The Return Of Big Government

Here's a little straight talk: Whether you pull the lever (or fill in the oval or touch the screen) for Hillary Clinton or Barack Obama or even John McCain in November, you're probably still going to end up in 2009 with a push for Big Government of the sort not seen in a generation. More taxes. More regulation. More spending. "It's going to be like watching That '70s Show," says Daniel Clifton, political analyst at Strategas Research Partners, which provides research to institutional investors.

Certainly there are some gaping policy differences between the White House contenders that will determine just how big Big Government gets. Both Clinton and Obama want to make national health plans available to all--partially paid for by rolling back the 2001 and 2003 Bush tax cuts for wealthier Americans. McCain prefers a more market-driven approach and wants to keep all the tax cuts on income and investments.

But all three candidates are in favor of a "cap and trade" regulatory system to reduce carbon emissions suspected of causing global warming and to nudge the economy toward energy independence. It's an approach that could serve as a de facto $100 billion-a-year tax, since companies having trouble meeting government limits may be forced to bid for pricey carbon permits. And all three candidates will have to confront a Social Security system whose cash flow turns negative in 2017. Almost any politically feasible compromise would require higher payroll taxes--an option McCain says he's steadfastly against--as part of the mix. And it would be tough for any politician to ignore America's rickety infrastructure, which may require a nearly $2 trillion overhaul. "We're talking about government playing a different role than it has over the past decade or two," says analyst Sherle Schwenninger of the New America Foundation, a centrist think tank.

The return of Big Government? The smart-aleck response here would be something like "Really? I didn't know it ever left." And there's some truth to that view. Even though Americans have elected a generation of political leaders espousing the wonder-working power of free markets, the United States has never come close to resembling a libertarian fantasyland. Social Security and Medicare are still here gobbling up more and more of the budget. Two federal executive departments have been added--Homeland Security and Veterans Affairs--with current budgets of over $100 billion a year. The idea of a flat tax is coming close to joining the gold standard in public-policy purgatory. And despite dozens of cable channels devoted to kids and education, Uncle Sam still subsidizes Bert and Ernie.

Yet it's undeniable that America experienced an economic and political revolution that saw voters push back hard against the high spending, confiscatory tax rates, and heavy regulation that were the negative legacies of FDR's New Deal and LBJ's Great Society, programs that by the late 1970s had left the U.S. economy caught in a stagflationary trap. "Government is not the solution," President Reagan declared in 1981, and most Americans seemed to agree. Top income tax rates fell from 70 percent to 28 percent, and spending not tied to either mandatory entitlements or smashing the "evil empire" fell by 1.3 percent a year under Reagan.

By 1996, even Democrats were preaching the small-is-beautiful gospel. That's when President Clinton declared in his State of the Union address that "the era of big government is over." By 2000, government spending had fallen to 18.4 percent of gross domestic product, down from 23.5 percent in 1983. That was its lowest level since 1966, a year when America chose both guns and butter in the simultaneous ramping up of the Great Society and the Vietnam War.

But more and more, it seems as if the end days of the 20th century were the high-water mark for America's movement toward freer markets and smaller government. After all, it is the current presient, a self-described conservative Republican, who created--in the prescription drug benefit--the first new entitlement program since Medicare; signed the expansive Sarbanes-Oxley financial regulation act, much loathed by Wall Street; and has presided over the fastest growth rate of spending in a generation. President Bush also offered up the first $2 trillion and $3 trillion annual budgets during his two terms. "The Bush administration has been a disaster for limited government," says Nick Gillespie, the former editor-in-chief of Reason, a magazine of libertarian thought.

Pushing the limits. If we are about to see the onset of Big Government 3.0 in earnest, future economic historians might well point to the housing-spawned credit crunch as the catalyst. The Federal Reserve's recent power play--instigating the takeover of Bear Stearns by JPMorgan Chase and backing up the deal with $30 billion in loan guarantees--was unprecedented, as was its move to open up its discount borrowing window, previously limited to commercial banks, to investment banks. "It's been pretty groundbreaking," says Brian Sack of Macroeconomic Advisers, who is a former Fed economist. "The steps we've seen in recent months ... have pushed well beyond the limits of what the Fed has traditionally done."

To prevent a repeat of the credit market catastrophe, Treasury Secretary Henry Paulson wants to transform the Fed into a regulatory supercop with vast oversight capabilities to ensure market stability. Expect Congress to go even further and push for new regulations on the financial industry. Too much regulation? Too bad. "Wall Street is not in a position to negotiate right now and won't be for quite some time," says economic analyst Ed Yardeni. "It's clear there will be a lot more regulation constricting Wall Street's ability to conduct the kind of financial engineering they have used over the last several years."

