There's been a lot of deficit spending over the last six years. Why were we deficit spending in a period of economic growth?

As you know, President Bush inherited a recession, and recessions always result in significant reduction in the amount of revenue coming in to government. And that happened again, and the president came in recognizing that a recession was beginning. He immediately recommended broad tax cuts, which he was able to get passed through Congress in the first year of his first term. That was in '01.

In '03 [he] came back with additional tax cuts, and the result was really very strong economic growth. And economic growth is the way you deal with deficits. When you have a strong, growing economy, then obviously there's a lot more revenue for lots of things, most importantly dealing with the deficit.

And the deficit under President Bush dropped dramatically. I think it peaked at $400-and-some-odd billion and then dropped to around $160 billion in fiscal year ending '07. And $160 billion is really a very small number, because what's important is not the absolute number; it's to look at the deficit as a percent of GDP [gross domestic product], and $160 billion was about 1.3 percent of GDP.

Anytime your deficit as a percent of GDP is lower than economic growth, then that means your overall debt as a percent of GDP is dropping. And that's what's important. ... So you don't have to run a zero deficit; you just have to run a deficit that's smaller than the growth of the GDP. That's what the president accomplished, and unfortunately we've now gone into another recession. And so this past fiscal year ending Sept. 30, '08, the deficit ballooned back to over $400 billion, and for '09 it's going to be significantly larger than that.

Going back to the tax cuts, we spoke to [Treasury Secretary from 2001 to 2002] Paul O'Neill last week, and he considered the second run of tax cuts to be gratuitous and politically motivated. What's your response to that?

Oh, my goodness. I'm a big believer -- and many economists certainly believe -- that the less you tax something, the more you get of it. We want a bigger economy because that means a higher standard of living for the American people. So anytime you're reducing taxes, it's a responsible move, obviously as long as you're not allowing the deficit to be out of control.

The tax cuts of '03 were very, very important, because they reduced taxes on capital, and capital investment is what drives economic growth. When you're investing in plants and equipment, when you're investing in research and development, when you're investing in new businesses and reducing the taxes on capital gains, the taxes on dividends, it was so, so important to economic growth. And I just hope that President-elect Obama and Congress will extend those taxes.

The other huge benefit from reducing taxes on dividends is now CEOs of public companies no longer have an excuse to not pay out dividends. The best way to figure out whether a company is successful or not is how much cash it's throwing off to its owners, or its shareholders. And now that the dividend tax has been dropped dramatically, the amount of dividends paid out has gone up, and that's a very good thing.

Another claim that O'Neill made about the Bush fiscal policy is that, at least when he was in the White House, there wasn't an organized process for policy that laid out pros and cons of the policy and all the alternatives. ... Was that your experience in the Bush White House?

No, not at all. ... I wasn't present during the first term. I was present during three of the four years of the second term, and certainly when I was there we ran an open process. ... All the Cabinet secretaries who had a vested interest in the issue participated. All the senior staff in the White House participated, and it was an opportunity for everyone to contribute their opinions and make their case, and then we would go to the president. And often we would go to the president -- and I would make certain when we went to the president that everyone's views were presented -- and the president would hear sometimes one view, but more often than not two or three different views. And the person who held a particular view was given plenty of opportunity. The president would ask questions, and then the president would make a decision about which way to go.

So there were times when there was only one view to present to the president?

Yeah, sometimes there was a consensus. I can actually remember one time there was a consensus about how to deal with a particular issue, and the president disagreed with the consensus, and he explained why he disagreed with the consensus and went a different direction. I can also remember another incident, another policy meeting with the president, when the president had already made up his mind that we should go a certain way, and all of his advisers felt differently. And we explained why we felt differently, and after hearing the explanation, he said, "I think you guys are right."

So the deficit in fiscal '09 is going to be large.

Very large.

In 2000, Vice President [Al] Gore suggested the surpluses should be taken and kept to deal with Social Security or with Medicare. ... President Bush ran on [the platform that] we should be giving a portion of it back to the American people. In retrospect, can you defend that choice that President Bush made?

Well, first off, President Bush didn't have a choice. When the economy goes into recession, revenues drop dramatically and spending actually grows. It's built in. Spending grows, even if they're not new programs, because of our appropriate social welfare system of unemployment, welfare, etc., to take care of people who are dislocated because of the recession.

The other thing that's very, very important for people to understand -- and no one ever talks about this -- the reason we had a surplus in the late '90s is because the government was collecting a very, very high percent of GDP in taxes. ... Since World War II, revenues coming into the federal government have averaged 18.2 percent of GDP. In the late '90s, we were collecting almost 21 percent of GDP -- an extra 3 percent GDP. That's why there was a surplus.

