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CHARLIE ROSE HOST: Welcome to the broadcast. Tonight, the debt and the deficit of the United States. More and more people are concerned, and we talk about it with Paul Krugman, the Nobel laureate and economics professor at Princeton, David Walker, president and CEO of the Peterson Foundation, Congressman John Spratt of South Carolina, chairman of the House budget committee, Mohamed el-Erian, CEO of Pimco, and Alan Auerbach, an economist from the University of California at Berkeley. The state of the U.S. economy, debts, deficits, budgets, and more, next.

CHARLIE ROSE: The fallout from the economic crises has brought one issue to the forefront of the nation`s political and economic agenda. It is the deficit and the country`s public debt burden. As entitlement programs have grown and as trillions have been spent to combat the recession, concerns about the country`s fiscal health have peaked. The Congressional Budget Office recently projected that total debt this year would climb to nearly $9 trillion, or 60 percent of GDP, the highest level in nearly 60 years. In response to such concerns, President Obama today established a bipartisan commission to bring the country back to fiscal responsibility and stability. The president acknowledged that difficult choices lay ahead for the country.

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BARACK OBAMA, PRESIDENT OF THE UNITED STATES OF AMERICA: I know the issue of deficits have stirred debate, and there are some of the left who believe that this issue can be deferred, and there are some on the right who want to enter into serious discussions about deficits without preconditions. But those who preach fiscal discipline have to be willing to take the hard steps necessarily to achieve it. And those who believe government has the responsibility to meet these urgent challenges have a great stake in bringing our deficits under control, because if we don`t, we won`t be able to meet our most basic obligations to one another. So America`s fiscal problems won`t be solved overnight. They`ve been growing for years. They`re going to take time to wind down. But when the commission that I`m establishing today and the other steps we`re pursuing, I believe we are finally putting America on the path towards fiscal reform and fiscal responsibility.

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CHARLIE ROSE: Joining me now is a group representing a range of views on this pressing issue. We begin in Charlotte, North Carolina with Congressman John Spratt of South Carolina. He is chairman of the House budget committee. From Newport Beach, California, Mohamed el-Erian, CEO of Pimco, the world`s largest bond fund, from Berkeley, California, Professor Alan Auerbach, an economist who has long studied the government`s finances. Here in New York with me, Paul Krugman, a Nobel laureate an economics professor at Princeton University. He recently wrote in his "New York Times" column that fear-mongering about the deficit has distorted the public`s understanding of the issue. Also here at the table, David Walker, president and CEO of the Peterson Foundation, an advocacy group that calls for fiscal responsibility. He has long service in the government dealing with important fiscal issues. Let`s do some definitions as we begin. When we talk about the deficit and when we talk about the debt, the federal and the national debt, tell me what we mean.

PAUL KRUGMAN, PRINCETON UNIVERSITY: Well, the deficit is the extent to which the government is spending more than it`s taking in in the way of revenues. The debt is what accumulates after you have done a number of years of that. So the debt is the amount of money that the government owes. The deficit is the extra money the government has to borrow this year, which adds, of course, to the debt. It`s like -- actually I don`t want -- analogies with households are pretty bad. The government is not like a family. But you know, in a family, if you`re spending more than you`re earning, you run a deficit, and you run up some debts at the bank, and that`s your debt. But the government is not like a family.

CHARLIE ROSE: Is there an acceptable range of which a deficit should be as a percentage of GDP and debt should be as a percentage of GDP?

PAUL KRUGMAN: It`s not really easy to come up with simple numbers on that. I mean, in emergencies, you do want to run deficits -- various kinds of emergencies, an economic emergency like we`re having now, a war. We ran deficits that hit about 28 percent of GDP during World War II, which would be $3 trillion if we were doing it right now, more than that. We had debt that was more than 120 percent of GDP, much, much larger, double where we are now at the end of World War II. So you can have pretty high numbers. The real question is always does the long run add up? Do you actually have a story which will enable the government to pay its bills under a plausible future evolution of policy? That`s the question. You can`t just say here is a number, that`s a bad number, that`s the red line.

CHARLIE ROSE: I mentioned the word "fear-mongering," which you have used. You believe this debate has been what?

PAUL KRUGMAN: I think it has been hijacked by people who really want to stop us from doing things to create employment now. And it`s political. The deficits have ballooned under the watch of the current president and there is a party that will do anything it can to bring the current president down. But people look at the numbers now and say oh, my god, look at all of that red ink, which is not the problem. The problem is not what the numbers are now. The problem is what do we think it will look like over the next couple of decades? And for that what the deficit is this year matters actually quite little. It only matters insofar as it`s a precursor, as it gives an indication of where we`re going, and the things we`re doing right now actually have little to do with the causes or the solutions of the long run deficit problem.

CHARLIE ROSE: All right, we`re going to get to all these issues. Professor Auerbach, put this whole thing in context for us so we can understand what we ought to be talking about, both the historical moment as well as the challenge that faces us.

