You've had a chance to drill down very deep into this. Just how bad is the problem that you've inherited?

We've really inherited two problems. One is the state of the economy, where we face a trillion-dollar gap each year between how much the economy is producing and how much it could be producing. And that's just a trillion dollars of lost income --

In borrowed money.

It is a foregone opportunity that we could have a trillion dollars more of income for the United States if we were producing at capacity rather than falling so far short of it.

The second problem that we're inheriting are these significant deficits, also about a trillion dollars a year, in the federal budget, that go out year after year after year, given the current policies that we have. We need to change.

It seems to me you've got three problems: One, the economy is not running at capacity. Two, you have these monstrous annual deficits. And three, you've got this looming tsunami of entitlement obligations.

Right. Those deficits that go out over the next five or 10 years just grow worse after the 10-year window, mostly because of rising health care [costs].

We keep hearing so many numbers about what that entitlement figure really is -- $53 trillion, according to some; others say less. What do you think the number is?

… I think under all of the projections, the key driver, the thing that really matters, is whether health care costs grow 2.5 percentage points per year faster than income, or 1.5 or 1 or 0.5. That swings those long-term numbers dramatically because of the power of compound interest. ... Let's say 5 to 10 percent of GDP [gross domestic product] is our long-term fiscal gap.

Would you put a number on it at all?

You can put a number, and I know lots of people like to do that, but it should be relative to something. In other words, to say we owe $500 million or $500 billion in 20 or 30 years doesn't tell you very much if you don't know how big the economy will be or how high your income will be. So to put things in context, I think it is best to do things as a share of the economy, which is what I gave you.

What deficit hawks are really saying is that the number is so huge that it's literally going to swarm over us and destroy us if we don't start dealing with it today.

There is no question that we are on an unsustainable fiscal course, and we need to change course.

And here's the obligation that you have. You have to do two contradictory things: On the one hand, you've got to jump-start the economy. That means you've got to spend a lot of money. And on the other hand, you've got to figure out how not to spend a lot of money. And you've got to do it at the same time.

You should put the policies in place at the same time, but the timing of when those policies actually take effect needs to differ. And it is quite difficult, because what's good for the economy right now, when it's falling a trillion dollars short of capacity, is exactly the opposite of what's good for it in five or 10 years after we've started to grow again.

In particular, right now, the key thing is we could be producing a lot more, so we need to jump-start the economy, add to aggregate demand, and the key constraint is how much we're spending. Over time, however, the key constraints on economic growth is how rapidly we're expanding the capacity to produce goods and services, and so it flips on its head.

In the very short run, it's good to have the government stepping in, allowing some increase in the deficit, because that helps fill in the hole in terms of how much we're actually producing this year. Over the medium to long term, though, those same deficits become quite harmful to economic growth.

Are you satisfied that you're putting a budget into place today that lays the groundwork for dealing with the unfunded liabilities of entitlements?

I think what's very clear, the single most important thing we can do on our long-term entitlement problem is to reduce the rate of growth of health care costs. Everything else is almost a footnote.

So, in particular, let's just look at the numbers. If health care costs grow at the same rate over the next four decades as they did over the past four decades, Medicare and Medicaid -- those are the two federal health insurance programs -- go from 5 percent of the economy today to 20 percent of the economy by 2050. That's basically the entire size of the federal government under normal conditions. That 15-percent-of-GDP increase can be compared to roughly a 1.5-percent-of-GDP increase in Social Security and roughly no increase in the rest of the budget.

So if you're looking at where the money is, it's in health care. We need to bend the curve on long-term health care costs. And this budget is the most aggressive budget that I have ever seen in terms of moving toward a more efficient health care system.

... Critics who have looked at this budget give you praise for saying this is, in many ways, a very transparent budget. In other ways, they say you're using, to quote one critic, some "gimmicks." [The administration claims] $2 trillion in savings. ... They say actually you're projecting war costs that would have gone away anyway, and of that $2 trillion, you've got tax increases. So you're not taking the money out of the budget; you're just fiddling some numbers around.

