CFR 90th Anniversary Series on Renewing America: American Power and Profligacy

RICHARD N. HAASS: Welcome to the Council on Foreign Relations. For many of you, I expect it's the first time back this year. so happy new year while we're at it.

Every year is a special year at the Council on Foreign Relations. But this year is more special than usual, we'd like to think, because it's our 90th anniversary. And what we've decided to do somewhat in a contrarian fashion is to dedicate -- a significant amount of our effort this 90th year are to policy questions that are more normally thought of as domestic rather than foreign, whether it's questions of infrastructure, questions of K through 12 education, various aspects of immigration policy, of regulatory policy, and the subject tonight of deficit and debt on the obvious -- based on the obvious thinking that our ability to act in the world, our ability to lead in the world, our ability to present the positive model to the world will in no small part depend upon what takes place here at home in the United States. And we begin with the assessment that our house in many ways is not in order, and a principle challenge to the United States is to take care of that, and to put its domestic house in order.

And tonight's meeting is focused on one of the most difficult if not the most difficult aspect of all of that, which is the question of the deficit and the debt.

The way we're going to talk about it is with three extraordinarily informed gentlemen. George Stephanopoulos you all know from his time in government, but also now as ABC's chief political correspondent, and, for those of you who are morning people, is the anchor of "Good Morning America." And one of the things we like to do, by the way, at the council is end meetings on time. And tonight we have a double reason to do it because George is to go straight from here to bed. (Scattered laughter.)

GEORGE STEPHANOPOULOS: I've got a very important interview with Joan Rivers tomorrow morning. (Laughter.)

HAASS: That's good. (Laughter.) I've learned not to say everything that pops into my mind. (Laughter.) This does show the possibility of progress. But can we talk?

Michael Mandelbaum is one of this country's leading thinkers and writers about American foreign policy. He directs the American Foreign Policy Program at Johns Hopkins School of Advanced International Studies where he's the Christian Herter professor of American foreign policy. And, most recently, he is the author of "The Frugal Superpower: America's Global Leadership in a Cash-Strapped Era," which is on sale tonight so Michael is not cash-strapped.

And last but not least is Roger Altman. Roger was deputy secretary of the Treasury under President Clinton, and he is now chair and CEO of Evercore Partners.

One or two administrative things, none of which will -- come as a surprise to please turn off your electronic devices. And we have quite a few people listening on the phone tonight, so the signals really will muck it up.

This meeting is on the record, so anything said can and will be used against you.

There will be national members. There are national members listening in. And, indeed, I may take a few questions from them if I can figure out how to use the iPad.

The -- what we're going to do is I'm going to ask some questions to start off, and then I'm going to try to reserve a good chunk of the time for you all to have questions. What I -- what I thought I'd do is begin with Roger, then migrate to George, then migrate to Michael, and essentially begin with the question to ask Roger to set the stage, which is about the scale of the deficit and debt, a little bit about how we got to this point, and just some basic -- his sense of what we may want to do about it, essentially to provide the baseline of the challenge that we are dealing with tonight.

So you can ignore what I just said, Roger, and say whatever you'd like.

ROGER C. ALTMAN: Well, three or four months ago, Richard briefly lowered his usually high standards, and co-authored a piece with me in Foreign Affairs on the U.S. deficit and debt path and the global consequences of that. And so I'm going to give a very short beginning summary, so to speak, of what we said, and update it for some important things, which have happened since then. And I might say at the beginning it's timely to have this discussion not just because of the council anniversary, of course, but because in about a week, President Obama will deliver of course his State of the Union address. And in one form or another, there will be references to this difficult deficit and debt outlook. And so I'm going to make a comment or two about how he may or may not address it.

But just to start with, the headlines of the past two months have temporarily clouded how truly dire the U.S. fiscal outlook and debt outlook is. And by headlines, I mean, of course, the Republican election sweep in November, the surprisingly productive lame-duck congressional session, the tragic events in Arizona and other developments. And as an example of that obscuring the very good and very emphatic recommendations, which the Bowles-Simpson Commission delivered only on December the 1st -- after all, that was a commission that President Obama and the congressional leadership put together on the budget outlook, -- have largely been forgotten, at least for the moment, despite their really being quite important. And I'm sure they will come back.

But despite these intervening headlines, the fiscal outlook, which already was very threatening, actually has worsened a bit in the past couple of months. And that's because while on the one hand there is some improvement in the -- in the economic growth outlook for 2011 and 2012, and the latest forecasts reflect that, the tax agreements struck during the lame-duck session and the revenue consequences of the tax agreements actually more than offset that improved growth outlook. And so the deficit outlook and the related debt outlook -- remember the federal debt is really just a dollar-for-dollar consequence of the deficits -- has actually worsened in the past two or three months.

Now, let's spend a minute on how bad that outlook really is. And I'm going to refer primarily to the most recent Congressional Budget Office forecast. You all know the Congressional Budget Office is nonpartisan. It's really quite widely respected. It's most recent forecast is a few months out of date, but my research suggests that the updated one, which will come out in a few weeks, will not be terribly different.

And what we're looking at, at least based on current policy is cumulative deficits between nine (trillion dollars) and $10 trillion over the next 10 years. And the federal debt, which I should say has tripled or virtually tripled in the last 10 years from its roughly historical long-term average of about 35 percent of GDP to a current level of 65 percent, is projected to reach, by the CBO, 90 percent by 2020 and, by the IMF, actually, 115 percent.

To put those in context, with the brief exception of the peak years of World War II, we have never had a debt-to-GDP relationship of that level in the history of the United States since record keeping began in 1792. And those levels, 90 (percent) to 100 percent of GDP, are typically associated with countries, for example, today, like Italy and Greece. And, as I said a minute ago, we would reach those levels within just nine years.

And the credit rating of the United States if we do actually get from here to 90 (percent) to 100 percent of GDP in the form of federal debt, will certainly be lowered, and there are some forecasts around that suggest it will be lowered quite considerably.

Now, let me try to spend a minute on what it would mean to have debt in that amount. It would mean that federal -- the interest expense, which the federal government was paying would rise from today's 1 percent of GDP to about 4 percent. But in more practical terms, the total interest expense of the United States government would exceed all of domestic discretionary spending. In other words, it would exceed the total each year that we today spend on infrastructure, on energy, on agriculture and on education. And it would be approximately equal to the amount that we spend on defense.

In addition, the United States would be borrowing at that time -- this is 2020, this is not way off -- approximately $5 trillion a year. It was just a few years ago, about 10 years ago, that the entire budget of the United States was $5 trillion. Maybe a little further back than 10, but not many years. I can see Bob Rubin rolling his eyes, saying, I think it's further back than that. In any event, it wasn't a long time ago when the entire federal budget deficit -- federal budget, total budget -- was 5 trillion (dollars).

Now, the thesis that Richard and I expounded in our piece was that, actually, the United States would not be allowed to go from where we are today in 2011, beginning of 2011, to that much debt in 2020. We wouldn't actually get there. Either we would address this in the right way, proactively by our nation's leaders through a deficit reduction agreement of the type, for example, we saw at Andrews Air Force Base in 1990 under President George H.W. Bush, or perhaps the type that we saw -- George and I were both very involved in this -- in 1993 under President Clinton. In other words, address it proactively or it will be done the ugly way: namely, that the global financial markets at some point between now and 2020 and before we reach that much debt will revolt and impose a solution on the United States.

Now, I know there are a lot of people who think, yes, I know that there have been sovereign debt crises in Ireland recently, and in Greece, and looking back over history, the U.K., Mexico, Russia, Argentina, but that can't happen to the United States. We're the world's largest economy, our currency is the reserve currency of the world and so forth.

Well, it's instructive in that context to look at the events of 1979. I was serving in the Treasury then, during my first my tour of duty, and that was the era of stagflation, of the Iranian oil embargo, and of course President Carter. And during the early months of 1979 -- I'm sorry, during the lead up to 1979, the dollar had been wobbly and generally declining. And then President Carter submitted his budget, which included a larger than expected deficit. By today's standards, it was minuscule, but it was large by the standards of 1979.

That was the last straw for the financial markets. The dollar crashed. All global markets plunged -- fixed income markets, equity markets, currency markets, commodity markets -- and a true global emergency ensued. And the key nations of the world, the industrialized world, got together overnight and put together a coordinated international rescue of the dollar. But the contributions which the United States had to make to that were, one, to cut in half its budget deficit within one week, and for the Federal Reserve to raise interest rates very sharply at a time when that was not the general direction that the Federal Reserve had been headed into. All of that happened in one week.

Now, if we don't address this proactively, it will be in our judgment addressed by the global financial markets, and unfortunately if that happens, it will be a replay of 1979, but of course, on a much bigger scale. But the main point is it will happen with very little warning. The, quote, "solution" will be very ugly and punitive; for example, across-the-board spending cuts. There won't be time to do any kind of real budget, tax surcharges, there won't be any time to do any true tax policy. And it will be solved that way.

If it is solved in the latter way, that will usher in an age of profound austerity in this country, and that in turn -- I mean, as an example, all categories of domestic spending would be cut in an across-the-board fashion; nothing would be spared, entitlements and so forth. Taxes on all -- virtually all individuals and businesses would be raised, probably, as I say, through some surcharge approach. And we would enter into an age of austerity of the type we haven't seen in this country for -- well, since the 1930s.

Now, as Richard and I argued in this piece, the global consequences of that, the consequences for the American -- for the global platform of the United States and the consequences for world coherence and world stability, as no one is likely to step into the role the United States will be pulling back from, would be particularly profound. And on that note, I'm going to stop and turn it back to you, Richard.

HAASS: Did I say Happy New Year? (Scattered laughter.) Just wanted to make sure I covered all of our bases here. By the way, when Roger and I wrote the article, he was the optimistic member of the team, just to give you a sense of perspective here.

We'll get in a few minutes to what we -- well, implicit in Roger's argument is obviously the United States needs to embark on a fairly steep path of dealing with the deficit, somewhere 250 (billion dollars), $300 billion a year of the deficit need to be reduced through some combination of increased revenues, either from growth or taxation or decreased spending.

So let me turn to George for a second. Could you imagine any scenario where policymaking and decision-making of that scale could come about?

STEPHANOPOULOS: Not before January 2013, certainly not. I mean, nothing -- I agree with Roger's analysis, I should say. But if you just look at the current lineup over the next two years with a election, presidential election coming next year, it's inconceivable to me absent a forcing crisis that Congress and the White House can work on this. I mean, if you just look at -- you talk about the surprisingly productive lame duck session. They did all the easy stuff. They cut taxes. The budget was not -- they just punted on the budget for last year.

Fundamental to the president, to the White House is that they cannot break his key campaign promise, which was not to raise any taxes on middle-class Americans. He flirted with it, some would say he broke it during the health care debate, and they can't do anything or propose anything that has any hint of a tax increase on middle-income Americans. So that knocks out a lot of solutions right there.

As much as Republicans talked about spending debt and deficits in the mid-term elections, I think all of the leadership on the Republican side has completely gone to school on the Newt Gingrich experience of 1995 and 1996 and realize that what a reelected -- in their minds -- President Clinton caused so much heartache for Republicans during the government shutdown was the commitment to cut Medicare. And that that cost them whatever advantage they had coming out of the 1994 election.

So as much as they talk about cutting spending, their leadership is not going to do anything that touches what is at the heart of most of the spending problems. So I don't see anything happening between now and the presidential election.

HAASS: Before you go on, let me just -- can I interrupt for one second? One event, though, that will happen long before that will be the raising of the federal debt limit.

STEPHANOPOULOS: Yeah, and --

HAASS: (Inaudible) -- just for those of you who haven't followed, sometime this spring the United States is going to need to act March, April, May. There's a $14.3 trillion ceiling on our debt, and we're going to have to raise that, or we're going to have not take on any more debt at that point -- (inaudible) --

STEPHANOPOULOS: And there's an awful lot of pressure from Republican presidential candidates, from tea party candidates who just got elected to not vote to raise the debt limit absent any kind of serious spending reductions. But I think there they're going to be talking about some cuts in domestic discretionary spending, maybe some budget process issues like, you know, coming out for a balanced budget amendment again. Even on the -- the Republican leadership started out with a rock-hard promise in the midterm elections to cut $100 billion in spending this year. That promise as far as I can tell is down to about $30 billion right now, and they may not even get there.

So even if that -- I think that could create a crisis and that could create the kind of crisis that Roger is talking about if because of the stalemate the debt limit is not extended and Tim Geithner runs out of all of the maneuvers he may have learned from Bob Rubin back in 1995 and 1996, then, yeah, we could have a crisis that creates a crisis in the bond markets that forces the issue. But I don't see any kind of proactive addressing of it.

HAASS: Let me ask you then -- let me interrupt with one other question. You mentioned that you thought nothing would happen until 2013. If most people in your business are right, by then, you will have not just a Republican House --

STEPHANOPOULOS: (Inaudible.)

HAASS: -- but a Republican Senate.

Why do you think that then would set the stage? Imagine either way a second Obama term, a first term of -- with X Republican. How do you imagine that --

STEPHANOPOULOS: That is what I was imagining.

HAASS: Okay.

STEPHANOPOULOS: Twenty-three Democratic senators up in 2012, only 10 Republican senators up in 2012. Kent Conrad announced his retirement today. You could bet if you were going to bet that he'd be replaced by a Republican. Joe Lieberman is announcing his retirement likely tomorrow. A Democrat could win that, but that's a little more iffy.

But if you had to just look at the numbers, the fact that the Democrats are defending so many Senate seats in 2012, absent a massive, you know, landslide for Obama, it's -- the odds are that Republicans will take control of the Senate in 2012. That sets up conceivably a situation like what Ronald Reagan had in 1986. And you Reagan, Gephardt and Bradley come out for a big tax reform plan. That combined with what is more likely, the problem continues to get worse.

Both sides feel pressure to govern. You're in the early years of a second presidential term. The new Republican majorities will have more clearly shared responsibility because they're they don't have the Democratic Senate to blame anymore for inaction. That could set the table, and that's the optimistic scenario. Now, the question would be that, in January 2013, has the crisis come or not? And I defer to the economic experts in the room.

HAASS: The answer is none of the experts know when it's going to come. I think there is no consensus that if and when it does come, it could come quite quickly at that point, a little bit almost like a Malcolm Gladwell scenario that you reach a tipping point.

Then, Michael, let me turn it to you, which is -- we sort of have two scenarios. One is the United States proactively deals with this and sets ourselves again on a more responsible, sustainable trajectory; the other is more reactively, where markets react, we're forced to raise interest rates, so forth and so on.

What do you see as the foreign policy consequences under each?

MICHAEL MANDELBAUM: Well, I think the foreign policy consequences are more or less the same, whichever the scenario is. Whether we're on a gentle glide path downward or we fall off a cliff, at some point in response to some event, the United States will get serious about the deficit. And when that happens, contrary to the promises of the Republicans, taxes will rise. And, contrary to the promises of the Democrats, benefits, including Social Security and Medicare benefits, will be cut.

When that happens, we will be in a different political world. And in that political world -- and this is the premise of "The Frugal Superpower" -- foreign policy will be -- to use a term not entirely appropriate, but not entirely inappropriate -- "collateral damage." When people are paying more to the government and getting less form it, they will be less generous in funding the kind of of foreign policy that we have carried out, really, I would say in the lifetime of virtually everybody in this room.

I think that we are heading for a world in which, for the first time, just to pick a date at random since December 8th, 1941, how much things cost becomes a serious constraint on American foreign policy. It hasn't been irrelevant for the last 70 years, but, in comparative historical terms, it's been pretty modest. That will change because people simply won't support the kind of foreign policy that we have been accustomed to carrying out when they feel cash-strapped.

Now, there's one other point I want to make about them, and I can go into the specific changes that I anticipate and favor. But the general point -- and it's an important point for all of us -- I think, is this. The United States is the most important country in the world. And the United States, in my view, plays an extraordinarily constructive role in the world. The United States provides some of the services to the world that governments provide within the societies that they govern. The world functions as well as it does economically and in security terms -- not perfect, but not bad -- in no small part because of a very extensive American foreign policy, because of American economic and military commitments around the world.

When those are called into question -- and I think they will be -- that endangers not just the interests of the United States, but global peace and prosperity. This is a very big deal. And even countries that are extremely critical of one or another of America's foreign policies will find that the only thing worse from their point of view than an America that's too powerful is an America that's too weak.

HAASS: This could be the be-careful-what-you-wish-for here for -- I guess -- (inaudible) -- one short question of each of you before I open it up. And let me start with Roger.

How does the president deal with what appears to be something of a dilemma? We've got formal unemployment between 9 (percent) and 10 percent. We've got real unemployment that's probably 50 percent higher than that, somewhere at 15 or so percent?

How does he deal with what we-- with the need to get things going, increase employment and the like, stimulate the economy; and, at the same time, put the United States on a, if you will, quote, unquote, "responsible trajectory," and gradually start reducing the deficit? How does one deal with that? Is it a dilemma, which is a word that's overused? Or is there a way essentially to have our cake and eat it?

ALTMAN: Well, I think most economic and fiscal experts would answer that, Richard, by saying -- and I would -- that the United States has really had to date the right response to the economic and financial collapse of 2008 and 2009. We've had a -- by standards of other parts of the world, we've had a forceful response. We've had a large response, and we had a relatively quick response.

And even though we have a 9.4 percent unemployment rate and a 16.3 (percent) underemployment rate, and the outlook for the labor market remains very, very difficult, we pulled ourselves out of this quite skillfully. I think historians will ultimately judge it that -- judge it that way. And this country should get very high marks for how we -- how we -- how we've got -- carried ourselves through the last two years.

And the emphasis of policy for 2011 and 2012 really should be -- and George was pointing out how it's politically necessary, but it actually is the right policy also -- to continue in every possible way to incentivize growth, and try to thaw out the frozen labor markets.

But at the same time, you would put in place if you could wave a wand a framework for changing this dire deficits and debt path, which would take effect probably in 2013, not for -- not for presidential cycle reasons, but for where we would then be in the economic cycle, because at that point the argument would be the economy will have strengthened to the point where it could withstand the contractionary impacts of a large deficit reduction plan.

So if you could wave a wand the next two years, the focus would be on growth and labor markets, and then would take effect, not just be worked on then, but take effect then a long-term plan for reducing the deficit and debt outlook.

STEPHANOPOULOS: I think you want to start fitting that suit, but don't sew it on in the State of the Union.

HAASS: That was my next -- (inaudible). Okay. So imagine you have this that next -- in the short run, if you will, we continue to emphasize growth, stimulus of one sort or another, get big corporations to start spending down some of the cash they've accumulated, but essentially two years from now have the "more responsible," quote, unquote, trajectory kick in. To what extent -- how far does the president go next week?

STEPHANOPOULOS: I don't know how far he will go. I think that the first point has to be Roger's point. You can't do anything that puts the recovery at risk, and we have to continue to create more jobs in this country. The number one job of a president, keep the economy -- keep the economy growing. I think he can then make a nod towards the election, and in a sort of a -- it was the framework President Clinton used. There's a right way and a wrong way to deal with these things. You have to make the right investments in education, in energy, in infrastructure. And we can make cuts in places where government is no longer as efficient and effective as it once was. And I think he did make a nod to that in his Wall Street Journal op-ed about regulation today.

And then I think it's conceivable -- and this is going to be a slightly different State of the Union from the kind we've seen recently. I think it is very likely that Republicans and Democrats are going to be sitting together for the most part. They're not going to be in two opposing camps. I think that gives the president an opportunity to give what appears to be a less political speech, and will sound more like a conversation, and that he could put the discussion of the long-term deficit in the context of everyone working together. and that's what the country has demanded, putting it in a more political process context than in an economic context.

And you can talk about -- we all know there are things that we're going to have to do over the long term. We're going to have to live within our means. I think you can give a rhetorical nod to the Simpson-Bowles Commission without boring in too much on any of the specifics. I think he can talk about tax reform and -- he'll -- without -- and show a little bit more leg. He's already done some of that without getting into specifics.

I think he'll still argue that his health care plan is one of the answers to entitlement reform, but he can also make a nod to saying, "We're going to do more." But I think they're going to have to be fairly careful about getting locked into a specific proposal on any one of those three areas.

HAASS: Michael, I think I know the answer to this question, but let me ask you anyhow, which is, the last 10 years of American foreign policy has been dominated by two extremely expensive interventions, one in Iraq, one now in Afghanistan. Will this sort of pressure both accelerate the end, particularly of Afghanistan? But, more important, will this now -- is this the end of that phase of what we might call "discretionary American interventions?" Is this basically over?

MANDELBAUM: Let's call them wars of choice. (Laughter.)

HAASS: I was trying to be uncharacteristically self-effacing here. But clearly it didn't hold. Okay.

MANDELBAUM: I think it is, Richard. And I think that this period really goes back two decades. I think the wars or the interventions in Somalia, in Bosnia, in Kosovo, in Haiti belong with the interventions in Afghanistan and Iraq, although they were undertaken by different administrations for different reasons, and had different costs. But all of them ended up in the protracted, unexpected, unwanted and expensive task of nation building.

Nation building has never been popular. The country has never liked it. It likes it even less now. And I think we're not going to do it again. We're not going to do it because there won't be enough money. We're not going to do it because there will be other demands on the public purse. We won't do it because we'll be busy enough doing the things that I think ought to be done in foreign policy. And we won't do it because it will be clear to politicians that the range of legitimate choices that they have in foreign policy will have narrowed and will exclude interventions of that kind. So I believe and I say in the book that the last -- the first two post-Cold War decades can be seen as a single unit. And that unit has come to an end.

HAASS: With that, the questions from our members has come to a beginning. If people would wait for a microphone, let us know who you are, pretty much limit yourself to one relatively brief question, I would be forever grateful.

Carol, why don't we start with you?

And I'll also try to take some questions from our national members.

QUESTIONER: Carol O'Cleireacain, Brookings. I want to pick up on what you just said, and ask, so where does the war on terror go in such a scenario?

MANDELBAUM: The war on terror will be waged not by trying to transform the countries that harbor terrorists. And, incidentally, even if that were our aim, our biggest task would be Pakistan. And that's hopeless for a variety of reasons. The war on terror, I believe, will be waged by effective intelligence and police work and cruise missiles.

QUESTIONER: And that's expensive -- (off mic) --

MANDELBAUM: Not nearly as expensive as what we're doing in Afghanistan and in Iraq.

HAASS: Yeah, I would say much more the Somalias and Yemens will be the model for the future much more than the Afghanistans.

K.T. McFarland?

QUESTIONER: Hi. K.T. McFarland of Fox News, and a former student of yours, Professor Mandelbaum. If --

MANDELBAUM: Always good to see a former student gainfully employed. (Laughs, laughter.)

QUESTIONER: Thank you. If it's inevitable that we've got to leave Afghanistan and Iraq, and not going to have conflicts of this sort, should we just get out now?

MANDELBAUM: You're asking me?

QUESTIONER: Yeah.

MANDELBAUM: Well, it's okay with me to get out now. And I think we certainly should be on a glide path downward. I refer those of you who are interested to Bob Blackwill's article in the current Foreign Affairs. His argument is we should, in effect, partition the country. We should leave the Pashtun areas. We should hold onto Kabul and the non-Pashtun parts. And we can do that with a much smaller force.

I'm not -- there are downsides to leaving Afghanistan completely. Bob goes into them. It could be a civil war. You know, all of the gains that have been made, such as they are, would be reversed. So if you can achieve something on the cheap, I guess that that would be okay with me. But my problem with Afghanistan is that I don't think it's important. What happens in Afghanistan stays in Afghanistan. It doesn't -- it doesn't affect anything in which we have any interest. It's no better than the fourth most important country in that general part of the world after Pakistan, Iraq and Iran. And since as a general principle, I think we ought to be spending our resources on issues and interests that are most important, since Afghanistan comes at or near the bottom of the list, I'm not in favor of any spending anything there.

HAASS: Roger, one issue that hasn't come up is state and local. And one of the questions I would have for you at this point is whether that's a potential trigger. Whether it's Illinois, California, New York, New Jersey, is that something that could accelerate this scenario by which a triggering event happens?

ALTMAN: Before directly answering that, I just might point out that none of the ratios and data that I used on federal debt include, A, the roughly 9 trillion (dollars) of debt that the United States has guaranteed, but which is not a direct obligation of the United States; B, the debt of the GSEs, which is not -- which are not explicitly guaranteed, Fannie Mae and Freddie Mac, but which are implicitly guaranteed of course; and of course any possible severe fiscal problems that some -- any of our larger states might have, which at least theoretically could require the United States to stand behind them.

So you can argue that the picture that we talked about at the beginning here is actually worse than it looks. I don't think, Richard, that that's going to be the flash point.

