that faith?
    Mr. Gramlich. I would say, put the deficit on a sustainable 
path. I mean, if you had the--I would prefer that the deficit 
be zero. I mean, that would be my heart of hearts. But there is 
a policy short of that where the debt-to-GDP ratio over time 
does not rise. It might be tantamount to deficits of 1 or 2 
percent continuing, I mean, without the explosion that you see 
in the charts there. If that were the case, I think, you know, 
the bond traders would be okay with it. What I think they don't 
like is the unsustainability.
    Mr. Andrews. Right.
    General, what do you think?
    Mr. Walker. I think you need to address the biggest deficit 
that America has, which is not budget, which is not balance of 
payments, which is not savings, it is leadership. All right? 
That is the biggest deficit we have.
    My view--I will come back to what I said before. If you 
improve transparency, if you enact meaningful budget controls 
and if you can achieve Social Security reform, round one of 
healthcare reform and round one of tax reform, that will go a 
long way towards helping to avert a potential crisis, and then 
we are going to have to reengineer and reprioritize government. 
It is going to take 20 years.
    Mr. Andrews. Do you think there is a quantitative 
manifestation of those goals, that either is percentage of debt 
to GDP or size of the deficit?
    Mr. Walker. I don't know that there is specific metric on 
that. I can just tell you right now that I think people are 
counting on Congress ultimately doing something and the 
President ultimately doing something, and I think it will by 
the way. We just need to do it sooner rather than later.
    Mr. Andrews. I certainly agree with that.
    Dr. Truman?
    Mr. Truman. On the first part of your question if we had 
that scenario, would the wolf bark at some point down the line? 
I think yes, but I can't tell you when. It could be as early as 
2 years from now, within the next 2 years or it could be 
another decade--but I think it is unsustainable; and, 
ultimately, that will read into everybody's desire to hold 
claims on us.
    The question of how much of a fix, I think--my view, and as 
I said in my testimony or as we said in our testimony, I think 
there is a sort of short-term objective, which might be phrased 
in terms of a surplus by the end of the deficit, preferably an 
on-budget surplus, so not on the unified basis.
    Mr. Andrews. You mean by the end of the decade?
    Mr. Truman. The decade. Excuse me. I misspoke. Thank you 
for correcting me. By the end of the decade, preferably an on-
budget surplus, because the off-budget surplus, as has been 
described, will go away anyhow. So you need to get yourself 
ready for that.
    The more sophisticated way of doing it would be to sort of 
set some longer-term sort of constraints, maybe buttressed by 
David Walker's triggers to sort of, when you go off the track, 
you are forced to go back and reconsider things. That would be 
a sensible way of forcing yourself to re-examine these kinds of 
issues.
    I am, however, tempted--maybe because I spent too many 
times in this hearing room sitting back there, rather than up 
here--to quote the two chairmen--two of the four chairmen of 
the Federal Reserve I worked for, Paul Volcker and Alan 
Greenspan, who, faced with similar circumstances, each said to 
a Budget Committee--I am not sure whether it was this one or 
whether it was your counterpart in the Senate--I don't lie 
awake worrying that you will do too much.
    Mr. Andrews. Thank you very much, gentlemen.
    Chairman Spratt. Thank you all.
    Could I put two questions to you quickly for Rosa DeLauro? 
She had to leave and go to a leadership meeting. And we will 
take a quick answer so Dr. Gramlich can get out of here, and 
particularly by 12:30.
    We face serious challenges in the energy sector, college 
tuition, healthcare cost, including some of the highest 
prescription drug prices in the world; and I, Rosa DeLauro, 
want to ask a simple question: How is the deficit, the cost of 
servicing the debt, impacting our ability to address these 
issues?
    Mr. Walker. The largest item of waste in the Federal budget 
arguably is interest on the Federal debt. It is the fastest-
growing line-item in the Federal budget; and, therefore, it 
serves to squeeze out the ability of the government to do other 
things at a given level of taxation.
    We have a number of sustainability challenges in America. 
Today, we have only talked about the fiscal one. I could give 
you 8 or 10 other ones.
    Mr. Gramlich. Just on that issue, it is always possible to 
go through the budget and find this good thing and this good 
thing and this good thing. Each of these good things should be 
evaluated on their face, but there is an overall test, and, as 
I said in my testimony, if you really want all these good 
things, well, we just have to pay for them.
    Mr. Truman. I agree. I don't have anything to add, in the 
interest of time.
    Chairman Spratt. Final question. Rosa DeLauro. Together tax 
cuts and spending increases for security programs account for 
84 percent of the increases in debt racked up by Congress and 
the President over this recent period. At the same time, the 
administration insists in making the tax cuts of 2001 and 2003 
permanent and, on the spending side, there is not much 
inclination to cut discretionary spending beyond the levels we 
have already cut. Given the long-range deficits that we face, 
what do you think is the wisdom of this proposal?
    I think by that she means what is the wisdom of the 
proposal to make permanent the 2001 and 2003 tax cuts?
    Mr. Walker. I think you need PAYGO rules on both sides of 
the ledger. If you want to make them permanent, you pay for 
them. And I also would say that there is waste in defense and 
homeland security, billions and billions and billions a year. 
Don't assume there is not, because there is.
    Chairman Spratt. Dr. Gramlich, do you agree?
    Mr. Gramlich. Fine, yes.
    Chairman Spratt. Dr. Truman?
    Mr. Truman. I think there is one qualification, right, that 
seems to me should be made, and that is that putting PAYGO into 
place at a time when you are dealing with the deficit that is 
already there, right, especially if you use some of the larger 
numbers that David Walker has in his little chart, that doesn't 
really help you because you actually--it helps you, it helps 
things from getting worse, but it doesn't help you dig out of 
the hole that you have already created.
    And one can argue about where the tax take is going to have 
to be over the next 25 years on average, and I think I agree 
with--as a projection, as a forecast, I agree with David in 
this, that 18 percent is going to be higher.