Let's be clear about this. First, the budget includes lots of hard savings. I mean, it includes $50 billion in reduced erroneous payments in Medicare and Social Security, because we're actually investing in cracking down on fraud and erroneous payments in those programs. It includes $50 billion in savings because we're eliminating inefficient subsidies to middlemen on loans to students, educational loans. We can keep going down the list.

But let's be very direct about the war costs. First, I think it is indisputable that the war will end faster because President Obama is in office, period. Ending the war saves money -- pretty clear. Furthermore, if you look back at past episodes when wars were ended -- the first Bush administration, for example, near the end of the Cold War -- same thing happened then. They projected savings from ending the Cold War, and guess what? That's exactly what happened. We did get those savings. Defense spending as a share of the economy dropped significantly during the early 1990s, and that was one of the things, along with other policy changes, that put us back on the path to a balanced budget.

Part of the problem is if you proclaim yourself to be transparent, you have to be a little like Caesar's wife, above even the suspicion of fiddling with the numbers. I talked with one reporter who said she was listening to the president address Congress, and when he said, "We're going to save $2 trillion; we went through line by line," and then when she looked at it, she said, "No, they didn't."

When the budget proposal was put out, we were in office for under six weeks. We did start going line by line; there's going to be more details to come. It makes sense to start with the biggest lines. The biggest lines are in the tax code and in health care. And in both areas you see very significant proposals contained in this budget. It does reduce the deficit by $2 trillion, relative to not doing anything at all.

And by the way, if we didn't do anything at all, ... not only would the deficit over the next decade be $2 trillion higher, we wouldn't be investing in education; we wouldn't be investing in energy; and we wouldn't be moving -- most importantly -- to a more efficient health care system that will not only improve quality but also reduce costs.

Might you have made a political mistake by framing it as $2 trillion of savings when you're looking at war costs and you're looking at tax increases?

Well, I'm not going to get into the semantics. I think, again, the bottom line is the deficit would be $2 trillion higher without this budget.

Here's what people say about what the deficit actually looks like with this budget, by your own numbers. First of all, they say the Obama administration is filled with optimists; you have a rosy scenario for how this recession is going to end. ... And if it doesn't turn out quite that way, it gets a lot uglier.

Let's address these, because I know a lot of people have been talking about a lot of things. Let's address them one by one. First, on the economic assumptions, let's compare us, for example, to the Congressional Budget Office, an independent outside arbiter. The Congressional Budget Office has a set of forecasts that do not include the Recovery [and Reinvestment] Act, but they have since put out an analysis of the Recovery Act. If you add their forecast before the Recovery Act to their estimated impact of the Recovery Act and then compare it to our projections, they're right in line with each other.

Now, since those projections were locked down, incoming data continued to suggest, if anything, an even weaker economy, and that just brings me back to the point that I started with, which is we are inheriting these two significant problems. ...

Today, would you say that the scenario that you proposed in your budget was too optimistic and the new numbers that are coming in suggest the economy is weaker, and thus your budget is going to be more difficult?

We're getting lots of new information in. The budget has a normal cycle to it in which projections are locked down. When we have a mid-session review later this year, we'll have an opportunity to revisit the economic assumptions. But you also have to realize the impact even in 2009 of a weaker economy, given that we did assume assumptions that were in line with the Congressional Budget Office and other outsiders, is not as large as you would imagine.

Just as an example, let's say even say a recession is 1 percent deeper this year. The impact on the deficit this year is something like $40 billion. Given a $1.3 trillion deficit that we're inheriting, obviously $40 billion matters, but it doesn't dramatically change the scale of the problem that we're inheriting. ...

Editor's Note: This interview was conducted before the Congressional Budget Office released an analysis of the budget which projected larger deficits than the administration's estimates. Read Orszag's reply on the OMB blog.

By the scenario that you put in your budget, some number crunchers say, ... if it goes as they propose, by fiscal year 2010, we're going to have a $14 trillion national debt, and by 2014, we will have doubled the national debt to somewhere around $22 trillion. And that is a best case.

Well, a couple things. First, not to get too wonky about the numbers, but I think the people who are using those numbers are not using the numbers that economists tend to like, which is the debt held by the public. I think that's the more analytically correct measure.