ALAN AUERBACH, UNIVERSITY OF CALIFORNIA, BERKELEY: Well, as Paul mentioned, we had a higher debt-to-GDP ratio at the end of World War II. But the difference between that period and now, as he said, is what we face in the future. One can think of these as implicit liabilities. They don`t show up as part of the national debt but they`re a much bigger problem. And like the national debt, they represent commitments that the federal government has made. So simply controlling the national debt or not going above a debt-to- GDP ratio in the near term that is higher than we were after World War II isn`t a satisfactory solution, because at that point we will be facing exploding entitlement programs that we have no means to pay for. And markets understanding that will not wait until our debt-to-GDP ratio gets that high. If we have no credible answer to the misalignment of revenues and spending that we face on our current trajectory, we will have a crisis far before we get to 110 percent debt-to-GDP ratio that we had at the end of World War II.

CHARLIE ROSE: Congressman Spratt, how much have we blamed Congress and the political risk that Congressional people see either for raising taxes or cutting spending?

REP. JOHN SPRATT, (D) SOUTH CAROLINA: I think the extreme deficit that we`re dealing with now is something that came at us out of the blue resulting from a crisis in high finance, a crisis in housing, a crisis in automobiles. The private sector created a lot of the problems that`s given rise to these huge recessionary deficits. I do think, however, and I`m not a hijacker, I do think we can do two things at the same time. We can apply countercyclical policies still to the economy to help get it on its feet and up and running and generating jobs again, at the same time we can begin building a credible and effective structure for reducing the deficit in the not so far future. That would include basically that the president is proposing, taking the deficit from this year`s estimate of $1.556 trillion down to about $1 trillion next year, $828 billion the next year. If we follow his budget we can cut the deficit in half, and I think that`s the best we can hope for over this period of time.

CHARLIE ROSE: Speak to the commission idea, first of all. The president thought he would be able to create a different kind of bipartisan commission, and the Republicans did not support it, so he is doing this by executive fiat.

DAVID WALKER, PETERSON FOUNDATION: Charlie, clearly it would have been preferable to have a statutory commission, because that way you would have gotten buy in from the Congress and the president, and the only way you can get a vote on the commission`s recommendations is if it`s a statutory commission. In the absence of getting the required number of votes in the Senate, you got 53 rather than 60, then the president has stepped in and shown leadership, and I commend him for that, and he has worked with the democratic leadership in the Senate and the House to try to help ensure that the commission will receive its recommendations. That`s easier for Speaker Pelosi to do than it is for Majority Leader Reid because he doesn`t control 60 votes. But clearly the problem is the deficits that will exist once the economy is growing, once unemployment is down, once the wars are over. That`s what threatens the ship of state, and it`s going to take a commission and some type of special process to make those tough choices.

CHARLIE ROSE: The tough choices that have to be made are what?

DAVID WALKER: First we will have to reimpose tough statutory budget controls once the economy turns around, tougher, frankly, than the ones that we have back in the 90s. We will have to reform Social Security, which is pretty darn easy to make it solvent, sustainable, secure, and more savings oriented. We will have to reform Medicare and Medicaid and focus on health care costs. We will have to reform our tax system and generate more revenue. We will have to do all of those things. Frankly, there`s waste in defense. There`s waste in homeland security. We will have to go after that, too. And we`re going to have to make progress on multiple fronts at once and before our foreign lenders lose confidence in our ability to put our own financial house in order.

CHARLIE ROSE: Pick up where you want to.

PAUL KRUGMAN: The way I look at it, there are really just two things that are top of the line. Everything else is secondary. First is health care. Nothing works unless you can get health care costs under control. You look at all of those projections that show federal spending going through the roof as a share GDP, very little of that is the aging of the population. Demography is much overrated as a problem.

CHARLIE ROSE: In this country.

PAUL KRUGMAN: Yes, in this country. We still have children in this country.

CHARLIE ROSE: Exactly.

(LAUGHTER)

PAUL KRUGMAN: So it`s really -- it`s about -- you have to bring health care costs under control. And if you do that, then you`re still left with a fairly sizable gap but not a huge one. And it`s the kind of thing that almost surely the bulk of it has to involve raising more revenue. You know, the United States is the lowest taxed nation among the major economies. If we move to moderately higher taxation, there will be endless negotiations about what form that will take, that plus health care cost control brings us within striking distance. Then we can talk about some others economies. I would not put Social Security high on the list. And I would say we`re still spending quite a lot of money to keep Soviet tanks from going across Germany, and so if we could stop doing that, that would help.

DAVID WALKER: I agree with Paul that health care is the real key issue, but we have to reduce health care costs and reduce the rate of increase in health care costs, and the latest health care reform debate was really not about that. The latest health care reform debate was how do we expand coverage and pay for that expansion of coverage? We have $38 trillion in unfunded promises in Medicare alone. We need to figure out what are we going to do. And that means tough choices, mechanism that provide some type of budgetary control like every other industrialized nation, looking at tax preferences for employer provided health care, looking at premium subsidies for people that are well off that sign up for Medicare Part B and Part D. It`s tough stuff that, frankly, is difficult for elected officials, and that`s why we`re going to have to a special process.

