Pete Peterson predicts markets will panic over our debt crisis. Sometime.

Inside Washington, Pete Peterson's name has become synonymous with deficit reduction. A former member of Richard Nixon's cabinet, a founding partner of Blackstone, and a lifelong Republican, Peterson has pledged to spend $1 billion of his Wall Street fortune to the cause of shrinking the debt. He's already given at least $458 million to his eponymous foundation, which has funded outside groups battling the federal deficit, including $5 million to the Fix the Debt campaign.

(Peter G. Peterson Foundation)

(Peter G. Peterson Foundation)

I spoke with Peterson about the ongoing fiscal fight on Friday morning. Here's a transcript of our conversation, lightly edited for length and clarity:

Suzy Khimm: You were among the business leaders and budget watchers who was really hoping that the fiscal cliff would be a springboard to major deficit reduction. The deal that was passed on January 1 fell significantly short of that goal. Why weren't the CEOS more effective in convincing Congress to take major action on the deficit?

Pete Peterson: Well, one of the questions we always ask in life is, "Compared to what?" You may recall Tom Friedman wrote an article not too long ago that the business community on fiscal issues was missing in action. The Fix the Debt effort we were a part of got over a 100 CEOs. I think they lobbied and communicated very hard on avoiding the fiscal cliff. The big remaining question of course, is the longer term, the structural problems and so forth. There're certainly trying to be effective. I think they have played an important role in the past, and it remains to be seen what effect they're going to have now.

As far as "fiscal cliff," they were quite an influence in avoiding that at almost any cost. The fiscal cliff [deal] didn't turn out to be nearly as complete as some of us might have wanted. On the other hand, it avoided the cliff. Second, it did get revenues on the table. Third, it made some contribution to the fiscal situation. I guess I'm not totally aware of the impact [the CEOs] are having right now.

Speaking of the fiscal cliff, we have a bit of a tendency now to give somewhat false assurances. There are columns and op-ed pieces that suggest we've stabilized the debt over the next 10 years at least or so. We've had our research people do an exhaustive study on that, and they conclude they are false assurances...it shows debt to GDP not stabilizing, but rising 73 to 87 percent. [The Peterson Foundation will be releasing this analysis in a new report next week.] We still haven't made progress on what the fundamental problem is, which is the long-term structural [deficit] problem.

SK: But the markets don't seem to have reacted very much to the fact that we haven't done the kind of long-term structural reforms to reduce the deficit—not just the stock market, but the bond market as well, the foreign investors in our government debt.  Some believe this means the market doesn't actually care about the deficit either.

PP: I think one important explanation is that we have a situation where the U.S. economy has been in recession. When the economy starts recovering, you'll see interest rates go up. Not enough attention being played to the softness of the economy.

SK: For the past year and a half, though, we've had a situation of very significant deficits but very low interest rates. So do you believe this is an anomaly that will eventually pass?

PP: I think it will pass. It will pass for two reasons: One, the economy, getting stronger and secondly, if we continue going from crisis to crisis, at some point... No one, certainly not Pete Peterson, can make predictions about the market reaction. But you know [Kenneth] Rogoff and [Carmen] Reinhart—I've talked to them, and they say [debt crises] are sudden, they're sharp, they're very substantial. The risk is simply too big. At some point, if we lurch form crisis to crisis, then confidence will decline on our economy in general.

SK: I know you say you can't predict when the market will turn because of a debt crisis. But, generally speaking, do you believe this something that's imminent—something that could happen over the next few months, the next year, or is it further down the road?

PP: I don't think anybody knows. If you study history, and I've tried to do this in a shallow way, the turns—they're sudden and they surprise nearly everybody. That's what I would expect here. You have to measure risks versus the rewards, and the risk versus the cost. The risk of market loss of confidence is so substantial. We're really playing with fire here. But I don't think there's anybody alive who can answer your question about precise timing.

There are two effects that I'm concerned about: Contrary to what you read, my primary concerns not this year's deficit or next year's deficit, it's long-term debt which is the problem. One, you will have the kind of fiscal crisis I was talking about. Two, even if we are able to avoid that kind of a crisis, it's clear that the resources we're going to have for investment, R&D, education, and training, go down. The inevitable effect will be less and less to invest—it would be what I call a slow-growth crisis. We need fundamental entitlement and tax reform.

SK: The president has said that he'd be willing to do entitlement reform, but only if spending cuts are paired 1:1 with more tax revenue, as he believes the fiscal cliff deal didn't get us far enough. Do you agree that we need more tax revenue for deficit reduction, not just from the individual side of the tax code, but from the corporate side as well?