Indeed, some on Wall Street, the supposed bastion of belief in free-market ideology, want further Fed action. David Rosenberg, Merrill Lynch's chief economist, thinks Uncle Sam hasn't done nearly enough to bolster the housing market or return confidence to the credit markets. He would prefer that the central bank start outright purchases of troublesome mortgage-backed securities as well as to see the federal government refinance the mortgages of struggling homeowners along the lines of the New Dealesque proposals of Democrats Sen. Christopher Dodd of Connecticut and Rep. Barney Frank of Massachusetts.

At least when it comes to housing and the credit markets, Big Government sure looks like the preferred solution to many folks in market-loving America. But as a politically attractive concept or slogan, Big Government doesn't have much pizazz. Take a look at the Obama campaign. Its top economic adviser, University of Chicago economist Austan Goolsbee, is quick to punch back against any hint that Obama's proposals reveal a Big Government approach. "The issue is not that we need high taxes or big government," Goolsbee says. "That is not what the Obama campaign is putting forward. ... That's just Republican spin and framing." Rather, Obama has pushed a far more friendly metaphor, "iPod government," to evoke a technologically advanced, transparent, and consumer-friendly image.

Goolsbee does have a point. While Obama does want to eliminate the Bush tax cuts for wealthier Americans, he's also pushing a middle-class tax cut and vows not to increase the deficit. Yet Obama has also spoken favorably of raising the income cap on payroll taxes, wants to reduce carbon emissions by 80 percent through a cap-and-trade system, proposes creating a "credit card Bill of Rights," advocates expanding the Family and Medical Leave Act, and, of course, touts a healthcare plan that would get the government involved in the sector as never before. You can argue whether this amounts to Big Government or not, but it certainly seemslike more government. Indeed, both the Obama and Clinton healthcare plans are based heavily on the work of Yale University political scientist Jacob Hacker, who has argued that modern, globalized capitalism has created a need for an expanded social safety net. "People are more worried about Big Insecurity than Big Government," says Hacker, author of The Great Risk Shift. "We are at a moment that has parallels to the moment that led to the New Deal. We have an economic order that is not well placed to deal with the challenges of the 21st century, just as back then there was a realization that the world had changed but the government hadn't."

"Big Government" doesn't do much for you? How about a "new New Deal"? The language of FDR certainly appeals to Rep. Rahm Emanuel, the outspoken Illinois Democrat, as does the idea that globalization has created a need for a new social compact between government and workers. Among his proposals, he wants expanded tax credits to make higher education less costly and the creation of a $30 billion-a-year government-run entity--modeled after the National Institutes of Health--that would conduct research in alternative energy technologies and, in turn, create high-paying jobs. "You can't just say to people: Here is a $1,000 tax cut; now go take on all those Chinese by yourself," Emanuel says. "That is why I think you need a new New Deal. ... Not big government--big solutions."

And into that mix you can toss big spending for infrastructure, a common element of various plans being concocted by Washington think tanks. New America's Schwenninger points to a backlog of public investment needs, including airports, bridges, broadband access, and energy delivery. "You will need $150 billion a year over the next five years to provide business what it needs to do business in this country," he says. "I don't think the normal argument about deficits apply. ... I think it will pay for itself through increased jobs, income, and returns to the economy."

Now the obstacle to all this is supposed to be McCain, who is pushing a free-market agenda of cutting corporate taxes, eliminating earmarks, and continuing open trade. While he does favor a cap-and-trade system, he never joined primary rivals Mitt Romney and Rudy Giuliani in calling for an expensive "Apollo program" to achieve energy independence. Nothing there for Reagan to disagree with. But Reagan-style "get government off our back" rhetoric is nowhere to be found at McCain campaign headquarters. "There is a role for government, and the primary thing is to identify that role and to make sure government does that well," says Douglas Holtz-Eakin, McCain's director of economic policy and former director of the Congressional Budget Office. "The striking thing that has come out of this campaign is the degree to which people have lost trust in government to pursue national priorities. They want it to work. They really do."

Take the issue of trade and how globalization is affecting workers. On that, Holtz-Eakin sounds a lot like Emanuel. "I don't think Americans are afraid to compete," he says. "They just don't want to feel like the government has left them out there to do it on their own." In addition to an update of America's entire worker retraining system, McCain has mused about creating a wage insurance program in which, for instance, a 55-year-old worker who once earned $50,000 and found a new job paying just $30,000 might receive $10,000 a year for a couple of years to partly make up the difference.

