Now, can Washington tackle the big economic issues?

By Neel Kashkari
Friday, December 10, 2010;

The agreement on the Bush tax cuts and unemployment benefits illustrates that Washington can tackle incremental issues. Lawmakers will undoubtedly agree to raise the debt ceiling and pass another federal budget to keep the government running.

But will this new divided government be able to make the major structural changes necessary for our economy to grow and prevent the fiscal crisis on the horizon?

Many Americans outside Washington prefer divided government. In theory, it forces our political parties to work together on initiatives that have the broadest possible popular support. It demands shared accountability: With one party in control, it is too easy for politicians to shower their constituents with largess and for the party out of power to simply object to everything. Divided government often leads to better governing.

Consider the landmark legislation that has been produced through divided government in the past 30 years: Working with a Democratic House, President Ronald Reagan enacted Social Security, tax and immigration reforms. President Bill Clinton achieved welfare reform with Republicans controlling both chambers of Congress. President George W. Bush got his No Child Left Behind legislation through a Democratic Senate.

This track record suggests our political leaders can work together to pursue bold legislation - but will they do it now?

The legislative examples I cited as products of divided government had another shared attribute: They occurred during times of economic growth and relative stability. For the past 30 years, our economy enjoyed strong growth in gross domestic product and asset-price appreciation, both of which were fueled, unfortunately, by increasing debt.

It is of course easier for politicians to make hard choices when the economy is growing and Americans feel economically secure. Americans are beginning to pay down their debt, a necessary course - but deleveraging is a headwind that results in slower GDP growth, slower asset-price appreciation and higher sustained unemployment. The result is more insecurity for American families and a more challenging political environment.

While there are no magic bullets to pierce this debt overhang, pro-growth economic policies could help make the adjustment less painful. So which policies should our leaders embrace?

Washington must start by acknowledging that our society is overly geared toward consumption rather than savings and investment. This was a fundamental component of the 30-year leveraging cycle we just concluded. Consider that consumer-device pioneer Apple has a larger market capitalization than technology infrastructure giants Microsoft, IBM or Cisco. Our political leaders lecture Asian economies that they should consume more and save less to facilitate a global economic rebalancing - but they should also be working at home toward reorienting our society to savings and investment.

When government taxes an activity, society gets less of that activity. Hence we tax cigarette and alcohol purchases. Those make sense. We also tax income and savings. Don't we want people to work and save more? Temporary measures such as the one-year payroll tax reduction in the tax cut compromise do not change long-term behavior.

Imagine if President Obama announced a plan to permanently replace income taxes with a consumption tax. Such a plan could be revenue-neutral. It could be combined with elements from the fiscal responsibility commission's thoughtful proposal to reform entitlements as part of a grand bargain to make our economy more competitive, accelerate the necessary adjustment toward savings and investment, put us on a path to fiscal solvency and - importantly - help create jobs.

Pundits would wail that this is naive. The president's political advisers would warn that this is risky. All would be correct. But we are facing a multi-year adjustment period, a "new normal" that many economists agree includes sustained high unemployment. The country needs bold economic leadership. It is time to stop allowing political pundits to chip away at courageous ideas with risk-averse incrementalism. Our country, economy and political system need a shot of adrenaline to spur action.

Given its record debt and spending commitments, the United States can't afford to waste the next two years. We must hold our political leaders accountable and demand that they work together. The proposal from the president's fiscal commission and the tax-cut compromise are promising starting points. But they are not nearly enough. Success should be defined as enacting major structural reforms to improve our economic competitiveness - and our leaders must answer to the American people if they fail.

The writer, a managing director of the investment management firm PIMCO, served as an assistant Treasury secretary during the George W. Bush administration. He led the Office of Financial Stability and ran the Troubled Assets Relief Program until May 2009.

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