CHARLIE ROSE: Just a moment about health care reform, because we can get lost in it. Was the proposal that the Senate passed, was that deficit neutral?

DAVID WALKER: Depends on who you ask. The CBO scored these bills, but they had all kinds of caveats. They had all kinds of concerns that they raised as to whether or not the assumptions that were contained were reasonable and whether they were sustainable. In my view for health care reform to be fiscally prudent it should meet four tests, first, pay for itself over 10 years, second, not add to deficits beyond 10 years, thirdly, result in a significant reduction in the tens of trillions of unfunded promises we already have, and fourthly, result in lower health care costs as a percentage of the economy than we would have had we not do the reform. The bills don`t pass that.

PAUL KRUGMAN: I want in here. Let me say, I actually think the CBO was underweighting the amount of the savings of the bills. These bills basically try all of the things that health care economists have been recommending to control costs. We don`t know which those are going to work and how well they`re going to work, and so the CBO scores those things as zero because it says it doesn`t know. But the odds are some of those things would work. I think there was a -- both the Senate and House bill are the most serious cost control efforts we have ever made. And if we can get something like those through at the end it will make a big difference.

CHARLIE ROSE: And if we don`t?

PAUL KRUGMAN: If we don`t, god help us, basically, because we will have not only failed to reform health care, but we will have failed because largely of a scare campaign about Medicare and death panels which will make any future health care reform almost impossible.

CHARLIE ROSE: Some arguments are being made that the president made a politically unwise decision given the economic climate that he accepted when he came to office and that she should not have gone for health care reform in the beginning even though it had this cost benefit, deficit reducing benefit, that he should have focused on jobs. Did the president make a mistake?

JOHN SPRATT: Once again, I think you can do both things at the same time. He was spending political capital on the jobs bill, the Recovery Act that he probably could have spent on the health care bill. But, look, he couldn`t not deal with the economy. At the same time, he had a substantial outstanding promise to do something about health care reform. By the way, he agreed with us completely and stipulated in his budget and we stipulated in the budget resolution whatever was done had to be deficit neutral over a 10 year and then 20 year period of time. And the CBO for better or worse has scored that as saving on average between the two bills about $150 billion. You could have proposed other things that I think would have added to the bill. For example, I think the prohibition that the Republican leadership put on the negotiation of pharmaceutical drugs, the negotiation of prices, bargaining for better prices, is indefensible, and I think there should have been a complete repeal of that language in the health care bill. But bills like this are seldom done in one sitting. I think it will be revisited numerous times before it is in full effect. And the bill is full of efforts to reduce costs, implement efficiency through information control and technology, and stressing prevention and wellness. Will that work? We don`t know and the CBO doesn`t know, but it is the biggest effort the federal government has made in that direction ever, and it could pay off in the long run mitigating the cost not only for the Medicare care program but the whole medical care system in the country.

ALAN AUERBACH: I wanted to say something about the revenue neutrality of these bills. Both the House and the Senate bill raised revenue in ways unrelated to health care, through taxes, in one case an increase in the Medicare payroll tax, and in the other case an increase in income taxes on high-income individuals, in both cases targeted higher-income individuals. There is not necessarily anything wrong with that, it`s just that, as has already been discussed, the long deficit problems we have will require increases in revenues combined with tax reform, and you could only go to the well a certain number of times. And if you`re going to rely on higher taxes and more progressive taxes and taxes on higher income individuals for an increase in revenues to deal with our future problems, then you`re stealing from the pot by devoting it to health care reform to pay for health care reform. You can`t use those revenues twice. So even if it`s true on paper that the House and the Senate bills were revenue neutral or even reduced deficits somewhat, that`s taking into account use of revenues that might have been used for another purpose, and these are scarce resources. Moreover, some of the ways of reducing costs that were in the bills are things that we can`t have any confidence would be sustained, such as cuts in med cared reimbursements. These are things that have been overridden in the past when they have been in law. And so while on the one hand we might save more money through some cost saving measures that are in the bill than the CBO estimates, we may also be overly optimistic in expecting that some of these very unpopular cuts will be sustained in the future.

CHARLIE ROSE: Mohamed?

MOHAMED EL-ERIAN, PIMCO: Charlie, it`s important to have a few principles out there, because part of this debate gets hijacked not just by fear mongering but also a lot of details. Why is it that we want fiscal consolidation and fiscal stability? It`s a means to an end. And the end is growth, employment creation, and welfare creation. Ultimately we look for financial stability and fiscal stability because it`s a means to an end. If we go back 12 months ago, the biggest issue is that we collectively, and Washington in particular, underestimated the headwinds facing employment creation and growth. If we had correctly estimated that the unemployment rate was going to go up to 10 percent as officially registered, but much higher, 17 percent if you also take into account the underemployed, then at that point there would have been a much bigger focus on growth. And if we could have gotten the economy moving 12 months ago then we could have dealt with this sequentially. We didn`t. So today we are torn between two objectives. One is employment and growth. It remains important, but the other is dealing with a debt stock that has increased by 20 percent of GDP and a deficit that is stubbornly high. Both elements have started to become structural in nature. We have a small window through structural measures to try to address both issues. There will be a time consistency issue, but there`s still a window if we can get agreement to address both issues. If we don`t, in a year`s time, the unemployment issue will be worst, the deficit will be worse, and at that point we will be forced into the other corner solution, which is deal with the fiscal situation first. So one cannot underestimate, Charlie, the urgency of moving quickly because the degrees of freedom are going down month after month given that we have two problems -- unemployment and the deficit, and not just one.

