NEW YORK (FORTUNE) - Following is an interview with Laura Tyson, dean of London Business School and former chairman of the Council of Economic Advisers during the Clinton administration, and Glenn Hubbard, dean of the Columbia Business School and chairman of the Council of Economic Advisers in the first years of the Bush administration.

FORTUNE: How are we doing?

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LAURA TYSON: The U.S. is doing very well in a cyclical sense. Productivity has been strong, inflation has been low, job creation in the last year has been relatively strong, wages have started to pick up.

But we have a frighteningly large trade deficit and current account deficit. We also have a situation where most of the wage growth is at the top of the wage distribution, not in the middle and not at the bottom. That is probably one reason why people do not seem to have the kind of good feeling about the economy, which looking at the unemployment rate or the growth rate would suggest.

The third issue is that, having eliminated the structural budget surplus and put ourselves on a path of structural budget deficits, we have created a much more difficult situation for dealing with the [retirement of the] Baby Boom population.

I'll add one other thing: By having a Medicare prescription drug program introduced in the absence of a fundamental reform of Medicare we missed a huge opportunity.

FORTUNE: Given all those "buts," are you surprised by the resilience of the economy?

TYSON: We should all admit we're all very surprised about the resilience of the U.S. economy and the global economy.

GLENN HUBBARD: I think the economy is actually extraordinary and I wouldn't just say in a cyclical sense. It is true that we're on the business cycle ramp up but ten years ago if we were sitting around this table and talking about whether the economy can grow in the 3 percent range, you would have thought we were nuts. I think that there is an excellent trend in the economy in productivity growth.

There are challenges to be sure. One would be the size of government going forward. To me, words like 'budget deficit' are accounting terms. The real choice is how big do you want government? This country, if we want to have growth rates of the type we're now celebrating, has to shrink the size of the state.

I also think we have an issue with emerging inequality in the country. The political support for high productivity growth and the kind of dynamism we're celebrating depends on most everybody participating in those gains. Identifying a problem isn't the same as suggesting a solution. One type solution might be, 'Well, we need to have more progressive taxation.' That I do not think is a solution. I would like to see us think more about training programs and ways to help people change careers.

FORTUNE: Why has the economy been so resilient in the face of high oil prices?

HUBBARD: The economy is less energy-intensive than it was in previous supply shocks. And those supply-shock eras were times associated with great geopolitical risk in oil markets. Much of what we've seen happening in oil markets recently has been demand.

I don't think, though, that you'd want to infer that if we ratcheted oil prices up yet again, the miracle of resilience stays. There is a level at which I would be very worried about yet another ratcheting up of oil prices.

FORTUNE: Have consumers simply absorbed the shock by borrowing money?

HUBBARD: It certainly cushioned the U.S. I don't think the American consumer is over-extended. If you look at levels of net worth, and if you buy the assumption of long-run productivity growth being high, I don't think the American household is over-extended. I do think the country as a whole in terms of national saving is under-saving. But the household, at the moment, I wouldn't describe as particularly vulnerable.

TYSON: When you say vulnerable you mean that on the balance sheet dimension...

HUBBARD: My expected future income is high because of productivity growth.

TYSON: But your income isn't high, because most American households aren't sharing in that. If the average American household is basically running a high level of debt relative to income, a historically low savings rate, a high level of debt service relative to current income - and we don't believe that projected future productivity growth is going to benefit the average household - then actually they are over-extended.

HUBBARD: Here's where we have to get down and dirty in the data. A lot of the deterioration in saving has come from upper-income households. There is no evidence to suggest that the delinquency rates are rising for low-income households.

TYSON: No, not right now. I'm just saying that if you look at the levels of debt people are carrying, and you look at their savings rate, and you don't project attractive income growth because you look at what's been happening to their income growth even as the economy has done well, then you actually would get worried about them.

FORTUNE: Laura, what do you think about the Bush administration's tax policies?

TYSON: I could understand, particularly in 2001-2002 when we were coming off of a major stock market correction, the argument for an expansionary fiscal policy, fine. I would have wanted it to be temporary and I would have wanted it to benefit the middle class.

We're dealing with a world in which technology and globalization are driving the returns increasingly to the top 10 percent and even to the top 1 percent. I don't see why one makes tax policy to aggravate those long term trends. I just don't get it. I don't think the evidence that I have seen over the course of my life as an economist makes a compelling case that savings and investment are affected very much by things like capital gains relief - within reason.