And I don't think it is because I wouldn't expect any of the larger state and local borrowers to actually default -- larger, now; not talking about Harrisburg, Pennsylvania, or some entity like that. And even if it did, the -- it isn't clear to me that the United States would come to a full rescue -- you know, their debt is our debt. I think there'd be a lot of pressure not to do that. So while anything could trigger this off, I would be surprised if that would be it.

HAASS: Okay. I see a hand. Mr. Rubin (sp), yes.

QUESTIONER: My question is for anybody, Richard.

The rest of the world is acutely aware of our fiscal situation, as you all so effectively described it. How is that affecting the way they look at geopolitics -- I think Mike may be the closest to commenting on this -- geopolitics and their planning for the future? China, Pakistan, or anybody else that you'd like to comment on.

MANDELBAUM: Well, it's a good question. First of all, as a general proposition, it will have consequences across the board. That we know. We don't know exactly what they are. We know that people in Afghanistan are preparing for our withdrawal. I believe that the radical forces in the Middle East, although they don't need much encouragement, are somewhat -- have been somewhat more aggressive as they see America turning inward and weakening.

And the most important place where one might see this -- and I don't know that this is the case, but I think there's some evidence -- is the Chinese policy has changed somewhat in the last two years, since -- perhaps it's a coincidence -- around September 15th, 2008. The Chinese are no longer the good followers, the people who keep their head down. There's a whole list of initiatives the Chinese have taken that individually don't -- may not represent anything frightening, but collectively suggest a change of course, a much more assertive policy. It's hard not to connect that with their perception of the United States.

And one thing -- and there are a lot of things we don't know about China, but one thing we know is that they keep a very close eye on us. They gear their policies to us. So I would -- I would suggest that there's at least some evidence that the other most important country in the world is behaving more in ways that we don't welcome because of the financial crisis and the recession and the anticipated consequences down the road.

HAASS: The gentleman in the back with the blue shirt.

QUESTIONER: Matthew Lee, with Inner City Press. I wanted to know, I guess, what you think -- how you think this -- how the deficit will impact the U.S. participation in the United Nations and its peacekeeping operations. I mean, there was a debate today in the Security Council about Sudan. There was talk about debt relief for south Sudan or north Sudan. You know, and just -- Professor Mandelbaum, you talked about the relative importance of countries. Do you see Africa, or any country in Africa -- maybe Somalia -- as being, you know, on your -- on your top 10 -- even top-10 list? Thanks a lot.

MANDELBAUM: No, it's not in the top 50, maybe not in the top hundred.

As for -- I mean, you -- now we're in a whole -- when the word "U.N." is mentioned, as Richard knows well -- (chuckles, soft laughter) -- we're in a different -- a different world. To be, I hope, not unkind, or flip, but in the interest of time, the American contribution to U.N. peacekeeping forces is a rounding error in the budget. Whether it stays or goes, we're not going to notice. The real money is in the American defense budget. The American defense budget, with all due respect to our friends at Turtle Bay, is far more important for global stability than anything that the U.N. does. That's where the action is, and that's what's important.

HAASS: I would just make the point that one area, though, of the U.S. budget which, while small, is vulnerable would be non-defense spending in the international arena. And various aspects of foreign assistance and the like are, I think, going to come under tremendous pressure, just because --

STEPHANOPOULOS: I think that's true, except I've actually been surprised in the last few years how little pressure it's been under, given how much -- how big the overall debt problem is.

HAASS: Well, hope you're right.

Sure. Fine.

QUESTIONER: What is the --

HAASS: Wait a second for the phone -- mic.

QUESTIONER: What's the future of the euro, and how will it affect the dollar and our financial problems?

HAASS: Roger, why don't you take that on, and particularly the question also about -- related to it, which is, how has the euro's weakness perhaps bought us more time here?

ALTMAN: Well, the biggest question vis-a-vis the euro right now, of course, is whether the euro zone as a whole will remain intact, or whether the sovereign debt crises that are afflicting, as I said, Greece, Ireland, Portugal, and may afflict others, will somehow break it up.

You never say never, of course, but it seems to me the euro zone will remain intact, because the costs of breaking it up at various levels are so high. For example, in the case of Germany, which is of course the strong -- economically strongest country and financially strongest country, if the euro zone were to break up and the Deutschmark somehow return, the Deutschmark would inevitably strengthen, much to the detriment of Germans -- Germany -- of the German exports and the overall German economy. I could go on down the list as to why that's unlikely, including the sheer out-of-pocket costs and the amount of time it would take to return to the status quo ante, pre-euro.

Now, short term, the actual trading value of the euro: So often in recent years, very learned analyses -- for example, from the Peterson Institute in Washington -- have quite correctly theorized that the size of our external imbalances should lead to a weaker dollar. And in general, the dollar has not been as weak as the theories have suggested it would be. For example, over the past year -- Bob, you might correct me -- I think it's down to about 6 percent on a trade-weighted basis, not -- and a year ago, a lot of people would have said it would be weaker than that.

But, of course, the dollar has long had a safe-haven nature, and the type of crises that have coursed through Europe -- sovereign debt crises -- have not just caused the dollar to strengthen on a day-to-day trading basis versus the euro, but the safe-haven character of the dollar has asserted itself again. But in any event, what might have been a weaker dollar under different circumstances has not, at least so far, materialized.

Maybe, Richard, some day, if we don't proactively address this problem and the financial markets address it for us, that will first begin -- that chain reaction will first begin as it did in '79, through the exchange markets in the dollar. But maybe it won't. There are so many different ways that we've seen in the last 20, 25 years crises arise, and each one seems to come from a different angle than the last one. It's impossible to judge how that might first start.

HAASS: Sir?

QUESTIONER: Steve Tananbaum from GoldenTree. Roger, you start saying if we keep on the current policies, the market is going to cause us to change our ways. Yet Japan is pretty much further down, yet the market has not disciplined them.

Why do you think that's so?

ALTMAN: Well, many people would challenge the premise of your question to the effect that Japan is -- in effect, Japan's fiscal condition is worse than ours.

QUESTIONER: Well, if you look at debt to -- (off mic) --

ALTMAN: Yes. Yes. But if you look at -- and you could argue this either way. But if you -- but -- you can argue it's a more indebted country than the United States because, of course, its federal debt to its -- the size of its economy is worse than ours, as you're suggesting. You're right. On the other hand, if you look at the savings rate in Japan and the percentage of Japan's debt that is held outside the country, it's a very different picture.

In contrast to your premise, many argue that Japan's debt is financed internally, not externally like ours is; and, therefore, the degree to which global financial markets would have an incentive to discipline Japan is very low because Japan's debts in effect to the rest of the world are very small.

Now, you can look at that a lot of different ways. But I think, in general, because of the contrasts between Japan and the United States in terms of a very low level of the Americans' saving rate -- even though it's ticked up a little bit recently -- and the degree to which we are financing so much of our deficits externally -- I mean, I've seen estimates at seven (hundred billion dollars) to 900 billion (dollars) a year in the last three to four years is being added to the store of dollar-denominated liabilities held overseas; obviously, China is a big participant in that -- I think the two situations are actually quite different.

HAASS: George, let me just go back to a political question, which is, can you imagine a politician standing up and talking about these issues like we are a little bit, and essentially thriving -- (laughter) -- as opposed to stepping on the proverbial third rail?

STEPHANOPOULOS: I think it depends on which level of politician. I think members of Congress can do it; I think Paul Ryan you see of Wisconsin. Although, he leaves out taxes in his plan. I think, you know, one of the encouraging things you've seen -- you talk about the Simpson-Bowles commission. I think there was a little more crossover and support for that menu of proposals than I expected. You had, you know, senior, kind of party Democrats like Dick Durbin coming out and supporting it. You had Republicans like Tom Coburn coming out and supporting it, even though it did include some talk of tax increases.

So, yeah, I mean, I think, it's hard for a president in an election year. It is impossible for a challenger to a president in an election year. But, below that, yeah, I think you see a lot of ferment and not only the Simpson-Bowles commission, but you're seeing -- you know, I think, the fact that, you know, people like Roger have written about at a VAT, the Center for American Progress has written about VAT on the Democratic side, you've started to see more ideas bubbling on the Republican side. I think those will bubble up, but just not at the top level yet.

ALTMAN: And, George, if I could just ask a question following up Richard's, I think the distinction between what national leaders can do or a president can do in the way Richard asked about it, and what some governors seem to be doing right now is a really interesting distinction. Some governors seem to be deciding our problem is so bad, it's both the right thing to do and maybe the politically smart thing to do to tell it like it is.

So Governor Cuomo in New York has come in, you know, in a very tough way in this regard, and Governor Christie of New Jersey and others around the country basically saying, "Folks, things are really, really bad. There's no easy, sugar-coating solution, and this is what we're going to have to -- (inaudible)."

STEPHANOPOULOS: Well, and, on the other side in Illinois, you know, 60 percent tax increase.

ALTMAN: Yeah, well, we'll see how that plays. But the question is, you know, you can argue that some governors, especially new ones, are deciding, "Not only do I need to fix it, but I could actually benefit. I could advantage myself by delivering -- by talking straight about it."

And my question is -

STEPHANOPOULOS: Well, I think the talking straight, I completely agree with. I mean -- I mean, we're at the beginning of their budget cycles right now. We'll end up seeing how much they actually get through. They're also -- a lot of the governors actually face requirements where they have to balance their budgets, so it's a very different situation.

But, yeah, I do think there's a -- I think there's no question that people want to hear politicians talking about these issues in what is perceived to be a straightforward manner. I just think there's less evidence that they -- the country actually wants the politicians to follow through on those promises.

HAASS: Do you think that what happens in Britain -- there you've got a government that has gone on a fairly, by our -- by our terms, drastic path, serious spending cuts, probably -- what -- $4 or whatever of spending cuts for every dollar of tax increases. Do you think that will have any impact on here, like, the debt, the British experiment, if you will?

STEPHANOPOULOS: How long does the government survive? I mean, the liberals are in trouble.

HAASS: Well, how well does the economy survive?

STEPHANOPOULOS: Yeah.

HAASS: Do you think -- do you imagine that experiment going on in Britain will have repercussions here?

ALTMAN: If it fails, we will take note of it. If it succeeds, we probably won't. That's right.

MR. : That's right.

ALTMAN: The British government has a rather smaller borrowing capacity than the American government does. So they don't have the short-term choices that we do. But it is interesting. They are running an experiment. And I take it that the economic theory behind their policy is that if they have a serious deficit reduction program, that will inspire such confidence there will be an outbreak of euphoria in the British economy, in the European economy, and that will make up for the gap in their consumption. Let's hope it works. But as George says, the government could fall.

HAASS: There's always that. Sure.

QUESTIONER: Sy Jacobs, Jacobs Asset Management. The question's for Roger. Given that you feel that the world doesn't have 10 years of patience and appetite for trillion-dollar-a-year deficits, is it reckless or is it brilliant that the central bank of that trillion-dollar-deficit country is -- has committed to buying $2 trillion of that country's paper?

ALTMAN: I have no quarrel with the quantitative easing approach that the Federal Reserve has taken. It's part of the point I made a little bit earlier about how I believe history will judge the United States, including our central bank, as having responded very effectively to what was really civilization-threatening events of, you know, the fall of '08 through early '09.

And I think a lot of the debate about the second round of quantitative easing, so-called QE2, is a little bit strange, because I really believe the Federal Reserve's main motivation was to try to provide an extra incentive for growth and labor markets. Remember, the mandate of the Federal Reserve is both price stability and full employment.

And I don't think it was, you know, a sneaky way to try to lower the value of the dollar, even though it was interpreted that way internationally in so many quarters.

So I don't think the Federal Reserve has overstepped its bounds or acted imprudently at all. And I might add that -- I'm not a monetary historian, but quantitative easing is actually a rather traditional monetary exercise. There's nothing new about it. There's nothing original about it. There's nothing infrequent about it in the modern monetary history of, you know, the industrialized world.

HAASS: Charlie Wolf From RAND asked a question about how -- what all this means for trends in American power. So let me ask the question directly -- I'll make it the last question -- which is, does this inevitably contribute to the relative decline -- not the absolute decline but where we are -- does this inevitably contribute to the relative decline of the United States, that we are essentially in this predicament and that we are going to be forced to do things that will limit the resources that are available for our role in the world and that essentially we will occupy less of a space consequently?

Michael.

MANDELBAUM: Well, I'm glad you asked that question. (Laughter.) And I want to commend you, Richard, and the council, for making the 90th anniversary project looking at the domestic sources of American power, because I think that is really the crucial issue for the next decade. And I'm so committed to that proposition, that I am writing a book about that subject with my friend Tom Friedman of the New York Times.

And there's good news and bad news. The good news is, we can deal with these problems. We know how to do it. We've done it before. The bad news is that the problem we've been discussing today, tonight, is only one of the problems. There are three others. And I think if we can get our act together and deal with the deficit and with the other problems, we will remain the most powerful country in the world and the global leader even with the rise of China and India because our values are in alignment with what most countries want and because most countries appreciate at some level the kind of leadership that we provide. I think our soft power is still intact.

But you've got to have hard power to back it up, and that depends on what we do. And when I think about this problem -- and incidentally, I don't see anybody else replacing us. I don't see us getting any help from the Europeans and the Japanese who have problems of their own. I don't see -- I see the Chinese possibly making trouble but not shouldering us aside and being the global leader or even the unchallenged leader of East Asia. So it's either us or nobody. And nobody is a lot worse than us.

What are the prospects? We've been talking about that, but when I think about this question -- and this is -- this is the major question that we as a country face -- I think about a saying that I first heard attributed to Abba Eban, the former Israeli foreign minister who once said, men and nations -- should have said "men and women and nations" -- will always do the right thing when all other alternatives have been exhausted. (Laughter.)

Well, we're running out of alternatives.

HAASS: Well, that was also a version of Churchill's comment about American democracy and the danger -- going back to where we began this conversation, if that's true, while we're going through doing some of the wrong things or not yet prepared to do the right thing, events may intervene. And we may not essentially be able to write the script in ways that will work out.

You've actually, though, come off fairly optimistic.

STEPHANOPOULOS: In the end, I think so. And we have -- we have -- we've been through these crises before. I think that we -- I agree with Roger that history, I think, is going to look back at the way, actually, both presidents in the end dealt with the financial crisis in 2008 and 2010 and say they did the right thing at a difficult time. And I do think that we're going to solve this in the next couple of years because we're going to have to.

ALTMAN: Hey Richard, you know, we've done some good things here tonight, one of which, obviously, is to give George all the briefing material he needs for his discussion tomorrow morning with Joan Rivers. (Laughter.)

STEPHANOPOULOS: She's great on the euro. (Laughter.)

MANDELBAUM: But more pessimistic than you are. (Laughter.)

HAASS: From that, well, we hope you've enjoyed the red carpet here tonight -- (laughter) -- and let me thank these three friends for starting what I hope really will be an extended and a thoughtful discussion throughout this year and beyond on the domestic challenges that really are so much now at the heart of what the United States does in the world. It may seem to be an odd place for the Council on Foreign relations to end up, but I think that tells you something. And I think this reinforces my sense that we've ended up in the right place.

Let me thank you all for getting us off to such a good start. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

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RICHARD N. HAASS: Welcome to the Council on Foreign Relations. For many of you, I expect it's the first time back this year. so happy new year while we're at it.

Every year is a special year at the Council on Foreign Relations. But this year is more special than usual, we'd like to think, because it's our 90th anniversary. And what we've decided to do somewhat in a contrarian fashion is to dedicate -- a significant amount of our effort this 90th year are to policy questions that are more normally thought of as domestic rather than foreign, whether it's questions of infrastructure, questions of K through 12 education, various aspects of immigration policy, of regulatory policy, and the subject tonight of deficit and debt on the obvious -- based on the obvious thinking that our ability to act in the world, our ability to lead in the world, our ability to present the positive model to the world will in no small part depend upon what takes place here at home in the United States. And we begin with the assessment that our house in many ways is not in order, and a principle challenge to the United States is to take care of that, and to put its domestic house in order.

And tonight's meeting is focused on one of the most difficult if not the most difficult aspect of all of that, which is the question of the deficit and the debt.

The way we're going to talk about it is with three extraordinarily informed gentlemen. George Stephanopoulos you all know from his time in government, but also now as ABC's chief political correspondent, and, for those of you who are morning people, is the anchor of "Good Morning America." And one of the things we like to do, by the way, at the council is end meetings on time. And tonight we have a double reason to do it because George is to go straight from here to bed. (Scattered laughter.)

GEORGE STEPHANOPOULOS: I've got a very important interview with Joan Rivers tomorrow morning. (Laughter.)

HAASS: That's good. (Laughter.) I've learned not to say everything that pops into my mind. (Laughter.) This does show the possibility of progress. But can we talk?

Michael Mandelbaum is one of this country's leading thinkers and writers about American foreign policy. He directs the American Foreign Policy Program at Johns Hopkins School of Advanced International Studies where he's the Christian Herter professor of American foreign policy. And, most recently, he is the author of "The Frugal Superpower: America's Global Leadership in a Cash-Strapped Era," which is on sale tonight so Michael is not cash-strapped.

And last but not least is Roger Altman. Roger was deputy secretary of the Treasury under President Clinton, and he is now chair and CEO of Evercore Partners.

One or two administrative things, none of which will -- come as a surprise to please turn off your electronic devices. And we have quite a few people listening on the phone tonight, so the signals really will muck it up.

This meeting is on the record, so anything said can and will be used against you.

There will be national members. There are national members listening in. And, indeed, I may take a few questions from them if I can figure out how to use the iPad.

The -- what we're going to do is I'm going to ask some questions to start off, and then I'm going to try to reserve a good chunk of the time for you all to have questions. What I -- what I thought I'd do is begin with Roger, then migrate to George, then migrate to Michael, and essentially begin with the question to ask Roger to set the stage, which is about the scale of the deficit and debt, a little bit about how we got to this point, and just some basic -- his sense of what we may want to do about it, essentially to provide the baseline of the challenge that we are dealing with tonight.

So you can ignore what I just said, Roger, and say whatever you'd like.

ROGER C. ALTMAN: Well, three or four months ago, Richard briefly lowered his usually high standards, and co-authored a piece with me in Foreign Affairs on the U.S. deficit and debt path and the global consequences of that. And so I'm going to give a very short beginning summary, so to speak, of what we said, and update it for some important things, which have happened since then. And I might say at the beginning it's timely to have this discussion not just because of the council anniversary, of course, but because in about a week, President Obama will deliver of course his State of the Union address. And in one form or another, there will be references to this difficult deficit and debt outlook. And so I'm going to make a comment or two about how he may or may not address it.

But just to start with, the headlines of the past two months have temporarily clouded how truly dire the U.S. fiscal outlook and debt outlook is. And by headlines, I mean, of course, the Republican election sweep in November, the surprisingly productive lame-duck congressional session, the tragic events in Arizona and other developments. And as an example of that obscuring the very good and very emphatic recommendations, which the Bowles-Simpson Commission delivered only on December the 1st -- after all, that was a commission that President Obama and the congressional leadership put together on the budget outlook, -- have largely been forgotten, at least for the moment, despite their really being quite important. And I'm sure they will come back.

But despite these intervening headlines, the fiscal outlook, which already was very threatening, actually has worsened a bit in the past couple of months. And that's because while on the one hand there is some improvement in the -- in the economic growth outlook for 2011 and 2012, and the latest forecasts reflect that, the tax agreements struck during the lame-duck session and the revenue consequences of the tax agreements actually more than offset that improved growth outlook. And so the deficit outlook and the related debt outlook -- remember the federal debt is really just a dollar-for-dollar consequence of the deficits -- has actually worsened in the past two or three months.

Now, let's spend a minute on how bad that outlook really is. And I'm going to refer primarily to the most recent Congressional Budget Office forecast. You all know the Congressional Budget Office is nonpartisan. It's really quite widely respected. It's most recent forecast is a few months out of date, but my research suggests that the updated one, which will come out in a few weeks, will not be terribly different.

And what we're looking at, at least based on current policy is cumulative deficits between nine (trillion dollars) and $10 trillion over the next 10 years. And the federal debt, which I should say has tripled or virtually tripled in the last 10 years from its roughly historical long-term average of about 35 percent of GDP to a current level of 65 percent, is projected to reach, by the CBO, 90 percent by 2020 and, by the IMF, actually, 115 percent.

To put those in context, with the brief exception of the peak years of World War II, we have never had a debt-to-GDP relationship of that level in the history of the United States since record keeping began in 1792. And those levels, 90 (percent) to 100 percent of GDP, are typically associated with countries, for example, today, like Italy and Greece. And, as I said a minute ago, we would reach those levels within just nine years.

And the credit rating of the United States if we do actually get from here to 90 (percent) to 100 percent of GDP in the form of federal debt, will certainly be lowered, and there are some forecasts around that suggest it will be lowered quite considerably.

Now, let me try to spend a minute on what it would mean to have debt in that amount. It would mean that federal -- the interest expense, which the federal government was paying would rise from today's 1 percent of GDP to about 4 percent. But in more practical terms, the total interest expense of the United States government would exceed all of domestic discretionary spending. In other words, it would exceed the total each year that we today spend on infrastructure, on energy, on agriculture and on education. And it would be approximately equal to the amount that we spend on defense.

In addition, the United States would be borrowing at that time -- this is 2020, this is not way off -- approximately $5 trillion a year. It was just a few years ago, about 10 years ago, that the entire budget of the United States was $5 trillion. Maybe a little further back than 10, but not many years. I can see Bob Rubin rolling his eyes, saying, I think it's further back than that. In any event, it wasn't a long time ago when the entire federal budget deficit -- federal budget, total budget -- was 5 trillion (dollars).

Now, the thesis that Richard and I expounded in our piece was that, actually, the United States would not be allowed to go from where we are today in 2011, beginning of 2011, to that much debt in 2020. We wouldn't actually get there. Either we would address this in the right way, proactively by our nation's leaders through a deficit reduction agreement of the type, for example, we saw at Andrews Air Force Base in 1990 under President George H.W. Bush, or perhaps the type that we saw -- George and I were both very involved in this -- in 1993 under President Clinton. In other words, address it proactively or it will be done the ugly way: namely, that the global financial markets at some point between now and 2020 and before we reach that much debt will revolt and impose a solution on the United States.

Now, I know there are a lot of people who think, yes, I know that there have been sovereign debt crises in Ireland recently, and in Greece, and looking back over history, the U.K., Mexico, Russia, Argentina, but that can't happen to the United States. We're the world's largest economy, our currency is the reserve currency of the world and so forth.

Well, it's instructive in that context to look at the events of 1979. I was serving in the Treasury then, during my first my tour of duty, and that was the era of stagflation, of the Iranian oil embargo, and of course President Carter. And during the early months of 1979 -- I'm sorry, during the lead up to 1979, the dollar had been wobbly and generally declining. And then President Carter submitted his budget, which included a larger than expected deficit. By today's standards, it was minuscule, but it was large by the standards of 1979.

That was the last straw for the financial markets. The dollar crashed. All global markets plunged -- fixed income markets, equity markets, currency markets, commodity markets -- and a true global emergency ensued. And the key nations of the world, the industrialized world, got together overnight and put together a coordinated international rescue of the dollar. But the contributions which the United States had to make to that were, one, to cut in half its budget deficit within one week, and for the Federal Reserve to raise interest rates very sharply at a time when that was not the general direction that the Federal Reserve had been headed into. All of that happened in one week.

Now, if we don't address this proactively, it will be in our judgment addressed by the global financial markets, and unfortunately if that happens, it will be a replay of 1979, but of course, on a much bigger scale. But the main point is it will happen with very little warning. The, quote, "solution" will be very ugly and punitive; for example, across-the-board spending cuts. There won't be time to do any kind of real budget, tax surcharges, there won't be any time to do any true tax policy. And it will be solved that way.

If it is solved in the latter way, that will usher in an age of profound austerity in this country, and that in turn -- I mean, as an example, all categories of domestic spending would be cut in an across-the-board fashion; nothing would be spared, entitlements and so forth. Taxes on all -- virtually all individuals and businesses would be raised, probably, as I say, through some surcharge approach. And we would enter into an age of austerity of the type we haven't seen in this country for -- well, since the 1930s.

Now, as Richard and I argued in this piece, the global consequences of that, the consequences for the American -- for the global platform of the United States and the consequences for world coherence and world stability, as no one is likely to step into the role the United States will be pulling back from, would be particularly profound. And on that note, I'm going to stop and turn it back to you, Richard.

HAASS: Did I say Happy New Year? (Scattered laughter.) Just wanted to make sure I covered all of our bases here. By the way, when Roger and I wrote the article, he was the optimistic member of the team, just to give you a sense of perspective here.

We'll get in a few minutes to what we -- well, implicit in Roger's argument is obviously the United States needs to embark on a fairly steep path of dealing with the deficit, somewhere 250 (billion dollars), $300 billion a year of the deficit need to be reduced through some combination of increased revenues, either from growth or taxation or decreased spending.