CHARLIE ROSE: Let me bring it back to the table.

PAUL KRUGMAN: OK. Actually, I have many things to say.

(LAUGHTER)

PAUL KRUGMAN: So let`s start. Let me give you my broader take, which is that the United States does worse than anybody at controlling health care costs. We also are the only advanced country without universality, and that plus a lot of evidence leads me to believe that universality, having a guarantee of coverage for every American is that the core of any way dealing with health care. We don`t get there -- you cannot push through, for example, even with the cost saving measures that will in the House and Senate bills without them being tied to a promise of health insurance for all. So there`s a reason why you have to do it this way. Yes, it looks like there are some extra costs of covering the current uninsured, but actually this is the only route we will ever take a rational approach to our health care problems.

CHARLIE ROSE: David?

DAVID WALKER: On health care, I personally believe that we need some level of universal coverage. I think it`s outrageous that this country doesn`t have it. But I also think we need to have an honest discussion and debate with the American people about what is appropriate, what is affordable, what is sustainable. When you listen to the American people, a lot of things they tell you is, look, we need protection against catastrophic accidents and illnesses that could wipe us out financially. It`s the number one cause of bankruptcy in the United States. Secondly it`s in our societal interest to have more prevention and wellness because you need as big of a pool as you can to be able to do that. We have a tendency in this country to want to give everybody a lot more that we can`t afford and sustain. We need a budget on health care. Yes, we need universal coverage, but we need to make sure that we don`t end up making more promises we can`t keep. We need a safety valve. You`re right about assumptions. Some maybe optimistic, some may be pessimistic. Why not one something that says if certain things don`t happen there will be automatic actions to make sure that budget is protected so we can guard against unrealistic assumptions? And the last thing -- the short-term is not the problem. We need to do more to get unemployment down in the short term, and that might cause the deficit to go up in the short-term.

CHARLIE ROSE: You mean some kind of stimulus?

DAVID WALKER: Some kind of stimulus that`s timely, targeted, and temporary. And John Spratt is right, you can do two things at once. If you do it the right way, we can deal with our short-term problem. But this commission has to help us deal with the structural problem that threatens our ship of state.

CHARLIE ROSE: Do you think if the president and members of the Congress went to the American people and said we have to talk common sense to you. If you want services we have to create more revenue and you have to therefore tax you more. If you want these services both in terms of national defense and in terms of social services, you have to pay for them. That argument would sell?

JOHN SPRATT: Don`t underestimate the difficulty of selling it. But look, for the talks to be successful, for negotiations for this commission to succeed, everything has to be on the table and everybody has to be on -- everything has to be on the table and everybody has to be at the table. And learning, looking back to 1997 when we did the balanced budget agreement of `97 and put the budget in balance for the first time in 30 years, the key to that was the president was, in effect through his proxy, present of at every meeting we had. It`s critically important that the leadership support in both parties what we`re doing. So I think the president is absolutely correct to put together this commission to try to find common ground.

MOHAMED EL-ERIAN: Worldwide we are starting to see a re-pricing of sovereign risk. Prices are starting to move. It is most visible in countries that don`t have the ability to sustain high debt, Greece, where there`s been a rapid increase in interest rates in what we call the sovereign risk. But also the United States. The ten year has now gone up to 3.80, the curve is steepening, so there`s also a recognition that fast in some cases in Greece, slow in other cases, the market is starting to re-price the sovereign risk. And that will re-price everything else because sovereign risk is at the center of all asset prices. So you are getting a couple of things that is fueling this debate and the concern that you`re seeing out there.

CHARLIE ROSE: OK.

PAUL KRUGMAN: I am extremely hesitant to argue with Pimco about bond prices.

(LAUGHTER)

MOHAMED EL-ERIAN: Go ahead, go ahead.

PAUL KRUGMAN: My read has been that those U.S. long-term interest rates have been moving one for one with beliefs about the future of the economy. There`s no sign at all that they`re reacting to fears of a U.S. sovereign default. What they are reacting to is gradually improving economic news leading people to believe the date when Ben Bernanke finally moves short term interest rates off zero is getting closer. I don`t see anything in that data. We don`t look like Greece. We don`t look like Spain or Italy, even. People are -- long up are up because we have had good news.

MOHAMED EL-ERIAN: Just take note of the extent to which the yield curve has steepened. The front end is being held by the Fed at zero and the concerns are starting to mount. And what you`re starting to see is the yield curve steepening even though the economic picture and the growth is not as strong as people has anticipated originally.

