The New Republic

As of late this summer, Democrats in Washington shared a tidy consensus about the economy: The stimulus was working more or less on schedule, and the job market was gradually recovering. That meant the administration could start thinking about how to rein in the country’s yawning budget deficit, if not actually scale it back yet.

What followed turned that tidy consensus into a pigsty. On October 2, the Labor Department announced that September’s job-loss total was roughly 60,000 higher than the previous month's, prompting a hastily convened powwow between the president, House Speaker Nancy Pelosi, and Senate Majority Leader Harry Reid. (The number has since been revised downward.) Then, in early November, Democratic candidates handily lost gubernatorial elections in New Jersey and Virginia, with independents deserting the party in droves. “For those up next year, it was a wake-up call on the deficit,” says one Senate Democratic aide. Suddenly, spending more money on jobs didn’t look so appetizing. That is, until the following Friday, when the next jobs report showed the unemployment rate jumping from 9.8 percent to 10.2 percent--clearing a psychological threshold that was no less terrifying for being foreseeable. And on and on it went. “The entire town is more schizophrenic than I’ve ever seen,” says one senior administration official. “Everyone cares about jobs, and everyone cares about fiscal discipline. The weight shifts week by week, unemployment report by unemployment report.”

The basic problem is that any additional stimulus adds to the deficit, while deficit reduction steps on a weak economy. And so, Democrats now find themselves having to pull off a balancing act that would seem to defy the laws of economics: taking on both tasks simultaneously. “We’ve got about as difficult an economic play as is possible,” the president observed at his recent jobs summit.

There was, of course, one famous attempt at this feat during the last generation: the Clinton administration’s in early 1993. The decision about whether to rein in the bulging deficit or spend money on the rickety economy divided the incoming Clinton team. But, in retrospect, the challenge was much easier than the one confronting Obama. For one thing, GDP had been growing for almost two years in early 1993, versus only a single quarter today; unemployment was almost three points lower. For another, the deficit was actually far more tractable back then. The end of the cold war promised a peace dividend, and the bill for the baby boomers’ Social Security and Medicare benefits was basically 20 to 25 years away. Today, the entitlement spending boom is right around the corner, we’re surging in Afghanistan, we’ve spent a few hundred billion dollars propping up the financial system, and we already have one pricey stimulus on the books.

The biggest problem facing the Clintonites back in 1993 was arguably political: The bond market assumed the first Democratic president in twelve years would unleash a wave of pent-up spending. Long-term interest rates stayed stubbornly high as a result. Hence the theory, embraced by Clinton adviser Robert Rubin (and another Clinton economic aide named Larry Summers), that a credible plan for deficit reduction could chip away at long-term rates and boost the economy. The Clintonites were gambling, in effect, that deficit reduction could itself be a form of stimulus because of the unique historical moment--that they might not have to choose between the two. Sure enough, interest rates abruptly fell (though inflation did, too), and the '90s boom commenced.

Alas, there’s no such win-win solution this time around--among other things, there’s little room for historically low rates to fall much more--meaning the only way to further stimulate the economy is to spend. “Now is not the time politically or economically to emphasize fiscal austerity,” says Simon Rosenberg, president of NDN, a Washington think tank. “That day will come.”

Rosenberg is surely right about the need to punt for the moment on the deficit. But it turns out that this choice is only the beginning of the discussion, not the end. Worse, it’s a discussion that rapidly degenerates into a giant catch-22. Take, for example, the fact that spending more money now could actually raise long-term rates, thereby offsetting its stimulative effect. “The reality is that it’s not too hard to find a Wall Street analyst that says a second stimulus basically cancels itself out almost immediately because of the impact at this stage on government financing costs,” says one senior administration official.

On paper, the way to deal with this is to spend now while pledging to cut later on, so as to persuade the bond market that the infusion is temporary. “Everyone would of course like to be able to do something substantial on jobs in the short term and lock in tough, fiscally responsible policies in the medium term,” says a second administration official. But actually executing this fiscal maneuver is unspeakably difficult.

Consider the political context: “The odds that you could get both done in an election year with ten percent unemployment are mighty low,” says this official. It would be hard enough to rally liberals around the cause of deficit reduction so soon after the deepest recession in 70 years; getting the GOP on board would be hopeless. Already, Republicans have shamelessly highlighted Medicare cuts in order to derail health care reform, even though they pale alongside the cuts the GOP touted in last year’s presidential campaign. It’s not hard to imagine conservatives attacking cuts to Medicare or Social Security (or, alternatively, tax increases) when the goal is something as abstract as deficit reduction and Democrats can’t deflect the abuse with a benefit like health care.