So let me turn to George for a second. Could you imagine any scenario where policymaking and decision-making of that scale could come about?

STEPHANOPOULOS: Not before January 2013, certainly not. I mean, nothing -- I agree with Roger's analysis, I should say. But if you just look at the current lineup over the next two years with a election, presidential election coming next year, it's inconceivable to me absent a forcing crisis that Congress and the White House can work on this. I mean, if you just look at -- you talk about the surprisingly productive lame duck session. They did all the easy stuff. They cut taxes. The budget was not -- they just punted on the budget for last year.

Fundamental to the president, to the White House is that they cannot break his key campaign promise, which was not to raise any taxes on middle-class Americans. He flirted with it, some would say he broke it during the health care debate, and they can't do anything or propose anything that has any hint of a tax increase on middle-income Americans. So that knocks out a lot of solutions right there.

As much as Republicans talked about spending debt and deficits in the mid-term elections, I think all of the leadership on the Republican side has completely gone to school on the Newt Gingrich experience of 1995 and 1996 and realize that what a reelected -- in their minds -- President Clinton caused so much heartache for Republicans during the government shutdown was the commitment to cut Medicare. And that that cost them whatever advantage they had coming out of the 1994 election.

So as much as they talk about cutting spending, their leadership is not going to do anything that touches what is at the heart of most of the spending problems. So I don't see anything happening between now and the presidential election.

HAASS: Before you go on, let me just -- can I interrupt for one second? One event, though, that will happen long before that will be the raising of the federal debt limit.

STEPHANOPOULOS: Yeah, and --

HAASS: (Inaudible) -- just for those of you who haven't followed, sometime this spring the United States is going to need to act March, April, May. There's a $14.3 trillion ceiling on our debt, and we're going to have to raise that, or we're going to have not take on any more debt at that point -- (inaudible) --

STEPHANOPOULOS: And there's an awful lot of pressure from Republican presidential candidates, from tea party candidates who just got elected to not vote to raise the debt limit absent any kind of serious spending reductions. But I think there they're going to be talking about some cuts in domestic discretionary spending, maybe some budget process issues like, you know, coming out for a balanced budget amendment again. Even on the -- the Republican leadership started out with a rock-hard promise in the midterm elections to cut $100 billion in spending this year. That promise as far as I can tell is down to about $30 billion right now, and they may not even get there.

So even if that -- I think that could create a crisis and that could create the kind of crisis that Roger is talking about if because of the stalemate the debt limit is not extended and Tim Geithner runs out of all of the maneuvers he may have learned from Bob Rubin back in 1995 and 1996, then, yeah, we could have a crisis that creates a crisis in the bond markets that forces the issue. But I don't see any kind of proactive addressing of it.

HAASS: Let me ask you then -- let me interrupt with one other question. You mentioned that you thought nothing would happen until 2013. If most people in your business are right, by then, you will have not just a Republican House --

STEPHANOPOULOS: (Inaudible.)

HAASS: -- but a Republican Senate.

Why do you think that then would set the stage? Imagine either way a second Obama term, a first term of -- with X Republican. How do you imagine that --

STEPHANOPOULOS: That is what I was imagining.

HAASS: Okay.

STEPHANOPOULOS: Twenty-three Democratic senators up in 2012, only 10 Republican senators up in 2012. Kent Conrad announced his retirement today. You could bet if you were going to bet that he'd be replaced by a Republican. Joe Lieberman is announcing his retirement likely tomorrow. A Democrat could win that, but that's a little more iffy.

But if you had to just look at the numbers, the fact that the Democrats are defending so many Senate seats in 2012, absent a massive, you know, landslide for Obama, it's -- the odds are that Republicans will take control of the Senate in 2012. That sets up conceivably a situation like what Ronald Reagan had in 1986. And you Reagan, Gephardt and Bradley come out for a big tax reform plan. That combined with what is more likely, the problem continues to get worse.

Both sides feel pressure to govern. You're in the early years of a second presidential term. The new Republican majorities will have more clearly shared responsibility because they're they don't have the Democratic Senate to blame anymore for inaction. That could set the table, and that's the optimistic scenario. Now, the question would be that, in January 2013, has the crisis come or not? And I defer to the economic experts in the room.

HAASS: The answer is none of the experts know when it's going to come. I think there is no consensus that if and when it does come, it could come quite quickly at that point, a little bit almost like a Malcolm Gladwell scenario that you reach a tipping point.

Then, Michael, let me turn it to you, which is -- we sort of have two scenarios. One is the United States proactively deals with this and sets ourselves again on a more responsible, sustainable trajectory; the other is more reactively, where markets react, we're forced to raise interest rates, so forth and so on.

What do you see as the foreign policy consequences under each?

MICHAEL MANDELBAUM: Well, I think the foreign policy consequences are more or less the same, whichever the scenario is. Whether we're on a gentle glide path downward or we fall off a cliff, at some point in response to some event, the United States will get serious about the deficit. And when that happens, contrary to the promises of the Republicans, taxes will rise. And, contrary to the promises of the Democrats, benefits, including Social Security and Medicare benefits, will be cut.

When that happens, we will be in a different political world. And in that political world -- and this is the premise of "The Frugal Superpower" -- foreign policy will be -- to use a term not entirely appropriate, but not entirely inappropriate -- "collateral damage." When people are paying more to the government and getting less form it, they will be less generous in funding the kind of of foreign policy that we have carried out, really, I would say in the lifetime of virtually everybody in this room.

I think that we are heading for a world in which, for the first time, just to pick a date at random since December 8th, 1941, how much things cost becomes a serious constraint on American foreign policy. It hasn't been irrelevant for the last 70 years, but, in comparative historical terms, it's been pretty modest. That will change because people simply won't support the kind of foreign policy that we have been accustomed to carrying out when they feel cash-strapped.

Now, there's one other point I want to make about them, and I can go into the specific changes that I anticipate and favor. But the general point -- and it's an important point for all of us -- I think, is this. The United States is the most important country in the world. And the United States, in my view, plays an extraordinarily constructive role in the world. The United States provides some of the services to the world that governments provide within the societies that they govern. The world functions as well as it does economically and in security terms -- not perfect, but not bad -- in no small part because of a very extensive American foreign policy, because of American economic and military commitments around the world.

When those are called into question -- and I think they will be -- that endangers not just the interests of the United States, but global peace and prosperity. This is a very big deal. And even countries that are extremely critical of one or another of America's foreign policies will find that the only thing worse from their point of view than an America that's too powerful is an America that's too weak.

HAASS: This could be the be-careful-what-you-wish-for here for -- I guess -- (inaudible) -- one short question of each of you before I open it up. And let me start with Roger.

How does the president deal with what appears to be something of a dilemma? We've got formal unemployment between 9 (percent) and 10 percent. We've got real unemployment that's probably 50 percent higher than that, somewhere at 15 or so percent?

How does he deal with what we-- with the need to get things going, increase employment and the like, stimulate the economy; and, at the same time, put the United States on a, if you will, quote, unquote, "responsible trajectory," and gradually start reducing the deficit? How does one deal with that? Is it a dilemma, which is a word that's overused? Or is there a way essentially to have our cake and eat it?

ALTMAN: Well, I think most economic and fiscal experts would answer that, Richard, by saying -- and I would -- that the United States has really had to date the right response to the economic and financial collapse of 2008 and 2009. We've had a -- by standards of other parts of the world, we've had a forceful response. We've had a large response, and we had a relatively quick response.

And even though we have a 9.4 percent unemployment rate and a 16.3 (percent) underemployment rate, and the outlook for the labor market remains very, very difficult, we pulled ourselves out of this quite skillfully. I think historians will ultimately judge it that -- judge it that way. And this country should get very high marks for how we -- how we -- how we've got -- carried ourselves through the last two years.

And the emphasis of policy for 2011 and 2012 really should be -- and George was pointing out how it's politically necessary, but it actually is the right policy also -- to continue in every possible way to incentivize growth, and try to thaw out the frozen labor markets.

But at the same time, you would put in place if you could wave a wand a framework for changing this dire deficits and debt path, which would take effect probably in 2013, not for -- not for presidential cycle reasons, but for where we would then be in the economic cycle, because at that point the argument would be the economy will have strengthened to the point where it could withstand the contractionary impacts of a large deficit reduction plan.

So if you could wave a wand the next two years, the focus would be on growth and labor markets, and then would take effect, not just be worked on then, but take effect then a long-term plan for reducing the deficit and debt outlook.

STEPHANOPOULOS: I think you want to start fitting that suit, but don't sew it on in the State of the Union.

HAASS: That was my next -- (inaudible). Okay. So imagine you have this that next -- in the short run, if you will, we continue to emphasize growth, stimulus of one sort or another, get big corporations to start spending down some of the cash they've accumulated, but essentially two years from now have the "more responsible," quote, unquote, trajectory kick in. To what extent -- how far does the president go next week?

STEPHANOPOULOS: I don't know how far he will go. I think that the first point has to be Roger's point. You can't do anything that puts the recovery at risk, and we have to continue to create more jobs in this country. The number one job of a president, keep the economy -- keep the economy growing. I think he can then make a nod towards the election, and in a sort of a -- it was the framework President Clinton used. There's a right way and a wrong way to deal with these things. You have to make the right investments in education, in energy, in infrastructure. And we can make cuts in places where government is no longer as efficient and effective as it once was. And I think he did make a nod to that in his Wall Street Journal op-ed about regulation today.

And then I think it's conceivable -- and this is going to be a slightly different State of the Union from the kind we've seen recently. I think it is very likely that Republicans and Democrats are going to be sitting together for the most part. They're not going to be in two opposing camps. I think that gives the president an opportunity to give what appears to be a less political speech, and will sound more like a conversation, and that he could put the discussion of the long-term deficit in the context of everyone working together. and that's what the country has demanded, putting it in a more political process context than in an economic context.

And you can talk about -- we all know there are things that we're going to have to do over the long term. We're going to have to live within our means. I think you can give a rhetorical nod to the Simpson-Bowles Commission without boring in too much on any of the specifics. I think he can talk about tax reform and -- he'll -- without -- and show a little bit more leg. He's already done some of that without getting into specifics.

I think he'll still argue that his health care plan is one of the answers to entitlement reform, but he can also make a nod to saying, "We're going to do more." But I think they're going to have to be fairly careful about getting locked into a specific proposal on any one of those three areas.

HAASS: Michael, I think I know the answer to this question, but let me ask you anyhow, which is, the last 10 years of American foreign policy has been dominated by two extremely expensive interventions, one in Iraq, one now in Afghanistan. Will this sort of pressure both accelerate the end, particularly of Afghanistan? But, more important, will this now -- is this the end of that phase of what we might call "discretionary American interventions?" Is this basically over?

MANDELBAUM: Let's call them wars of choice. (Laughter.)

HAASS: I was trying to be uncharacteristically self-effacing here. But clearly it didn't hold. Okay.

MANDELBAUM: I think it is, Richard. And I think that this period really goes back two decades. I think the wars or the interventions in Somalia, in Bosnia, in Kosovo, in Haiti belong with the interventions in Afghanistan and Iraq, although they were undertaken by different administrations for different reasons, and had different costs. But all of them ended up in the protracted, unexpected, unwanted and expensive task of nation building.

Nation building has never been popular. The country has never liked it. It likes it even less now. And I think we're not going to do it again. We're not going to do it because there won't be enough money. We're not going to do it because there will be other demands on the public purse. We won't do it because we'll be busy enough doing the things that I think ought to be done in foreign policy. And we won't do it because it will be clear to politicians that the range of legitimate choices that they have in foreign policy will have narrowed and will exclude interventions of that kind. So I believe and I say in the book that the last -- the first two post-Cold War decades can be seen as a single unit. And that unit has come to an end.

HAASS: With that, the questions from our members has come to a beginning. If people would wait for a microphone, let us know who you are, pretty much limit yourself to one relatively brief question, I would be forever grateful.

Carol, why don't we start with you?

And I'll also try to take some questions from our national members.

QUESTIONER: Carol O'Cleireacain, Brookings. I want to pick up on what you just said, and ask, so where does the war on terror go in such a scenario?

MANDELBAUM: The war on terror will be waged not by trying to transform the countries that harbor terrorists. And, incidentally, even if that were our aim, our biggest task would be Pakistan. And that's hopeless for a variety of reasons. The war on terror, I believe, will be waged by effective intelligence and police work and cruise missiles.

QUESTIONER: And that's expensive -- (off mic) --

MANDELBAUM: Not nearly as expensive as what we're doing in Afghanistan and in Iraq.

HAASS: Yeah, I would say much more the Somalias and Yemens will be the model for the future much more than the Afghanistans.

K.T. McFarland?

QUESTIONER: Hi. K.T. McFarland of Fox News, and a former student of yours, Professor Mandelbaum. If --

MANDELBAUM: Always good to see a former student gainfully employed. (Laughs, laughter.)

QUESTIONER: Thank you. If it's inevitable that we've got to leave Afghanistan and Iraq, and not going to have conflicts of this sort, should we just get out now?

MANDELBAUM: You're asking me?

QUESTIONER: Yeah.

MANDELBAUM: Well, it's okay with me to get out now. And I think we certainly should be on a glide path downward. I refer those of you who are interested to Bob Blackwill's article in the current Foreign Affairs. His argument is we should, in effect, partition the country. We should leave the Pashtun areas. We should hold onto Kabul and the non-Pashtun parts. And we can do that with a much smaller force.

I'm not -- there are downsides to leaving Afghanistan completely. Bob goes into them. It could be a civil war. You know, all of the gains that have been made, such as they are, would be reversed. So if you can achieve something on the cheap, I guess that that would be okay with me. But my problem with Afghanistan is that I don't think it's important. What happens in Afghanistan stays in Afghanistan. It doesn't -- it doesn't affect anything in which we have any interest. It's no better than the fourth most important country in that general part of the world after Pakistan, Iraq and Iran. And since as a general principle, I think we ought to be spending our resources on issues and interests that are most important, since Afghanistan comes at or near the bottom of the list, I'm not in favor of any spending anything there.

HAASS: Roger, one issue that hasn't come up is state and local. And one of the questions I would have for you at this point is whether that's a potential trigger. Whether it's Illinois, California, New York, New Jersey, is that something that could accelerate this scenario by which a triggering event happens?

ALTMAN: Before directly answering that, I just might point out that none of the ratios and data that I used on federal debt include, A, the roughly 9 trillion (dollars) of debt that the United States has guaranteed, but which is not a direct obligation of the United States; B, the debt of the GSEs, which is not -- which are not explicitly guaranteed, Fannie Mae and Freddie Mac, but which are implicitly guaranteed of course; and of course any possible severe fiscal problems that some -- any of our larger states might have, which at least theoretically could require the United States to stand behind them.

So you can argue that the picture that we talked about at the beginning here is actually worse than it looks. I don't think, Richard, that that's going to be the flash point.

And I don't think it is because I wouldn't expect any of the larger state and local borrowers to actually default -- larger, now; not talking about Harrisburg, Pennsylvania, or some entity like that. And even if it did, the -- it isn't clear to me that the United States would come to a full rescue -- you know, their debt is our debt. I think there'd be a lot of pressure not to do that. So while anything could trigger this off, I would be surprised if that would be it.

HAASS: Okay. I see a hand. Mr. Rubin (sp), yes.

QUESTIONER: My question is for anybody, Richard.

The rest of the world is acutely aware of our fiscal situation, as you all so effectively described it. How is that affecting the way they look at geopolitics -- I think Mike may be the closest to commenting on this -- geopolitics and their planning for the future? China, Pakistan, or anybody else that you'd like to comment on.

MANDELBAUM: Well, it's a good question. First of all, as a general proposition, it will have consequences across the board. That we know. We don't know exactly what they are. We know that people in Afghanistan are preparing for our withdrawal. I believe that the radical forces in the Middle East, although they don't need much encouragement, are somewhat -- have been somewhat more aggressive as they see America turning inward and weakening.

And the most important place where one might see this -- and I don't know that this is the case, but I think there's some evidence -- is the Chinese policy has changed somewhat in the last two years, since -- perhaps it's a coincidence -- around September 15th, 2008. The Chinese are no longer the good followers, the people who keep their head down. There's a whole list of initiatives the Chinese have taken that individually don't -- may not represent anything frightening, but collectively suggest a change of course, a much more assertive policy. It's hard not to connect that with their perception of the United States.

And one thing -- and there are a lot of things we don't know about China, but one thing we know is that they keep a very close eye on us. They gear their policies to us. So I would -- I would suggest that there's at least some evidence that the other most important country in the world is behaving more in ways that we don't welcome because of the financial crisis and the recession and the anticipated consequences down the road.

HAASS: The gentleman in the back with the blue shirt.

QUESTIONER: Matthew Lee, with Inner City Press. I wanted to know, I guess, what you think -- how you think this -- how the deficit will impact the U.S. participation in the United Nations and its peacekeeping operations. I mean, there was a debate today in the Security Council about Sudan. There was talk about debt relief for south Sudan or north Sudan. You know, and just -- Professor Mandelbaum, you talked about the relative importance of countries. Do you see Africa, or any country in Africa -- maybe Somalia -- as being, you know, on your -- on your top 10 -- even top-10 list? Thanks a lot.

MANDELBAUM: No, it's not in the top 50, maybe not in the top hundred.

As for -- I mean, you -- now we're in a whole -- when the word "U.N." is mentioned, as Richard knows well -- (chuckles, soft laughter) -- we're in a different -- a different world. To be, I hope, not unkind, or flip, but in the interest of time, the American contribution to U.N. peacekeeping forces is a rounding error in the budget. Whether it stays or goes, we're not going to notice. The real money is in the American defense budget. The American defense budget, with all due respect to our friends at Turtle Bay, is far more important for global stability than anything that the U.N. does. That's where the action is, and that's what's important.

HAASS: I would just make the point that one area, though, of the U.S. budget which, while small, is vulnerable would be non-defense spending in the international arena. And various aspects of foreign assistance and the like are, I think, going to come under tremendous pressure, just because --

STEPHANOPOULOS: I think that's true, except I've actually been surprised in the last few years how little pressure it's been under, given how much -- how big the overall debt problem is.

HAASS: Well, hope you're right.

Sure. Fine.

QUESTIONER: What is the --

HAASS: Wait a second for the phone -- mic.

QUESTIONER: What's the future of the euro, and how will it affect the dollar and our financial problems?

HAASS: Roger, why don't you take that on, and particularly the question also about -- related to it, which is, how has the euro's weakness perhaps bought us more time here?

ALTMAN: Well, the biggest question vis-a-vis the euro right now, of course, is whether the euro zone as a whole will remain intact, or whether the sovereign debt crises that are afflicting, as I said, Greece, Ireland, Portugal, and may afflict others, will somehow break it up.

You never say never, of course, but it seems to me the euro zone will remain intact, because the costs of breaking it up at various levels are so high. For example, in the case of Germany, which is of course the strong -- economically strongest country and financially strongest country, if the euro zone were to break up and the Deutschmark somehow return, the Deutschmark would inevitably strengthen, much to the detriment of Germans -- Germany -- of the German exports and the overall German economy. I could go on down the list as to why that's unlikely, including the sheer out-of-pocket costs and the amount of time it would take to return to the status quo ante, pre-euro.

Now, short term, the actual trading value of the euro: So often in recent years, very learned analyses -- for example, from the Peterson Institute in Washington -- have quite correctly theorized that the size of our external imbalances should lead to a weaker dollar. And in general, the dollar has not been as weak as the theories have suggested it would be. For example, over the past year -- Bob, you might correct me -- I think it's down to about 6 percent on a trade-weighted basis, not -- and a year ago, a lot of people would have said it would be weaker than that.

But, of course, the dollar has long had a safe-haven nature, and the type of crises that have coursed through Europe -- sovereign debt crises -- have not just caused the dollar to strengthen on a day-to-day trading basis versus the euro, but the safe-haven character of the dollar has asserted itself again. But in any event, what might have been a weaker dollar under different circumstances has not, at least so far, materialized.

Maybe, Richard, some day, if we don't proactively address this problem and the financial markets address it for us, that will first begin -- that chain reaction will first begin as it did in '79, through the exchange markets in the dollar. But maybe it won't. There are so many different ways that we've seen in the last 20, 25 years crises arise, and each one seems to come from a different angle than the last one. It's impossible to judge how that might first start.

HAASS: Sir?

QUESTIONER: Steve Tananbaum from GoldenTree. Roger, you start saying if we keep on the current policies, the market is going to cause us to change our ways. Yet Japan is pretty much further down, yet the market has not disciplined them.

Why do you think that's so?

ALTMAN: Well, many people would challenge the premise of your question to the effect that Japan is -- in effect, Japan's fiscal condition is worse than ours.

QUESTIONER: Well, if you look at debt to -- (off mic) --

ALTMAN: Yes. Yes. But if you look at -- and you could argue this either way. But if you -- but -- you can argue it's a more indebted country than the United States because, of course, its federal debt to its -- the size of its economy is worse than ours, as you're suggesting. You're right. On the other hand, if you look at the savings rate in Japan and the percentage of Japan's debt that is held outside the country, it's a very different picture.

In contrast to your premise, many argue that Japan's debt is financed internally, not externally like ours is; and, therefore, the degree to which global financial markets would have an incentive to discipline Japan is very low because Japan's debts in effect to the rest of the world are very small.

Now, you can look at that a lot of different ways. But I think, in general, because of the contrasts between Japan and the United States in terms of a very low level of the Americans' saving rate -- even though it's ticked up a little bit recently -- and the degree to which we are financing so much of our deficits externally -- I mean, I've seen estimates at seven (hundred billion dollars) to 900 billion (dollars) a year in the last three to four years is being added to the store of dollar-denominated liabilities held overseas; obviously, China is a big participant in that -- I think the two situations are actually quite different.

HAASS: George, let me just go back to a political question, which is, can you imagine a politician standing up and talking about these issues like we are a little bit, and essentially thriving -- (laughter) -- as opposed to stepping on the proverbial third rail?

STEPHANOPOULOS: I think it depends on which level of politician. I think members of Congress can do it; I think Paul Ryan you see of Wisconsin. Although, he leaves out taxes in his plan. I think, you know, one of the encouraging things you've seen -- you talk about the Simpson-Bowles commission. I think there was a little more crossover and support for that menu of proposals than I expected. You had, you know, senior, kind of party Democrats like Dick Durbin coming out and supporting it. You had Republicans like Tom Coburn coming out and supporting it, even though it did include some talk of tax increases.

So, yeah, I mean, I think, it's hard for a president in an election year. It is impossible for a challenger to a president in an election year. But, below that, yeah, I think you see a lot of ferment and not only the Simpson-Bowles commission, but you're seeing -- you know, I think, the fact that, you know, people like Roger have written about at a VAT, the Center for American Progress has written about VAT on the Democratic side, you've started to see more ideas bubbling on the Republican side. I think those will bubble up, but just not at the top level yet.

ALTMAN: And, George, if I could just ask a question following up Richard's, I think the distinction between what national leaders can do or a president can do in the way Richard asked about it, and what some governors seem to be doing right now is a really interesting distinction. Some governors seem to be deciding our problem is so bad, it's both the right thing to do and maybe the politically smart thing to do to tell it like it is.

So Governor Cuomo in New York has come in, you know, in a very tough way in this regard, and Governor Christie of New Jersey and others around the country basically saying, "Folks, things are really, really bad. There's no easy, sugar-coating solution, and this is what we're going to have to -- (inaudible)."

STEPHANOPOULOS: Well, and, on the other side in Illinois, you know, 60 percent tax increase.

ALTMAN: Yeah, well, we'll see how that plays. But the question is, you know, you can argue that some governors, especially new ones, are deciding, "Not only do I need to fix it, but I could actually benefit. I could advantage myself by delivering -- by talking straight about it."

And my question is -

STEPHANOPOULOS: Well, I think the talking straight, I completely agree with. I mean -- I mean, we're at the beginning of their budget cycles right now. We'll end up seeing how much they actually get through. They're also -- a lot of the governors actually face requirements where they have to balance their budgets, so it's a very different situation.

But, yeah, I do think there's a -- I think there's no question that people want to hear politicians talking about these issues in what is perceived to be a straightforward manner. I just think there's less evidence that they -- the country actually wants the politicians to follow through on those promises.

HAASS: Do you think that what happens in Britain -- there you've got a government that has gone on a fairly, by our -- by our terms, drastic path, serious spending cuts, probably -- what -- $4 or whatever of spending cuts for every dollar of tax increases. Do you think that will have any impact on here, like, the debt, the British experiment, if you will?

STEPHANOPOULOS: How long does the government survive? I mean, the liberals are in trouble.

HAASS: Well, how well does the economy survive?

STEPHANOPOULOS: Yeah.

HAASS: Do you think -- do you imagine that experiment going on in Britain will have repercussions here?

ALTMAN: If it fails, we will take note of it. If it succeeds, we probably won't. That's right.

