In a last-minute attempt to stop the U.S. from defaulting for the first time ever on its loan obligations, Congress voted this week to increase the country’s debt ceiling by at least $2.1 trillion. The deal includes $917 billion in spending cuts over the next 10 years, and the establishment of a congressional committee to reduce the deficit further by $1.5 trillion. Questions remain, however, about what is at stake: Where will these cuts come from? How will social safety nets such as Medicare be affected? And can the country continue to recover from the recession with government spending drastically reduced? To answer these and other questions, Knowledge at Wharton spoke with Wharton professors Olivia S. Mitchell and Kent Smetters.

An edited transcript of the conversation follows.

Knowledge at Wharton: Who are the winners and losers under this deal? Olivia, let’s start with you.

Mitchell: In the short term, the winners are probably holders of U.S. debt. Those are the parties both within the U.S. — the pension funds, the insurance companies — and outside the U.S. — the Chinese, the Japanese and so forth — that hold U.S. treasuries and have been worried about a potential default. The fact that the U.S. has now been able to raise the debt ceiling means that the chances of default are much, much lower.

The losers may well be a whole variety of groups — individuals and programs which will have to be cut in order to execute the reductions in spending that Congress has talked about. But we don’t quite know yet exactly who those will be.

Knowledge at Wharton: Kent?

Smetters: I agree with that. I don’t think the winners are big winners here because the changes are so small in comparison to what needs to be done. In particular, in phase one, they’ll cut roughly about $1 trillion worth of spending. Phase two, if it gets implemented, is another $2 trillion. Over the next 10 years, we’ll spend about $7.5 trillion more than we take in. And that’s assuming that the Bush tax cuts expire, and the AMT — the alternative minimum tax — is allowed to continue to collect more revenue than it currently does. This is a very small change relative to what really needs to be done in order to make capital markets happy.

So those are the winners, but they are pretty small winners at this point. It’s still very much wait-and-see about what the government’s going to do. … A lot of emphasis will be placed on [the new congressional committee] in terms of whether they really come up with something substantial. And if they don’t, then I think you’ll see capital markets really respond.

Knowledge at Wharton: What would you have preferred to have seen done differently under this plan?

Smetters: I would have liked to have seen probably guys on the right give a little bit more on thinking about tax reform at this point. There is enormous opportunity and a large consensus to broaden the base and potentially even lower rates. Right now in the United States, we tax about 60% of the potential tax base; it’s much smaller than what we see in other countries. The reason is that the government effectively is helping to pay for your mortgage, and it does that through the mortgage interest deduction. It’s helping to pay for your health care, and it does that through giving you the ability to buy your health care pre-taxed. Those are government programs that don’t show up as revenue, but really do cost us a lot and force tax rates to be much higher than they need to be. So, I would have liked to have seen more revenue with lower rates as part of the deal.

Knowledge at Wharton: And Olivia, how about you? What would you have argued for differently?

Mitchell: I would agree that raising the revenue in sensible ways makes sense. I concur with Kent on that front. I also believe that we had a wonderful opportunity to start taking seriously the pending insolvency of both Social Security and Medicare. If you add up the Social Security liability and the Medicare liabilities, the implicit debt is somewhat over $100 trillion. Or, if you divide that across current taxpayers, it would be about $1 million per taxpayer. It’s that long-term overhang that really bodes ill for the economy, on top of a budget deficit of about $1.4 trillion and a national debt of $14.6 trillion. So, the fact is that these are really Band-Aids, and we haven’t dramatically changed people’s awareness of the need to reduce spending and raise revenue just to keep the promises we made in the past.

Smetters: I want to add to that. I think that’s exactly right. The commission this December really has to do a fundamental tackling of the entitlement programs. That’s really the driver of this. If they fail to do that, then we’re in a very serious situation.

Knowledge at Wharton: Why is Medicare in jeopardy under this plan especially?

Mitchell: Medicare and Social Security together represent an enormous portion of federal spending. Annual spending at the U.S. level is about $3.6 trillion. Medicare is about $800 billion and Social Security is about $700 billion. So, those two are the single biggest identifiable programs that stick out, quite frankly. Social Security in some sense is an easier problem because, with some reasonable changes in benefit structures and perhaps some tax changes, we can bring that situation into solvency. What is much less clear is how to reduce the rate of increase in medical spending in the face of a very rapidly aging population, which is going to be quite expensive.

Knowledge at Wharton: Will Social Security be impacted as well down the road?

Mitchell: Social Security in a sense has already been impacted by the current recession because the government and the administration last December reduced payroll taxes to try to serve as a stimulus, thereby reducing the amount of revenue going in to pay for the benefits of many of our elders in the economy. At the same time, Social Security benefit payments went up because many more people applied for benefits than had been expected. So, we’re already in this situation where the benefit money going out exceeds the revenue money coming in. And that doesn’t bode well for the system in the near future.