    I also agree that going to 40 percent will not sustain the 
U.S. economy. And I suspect it will be lower, the bottom end of 
that range, rather than the top of that range.
    These things, again, have to add up, and I think the thrust 
of Congresswoman DeLauro's question is that, in a way--and this 
was the thrust of David Walker's answer earlier, put another 
way--is you now have to pay for some of the things that you 
have been doing over the last 5 years, both in terms of actual 
expenditures and in terms of commitments to future 
expenditures. And that I think is a really tough issue that the 
Congress has to address.
    Mr. Walker. Just to quickly reinforce, PAYGO is not enough. 
We need discretionary spending caps, mandatory spending 
reconsideration triggers. We need to disclose the discounted 
present value dollar cost of major tax and spending dollar 
proposals in present value terms. We need to do a lot more, 
because we are in rougher shape today, and the tsunami is 
closer to hitting our shores.
    Chairman Spratt. The problem with discretionary caps is 
that half or more of discretionary is defense, and there are 
substantial variables to deal with that due to the cost of the 
war which comes to us in the form of supplemental.
    But, quickly, I turn to Mr. Ryan for a final question.
    Mr. Ryan. I know, Dr. Gramlich, you have to get going, so I 
am going to ask David a question.
    First, just to kind of correct the record, we don't think 
that all tax cuts pay for themselves. No one says that on our 
side of the aisle. Just the point is that not all tax cuts are 
the same. Some produce more growth than others, some produce 
more jobs and realizations and economic growth than others, 
some may partially offset each other. So that is just a point 
the for the record.
    My question for you--well, and one more point. It may be 
easier to just reform the whole Tax Code than get rid of the 
AMT and make the tax cuts permanent. We have got a whole tax 
tidal wave hitting us at the end of this decade where we will 
have 25 million people paying the AMT and we will have 
something close to a $2 trillion tax increase when these things 
expire which would wreak havoc on our economy. So maybe the way 
out of this thing is to fundamentally reform our Tax Code and 
do it based on a consumption and one that is internationally 
competitive.
    I just throw that out there. I am a member of Ways and 
Means, and we spend a lot of our time thinking about that.
    David, the quick question I have is this: You mentioned 
doing benefit changes on Social Security to get solvency, but 
then you threw sort of--I guess I will just paraphrase it--add-
on accounts on top. Clawback accounts can be a part of reaching 
solvency; add-on accounts don't. But you can have a--component 
add-on accounts that do ultimately contribute to solvency. I 
hate using the word ``clawback,'' but that is the feature that 
some--and I have been more of a clawback guy. Are you proposing 
that we do mandatory add-on accounts with some kind of a 
solvency gaining feature to them or just total free add-ons?
    Mr. Walker. A possible way forward--I am not saying ``the'' 
possible way forward--would be as follows: Increase the normal 
retirement age gradually and index it to life expectancy.
    Mr. Ryan. Longevity indexing?
    Mr. Walker. Right, change the replacement rates to reduce 
the replacement rates for middle- and upper-income individuals.
    Mr. Ryan. Indexing factors?
    Mr. Walker. That is one way to do it, the indexing factors 
or whatever.
    Thirdly, strengthen the minimum benefit for the poor.
    Fourth, you can do that and a few other things without more 
revenues. You may politically have to consider an increase in 
the taxable wage base. You don't--politically, you may have to 
do it. You can make the numbers work without doing that.
    And then, on top of a restructured, solvent, sustainable 
and secure defined benefit program, consider mandatory 
individual savings on top of that would go--that would be real 
savings into a real trust fund with a limited investment option 
like the Federal Thrift Savings Plan on top of that.
    Now that Congress is poised to increase the minimum wage, 
the people that would be the most pressed by that would be 
those persons--and history has shown that when you end up 
saving on a payroll deduction basis and it is automatic and 
people don't touch the money, you actually can get real savings 
increases.
    Mr. Ryan. Okay. So, just to paraphrase, progressive 
indexing plus longevity indexing gets you solvency, basically, 
right there. Correct me if I am wrong. And then you are saying, 
throw some add-on accounts on top that are mandatory add-on 
accounts that are pre-taxed, that are carved out from your 
current tax base?
    Mr. Walker. It is mandatory. I don't know why you would 
make it pre-taxed.
    The question is, what are you going to do with the build-
up? If it is mandatory, it is mandatory. Why give a tax 
preference? They have to do it. It is their money.
    I will also argue that is not a tax increase, because it is 
their money, and they will have an irrevocable right to it from 
day one. It will go to a trust fund in their name, and they 
will be able to control the investment of it, pre-retirement 
death benefit and funding mechanism for long-term care, et 
cetera, et cetera.
    Mr. Ryan. And the money goes to you free and clear at the 
end when you retire?
    Mr. Gramlich. Yes. Congressman, I think a lot of us like 
these add-on accounts, but it is fundamentally about saving, 
and it is not about solvency at the system. It is a separate 
issue.
    Mr. Ryan. Exactly. Some people who propose add-ons add a 
solvency component to it. I just wanted to see if that is what 
he was saying or not.
    Mr. Walker. Solvency sustainability is outside of the 
individual accounts. I am talking primarily for savings, pre-
retirement, death benefit, et cetera, et cetera, having this 
supplemental individual account.
    Mr. Ryan. Thanks for clearing it up.
    Chairman Spratt. Thank you very much indeed for your 
valuable contribution, understanding the problem we are faced 
with.
    Mr. Scott.
    Mr. Scott. The ranking member asked about tax cuts having a 
different effect. Could you give us some information on which 
tax cuts actually do stimulate the economy more than others? Is 
there information on that for the record?
    Mr. Walker. We will coordinate with CBO and others and see 
what we can do here.
    Chairman Spratt. I ask unanimous consent that members who 
did not have the opportunity to put questions to our witnesses 
today be permitted to do so by submitting questions for the 
record.
    [The information follows:]

