Balanced budget amendment may be needed. From Ancient Rome to modern America, great powers have fallen when their politics could not keep up with economics.

 

And now the U.S. faces a financial imbalance that threatens its world leadership as an economy and a power, says Glenn Hubbard, dean of Columbia University’s Graduate School of Business in a new book, ‘Balance,’ coauthored with Tim Kane, the chief economist of the Hudson Institute.Hubbard notes that Medicare outlays were $14.1 billion in 1975. They have spiraled to $520.4 billion in 2010.

 

“But now that the fiscal train is heading for a cliff, it is hard to stop,” he said. Social Security has morphed from a modest program to fight destitution among the elderly into a major retirement pension with demographics pushing it toward bankruptcy, Hubbard argues. Entitlement outlays are on track to double to 17.9% of GDP by 2040 from 8.7% in the 2000s. And our politicians don’t have the courage to deal with these problems, he said.

 

Hubbard, a former top economic advisor to Mitt Romney and President George W. Bush, spoke with MarketWatch as the Congress and the Obama White House have made little progress in any “grand bargain” to put the deficit on a sustainable path. The clock is ticking as Congress has until Labor Day to pass an increase in the nation’s debt limit or risk a default on U.S. debt.

 

MarketWatch: The theme of your book is that the fiscal crisis threatens to undermine every thing else?

 

I think Bernanke, on balance, has done an excellent job. Whether the president wants to reappoint him or Ben wants to stay are just things I don’t know.

 

Hubbard: That is certainly the today lens. The book is a book about great powers and why great powers rise and why they fall. And the basic thesis is that, it is when politics doesn’t keep up with economics that great powers stumble. And so the example for the current U.S. is the fiscal crisis.

 

MarketWatch: So in the U.S., the politics are not keeping up with the economics?

 

Hubbard: Yes. So in the case of the U.S., the fact is that our budget rules were really built for a time when debt booms were really about war, and then paying down debt was about peace. But of course what has happened since the late 1960s is really the rise of debt having to do with the entitlement state. And that is just a very different situation, and we need different types of politics and budget rules.MarketWatch: And Republicans and Democrats don’t have incentives to solve the entitlement mess?

 

Hubbard: Neither party is blameless here, so it is not a partisan issue. The question is, what do you do to focus the American people on the entitlement problem? A variety of things could be done - we probably need more political competition for ideas. The optimal number of political parties is two, but it doesn’t have to be these two. Which is one of the reasons Tim Kane and I in the book argue that we are actually pleased with things like Citizens United, that actually could open up political competition. Another potential remedy is to change budget rules so that you really have to force the Congress to look at changes in entitlement spending and pay for them or cut something else. It is that kind of transparency that is needed. And we use the historical case studies in the book to talk about how other Great Powers found their trouble spots and then often were unable to get over them.

 

MarketWatch: So there is stagnation in Washington.

 

Hubbard: You have an equilibrium, where Republicans say “all we care about is lower taxes” and Democrats say “all we care about is higher spending,” then you have a polarized Congress and you could wind up getting both. The problem is we can’t afford that, as a country. So if we really want a very large entitlement state, then we have to accept the fact that that is going to crowd out everything else government does and we’re going to have to raise taxes substantially on all Americans, or we could reform these programs, it is really a choice.

 

MarketWatch: One of the pillars of your book, the Reinhart and Rogoff paper arguing there is a tipping point where debt would constrain growth, has been called into question.

 

Hubbard: We certainly mention Reinhart and Rogoff [but] the idea of debt burdens constraining growth is a feature of many, many empirical studies over many years. What is important for our argument is that there comes a level in which high levels of debt threaten growth simply because of high future tax burdens. And that is really arithmetic, not even economics.MarketWatch: In 2001, when you were in the White House, were entitlements a problem?

 

Hubbard: Definitely, it has gotten worse over time because of changes in demographics, but we’ve had a problem for years in the United States of incipient and growing problems in our entitlement programs, Social Security and Medicare. It is not a new problem. It is not a Democrat or Republican problem.