PAUL KRUGMAN: That`s not how I read the data. Long-range dates went up today, the day we are taping, because the Philly Fed survey suggested stronger manufacturing growth. It was optimism not pessimism driving them.

MOHAMED EL-ERIAN: We issued $1.7 trillion of U.S. treasuries into this market.

DAVID WALKER: Even if interest rates do not go up, which I think is a totally unrealistic assumption over time based on the size deficits that we`re talking about.

CHARLIE ROSE: And based on what Bernanke sort of telegraphed.

DAVID WALKER: Right. They eventually will go up. We can debate how quickly and fast, but here is the key. Even if they don`t go up, the single largest line item in the federal budget within 12 years will be interest on the federal debt -- larger than defense, larger than Medicare, larger than Social Security. And what do we get for that? Nothing. And the simple fact is we have all agreed that they`re going to go up. We can debate when and how much.

CHARLIE ROSE: OK.

PAUL KRUGMAN: I`m really -- I really hate that calculation. I share your concerns about the long term, but I really hate that calculation. Take the Obama budget, I happen to know the numbers. It says in 10 years we will be spending 3.5 percent of GDP on interest payments. And when did we last do that? We did it when the first George Bush was president. It wasn`t catastrophic then and it isn`t catastrophic now. It`s a very misleading number in calculating the real burden. Those interest payments are the least -- if that is all that is going to happen, we could handle it easily. I think what is a concern is whether there does come a point when people do start to view the United States as being Greece. I think we`re quite some ways from that, and that`s when it matters.

CHARLIE ROSE: Mohamed, you made this point very early in the conversation, whether those people who hold a lot of American debt are beginning to get nervous because we`re not handling our debt or deficit very well, and, b, they therefore, not that they unload what they, but that in fact they stop coming to buy our debt. Is that a real possibility?

MOHAMED EL-ERIAN: It is not an immediate possibility. So I agree we`re not Greece. But let`s understand why we`re not Greece. We`re not Greece because we supply what are called global public goods. We have something other people want and it cannot be replaced. The dollar is a reserve currency in very deep and predictable financial markets. Now, we can`t replace something with nothing, so there is nothing to step in to substitute for us at this time. So we are not Greece, right, but if we continue to abuse the fiscal situation, if we`re unable to promote growth, if we`re unable to promote employment, then the rest of the world will start having more and more questions. It`s not an overnight issue, but it is a gradually erosion that becomes difficult to counter over time.

CHARLIE ROSE: How do you see the urgency of the issue and the danger to America`s reputation in the world?

JOHN SPRATT: I think we all know that somewhere there`s a wall beyond which we cannot easily go. That is to say the holders of our debt will conclude that they have been saturated with dollars and they have all of the portfolios they want. They either start selling what they hold or not coming to the sales to buy more. I would like to say as a practical politician going back to net interest on the national debt -- this year it`s $188 billion, 10 years from now it`s $720 billion. David Walker is right. This is a problem politically for us in the sense that I have to go back to my constituents and explain to them why their taxes have gone up to pay net interest on the national debt for which they see no real return that`s relevant to them. That`s a problem.

CHARLIE ROSE: How do you handle the problem?

JOHN SPRATT: Well, you have to address it. As I said, the president`s budget takes the deficit down $1.5 trillion to $700 billion over a period of four years. That`s not bad progress, cutting the deficit in half over a four year period of time. But at that point it peters out. And we need a second effort at that point. And I`m hopeful the commission can provide that coherence and second effort to take the deficit on to the second five year period of time to move us to a much better relationship of debt-to-GDP.

CHARLIE ROSE: Is there anything the president is not doing that you want him to do, either to say or to do.

JOHN SPRATT: I think the president has done what he should have done with respect to the commission. And I think that this commission is going to have every bit as much influence and effect as a statutory commission would have had so long as the leadership on both sides of the Congress stands behind it. I know that the speaker and the majority leader both have personally pledged that they would see to the commitment that this so-called budget director would make recommendations in December would be voted upon. So the one thing we would have had with a statutory bill with a statutory promise to fast track a piece of legislation is there.

DAVID WALKER: I have two real concerns about the commission that I hope the president is going to address. One, he has talked about the goal is to achieve primary balance by 2015. He has talked about the need to do something beyond that. We clearly need to be looking at the growing structural deficits that get worse with the passage of time beyond 2015. We have to look at trying to stabilize debt-to-GDP at some reasonable level, an appropriate metric. Second, the only way that Congress will be able to make the tough choices that they have to make on budget control, Social Security, health care, and taxes is if the American people outside of the beltway are engaged in a meaningful way. And that`s going to have to be done by people that are capable and credible to the American people beyond the beltway. And that will depend to a certain extent on who he has on the commission to do that.

JOHN SPRATT: He`s off to a good start with Erskine Bowles and Alan Simpson.

DAVID WALKER: I agree with that.