MR. : That's right.

ALTMAN: The British government has a rather smaller borrowing capacity than the American government does. So they don't have the short-term choices that we do. But it is interesting. They are running an experiment. And I take it that the economic theory behind their policy is that if they have a serious deficit reduction program, that will inspire such confidence there will be an outbreak of euphoria in the British economy, in the European economy, and that will make up for the gap in their consumption. Let's hope it works. But as George says, the government could fall.

HAASS: There's always that. Sure.

QUESTIONER: Sy Jacobs, Jacobs Asset Management. The question's for Roger. Given that you feel that the world doesn't have 10 years of patience and appetite for trillion-dollar-a-year deficits, is it reckless or is it brilliant that the central bank of that trillion-dollar-deficit country is -- has committed to buying $2 trillion of that country's paper?

ALTMAN: I have no quarrel with the quantitative easing approach that the Federal Reserve has taken. It's part of the point I made a little bit earlier about how I believe history will judge the United States, including our central bank, as having responded very effectively to what was really civilization-threatening events of, you know, the fall of '08 through early '09.

And I think a lot of the debate about the second round of quantitative easing, so-called QE2, is a little bit strange, because I really believe the Federal Reserve's main motivation was to try to provide an extra incentive for growth and labor markets. Remember, the mandate of the Federal Reserve is both price stability and full employment.

And I don't think it was, you know, a sneaky way to try to lower the value of the dollar, even though it was interpreted that way internationally in so many quarters.

So I don't think the Federal Reserve has overstepped its bounds or acted imprudently at all. And I might add that -- I'm not a monetary historian, but quantitative easing is actually a rather traditional monetary exercise. There's nothing new about it. There's nothing original about it. There's nothing infrequent about it in the modern monetary history of, you know, the industrialized world.

HAASS: Charlie Wolf From RAND asked a question about how -- what all this means for trends in American power. So let me ask the question directly -- I'll make it the last question -- which is, does this inevitably contribute to the relative decline -- not the absolute decline but where we are -- does this inevitably contribute to the relative decline of the United States, that we are essentially in this predicament and that we are going to be forced to do things that will limit the resources that are available for our role in the world and that essentially we will occupy less of a space consequently?

Michael.

MANDELBAUM: Well, I'm glad you asked that question. (Laughter.) And I want to commend you, Richard, and the council, for making the 90th anniversary project looking at the domestic sources of American power, because I think that is really the crucial issue for the next decade. And I'm so committed to that proposition, that I am writing a book about that subject with my friend Tom Friedman of the New York Times.

And there's good news and bad news. The good news is, we can deal with these problems. We know how to do it. We've done it before. The bad news is that the problem we've been discussing today, tonight, is only one of the problems. There are three others. And I think if we can get our act together and deal with the deficit and with the other problems, we will remain the most powerful country in the world and the global leader even with the rise of China and India because our values are in alignment with what most countries want and because most countries appreciate at some level the kind of leadership that we provide. I think our soft power is still intact.

But you've got to have hard power to back it up, and that depends on what we do. And when I think about this problem -- and incidentally, I don't see anybody else replacing us. I don't see us getting any help from the Europeans and the Japanese who have problems of their own. I don't see -- I see the Chinese possibly making trouble but not shouldering us aside and being the global leader or even the unchallenged leader of East Asia. So it's either us or nobody. And nobody is a lot worse than us.

What are the prospects? We've been talking about that, but when I think about this question -- and this is -- this is the major question that we as a country face -- I think about a saying that I first heard attributed to Abba Eban, the former Israeli foreign minister who once said, men and nations -- should have said "men and women and nations" -- will always do the right thing when all other alternatives have been exhausted. (Laughter.)

Well, we're running out of alternatives.

HAASS: Well, that was also a version of Churchill's comment about American democracy and the danger -- going back to where we began this conversation, if that's true, while we're going through doing some of the wrong things or not yet prepared to do the right thing, events may intervene. And we may not essentially be able to write the script in ways that will work out.

You've actually, though, come off fairly optimistic.

STEPHANOPOULOS: In the end, I think so. And we have -- we have -- we've been through these crises before. I think that we -- I agree with Roger that history, I think, is going to look back at the way, actually, both presidents in the end dealt with the financial crisis in 2008 and 2010 and say they did the right thing at a difficult time. And I do think that we're going to solve this in the next couple of years because we're going to have to.

ALTMAN: Hey Richard, you know, we've done some good things here tonight, one of which, obviously, is to give George all the briefing material he needs for his discussion tomorrow morning with Joan Rivers. (Laughter.)

STEPHANOPOULOS: She's great on the euro. (Laughter.)

MANDELBAUM: But more pessimistic than you are. (Laughter.)

HAASS: From that, well, we hope you've enjoyed the red carpet here tonight -- (laughter) -- and let me thank these three friends for starting what I hope really will be an extended and a thoughtful discussion throughout this year and beyond on the domestic challenges that really are so much now at the heart of what the United States does in the world. It may seem to be an odd place for the Council on Foreign relations to end up, but I think that tells you something. And I think this reinforces my sense that we've ended up in the right place.

Let me thank you all for getting us off to such a good start. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

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RICHARD N. HAASS: Welcome to the Council on Foreign Relations. For many of you, I expect it's the first time back this year. so happy new year while we're at it.

Every year is a special year at the Council on Foreign Relations. But this year is more special than usual, we'd like to think, because it's our 90th anniversary. And what we've decided to do somewhat in a contrarian fashion is to dedicate -- a significant amount of our effort this 90th year are to policy questions that are more normally thought of as domestic rather than foreign, whether it's questions of infrastructure, questions of K through 12 education, various aspects of immigration policy, of regulatory policy, and the subject tonight of deficit and debt on the obvious -- based on the obvious thinking that our ability to act in the world, our ability to lead in the world, our ability to present the positive model to the world will in no small part depend upon what takes place here at home in the United States. And we begin with the assessment that our house in many ways is not in order, and a principle challenge to the United States is to take care of that, and to put its domestic house in order.

And tonight's meeting is focused on one of the most difficult if not the most difficult aspect of all of that, which is the question of the deficit and the debt.

The way we're going to talk about it is with three extraordinarily informed gentlemen. George Stephanopoulos you all know from his time in government, but also now as ABC's chief political correspondent, and, for those of you who are morning people, is the anchor of "Good Morning America." And one of the things we like to do, by the way, at the council is end meetings on time. And tonight we have a double reason to do it because George is to go straight from here to bed. (Scattered laughter.)

GEORGE STEPHANOPOULOS: I've got a very important interview with Joan Rivers tomorrow morning. (Laughter.)

HAASS: That's good. (Laughter.) I've learned not to say everything that pops into my mind. (Laughter.) This does show the possibility of progress. But can we talk?

Michael Mandelbaum is one of this country's leading thinkers and writers about American foreign policy. He directs the American Foreign Policy Program at Johns Hopkins School of Advanced International Studies where he's the Christian Herter professor of American foreign policy. And, most recently, he is the author of "The Frugal Superpower: America's Global Leadership in a Cash-Strapped Era," which is on sale tonight so Michael is not cash-strapped.

And last but not least is Roger Altman. Roger was deputy secretary of the Treasury under President Clinton, and he is now chair and CEO of Evercore Partners.

One or two administrative things, none of which will -- come as a surprise to please turn off your electronic devices. And we have quite a few people listening on the phone tonight, so the signals really will muck it up.

This meeting is on the record, so anything said can and will be used against you.

There will be national members. There are national members listening in. And, indeed, I may take a few questions from them if I can figure out how to use the iPad.

The -- what we're going to do is I'm going to ask some questions to start off, and then I'm going to try to reserve a good chunk of the time for you all to have questions. What I -- what I thought I'd do is begin with Roger, then migrate to George, then migrate to Michael, and essentially begin with the question to ask Roger to set the stage, which is about the scale of the deficit and debt, a little bit about how we got to this point, and just some basic -- his sense of what we may want to do about it, essentially to provide the baseline of the challenge that we are dealing with tonight.

So you can ignore what I just said, Roger, and say whatever you'd like.

ROGER C. ALTMAN: Well, three or four months ago, Richard briefly lowered his usually high standards, and co-authored a piece with me in Foreign Affairs on the U.S. deficit and debt path and the global consequences of that. And so I'm going to give a very short beginning summary, so to speak, of what we said, and update it for some important things, which have happened since then. And I might say at the beginning it's timely to have this discussion not just because of the council anniversary, of course, but because in about a week, President Obama will deliver of course his State of the Union address. And in one form or another, there will be references to this difficult deficit and debt outlook. And so I'm going to make a comment or two about how he may or may not address it.

But just to start with, the headlines of the past two months have temporarily clouded how truly dire the U.S. fiscal outlook and debt outlook is. And by headlines, I mean, of course, the Republican election sweep in November, the surprisingly productive lame-duck congressional session, the tragic events in Arizona and other developments. And as an example of that obscuring the very good and very emphatic recommendations, which the Bowles-Simpson Commission delivered only on December the 1st -- after all, that was a commission that President Obama and the congressional leadership put together on the budget outlook, -- have largely been forgotten, at least for the moment, despite their really being quite important. And I'm sure they will come back.

But despite these intervening headlines, the fiscal outlook, which already was very threatening, actually has worsened a bit in the past couple of months. And that's because while on the one hand there is some improvement in the -- in the economic growth outlook for 2011 and 2012, and the latest forecasts reflect that, the tax agreements struck during the lame-duck session and the revenue consequences of the tax agreements actually more than offset that improved growth outlook. And so the deficit outlook and the related debt outlook -- remember the federal debt is really just a dollar-for-dollar consequence of the deficits -- has actually worsened in the past two or three months.

Now, let's spend a minute on how bad that outlook really is. And I'm going to refer primarily to the most recent Congressional Budget Office forecast. You all know the Congressional Budget Office is nonpartisan. It's really quite widely respected. It's most recent forecast is a few months out of date, but my research suggests that the updated one, which will come out in a few weeks, will not be terribly different.

And what we're looking at, at least based on current policy is cumulative deficits between nine (trillion dollars) and $10 trillion over the next 10 years. And the federal debt, which I should say has tripled or virtually tripled in the last 10 years from its roughly historical long-term average of about 35 percent of GDP to a current level of 65 percent, is projected to reach, by the CBO, 90 percent by 2020 and, by the IMF, actually, 115 percent.

To put those in context, with the brief exception of the peak years of World War II, we have never had a debt-to-GDP relationship of that level in the history of the United States since record keeping began in 1792. And those levels, 90 (percent) to 100 percent of GDP, are typically associated with countries, for example, today, like Italy and Greece. And, as I said a minute ago, we would reach those levels within just nine years.

And the credit rating of the United States if we do actually get from here to 90 (percent) to 100 percent of GDP in the form of federal debt, will certainly be lowered, and there are some forecasts around that suggest it will be lowered quite considerably.

Now, let me try to spend a minute on what it would mean to have debt in that amount. It would mean that federal -- the interest expense, which the federal government was paying would rise from today's 1 percent of GDP to about 4 percent. But in more practical terms, the total interest expense of the United States government would exceed all of domestic discretionary spending. In other words, it would exceed the total each year that we today spend on infrastructure, on energy, on agriculture and on education. And it would be approximately equal to the amount that we spend on defense.

In addition, the United States would be borrowing at that time -- this is 2020, this is not way off -- approximately $5 trillion a year. It was just a few years ago, about 10 years ago, that the entire budget of the United States was $5 trillion. Maybe a little further back than 10, but not many years. I can see Bob Rubin rolling his eyes, saying, I think it's further back than that. In any event, it wasn't a long time ago when the entire federal budget deficit -- federal budget, total budget -- was 5 trillion (dollars).

Now, the thesis that Richard and I expounded in our piece was that, actually, the United States would not be allowed to go from where we are today in 2011, beginning of 2011, to that much debt in 2020. We wouldn't actually get there. Either we would address this in the right way, proactively by our nation's leaders through a deficit reduction agreement of the type, for example, we saw at Andrews Air Force Base in 1990 under President George H.W. Bush, or perhaps the type that we saw -- George and I were both very involved in this -- in 1993 under President Clinton. In other words, address it proactively or it will be done the ugly way: namely, that the global financial markets at some point between now and 2020 and before we reach that much debt will revolt and impose a solution on the United States.

Now, I know there are a lot of people who think, yes, I know that there have been sovereign debt crises in Ireland recently, and in Greece, and looking back over history, the U.K., Mexico, Russia, Argentina, but that can't happen to the United States. We're the world's largest economy, our currency is the reserve currency of the world and so forth.

Well, it's instructive in that context to look at the events of 1979. I was serving in the Treasury then, during my first my tour of duty, and that was the era of stagflation, of the Iranian oil embargo, and of course President Carter. And during the early months of 1979 -- I'm sorry, during the lead up to 1979, the dollar had been wobbly and generally declining. And then President Carter submitted his budget, which included a larger than expected deficit. By today's standards, it was minuscule, but it was large by the standards of 1979.

That was the last straw for the financial markets. The dollar crashed. All global markets plunged -- fixed income markets, equity markets, currency markets, commodity markets -- and a true global emergency ensued. And the key nations of the world, the industrialized world, got together overnight and put together a coordinated international rescue of the dollar. But the contributions which the United States had to make to that were, one, to cut in half its budget deficit within one week, and for the Federal Reserve to raise interest rates very sharply at a time when that was not the general direction that the Federal Reserve had been headed into. All of that happened in one week.

Now, if we don't address this proactively, it will be in our judgment addressed by the global financial markets, and unfortunately if that happens, it will be a replay of 1979, but of course, on a much bigger scale. But the main point is it will happen with very little warning. The, quote, "solution" will be very ugly and punitive; for example, across-the-board spending cuts. There won't be time to do any kind of real budget, tax surcharges, there won't be any time to do any true tax policy. And it will be solved that way.

If it is solved in the latter way, that will usher in an age of profound austerity in this country, and that in turn -- I mean, as an example, all categories of domestic spending would be cut in an across-the-board fashion; nothing would be spared, entitlements and so forth. Taxes on all -- virtually all individuals and businesses would be raised, probably, as I say, through some surcharge approach. And we would enter into an age of austerity of the type we haven't seen in this country for -- well, since the 1930s.

Now, as Richard and I argued in this piece, the global consequences of that, the consequences for the American -- for the global platform of the United States and the consequences for world coherence and world stability, as no one is likely to step into the role the United States will be pulling back from, would be particularly profound. And on that note, I'm going to stop and turn it back to you, Richard.

HAASS: Did I say Happy New Year? (Scattered laughter.) Just wanted to make sure I covered all of our bases here. By the way, when Roger and I wrote the article, he was the optimistic member of the team, just to give you a sense of perspective here.

We'll get in a few minutes to what we -- well, implicit in Roger's argument is obviously the United States needs to embark on a fairly steep path of dealing with the deficit, somewhere 250 (billion dollars), $300 billion a year of the deficit need to be reduced through some combination of increased revenues, either from growth or taxation or decreased spending.

So let me turn to George for a second. Could you imagine any scenario where policymaking and decision-making of that scale could come about?

STEPHANOPOULOS: Not before January 2013, certainly not. I mean, nothing -- I agree with Roger's analysis, I should say. But if you just look at the current lineup over the next two years with a election, presidential election coming next year, it's inconceivable to me absent a forcing crisis that Congress and the White House can work on this. I mean, if you just look at -- you talk about the surprisingly productive lame duck session. They did all the easy stuff. They cut taxes. The budget was not -- they just punted on the budget for last year.

Fundamental to the president, to the White House is that they cannot break his key campaign promise, which was not to raise any taxes on middle-class Americans. He flirted with it, some would say he broke it during the health care debate, and they can't do anything or propose anything that has any hint of a tax increase on middle-income Americans. So that knocks out a lot of solutions right there.

As much as Republicans talked about spending debt and deficits in the mid-term elections, I think all of the leadership on the Republican side has completely gone to school on the Newt Gingrich experience of 1995 and 1996 and realize that what a reelected -- in their minds -- President Clinton caused so much heartache for Republicans during the government shutdown was the commitment to cut Medicare. And that that cost them whatever advantage they had coming out of the 1994 election.

So as much as they talk about cutting spending, their leadership is not going to do anything that touches what is at the heart of most of the spending problems. So I don't see anything happening between now and the presidential election.

HAASS: Before you go on, let me just -- can I interrupt for one second? One event, though, that will happen long before that will be the raising of the federal debt limit.

STEPHANOPOULOS: Yeah, and --

HAASS: (Inaudible) -- just for those of you who haven't followed, sometime this spring the United States is going to need to act March, April, May. There's a $14.3 trillion ceiling on our debt, and we're going to have to raise that, or we're going to have not take on any more debt at that point -- (inaudible) --

STEPHANOPOULOS: And there's an awful lot of pressure from Republican presidential candidates, from tea party candidates who just got elected to not vote to raise the debt limit absent any kind of serious spending reductions. But I think there they're going to be talking about some cuts in domestic discretionary spending, maybe some budget process issues like, you know, coming out for a balanced budget amendment again. Even on the -- the Republican leadership started out with a rock-hard promise in the midterm elections to cut $100 billion in spending this year. That promise as far as I can tell is down to about $30 billion right now, and they may not even get there.

So even if that -- I think that could create a crisis and that could create the kind of crisis that Roger is talking about if because of the stalemate the debt limit is not extended and Tim Geithner runs out of all of the maneuvers he may have learned from Bob Rubin back in 1995 and 1996, then, yeah, we could have a crisis that creates a crisis in the bond markets that forces the issue. But I don't see any kind of proactive addressing of it.

HAASS: Let me ask you then -- let me interrupt with one other question. You mentioned that you thought nothing would happen until 2013. If most people in your business are right, by then, you will have not just a Republican House --

STEPHANOPOULOS: (Inaudible.)

HAASS: -- but a Republican Senate.

Why do you think that then would set the stage? Imagine either way a second Obama term, a first term of -- with X Republican. How do you imagine that --

STEPHANOPOULOS: That is what I was imagining.

HAASS: Okay.

STEPHANOPOULOS: Twenty-three Democratic senators up in 2012, only 10 Republican senators up in 2012. Kent Conrad announced his retirement today. You could bet if you were going to bet that he'd be replaced by a Republican. Joe Lieberman is announcing his retirement likely tomorrow. A Democrat could win that, but that's a little more iffy.

But if you had to just look at the numbers, the fact that the Democrats are defending so many Senate seats in 2012, absent a massive, you know, landslide for Obama, it's -- the odds are that Republicans will take control of the Senate in 2012. That sets up conceivably a situation like what Ronald Reagan had in 1986. And you Reagan, Gephardt and Bradley come out for a big tax reform plan. That combined with what is more likely, the problem continues to get worse.

Both sides feel pressure to govern. You're in the early years of a second presidential term. The new Republican majorities will have more clearly shared responsibility because they're they don't have the Democratic Senate to blame anymore for inaction. That could set the table, and that's the optimistic scenario. Now, the question would be that, in January 2013, has the crisis come or not? And I defer to the economic experts in the room.

HAASS: The answer is none of the experts know when it's going to come. I think there is no consensus that if and when it does come, it could come quite quickly at that point, a little bit almost like a Malcolm Gladwell scenario that you reach a tipping point.

Then, Michael, let me turn it to you, which is -- we sort of have two scenarios. One is the United States proactively deals with this and sets ourselves again on a more responsible, sustainable trajectory; the other is more reactively, where markets react, we're forced to raise interest rates, so forth and so on.

What do you see as the foreign policy consequences under each?

MICHAEL MANDELBAUM: Well, I think the foreign policy consequences are more or less the same, whichever the scenario is. Whether we're on a gentle glide path downward or we fall off a cliff, at some point in response to some event, the United States will get serious about the deficit. And when that happens, contrary to the promises of the Republicans, taxes will rise. And, contrary to the promises of the Democrats, benefits, including Social Security and Medicare benefits, will be cut.

When that happens, we will be in a different political world. And in that political world -- and this is the premise of "The Frugal Superpower" -- foreign policy will be -- to use a term not entirely appropriate, but not entirely inappropriate -- "collateral damage." When people are paying more to the government and getting less form it, they will be less generous in funding the kind of of foreign policy that we have carried out, really, I would say in the lifetime of virtually everybody in this room.

I think that we are heading for a world in which, for the first time, just to pick a date at random since December 8th, 1941, how much things cost becomes a serious constraint on American foreign policy. It hasn't been irrelevant for the last 70 years, but, in comparative historical terms, it's been pretty modest. That will change because people simply won't support the kind of foreign policy that we have been accustomed to carrying out when they feel cash-strapped.

Now, there's one other point I want to make about them, and I can go into the specific changes that I anticipate and favor. But the general point -- and it's an important point for all of us -- I think, is this. The United States is the most important country in the world. And the United States, in my view, plays an extraordinarily constructive role in the world. The United States provides some of the services to the world that governments provide within the societies that they govern. The world functions as well as it does economically and in security terms -- not perfect, but not bad -- in no small part because of a very extensive American foreign policy, because of American economic and military commitments around the world.

When those are called into question -- and I think they will be -- that endangers not just the interests of the United States, but global peace and prosperity. This is a very big deal. And even countries that are extremely critical of one or another of America's foreign policies will find that the only thing worse from their point of view than an America that's too powerful is an America that's too weak.

HAASS: This could be the be-careful-what-you-wish-for here for -- I guess -- (inaudible) -- one short question of each of you before I open it up. And let me start with Roger.

How does the president deal with what appears to be something of a dilemma? We've got formal unemployment between 9 (percent) and 10 percent. We've got real unemployment that's probably 50 percent higher than that, somewhere at 15 or so percent?

How does he deal with what we-- with the need to get things going, increase employment and the like, stimulate the economy; and, at the same time, put the United States on a, if you will, quote, unquote, "responsible trajectory," and gradually start reducing the deficit? How does one deal with that? Is it a dilemma, which is a word that's overused? Or is there a way essentially to have our cake and eat it?

ALTMAN: Well, I think most economic and fiscal experts would answer that, Richard, by saying -- and I would -- that the United States has really had to date the right response to the economic and financial collapse of 2008 and 2009. We've had a -- by standards of other parts of the world, we've had a forceful response. We've had a large response, and we had a relatively quick response.

And even though we have a 9.4 percent unemployment rate and a 16.3 (percent) underemployment rate, and the outlook for the labor market remains very, very difficult, we pulled ourselves out of this quite skillfully. I think historians will ultimately judge it that -- judge it that way. And this country should get very high marks for how we -- how we -- how we've got -- carried ourselves through the last two years.

And the emphasis of policy for 2011 and 2012 really should be -- and George was pointing out how it's politically necessary, but it actually is the right policy also -- to continue in every possible way to incentivize growth, and try to thaw out the frozen labor markets.

But at the same time, you would put in place if you could wave a wand a framework for changing this dire deficits and debt path, which would take effect probably in 2013, not for -- not for presidential cycle reasons, but for where we would then be in the economic cycle, because at that point the argument would be the economy will have strengthened to the point where it could withstand the contractionary impacts of a large deficit reduction plan.

So if you could wave a wand the next two years, the focus would be on growth and labor markets, and then would take effect, not just be worked on then, but take effect then a long-term plan for reducing the deficit and debt outlook.

STEPHANOPOULOS: I think you want to start fitting that suit, but don't sew it on in the State of the Union.

HAASS: That was my next -- (inaudible). Okay. So imagine you have this that next -- in the short run, if you will, we continue to emphasize growth, stimulus of one sort or another, get big corporations to start spending down some of the cash they've accumulated, but essentially two years from now have the "more responsible," quote, unquote, trajectory kick in. To what extent -- how far does the president go next week?

STEPHANOPOULOS: I don't know how far he will go. I think that the first point has to be Roger's point. You can't do anything that puts the recovery at risk, and we have to continue to create more jobs in this country. The number one job of a president, keep the economy -- keep the economy growing. I think he can then make a nod towards the election, and in a sort of a -- it was the framework President Clinton used. There's a right way and a wrong way to deal with these things. You have to make the right investments in education, in energy, in infrastructure. And we can make cuts in places where government is no longer as efficient and effective as it once was. And I think he did make a nod to that in his Wall Street Journal op-ed about regulation today.

And then I think it's conceivable -- and this is going to be a slightly different State of the Union from the kind we've seen recently. I think it is very likely that Republicans and Democrats are going to be sitting together for the most part. They're not going to be in two opposing camps. I think that gives the president an opportunity to give what appears to be a less political speech, and will sound more like a conversation, and that he could put the discussion of the long-term deficit in the context of everyone working together. and that's what the country has demanded, putting it in a more political process context than in an economic context.

And you can talk about -- we all know there are things that we're going to have to do over the long term. We're going to have to live within our means. I think you can give a rhetorical nod to the Simpson-Bowles Commission without boring in too much on any of the specifics. I think he can talk about tax reform and -- he'll -- without -- and show a little bit more leg. He's already done some of that without getting into specifics.

