>> the federal reserve -- >> stop a run? >> that's a good question on the money market funds. i believe -- i thinkof the firsf your description around the liquidating -- the options for aig and the liquidation of systemically risky enterprises, failing enterprises is absolutely correct. on the guaranteed money markets, the use of the federal reserve emergency powers or so-called 133 are much more con strained. the view from officials -- they can speak for themselves, but this is my impression. they would feel much more con strained on the use of those powers relative to the fall of 2008, but they do say both current officials and former officials when needed they will come in and save the day. >> let me say to you the chairman of the federal reserve told me yesterday, the chairman of the federal reserve, that he does not believe they would be

able to guarantee money market funds as they did in the 2008 crisis. he does not believe. doctor. >> i'm sure he's -- i'm sure that's what he believes. of course, there is the problem or issue we have a very powerful and resourceful country with extremely smart people running the xex tifl branch, which is what you want. there are many innovations to come up with, and the key to any credible ability to imagine failing our system is we have individual banks or a small group of pounds fail and be liquidated without massively damaging the rest of the system and worsening our budget. if you can credibly threaten that to the markets, you're in relatively good shape. the markets understand na and price risk in a more appropriate manner. if you get into a situation where they think there's a bailout and you play chicken with them, i would submit to you that there are very smart people

running the fed and treasury and white house will propose to you, congress, that they find some emergency powers to provide unanticipated forms of bailout in order to prevent a global collapse. dp they give you the choice of a 20 or 30% decline in gdp or some innovative interpretation of the legal powers, i'm not sure which wa gdon't want the 30% collapse in gdp. all of this should be moving much faster towards making failure possible. capitalism without failure is not capitalism. it's really a bad form of socialism, to be frank, and that's what we have in regard to megabanks and certain humongous financial institutions in our country. >> no matter what the regulations say, no matter what law congress has written, no matter what executive order has been published, when they called secretary of treasury and the head of the federal reserve and

the president and the leaders of the congress into a room and say, p if you don't do this, it going to be the end of the world, you will do it. all right? the rule of law -- one thing i've learned looking at financial crises over the last 15 years in person and looking at this, when push comes it to shove and the danger is great enough every government will forgo the rule of law and change the law and the rules right then and there. it's a sad fact. we all like to think we live by the rule of law. the only difference between a banana republic and a stable democracy is you how big the danger has to be before the government rewrites the rule of law. >> well, i think -- i want to add one sentence. i'm not sure you'd even have to ignore the law, because there are laws that sometimes are not even mentioned in this context that could be invoked.

the international economic powers act, which applied if in principal to u.s. international financial involvement but is often invoked for much broader purposes and would be directly relevant if there was a currency dimension to the crisis, any international dimension, that law can be invoked to do, in fact, almost anything. so it was the successor of the trading with the enemy act which was changed in the 1970s that happened to be involved, but it does give authority to an executive branch to do almost anything under the guise of dealing with an international economic emergency, which you have prof sized would be. whether one violates the law or come up with interpretations, i think adam's right. >> i hope adam's right. >> we have an example in this

country. when you had the chrysler bankruptcy, the government rewrote the bankruptcy code in terms of proprietary of creditors. >> let me say that before we ever get there, my hope is that we take steps necessary to prevent getting in that spot again, which is really in large part what this hearing is about. so let me go back it to each of you. if you had the power to take a series of steps to protect the united states, given the risks that were known and those that are unknown, what would be the advice that you would give to this committee and what we should do to protect the united states? >> i think it's conceptually simple and actually do-able

politically. you should prepare for enactment right after next -- the elections later this year, 2013, a budget plan which simultaneously provided some support to economic growth in the short run by continuing, for example, the payroll tax cuts for another year or so. but -- that's the huge but, put into place concrete, tangible measures that would reduce the budget deficit to achieve the 50% to 60% debt-to-gdp ratio over the next five to seven years. i don't mean procedures like you did last summer where you commissioned certain deficit reduction going on now, set up a subcommittee and put in place sequestration. that put in place procedures,

not budget correction. so i think you need to actually vote two or three major measures that would phase in over a five it to ten-year period and concretely reduce the budget deficit to the target of limit over that time. for example, social security reform, where you would change the indexization formula, increase the retirement age, maybe one or two other elements to that which would by definition phase in over a number of years, which is what you want, but would take 1% to 1.5% of gdp over that time, which is what the markets want to hear. that's one. secondly, if you could agree on some revenue increases, which i think will be necessary, as part of thepackage, then you come up with the kind of tax change that's necessary to do that and phase it in over ten years. so it has a gradual impact on