But leave that aside. I think the key point is, we are on a path -- because of rising health care costs, because of a weak economy, because of policy choices that have been made -- of dramatically increasing debt. The budget will reduce the debt that we wind up with after 10 years by $2 trillion relative to not adopting the budget. ...

As bad as this budget looks in terms of the future and the debt that our children and our grandchildren are going to have to wrestle with, you're saying it would have been dramatically worse if you didn't have this budget?

It would be worse even over a 10-year window. ... I have young kids. The fiscal burden that will be imposed on them is going to depend primarily on whether we tackle this looming problem in our health care system -- with rising costs that don't seem, by the way, to be necessarily associated with higher quality. That is the key burden that they will face.

And if we can succeed, as this budget attempts to do, in putting in place a more efficient system that has health information technology, that allows doctors to examine more evidence on what works and what doesn't, that provides incentives for better care rather than more care, the burden on my kids is going to be dramatically reduced because we will save significant amounts in health care. And that is the key driver of our long-term budget problem.

You have famously said health care reform is entitlement reform.

I don't know if it was famous, but I did say that.

Lots of people quote it. But they quote it with puzzlement because they're not sure what you mean. ... Are you saying that what you really want to do is work with the health care system and make dramatic changes in that and thus reduce costs, and leave Medicare and Medicaid alone in terms of benefits and in terms of taxes that will have to be dealt with that? Or are you saying we're going to wade into entitlements, and we're going to start considering some cuts?

The budget includes $300 billion in Medicare savings already, so we are wading into Medicare and Medicaid. Actually, let me try to explain this, because I think this is absolutely central to what we face.

We need to make changes to Medicare and Medicaid. We particularly need to create better incentives for providers to deliver high-quality care, because right now the incentives that we have in our health care system is for your doctor or your hospital just to provide more care, and that's not always better care. Spending more time in the hospital or having more tests or seeing more specialists doesn't necessarily mean better care, and that's what all of the evidence suggests.

They need, those hospitals and doctors, incentives to deliver better care. That can be started through Medicare and Medicaid, but in order for it to be sustainable, it needs to spread throughout the whole health care system, because if all we did was reduce the growth rate in Medicare and Medicaid, and health care-cost inflation continued in the rest of the system, you'd create massive access problems under Medicare and Medicaid. It wouldn't be sustainable.

So what we need to do is start with Medicare and Medicaid, but do so in a way that affects the overall rate of health care-cost growth. Now, let me give you an example: In the early 1980s, Medicare moved to ... a fixed payment for each hospital stay. It created an incentive for hospitals to shorten the number of days that Medicare patients spent in the hospital because they were only getting paid a fixed amount -- not per day. The result, though, was shortened hospital stays not only for Medicare patients but for everyone, because it changed the way hospitals practice medicine. That is what we need to do. ...

Here's part of your problem. You have $630-plus billion in the budget for dealing with the medical system, but it appears you don't have a plan that you're putting forth. You're essentially saying, and the president is saying, "I want to listen to what other people have to say," and that leads to tremendous confusion, because they're not certain where you want to lead them.

... What we've done is we put a significant amount of funding on the table to kick-start this process, and contained in that funding is a whole series of reforms to the delivery system in health care.

Why not just step forward and say, as the president talked about in his campaign: "Here is a plan for entitlement reform and the medical system. Take a look at it; cut away; let's talk"?

I think the test will be ... whether we actually get health care reform done this year. We are trying to avoid some of the mistakes in the past in which the administration has stepped forward with this big thick plan, plopped it on the floor at the door of Congress and said, OK. And the result was not what any of us wanted.

We held a health summit in which participants, from the health insurance plans to small business to the American Medical Association to AARP, all said this is the year, and you're going about doing it in the right way; you're creating a collaborative process for us to get it done. And we have put money on the table to fund that effort.

This is the way to avoid what happened to the Clinton administration?

That would be one way of interpreting. We certainly want to avoid the mistakes of the past.