I think he'll still argue that his health care plan is one of the answers to entitlement reform, but he can also make a nod to saying, "We're going to do more." But I think they're going to have to be fairly careful about getting locked into a specific proposal on any one of those three areas.

HAASS: Michael, I think I know the answer to this question, but let me ask you anyhow, which is, the last 10 years of American foreign policy has been dominated by two extremely expensive interventions, one in Iraq, one now in Afghanistan. Will this sort of pressure both accelerate the end, particularly of Afghanistan? But, more important, will this now -- is this the end of that phase of what we might call "discretionary American interventions?" Is this basically over?

MANDELBAUM: Let's call them wars of choice. (Laughter.)

HAASS: I was trying to be uncharacteristically self-effacing here. But clearly it didn't hold. Okay.

MANDELBAUM: I think it is, Richard. And I think that this period really goes back two decades. I think the wars or the interventions in Somalia, in Bosnia, in Kosovo, in Haiti belong with the interventions in Afghanistan and Iraq, although they were undertaken by different administrations for different reasons, and had different costs. But all of them ended up in the protracted, unexpected, unwanted and expensive task of nation building.

Nation building has never been popular. The country has never liked it. It likes it even less now. And I think we're not going to do it again. We're not going to do it because there won't be enough money. We're not going to do it because there will be other demands on the public purse. We won't do it because we'll be busy enough doing the things that I think ought to be done in foreign policy. And we won't do it because it will be clear to politicians that the range of legitimate choices that they have in foreign policy will have narrowed and will exclude interventions of that kind. So I believe and I say in the book that the last -- the first two post-Cold War decades can be seen as a single unit. And that unit has come to an end.

HAASS: With that, the questions from our members has come to a beginning. If people would wait for a microphone, let us know who you are, pretty much limit yourself to one relatively brief question, I would be forever grateful.

Carol, why don't we start with you?

And I'll also try to take some questions from our national members.

QUESTIONER: Carol O'Cleireacain, Brookings. I want to pick up on what you just said, and ask, so where does the war on terror go in such a scenario?

MANDELBAUM: The war on terror will be waged not by trying to transform the countries that harbor terrorists. And, incidentally, even if that were our aim, our biggest task would be Pakistan. And that's hopeless for a variety of reasons. The war on terror, I believe, will be waged by effective intelligence and police work and cruise missiles.

QUESTIONER: And that's expensive -- (off mic) --

MANDELBAUM: Not nearly as expensive as what we're doing in Afghanistan and in Iraq.

HAASS: Yeah, I would say much more the Somalias and Yemens will be the model for the future much more than the Afghanistans.

K.T. McFarland?

QUESTIONER: Hi. K.T. McFarland of Fox News, and a former student of yours, Professor Mandelbaum. If --

MANDELBAUM: Always good to see a former student gainfully employed. (Laughs, laughter.)

QUESTIONER: Thank you. If it's inevitable that we've got to leave Afghanistan and Iraq, and not going to have conflicts of this sort, should we just get out now?

MANDELBAUM: You're asking me?

QUESTIONER: Yeah.

MANDELBAUM: Well, it's okay with me to get out now. And I think we certainly should be on a glide path downward. I refer those of you who are interested to Bob Blackwill's article in the current Foreign Affairs. His argument is we should, in effect, partition the country. We should leave the Pashtun areas. We should hold onto Kabul and the non-Pashtun parts. And we can do that with a much smaller force.

I'm not -- there are downsides to leaving Afghanistan completely. Bob goes into them. It could be a civil war. You know, all of the gains that have been made, such as they are, would be reversed. So if you can achieve something on the cheap, I guess that that would be okay with me. But my problem with Afghanistan is that I don't think it's important. What happens in Afghanistan stays in Afghanistan. It doesn't -- it doesn't affect anything in which we have any interest. It's no better than the fourth most important country in that general part of the world after Pakistan, Iraq and Iran. And since as a general principle, I think we ought to be spending our resources on issues and interests that are most important, since Afghanistan comes at or near the bottom of the list, I'm not in favor of any spending anything there.

HAASS: Roger, one issue that hasn't come up is state and local. And one of the questions I would have for you at this point is whether that's a potential trigger. Whether it's Illinois, California, New York, New Jersey, is that something that could accelerate this scenario by which a triggering event happens?

ALTMAN: Before directly answering that, I just might point out that none of the ratios and data that I used on federal debt include, A, the roughly 9 trillion (dollars) of debt that the United States has guaranteed, but which is not a direct obligation of the United States; B, the debt of the GSEs, which is not -- which are not explicitly guaranteed, Fannie Mae and Freddie Mac, but which are implicitly guaranteed of course; and of course any possible severe fiscal problems that some -- any of our larger states might have, which at least theoretically could require the United States to stand behind them.

So you can argue that the picture that we talked about at the beginning here is actually worse than it looks. I don't think, Richard, that that's going to be the flash point.

And I don't think it is because I wouldn't expect any of the larger state and local borrowers to actually default -- larger, now; not talking about Harrisburg, Pennsylvania, or some entity like that. And even if it did, the -- it isn't clear to me that the United States would come to a full rescue -- you know, their debt is our debt. I think there'd be a lot of pressure not to do that. So while anything could trigger this off, I would be surprised if that would be it.

HAASS: Okay. I see a hand. Mr. Rubin (sp), yes.

QUESTIONER: My question is for anybody, Richard.

The rest of the world is acutely aware of our fiscal situation, as you all so effectively described it. How is that affecting the way they look at geopolitics -- I think Mike may be the closest to commenting on this -- geopolitics and their planning for the future? China, Pakistan, or anybody else that you'd like to comment on.

MANDELBAUM: Well, it's a good question. First of all, as a general proposition, it will have consequences across the board. That we know. We don't know exactly what they are. We know that people in Afghanistan are preparing for our withdrawal. I believe that the radical forces in the Middle East, although they don't need much encouragement, are somewhat -- have been somewhat more aggressive as they see America turning inward and weakening.

And the most important place where one might see this -- and I don't know that this is the case, but I think there's some evidence -- is the Chinese policy has changed somewhat in the last two years, since -- perhaps it's a coincidence -- around September 15th, 2008. The Chinese are no longer the good followers, the people who keep their head down. There's a whole list of initiatives the Chinese have taken that individually don't -- may not represent anything frightening, but collectively suggest a change of course, a much more assertive policy. It's hard not to connect that with their perception of the United States.

And one thing -- and there are a lot of things we don't know about China, but one thing we know is that they keep a very close eye on us. They gear their policies to us. So I would -- I would suggest that there's at least some evidence that the other most important country in the world is behaving more in ways that we don't welcome because of the financial crisis and the recession and the anticipated consequences down the road.

HAASS: The gentleman in the back with the blue shirt.

QUESTIONER: Matthew Lee, with Inner City Press. I wanted to know, I guess, what you think -- how you think this -- how the deficit will impact the U.S. participation in the United Nations and its peacekeeping operations. I mean, there was a debate today in the Security Council about Sudan. There was talk about debt relief for south Sudan or north Sudan. You know, and just -- Professor Mandelbaum, you talked about the relative importance of countries. Do you see Africa, or any country in Africa -- maybe Somalia -- as being, you know, on your -- on your top 10 -- even top-10 list? Thanks a lot.

MANDELBAUM: No, it's not in the top 50, maybe not in the top hundred.

As for -- I mean, you -- now we're in a whole -- when the word "U.N." is mentioned, as Richard knows well -- (chuckles, soft laughter) -- we're in a different -- a different world. To be, I hope, not unkind, or flip, but in the interest of time, the American contribution to U.N. peacekeeping forces is a rounding error in the budget. Whether it stays or goes, we're not going to notice. The real money is in the American defense budget. The American defense budget, with all due respect to our friends at Turtle Bay, is far more important for global stability than anything that the U.N. does. That's where the action is, and that's what's important.

HAASS: I would just make the point that one area, though, of the U.S. budget which, while small, is vulnerable would be non-defense spending in the international arena. And various aspects of foreign assistance and the like are, I think, going to come under tremendous pressure, just because --

STEPHANOPOULOS: I think that's true, except I've actually been surprised in the last few years how little pressure it's been under, given how much -- how big the overall debt problem is.

HAASS: Well, hope you're right.

Sure. Fine.

QUESTIONER: What is the --

HAASS: Wait a second for the phone -- mic.

QUESTIONER: What's the future of the euro, and how will it affect the dollar and our financial problems?

HAASS: Roger, why don't you take that on, and particularly the question also about -- related to it, which is, how has the euro's weakness perhaps bought us more time here?

ALTMAN: Well, the biggest question vis-a-vis the euro right now, of course, is whether the euro zone as a whole will remain intact, or whether the sovereign debt crises that are afflicting, as I said, Greece, Ireland, Portugal, and may afflict others, will somehow break it up.

You never say never, of course, but it seems to me the euro zone will remain intact, because the costs of breaking it up at various levels are so high. For example, in the case of Germany, which is of course the strong -- economically strongest country and financially strongest country, if the euro zone were to break up and the Deutschmark somehow return, the Deutschmark would inevitably strengthen, much to the detriment of Germans -- Germany -- of the German exports and the overall German economy. I could go on down the list as to why that's unlikely, including the sheer out-of-pocket costs and the amount of time it would take to return to the status quo ante, pre-euro.

Now, short term, the actual trading value of the euro: So often in recent years, very learned analyses -- for example, from the Peterson Institute in Washington -- have quite correctly theorized that the size of our external imbalances should lead to a weaker dollar. And in general, the dollar has not been as weak as the theories have suggested it would be. For example, over the past year -- Bob, you might correct me -- I think it's down to about 6 percent on a trade-weighted basis, not -- and a year ago, a lot of people would have said it would be weaker than that.

But, of course, the dollar has long had a safe-haven nature, and the type of crises that have coursed through Europe -- sovereign debt crises -- have not just caused the dollar to strengthen on a day-to-day trading basis versus the euro, but the safe-haven character of the dollar has asserted itself again. But in any event, what might have been a weaker dollar under different circumstances has not, at least so far, materialized.

Maybe, Richard, some day, if we don't proactively address this problem and the financial markets address it for us, that will first begin -- that chain reaction will first begin as it did in '79, through the exchange markets in the dollar. But maybe it won't. There are so many different ways that we've seen in the last 20, 25 years crises arise, and each one seems to come from a different angle than the last one. It's impossible to judge how that might first start.

HAASS: Sir?

QUESTIONER: Steve Tananbaum from GoldenTree. Roger, you start saying if we keep on the current policies, the market is going to cause us to change our ways. Yet Japan is pretty much further down, yet the market has not disciplined them.

Why do you think that's so?

ALTMAN: Well, many people would challenge the premise of your question to the effect that Japan is -- in effect, Japan's fiscal condition is worse than ours.

QUESTIONER: Well, if you look at debt to -- (off mic) --

ALTMAN: Yes. Yes. But if you look at -- and you could argue this either way. But if you -- but -- you can argue it's a more indebted country than the United States because, of course, its federal debt to its -- the size of its economy is worse than ours, as you're suggesting. You're right. On the other hand, if you look at the savings rate in Japan and the percentage of Japan's debt that is held outside the country, it's a very different picture.

In contrast to your premise, many argue that Japan's debt is financed internally, not externally like ours is; and, therefore, the degree to which global financial markets would have an incentive to discipline Japan is very low because Japan's debts in effect to the rest of the world are very small.

Now, you can look at that a lot of different ways. But I think, in general, because of the contrasts between Japan and the United States in terms of a very low level of the Americans' saving rate -- even though it's ticked up a little bit recently -- and the degree to which we are financing so much of our deficits externally -- I mean, I've seen estimates at seven (hundred billion dollars) to 900 billion (dollars) a year in the last three to four years is being added to the store of dollar-denominated liabilities held overseas; obviously, China is a big participant in that -- I think the two situations are actually quite different.

HAASS: George, let me just go back to a political question, which is, can you imagine a politician standing up and talking about these issues like we are a little bit, and essentially thriving -- (laughter) -- as opposed to stepping on the proverbial third rail?

STEPHANOPOULOS: I think it depends on which level of politician. I think members of Congress can do it; I think Paul Ryan you see of Wisconsin. Although, he leaves out taxes in his plan. I think, you know, one of the encouraging things you've seen -- you talk about the Simpson-Bowles commission. I think there was a little more crossover and support for that menu of proposals than I expected. You had, you know, senior, kind of party Democrats like Dick Durbin coming out and supporting it. You had Republicans like Tom Coburn coming out and supporting it, even though it did include some talk of tax increases.

So, yeah, I mean, I think, it's hard for a president in an election year. It is impossible for a challenger to a president in an election year. But, below that, yeah, I think you see a lot of ferment and not only the Simpson-Bowles commission, but you're seeing -- you know, I think, the fact that, you know, people like Roger have written about at a VAT, the Center for American Progress has written about VAT on the Democratic side, you've started to see more ideas bubbling on the Republican side. I think those will bubble up, but just not at the top level yet.

ALTMAN: And, George, if I could just ask a question following up Richard's, I think the distinction between what national leaders can do or a president can do in the way Richard asked about it, and what some governors seem to be doing right now is a really interesting distinction. Some governors seem to be deciding our problem is so bad, it's both the right thing to do and maybe the politically smart thing to do to tell it like it is.

So Governor Cuomo in New York has come in, you know, in a very tough way in this regard, and Governor Christie of New Jersey and others around the country basically saying, "Folks, things are really, really bad. There's no easy, sugar-coating solution, and this is what we're going to have to -- (inaudible)."

STEPHANOPOULOS: Well, and, on the other side in Illinois, you know, 60 percent tax increase.

ALTMAN: Yeah, well, we'll see how that plays. But the question is, you know, you can argue that some governors, especially new ones, are deciding, "Not only do I need to fix it, but I could actually benefit. I could advantage myself by delivering -- by talking straight about it."

And my question is -

STEPHANOPOULOS: Well, I think the talking straight, I completely agree with. I mean -- I mean, we're at the beginning of their budget cycles right now. We'll end up seeing how much they actually get through. They're also -- a lot of the governors actually face requirements where they have to balance their budgets, so it's a very different situation.

But, yeah, I do think there's a -- I think there's no question that people want to hear politicians talking about these issues in what is perceived to be a straightforward manner. I just think there's less evidence that they -- the country actually wants the politicians to follow through on those promises.

HAASS: Do you think that what happens in Britain -- there you've got a government that has gone on a fairly, by our -- by our terms, drastic path, serious spending cuts, probably -- what -- $4 or whatever of spending cuts for every dollar of tax increases. Do you think that will have any impact on here, like, the debt, the British experiment, if you will?

STEPHANOPOULOS: How long does the government survive? I mean, the liberals are in trouble.

HAASS: Well, how well does the economy survive?

STEPHANOPOULOS: Yeah.

HAASS: Do you think -- do you imagine that experiment going on in Britain will have repercussions here?

ALTMAN: If it fails, we will take note of it. If it succeeds, we probably won't. That's right.

MR. : That's right.

ALTMAN: The British government has a rather smaller borrowing capacity than the American government does. So they don't have the short-term choices that we do. But it is interesting. They are running an experiment. And I take it that the economic theory behind their policy is that if they have a serious deficit reduction program, that will inspire such confidence there will be an outbreak of euphoria in the British economy, in the European economy, and that will make up for the gap in their consumption. Let's hope it works. But as George says, the government could fall.

HAASS: There's always that. Sure.

QUESTIONER: Sy Jacobs, Jacobs Asset Management. The question's for Roger. Given that you feel that the world doesn't have 10 years of patience and appetite for trillion-dollar-a-year deficits, is it reckless or is it brilliant that the central bank of that trillion-dollar-deficit country is -- has committed to buying $2 trillion of that country's paper?

ALTMAN: I have no quarrel with the quantitative easing approach that the Federal Reserve has taken. It's part of the point I made a little bit earlier about how I believe history will judge the United States, including our central bank, as having responded very effectively to what was really civilization-threatening events of, you know, the fall of '08 through early '09.

And I think a lot of the debate about the second round of quantitative easing, so-called QE2, is a little bit strange, because I really believe the Federal Reserve's main motivation was to try to provide an extra incentive for growth and labor markets. Remember, the mandate of the Federal Reserve is both price stability and full employment.

And I don't think it was, you know, a sneaky way to try to lower the value of the dollar, even though it was interpreted that way internationally in so many quarters.

So I don't think the Federal Reserve has overstepped its bounds or acted imprudently at all. And I might add that -- I'm not a monetary historian, but quantitative easing is actually a rather traditional monetary exercise. There's nothing new about it. There's nothing original about it. There's nothing infrequent about it in the modern monetary history of, you know, the industrialized world.

HAASS: Charlie Wolf From RAND asked a question about how -- what all this means for trends in American power. So let me ask the question directly -- I'll make it the last question -- which is, does this inevitably contribute to the relative decline -- not the absolute decline but where we are -- does this inevitably contribute to the relative decline of the United States, that we are essentially in this predicament and that we are going to be forced to do things that will limit the resources that are available for our role in the world and that essentially we will occupy less of a space consequently?

Michael.

MANDELBAUM: Well, I'm glad you asked that question. (Laughter.) And I want to commend you, Richard, and the council, for making the 90th anniversary project looking at the domestic sources of American power, because I think that is really the crucial issue for the next decade. And I'm so committed to that proposition, that I am writing a book about that subject with my friend Tom Friedman of the New York Times.

And there's good news and bad news. The good news is, we can deal with these problems. We know how to do it. We've done it before. The bad news is that the problem we've been discussing today, tonight, is only one of the problems. There are three others. And I think if we can get our act together and deal with the deficit and with the other problems, we will remain the most powerful country in the world and the global leader even with the rise of China and India because our values are in alignment with what most countries want and because most countries appreciate at some level the kind of leadership that we provide. I think our soft power is still intact.

But you've got to have hard power to back it up, and that depends on what we do. And when I think about this problem -- and incidentally, I don't see anybody else replacing us. I don't see us getting any help from the Europeans and the Japanese who have problems of their own. I don't see -- I see the Chinese possibly making trouble but not shouldering us aside and being the global leader or even the unchallenged leader of East Asia. So it's either us or nobody. And nobody is a lot worse than us.

What are the prospects? We've been talking about that, but when I think about this question -- and this is -- this is the major question that we as a country face -- I think about a saying that I first heard attributed to Abba Eban, the former Israeli foreign minister who once said, men and nations -- should have said "men and women and nations" -- will always do the right thing when all other alternatives have been exhausted. (Laughter.)

Well, we're running out of alternatives.

HAASS: Well, that was also a version of Churchill's comment about American democracy and the danger -- going back to where we began this conversation, if that's true, while we're going through doing some of the wrong things or not yet prepared to do the right thing, events may intervene. And we may not essentially be able to write the script in ways that will work out.

You've actually, though, come off fairly optimistic.

STEPHANOPOULOS: In the end, I think so. And we have -- we have -- we've been through these crises before. I think that we -- I agree with Roger that history, I think, is going to look back at the way, actually, both presidents in the end dealt with the financial crisis in 2008 and 2010 and say they did the right thing at a difficult time. And I do think that we're going to solve this in the next couple of years because we're going to have to.

ALTMAN: Hey Richard, you know, we've done some good things here tonight, one of which, obviously, is to give George all the briefing material he needs for his discussion tomorrow morning with Joan Rivers. (Laughter.)

STEPHANOPOULOS: She's great on the euro. (Laughter.)

MANDELBAUM: But more pessimistic than you are. (Laughter.)

HAASS: From that, well, we hope you've enjoyed the red carpet here tonight -- (laughter) -- and let me thank these three friends for starting what I hope really will be an extended and a thoughtful discussion throughout this year and beyond on the domestic challenges that really are so much now at the heart of what the United States does in the world. It may seem to be an odd place for the Council on Foreign relations to end up, but I think that tells you something. And I think this reinforces my sense that we've ended up in the right place.

Let me thank you all for getting us off to such a good start. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

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RICHARD N. HAASS: Welcome to the Council on Foreign Relations. For many of you, I expect it's the first time back this year. so happy new year while we're at it.

Every year is a special year at the Council on Foreign Relations. But this year is more special than usual, we'd like to think, because it's our 90th anniversary. And what we've decided to do somewhat in a contrarian fashion is to dedicate -- a significant amount of our effort this 90th year are to policy questions that are more normally thought of as domestic rather than foreign, whether it's questions of infrastructure, questions of K through 12 education, various aspects of immigration policy, of regulatory policy, and the subject tonight of deficit and debt on the obvious -- based on the obvious thinking that our ability to act in the world, our ability to lead in the world, our ability to present the positive model to the world will in no small part depend upon what takes place here at home in the United States. And we begin with the assessment that our house in many ways is not in order, and a principle challenge to the United States is to take care of that, and to put its domestic house in order.

And tonight's meeting is focused on one of the most difficult if not the most difficult aspect of all of that, which is the question of the deficit and the debt.

The way we're going to talk about it is with three extraordinarily informed gentlemen. George Stephanopoulos you all know from his time in government, but also now as ABC's chief political correspondent, and, for those of you who are morning people, is the anchor of "Good Morning America." And one of the things we like to do, by the way, at the council is end meetings on time. And tonight we have a double reason to do it because George is to go straight from here to bed. (Scattered laughter.)

GEORGE STEPHANOPOULOS: I've got a very important interview with Joan Rivers tomorrow morning. (Laughter.)

HAASS: That's good. (Laughter.) I've learned not to say everything that pops into my mind. (Laughter.) This does show the possibility of progress. But can we talk?

Michael Mandelbaum is one of this country's leading thinkers and writers about American foreign policy. He directs the American Foreign Policy Program at Johns Hopkins School of Advanced International Studies where he's the Christian Herter professor of American foreign policy. And, most recently, he is the author of "The Frugal Superpower: America's Global Leadership in a Cash-Strapped Era," which is on sale tonight so Michael is not cash-strapped.

And last but not least is Roger Altman. Roger was deputy secretary of the Treasury under President Clinton, and he is now chair and CEO of Evercore Partners.

One or two administrative things, none of which will -- come as a surprise to please turn off your electronic devices. And we have quite a few people listening on the phone tonight, so the signals really will muck it up.

This meeting is on the record, so anything said can and will be used against you.

There will be national members. There are national members listening in. And, indeed, I may take a few questions from them if I can figure out how to use the iPad.

The -- what we're going to do is I'm going to ask some questions to start off, and then I'm going to try to reserve a good chunk of the time for you all to have questions. What I -- what I thought I'd do is begin with Roger, then migrate to George, then migrate to Michael, and essentially begin with the question to ask Roger to set the stage, which is about the scale of the deficit and debt, a little bit about how we got to this point, and just some basic -- his sense of what we may want to do about it, essentially to provide the baseline of the challenge that we are dealing with tonight.

So you can ignore what I just said, Roger, and say whatever you'd like.

ROGER C. ALTMAN: Well, three or four months ago, Richard briefly lowered his usually high standards, and co-authored a piece with me in Foreign Affairs on the U.S. deficit and debt path and the global consequences of that. And so I'm going to give a very short beginning summary, so to speak, of what we said, and update it for some important things, which have happened since then. And I might say at the beginning it's timely to have this discussion not just because of the council anniversary, of course, but because in about a week, President Obama will deliver of course his State of the Union address. And in one form or another, there will be references to this difficult deficit and debt outlook. And so I'm going to make a comment or two about how he may or may not address it.

But just to start with, the headlines of the past two months have temporarily clouded how truly dire the U.S. fiscal outlook and debt outlook is. And by headlines, I mean, of course, the Republican election sweep in November, the surprisingly productive lame-duck congressional session, the tragic events in Arizona and other developments. And as an example of that obscuring the very good and very emphatic recommendations, which the Bowles-Simpson Commission delivered only on December the 1st -- after all, that was a commission that President Obama and the congressional leadership put together on the budget outlook, -- have largely been forgotten, at least for the moment, despite their really being quite important. And I'm sure they will come back.

But despite these intervening headlines, the fiscal outlook, which already was very threatening, actually has worsened a bit in the past couple of months. And that's because while on the one hand there is some improvement in the -- in the economic growth outlook for 2011 and 2012, and the latest forecasts reflect that, the tax agreements struck during the lame-duck session and the revenue consequences of the tax agreements actually more than offset that improved growth outlook. And so the deficit outlook and the related debt outlook -- remember the federal debt is really just a dollar-for-dollar consequence of the deficits -- has actually worsened in the past two or three months.

Now, let's spend a minute on how bad that outlook really is. And I'm going to refer primarily to the most recent Congressional Budget Office forecast. You all know the Congressional Budget Office is nonpartisan. It's really quite widely respected. It's most recent forecast is a few months out of date, but my research suggests that the updated one, which will come out in a few weeks, will not be terribly different.