It's just like Glenn says - when you get to a certain level of oil price it matters. You get to a certain marginal income tax rate, it matters. You get to a certain dividend tax rate, it matters. But within the ranges that we were dealing with, this is just not my policy priority.

I think we should have used the surpluses that were available to us to deal with Social Security and Medicare, not generate this kind of very significant tax relief for those at the top of the income distribution. That's just not my policy priority.

It's hard to imagine the [size of the] federal government going any lower than where it is right now - 20 percent, 21 percent of GDP. First of all I cannot believe that we can actually run it at much less. But second, I just don't believe that to run it at slightly more would have anything to do with the long term growth of the economy.

HUBBARD: I think we have a difference of opinion. I speak a lot on college campuses. I always tell every group of young people that the central domestic policy question facing them is the future size of the state. I usually segue into that to talk about health care. But it is not so much about whether government is 20 or 21 percent now. If you look at the CBO's long term forecast, if we don't make any changes in our entitlement programs, we're locked and loaded to head to 33, 34, 40 percent.

FORTUNE: That's just federal spending?

HUBBARD: Right. What I would start with is the entitlement programs. And I would not give the Bush administration 100 percent success on this. It's no secret that I wasn't a fan of the Medicare prescription drug bill, because I didn't think it got enough reform. But the overall question anybody has to ask is first and foremost how big a government do you want?

Now we get to taxes. I think the president was right to focus on the tax elements that he did because, as somebody who has toiled at these fields all my academic life, the biggest deadweight-loss taxes happen to be things that aren't politically appealing.

They happen to be the top rate, because it discourages entrepreneurship as well as investment. They happen to be capital income taxes generally, so dividend and capital gains taxes. I understand that those won't get you a good political campaign, but speaking as an economist, that's where the excess burden of the tax code is.

Now my criticism would be, and here I probably join Laura, is you've got to remember when you adopt pro-efficiency policies that you do have to make sure that there are other fairness elements. I just question whether those should be done through a tax code that strikes me as riddled with distortions, as opposed to explicitly helping people.

I do think that we've got a serious tax reform debate ahead of us. Because if the whole notion of the tax code is about fairness, that's a very different conversation than if the tax code is about economic growth.

TYSON: I think it's a balancing act. I mean, I'm an economist too and I believe in efficiency as well. But I think that we know there are trade-offs. And I don't think those deadweight losses that you're talking about are that large.

HUBBARD: Well that's where we differ.

TYSON: You know this is a magnitude problem.

HUBBARD: What I was saying is that there are tax changes that in and of themselves are growth-promoting. The issue that really ought to confront more politicians is that high-growth economies tend to be very dynamic economies. We often use the term dynamic in this very positive sense - and for those of us who spend our lives around the A students of the planet that is a big plus sign.

TYSON: Yes, that's right.

HUBBARD: But there are a lot of people for whom dynamism and change are not opportunities. When I think of the protectionist wave facing the country right now, whether it's China, whether it's offshoring, whether it's the brouhaha over Dubai ports, a lot of this is again because we haven't talked to average people enough about what is going to be in place to buffer them against dynamism. For our MBA students, again, dynamism is just: 'Am I going to make a lot of money or really a lot of money.'

TYSON: But the point is there's nothing in place. I agree with you, but what can we say to these people? We're going to significantly curtail what you can expect from health care for the elderly, so that's going to fall on you and your family. We're going to significantly curtail what you and your family can expect from pensions through Social Security. We're going to significantly curtail - this is part of the current budget proposal - funding for grants to go to college.

So we're going to do all of these things but, by the way, it's a dynamic economy and you're going to have a lot of opportunities. Frankly, there is no compelling message there at all.

HUBBARD: Well I see it differently and I hope this is compelling. The bulk of the fiscal adjustments in entitlements, we can balance the books by focusing the adjustment on upper income households.

TYSON: The last time I looked you couldn't do that. 'Upper income' is $50,000 and up, as I remember. If you want to balance it using upper income at that definition, yes, you could do it.

HUBBARD: And you can give savings incentives and other things to help people. But we can't promise ourselves things that we collectively can't keep. I agree with you on education and training but we've doubled the budgets in health research. We've significantly increased support for community colleges.

