FROM THE OFFICE OF PUBLIC AFFAIRS

Thank you for this great honor.

We come together at a remarkable moment in our economic history. But prosperity and credibility are attributes that are rented, not owned. If we as a country - families, businesses and government - are to take maximum advantage of this moment, we must understand how we got here, not take the current good times for granted, and make prudent choices for our economic future.

Only infrequently does the nation face major fiscal choices. Since World War II, the U.S. made a major fiscal choice every decade or two, Some we have made wisely; others less so.

• After World War II, we chose to redress the expansion of the debt that had been used to finance the war and to bring us out of the Great Depression. The ratio of debt to GDP fell sharply, helping to lay the foundation for the growth of the following decades.
• During the late 1960s, we chose to finance expanded outlays on both "guns and butter" partly by relying on budget deficits. These contributed to the over-heating of the economy which, in turn, contributed to rising inflation, higher interest rates, and a long period of slow productivity and real wage growth starting in the 1970s.
• In the 1980s we chose to increase defense spending significantly while cutting taxes. As a result, real interest rates increased to record levels, the rate of net private investment declined sharply, productivity growth continued to stagnate, and the stock of public debt almost quadrupled.
• And in the 1990s, rather than continue with the policies of the 1980s, we chose to move strongly in the direction of fiscal discipline. That decision was a crucial building block for the prosperity that we currently enjoy. By adopting budget discipline, we have allowed roughly $2.5 trillion that would otherwise have been absorbed by government borrowing to have been invested in making America's economy more productive.

Now with major projected budget surpluses and the approach of the retirement of the baby boom generation, we face another major choice.

Tonight I would like to discuss the recent sea change in economic thinking regarding budget deficits and the role of fiscal policies; and then discuss the major fiscal choices that lie ahead: both with respect to maintaining fiscal discipline and with respect to the challenge of an aging society and the challenge of Social Security reform.

If we are to make the right fiscal choices in the years ahead it will be important to be guided by our best understanding of its role.

It is intriguing to track changes in the conventional wisdom regarding fiscal policy over the years. One benchmark for me is my undergraduate education in economics. Another is my wife's, since she was a more assiduous student and kept better notes. Our respective educations at leading American universities in the 1970s had a common thrust:

• That it was the essence of economic thinking, disputed only by intellectual troglodytes from the University of Chicago and uninitiated businessmen, that budget deficits operated through a multiplier effect to stimulate demand, economic growth and the creation of jobs;
• That it had been a major triumph of economic thinking to induce the pursuit of these policies to overcome economic stagnation in the 1960s;
• And that the modern and enlightened approach to fiscal policy recognized the desirability of fiscal stimulus.

This Keynesian conventional wisdom, that budget deficits can be used to stimulate demand in an economy producing well short of its capacity, still captures a very important truth about certain economies at certain times. It was surely the right prescription for the economy of the 1930s and, indeed, for Japan's economy of today.

However, if ever there was a real world example of the old joke about economics examinations -- that the questions never change, only the answers -- it must be with regard to the question of fiscal policy. For, today, propelled by the experience of recent years, it has become conventional wisdom that reducing budget deficits and running surpluses is expansionary, not contractionary; and that that is the way forward.

Why this fundamental change? The new approach reflected a greater recognition of the importance of three factors that will weigh differently in different circumstances:

• First, there is now a much greater emphasis on the importance of supply factors for long-term growth. In an economy close to full capacity, excessive stimulus can increase inflationary pressures, raise risk premiums, and lead to higher interest rates.
• Second, financial markets are now seen as much more forward-looking, and more sensitive to changes in the outlook for fiscal policy. As a result, a change in the budget outlook was thought likely to provoke a more aggressive and offsetting response from financial markets.
• Third, there is now greater recognition that capital costs would play a central role in determining demand for new investment, and fiscal policy, through the market reaction, a greater role in the determination of capital costs.