So, may I assume that you have in your mind, and the president has in his mind, what he would like, [but he] just doesn't want to lead with it because --

He had a plan during the campaign; you already mentioned it. He thought it was a great plan. It is a very good plan. We don't have a monopoly on good ideas. There are those in Congress who would like to tweak, change, what have you, and so what we're trying to do is create a process through which we can get this done this year. And I think there's a lot of bipartisan interest in getting it done this year, because not only is it a key fiscal issue -- you've been focused on entitlements -- this is also affecting state governments today; it's affecting workers today. The system has huge costs embedded in it that are unnecessary. Estimates from Dartmouth College suggest we could reduce health care spending by $700 billion a year without harming health outcomes if we could just get the more efficient practices in some parts of the country into the less efficient rest of the country.

Social Security -- liberals say leave it alone; it's perfectly healthy, and it's not a big problem. On your right, deficit hawks say you have got to dig into Social Security just like you do with Medicare and Medicaid. Do you believe that Social Security should be opened up and questioned about the benefits that are offered and the way that it is offered?

Sure. Social Security faces a long-term deficit. It needs to be addressed. But ... the big problem that we face from a fiscal perspective over the long term is health care. We're trying to get that done now, this year. We'd also like to, after dealing with that, deal with Social Security. We will need to deal with Social Security.

Social Security is not sound as it is.

Social Security faces a long-term actuarial deficit, yes.

So you'll have something like raising the age of retirees who benefit from Social Security, or something else?

There are lots of options, but Social Security does face an imbalance between how much it's paying out and how much is coming in over the long term. And you need to bring those two together.

As you look forward, would you consider extending tax increases beyond the 5 percent of people who are taxed now in this budget to someone in the lower 95 percent? Is that on the table?

This budget doesn't embody that. The president campaigned on a set of proposals where we reduce the taxes for 95 percent of working families, and that's what this budget proposes.

I understand. But you know the problems looking forward and how deep they are. Is it something that the president would consider looking forward?

Well, I think, again, what makes most sense is to try to get health care reform done. Let's then see what that does to our long-term imbalance. And then yes, there may be some underlying problem that still needs to be addressed even after that.

But again, we don't even have a great sense of -- until we get healthcare reform done, we don't know how big a problem we are left with. And, from my perspective, let's again -- if you just look at these graphs out over time, healthcare goes like this. Let's see, you know, how far we can get that down and then any additional steps should be examined at that point. ...

This budget now goes to the Congress and then the appropriations process.

Yeah.

It's going to be a fight.

No doubt about it.

A knockdown, drag-out fight.

There is not a single line in the thorough budget that one could affect in any significant way without causing concern somewhere in this town, in Washington, or in the rest of the country. There is no way to make significant change -- investing in health care and education and energy, bringing those medium- and long-term deficits down -- without creating a bit of a ruckus. That's part of the process.

As you know, in the past, reconciliation has been used by the Bush administration, by others, to avoid a filibuster. A filibuster would be a tough thing for you to overcome. Are you prepared to use a reconciliation process?

I think, again, the president said we don't want to go there first. But at this point, I think it would be premature to take something like that off the table, so we're going to just have to see how this plays out.

So that means, politically speaking, you walk in, you put the gun on the table and just let them look at it.

I don't know that the gun's on the table, but it would also be premature to be taking options off the table before we know what all the reactions are like.

The Obama people have been very good about saying, "Look, judge us by how we perform against the standards that we set." A year from now, what are things going to look like?

Let's hope that the economy is starting to recover, in part because of the Recovery Act. The labor market -- so jobs and unemployment -- will undoubtedly remain somewhat weak, because even after the economy starts to recover, the labor market tends to lag behind. And frankly, in a year, what I hope is that we will have gotten health care reform done this year, so that long-term entitlement problem that we've been discussing will be somewhat better, and we can turn to our kids and grandkids and say, "At least we did something for you." ...

We're talking about addressing entitlements. And the people we talked to say, "Look, this is a tough, tough problem, and you're going to have to do either higher taxes or lower benefits or some combination of both to be able to really wrestle this problem down." Do you agree?

That is the situation with Social Security, which involves a variety of basically cash flows -- cash coming in, cash going out. It's really missing the boat on health care, because so much of the cost of health care now, in terms of "benefits," doesn't actually make beneficiaries healthier. And we come back to that Dartmouth College estimate: $700 billion a year in health care services delivered each year -- unnecessary tests, unnecessary days in the hospital, so on and so forth -- that don't actually improve health outcomes.