The reason there was this extra money coming in is because of the dot-com boom and all the stock options and everyone exercising those options, and the result was that everyone was shocked at how much money was coming into the government. Well, that's not sustain -- I hope it's not sustainable. The economy will grow much faster if we keep revenues [as] a percentage of GDP close to the 18.2 percent. ...

Was there any sense in the Bush White House that we were heading toward this mortgage crisis?

Well, it depends on at what point you're talking about.

While you were there.

In the beginning, no, absolutely not. We were amazed at how strong the housing market was. We obviously recognized that the appreciation in housing, people were taking out, increasing their mortgages, which was being used to spend money which continued to make the economy grow. ...

The economic team meets every Wednesday for lunch, including the secretary of the Treasury, the secretary of commerce, the OMB [Office of Management and Budget] director, the NEC [National Economic Council] director and his deputy, the CEA [Council of Economic Advisers] chairman, the deputy chief of staff, and we would meet and often talk about, you know, what aren't we seeing? What should we be seeing? Certainly in the beginning we had no clue that this was going to happen. And to be honest, as time has gone on, as I think we've all seen that it's grown much bigger than anyone ever expected.

Once we saw the subprime problem and the subprime defaults, we thought that was contained. We knew the size of it, and relative to the overall economy and the overall credit markets, it was relatively small, and so we didn't think it would systemically have such a negative impact. But obviously it wasn't just subprime. I mean, there was just an enormous amount of toxic securities out there that had become so opaque and so impossible to understand -- that had been bought, by the way, by sophisticated investors. We always think sophisticated investors will take care of themselves, but they obviously were not doing their due diligence. And so the result was we are where we are, where people have lost total confidence, or institutions have lost confidence in the balance sheets of other institutions.

So the market wasn't able to police itself?

I think the market is policing itself. It's using a sledgehammer to police itself. Absolutely, the market is policing itself. It's painful, though. It is very painful.

So in 2005, the president won the election. He's got political capital, and he decides to do what?

That's, by the way, when I joined the administration, January '05, and he said to me: "Hubbard, your job is to get Social Security passed on Capitol Hill. You should know you have my total support, and let's make it happen. It's not going to be easy. It's incredibly important to the American people. We all know what a ticking time bomb this is. We ought to deal with it now, because it's less expensive and less difficult to deal with now than it is to put it off. Let's make that happen." ...

The accounting system for the government is totally inconsistent with the accounting principles that we all believe in and that we require the private sector to do, which is to disclose all liabilities, and to, if they're not on the balance sheet, at least put them in the notes to the balance sheet. ...

The federal government has huge debts that are off-balance sheet. They have these pension obligations called Social Security that represent $13 trillion of liability, and we have not paid for [them]. And if a president of a private company did that, he would go to jail.

What are the positive effects of putting Social Security money into the market rather than into the government?

Right now, ... we treat [Social Security] as a separate entity. We have Social Security taxes which we pay every year, which is about 12.4 percent of your payroll, up to about $100,000, and that goes into what's called a trust fund. We spend about 11 percent. ... So we actually run a surplus of about $80 billion right now with respect to the Social Security, basically this pension fund.

And by the way, the $80 billion -- guess where it goes? It goes and is spent to reduce the deficit of the rest of the government. There's no savings. It's not like in a private company where that $80 billion is accumulating every year to be paid off in the future, no. ... It's loaned to the general fund, and then the general fund spends it. But when we talk about the deficit being, say, $400 billion, that's $400 billion after spending the $80 billion, so you really have a $480 billion deficit. ...

When Social Security was created, we had like 40 people working for every single retiree. Now it's something like three people working for every single retiree, and in another 10 years it will be two people working for every single retiree. Those numbers aren't perfect, but it gives you the problem. And what's going to happen is, by 2017, 2018, that surplus of $80 billion a year is going to go to zero. ...

By 2033 the deficit will be -- for Social Security only -- $300 billion. So we're going to go from an $80 billion surplus today to a $300 billion deficit by 2033. And this is a gigantic ticking time bomb. It's like having ... termites and not dealing with it. You know, you see the first sign of termites, and you say, "Well, we'll put it off," and so 10 years later the house collapses. Well, that's what we've got with Social Security. It is going to collapse.