Together, these points imply that budget deficit can crowd out investment, slow productivity growth and lead to a vicious cycle: with higher public borrowing leading to higher interest rates, lower investment, slower economic growth, and thus still higher budget deficits. In contrast, budget surpluses can create a virtuous circle of higher investment, faster growth, and bigger surpluses.

These arguments, which were pushed by many members of the Concord Coalition and embedded in the 1993 budget agreement, used to be hypotheses, albeit highly credible ones. They now have the much greater status of having been empirically confirmed. In that sense if the 1964 tax cut was the exemplar for a generation of budget policy, the deficit reduction actions of the 1990s have been exemplars for this new generation. With the success of US economic policies, and their emulation abroad, the new thinking about fiscal policy is an accepted truth, with enormous potential to improve economic performance around the world.

Against this broader intellectual backdrop, let me briefly address a number of issues that arise in considering the most appropriate fiscal policies for our nation in the years ahead.

Large annual budget surpluses are now in prospect for the next decade and beyond. This is a profoundly favorable situation for our country to be in. But all of us here recognize the enormous uncertainty attached to those projections - uncertainty relating not just to the pace of economic growth but also to the amount of tax revenue that will be generated by a given rate of economic growth.

Some simple calculations based on historical budget projections highlight the magnitude of this uncertainty:

• Over the past 15 years, the average error in CBO forecasts of the unified surplus five years out was equivalent to nearly 2.5 percent of GDP, or, for example, $300 billion in 2005. Neither CBO nor OMB have published 10-year budget forecasts for long enough to assess their ultimate accuracy. However, a conservative extrapolation of CBO's findings implies that an "average" error over the next 10 years would amount to over $3 trillion in unified surpluses.
• This uncertainty is also revealed in the magnitude of revisions to cumulative surpluses over 10-year periods. In the 8 years during which CBO has reported 10-year surplus projections, the annual revision to those projections - excluding legislative changes - has averaged nearly $1 trillion. I would note that most of the recent revisions have applied to tax revenue and health spending in the non-Social Security part of the budget.

Given these uncertainties, one might say that just as complacency with respect to national security is the greatest risk when the world is most peaceful, so the risk of complacency in fiscal policy is greatest when the outlook for the budget seems brightest.

What sorts of fiscal policies are appropriate at this moment? I will address the question of Social Security in more detail in a few moments. But it seems to me that, with respect to the broad budget picture, there are a number of constructive steps on which we can all agree:

• First, we should assure that the focus of popular and political debate over the budget surplus should continue to exclude the Social Security surpluses. The experience of the last two years has shown that the framing of the political conversation about the budget is crucially important. Can there be any doubt about the importance of the fact that the current debate over surpluses is framed in terms of the disposition of $2 trillion in on-budget surpluses rather than $4 trillion in unified surpluses?
• Second, and in the same spirit, we should agree to take Medicare out of the budget. Over the next decade, the balance in the Hospital Insurance Trust Fund is projected to increase by about $400 billion. We owe it to our seniors to ensure that those Trust Fund accumulations are backed by government saving, just as we have done for Social Security.
• Third, we should reserve funds against the possibility that our current projections are not borne out. We should not lock in difficult-to-reverse commitments that would absorb all of the revenues currently being projected. Prudently run institutions do not ratchet up expenditures in response to possibly transitory changes in their endowments.
• Fourth, we should be sure always to stress the tangible and real benefits of debt reduction. By maintaining downward pressure on real interest rates, paying down public debt operates like a tax cut by putting more disposable income in people's pockets. Furthermore, debt paydown also operates like a deferred tax cut. In the same way that a purchase reduces one's future discretionary income whether you pay cash or buy it on a credit card, the contemporaneous tax burden understates the full tax burden during periods of budget deficit; both in terms of the annual interest cost, and the eventual cost of paying off the debt. Of course, during periods of budget surpluses, like today, the deferred tax burden is that much smaller.

