There's been a lot of deficit spending over the last six years. Why were we deficit spending in a period of economic growth?

As you know, President Bush inherited a recession, and recessions always result in significant reduction in the amount of revenue coming in to government. And that happened again, and the president came in recognizing that a recession was beginning. He immediately recommended broad tax cuts, which he was able to get passed through Congress in the first year of his first term. That was in '01.

In '03 [he] came back with additional tax cuts, and the result was really very strong economic growth. And economic growth is the way you deal with deficits. When you have a strong, growing economy, then obviously there's a lot more revenue for lots of things, most importantly dealing with the deficit.

And the deficit under President Bush dropped dramatically. I think it peaked at $400-and-some-odd billion and then dropped to around $160 billion in fiscal year ending '07. And $160 billion is really a very small number, because what's important is not the absolute number; it's to look at the deficit as a percent of GDP [gross domestic product], and $160 billion was about 1.3 percent of GDP.

Anytime your deficit as a percent of GDP is lower than economic growth, then that means your overall debt as a percent of GDP is dropping. And that's what's important. ... So you don't have to run a zero deficit; you just have to run a deficit that's smaller than the growth of the GDP. That's what the president accomplished, and unfortunately we've now gone into another recession. And so this past fiscal year ending Sept. 30, '08, the deficit ballooned back to over $400 billion, and for '09 it's going to be significantly larger than that.

Going back to the tax cuts, we spoke to [Treasury Secretary from 2001 to 2002] Paul O'Neill last week, and he considered the second run of tax cuts to be gratuitous and politically motivated. What's your response to that?

Oh, my goodness. I'm a big believer -- and many economists certainly believe -- that the less you tax something, the more you get of it. We want a bigger economy because that means a higher standard of living for the American people. So anytime you're reducing taxes, it's a responsible move, obviously as long as you're not allowing the deficit to be out of control.

The tax cuts of '03 were very, very important, because they reduced taxes on capital, and capital investment is what drives economic growth. When you're investing in plants and equipment, when you're investing in research and development, when you're investing in new businesses and reducing the taxes on capital gains, the taxes on dividends, it was so, so important to economic growth. And I just hope that President-elect Obama and Congress will extend those taxes.

The other huge benefit from reducing taxes on dividends is now CEOs of public companies no longer have an excuse to not pay out dividends. The best way to figure out whether a company is successful or not is how much cash it's throwing off to its owners, or its shareholders. And now that the dividend tax has been dropped dramatically, the amount of dividends paid out has gone up, and that's a very good thing.

Another claim that O'Neill made about the Bush fiscal policy is that, at least when he was in the White House, there wasn't an organized process for policy that laid out pros and cons of the policy and all the alternatives. ... Was that your experience in the Bush White House?

No, not at all. ... I wasn't present during the first term. I was present during three of the four years of the second term, and certainly when I was there we ran an open process. ... All the Cabinet secretaries who had a vested interest in the issue participated. All the senior staff in the White House participated, and it was an opportunity for everyone to contribute their opinions and make their case, and then we would go to the president. And often we would go to the president -- and I would make certain when we went to the president that everyone's views were presented -- and the president would hear sometimes one view, but more often than not two or three different views. And the person who held a particular view was given plenty of opportunity. The president would ask questions, and then the president would make a decision about which way to go.

So there were times when there was only one view to present to the president?

Yeah, sometimes there was a consensus. I can actually remember one time there was a consensus about how to deal with a particular issue, and the president disagreed with the consensus, and he explained why he disagreed with the consensus and went a different direction. I can also remember another incident, another policy meeting with the president, when the president had already made up his mind that we should go a certain way, and all of his advisers felt differently. And we explained why we felt differently, and after hearing the explanation, he said, "I think you guys are right."

So the deficit in fiscal '09 is going to be large.

Very large.

