Wednesday, August 24, 2011

The 3 Percent Solution

Warren Buffett
14 September 1993
Washington Post

What could be more foolish than a governing system that rewards undesirable behavior and severely penalizes exemplary conduct? Yet, as deficit-reduction efforts demonstrate, that is precisely the sort of upside-down incentive system that exists in Congress.

In the absence of scandal, every senator and representative understands that the gravest threat to his reelection is any vote he casts to either raise taxes or seriously cut spending. He knows, of course, that voters regularly endorse lower deficits as an abstract goal. But he also knows that the specific actions needed to achieve that goal just as regularly anger and energize camps whose votes may prove decisive in the next election. And legislators are understandably reluctant to trade punishment in November for rewards in the hereafter.

With every line in the budget and every paragraph in the tax code crucial to some voting group, it's hardly surprising that annual deficits have been rising in relation to GDP, the output of the nation. Our deficits averaged less than 1 percent of GDP in the 1960s, rose to 2 percent in the 1970s and climbed above 4 percent in the 1980s. In the 1990s they are so far running over 5 percent. Clearly, perverse incentives are producing unhealthy results.

The solution is to reverse the risks and rewards for our legislators: Enact a constitutional amendment stipulating that every sitting representative and senator becomes ineligible for reelection if in any year of his term our budget deficit runs over 3 percent of GDP. Were this amendment passed, the interests of the nation and the personal interests of our legislators would instantly merge.

I do not suggest this amendment because Armageddon has arrived: Our country does not face bankruptcy, and the current national debt, totaling 70 percent of GDP, is not at a proportion that is inconsistent with a healthy economy. But that proportion, up from 33 percent in 1981, is heading in the wrong direction at a fast pace. And fully as threatening are changing demographics that within a few decades are certain to make today's "tough" choices seem like child's play. Both of these factors mean congressional incentives must be aligned with sensible fiscal behavior - and soon.

The Balanced Budget Amendment would not produce this needed alignment. It does not change congressional incentives but merely requires a 60 percent vote instead of the normal 50 percent to continue present irresponsible behavior. Additionally, the Balanced Budget Amendment, were it to work, would restrict fiscal policy in an unwise manner. It's not debt per se that overwhelms an individual, corporation or country. Rather it's a continuous increase in debt in relation to income that causes trouble.

The Deficit Limitation Amendment I propose would allow the U.S. debt to grow at roughly the same rate as the economy. This would be true in part because Congress would undoubtedly address the 3 percent limitation by leaving a significant margin of safety, to guard against budget or GDP surprises. No legislator would want to stake his job on the accuracy of a 2.9 percent projection: Goodbye, Rosy Scenario. As a result, deficits would probably average no more than 2 percent of GDP, which would today make the deficit about $120 billion. At that level of deficit, our $4 trillion gross national debt would rise about 3 percent annually, a rate keeping step with or slightly trailing the growth in GDP.

If interest rates did not change, this equilibrium between growth in GDP and debt would stabilize the portion of the budget required for interest. In contrast, the outsized deficits we have been running have pushed the interest component of the budget upward, thereby creating a snowball effect unpleasantly familiar to students of compound interest. The time to arrest this progression is now. Delay will only make the task harder.

I would not expect the Deficit Limitation Amendment to cost any member of Congress his job. Facing certain loss of employment from irresponsible fiscal actions, legislators would surely embrace the modest discipline the new measure would require. The amendment would be like the Doomsday Machine in nuclear scenarios, achieving its goal not by being activated but simply by being there.

Indeed, there could be a silver lining for Congress in this proposal. Many of the present proponents of term limits might lose their enthusiasm for them once they saw fiscal responsibility introduced into the system. Instead of pay-for-performance, we'd give Congress a "stay-for-performance" reward.

A few technicalities:
A phase-in period for this new arrangement is probably advisable. But it should be short, since Washington's gambit of promising wondrous results in the out-years is thoroughly discredited and is now regarded by the electorate much as my family views my I'll-start-dieting-next-week proclamations.

Once in place, the new rules should not be suspended by wars. Military actions of the post-World War II variety could be easily handled within the 3 percent. Deficits during the Korean and Vietnam conflicts were in fact well below that level.

Finally, because the U.S. fiscal year ends Sept. 30, the ineligibility of a senator or representative should commence in the calendar year following a disqualifying deficit.
Though many states have budget limits in their constitutions, I'll confess to a certain queasiness in suggesting an amendment to the U.S. Constitution. But it's been 10 years since the Tax Equity and Fiscal Responsibility Act, eight years since Gramm-Rudman-Hollings, six years since GRH II and three years since the Budget Summit Agreement. Clearly, the honor system has failed: There simply aren't enough saints available to staff a large institution that requires its members to voluntarily act against their own well-being. It's time to quit fighting human instincts and instead link that well-being with the fiscal well-being of the country.
The writer is chairman of the board of Berkshire Hathaway Inc., a diversified company with insurance operations.