JOHN SPRATT: I was in Congress in 1983 when we did the Social Security bailout, which made the system solvent for another 50 years. And the key to that was not the commission. It was not even Alan Greenspan as chairman of it. It was Jim Baker. And the key votes, the key decisions were made -- not really made, were around the conference table, I`m told, were in his living room. And you need that kind of personal leadership again to enable this commission to really realize its potential. When it does realize its potential, I think they will go on to deal with the entitlements question. As it is, the executive order only calls for observations and thoughts and proposals without proposing that they be reduced to legislation when it comes to entitlement issues.

CHARLIE ROSE: Go ahead.

PAUL KRUGMAN: I was going to say, it`s -- the problem really is not with what the president is doing or not doing. The problem is with the state of our political discourse. And I think there`s only so much he can do there. Try to think, let`s find a figure who is universally respected - - dead stop. There is no such figure in America today.

ALAN AUERBACH: I think the hardest thing to confront our leaders in terms of coming to grips with the problem is that the real problem is in the future. These are implicit liabilities that we have now but they`re not showing up in the current deficit. So if the economy improves and the deficit starts to go down, as this committee is going through its deliberations, people will look and say why do we have to do any of this? And the point is, the time to act is now even if these problems start piling up in the future, because, as I said before, you can`t change it very quickly. You need a very long lead time to take care of these things. So the biggest payoff in terms of budget reform will be through measures that only take effect gradually over time and have a big really effect in the future. And those are things for which I think it`s very hard to make a case to people who aren`t really involved in the process and understand it.

CHARLIE ROSE: Isn`t this part of the problem, that some governments and people around the world look at the United States and say I don`t know if they`re really capable of dealing with their problem and therefore I wonder if their best days are behind him?

PAUL KRUGMAN: Sure. That is the risk. The thing to bear in mind, it has nothing to do with this year`s deficit numbers, has nothing to do even with the five year Obama budget.

CHARLIE ROSE: It has everything to do with the capacity to solve problems and legislative solutions.

PAUL KRUGMAN: We haven`t really made a major move of any sort in this country on domestic policy for 20 years. Arguably maybe the Reagan era tax reform was the closest thing we got to a really major.

CHARLIE ROSE: What about welfare reform?

PAUL KRUGMAN: That affected a relatively small number of people and people who by and large don`t vote. So no, we really haven`t done a big thing. And this is the problem, but I`m not sure that creating a commission solves it or makes much of a dent in it?

CHARLIE ROSE: What would. Obviously you said there`s no one human being live in America that you think as the credibility to provide of the kind of leadership that Congressman Spratt said Jim Baker did.

PAUL KRUGMAN: I think the crazies need to lose a couple of election is what I really think. If you look at bipartisanship in America, it is really the 30 or so years after the 1948 election when Republicans realized the New Deal would not be overthrown.

CHARLIE ROSE: I do with some respect, I have problem saying, if you are talking about the people of Massachusetts that they`re crazy because they voted the way they did. I have a hard time saying people are crazy because they win elections.

PAUL KRUGMAN: Let me put it this way -- you need a situation where irresponsible rhetoric actually loses people elections. And that has not been the case in America for a while.

CHARLIE ROSE: What does that say about us?

PAUL KRUGMAN: I know. That`s a problem.

DAVID WALKER: I think one of the problems -- I have been to 46 states doing town hall meetings. And the fact is there are a couple of reasons why the American people are really concerned right now. Number one, we have gone from billions to trillions, just like in the 1930`s, we went from millions to billions. It`s 1,000 times the other, and people are having difficulty with it. Secondly, it`s the off balance sheet obligation. It`s not our current deficits or debt. It`s the fact that when you add in the unfunded promises that have been, made this country is in a $60 trillion-dollar hole. Just Medicare and Social Security, pensions and health for civilians and military. That`s three times what it was when George Bush became president. The debt has doubled, more than doubled, since George Bush, this is 43, became president. That`s what they`re concerned about. Frankly, we have a dysfunctional democracy. And the problem isn`t so much the partisanship, although that`s an issue, it`s the ideological divide. It`s the fact the country is more in the center but a disproportionate share of representatives are on the poles and you can`t get a deal done on the poles.

CHARLIE ROSE: So what is the answer to that?

DAVID WALKER: The answer is that it will take special processes to get fiscal reforms and political reforms in the area of redistricting and campaign finance and other things that will take more time in order to help heal our dysfunctional democracy.

MOHAMED EL-ERIAN: It`s not that out democracy has become dysfunctional. It`s really that we`re going through a paradigm shift. We have a seen a 20 percent increase in the debt to GDP ratio in a very short period of time. We have seen unemployment go up to levels that were unthinkable and is likely to stay there. And this is in a system built on the assumption that unemployment cannot stay high for a long time. That`s why our safety nets are so week. We have seen major questions being raised about institutions, about the Fed, about the banks. This is a paradigm shift. If you look at how symptoms cope with paradigm shifts they have difficulty because most of the time paradigms do not shift and therefore systems manage well through checks and balances to maintain the equilibrium. But when the paradigm shift people fall into, and Paul can speak more about it, to being hostage to their prior internal comment commitments. You do something but it`s really doing more of what you have done before. And the way we see it, not only in the United States, is this paradigm shift has taken the system by surprise and the system is still trying to adapt and react. And I think it will take time. And I don`t think as much a question of the democracy no longer functioning as it is that democracies or any systems don`t deal well with paradigm short.