In 2000, Vice President [Al] Gore suggested the surpluses should be taken and kept to deal with Social Security or with Medicare. ... President Bush ran on [the platform that] we should be giving a portion of it back to the American people. In retrospect, can you defend that choice that President Bush made?

Well, first off, President Bush didn't have a choice. When the economy goes into recession, revenues drop dramatically and spending actually grows. It's built in. Spending grows, even if they're not new programs, because of our appropriate social welfare system of unemployment, welfare, etc., to take care of people who are dislocated because of the recession.

The other thing that's very, very important for people to understand -- and no one ever talks about this -- the reason we had a surplus in the late '90s is because the government was collecting a very, very high percent of GDP in taxes. ... Since World War II, revenues coming into the federal government have averaged 18.2 percent of GDP. In the late '90s, we were collecting almost 21 percent of GDP -- an extra 3 percent GDP. That's why there was a surplus.

The reason there was this extra money coming in is because of the dot-com boom and all the stock options and everyone exercising those options, and the result was that everyone was shocked at how much money was coming into the government. Well, that's not sustain -- I hope it's not sustainable. The economy will grow much faster if we keep revenues [as] a percentage of GDP close to the 18.2 percent. ...

Was there any sense in the Bush White House that we were heading toward this mortgage crisis?

Well, it depends on at what point you're talking about.

While you were there.

In the beginning, no, absolutely not. We were amazed at how strong the housing market was. We obviously recognized that the appreciation in housing, people were taking out, increasing their mortgages, which was being used to spend money which continued to make the economy grow. ...

The economic team meets every Wednesday for lunch, including the secretary of the Treasury, the secretary of commerce, the OMB [Office of Management and Budget] director, the NEC [National Economic Council] director and his deputy, the CEA [Council of Economic Advisers] chairman, the deputy chief of staff, and we would meet and often talk about, you know, what aren't we seeing? What should we be seeing? Certainly in the beginning we had no clue that this was going to happen. And to be honest, as time has gone on, as I think we've all seen that it's grown much bigger than anyone ever expected.

Once we saw the subprime problem and the subprime defaults, we thought that was contained. We knew the size of it, and relative to the overall economy and the overall credit markets, it was relatively small, and so we didn't think it would systemically have such a negative impact. But obviously it wasn't just subprime. I mean, there was just an enormous amount of toxic securities out there that had become so opaque and so impossible to understand -- that had been bought, by the way, by sophisticated investors. We always think sophisticated investors will take care of themselves, but they obviously were not doing their due diligence. And so the result was we are where we are, where people have lost total confidence, or institutions have lost confidence in the balance sheets of other institutions.

So the market wasn't able to police itself?

I think the market is policing itself. It's using a sledgehammer to police itself. Absolutely, the market is policing itself. It's painful, though. It is very painful.

So in 2005, the president won the election. He's got political capital, and he decides to do what?

That's, by the way, when I joined the administration, January '05, and he said to me: "Hubbard, your job is to get Social Security passed on Capitol Hill. You should know you have my total support, and let's make it happen. It's not going to be easy. It's incredibly important to the American people. We all know what a ticking time bomb this is. We ought to deal with it now, because it's less expensive and less difficult to deal with now than it is to put it off. Let's make that happen." ...

The accounting system for the government is totally inconsistent with the accounting principles that we all believe in and that we require the private sector to do, which is to disclose all liabilities, and to, if they're not on the balance sheet, at least put them in the notes to the balance sheet. ...

The federal government has huge debts that are off-balance sheet. They have these pension obligations called Social Security that represent $13 trillion of liability, and we have not paid for [them]. And if a president of a private company did that, he would go to jail.

What are the positive effects of putting Social Security money into the market rather than into the government?

Right now, ... we treat [Social Security] as a separate entity. We have Social Security taxes which we pay every year, which is about 12.4 percent of your payroll, up to about $100,000, and that goes into what's called a trust fund. We spend about 11 percent. ... So we actually run a surplus of about $80 billion right now with respect to the Social Security, basically this pension fund.

And by the wa