What I am sensing is not a program-by-program lack of things, but just on either aisle of the aisle somebody who identifies this as a central problem. It needs an actual vision that we have to address dynamism's negatives as well as its positives.

TYSON: I wouldn't say that that's been entirely absent. Certainly if I go back to 1995 and 1994, Clinton was very good at talking about globalization. We were already talking about dynamism and change and insecurity. And the agenda there was actually pretty clear.

The agenda was we needed portable pensions, we needed a system where people were not being dropped at an increasing rate from health coverage. We needed a significant increase in spending on things like Pell grants. We passed - and I didn't love it just as you didn't love a lot of things your administration did - a bunch of targeted tax incentives for education which are hardly an efficient way to get people to spend on college education.

HUBBARD: I called this the Columbia Professors' Salary Increase Act, for which I was grateful.

TYSON: So while the motivation was sound, the execution was questionable. But there was even then, ten years ago, an understanding that this was a set of issues that we needed to address by policy. And since then what has happened?

HUBBARD: Well then let's come right to that. That says to me you want more personally oriented savings accounts. It says you want healthcare delivered in part through individual markets which is exactly what the president's new proposal is trying to champion. The Left to me today seems to be back towards a more state-oriented solution than the Clinton administration would have suggested.

TYSON: In health?

HUBBARD: Well certainly in healthcare but also in its total objection to Social Security reform.

TYSON: Oh I really don't think that that's fair. Go and re-read the book by Peter Orszag and Peter Diamond. There is a perfectly legitimate set of Social Security reforms which are meaningful, which can address the problem. They don't have anything to do with private accounts, which clearly made the Social Security problem worse rather than better from an actuarial point of view for the next 50 years. So yeah, I think there is an agenda that the Left...

HUBBARD: The Diamond-Orszag proposal amounted to just raising taxes to cover the shortfall.

TYSON: There was some tax increase and there were also some cuts at the top and there was also some redistribution within. So there was some tax increase, absolutely right. And I think that actually that is a part of the solution. It was a package. It wasn't all tax. Yes, there are people on the Left who used Social Security as a perfect political football. Your president said he had a lot of political capital...

HUBBARD: He's all of our president.

TYSON: Okay, our president, our current president said that he had a lot of political capital and he was going to use it on this. The political capital is gone and so this is an opportunity now for those who don't want to do anything about it to just basically hunker down. So we've lost an opportunity to do something.

HUBBARD: There was a deal that could have been had and it was pretty simple. If President Bush had dropped personal accounts but used words like 'savings incentives,' which had enormous Democratic support in the congress, that would have passed.

FORTUNE: So do personal accounts outside of Social Security?

HUBBARD: The lifetime savings account and retirement savings are two proposals in his budget could have effectively done what he wanted. And you could have even put public money in them for low income households and make the whole thing happen. What you would have lost is the word personal account. As somebody who is just a tech guy and not a politician I wouldn't go to battle over a word, I'd go to battle over an idea. We could have won that.

TYSON: Tech guys and gals don't always win in politics. It didn't happen because the politics and because President Bush defined his second term agenda significantly around the personal accounts. And having done that how could he walk away from that?

HUBBARD: My point is he could have actually gotten them, just without the word. And after he'd won he could have said, 'I got what I really wanted.'

TYSON: But a lot of his political base would not have thought that was what he asked for. So it would have been a huge cave-in. And the moment was lost.

FORTUNE: Can you address why the cost of college tuition has essentially doubled inflation now for 25 years?

HUBBARD: Even at a business school where almost everybody is paying their own way, tuition is only about two-thirds of our budget. Even in a business school. So the rest of that would have to be raised from alumni, from research grants the faculty get from the outside. The reason is that a lot of what goes on is the production of ideas and new curriculum. That takes a lot of time. Tuition alone doesn't cover that.

In the broad university, there's also a great deal of cross subsidization across parts of universities. So some high-revenue parts of universities might subsidize other parts.

FORTUNE: The productivity gains we've been talking about haven't really translated to the academic setting.

HUBBARD: It's the Baumol disease.