the economy, can be accommodated by the private sector, not interrupt either growth or their business transactions because it's phased in but get to an end point which has a significant impact in reducing the budget deficit. if you could final similar measures on the health care side, obviously it would be desirable to do that. the point being, however, to actually vote substantive, tangible, concrete measures, put them in law that sets you on a path to phase in the budget correction over the desired time period. that seems, to me, squares the short term with the longer term, and i think only that will avoid the risk it on to our country that continues to kick our can down the road otherwise generates. >> dr. johnson. >> i agree that making progress on the budget would be huge,

particularly in this context. the extent of fiscal adjustment you need if you go to a 50% debt-to-gdp target to 2030, it's about a six percentage point fiscal adjustment. it's pretty large to historical standards. the one step that -- i think there are many ideas on the table, and i don't see many political traction for any of them at the moment. that's a good reason to be concerned. what you may do is you might not extend the so-called bush era tax cuts. perhaps we should start calling the bush-obama tax cuts. it requires agreement between both houses of congress and the president to extend them. i understand you don't want to do there at this point, but if you were to do that, that would be huge. if you look at the fiscal adjustment the united states needs to make, this would take the issue off the table. if you don't extend them, half the fiscal adjustment you need

to make. there are other things that need to be considered. i would go after many of the tax expenditures and phase them out over a decade, totally responsible. can you communicate politically to the markets that i think we all agree will be looking increasingly skeptically at the united states in the future that we can do some fiscal adjustment. we did it in the 1990s the in the united states, we did in the somewhat distant past. the markets are going to question us. when the markets wake up and start pushing us around, that comes very quickly. we do not get a letter saying, in 90 days the markets will turn against you. absolutely not. we should get ahead of that. we'll be forced into self-defeating austerity where the europeans are. >> let me say the cbo told us yesterday p if we were it to let all the bush era tax cuts lapse and if we were allowed sequestration to proceed, as is

currently in the law, that economic growth in this country would drop dramatically. that we would go from, you know, 2.2%, 2.5% growth this year to just over 1% growth next year. that kind of precipitous change, to me, does not make sense. what does make sense is to have -- fred, i like what you described, which is something in the short term that gives additional lift. by the way, i personally believe we should look at infrastructure. i know economists have resistance to that because of the time necessary. i'll tell you, if you told the states of this country there was going to be priority funding available for projects that have national importance in the transportation infrastructure of the united states, and you gave them a certain amount of time to

obligate those funds, it would happen. but only, only if simultaneous, simultaneously you put in place a policy that made the adjustments to entitlement and, yes, revenue, that, to me, i would like the goal balancing in ten years. that would take us a lot way in the direction to getting to a debt-to-gdp that is sustainable. dr. larick, your recommendation to us. >> first of all, senator, i think that the u.s. government is lulled into a false sense of security by the level -- how low interest rates are on our debt. >> right now. >> right now. it's driven by basically three factors. one, the mess in europe, so there's no other place for international investors to place their funds. two, the fact that the dollar is a reserved currency so

foreigners are forced to buy huge amounts of treasuries and finally that the federal reserve is buying so many themselves. you have very few private investors in the united states buying u.s. treasuries. i think going back what is lacking in this couldn't from a government policy standpoint is a simple program that answers five questions. those questions are, what are you trying to do? how are you going to do it? why is it going to work? how much is it going to cost? and where are you going to get the money? congress hasn't answered that question. the administration has not answered that question. the markets are waiting for an answer to that question. >> i think he's right. >> the great innovation of economic science over the last 50 years has been the role of expectations in how people and the economy and financial markets work. if the u.s. government were able to announce a program that

answered those five questions, the markets would immediately -- and it was credible, the markets would take that inspection of future stability and give us stability today. until we answer those questions, any stable stability will be short-lived and could vanish at any moment, as mr. johnson said. >> thank you. senator johnson's recognized for the equivalent amount of time i just consumed. >> i'll be quick, because your line of questioning covered a lot of what i wanted to talk about. we're obviously talking about structural reform here, and we've talked about the book they write "this time it's different." the question that popped into my brain, past history, nation, states, got high levels of debt and got themselves up by inflating the currency and devaluing the debt. our debt is structural in terms of entitlements. our liabilities that are tied to

inflation. from my standpoint i'm saying we can't inflate our way out of this debt. the question i'm asking is like your comments on -- are we in a bigger pickle than past nations that couldn't inflate their way out of the debt. dr. johnson, you're shaking your head, so i'll go to you first. >> it was not in my head actually, but we're certainly in a big pickle. there's no question about that. i like your point that you can't inflate your way out of some of the liabilities. you can try to inflate your way out of the debt, but our debt maturity is pretty short. the uk is about 14 years. the uk has much more incentive to inflate in the classic ryan hart way than we do. ultimately we need to look at the liabilities and the revenues that we're willing to raise to back those. clearly there's an imbalance.