CHARLIE ROSE: Before anybody answers that, what are you referring to, making sure I understand you, the paradigm shift that you`re talk be at.

MOHAMED EL-ERIAN: What I`m talking is there are things that are happening that were unthinkable. It was absolutely unthinkable that we would have a 20 percent increase in the debt to GDP. It was unthinkable one in six would be under or unemployed. It was unthinkable that the growth potential of the U.S. economy would come down from three percent to two percent. The system is now trying to react to that. Just look -- let me take another example to show you where the inconsistencies sees are. Look at debate on the banks. In the morning we will argue that the banks are not lending enough. And that`s correct. In the afternoon, we will argue that the banks pose too much risk to the system and we need to de-risk the banks. There are inconsistencies all over that speak to a paradigm shift that has occurred and the system as a whole is not agile enough as yet, it will be, but it`s not agile yet to navigate through that.

PAUL KRUGMAN: I disagree with David about a fair number of things, but one thing David Walker has been doing is he has been campaigning for years on the need to do something and our inability to do something about this long run budget picture. And while I hate that $60 trillion-dollar calculation, I think that is misleading, but the fact of the matter is, we were dead stuck on health care reform, on Medicare reform, on the long run budget issues before any of the things that Mohammed is talking about started.

CHARLIE ROSE: Pension entitlement and all that.

PAUL KRUGMAN: We were. People like Alan were warning us about it and we all knew about it but the political process wasn`t dealing with it. So it`s not as if we had a functioning, effective system and then came this inconceivable crisis and we lost our bearings. We never had our bearings to begin with. So this is not the problem.

CHARLIE ROSE: But it exacerbated.

PAUL KRUGMAN: It`s much worse now. Now we are simultaneously failing to deal with mass unemployment and failing to deal with the long run budget economic.

CHARLIE ROSE: And therefore.

PAUL KRUGMAN: And there we need some kind of major political, psychological realignment. It`s not just enough that we can convene commission, but there has to be a point where the body politic comes to its senses. I don`t know how that happens.

CHARLIE ROSE: And you thought that was happening with President Obama but you do not think so now.

PAUL KRUGMAN: I was much more optimistic a year ago than I am now.

CHARLIE ROSE: John Spratt, we`re talking politics. Comment on that, would you?

JOHN SPRATT: Well, the problem now is that with the majority we`ve got, particularly on health care, five votes in the House, one vote in the Senate, it`s very difficult to make the best of decisions because sometimes those are the toughest decisions that you have to make. You need a working majority so that you can afford to lose a vote here and lose a vote there and still adopt amendments and changes to your legislation that are good solid policy. Let me tell you one other thing I say to my Democratic caucus when we`re trying to pass a budget resolution, referring to the incumbents about what the rest of the world thinks of us. I tell them, if you can`t budget, you can`t govern. That`s the way it is looked upon. And if you look at other, true parliament systems is it particularly a condition or rule of the parliament, if they fail to pass the budget it`s a call for dissolution of the parliament. And frankly we should be held accountable for what we do to a far greater extent than we are.

CHARLIE ROSE: And how would you create that?

JOHN SPRATT: The American public needs to inform itself about conditions that we`re dealing with. This is a very difficult issue to discuss. It`s latent with numbers and concepts and jargon and it doesn`t always get the clearest coverage in the media. And as one who went from civic club to civic club with his budget speech and seeing that people titling over as I go through my numbers and my charts, I can tell you this is not easy.

(LAUGHTER)

CHARLIE ROSE: I know.

DAVID WALKER: People can get it. Look. Think back to the movie "Thelma and Louise," right? We`re in a car headed for a fiscal cliff. And it`s not the current deficit, it`s not the current debt. It`s where we`re headed. We need to do something to change course. This country is not going to default but people are legitimately asking what about what will the dollar be worth and how much risk is there?

CHARLIE ROSE: David, there`s a gap between -- you have been preaching this sermon, you and Pete Peterson, for at least 10 years, right?

DAVID WALKER: Well, Pete for 30.

CHARLIE ROSE: Pete for 30 and you for 10, right? And you`ve been saying we`re going off the cliff folks. If we don`t deal with future.

DAVID WALKER: But people get it now. And they`re starting to see it in public opinion polls. You`re starting to see it in elections. Massachusetts was not a win for Republicans.

CHARLIE ROSE: Getting it does not bring them to the point of saying therefore I`m prepared to see make changes in political leadership.

DAVID WALKER: That`s why you have to speak the truth, talk about the tough choices, help them understand you can`t having something for nothing and help them understand the moral aspect of this. We are mortgaging the future of our children and grandchildren and expecting those two young to vote and those not born yet to pay the bill, and that is immoral.