And so the president said, "Let's fix that, and let's fix it now, and let's get it on firm footing." And what he suggested was giving people the option of taking a portion of their Social Security taxes and putting them into a private account. They wouldn't be required, but they would be allowed to. And then our proposal was they would be given a choice of different things they could invest in, from Treasuries, which are totally safe -- they're the safest investment in the world, literally, [on] which you get a lower return. A money market fund would be another alternative, or a mutual fund that invests in common stocks -- either U.S. or international or a combination of the two. But it would be very limited. People wouldn't be picking and choosing. And again, people would be given the option, not be required to do it. But we could not get traction on Capitol Hill.

Why not?

I've spent lots of time thinking about why we were not able to get traction on Capitol Hill, and I think it comes down to one reason: Social Security is not a crisis today. Congress does not deal with anything that's painful that is not a crisis. They just don't. They're politicians. They want to make sure they get elected. That's their number one goal, and if they're going to inflict pain on their constituents, then it's got to be a crisis. Otherwise they will not do it. ...

What was going to be hard about the president's Social Security plan?

What the Democrats like to attack us on was that we were privatizing it, and we were not privatizing it. There's 12.4 percent of your first $100,000 goes to payroll taxes. We would be giving people the option of taking about 2 percent, or 1/6 of that, to put into a private account. Again, it was an option -- not a requirement, an option.

But secondly, that in itself won't balance Social Security. The only way to balance Social Security is you have to deal with future payout, and we have promised the American people more than we can afford to give them. So we've got to reduce how much we pay them in the future. There are several ways you could do it. You could raise the retirement age, ... or you can reduce the benefits.

But what we had talked about and the president talked about publicly is an idea that was developed by a fellow named [Robert C.] Pozen, who's a Democrat, by the way, who's on the Social Security commission and who made recommendations to the president on Social Security. His idea was that right now Social Security benefits go up at the rate as wages go up, the same percentage. If, by the way, Social Security benefits went up at inflation, as opposed to at the rate of wages, the problem would go away overnight.

What Pozen suggested was higher-income people, people that earn $90,000 to $100,000, let's let their benefits go up at the rate of inflation. For lower-income people, let's let their benefits go up just like they do now, at the rate of wage increases, and then let's smooth it between the two. So if you were, say, making $50,000 or $60,000, your benefit would go up somewhere between wage growth and inflation. If we did that, that would take care of 70 percent of the problem.

And then there were some other tweaks we could do that, again, were taking away benefits -- maybe raise retirement age slightly; maybe reduce the incentive to retire early. Right now you can start collecting your benefits at 62 years old, and you don't get penalized very much for doing that. ... Well, we shouldn't encourage people to start taking benefits at 62. So if you made a few of those little tweaks, plus take to the Pozen plan, we would solve the problem. But the problem is now the longer we wait, you're going to have to have a more draconian approach to reducing benefits to deal with the problem. ...

What are the macroeconomic positive effects of Social Security private accounts?

When the money is paid into the government -- 100 percent of your payroll taxes goes into the government, as I've already pointed out -- that money is poof, spent, gone. It's used to pay down the deficit. But if we were using it to actually build up private accounts that people chose, ... then that money is actually invested and saved for. That will make the economy grow that much faster. It would increase the savings rate in America.

Now, it's going to put more pressure on Congress to be more responsible in their spending, but that's good. They need to be more responsible. And Congress -- honestly, if there's one thing I learned spending three years on Capitol Hill, and I say this about both sides of the aisle, they truly spend money as if it grew on trees. They do not spend it as if it's going to come out of somebody's pocket. ...

So it seems to me that the Congress wants to have lower taxes and higher spending. That's what gets you elected.

Yeah, but they're a lot more interested in higher spending. The only way to control spending -- and I truly believe this -- the only way to control spending is that you've got to minimize taxes, because if you minimize taxes, they know the deficit can't be too big. And that's what keeps pressure on them to reduce spending. You can go talk to conservative Republicans who are normally fiscally responsible, and they will tell you in the late '90s when we were running the surpluses because of the increased revenue that was coming from the dot-com boom, even they were looking at ways to spend that money. ...

President Obama has said that, with Peter Orszag, who, by the way, is terrific and is going to be OMB director, he wants to go through every single page of the budget and figure out how to save money. Now, I hope he comes through. Presidents are good at saying that, and then it's hard to cut the budget because there's a constituency that is enjoying the benefits of whatever that expenditure is.

I would love if President Obama actually did that and Peter Orszag actually did that. The reason they're talking about doing it is they know that the deficit is going to be gigantic and that we have some gigantic challenges ahead, and so we need to eliminate unnecessary spending. But no one ever does it. No one ever does it.

Going back to the Social Security, was there one moment where you were sitting with the Congress and they said, "Look, I know this is a ticking time bomb, but I'm not going to risk my seat"?