But, as it happens, politics may not even be the binding constraint. “Even if you had an autocracy and could X out the politics, getting it right substantively is enormously challenging,” says Orin Kramer, a hedge-fund manager and prominent Obama supporter. Probably the biggest complicating factor is that the public isn’t a passive actor in all this. If the administration were to announce, say, a $200 billion job-creation bill along with a tough deficit-reduction package beginning in three or four years, anticipation of the latter could undercut the former. The reason: People who think their taxes will get raised typically save more and consume less. And, of course, the whole point of additional stimulus is to goose consumption.

The job facing the administration over the next several weeks is to massage these contradictions, a process that’s been unfolding in a more public way on Capitol Hill. Allen Sinai, a private-sector economist with close ties to the House leadership, has advised Democrats to pair a short-term stimulus with a new tax on financial transactions, which would pass by the average consumer largely unnoticed. But administration officials worry that a tax would simply push many of these transactions offshore, netting little income and hurting the financial sector. Moderate Democrats like North Dakota Senator Kent Conrad favor setting up a commission to hash out future spending cuts and tax reforms in order to narrow the deficit. The idea would be to let the commission work through next year, then put its proposal to an up-or-down vote after the midterm elections. But no one knows how seriously the bond market would treat that sort of deferred abnegation.

One partial fix is to pay for an additional stimulus using savings from TARP, the $700 billion financial bailout. Obama himself nodded at this idea in his December 8 speech on the economy, noting that the administration now expects TARP to be $200 billion cheaper than anticipated as recently as August. “This gives us a chance to pay down the deficit faster than we thought possible and to shift funds ... to help create jobs on Main Street,” the president said. But, while the extra bailout money is clearly helpful, it hardly solves the stimulus-deficit tension. The markets have to some extent already priced the savings into the deficit and are still registering anxiety. The day of the speech, Moody’s released a report identifying the United States and the U.K. as the only two triple-A rated countries whose debts are at risk (albeit remote) of a downgrade. The key, the agency said, would be a “credible fiscal consolidation strategy” that avoids stifling growth. Sound familiar?

Within the administration, White House budget director Peter Orszag appears to have settled on another solution. Last month, Orszag raised eyebrows when word leaked that he’d asked most cabinet agencies to prepare two budgets: one that freezes spending, the other that cuts it by 5 percent. Many congressional liberals were livid, and, according to multiple sources, Larry Summers’s National Economic Council reacted negatively to the emphasis on the deficit. (“The economic team has a healthy debate about most major issues,” says an administration official. “Getting people back to work is central to addressing the deficit. Similarly, putting the country back on a fiscally sustainable path is vital to confidence in the economy.”) The concern among wonks outside the administration is that clamping down on domestic discretionary spending without touching entitlements would take money out of the economy in the short term while doing nothing to close the long-term deficit.

These same liberals and wonks rejoiced when Obama backed job creation. But there is a logic to Orszag’s gambit, which runs roughly as follows: It’s almost certain that Congress will pass, and the president will sign, a jobs bill early next year, probably in the neighborhood of $100 billion to $200 billion. Given that, and given the difficulty of doing anything about the long-term deficit next year, the administration needs some signal to U.S. bondholders that it takes the deficit seriously. Just not so seriously that it undercuts the extra stimulus.

The Orszag approach just might accomplish that. Given the amount of domestic discretionary spending in the federal budget--about $700 billion this fiscal year--we’re talking about cuts of, at most, several tens of billions of dollars if Orszag holds the line on spending (and probably less once Congress weighs in). Which means the cuts wouldn’t come close to offsetting the likely stimulus. But they just might buy some credibility in the bond market, which could defer the day when the real deficit cutting has to start. “It’s a little bit of form over substance,” says Michael Granoff, a money manager who served on the advisory council of the Brookings-based Hamilton Project when Orszag ran it. “But, if you show resolve, that you care about this stuff, it gets into the psychology of bond traders.” The laws of psychology may prove easier to finesse than the laws of economics.

Noam Scheiber is a senior editor at The New Republic.

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