    Peterson Institute for International Economics,
                             1750 Massachusetts Avenue, NW,
                                 Washington, DC, February 15, 2007.
Mr. John M. Spratt, Jr.,
Chairman, Committee on the Budget, House of Representatives, 
        Washington, DC.
    Dear Chairman Spratt: Enclosed are my answers to Representative 
Kaptur's questions that you transmitted to me on February 8.
    Again, I appreciated the opportunity of testifying before the 
committee on this important set of issues.
            Sincerely,
                                           Edwin M. Truman,
                                                     Senior Fellow.

            RESPONSES TO QUESTIONS BY REPRESENTATIVE KAPTUR

    1. I understand that in the recent past nearly 90% of new public 
debt was purchased by foreigners. To your knowledge, is there any 
linkage between our trade deficit and this increased foreign holdings 
of US debt?

    Foreigners have purchased a very large proportion of the net 
increase in US Treasury debt outstanding in recent years. From December 
2001 to November 2006, they purchased an estimated 85 percent. Over the 
immediately preceding 12 months, the share was 86 percent. There is no 
direct connection between our trade deficit and foreign purchases of US 
Treasury debt. In 2006 our deficit on goods and services rose $46.9 
billion (census basis) while foreign purchases of treasuries rose only 
$5 billion. However, our large trade and current account deficits along 
with US capital outflows have as their counterpart inflows of foreign 
capital from abroad. During the first three quarters of 2006, the gross 
inflow of foreign capital to the United States was an annualized $1,723 
billion, $1,543 billion excluding foreign direct investment in the 
United States. Foreign purchases of treasures were only 14 percent of 
the $1,543 billion in financial inflows. We require financing from 
abroad for our large trade and current account deficits. What is 
important is that foreigners buy some type of US assets not what type 
of assets they purchase.

    2. Why is it that foreign buyers are purchasing this [US Treasury] 
debt and not American buyers? Do American investors simply not have the 
resources, or do they consider American debt an unwise investment?

    As of the end of 2005, foreign holdings of US financial assets 
(excluding foreign direct investment) were an estimated $10,828, of 
which $1,994 billion or 18.4 percent was US Treasury debt. About 65 
percent of that amount was foreign official holdings although that 
figure is probably somewhat understated. Thus, foreigners purchase a 
wide range of US financial assets, but they have a relative preference 
for US Treasury debt compared with US investors. There are many 
possible explanations for that relative preference, but the most likely 
is that US Treasury debt is liquid and the highest quality even though 
as a consequence its yield is lower than on other types of US financial 
assets. According to the Board of Governors of the Federal Reserve 
System, the personal sector (households, non-farm non-corporate 
business, and farm business) added $1,977 billion to their financial 
assets (at an annual rate) over the first three quarters of 2006, 
increased holdings of US Treasury debt were about 3 percent of that 
total. As noted in my answer to the previous question, US Treasury debt 
was 14 percent of foreign purchases of US financial assets over the 
same period (at an annual rate). Thus, American investors have the 
resources to acquire financial assets and are doing so. However, they 
have a relative preference for higher yielding and less liquid assets 
than US Treasury debt.

    Chairman Spratt. Once again, thank you for your 
contribution to understanding the daunting and difficult 
problems we are faced with. Thank you very much for coming 
today.
    [Whereupon, at 12:30 p.m., the committee was adjourned.]

                                  
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