JOHN SPRATT: I want to make the clear the people I represent in the Carolinas in particular are concerned, deeply concerned about the deficit. Rightly or wrongly they see it as symbolic of something wrong in government. And they see GM brought to its knees, California and New York virtually insolvent, AIG and all of the other business failures and they say this is just a prelude lewd of what could happen to our country.

CHARLIE ROSE: That suggests to me, Paul Krugman, as referring to an earlier point, that what we have gone through has really exacerbated the situation and the pain and the awareness.

PAUL KRUGMAN: Maybe. The awareness is there, certainly. I think people were sleepwalking a bit a couple of years ago. And it`s possible, but we do not yet have anything like a realistic appreciation on the part of the public on what the choices are, and that`s because we are not hearing realistic things for many of our leading politicians. I actually think the president has been quite good on this, but there is a cacophony of voices drowning out what he and other sensible people are trying to say.

CHARLIE ROSE: I want to bring Professor Auerbach back in. Just on the point that we are --

ALAN AUERBACH: I as long as there are politicians whose will respond to any warnings about our need to act by saying that we don`t have to do anything and we can have tax cuts and spending increases and everything will be fine, that, you know, people may not be sure that is right but it`s a much more comfortable thing to hear that being warned that you have to suffer spending cuts and pay more taxes. And I think that the jury is still out as to whether any of -- anything can be done here without some sort of financial crises having to do with loss of confidence in U.S. securities.

CHARLIE ROSE: Before you go, that`s a tantalizing idea. You think the scenario that might be required to cause the kind of urgency, to use an easy word, is what?

ALAN AUERBACH: Something -- look, in 1983 when the Social Security reforms were adopted, the Social Security trust fund was about to run out of money, and that would have necessitated a cut in Social Security benefits. You might say that was not a real crisis because the government could have put more money into the trust fund, but it I was a mini crisis of sorts, and I think it induced action. If instead we had been saying the Social Security system over the long run is not sustainable, we need to do something about it, I don`t think that would have happened. And I think in the same way something like that, and that is pretty innocuous, may be required to get us away from the current political stalemate.

DAVID WALKER: We`re already seeing early warning signals. We`re seeing the Chinese with the portfolio.

CHARLIE ROSE: And maturities.

DAVID WALKER: And we are also seeing them wanting to have more inflation indexed treasury instrument. We`re also seeing their appetite with regard to our debt to begin with coming down. So there are market signals going on out there and people are still asleep at the situation.

CHARLIE ROSE: Mohammed was making that point earlier.

PAUL KRUGMAN: These things, you know, advanced countries and advanced democracies are amazingly resilient. I wish we had a Canadian on this panel, because Canada in the early years of the 90s was looking pretty grim on budget terms and they had the kind of political, you know, moment of revelation, where they weren`t really on the edge of a Greek style crisis or anything like that. But it was bad enough that they -- it became ingrained in their political system that politicians must appear to be fiscally responsible, and maybe that happens here. But looking at the current cast of characters in Washington I don`t see any of them playing that role, but maybe it`s coming.

CHARLIE ROSE: I can only imagine who you mean.

DAVID WALKER: Paul, as you know and as John said, they have a parliamentary system. And parliamentary system are such that by definition if you don`t get the program together, you lose --

CHARLIE ROSE: Your party is voted down.

PAUL KRUGMAN: Remember, if we had majority rule -- the house has passed a major financial reform, a major health care reform, and a major environment reform.

CHARLIE ROSE: But with financial reform, whether it`s Volcker rules or some variation, would do what for the crisis we`re talking about.

PAUL KRUGMAN: It`s just an illustration that we do have a majority of Congress people willing to do stuff, but we don`t have a 60 percent majority Congress people willing to do stuff. These are pretty hard issues which have been addressed pretty well by one house of Congress.

CHARLIE ROSE: Health care, jobs, and climate change.

PAUL KRUGMAN: Jobs not.

CHARLIE ROSE: Is there anything that the Federal Reserve should be doing or isn`t doing or that the Federal Reserve has a role to play it`s not playing or the Federal Reserve will do something, it`s just a question as to when.

PAUL KRUGMAN: Right now we need job creation, and one of the few players in the system that still has some more room for action is the Fed. The Fed could be expanding its balance sheet. They don`t like it. It`s a little bit risky, but the Fed could be doing considerably more to expand the economy and is choosing not to. And that is -- they are -- there`s a sin of omission on their part.

CHARLIE ROSE: OK, Mohammed, thank you very much, Alan Auerbach, thank you very much, John Spratt, thank you. The people in South Carolina that you know or the same people I know in North Carolina, as you know. And David Walker`s book is called "Come Back America, Turning the Country around and Restoring Fiscal Responsibility," president and CEO of the Pete Peterson Foundation and former controller general of the United States sales in Washington. And Paul Krugman, Nobel laureate, writes a column and teaches at Princeton and does other things. Thank you for joining us. See you next time.

Originally broadcast, 2.18.10