And what we're looking at, at least based on current policy is cumulative deficits between nine (trillion dollars) and $10 trillion over the next 10 years. And the federal debt, which I should say has tripled or virtually tripled in the last 10 years from its roughly historical long-term average of about 35 percent of GDP to a current level of 65 percent, is projected to reach, by the CBO, 90 percent by 2020 and, by the IMF, actually, 115 percent.

To put those in context, with the brief exception of the peak years of World War II, we have never had a debt-to-GDP relationship of that level in the history of the United States since record keeping began in 1792. And those levels, 90 (percent) to 100 percent of GDP, are typically associated with countries, for example, today, like Italy and Greece. And, as I said a minute ago, we would reach those levels within just nine years.

And the credit rating of the United States if we do actually get from here to 90 (percent) to 100 percent of GDP in the form of federal debt, will certainly be lowered, and there are some forecasts around that suggest it will be lowered quite considerably.

Now, let me try to spend a minute on what it would mean to have debt in that amount. It would mean that federal -- the interest expense, which the federal government was paying would rise from today's 1 percent of GDP to about 4 percent. But in more practical terms, the total interest expense of the United States government would exceed all of domestic discretionary spending. In other words, it would exceed the total each year that we today spend on infrastructure, on energy, on agriculture and on education. And it would be approximately equal to the amount that we spend on defense.

In addition, the United States would be borrowing at that time -- this is 2020, this is not way off -- approximately $5 trillion a year. It was just a few years ago, about 10 years ago, that the entire budget of the United States was $5 trillion. Maybe a little further back than 10, but not many years. I can see Bob Rubin rolling his eyes, saying, I think it's further back than that. In any event, it wasn't a long time ago when the entire federal budget deficit -- federal budget, total budget -- was 5 trillion (dollars).

Now, the thesis that Richard and I expounded in our piece was that, actually, the United States would not be allowed to go from where we are today in 2011, beginning of 2011, to that much debt in 2020. We wouldn't actually get there. Either we would address this in the right way, proactively by our nation's leaders through a deficit reduction agreement of the type, for example, we saw at Andrews Air Force Base in 1990 under President George H.W. Bush, or perhaps the type that we saw -- George and I were both very involved in this -- in 1993 under President Clinton. In other words, address it proactively or it will be done the ugly way: namely, that the global financial markets at some point between now and 2020 and before we reach that much debt will revolt and impose a solution on the United States.

Now, I know there are a lot of people who think, yes, I know that there have been sovereign debt crises in Ireland recently, and in Greece, and looking back over history, the U.K., Mexico, Russia, Argentina, but that can't happen to the United States. We're the world's largest economy, our currency is the reserve currency of the world and so forth.

Well, it's instructive in that context to look at the events of 1979. I was serving in the Treasury then, during my first my tour of duty, and that was the era of stagflation, of the Iranian oil embargo, and of course President Carter. And during the early months of 1979 -- I'm sorry, during the lead up to 1979, the dollar had been wobbly and generally declining. And then President Carter submitted his budget, which included a larger than expected deficit. By today's standards, it was minuscule, but it was large by the standards of 1979.

That was the last straw for the financial markets. The dollar crashed. All global markets plunged -- fixed income markets, equity markets, currency markets, commodity markets -- and a true global emergency ensued. And the key nations of the world, the industrialized world, got together overnight and put together a coordinated international rescue of the dollar. But the contributions which the United States had to make to that were, one, to cut in half its budget deficit within one week, and for the Federal Reserve to raise interest rates very sharply at a time when that was not the general direction that the Federal Reserve had been headed into. All of that happened in one week.

Now, if we don't address this proactively, it will be in our judgment addressed by the global financial markets, and unfortunately if that happens, it will be a replay of 1979, but of course, on a much bigger scale. But the main point is it will happen with very little warning. The, quote, "solution" will be very ugly and punitive; for example, across-the-board spending cuts. There won't be time to do any kind of real budget, tax surcharges, there won't be any time to do any true tax policy. And it will be solved that way.

If it is solved in the latter way, that will usher in an age of profound austerity in this country, and that in turn -- I mean, as an example, all categories of domestic spending would be cut in an across-the-board fashion; nothing would be spared, entitlements and so forth. Taxes on all -- virtually all individuals and businesses would be raised, probably, as I say, through some surcharge approach. And we would enter into an age of austerity of the type we haven't seen in this country for -- well, since the 1930s.

Now, as Richard and I argued in this piece, the global consequences of that, the consequences for the American -- for the global platform of the United States and the consequences for world coherence and world stability, as no one is likely to step into the role the United States will be pulling back from, would be particularly profound. And on that note, I'm going to stop and turn it back to you, Richard.

HAASS: Did I say Happy New Year? (Scattered laughter.) Just wanted to make sure I covered all of our bases here. By the way, when Roger and I wrote the article, he was the optimistic member of the team, just to give you a sense of perspective here.

We'll get in a few minutes to what we -- well, implicit in Roger's argument is obviously the United States needs to embark on a fairly steep path of dealing with the deficit, somewhere 250 (billion dollars), $300 billion a year of the deficit need to be reduced through some combination of increased revenues, either from growth or taxation or decreased spending.

So let me turn to George for a second. Could you imagine any scenario where policymaking and decision-making of that scale could come about?

STEPHANOPOULOS: Not before January 2013, certainly not. I mean, nothing -- I agree with Roger's analysis, I should say. But if you just look at the current lineup over the next two years with a election, presidential election coming next year, it's inconceivable to me absent a forcing crisis that Congress and the White House can work on this. I mean, if you just look at -- you talk about the surprisingly productive lame duck session. They did all the easy stuff. They cut taxes. The budget was not -- they just punted on the budget for last year.

Fundamental to the president, to the White House is that they cannot break his key campaign promise, which was not to raise any taxes on middle-class Americans. He flirted with it, some would say he broke it during the health care debate, and they can't do anything or propose anything that has any hint of a tax increase on middle-income Americans. So that knocks out a lot of solutions right there.

As much as Republicans talked about spending debt and deficits in the mid-term elections, I think all of the leadership on the Republican side has completely gone to school on the Newt Gingrich experience of 1995 and 1996 and realize that what a reelected -- in their minds -- President Clinton caused so much heartache for Republicans during the government shutdown was the commitment to cut Medicare. And that that cost them whatever advantage they had coming out of the 1994 election.

So as much as they talk about cutting spending, their leadership is not going to do anything that touches what is at the heart of most of the spending problems. So I don't see anything happening between now and the presidential election.

HAASS: Before you go on, let me just -- can I interrupt for one second? One event, though, that will happen long before that will be the raising of the federal debt limit.

STEPHANOPOULOS: Yeah, and --

HAASS: (Inaudible) -- just for those of you who haven't followed, sometime this spring the United States is going to need to act March, April, May. There's a $14.3 trillion ceiling on our debt, and we're going to have to raise that, or we're going to have not take on any more debt at that point -- (inaudible) --

STEPHANOPOULOS: And there's an awful lot of pressure from Republican presidential candidates, from tea party candidates who just got elected to not vote to raise the debt limit absent any kind of serious spending reductions. But I think there they're going to be talking about some cuts in domestic discretionary spending, maybe some budget process issues like, you know, coming out for a balanced budget amendment again. Even on the -- the Republican leadership started out with a rock-hard promise in the midterm elections to cut $100 billion in spending this year. That promise as far as I can tell is down to about $30 billion right now, and they may not even get there.

So even if that -- I think that could create a crisis and that could create the kind of crisis that Roger is talking about if because of the stalemate the debt limit is not extended and Tim Geithner runs out of all of the maneuvers he may have learned from Bob Rubin back in 1995 and 1996, then, yeah, we could have a crisis that creates a crisis in the bond markets that forces the issue. But I don't see any kind of proactive addressing of it.

HAASS: Let me ask you then -- let me interrupt with one other question. You mentioned that you thought nothing would happen until 2013. If most people in your business are right, by then, you will have not just a Republican House --

STEPHANOPOULOS: (Inaudible.)

HAASS: -- but a Republican Senate.

Why do you think that then would set the stage? Imagine either way a second Obama term, a first term of -- with X Republican. How do you imagine that --

STEPHANOPOULOS: That is what I was imagining.

HAASS: Okay.

STEPHANOPOULOS: Twenty-three Democratic senators up in 2012, only 10 Republican senators up in 2012. Kent Conrad announced his retirement today. You could bet if you were going to bet that he'd be replaced by a Republican. Joe Lieberman is announcing his retirement likely tomorrow. A Democrat could win that, but that's a little more iffy.

But if you had to just look at the numbers, the fact that the Democrats are defending so many Senate seats in 2012, absent a massive, you know, landslide for Obama, it's -- the odds are that Republicans will take control of the Senate in 2012. That sets up conceivably a situation like what Ronald Reagan had in 1986. And you Reagan, Gephardt and Bradley come out for a big tax reform plan. That combined with what is more likely, the problem continues to get worse.

Both sides feel pressure to govern. You're in the early years of a second presidential term. The new Republican majorities will have more clearly shared responsibility because they're they don't have the Democratic Senate to blame anymore for inaction. That could set the table, and that's the optimistic scenario. Now, the question would be that, in January 2013, has the crisis come or not? And I defer to the economic experts in the room.

HAASS: The answer is none of the experts know when it's going to come. I think there is no consensus that if and when it does come, it could come quite quickly at that point, a little bit almost like a Malcolm Gladwell scenario that you reach a tipping point.

Then, Michael, let me turn it to you, which is -- we sort of have two scenarios. One is the United States proactively deals with this and sets ourselves again on a more responsible, sustainable trajectory; the other is more reactively, where markets react, we're forced to raise interest rates, so forth and so on.

What do you see as the foreign policy consequences under each?

MICHAEL MANDELBAUM: Well, I think the foreign policy consequences are more or less the same, whichever the scenario is. Whether we're on a gentle glide path downward or we fall off a cliff, at some point in response to some event, the United States will get serious about the deficit. And when that happens, contrary to the promises of the Republicans, taxes will rise. And, contrary to the promises of the Democrats, benefits, including Social Security and Medicare benefits, will be cut.

When that happens, we will be in a different political world. And in that political world -- and this is the premise of "The Frugal Superpower" -- foreign policy will be -- to use a term not entirely appropriate, but not entirely inappropriate -- "collateral damage." When people are paying more to the government and getting less form it, they will be less generous in funding the kind of of foreign policy that we have carried out, really, I would say in the lifetime of virtually everybody in this room.

I think that we are heading for a world in which, for the first time, just to pick a date at random since December 8th, 1941, how much things cost becomes a serious constraint on American foreign policy. It hasn't been irrelevant for the last 70 years, but, in comparative historical terms, it's been pretty modest. That will change because people simply won't support the kind of foreign policy that we have been accustomed to carrying out when they feel cash-strapped.

Now, there's one other point I want to make about them, and I can go into the specific changes that I anticipate and favor. But the general point -- and it's an important point for all of us -- I think, is this. The United States is the most important country in the world. And the United States, in my view, plays an extraordinarily constructive role in the world. The United States provides some of the services to the world that governments provide within the societies that they govern. The world functions as well as it does economically and in security terms -- not perfect, but not bad -- in no small part because of a very extensive American foreign policy, because of American economic and military commitments around the world.

When those are called into question -- and I think they will be -- that endangers not just the interests of the United States, but global peace and prosperity. This is a very big deal. And even countries that are extremely critical of one or another of America's foreign policies will find that the only thing worse from their point of view than an America that's too powerful is an America that's too weak.

HAASS: This could be the be-careful-what-you-wish-for here for -- I guess -- (inaudible) -- one short question of each of you before I open it up. And let me start with Roger.

How does the president deal with what appears to be something of a dilemma? We've got formal unemployment between 9 (percent) and 10 percent. We've got real unemployment that's probably 50 percent higher than that, somewhere at 15 or so percent?

How does he deal with what we-- with the need to get things going, increase employment and the like, stimulate the economy; and, at the same time, put the United States on a, if you will, quote, unquote, "responsible trajectory," and gradually start reducing the deficit? How does one deal with that? Is it a dilemma, which is a word that's overused? Or is there a way essentially to have our cake and eat it?

ALTMAN: Well, I think most economic and fiscal experts would answer that, Richard, by saying -- and I would -- that the United States has really had to date the right response to the economic and financial collapse of 2008 and 2009. We've had a -- by standards of other parts of the world, we've had a forceful response. We've had a large response, and we had a relatively quick response.

And even though we have a 9.4 percent unemployment rate and a 16.3 (percent) underemployment rate, and the outlook for the labor market remains very, very difficult, we pulled ourselves out of this quite skillfully. I think historians will ultimately judge it that -- judge it that way. And this country should get very high marks for how we -- how we -- how we've got -- carried ourselves through the last two years.

And the emphasis of policy for 2011 and 2012 really should be -- and George was pointing out how it's politically necessary, but it actually is the right policy also -- to continue in every possible way to incentivize growth, and try to thaw out the frozen labor markets.

But at the same time, you would put in place if you could wave a wand a framework for changing this dire deficits and debt path, which would take effect probably in 2013, not for -- not for presidential cycle reasons, but for where we would then be in the economic cycle, because at that point the argument would be the economy will have strengthened to the point where it could withstand the contractionary impacts of a large deficit reduction plan.

So if you could wave a wand the next two years, the focus would be on growth and labor markets, and then would take effect, not just be worked on then, but take effect then a long-term plan for reducing the deficit and debt outlook.

STEPHANOPOULOS: I think you want to start fitting that suit, but don't sew it on in the State of the Union.

HAASS: That was my next -- (inaudible). Okay. So imagine you have this that next -- in the short run, if you will, we continue to emphasize growth, stimulus of one sort or another, get big corporations to start spending down some of the cash they've accumulated, but essentially two years from now have the "more responsible," quote, unquote, trajectory kick in. To what extent -- how far does the president go next week?

STEPHANOPOULOS: I don't know how far he will go. I think that the first point has to be Roger's point. You can't do anything that puts the recovery at risk, and we have to continue to create more jobs in this country. The number one job of a president, keep the economy -- keep the economy growing. I think he can then make a nod towards the election, and in a sort of a -- it was the framework President Clinton used. There's a right way and a wrong way to deal with these things. You have to make the right investments in education, in energy, in infrastructure. And we can make cuts in places where government is no longer as efficient and effective as it once was. And I think he did make a nod to that in his Wall Street Journal op-ed about regulation today.

And then I think it's conceivable -- and this is going to be a slightly different State of the Union from the kind we've seen recently. I think it is very likely that Republicans and Democrats are going to be sitting together for the most part. They're not going to be in two opposing camps. I think that gives the president an opportunity to give what appears to be a less political speech, and will sound more like a conversation, and that he could put the discussion of the long-term deficit in the context of everyone working together. and that's what the country has demanded, putting it in a more political process context than in an economic context.

And you can talk about -- we all know there are things that we're going to have to do over the long term. We're going to have to live within our means. I think you can give a rhetorical nod to the Simpson-Bowles Commission without boring in too much on any of the specifics. I think he can talk about tax reform and -- he'll -- without -- and show a little bit more leg. He's already done some of that without getting into specifics.

I think he'll still argue that his health care plan is one of the answers to entitlement reform, but he can also make a nod to saying, "We're going to do more." But I think they're going to have to be fairly careful about getting locked into a specific proposal on any one of those three areas.

HAASS: Michael, I think I know the answer to this question, but let me ask you anyhow, which is, the last 10 years of American foreign policy has been dominated by two extremely expensive interventions, one in Iraq, one now in Afghanistan. Will this sort of pressure both accelerate the end, particularly of Afghanistan? But, more important, will this now -- is this the end of that phase of what we might call "discretionary American interventions?" Is this basically over?

MANDELBAUM: Let's call them wars of choice. (Laughter.)

HAASS: I was trying to be uncharacteristically self-effacing here. But clearly it didn't hold. Okay.

MANDELBAUM: I think it is, Richard. And I think that this period really goes back two decades. I think the wars or the interventions in Somalia, in Bosnia, in Kosovo, in Haiti belong with the interventions in Afghanistan and Iraq, although they were undertaken by different administrations for different reasons, and had different costs. But all of them ended up in the protracted, unexpected, unwanted and expensive task of nation building.

Nation building has never been popular. The country has never liked it. It likes it even less now. And I think we're not going to do it again. We're not going to do it because there won't be enough money. We're not going to do it because there will be other demands on the public purse. We won't do it because we'll be busy enough doing the things that I think ought to be done in foreign policy. And we won't do it because it will be clear to politicians that the range of legitimate choices that they have in foreign policy will have narrowed and will exclude interventions of that kind. So I believe and I say in the book that the last -- the first two post-Cold War decades can be seen as a single unit. And that unit has come to an end.

HAASS: With that, the questions from our members has come to a beginning. If people would wait for a microphone, let us know who you are, pretty much limit yourself to one relatively brief question, I would be forever grateful.

Carol, why don't we start with you?

And I'll also try to take some questions from our national members.

QUESTIONER: Carol O'Cleireacain, Brookings. I want to pick up on what you just said, and ask, so where does the war on terror go in such a scenario?

MANDELBAUM: The war on terror will be waged not by trying to transform the countries that harbor terrorists. And, incidentally, even if that were our aim, our biggest task would be Pakistan. And that's hopeless for a variety of reasons. The war on terror, I believe, will be waged by effective intelligence and police work and cruise missiles.

QUESTIONER: And that's expensive -- (off mic) --

MANDELBAUM: Not nearly as expensive as what we're doing in Afghanistan and in Iraq.

HAASS: Yeah, I would say much more the Somalias and Yemens will be the model for the future much more than the Afghanistans.

K.T. McFarland?

QUESTIONER: Hi. K.T. McFarland of Fox News, and a former student of yours, Professor Mandelbaum. If --

MANDELBAUM: Always good to see a former student gainfully employed. (Laughs, laughter.)

QUESTIONER: Thank you. If it's inevitable that we've got to leave Afghanistan and Iraq, and not going to have conflicts of this sort, should we just get out now?

MANDELBAUM: You're asking me?

QUESTIONER: Yeah.

MANDELBAUM: Well, it's okay with me to get out now. And I think we certainly should be on a glide path downward. I refer those of you who are interested to Bob Blackwill's article in the current Foreign Affairs. His argument is we should, in effect, partition the country. We should leave the Pashtun areas. We should hold onto Kabul and the non-Pashtun parts. And we can do that with a much smaller force.

I'm not -- there are downsides to leaving Afghanistan completely. Bob goes into them. It could be a civil war. You know, all of the gains that have been made, such as they are, would be reversed. So if you can achieve something on the cheap, I guess that that would be okay with me. But my problem with Afghanistan is that I don't think it's important. What happens in Afghanistan stays in Afghanistan. It doesn't -- it doesn't affect anything in which we have any interest. It's no better than the fourth most important country in that general part of the world after Pakistan, Iraq and Iran. And since as a general principle, I think we ought to be spending our resources on issues and interests that are most important, since Afghanistan comes at or near the bottom of the list, I'm not in favor of any spending anything there.

HAASS: Roger, one issue that hasn't come up is state and local. And one of the questions I would have for you at this point is whether that's a potential trigger. Whether it's Illinois, California, New York, New Jersey, is that something that could accelerate this scenario by which a triggering event happens?

ALTMAN: Before directly answering that, I just might point out that none of the ratios and data that I used on federal debt include, A, the roughly 9 trillion (dollars) of debt that the United States has guaranteed, but which is not a direct obligation of the United States; B, the debt of the GSEs, which is not -- which are not explicitly guaranteed, Fannie Mae and Freddie Mac, but which are implicitly guaranteed of course; and of course any possible severe fiscal problems that some -- any of our larger states might have, which at least theoretically could require the United States to stand behind them.

So you can argue that the picture that we talked about at the beginning here is actually worse than it looks. I don't think, Richard, that that's going to be the flash point.

And I don't think it is because I wouldn't expect any of the larger state and local borrowers to actually default -- larger, now; not talking about Harrisburg, Pennsylvania, or some entity like that. And even if it did, the -- it isn't clear to me that the United States would come to a full rescue -- you know, their debt is our debt. I think there'd be a lot of pressure not to do that. So while anything could trigger this off, I would be surprised if that would be it.

HAASS: Okay. I see a hand. Mr. Rubin (sp), yes.

QUESTIONER: My question is for anybody, Richard.

The rest of the world is acutely aware of our fiscal situation, as you all so effectively described it. How is that affecting the way they look at geopolitics -- I think Mike may be the closest to commenting on this -- geopolitics and their planning for the future? China, Pakistan, or anybody else that you'd like to comment on.

MANDELBAUM: Well, it's a good question. First of all, as a general proposition, it will have consequences across the board. That we know. We don't know exactly what they are. We know that people in Afghanistan are preparing for our withdrawal. I believe that the radical forces in the Middle East, although they don't need much encouragement, are somewhat -- have been somewhat more aggressive as they see America turning inward and weakening.

And the most important place where one might see this -- and I don't know that this is the case, but I think there's some evidence -- is the Chinese policy has changed somewhat in the last two years, since -- perhaps it's a coincidence -- around September 15th, 2008. The Chinese are no longer the good followers, the people who keep their head down. There's a whole list of initiatives the Chinese have taken that individually don't -- may not represent anything frightening, but collectively suggest a change of course, a much more assertive policy. It's hard not to connect that with their perception of the United States.

And one thing -- and there are a lot of things we don't know about China, but one thing we know is that they keep a very close eye on us. They gear their policies to us. So I would -- I would suggest that there's at least some evidence that the other most important country in the world is behaving more in ways that we don't welcome because of the financial crisis and the recession and the anticipated consequences down the road.

HAASS: The gentleman in the back with the blue shirt.

QUESTIONER: Matthew Lee, with Inner City Press. I wanted to know, I guess, what you think -- how you think this -- how the deficit will impact the U.S. participation in the United Nations and its peacekeeping operations. I mean, there was a debate today in the Security Council about Sudan. There was talk about debt relief for south Sudan or north Sudan. You know, and just -- Professor Mandelbaum, you talked about the relative importance of countries. Do you see Africa, or any country in Africa -- maybe Somalia -- as being, you know, on your -- on your top 10 -- even top-10 list? Thanks a lot.

MANDELBAUM: No, it's not in the top 50, maybe not in the top hundred.

As for -- I mean, you -- now we're in a whole -- when the word "U.N." is mentioned, as Richard knows well -- (chuckles, soft laughter) -- we're in a different -- a different world. To be, I hope, not unkind, or flip, but in the interest of time, the American contribution to U.N. peacekeeping forces is a rounding error in the budget. Whether it stays or goes, we're not going to notice. The real money is in the American defense budget. The American defense budget, with all due respect to our friends at Turtle Bay, is far more important for global stability than anything that the U.N. does. That's where the action is, and that's what's important.

HAASS: I would just make the point that one area, though, of the U.S. budget which, while small, is vulnerable would be non-defense spending in the international arena. And various aspects of foreign assistance and the like are, I think, going to come under tremendous pressure, just because --

STEPHANOPOULOS: I think that's true, except I've actually been surprised in the last few years how little pressure it's been under, given how much -- how big the overall debt problem is.

HAASS: Well, hope you're right.

Sure. Fine.

QUESTIONER: What is the --

HAASS: Wait a second for the phone -- mic.

QUESTIONER: What's the future of the euro, and how will it affect the dollar and our financial problems?

HAASS: Roger, why don't you take that on, and particularly the question also about -- related to it, which is, how has the euro's weakness perhaps bought us more time here?

ALTMAN: Well, the biggest question vis-a-vis the euro right now, of course, is whether the euro zone as a whole will remain intact, or whether the sovereign debt crises that are afflicting, as I said, Greece, Ireland, Portugal, and may afflict others, will somehow break it up.

You never say never, of course, but it seems to me the euro zone will remain intact, because the costs of breaking it up at various levels are so high. For example, in the case of Germany, which is of course the strong -- economically strongest country and financially strongest country, if the euro zone were to break up and the Deutschmark somehow return, the Deutschmark would inevitably strengthen, much to the detriment of Germans -- Germany -- of the German exports and the overall German economy. I could go on down the list as to why that's unlikely, including the sheer out-of-pocket costs and the amount of time it would take to return to the status quo ante, pre-euro.

Now, short term, the actual trading value of the euro: So often in recent years, very learned analyses -- for example, from the Peterson Institute in Washington -- have quite correctly theorized that the size of our external imbalances should lead to a weaker dollar. And in general, the dollar has not been as weak as the theories have suggested it would be. For example, over the past year -- Bob, you might correct me -- I think it's down to about 6 percent on a trade-weighted basis, not -- and a year ago, a lot of people would have said it would be weaker than that.

But, of course, the dollar has long had a safe-haven nature, and the type of crises that have coursed through Europe -- sovereign debt crises -- have not just caused the dollar to strengthen on a day-to-day trading basis versus the euro, but the safe-haven character of the dollar has asserted itself again. But in any event, what might have been a weaker dollar under different circumstances has not, at least so far, materialized.