Of course, another great issue confronting the nation, in addition to broader questions of budget policy, is the future of our major entitlement programs: particularly Social Security. You will not be surprised to hear that I do not intend to break new ground on this topic here by introducing a new blueprint for reform.

Clearly, different conceptions of the value of individual reliance versus collective insurance can point people to different policy recommendations. But I would like to highlight some basic conceptual issues on which we should all be able to agree:

This is a simple point but no less fundamental for that. If we wish to prepare ourselves -- whether as individuals or as a nation -- for the additional financial demands that will come from aging, we have to take steps that will provide us with greater financial wherewithal in the future than we would otherwise have had. At a national level, that can only mean steps that increase our rate of national saving and thus generate more wealth in the future. Simple reshuffling of financial assets does not contribute to that objective.

Even in the context of significant demographic change, it does not seem to me as necessary a proposition as it does to many in this room that we must take steps today that will have the effect of reducing future Social Security benefits. Under current law, the cost of providing Social Security benefits in 2030 is expected to equal 2.5 percent more of GDP than it does today. But this increased burden must be viewed against a backdrop of rising productivity and incomes, which are likely to make real GDP in 2030 more than twice as large as it is today. If seniors are going to account for a significantly larger share of our population in thirty years' time, it does not seem to me unreasonable that they should absorb a greater share of the nation's resources or Federal outlays.

What is self-evident is that if we wish to fulfill our current commitments to tomorrow's seniors we will need to earmark the necessary additional resources. Paying down the debt provides us with a remarkably neat way of doing just that. The Social Security financing gap - the difference between promised benefits and expected tax revenues under current law - grows to approximately 2.2 percent of GDP by 2075. But that gap is smaller than the percent of GDP that the federal government has devoted to paying interest on the debt held by the public over the past two decades. Therefore, by eliminating the debt, we would improve the financial position of the government by enough to meet our existing obligations to Social Security beneficiaries.

One can make a number of logical arguments for diverting a portion of the Social Security tax base to the creation of individual accounts. But a comparison of the rate of return for Social Security and financial assets is not one of them. Why? Because more than 80 percent of Social Security payroll taxes are not invested at all, but rather go to pay current benefits.

Vital as Social Security is, we can also agree that it can at most be a foundation stone for a sustainable national retirement system. It cannot be the entire edifice. And whatever approach we take to Social Security, it will be essential to meeting the national challenge of aging to raise the level of personal saving in the United States. Although the level of saving is determined by many forces acting on millions of American households, we know several steps that we can take to achieve the goal of raising saving:

• By improving financial literacy, because we have learned now that saving behavior is as much a matter of habit formation as it is of economic incentives. If we focus on influencing people's tastes, creating effective habits, and taking a range of measures that have an influence on people's behavior, we can provide every American with the understanding they need to improve their financial situation.
• By making it easier to save, because study after study shows us that people are much more likely to save when it is easy to do so. That is one reason why 401(k) plans have become America's most popular savings vehicle: because much like a Christmas Club, 401(k) payroll deduction is convenient and regular, and the money goes into savings before there is an opportunity to spend it. I hope it can remain a policy priority to continue to facilitate these kinds of savings vehicles for all Americans.
• And by targeting new saving incentives at people who presently save least: specifically low- and middle-income Americans to whom the tax system currently provides the least incentive to save. Two thirds of pension tax expenditures go to families in the top 20 percent of the income distribution, while just 12 percent goes to families in the bottom 60 percent.

Let me conclude where I began. We are enjoying a remarkable moment. But this is not the time for complacency. We owe our unprecedented economic success to many factors. But this moment of prosperity would not have been possible without the responsible policy of fiscal discipline that we have pursued over the past nearly eight years, and the broader increase in confidence and market credibility that such discipline has helped to promote. Just as such credibility can be won - so too can it be lost. That is why the fiscal choices that we make now will be so consequential, as they have been at similar crucial moments in the past. Thank you.