03/15/2012 05:00 pm ET Updated Mar 15, 2012

Paul Volcker: National Debt 'Strangles' Us

WASHINGTON -- Some of the country's most high-profile economists say the U.S. government needs to reach a long-term deficit reduction agreement soon in order to avoid an investor revolt that would make interest rates on government debt unsustainable.

Paul Volcker, the former Federal Reserve chairman, urged both political parties to make detailed deficit reduction proposals this year and pass legislation in the areas on which they agree.

"If the electoral process doesn't produce some common ground for constructive policy decisions, then I fear that, sooner rather than later, variable pressures will come to bear on monetary policy and some combination of a weak dollar and rising interest rates," said Volcker, speaking Wednesday at the Economy Summit organized by The Atlantic. "Financial institutions and markets ... would then again be in jeopardy."

"At the end of the day, it [debt] strangles," said Volcker, who has served as an economic adviser to President Barack Obama.

Volcker warned that the government's current spending is "well above any peacetime levels" and that "it would take years" to reduce federal spending enough to bring it more in line with tax revenue.

As for taxes, he said, "The revenue system is so sucked through with exceptions, exemptions and credits that it's leaking badly. The system is so complicated, it's hardly comprehensible."

"Nor does political reality, administrative capability or economic analysis suggest marginal tax rates can be appreciably increased across the board and still generate enough revenue," Volcker added. He said the government needs to rely more on consumption taxes and consider integrating corporate and personal income taxes.

The idea that the government might resort to inflation to reduce its national debt burden he called "dangerous" and "kind of a doomsday scenario."

Also at the summit, Lawrence Summers, a former Treasury secretary and top economic adviser to President Obama, emphasized the importance of deficit reduction through tax reform and economic growth. "It is tax reform that is central to revenue, that is central to the budgetary challenge," Summers said.

Robert Rubin, a former Treasury secretary under President Bill Clinton who mentored both Summers and current Treasury Secretary Timothy Geithner, warned that investors could demand unsustainably high interest rates as soon as next year if the government does not agree to a 10-year debt reduction plan.

"I think the probability of a serious set of adverse effects as a result of our fiscal situation, if we don't address it, at some unpredictable time is extremely high, and one of the kinds of effects it would have is a severe bond and currency market crisis. And whether that's a year off in time or five years off in time or 10 years off in time is absolutely unpredictable," Rubin said.

He continued, "One thing I can tell you for sure -- and I have watched markets my entire adult life -- is markets can change dramatically, and it's almost instantaneous and with no notice. And I think it is imperative to react. And I think the probability of a crisis increases as time goes on."

Just the fear that the government will monetize its debt through inflation, Rubin said, "can increase the probability of that happening" by causing investors to demand higher interest rates, thus increasing the government's debt burden.

"We are tremendously dependent as an economy on confidence that the Fed ultimately will combat inflation," he said.

Rubin noted that interest rates on U.S. Treasury bonds are low now due to unusual circumstances: Corporations are not investing, and professional investors are fleeing to safety in Treasury bonds because of the crisis in Europe and the threat of a sharp economic slowdown in China. He said interest rates eventually will return to normal.

It's a "false choice" that we have to pick between public investment and deficit reduction, Rubin said in response to a question from The Huffington Post. "We have to make room" for public investment, he said.

"Within the context of re-establishing a sound fiscal regime, it is absolutely essential to have robust public investment because we want to be competitive with an emerging market world, with China, etc., and they're investing heavily in these areas to increase productivity," Rubin said. "We have to do the same thing with research and infrastructure and a whole host of areas."