... You had two things going on. The Democrats did not want to give President Bush the victory of fixing Social Security -- and, by the way, there was going to be some pain involved in fixing Social Security, and they didn't want to participate in that. ... Their whole focus in '05 was, we want to win in '06, so the worse President Bush looks, the better it's going to help us win in '06.

And then on the Republican side, obviously we had a lot of supporters, but we didn't have everyone in, because they didn't want to go through the pain. ...

Let's talk about Medicare. The Bush administration passed a huge increase in Medicare entitlements. What was the thought on how that was going to be paid for?

Let me just first say that the president felt like -- and he was absolutely right -- that if Medicare is supposed to be our health care program for people who are over 65, it needs to change as health care changes. Back when Medicare was created, ... pharmaceutical costs were tiny, teeny-tiny, so that was not covered by Medicare. ...

Private health care programs now cover a portion of pharmaceutical costs. Because Medicare is a government program and the government's a big bureaucracy and doesn't change with the times, the president recognized that if we're truly going to provide an insurance system for retired people, it's got to be a good insurance system. And a good insurance system has got to cover a portion of the pharmaceutical cost because that's a big piece of health care costs, particularly for retired people. And so that's why he did it. There's no question that it increased the unfunded liability of Medicare, but it modernized our health care system, and it was important.

Social Security is a small problem compared to Medicare. How do we deal with those costs?

Just to give you a sense of the size of Medicare, Social Security is a $13 trillion unfunded liability. Medicare is about a $70 trillion unfunded liability that's growing at $2 trillion a year. Social Security, by the way, is growing at $700 million a year. ...

What do we do? Fundamentally -- and this is me speaking -- but the only way to confront this Medicare issue is we've got to change our whole health care system. Health care in the U.S. represents 17 percent of GDP and has been growing at twice the rate of inflation. And it just cannot continue. ...

Our system is a third-party pay system. Most people get their health care either through their employer-paid health insurance or through government-paid health insurance, or some sort of health program. So when we go to the doctor, go to the hospital, we act as if the service is free. When's the last time you actually shopped for a medical service? When's the last time you shopped hospitals before you got an MRI and found the least expensive MRI? When's the last time you shopped seeing a doctor for some procedure and compared prices, compared services, compared quality? It just doesn't happen, and that's because we consume it as if it were free because there's a third party paying for it.

Now, there are two big problems with consuming it as if it were free. Number one is, we overconsume. If you thought that food were free when you went to the grocery story, it was already paid for by your employer, you would buy a lot more than you needed, and you would buy expensive steak, caviar, etc., a lot more than you buy today. ... And the second problem is the consumer does not put pressure on the provider to control costs.

And so think about it: If you're the provider and the consumer is not putting pressure on you to control costs, what are you going to do? You're going to raise your prices, and you're also going to suggest procedures that are perhaps unnecessary, because there's no pushback from the consumer. The only way for this to work is for the consumer to have vested interest in the cost of the procedure, and then the consumer will make certain that he or she is not overutilizing and that he or she is getting a good deal.

What is the argument for medical savings accounts?

There are really two ways of dealing with [the] third-party pay system. And by the way, we're at the tipping point, and we're going to go one of two ways. One way of dealing with it, which is what unfortunately the Democrats, particularly Secretary [of State Hillary] Clinton and President Obama, have talked about, is the federal government controlling costs, so doing what Medicare does today, which is set pricing and decide what's appropriate to consume. So it's basically rationing care and deciding that no, you can't have this procedure, but you can have that procedure. ...

The other approach is to incent the consumer to be a good, wise consumer, to care about price and to care about utilization, so he or she has to have a vested interest. ... That's why health savings accounts were created, which basically is a savings account that you can put tax-deductible dollars in. And then you have high-deductible health care plans, and you pay for the cost of health care till it gets to a certain high deductible, so therefore you are paying for the MRI. ...

Unfortunately, our providers aren't used to providing prices, so this is something they're going to have to learn to do.

The interesting thing is, there are two parts of health care where people have always paid for it themselves, and there the providers are absolutely set up to provide you with the total information. And it shows that the marketplace will work.

With Lasik surgery -- 15 years ago it cost about $2,500 an eye to get Lasik surgery. Today it costs about $1,000 an eye, and that's not adjusting for inflation, so it's dropped even more than that. ... The quality has dramatically improved. And, by the way, the ophthalmologists are still making plenty of money, because they figured out how to do it more efficiently.