we have a huge advantage potentially relative to other countries, countries in the book, which is we are the reserve currency and can borrow unsurpassed by anything any country has ever had, and welin. we're in the process of wasting that credit line. weert not investing in public assets and upgrades the system and we're just spending that, borrowing to finance consumption in excess of our income. that will absolutely end badly. so the pickle we are in is a large one and maybe bigger than what other countries have had. we have an opportunity to fix it. an opportunity that the europeans don't have right now. the europes are in a different place from us and a much, much tougher place. we should take that as a cautionary tale and use that to fix our own budget today. i think we're all on the same page with regard to your general points, senator. >> you touched on my next point

i wanted to ask about the reserve currency. i know some countries are talking about maybe a basket of currencies. how long do we have? i realize you can't answer that. is there really a concerted effort to move away from the u.s. dollar? >> i wrote a book on that a long time ago and try to keep close to it. it's critical to remember that the reserve currency role is a two-edged sword. it buys us more time, as colleagues have said, but that also means we tend not to have the pressure that we need to adjust. so even in fundamental terms is it a good thing in the national interest, it's ambiguous. once the reserve turns, then it can be a huge sort of dam cleez. there are about $25 trillion of foreign-held dollars floating around the world economy. that's the sum of the

accumulation over the years that let us run the deficits we're talking about. we used to call that a dollar overhang, which implies correctly that it could come cascading down. so if the worm turned and the markets began to look he is consequenced at what we d-then they intensify the pressure on us as people around the world sell those dollars they accumulated over the past decades. whether that happens depends on two things. a s-is there an alternative to the dollar. in underlying structural terms the euro is one. it's a bigger economy and definancial markets and meets all the criteria. right now it's not an attractive alternative. if any get the act together and get their house if in order two or three years out, they certainly could be. here comes china, which will be the biggest economy. it's going to have to have by far the world's largest trade

and foreign investment flows. once they decide to move off capital controls and make the currency convertible, that's another alternative. we're headed toward at least a three-part global monetary system called a multiple currency system, dollar and euro and rmb over different periods, but if if we're thinking five years, the euro is in the problem. if we think ten the rmb is probably in it, too. so the nonalternative that adam rightly pointed to now does become very different. even in an annual flow sense people are not compelled to put their money in dowers. to the extent the reserve currency role is an asset, as it certainly is in the short run, that two will be fading. if the worm turns, it could become a huge liability. i would never rely very much on that one to deal with the sustainability of our situation over any reasonable period of time. >> senator, i think i spent five

years in argentina on their debt restructuring. every argentinian school child knows there's three solutions to an overindebted economy. you write down the debt. you raise the surplus to pay the debt, or you inflate the debt away. there are no other solutions. we've learned that after 200 years. the question of the reserve currency, should there be a basket as an alternative? >> i'm talking about it. >> every person in the world can create their own reserve basket. if you like -- if you think that you like a basket of reserves that's 20% yen and 10% -- 40% euros and 30% dollars and throw in some -- the brazilian real, you can create that yourself. central banks do that all the

time. the idea of creating a, quote, official reserve currency basket such as the sdo or the special drawing right the at the imf was supposed to be, that's a very inefficient outcome. that's saying we decided what the optimal basket is. we set the weights and percentage of each currency. i might like those weights. fred may think, i don't like those weights. i want a different basket. simon may want a third basket. there's no purpose in creating a basket currency today. finally, as fred pointed out, the reserve currency can change very quickly. what has held us up and what has taken the pressure off the u.s. government to actually make the decisions it should have made years ago is because there's been no viable alternative. the euro was a viable alternative and it now isn't for the moment. as fred said, if over the next three years as i believe they do actually put in place a stable system, then it will be. you will see massive flows.