Knowledge at Wharton: Aside from Medicare and defense, which has been named as a place where cuts will be made, where do you think the likeliest targets for cuts will be?

Smetters: There’s not a lot of room outside of Medicare and Social Security. And the fact of the matter is … that our defense spending has come down dramatically over the last 30 years. At one time, we were spending about 8% of GDP on defense, and today it’s less than half of that. And that’s why [Defense] Secretary [Robert] Gates on his way out was basically saying: Do we care about where the United States stands in [terms] of its world prominence and so forth? Even with the wars in Afghanistan and Iraq, we’re still spending a lot less on defense than we were during the height of the Cold War. So this is really a Medicare, Social Security and, to some extent, Medicaid problem. That’s where a lot of the focus has to be.

And just to follow up on Olivia’s interesting points on Social Security, what’s not well known is that when we did this temporary cut into the tax rate, we actually continued to credit the Social Security trust fund as though the payments were being made. That really emphasizes just how much we have to be careful about the numbers that we see. But clearly Medicare is, of all the programs — as Olivia pointed out — the one that’s growing the fastest. It’s also a program that doesn’t have as dedicated a payroll tax the way Social Security has. It has one, but it’s much smaller.

But also what makes it very tricky to cut is the nature of the benefit that’s being paid. With Social Security, as Olivia noted, we could do creative things — like we could control the growth rate of the benefits for richer people, and maybe even help poorer people increase their benefits a little bit faster. But with Medicare, it’s not a dollar benefit, it’s [paying for services like] a surgery. So what does the government do? Do they say, “We’ll pay for half the surgery and you pay for the other half?” It’s a much more difficult situation. We have to start talking about rationing and all of those types of things. It’s a very challenging circumstance. And at the end of the day, we cannot continue with the fee-for-service model. That’s the fundamental problem. When people don’t have the incentive to think about the costs, they’ll just always want the best thing.

Knowledge at Wharton: How will the average person be impacted by this plan over the next several years? What kinds of changes will people notice?

Mitchell: Unfortunately, the last few years of economic policy have already had a very dire effect on a number of different groups in the economy. Of course, the job market declined, and the large number of unemployed makes it very difficult for young people — but also for baby boomers, people in my generation who are still trying to build up that nest egg, and perhaps replace some of the assets they lost when the stock market crashed. And yet it’s turning out to be a lot more difficult than we expected.

There has been a tremendous transfer of wealth away from retirees as a result of these low interest rates we’ve experienced over the last several years. That’s something that a lot of people haven’t really realized — that retirees who used to be able to expect to do well in retirement are really struggling now as a result of the continued recession and the low interest rates. So, one possibility of raising the debt ceiling is that people might still be willing to loan the U.S. money. But it’s unlikely in my mind to raise interest rates much, and therefore it might not help those retirees who were expecting to do better.

The other big unknown in this whole mix is inflation. To the extent that the government does keep printing money, this will put all of us in jeopardy, especially people who have been relying on nominal assets like treasuries to … live on. So, there are a lot of groups that are still in pretty dire straits. I’m not sure raising the debt ceiling is going to change that significantly.

Smetters: One of the things that some people will be shocked about in the next couple of years is the AMT, the alternative minimum tax. It’s something that Congress always fixes on an ad hoc basis…. The Bush tax cuts [will also] expire. Those two programs will cost about $4 trillion over the next 10 years. If Congress is really going to cut $2 trillion and they want to fix those two programs, they actually have to come up with an additional $6 trillion in cuts altogether.

And so that’s something that we may not see, this AMT fix continuing on. That’s something people will be shocked about: “Oh, I’m paying this alternative minimum tax now.” A lot of the Bush tax cuts will have to be financed somehow under this approach, and that’s going to be costly [for taxpayers] as well. So, that’s the more immediate [impact].

And over longer periods of time, I agree with Olivia — it’s all about inflation. Why would someone care about that now? Well, if you’re holding a 30-year treasury, you had better care a lot about inflation because, as Olivia pointed out, most of those [treasuries] are not being held in inflation-protected securities. The vast majority are not inflation protected. And so people should be thinking about that 30-year Treasury bond: What am I really going to get? It’s paying four and a quarter [interest], or four and a half — is that really going to cover inflation?

Knowledge at Wharton: Some economists have noted that drastic reductions in government spending will stall growth and further injure the economy. So, instead of this agreement being a fix in the longer term, it’s going to actually cause more damage. Do you agree with that perspective, Olivia?

Mitchell: My sense is that the damage was done a long time ago — that this current tempest around raising the debt ceiling is maybe the logical ending of a series of discussions. The fact is that 10 years ago, when I served on the President’s Commission to Strengthen Social Security, we had already been raising public awareness of the fact that Social Security was facing insolvency, and that many other programs were as well. Back then, we had an opportunity to start to fix things gradually so we would never get to the problem that we have arrived at today. And yet it was ignored….