A swing in the pendulum. But even if Big Government is back, will it stick around for a while? Or is the current bloom merely a temporary burst of activity, much like an interglacial warm period during an ice age that eventually gives way once again to the big freeze? That's the best guess of Rep. Paul Ryan, a conservative Wisconsin Republican. "I think we are definitely seeing a swing in the pendulum," Ryan says."But I think it will swing back our way pretty fast just because logic and reason will ultimately prevail."

Well, one could go broke inside the beltway waiting for logic and reason to prevail. But Ryan, who thinks gen X-ers and "millennial" voters crave the choice and service that Big Government can never provide, might be eventually proved right. There are some formidable constraints on the size and scope of government that Roosevelt and LBJ didn't have to face. For one thing, the potential sweep of any new New Deal or Really Great Society is limited by the ongoing costs of the original New Deal and Great Society. When the bills creating Social Security in 1935 and Medicare in 1965 were signed, taxpayers weren't facing a looming deluge of debt from existing entitlement liabilities. "You know the first rule of digging holes, don't you?" asks David Walker, the former U.S. comptroller general and now head of the Peter G. Peterson Foundation. "When you're in deep, you stop digging."

And as Walker sees it, the United States is already in pretty deep, with a $9 trillion national debt and some $44 trillion in unfunded entitlement obligations. He thinks politicians would be wise to pay close attention to the downfall of Bear Stearns. "Look at what happened," he says. "They had a tremendous market cap and reasonably strong balance sheet, but they sold off for fire-sale prices because they ran out of cash." Medicare, he further notes, is already cash-flow negative, and Social Security will be too in less than a decade.

Priorities. Many of the same folks who are talking about investing in human capital and infrastructure today were also talking about it back in 1992, when Bill Clinton was elected on a "Putting People First" agenda. Yet Clinton was convinced by then Fed Chairman Alan Greenspan that dealing with America's fiscal problem should take priority, and he instead adopted what might be called a "Putting the Bond Market First" strategy. Indeed, Clifton of Strategas Research envisions a similar scenario in 2009, especially with some private estimates putting the 2009 budget deficit at $500 billion and climbing. Federal Reserve Chairman Ben Bernanke "has to sit down with the next president and tell him that if he raises taxes, they can't spend any of the money," he says. So while higher payroll or income taxes may represent more government intrusion, they may translate into deficit reduction rather than higher spending.

FDR and LBJ also didn't have to deal with a ruthless legion of foreign investors who daily buy and sell U.S. stocks, bonds, and dollars, in effect voting on American economic policies and the prospects for earning a high return here vs. elsewhere. "We are dependent on the kindness of strangers as never before," says Yardeni, who coined the term "bond market vigilantes" two decades ago. "Today, we have global financial vigilantes monitoring financial markets around the world who can invest anywhere they like ... and the United States will in a sense be forced to get our fiscal act together, because right now we are not managing our economy in a way that is attractive to foreign investors." Walker puts a finer point on it: "The next president is going to have to deal with this because the window is closing. ... I don't think we can count on forever being able to borrow whatever we need, whenever we need it at attractive interest rates from foreign lenders."

Nor did FDR and LBJ have to fret about competing with scores of countries that have adopted the American model of lower taxes and regulation. As Chris Edwards of the Cato Institute notes, America's corporate tax used to be about average for an advanced industrial economy, but "we're now at 40 percent, so we have one that is 16 points higher than the average." This is a fact not ignored even by those on the left. Rep. Charles Rangel, the New York Democrat who chairs the House Ways and Means Committee, has proposed cutting he corporate income tax in the name of global competitiveness, while Schwenninger advocates doing away with it completely. More and more future tax, spending, and regulatory moves will be viewed through that harsh comparative lens.

Then there's the American public. The free-market policies of the past 25 years were preceded by a huge decline in American trust in government. But there's little sign that a decade of corporate blunders and scandals--from Enron to Citigroup--or even political fiascoes like Katrina has created a renewed enthusiasm for government. It's more like a pox on both their houses. Indeed, as public-opinion analyst Karlyn Bowman notes, times of economic trouble generally make people less favorably disposed toward government. And even Hacker, a fellow itching for more activism, concedes there is little public support for radical change. "You have to establish public trust by doing relatively small things and then working from there," he says. Big government? Small government? Maybe all Americans really want is a bit of effective government.


By James Pethokoukis
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