Another example is plastic surgery. Plastic surgery prices have also dropped, and ... when you go to get plastic surgery, you get a package price, because the doctor understands that you are paying for that. So he will say, "OK, you have to pay $5,000 for XYZ service, and that includes not only my fee; it includes the hospital fee; it includes the anesthesiologist, the radiologist; it's all in." And that's the way we should consume all of medicine. ...

President Obama, Democratic House, Democratic Senate, they're planning to spend [up to] $800 billion in stimulus. Is that a good idea?

The economy is very, very soft. I can tell you from my own businesses. I own five businesses right now, and every one of them is suffering because of the economy. The American people are suffering, and obviously the unemployment rate has increased dramatically. There's no question the government should respond. ...

Should there be a stimulus package? I support a stimulus package. I do not agree that what President Obama has proposed is the best way to go about it. There's some good things about what President Obama has proposed. ... There's no question we've got infrastructure challenges in the country. There's no question that we need to be developing alternative sources of energy. Those are all positive things that need to be done, and if we are going to spend money, I hope we spend it on things that we actually need.

The problem, if you're looking at a stimulus, you want it to be broad-based and basically hit the whole economy, and you want it to occur as quickly as possible. Infrastructure -- [it] takes a long time to build a new road; even to repair a road, that's a long time. ... Most people think that if a big infrastructure bill is passed this year, no more than 25 percent of it will be spent this year.

I think a much better approach is to reduce taxes; i.e., put more money in the American people's hands, and reduce the withholding tables, and reduce across-the-board taxes where people have more money. Now, the argument against that is, well, they're just going to save it, and they're not going to spend it. This is a very important point. ... If it's a temporary tax reduction, they're going to save it because they're not going to have it next year. But if it's permanent [and] they know they're going to have for the foreseeable future, then they will spend a much bigger percentage of it. … They, better than the government, know where spending should occur, and they are the best at deciding what makes the most sense for economic growth. ...

But if we did that, then our deficits every year would be enormous.

Not if the government would reduce spending. There's so many opportunities to reduce spending, and to be perfectly honest, no one's really done it. And I'm hopeful that President Obama will do it. He says he will do it.

The sad thing about our farm programs, number one is they were created in the '30s, and they were created to be temporary till we got out of the Depression. And here we are 80 years later, still with these farm programs, paying people not to grow crops; paying people, ensuring that they get high prices; providing them with drought insurance, and then when there's a drought, giving them additional money on top of the drought insurance. The farm program is a disaster. ...

So who stops that?

It's going to take a president to deal with that. It absolutely will take a president, and it's going to take him using his big microphone to convince the American people. And by the way, it shouldn't just be agriculture; there are many other programs that should be abolished, and we need to abolish them. You can't just cut them back, because they're like weeds: They will grow right back. And each has its own constituents, and for those constituents it's worth a lot more than it is to the public at large, and that's why they've been able to preserve these programs. ...

Can the United States government go bankrupt?

I don't know whether [it can go] bankrupt. ... The interesting thing is that our debt level is really quite low compared to other developed countries. Our total debt owed to the public, as a percent of GDP, is 35 percent of GDP, where you have other countries like Japan that it's over 100 percent, and most European countries' are much higher than we are.

But absolutely, we could put ourselves into a situation -- and the projections on entitlements are that the entitlements, 50 years from now, will literally consume every dollar that the government is raising. If we continue to spend, then we will get into a situation that is not sustainable, and it will have a dramatically adverse impact on the standard of living of the American people.

Do you think it's possible that investors could look at our unfettered liabilities and stop buying U.S. Treasuries because they didn't think they were going to get paid back?

Not in the short term, because we've always been responsible and confronted it when we had to. But the last time we dealt with Social Security is literally in the early '80s with [former Federal Reserve Chairman] Alan Greenspan as the chairman [of the National Commission of Social Security Reform]. It was literally -- we were at the point where we weren't going to be able to send out checks. But when we were at that point, Congress finally agreed to do something. And the debt of the U.S. government is still thought of as the most secure debt in the world. That's why during these very difficult credit times, money has been flying into Treasuries because it's perceived by investors as the safest investment in the world.

But is it?

We need to deal with our problems, and the sad thing that's going to happen is if we don't deal with our problems, we're going to have to raise taxes. The only way to pay off that debt is to raise taxes. When you raise taxes, it has a dramatically adverse impact on economic growth, and that's going to hurt the American people. So that's why we need to deal with it now.

I would hope President Obama would make a commitment to keep taxes basically at the same level as they've been since World War II -- 18.2 percent. We've had great economic growth since World War II. But to do that, he's going to have to deal with these unfunded liabilities. ...