We’ve already arrived at much more uncertainty, an environment of more risk where not only Americans but people in the rest of the world don’t trust the full faith and credit of the government as much anymore. I find that a very sorry state because we have, still, I think, one of the best financial systems and strongest economies in the world. But we’re not really capitalizing on that. We’re [creating] a bad impression and, in fact, uncertainty in capital markets everywhere.

Smetters: The economy seems like it’s stuck in a rut of sorts. It’s between a rock and a hard place. It is true that if you cut back in government spending … that could lead us a little bit more into recession. On the other hand, capital markets are so nervous — and over time, if we don’t fix this problem, if we continue to spend, higher deficits are also going to mean lots of concern there. There’s absolutely no question that the U.S. government will pay back every dollar it owes. I don’t question that at all. The U.S. government will print enough money to pay back every dollar it owes. The real question is: What’s the power of the money that it’s paying back — and that’s the concern about inflation.

No president wants to have it happen on his or her watch. But somebody has to bite the bullet and say, “You know what, we’re going to have to go through some pain, some austerity.” We don’t use that language in the United States, but that’s really what it is. And we actually need to bite the bullet here, reduce spending –and it could actually increase the pain in the short run. But that will in fact help us in the long run.

And we’ve had presidents like Ronald Reagan in the early 1980s who said, “We’ve got to nip inflation in the bud. And so we’re going to reduce how quickly we’re printing money.” It caused a sharp recession, lots of pain. But then we benefited over the long term, and that’s what we need as well.

Knowledge at Wharton: How do you think this agreement is going to impact the next election? Or, vice versa, how do you think the next election will affect the execution of the plan?

Mitchell: I think it’s all political. The institution of the committee whose responsibility it is to make cuts in the future will be coming out with some decisions in hopefully the next year. All of that is going to be extremely nuanced by, and attentive to, the next election and what the consequences will be. We know that in the Republican side of the House, most of the Tea Partiers are quite happy about this resolution of the cap on the debt because they think they won. They got cuts in spending without any increases in revenue. We’ll see whether the committee of 12 whose job it is to move the ball forward thereafter will be able to dislodge parties from their current lines, but I’m quite skeptical of that.

Smetters: I agree. Obviously the Republicans’ wish was to continue to have this debate before the election. President Obama wanted to make sure it happened right after the election. In that sense, the Republicans won in that they get to continue this debate and so forth. The real question comes down to President Obama: He could take this by the reins and say, “You know what, it’s true my bipartisan commission last December came out with [a plan]. I really didn’t support them publicly; I didn’t get behind them. I didn’t rally for them.” And in some sense, I think he lacked a showing of leadership in that [situation], because it was actually a very good plan. It didn’t solve everything, but it had lots of the basic elements there.

This is an opportunity for him to really step up — and in many ways, outflank some of the Republicans by saying, “We’re going to really take this [plan] and be fiscally responsible. I’m going to lead the charge here.” And his fear about the far left abandoning him is just not going to happen. They’re going to stick by him because they’re certainly not going to vote for a Republican candidate. And I don’t really buy the idea they’re not going to go to the polls. They’re going to realize that he is, in fact, the best person for them. So this is, I think, a tremendous opportunity for President Obama, and this could — if he plays it right — be a very winning position for him.

Knowledge at Wharton: The agreement is supposed to cover the government’s borrowing needs until 2013. Looking ahead, do you think that we’ll be in the same position at that point in time? Or do you think we’ll maybe have some significant improvement by then?

Smetters: By same position, you mean the economy or the budget?

Knowledge at Wharton: That we’ll be back at square one debating the debt ceiling.

Smetters: I think that it really comes down to two key issues — the alternative minimum tax and the Bush tax cuts, in the sense that if [the government] tries to continue those things, again, they’re going to have to somehow come up with roughly another $4 trillion in the next 10 years. They are not going to be able to come up with that [in addition to] the $2 trillion that they’ve promised to figure out in terms of cuts. But if they try, not only will we be potentially in the same spot, we could even be in a bigger deficit two years from now. So they’re going to have to figure that one out very soon.

Mitchell: What I would add is that it depends a lot on what happens in the 2012 elections. If the Democrats gain a greater majority in both houses, then it’s possible that there will be some bigger actions, and it won’t be necessary to return to this decision in 2013. But my sense is that probably the stalemate will continue. So, we may well be in a deeper hole — which really gets us back to the question of what are we going to do in the meanwhile. What are we going to invest in? What are we going to keep our pennies in? As someone who works on pensions and retirement savings, [I ask] what are retirees going to do? I don’t have a good answer.