Maybe, Richard, some day, if we don't proactively address this problem and the financial markets address it for us, that will first begin -- that chain reaction will first begin as it did in '79, through the exchange markets in the dollar. But maybe it won't. There are so many different ways that we've seen in the last 20, 25 years crises arise, and each one seems to come from a different angle than the last one. It's impossible to judge how that might first start.

HAASS: Sir?

QUESTIONER: Steve Tananbaum from GoldenTree. Roger, you start saying if we keep on the current policies, the market is going to cause us to change our ways. Yet Japan is pretty much further down, yet the market has not disciplined them.

Why do you think that's so?

ALTMAN: Well, many people would challenge the premise of your question to the effect that Japan is -- in effect, Japan's fiscal condition is worse than ours.

QUESTIONER: Well, if you look at debt to -- (off mic) --

ALTMAN: Yes. Yes. But if you look at -- and you could argue this either way. But if you -- but -- you can argue it's a more indebted country than the United States because, of course, its federal debt to its -- the size of its economy is worse than ours, as you're suggesting. You're right. On the other hand, if you look at the savings rate in Japan and the percentage of Japan's debt that is held outside the country, it's a very different picture.

In contrast to your premise, many argue that Japan's debt is financed internally, not externally like ours is; and, therefore, the degree to which global financial markets would have an incentive to discipline Japan is very low because Japan's debts in effect to the rest of the world are very small.

Now, you can look at that a lot of different ways. But I think, in general, because of the contrasts between Japan and the United States in terms of a very low level of the Americans' saving rate -- even though it's ticked up a little bit recently -- and the degree to which we are financing so much of our deficits externally -- I mean, I've seen estimates at seven (hundred billion dollars) to 900 billion (dollars) a year in the last three to four years is being added to the store of dollar-denominated liabilities held overseas; obviously, China is a big participant in that -- I think the two situations are actually quite different.

HAASS: George, let me just go back to a political question, which is, can you imagine a politician standing up and talking about these issues like we are a little bit, and essentially thriving -- (laughter) -- as opposed to stepping on the proverbial third rail?

STEPHANOPOULOS: I think it depends on which level of politician. I think members of Congress can do it; I think Paul Ryan you see of Wisconsin. Although, he leaves out taxes in his plan. I think, you know, one of the encouraging things you've seen -- you talk about the Simpson-Bowles commission. I think there was a little more crossover and support for that menu of proposals than I expected. You had, you know, senior, kind of party Democrats like Dick Durbin coming out and supporting it. You had Republicans like Tom Coburn coming out and supporting it, even though it did include some talk of tax increases.

So, yeah, I mean, I think, it's hard for a president in an election year. It is impossible for a challenger to a president in an election year. But, below that, yeah, I think you see a lot of ferment and not only the Simpson-Bowles commission, but you're seeing -- you know, I think, the fact that, you know, people like Roger have written about at a VAT, the Center for American Progress has written about VAT on the Democratic side, you've started to see more ideas bubbling on the Republican side. I think those will bubble up, but just not at the top level yet.

ALTMAN: And, George, if I could just ask a question following up Richard's, I think the distinction between what national leaders can do or a president can do in the way Richard asked about it, and what some governors seem to be doing right now is a really interesting distinction. Some governors seem to be deciding our problem is so bad, it's both the right thing to do and maybe the politically smart thing to do to tell it like it is.

So Governor Cuomo in New York has come in, you know, in a very tough way in this regard, and Governor Christie of New Jersey and others around the country basically saying, "Folks, things are really, really bad. There's no easy, sugar-coating solution, and this is what we're going to have to -- (inaudible)."

STEPHANOPOULOS: Well, and, on the other side in Illinois, you know, 60 percent tax increase.

ALTMAN: Yeah, well, we'll see how that plays. But the question is, you know, you can argue that some governors, especially new ones, are deciding, "Not only do I need to fix it, but I could actually benefit. I could advantage myself by delivering -- by talking straight about it."

And my question is -

STEPHANOPOULOS: Well, I think the talking straight, I completely agree with. I mean -- I mean, we're at the beginning of their budget cycles right now. We'll end up seeing how much they actually get through. They're also -- a lot of the governors actually face requirements where they have to balance their budgets, so it's a very different situation.

But, yeah, I do think there's a -- I think there's no question that people want to hear politicians talking about these issues in what is perceived to be a straightforward manner. I just think there's less evidence that they -- the country actually wants the politicians to follow through on those promises.

HAASS: Do you think that what happens in Britain -- there you've got a government that has gone on a fairly, by our -- by our terms, drastic path, serious spending cuts, probably -- what -- $4 or whatever of spending cuts for every dollar of tax increases. Do you think that will have any impact on here, like, the debt, the British experiment, if you will?

STEPHANOPOULOS: How long does the government survive? I mean, the liberals are in trouble.

HAASS: Well, how well does the economy survive?

STEPHANOPOULOS: Yeah.

HAASS: Do you think -- do you imagine that experiment going on in Britain will have repercussions here?

ALTMAN: If it fails, we will take note of it. If it succeeds, we probably won't. That's right.

MR. : That's right.

ALTMAN: The British government has a rather smaller borrowing capacity than the American government does. So they don't have the short-term choices that we do. But it is interesting. They are running an experiment. And I take it that the economic theory behind their policy is that if they have a serious deficit reduction program, that will inspire such confidence there will be an outbreak of euphoria in the British economy, in the European economy, and that will make up for the gap in their consumption. Let's hope it works. But as George says, the government could fall.

HAASS: There's always that. Sure.

QUESTIONER: Sy Jacobs, Jacobs Asset Management. The question's for Roger. Given that you feel that the world doesn't have 10 years of patience and appetite for trillion-dollar-a-year deficits, is it reckless or is it brilliant that the central bank of that trillion-dollar-deficit country is -- has committed to buying $2 trillion of that country's paper?

ALTMAN: I have no quarrel with the quantitative easing approach that the Federal Reserve has taken. It's part of the point I made a little bit earlier about how I believe history will judge the United States, including our central bank, as having responded very effectively to what was really civilization-threatening events of, you know, the fall of '08 through early '09.

And I think a lot of the debate about the second round of quantitative easing, so-called QE2, is a little bit strange, because I really believe the Federal Reserve's main motivation was to try to provide an extra incentive for growth and labor markets. Remember, the mandate of the Federal Reserve is both price stability and full employment.

And I don't think it was, you know, a sneaky way to try to lower the value of the dollar, even though it was interpreted that way internationally in so many quarters.

So I don't think the Federal Reserve has overstepped its bounds or acted imprudently at all. And I might add that -- I'm not a monetary historian, but quantitative easing is actually a rather traditional monetary exercise. There's nothing new about it. There's nothing original about it. There's nothing infrequent about it in the modern monetary history of, you know, the industrialized world.

HAASS: Charlie Wolf From RAND asked a question about how -- what all this means for trends in American power. So let me ask the question directly -- I'll make it the last question -- which is, does this inevitably contribute to the relative decline -- not the absolute decline but where we are -- does this inevitably contribute to the relative decline of the United States, that we are essentially in this predicament and that we are going to be forced to do things that will limit the resources that are available for our role in the world and that essentially we will occupy less of a space consequently?

Michael.

MANDELBAUM: Well, I'm glad you asked that question. (Laughter.) And I want to commend you, Richard, and the council, for making the 90th anniversary project looking at the domestic sources of American power, because I think that is really the crucial issue for the next decade. And I'm so committed to that proposition, that I am writing a book about that subject with my friend Tom Friedman of the New York Times.

And there's good news and bad news. The good news is, we can deal with these problems. We know how to do it. We've done it before. The bad news is that the problem we've been discussing today, tonight, is only one of the problems. There are three others. And I think if we can get our act together and deal with the deficit and with the other problems, we will remain the most powerful country in the world and the global leader even with the rise of China and India because our values are in alignment with what most countries want and because most countries appreciate at some level the kind of leadership that we provide. I think our soft power is still intact.

But you've got to have hard power to back it up, and that depends on what we do. And when I think about this problem -- and incidentally, I don't see anybody else replacing us. I don't see us getting any help from the Europeans and the Japanese who have problems of their own. I don't see -- I see the Chinese possibly making trouble but not shouldering us aside and being the global leader or even the unchallenged leader of East Asia. So it's either us or nobody. And nobody is a lot worse than us.

What are the prospects? We've been talking about that, but when I think about this question -- and this is -- this is the major question that we as a country face -- I think about a saying that I first heard attributed to Abba Eban, the former Israeli foreign minister who once said, men and nations -- should have said "men and women and nations" -- will always do the right thing when all other alternatives have been exhausted. (Laughter.)

Well, we're running out of alternatives.

HAASS: Well, that was also a version of Churchill's comment about American democracy and the danger -- going back to where we began this conversation, if that's true, while we're going through doing some of the wrong things or not yet prepared to do the right thing, events may intervene. And we may not essentially be able to write the script in ways that will work out.

You've actually, though, come off fairly optimistic.

STEPHANOPOULOS: In the end, I think so. And we have -- we have -- we've been through these crises before. I think that we -- I agree with Roger that history, I think, is going to look back at the way, actually, both presidents in the end dealt with the financial crisis in 2008 and 2010 and say they did the right thing at a difficult time. And I do think that we're going to solve this in the next couple of years because we're going to have to.

ALTMAN: Hey Richard, you know, we've done some good things here tonight, one of which, obviously, is to give George all the briefing material he needs for his discussion tomorrow morning with Joan Rivers. (Laughter.)

STEPHANOPOULOS: She's great on the euro. (Laughter.)

MANDELBAUM: But more pessimistic than you are. (Laughter.)

HAASS: From that, well, we hope you've enjoyed the red carpet here tonight -- (laughter) -- and let me thank these three friends for starting what I hope really will be an extended and a thoughtful discussion throughout this year and beyond on the domestic challenges that really are so much now at the heart of what the United States does in the world. It may seem to be an odd place for the Council on Foreign relations to end up, but I think that tells you something. And I think this reinforces my sense that we've ended up in the right place.

Let me thank you all for getting us off to such a good start. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

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RICHARD N. HAASS: Welcome to the Council on Foreign Relations. For many of you, I expect it's the first time back this year. so happy new year while we're at it.

Every year is a special year at the Council on Foreign Relations. But this year is more special than usual, we'd like to think, because it's our 90th anniversary. And what we've decided to do somewhat in a contrarian fashion is to dedicate -- a significant amount of our effort this 90th year are to policy questions that are more normally thought of as domestic rather than foreign, whether it's questions of infrastructure, questions of K through 12 education, various aspects of immigration policy, of regulatory policy, and the subject tonight of deficit and debt on the obvious -- based on the obvious thinking that our ability to act in the world, our ability to lead in the world, our ability to present the positive model to the world will in no small part depend upon what takes place here at home in the United States. And we begin with the assessment that our house in many ways is not in order, and a principle challenge to the United States is to take care of that, and to put its domestic house in order.

And tonight's meeting is focused on one of the most difficult if not the most difficult aspect of all of that, which is the question of the deficit and the debt.

The way we're going to talk about it is with three extraordinarily informed gentlemen. George Stephanopoulos you all know from his time in government, but also now as ABC's chief political correspondent, and, for those of you who are morning people, is the anchor of "Good Morning America." And one of the things we like to do, by the way, at the council is end meetings on time. And tonight we have a double reason to do it because George is to go straight from here to bed. (Scattered laughter.)

GEORGE STEPHANOPOULOS: I've got a very important interview with Joan Rivers tomorrow morning. (Laughter.)

HAASS: That's good. (Laughter.) I've learned not to say everything that pops into my mind. (Laughter.) This does show the possibility of progress. But can we talk?

Michael Mandelbaum is one of this country's leading thinkers and writers about American foreign policy. He directs the American Foreign Policy Program at Johns Hopkins School of Advanced International Studies where he's the Christian Herter professor of American foreign policy. And, most recently, he is the author of "The Frugal Superpower: America's Global Leadership in a Cash-Strapped Era," which is on sale tonight so Michael is not cash-strapped.

And last but not least is Roger Altman. Roger was deputy secretary of the Treasury under President Clinton, and he is now chair and CEO of Evercore Partners.

One or two administrative things, none of which will -- come as a surprise to please turn off your electronic devices. And we have quite a few people listening on the phone tonight, so the signals really will muck it up.

This meeting is on the record, so anything said can and will be used against you.

There will be national members. There are national members listening in. And, indeed, I may take a few questions from them if I can figure out how to use the iPad.

The -- what we're going to do is I'm going to ask some questions to start off, and then I'm going to try to reserve a good chunk of the time for you all to have questions. What I -- what I thought I'd do is begin with Roger, then migrate to George, then migrate to Michael, and essentially begin with the question to ask Roger to set the stage, which is about the scale of the deficit and debt, a little bit about how we got to this point, and just some basic -- his sense of what we may want to do about it, essentially to provide the baseline of the challenge that we are dealing with tonight.

So you can ignore what I just said, Roger, and say whatever you'd like.

ROGER C. ALTMAN: Well, three or four months ago, Richard briefly lowered his usually high standards, and co-authored a piece with me in Foreign Affairs on the U.S. deficit and debt path and the global consequences of that. And so I'm going to give a very short beginning summary, so to speak, of what we said, and update it for some important things, which have happened since then. And I might say at the beginning it's timely to have this discussion not just because of the council anniversary, of course, but because in about a week, President Obama will deliver of course his State of the Union address. And in one form or another, there will be references to this difficult deficit and debt outlook. And so I'm going to make a comment or two about how he may or may not address it.

But just to start with, the headlines of the past two months have temporarily clouded how truly dire the U.S. fiscal outlook and debt outlook is. And by headlines, I mean, of course, the Republican election sweep in November, the surprisingly productive lame-duck congressional session, the tragic events in Arizona and other developments. And as an example of that obscuring the very good and very emphatic recommendations, which the Bowles-Simpson Commission delivered only on December the 1st -- after all, that was a commission that President Obama and the congressional leadership put together on the budget outlook, -- have largely been forgotten, at least for the moment, despite their really being quite important. And I'm sure they will come back.

But despite these intervening headlines, the fiscal outlook, which already was very threatening, actually has worsened a bit in the past couple of months. And that's because while on the one hand there is some improvement in the -- in the economic growth outlook for 2011 and 2012, and the latest forecasts reflect that, the tax agreements struck during the lame-duck session and the revenue consequences of the tax agreements actually more than offset that improved growth outlook. And so the deficit outlook and the related debt outlook -- remember the federal debt is really just a dollar-for-dollar consequence of the deficits -- has actually worsened in the past two or three months.

Now, let's spend a minute on how bad that outlook really is. And I'm going to refer primarily to the most recent Congressional Budget Office forecast. You all know the Congressional Budget Office is nonpartisan. It's really quite widely respected. It's most recent forecast is a few months out of date, but my research suggests that the updated one, which will come out in a few weeks, will not be terribly different.

And what we're looking at, at least based on current policy is cumulative deficits between nine (trillion dollars) and $10 trillion over the next 10 years. And the federal debt, which I should say has tripled or virtually tripled in the last 10 years from its roughly historical long-term average of about 35 percent of GDP to a current level of 65 percent, is projected to reach, by the CBO, 90 percent by 2020 and, by the IMF, actually, 115 percent.

To put those in context, with the brief exception of the peak years of World War II, we have never had a debt-to-GDP relationship of that level in the history of the United States since record keeping began in 1792. And those levels, 90 (percent) to 100 percent of GDP, are typically associated with countries, for example, today, like Italy and Greece. And, as I said a minute ago, we would reach those levels within just nine years.

And the credit rating of the United States if we do actually get from here to 90 (percent) to 100 percent of GDP in the form of federal debt, will certainly be lowered, and there are some forecasts around that suggest it will be lowered quite considerably.

Now, let me try to spend a minute on what it would mean to have debt in that amount. It would mean that federal -- the interest expense, which the federal government was paying would rise from today's 1 percent of GDP to about 4 percent. But in more practical terms, the total interest expense of the United States government would exceed all of domestic discretionary spending. In other words, it would exceed the total each year that we today spend on infrastructure, on energy, on agriculture and on education. And it would be approximately equal to the amount that we spend on defense.

In addition, the United States would be borrowing at that time -- this is 2020, this is not way off -- approximately $5 trillion a year. It was just a few years ago, about 10 years ago, that the entire budget of the United States was $5 trillion. Maybe a little further back than 10, but not many years. I can see Bob Rubin rolling his eyes, saying, I think it's further back than that. In any event, it wasn't a long time ago when the entire federal budget deficit -- federal budget, total budget -- was 5 trillion (dollars).

Now, the thesis that Richard and I expounded in our piece was that, actually, the United States would not be allowed to go from where we are today in 2011, beginning of 2011, to that much debt in 2020. We wouldn't actually get there. Either we would address this in the right way, proactively by our nation's leaders through a deficit reduction agreement of the type, for example, we saw at Andrews Air Force Base in 1990 under President George H.W. Bush, or perhaps the type that we saw -- George and I were both very involved in this -- in 1993 under President Clinton. In other words, address it proactively or it will be done the ugly way: namely, that the global financial markets at some point between now and 2020 and before we reach that much debt will revolt and impose a solution on the United States.

Now, I know there are a lot of people who think, yes, I know that there have been sovereign debt crises in Ireland recently, and in Greece, and looking back over history, the U.K., Mexico, Russia, Argentina, but that can't happen to the United States. We're the world's largest economy, our currency is the reserve currency of the world and so forth.

Well, it's instructive in that context to look at the events of 1979. I was serving in the Treasury then, during my first my tour of duty, and that was the era of stagflation, of the Iranian oil embargo, and of course President Carter. And during the early months of 1979 -- I'm sorry, during the lead up to 1979, the dollar had been wobbly and generally declining. And then President Carter submitted his budget, which included a larger than expected deficit. By today's standards, it was minuscule, but it was large by the standards of 1979.

That was the last straw for the financial markets. The dollar crashed. All global markets plunged -- fixed income markets, equity markets, currency markets, commodity markets -- and a true global emergency ensued. And the key nations of the world, the industrialized world, got together overnight and put together a coordinated international rescue of the dollar. But the contributions which the United States had to make to that were, one, to cut in half its budget deficit within one week, and for the Federal Reserve to raise interest rates very sharply at a time when that was not the general direction that the Federal Reserve had been headed into. All of that happened in one week.

Now, if we don't address this proactively, it will be in our judgment addressed by the global financial markets, and unfortunately if that happens, it will be a replay of 1979, but of course, on a much bigger scale. But the main point is it will happen with very little warning. The, quote, "solution" will be very ugly and punitive; for example, across-the-board spending cuts. There won't be time to do any kind of real budget, tax surcharges, there won't be any time to do any true tax policy. And it will be solved that way.

If it is solved in the latter way, that will usher in an age of profound austerity in this country, and that in turn -- I mean, as an example, all categories of domestic spending would be cut in an across-the-board fashion; nothing would be spared, entitlements and so forth. Taxes on all -- virtually all individuals and businesses would be raised, probably, as I say, through some surcharge approach. And we would enter into an age of austerity of the type we haven't seen in this country for -- well, since the 1930s.

Now, as Richard and I argued in this piece, the global consequences of that, the consequences for the American -- for the global platform of the United States and the consequences for world coherence and world stability, as no one is likely to step into the role the United States will be pulling back from, would be particularly profound. And on that note, I'm going to stop and turn it back to you, Richard.

HAASS: Did I say Happy New Year? (Scattered laughter.) Just wanted to make sure I covered all of our bases here. By the way, when Roger and I wrote the article, he was the optimistic member of the team, just to give you a sense of perspective here.

We'll get in a few minutes to what we -- well, implicit in Roger's argument is obviously the United States needs to embark on a fairly steep path of dealing with the deficit, somewhere 250 (billion dollars), $300 billion a year of the deficit need to be reduced through some combination of increased revenues, either from growth or taxation or decreased spending.

So let me turn to George for a second. Could you imagine any scenario where policymaking and decision-making of that scale could come about?

STEPHANOPOULOS: Not before January 2013, certainly not. I mean, nothing -- I agree with Roger's analysis, I should say. But if you just look at the current lineup over the next two years with a election, presidential election coming next year, it's inconceivable to me absent a forcing crisis that Congress and the White House can work on this. I mean, if you just look at -- you talk about the surprisingly productive lame duck session. They did all the easy stuff. They cut taxes. The budget was not -- they just punted on the budget for last year.

Fundamental to the president, to the White House is that they cannot break his key campaign promise, which was not to raise any taxes on middle-class Americans. He flirted with it, some would say he broke it during the health care debate, and they can't do anything or propose anything that has any hint of a tax increase on middle-income Americans. So that knocks out a lot of solutions right there.

As much as Republicans talked about spending debt and deficits in the mid-term elections, I think all of the leadership on the Republican side has completely gone to school on the Newt Gingrich experience of 1995 and 1996 and realize that what a reelected -- in their minds -- President Clinton caused so much heartache for Republicans during the government shutdown was the commitment to cut Medicare. And that that cost them whatever advantage they had coming out of the 1994 election.

So as much as they talk about cutting spending, their leadership is not going to do anything that touches what is at the heart of most of the spending problems. So I don't see anything happening between now and the presidential election.

HAASS: Before you go on, let me just -- can I interrupt for one second? One event, though, that will happen long before that will be the raising of the federal debt limit.

STEPHANOPOULOS: Yeah, and --

HAASS: (Inaudible) -- just for those of you who haven't followed, sometime this spring the United States is going to need to act March, April, May. There's a $14.3 trillion ceiling on our debt, and we're going to have to raise that, or we're going to have not take on any more debt at that point -- (inaudible) --

STEPHANOPOULOS: And there's an awful lot of pressure from Republican presidential candidates, from tea party candidates who just got elected to not vote to raise the debt limit absent any kind of serious spending reductions. But I think there they're going to be talking about some cuts in domestic discretionary spending, maybe some budget process issues like, you know, coming out for a balanced budget amendment again. Even on the -- the Republican leadership started out with a rock-hard promise in the midterm elections to cut $100 billion in spending this year. That promise as far as I can tell is down to about $30 billion right now, and they may not even get there.

So even if that -- I think that could create a crisis and that could create the kind of crisis that Roger is talking about if because of the stalemate the debt limit is not extended and Tim Geithner runs out of all of the maneuvers he may have learned from Bob Rubin back in 1995 and 1996, then, yeah, we could have a crisis that creates a crisis in the bond markets that forces the issue. But I don't see any kind of proactive addressing of it.

HAASS: Let me ask you then -- let me interrupt with one other question. You mentioned that you thought nothing would happen until 2013. If most people in your business are right, by then, you will have not just a Republican House --

STEPHANOPOULOS: (Inaudible.)

HAASS: -- but a Republican Senate.

Why do you think that then would set the stage? Imagine either way a second Obama term, a first term of -- with X Republican. How do you imagine that --

STEPHANOPOULOS: That is what I was imagining.

HAASS: Okay.

STEPHANOPOULOS: Twenty-three Democratic senators up in 2012, only 10 Republican senators up in 2012. Kent Conrad announced his retirement today. You could bet if you were going to bet that he'd be replaced by a Republican. Joe Lieberman is announcing his retirement likely tomorrow. A Democrat could win that, but that's a little more iffy.

But if you had to just look at the numbers, the fact that the Democrats are defending so many Senate seats in 2012, absent a massive, you know, landslide for Obama, it's -- the odds are that Republicans will take control of the Senate in 2012. That sets up conceivably a situation like what Ronald Reagan had in 1986. And you Reagan, Gephardt and Bradley come out for a big tax reform plan. That combined with what is more likely, the problem continues to get worse.

Both sides feel pressure to govern. You're in the early years of a second presidential term. The new Republican majorities will have more clearly shared responsibility because they're they don't have the Democratic Senate to blame anymore for inaction. That could set the table, and that's the optimistic scenario. Now, the question would be that, in January 2013, has the crisis come or not? And I defer to the economic experts in the room.

HAASS: The answer is none of the experts know when it's going to come. I think there is no consensus that if and when it does come, it could come quite quickly at that point, a little bit almost like a Malcolm Gladwell scenario that you reach a tipping point.

Then, Michael, let me turn it to you, which is -- we sort of have two scenarios. One is the United States proactively deals with this and sets ourselves again on a more responsible, sustainable trajectory; the other is more reactively, where markets react, we're forced to raise interest rates, so forth and so on.

What do you see as the foreign policy consequences under each?

MICHAEL MANDELBAUM: Well, I think the foreign policy consequences are more or less the same, whichever the scenario is. Whether we're on a gentle glide path downward or we fall off a cliff, at some point in response to some event, the United States will get serious about the deficit. And when that happens, contrary to the promises of the Republicans, taxes will rise. And, contrary to the promises of the Democrats, benefits, including Social Security and Medicare benefits, will be cut.