 

MarketWatch: But instead of addressing the problem the Bush White House cuts taxes in 2001.

 

Hubbard: Well, an alternative to a tax cut might have been pre-funding entitlement programs, if that had been on offer from the Congress. But that was not what was done. Arguably, if you didn’t pre-fund entitlement programs then Congress would have spent the money anyway. If you look at the first decade of the 2000s, and you look at what happened to the deficits, about half of that is spending changes, about a quarter is economic underperformance and another quarter is taxes. Going forward, if you look at the country’s fiscal situation, it is not too much of a stretch to say it is almost entirely about entitlement spending. That doesn’t mean we can’t fulfill it if we want to fulfill everything that we have on the books now, we’ll just have to raise taxes dramatically to do it and suffer the growth consequences.

 

MarketWatch: But what about the changes to entitlement programs President Obama has offered. I take it you are not impressed by them?

 

Hubbard: I think these are good steps. I think the president ought to be praised for these steps. And they ought to be part of a conversation about how we can gradually change the entitlement programs. But I think people are looking for silver-bullet or one-shot solutions. Those really don’t exist in democracies and political systems. More needs to be done, but I certainly give him credit for what he’s suggested.

 

MarketWatch: Republicans have said they are worried about a debt crisis but don’t want to raise taxes, even for a brief time, to get the debt under control.

 

Hubbard: Unfortunately getting the debt under control requires long-term gradual changes, whether they are on the tax side or the spending side. One of the problems both in the U.S. and Europe today is that because politicians don’t have the courage to deal with the long-term problems, they are trying to solve things in the short-term – sequesters and one-time tax changes. What we really need is to solve those long-term problems. I hope we do it on the spending side, but if the American people want to do it on the tax side, that is their choice.

 

MarketWatch: Is it that we’ve over-promised?

 

Hubbard: We can’t afford the current system of entitlements along with everything else government does and the standard of living we want. One of those has to give.

 

MarketWatch: So your solution is a balanced budget amendment to the constitution?

 

Hubbard: That is the outer bound. I would hope we could do something less dramatic. Putting changes in accrued liabilities in the entitlement programs on the budget, which is an idea we talk about in the book. But if that doesn’t work, then a balanced budget amendment, yes, would be needed. But the previous balanced budget amendments have all been pretty flawed. They would make recessions worse, they were poorly designed. What Tim and I suggest is effectively a spending limit linked to a moving average of inflation-adjusted revenues. We put it that way because we think we ought to be agnostic by gradually reducing spending or by raising taxes. That is a political choice.

 

MarketWatch: Let’s turn to Fed policy. You’ve never been a big fan of QE. So do you think the Fed should begin to taper?

 

Hubbard: My view is that QE1, in particular had a positive effect on the mortgage market. I don’t think [subsequent] quantitative easing has had much a positive effect and it runs large risks associated with the exit. So what I think what the Fed needs to be doing is thinking about, very carefully, what its exit will be. And I think that discussion is already happening.

 

MarketWatch: Why don’t you think QE has been effective?

 

Hubbard: We just don’t see it in the data, in the real economy. We see some spillovers into asset markets but very little positive impact on the real economy. And at the same time it is creating significant risks associated with the exit and it runs the risk of misallocating very large amounts of capital.

 

By pushing funds into risky assets, you are already seeing risk spreads coming in in the leveraged loan market and the run-up in the stock market that is not entirely due to economic fundamentals.

 

MarketWatch: You played a role in Bernanke’s appointment to the Fed, when you were with the Bush administration.

 

Hubbard: Yes, I recommended him.

 

MarketWatch: So his term is about to expire, would you like him to stay?

 

Hubbard: There is only one person who counts and that is the president. I think Bernanke, on balance, has done an excellent job. Whether the president wants to reappoint him or Ben wants to stay are just things I don’t know.

 

MarketWatch: What would your recommendation be if the president called?

 

Hubbard: I would certainly recommend Ben to him as the best choice. 

 

Greg Robb is a senior reporter for MarketWatch in Washington. Follow him on Twitter @grobb2000.