the only thing that will surprise you more than the size of the flows as they move out of the dollars into the you're roadway will be the speed in which it will take place. >> beg indulgence for one more question. this is about taxes and the effect on growth. during my lifetime the highest marginal tax rate is 70%, 50%, 28%, 39.6%. for the last ten years the average amount of revenue generated or extracted from the economy is 18.1%. the variation has been tight around that mean. it goes up too much, you end up with a recession. i don't know what the causebut . i i'm not sure what causes that. i realize tax policy drives it. have all kinds of deductions. i have a suspicion as well like with capital gains taxes, when

you raise them higher, people expose less of their income to that capital gains tax. so i am highly concerned if we raise taxes we're going to harm economic growth, and i do sincerely believe that the number one component of the solution is economic growth. so if you could just sort of speak to the effect of marginal tax rates, the ability of the united states government to extract much more than the 50-year average over any long period of time. really speak to increasing tax rates basically to try and drive more revenue. i know that's kind of a big subject. in 30 seconds or less. >> that's a huge and terrific subject, senator, and take this coming. you may disagree on the evidence and on the ability to raise revenue. i take your point there's a stability about federal reeve news for a long time prior to the crisis and we should reflect on that. of course, there isn't stability to the future medical costs.

that's the big collision if you look over a 20 or 30-year time profile. if you cap federal revenue at 18% or 19%, that has major consequences of what you pay in terms of health care costs of elderly americans, and i think we should have that conversation. i would go on the side of covering more health care costs. we try to control the costs obvious obviously, and those are tough to control. that means the costs will incrcbo is very honest about what the future costs are going to be. the europeans not so much. at least that's table. guild a little bit more towards allowing revenue to increase, and i think there's ways to do that over the medium term. but i think over the medium term we can do that without damaging growth and do that in a way that is pro-growth and also quite reasonable. i don't expect that you and i

will agree on that in the end, senator. i think now's a good year to have that discussion and to get these issues p in the open and to show people what's the menu. in our book we lay out a menu of options, but you can pick whatever you want off the menu as long as you get onto what we've agreed on, a path to fiscal sustainability and a debt-to-gdp level under control. >> does everyone agree with me? >> just partly. two one-sentence responses. one, i think it is more important to get the overall budget into sustainable balance than it is to avoid an increase in government revenues as a share of the economy. point two, i think w contribution to that outcome with higher government revenues without raising marginal tax rates, which you stress. getting rid of a lot of tax expenditures and finding a lot of base broadening to go along with maintaining our even

possibly cuts, like in the corporate case, some of the tax rates. so i think there's a perfectly do-able package here that addresses at least what seems to be your main concern, marginal rates, at the same time increasing revenues as part of an overall budget package, which, to me, is the most important priority. >> senator, i think your concern about tax rates is very well-focused. i think two things. one, we have to pay for the miss takes over the last years. we have to pay r for it. that requires a right in tax revenue, not in tax rates fraesd absolutely right. p if you raise marginal tax

rates on high income people, you won't generate the revenue -- there's a question of how much more revenue you'll generate, and you won't generate anywhere near the revenue you need to close the gaps significantly. you have to think of how do you broaden the tax base, and how do you broaden the tax base without affecting economic growth or minimal impact on economic growth? that is the key issue. raising marginal tax rates can be politically attractive, politically popular. in this country we have 50% of u.s. voters that don't pay any income tax. 60% receive more from the government than they pay in taxes. raising on the highest 20% or 30% can be politically expeditious. you have to broad any meaning -- it would require a broadening of the tax base. raising tax rates will not help it. >> even though they don't pay

political taxes, it's aa historical distinction. most other countries don't make that distinction. you fund social security and medicare out of the payroll taxes. that is an important federal tax obligation that most voters actually do pay. >> i would raise a quick point on that. i view medicare and payroll taxes. those are pension funds and health care costs. those are not taxes to pay for general government expenditures. >> i agree. >> let me make this point, because this is where we have a disagreement. wheth when i look back at the five years we balanced budget in the last 30 years, tax revenue was close to 20% of gdp, 19.7 one year, 19.8, 20.6. so in the years we've actually balanced the budget, tax revenue has not been 18.1. it's been close to 20% of gdp.

we have the additional problem of the demographics of the country changing. an aging population, so my personal belief is we've got to be in the high 19% of gdp range to get a package. i agree entirely the way to do that is not raising marginal tax rates, and, you know, if you look at somebody like martin feldste feldstein, pretty credible conservative. he says don't raise marginal tax rates. broaden the base, reduce and in some cases eliminate tax expenditur expenditures. i don't want to put words in his mouth. he said you ought to focus on tax expenditures, because it's just spending by a different name. some of these tax expenditures run 1.1 du$1.1 trillion. we spend more money through