When that happens, we will be in a different political world. And in that political world -- and this is the premise of "The Frugal Superpower" -- foreign policy will be -- to use a term not entirely appropriate, but not entirely inappropriate -- "collateral damage." When people are paying more to the government and getting less form it, they will be less generous in funding the kind of of foreign policy that we have carried out, really, I would say in the lifetime of virtually everybody in this room.

I think that we are heading for a world in which, for the first time, just to pick a date at random since December 8th, 1941, how much things cost becomes a serious constraint on American foreign policy. It hasn't been irrelevant for the last 70 years, but, in comparative historical terms, it's been pretty modest. That will change because people simply won't support the kind of foreign policy that we have been accustomed to carrying out when they feel cash-strapped.

Now, there's one other point I want to make about them, and I can go into the specific changes that I anticipate and favor. But the general point -- and it's an important point for all of us -- I think, is this. The United States is the most important country in the world. And the United States, in my view, plays an extraordinarily constructive role in the world. The United States provides some of the services to the world that governments provide within the societies that they govern. The world functions as well as it does economically and in security terms -- not perfect, but not bad -- in no small part because of a very extensive American foreign policy, because of American economic and military commitments around the world.

When those are called into question -- and I think they will be -- that endangers not just the interests of the United States, but global peace and prosperity. This is a very big deal. And even countries that are extremely critical of one or another of America's foreign policies will find that the only thing worse from their point of view than an America that's too powerful is an America that's too weak.

HAASS: This could be the be-careful-what-you-wish-for here for -- I guess -- (inaudible) -- one short question of each of you before I open it up. And let me start with Roger.

How does the president deal with what appears to be something of a dilemma? We've got formal unemployment between 9 (percent) and 10 percent. We've got real unemployment that's probably 50 percent higher than that, somewhere at 15 or so percent?

How does he deal with what we-- with the need to get things going, increase employment and the like, stimulate the economy; and, at the same time, put the United States on a, if you will, quote, unquote, "responsible trajectory," and gradually start reducing the deficit? How does one deal with that? Is it a dilemma, which is a word that's overused? Or is there a way essentially to have our cake and eat it?

ALTMAN: Well, I think most economic and fiscal experts would answer that, Richard, by saying -- and I would -- that the United States has really had to date the right response to the economic and financial collapse of 2008 and 2009. We've had a -- by standards of other parts of the world, we've had a forceful response. We've had a large response, and we had a relatively quick response.

And even though we have a 9.4 percent unemployment rate and a 16.3 (percent) underemployment rate, and the outlook for the labor market remains very, very difficult, we pulled ourselves out of this quite skillfully. I think historians will ultimately judge it that -- judge it that way. And this country should get very high marks for how we -- how we -- how we've got -- carried ourselves through the last two years.

And the emphasis of policy for 2011 and 2012 really should be -- and George was pointing out how it's politically necessary, but it actually is the right policy also -- to continue in every possible way to incentivize growth, and try to thaw out the frozen labor markets.

But at the same time, you would put in place if you could wave a wand a framework for changing this dire deficits and debt path, which would take effect probably in 2013, not for -- not for presidential cycle reasons, but for where we would then be in the economic cycle, because at that point the argument would be the economy will have strengthened to the point where it could withstand the contractionary impacts of a large deficit reduction plan.

So if you could wave a wand the next two years, the focus would be on growth and labor markets, and then would take effect, not just be worked on then, but take effect then a long-term plan for reducing the deficit and debt outlook.

STEPHANOPOULOS: I think you want to start fitting that suit, but don't sew it on in the State of the Union.

HAASS: That was my next -- (inaudible). Okay. So imagine you have this that next -- in the short run, if you will, we continue to emphasize growth, stimulus of one sort or another, get big corporations to start spending down some of the cash they've accumulated, but essentially two years from now have the "more responsible," quote, unquote, trajectory kick in. To what extent -- how far does the president go next week?

STEPHANOPOULOS: I don't know how far he will go. I think that the first point has to be Roger's point. You can't do anything that puts the recovery at risk, and we have to continue to create more jobs in this country. The number one job of a president, keep the economy -- keep the economy growing. I think he can then make a nod towards the election, and in a sort of a -- it was the framework President Clinton used. There's a right way and a wrong way to deal with these things. You have to make the right investments in education, in energy, in infrastructure. And we can make cuts in places where government is no longer as efficient and effective as it once was. And I think he did make a nod to that in his Wall Street Journal op-ed about regulation today.

And then I think it's conceivable -- and this is going to be a slightly different State of the Union from the kind we've seen recently. I think it is very likely that Republicans and Democrats are going to be sitting together for the most part. They're not going to be in two opposing camps. I think that gives the president an opportunity to give what appears to be a less political speech, and will sound more like a conversation, and that he could put the discussion of the long-term deficit in the context of everyone working together. and that's what the country has demanded, putting it in a more political process context than in an economic context.

And you can talk about -- we all know there are things that we're going to have to do over the long term. We're going to have to live within our means. I think you can give a rhetorical nod to the Simpson-Bowles Commission without boring in too much on any of the specifics. I think he can talk about tax reform and -- he'll -- without -- and show a little bit more leg. He's already done some of that without getting into specifics.

I think he'll still argue that his health care plan is one of the answers to entitlement reform, but he can also make a nod to saying, "We're going to do more." But I think they're going to have to be fairly careful about getting locked into a specific proposal on any one of those three areas.

HAASS: Michael, I think I know the answer to this question, but let me ask you anyhow, which is, the last 10 years of American foreign policy has been dominated by two extremely expensive interventions, one in Iraq, one now in Afghanistan. Will this sort of pressure both accelerate the end, particularly of Afghanistan? But, more important, will this now -- is this the end of that phase of what we might call "discretionary American interventions?" Is this basically over?

MANDELBAUM: Let's call them wars of choice. (Laughter.)

HAASS: I was trying to be uncharacteristically self-effacing here. But clearly it didn't hold. Okay.

MANDELBAUM: I think it is, Richard. And I think that this period really goes back two decades. I think the wars or the interventions in Somalia, in Bosnia, in Kosovo, in Haiti belong with the interventions in Afghanistan and Iraq, although they were undertaken by different administrations for different reasons, and had different costs. But all of them ended up in the protracted, unexpected, unwanted and expensive task of nation building.

Nation building has never been popular. The country has never liked it. It likes it even less now. And I think we're not going to do it again. We're not going to do it because there won't be enough money. We're not going to do it because there will be other demands on the public purse. We won't do it because we'll be busy enough doing the things that I think ought to be done in foreign policy. And we won't do it because it will be clear to politicians that the range of legitimate choices that they have in foreign policy will have narrowed and will exclude interventions of that kind. So I believe and I say in the book that the last -- the first two post-Cold War decades can be seen as a single unit. And that unit has come to an end.

HAASS: With that, the questions from our members has come to a beginning. If people would wait for a microphone, let us know who you are, pretty much limit yourself to one relatively brief question, I would be forever grateful.

Carol, why don't we start with you?

And I'll also try to take some questions from our national members.

QUESTIONER: Carol O'Cleireacain, Brookings. I want to pick up on what you just said, and ask, so where does the war on terror go in such a scenario?

MANDELBAUM: The war on terror will be waged not by trying to transform the countries that harbor terrorists. And, incidentally, even if that were our aim, our biggest task would be Pakistan. And that's hopeless for a variety of reasons. The war on terror, I believe, will be waged by effective intelligence and police work and cruise missiles.

QUESTIONER: And that's expensive -- (off mic) --

MANDELBAUM: Not nearly as expensive as what we're doing in Afghanistan and in Iraq.

HAASS: Yeah, I would say much more the Somalias and Yemens will be the model for the future much more than the Afghanistans.

K.T. McFarland?

QUESTIONER: Hi. K.T. McFarland of Fox News, and a former student of yours, Professor Mandelbaum. If --

MANDELBAUM: Always good to see a former student gainfully employed. (Laughs, laughter.)

QUESTIONER: Thank you. If it's inevitable that we've got to leave Afghanistan and Iraq, and not going to have conflicts of this sort, should we just get out now?

MANDELBAUM: You're asking me?

QUESTIONER: Yeah.

MANDELBAUM: Well, it's okay with me to get out now. And I think we certainly should be on a glide path downward. I refer those of you who are interested to Bob Blackwill's article in the current Foreign Affairs. His argument is we should, in effect, partition the country. We should leave the Pashtun areas. We should hold onto Kabul and the non-Pashtun parts. And we can do that with a much smaller force.

I'm not -- there are downsides to leaving Afghanistan completely. Bob goes into them. It could be a civil war. You know, all of the gains that have been made, such as they are, would be reversed. So if you can achieve something on the cheap, I guess that that would be okay with me. But my problem with Afghanistan is that I don't think it's important. What happens in Afghanistan stays in Afghanistan. It doesn't -- it doesn't affect anything in which we have any interest. It's no better than the fourth most important country in that general part of the world after Pakistan, Iraq and Iran. And since as a general principle, I think we ought to be spending our resources on issues and interests that are most important, since Afghanistan comes at or near the bottom of the list, I'm not in favor of any spending anything there.

HAASS: Roger, one issue that hasn't come up is state and local. And one of the questions I would have for you at this point is whether that's a potential trigger. Whether it's Illinois, California, New York, New Jersey, is that something that could accelerate this scenario by which a triggering event happens?

ALTMAN: Before directly answering that, I just might point out that none of the ratios and data that I used on federal debt include, A, the roughly 9 trillion (dollars) of debt that the United States has guaranteed, but which is not a direct obligation of the United States; B, the debt of the GSEs, which is not -- which are not explicitly guaranteed, Fannie Mae and Freddie Mac, but which are implicitly guaranteed of course; and of course any possible severe fiscal problems that some -- any of our larger states might have, which at least theoretically could require the United States to stand behind them.

So you can argue that the picture that we talked about at the beginning here is actually worse than it looks. I don't think, Richard, that that's going to be the flash point.

And I don't think it is because I wouldn't expect any of the larger state and local borrowers to actually default -- larger, now; not talking about Harrisburg, Pennsylvania, or some entity like that. And even if it did, the -- it isn't clear to me that the United States would come to a full rescue -- you know, their debt is our debt. I think there'd be a lot of pressure not to do that. So while anything could trigger this off, I would be surprised if that would be it.

HAASS: Okay. I see a hand. Mr. Rubin (sp), yes.

QUESTIONER: My question is for anybody, Richard.

The rest of the world is acutely aware of our fiscal situation, as you all so effectively described it. How is that affecting the way they look at geopolitics -- I think Mike may be the closest to commenting on this -- geopolitics and their planning for the future? China, Pakistan, or anybody else that you'd like to comment on.

MANDELBAUM: Well, it's a good question. First of all, as a general proposition, it will have consequences across the board. That we know. We don't know exactly what they are. We know that people in Afghanistan are preparing for our withdrawal. I believe that the radical forces in the Middle East, although they don't need much encouragement, are somewhat -- have been somewhat more aggressive as they see America turning inward and weakening.

And the most important place where one might see this -- and I don't know that this is the case, but I think there's some evidence -- is the Chinese policy has changed somewhat in the last two years, since -- perhaps it's a coincidence -- around September 15th, 2008. The Chinese are no longer the good followers, the people who keep their head down. There's a whole list of initiatives the Chinese have taken that individually don't -- may not represent anything frightening, but collectively suggest a change of course, a much more assertive policy. It's hard not to connect that with their perception of the United States.

And one thing -- and there are a lot of things we don't know about China, but one thing we know is that they keep a very close eye on us. They gear their policies to us. So I would -- I would suggest that there's at least some evidence that the other most important country in the world is behaving more in ways that we don't welcome because of the financial crisis and the recession and the anticipated consequences down the road.

HAASS: The gentleman in the back with the blue shirt.

QUESTIONER: Matthew Lee, with Inner City Press. I wanted to know, I guess, what you think -- how you think this -- how the deficit will impact the U.S. participation in the United Nations and its peacekeeping operations. I mean, there was a debate today in the Security Council about Sudan. There was talk about debt relief for south Sudan or north Sudan. You know, and just -- Professor Mandelbaum, you talked about the relative importance of countries. Do you see Africa, or any country in Africa -- maybe Somalia -- as being, you know, on your -- on your top 10 -- even top-10 list? Thanks a lot.

MANDELBAUM: No, it's not in the top 50, maybe not in the top hundred.

As for -- I mean, you -- now we're in a whole -- when the word "U.N." is mentioned, as Richard knows well -- (chuckles, soft laughter) -- we're in a different -- a different world. To be, I hope, not unkind, or flip, but in the interest of time, the American contribution to U.N. peacekeeping forces is a rounding error in the budget. Whether it stays or goes, we're not going to notice. The real money is in the American defense budget. The American defense budget, with all due respect to our friends at Turtle Bay, is far more important for global stability than anything that the U.N. does. That's where the action is, and that's what's important.

HAASS: I would just make the point that one area, though, of the U.S. budget which, while small, is vulnerable would be non-defense spending in the international arena. And various aspects of foreign assistance and the like are, I think, going to come under tremendous pressure, just because --

STEPHANOPOULOS: I think that's true, except I've actually been surprised in the last few years how little pressure it's been under, given how much -- how big the overall debt problem is.

HAASS: Well, hope you're right.

Sure. Fine.

QUESTIONER: What is the --

HAASS: Wait a second for the phone -- mic.

QUESTIONER: What's the future of the euro, and how will it affect the dollar and our financial problems?

HAASS: Roger, why don't you take that on, and particularly the question also about -- related to it, which is, how has the euro's weakness perhaps bought us more time here?

ALTMAN: Well, the biggest question vis-a-vis the euro right now, of course, is whether the euro zone as a whole will remain intact, or whether the sovereign debt crises that are afflicting, as I said, Greece, Ireland, Portugal, and may afflict others, will somehow break it up.

You never say never, of course, but it seems to me the euro zone will remain intact, because the costs of breaking it up at various levels are so high. For example, in the case of Germany, which is of course the strong -- economically strongest country and financially strongest country, if the euro zone were to break up and the Deutschmark somehow return, the Deutschmark would inevitably strengthen, much to the detriment of Germans -- Germany -- of the German exports and the overall German economy. I could go on down the list as to why that's unlikely, including the sheer out-of-pocket costs and the amount of time it would take to return to the status quo ante, pre-euro.

Now, short term, the actual trading value of the euro: So often in recent years, very learned analyses -- for example, from the Peterson Institute in Washington -- have quite correctly theorized that the size of our external imbalances should lead to a weaker dollar. And in general, the dollar has not been as weak as the theories have suggested it would be. For example, over the past year -- Bob, you might correct me -- I think it's down to about 6 percent on a trade-weighted basis, not -- and a year ago, a lot of people would have said it would be weaker than that.

But, of course, the dollar has long had a safe-haven nature, and the type of crises that have coursed through Europe -- sovereign debt crises -- have not just caused the dollar to strengthen on a day-to-day trading basis versus the euro, but the safe-haven character of the dollar has asserted itself again. But in any event, what might have been a weaker dollar under different circumstances has not, at least so far, materialized.

Maybe, Richard, some day, if we don't proactively address this problem and the financial markets address it for us, that will first begin -- that chain reaction will first begin as it did in '79, through the exchange markets in the dollar. But maybe it won't. There are so many different ways that we've seen in the last 20, 25 years crises arise, and each one seems to come from a different angle than the last one. It's impossible to judge how that might first start.

HAASS: Sir?

QUESTIONER: Steve Tananbaum from GoldenTree. Roger, you start saying if we keep on the current policies, the market is going to cause us to change our ways. Yet Japan is pretty much further down, yet the market has not disciplined them.

Why do you think that's so?

ALTMAN: Well, many people would challenge the premise of your question to the effect that Japan is -- in effect, Japan's fiscal condition is worse than ours.

QUESTIONER: Well, if you look at debt to -- (off mic) --

ALTMAN: Yes. Yes. But if you look at -- and you could argue this either way. But if you -- but -- you can argue it's a more indebted country than the United States because, of course, its federal debt to its -- the size of its economy is worse than ours, as you're suggesting. You're right. On the other hand, if you look at the savings rate in Japan and the percentage of Japan's debt that is held outside the country, it's a very different picture.

In contrast to your premise, many argue that Japan's debt is financed internally, not externally like ours is; and, therefore, the degree to which global financial markets would have an incentive to discipline Japan is very low because Japan's debts in effect to the rest of the world are very small.

Now, you can look at that a lot of different ways. But I think, in general, because of the contrasts between Japan and the United States in terms of a very low level of the Americans' saving rate -- even though it's ticked up a little bit recently -- and the degree to which we are financing so much of our deficits externally -- I mean, I've seen estimates at seven (hundred billion dollars) to 900 billion (dollars) a year in the last three to four years is being added to the store of dollar-denominated liabilities held overseas; obviously, China is a big participant in that -- I think the two situations are actually quite different.

HAASS: George, let me just go back to a political question, which is, can you imagine a politician standing up and talking about these issues like we are a little bit, and essentially thriving -- (laughter) -- as opposed to stepping on the proverbial third rail?

STEPHANOPOULOS: I think it depends on which level of politician. I think members of Congress can do it; I think Paul Ryan you see of Wisconsin. Although, he leaves out taxes in his plan. I think, you know, one of the encouraging things you've seen -- you talk about the Simpson-Bowles commission. I think there was a little more crossover and support for that menu of proposals than I expected. You had, you know, senior, kind of party Democrats like Dick Durbin coming out and supporting it. You had Republicans like Tom Coburn coming out and supporting it, even though it did include some talk of tax increases.

So, yeah, I mean, I think, it's hard for a president in an election year. It is impossible for a challenger to a president in an election year. But, below that, yeah, I think you see a lot of ferment and not only the Simpson-Bowles commission, but you're seeing -- you know, I think, the fact that, you know, people like Roger have written about at a VAT, the Center for American Progress has written about VAT on the Democratic side, you've started to see more ideas bubbling on the Republican side. I think those will bubble up, but just not at the top level yet.

ALTMAN: And, George, if I could just ask a question following up Richard's, I think the distinction between what national leaders can do or a president can do in the way Richard asked about it, and what some governors seem to be doing right now is a really interesting distinction. Some governors seem to be deciding our problem is so bad, it's both the right thing to do and maybe the politically smart thing to do to tell it like it is.

So Governor Cuomo in New York has come in, you know, in a very tough way in this regard, and Governor Christie of New Jersey and others around the country basically saying, "Folks, things are really, really bad. There's no easy, sugar-coating solution, and this is what we're going to have to -- (inaudible)."

STEPHANOPOULOS: Well, and, on the other side in Illinois, you know, 60 percent tax increase.

ALTMAN: Yeah, well, we'll see how that plays. But the question is, you know, you can argue that some governors, especially new ones, are deciding, "Not only do I need to fix it, but I could actually benefit. I could advantage myself by delivering -- by talking straight about it."

And my question is -

STEPHANOPOULOS: Well, I think the talking straight, I completely agree with. I mean -- I mean, we're at the beginning of their budget cycles right now. We'll end up seeing how much they actually get through. They're also -- a lot of the governors actually face requirements where they have to balance their budgets, so it's a very different situation.

But, yeah, I do think there's a -- I think there's no question that people want to hear politicians talking about these issues in what is perceived to be a straightforward manner. I just think there's less evidence that they -- the country actually wants the politicians to follow through on those promises.

HAASS: Do you think that what happens in Britain -- there you've got a government that has gone on a fairly, by our -- by our terms, drastic path, serious spending cuts, probably -- what -- $4 or whatever of spending cuts for every dollar of tax increases. Do you think that will have any impact on here, like, the debt, the British experiment, if you will?

STEPHANOPOULOS: How long does the government survive? I mean, the liberals are in trouble.

HAASS: Well, how well does the economy survive?

STEPHANOPOULOS: Yeah.

HAASS: Do you think -- do you imagine that experiment going on in Britain will have repercussions here?

ALTMAN: If it fails, we will take note of it. If it succeeds, we probably won't. That's right.

MR. : That's right.

ALTMAN: The British government has a rather smaller borrowing capacity than the American government does. So they don't have the short-term choices that we do. But it is interesting. They are running an experiment. And I take it that the economic theory behind their policy is that if they have a serious deficit reduction program, that will inspire such confidence there will be an outbreak of euphoria in the British economy, in the European economy, and that will make up for the gap in their consumption. Let's hope it works. But as George says, the government could fall.

HAASS: There's always that. Sure.

QUESTIONER: Sy Jacobs, Jacobs Asset Management. The question's for Roger. Given that you feel that the world doesn't have 10 years of patience and appetite for trillion-dollar-a-year deficits, is it reckless or is it brilliant that the central bank of that trillion-dollar-deficit country is -- has committed to buying $2 trillion of that country's paper?

ALTMAN: I have no quarrel with the quantitative easing approach that the Federal Reserve has taken. It's part of the point I made a little bit earlier about how I believe history will judge the United States, including our central bank, as having responded very effectively to what was really civilization-threatening events of, you know, the fall of '08 through early '09.

And I think a lot of the debate about the second round of quantitative easing, so-called QE2, is a little bit strange, because I really believe the Federal Reserve's main motivation was to try to provide an extra incentive for growth and labor markets. Remember, the mandate of the Federal Reserve is both price stability and full employment.

And I don't think it was, you know, a sneaky way to try to lower the value of the dollar, even though it was interpreted that way internationally in so many quarters.

So I don't think the Federal Reserve has overstepped its bounds or acted imprudently at all. And I might add that -- I'm not a monetary historian, but quantitative easing is actually a rather traditional monetary exercise. There's nothing new about it. There's nothing original about it. There's nothing infrequent about it in the modern monetary history of, you know, the industrialized world.

HAASS: Charlie Wolf From RAND asked a question about how -- what all this means for trends in American power. So let me ask the question directly -- I'll make it the last question -- which is, does this inevitably contribute to the relative decline -- not the absolute decline but where we are -- does this inevitably contribute to the relative decline of the United States, that we are essentially in this predicament and that we are going to be forced to do things that will limit the resources that are available for our role in the world and that essentially we will occupy less of a space consequently?

Michael.

MANDELBAUM: Well, I'm glad you asked that question. (Laughter.) And I want to commend you, Richard, and the council, for making the 90th anniversary project looking at the domestic sources of American power, because I think that is really the crucial issue for the next decade. And I'm so committed to that proposition, that I am writing a book about that subject with my friend Tom Friedman of the New York Times.

And there's good news and bad news. The good news is, we can deal with these problems. We know how to do it. We've done it before. The bad news is that the problem we've been discussing today, tonight, is only one of the problems. There are three others. And I think if we can get our act together and deal with the deficit and with the other problems, we will remain the most powerful country in the world and the global leader even with the rise of China and India because our values are in alignment with what most countries want and because most countries appreciate at some level the kind of leadership that we provide. I think our soft power is still intact.

But you've got to have hard power to back it up, and that depends on what we do. And when I think about this problem -- and incidentally, I don't see anybody else replacing us. I don't see us getting any help from the Europeans and the Japanese who have problems of their own. I don't see -- I see the Chinese possibly making trouble but not shouldering us aside and being the global leader or even the unchallenged leader of East Asia. So it's either us or nobody. And nobody is a lot worse than us.

What are the prospects? We've been talking about that, but when I think about this question -- and this is -- this is the major question that we as a country face -- I think about a saying that I first heard attributed to Abba Eban, the former Israeli foreign minister who once said, men and nations -- should have said "men and women and nations" -- will always do the right thing when all other alternatives have been exhausted. (Laughter.)

Well, we're running out of alternatives.

HAASS: Well, that was also a version of Churchill's comment about American democracy and the danger -- going back to where we began this conversation, if that's true, while we're going through doing some of the wrong things or not yet prepared to do the right thing, events may intervene. And we may not essentially be able to write the script in ways that will work out.

You've actually, though, come off fairly optimistic.

STEPHANOPOULOS: In the end, I think so. And we have -- we have -- we've been through these crises before. I think that we -- I agree with Roger that history, I think, is going to look back at the way, actually, both presidents in the end dealt with the financial crisis in 2008 and 2010 and say they did the right thing at a difficult time. And I do think that we're going to solve this in the next couple of years because we're going to have to.

ALTMAN: Hey Richard, you know, we've done some good things here tonight, one of which, obviously, is to give George all the briefing material he needs for his discussion tomorrow morning with Joan Rivers. (Laughter.)

STEPHANOPOULOS: She's great on the euro. (Laughter.)

MANDELBAUM: But more pessimistic than you are. (Laughter.)

HAASS: From that, well, we hope you've enjoyed the red carpet here tonight -- (laughter) -- and let me thank these three friends for starting what I hope really will be an extended and a thoughtful discussion throughout this year and beyond on the domestic challenges that really are so much now at the heart of what the United States does in the world. It may seem to be an odd place for the Council on Foreign relations to end up, but I think that tells you something. And I think this reinforces my sense that we've ended up in the right place.

Let me thank you all for getting us off to such a good start. (Applause.)

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