PP: I have thought for some time that a critical component of tax reform is doing something about tax expenditures...They are disguised spending. Reducing tax expenditures, most of which go to well off and corporations, could provide those revenues. Tax reform combined with entitlements are the crucial element.

SK: So if tax reform is important for deficit reduction, do you believe that we should be considering revenue-positive corporate tax reform? That would eliminate expenditures not simply to reduce rates, but to reduce the deficit. I ask because both Republicans and the White House have previously promised to do revenue-neutral tax reform, which wouldn't reduce the deficit.

PP: That's going to be an inevitable political battle—how you split [the revenues] you get out of it. The argument I use with my Republican friends is that essentially these expenditures are market distortions. If you believe in freeing up the market, the logical thing would be to reduce those to a minimum state. I think tax reform should very much be on the table.

Of course, entitlements should also be on the table. To some, the mere mention of entitlement reform is overdramatized and reinterpreted as tearing up the safety net for the needy and vulnerable. Entitlement reform should be used to secure the benefits for the needy and vulnerable.

The same way that we have progressive income taxes, we should have progressive [entitlement] benefits. The thought that those of us who are well off should have the full complement of benefits, with number of elderly doubling, living 8 or 9 years longer than originally, with the explosion in health care costs—obviously in the face of it, we've got to have a national conversation. Decisions are going to have to be made.

With sequestration, one of things that troubles me is that half of total is going to discretionary instead of mandatory spending...How do we get at these larger issues—namely entitlements, tax reform, and defense. How do define your strategic [defense] needs in a new era? We need to look at the threats of this century, not the last century.

But the overwhelming problem of course is health care, which is why we're devoting most of our efforts to health care costs. I probably sound kind of dubious and pessimistic, but I am devoting most of my life to the longer term. We haven't made much progress at this area. Maybe you have an idea? You know how to reach me.

SK: You mention the sequester as a forcing mechanism for deficit reduction. But do you think it's good idea to negotiate over the debt ceiling, to tie conditions to it, as Republicans have been demanding?

PP: I don't think we should default under any circumstances. I think it is the wrong message to send to markets. I would say we have to raise the debt ceiling. I will be very surprised, if they really think about it, that they will let that happen. I know people are verbalizing that they would, but that would have a very serious effect.

SK: But is the debt ceiling even something we should be negotiating over in the first place?

PP: We have to ask ourselves the next question—suppose they can't agree, then what do we do?

SK: Well, some Republicans are suggesting that we wouldn't technically default, that the Treasury Department would prioritize payments—

PP: I've heard of the technical default. If you think it through, what the process is by which we should prioritize? That could result in a very messy political fight. I don't favor that approach.

SK: What I'm asking is, do you believe that there is any upside to negotiating over the debt-ceiling, or do you believe the risks are too great?

PP: No, if I had a preference, it would be that the discussions would be less about the debt limit. I don't like those discussions to occur very often. Rather they are in the context, for example, of the sequestration discussion. The Continuing Resolution is another place where these things can be discussed. I would prefer that the debt limit not be.

The position of the White House on that is so firm that it's likely to be a very fruitless discussion, with negative psychological effects on markets. What period of time should we be continuing the debt limit? There are approaches being suggested for not a long-term [extension], but for X months, during which we negotiate. Pete Domenici and others have suggested that is a less onerous way of having negotiations on the debt limit.

SK: Both the White House and the Center on Budget and Policy Priorities have concluded that we need only about $1.4 to $1.5 trillion in additional deficit reduction to stabilize the debt to GDP ratio over the next 10 years, given all the deficit reduction that's already been done since 2011. Altogether, their plan would total about $4 trillion in deficit reduction over 10 years. What do you think about this kind of target?

PP: This is an important part of the problem: Conveying the impression we've gone a lot of way already, it reduces urgency of doing something. Our analysis suggests that we haven't stabilized the debt, even over a 10 year basis, and the effect is absolutely de minimus over the long term. The question is, is the long term unsustainable or not? Unless I'm mistaken, there is unanimity that the long-term is the real problem. False assurances aren't helpful in this situation.

SK: In Congress, however, both parties seem to want to avoid deficit reduction when it comes down to actually passing something—in theory, they all say it's something that they want, but in practice, people don't actually like it. Some have concluded that this means that Peterson-ism has failed. What do you think?

PP: One of the problems in attacking some of these problems is that they require a) sacrifice and b) compromise—two of dirtiest words in American politics. We're going to need revenues and spending cuts. Is it going to take a crisis to get us to act? We see what happens with crises—there are not only dramatic short term, but serious long-term effects. Getting out of crisis is a very long-term effort, as Europe is now demonstrating.

I understand that people who are not actually attacking it say we were going to grow out of the problem. It's nonsense. We're not going to grow out of the problem.

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