If we can get at that by investing in health information technology, examining what works and what doesn't, and creating incentives for what works, we can put the nation back on a sound fiscal path without causing any harm, and, in fact, if anything, improving the quality of the health care delivered to beneficiaries.

Now, obviously, cost for the health care system is income to providers. So a big part of the adjustment here is going to be making sure that providers have better aligned incentives to deliver the kind of health care we should be getting.

When it comes to Medicare and Medicaid, are you saying that adjustment will not necessarily entail higher taxes or lower benefits?

I think there's a huge amount of opportunity to improve the efficiency of the programs -- that is, reduce their cost over time -- by changing the incentives and the information available to providers. Now, it may well be that some changes on the beneficiary side are also necessary, and I note in our budget we actually do include a change for high-income beneficiaries to pay a larger share -- or to receive smaller subsidy, I should say -- under the prescription drug benefit, just like they already do under Part B, the outpatient part of Medicare. ...

Understood, but I want to be very clear: When it comes to both Social Security, Medicare and Medicaid, higher taxes and/or lower benefits -- which is really what it means -- are not off the table?

No, they're not off the table, but I again want to come back. On Medicare and Medicaid, ... the cost of benefits may not correspond to the outcomes or quality for beneficiaries. So if we bend the curve on health care costs and reduce the rate at which they're increasing, that doesn't necessarily mean beneficiaries will be worse off. And in fact, if anything I think the overwhelming majority of evidence suggests they'll actually be better off if we can move to a more efficient system.

Let me give you an example. [The] last six months of life ... costs you and me today $25,000 for each Medicare beneficiary at the Mayo Clinic. Medicare beneficiaries, last six months of life at UCLA Medical, $50,000 a year. These are two leading medical centers; they both deliver the best medical care in the world. One of them costs twice as much as the other, and I can tell you that we have no idea what we're getting in exchange for the extra $25,000 a year at UCLA Medical, because the quality indicators, if anything, are all higher at the Mayo Clinic.

All that we seem to be receiving is more tests, more days in the hospital, more visits to the specialist, none of which actually make the beneficiaries better off. If we can move toward practice norms that are more like that $25,000 a year, we can save substantial amounts of money without harming beneficiaries and actually delivering them better care. Because who wants to spend unnecessary days in the hospital or go to lots of unnecessary doctor visits? …

We can no longer afford an overall health care system in which the thought is more is always better, because it's not. The evidence is very clear, that's just not factually true. …

Looking down the road, could you see what so many other nations have, which is a single-payer health care plan?

We're America, and we're going to have an American health plan and health system, and undoubtedly there's going to be some public and private aspects to it.

The president is a remarkable orator, and in soaring rhetoric that calls to mind Franklin Roosevelt and Abraham Lincoln, he has said we are in a tough place and the nation must sacrifice. We are all going to have to sacrifice, he said. And then the budget came out, and people had a look at it, and they said: "I see some sacrifices in the top 5 percent here, but where is the sacrifice for everybody else? You're not calling for sacrifice. You're spending money."

Actually, I have a different perspective. The president had to cut back on the tax proposal that he favored for middle-class families. It had, during the campaign, then $1,000 per couple maximum, now $800. Had to cut that back.

The budget includes a variety of proposals that may be surprising. For example, the president strongly supports helping moderate- and low-income workers engage in the labor force. There's a program, the advance Earned Income Tax Credit, which is part of the overall Earned Income Tax Credit, that doesn't work very well. One percent of EITC recipients claimed advance EITC. It's subject to very high error rates. [This] budget eliminates it.

We can keep going down the list, and what we're looking for are things, even in the areas that we think are worthy and beneficial, when things don't work, we're going to try to get rid of them.

The sacrifices, as I hear you, are less help will be offered just now than we would like to have been able to give you, but we are not asking anything from you.

No, I don't think that that's the case either. ... We are in a severe economic contraction now. People are suffering. The Recovery Act will help take the bite off of that, but it is still going to be the case that too many families will be experiencing bankruptcy and job loss and losing their home because of this severe downturn that we're inheriting and we're trying to mitigate the effects of. So I don't think the problem facing most families is lack of sacrifice, let me put it that way.