TYSON: Yes, it's the Baumol disease. It's a great article to go re-read, and basically it's just that the productivity of a very labor intensive type of service is always going to lag average productivity, it's always going to substantially lag manufacturing productivity. And if compensation, in order to compete with the alternatives in the private sector, rises significantly faster than productivity, it's going to be a big cost push.

HUBBARD: And certainly in business schools, the opportunity cost of our faculty is very, very high. My biggest fear is not so much that LBS or the University of Chicago is going to steal one of my finance faculty. It's that a hedge fund is going to steal one of my finance faculty. I know how to compete with Laura to hire a faculty member because we have our own little narrow range of pay. Once you get to competing with a hedge fund I've got to dance pretty fast.

FORTUNE: Are you losing people to hedge funds?

HUBBARD: We have fought very hard. We have lost very, very few people. But it is a constant challenge. And it usually requires with our coming up with more research support.

TYSON: People teach less. What happens over time is that you pay them the same or more and they actually teach less. And that actually exacerbates the problem.

FORTUNE: Well what do they do with all that extra time?

TYSON: They write papers to put them in the Journal of Finance and some of those papers probably do influence hedge fund traders.

HUBBARD: I would say that part of that research has a big pay-off. If I looked at the biggest ideas in business just in the 25 years I've been in the economics profession, most of it came out of academia.

The entire infrastructure for derivatives was on blackboards even in my time since graduate school. The whole field of strategy came about in business schools largely because that was the only place economists, sociologists, psychologists talked to one another and to business people at the same time. It's true for organizations. Increasingly it's true for the new field of behavioral finance and neuroeconomics.

I think business schools have been very fertile places. You don't need too many of those really big ideas to make it pay on average. At least for top business schools

FORTUNE: With trading becoming arguably the dominant source of profit for Wall Street, does that change a curriculum like the one at Columbia Business School?

HUBBARD: We've always had courses in asset pricing, risk management and so on. I'd say frankly a lot of the student interest is more in the main line of business: private equity, operations, actually running companies. Yes, any top business school would offer a great background for sales and trading. But I think the students' interest lies in bigger things.

FORTUNE: Somebody sent me statistics about private equity at Harvard and Wharton and Columbia. Harvard's venture capital and private equity course has 192 slots but 400 students have applied. At Columbia, 600 of 2,000 students are members of the private equity club.

HUBBARD: I actually teach the Columbia class - even though I'm dean I'm still teaching one class - called Entrepreneurial Finance. It's a very, very large class. The reason that I wanted to teach this class and I think the reason students at Columbia and probably at Harvard, Wharton or LBS are so interested in this isn't just private equity but that when you think about entrepreneurial developments in a company, and how to structure deals, that's a metaphor for what students are doing as they become more successful anyway.

A lot of the people who take my class intend to work for General Electric. But running a division of GE arguably is the same kind of thing - you identify and capture opportunity. I think that's where the student interest is coming from. There's a real hunger from MBA students, and I would say it's entirely positive, to want to run something.

FORTUNE: Is that a shift away from deal-making to operations?

HUBBARD: I wouldn't say that there's no student interest in deal-making. Obviously investment banking is big at both of our schools. But I do think students understand that if you look at the business leaders they most admire, whether they admire them because of money or just their imprint on the business world, those are people who spotted some big opportunity other people didn't see. And the question is what can we do in business schools to help prepare them to do that. I think that explains both the interest in private equity and why students are suddenly again interested in business school.

FORTUNE: But I find it difficult on the private equity front to think of these people as really wanting to run something since the whole culture of private equity is to buy something and then flip it.

TYSON: It's supposed to be to buy it and make it run better.

FORTUNE: And then flip it.

TYSON: But the value of the flip depends upon getting it to run better.

HUBBARD: There was an era, but I think it is long past, where financial engineering - taking over a company and flipping it - made money. Early LBOs were very much just using capital-structure shifts. But I'm on the board of Ripplewood, where we've done amazing turnarounds, and I'm associated with the board of KKR where we have as well. I don't think those are flipping exercises. I think those are exercises in making business run better.

If I thought it was just financial engineering I'd be less excited about it as a dean. But the students who tend to be interested in financial engineering these days are more trying to think of new risk management contracts. And they tend to be techier.

TYSON: I do think that with business school students there are fads. Just as in the late 1990s, business school students were disproportionately attracted to venture capital - you know instead of going to a Goldman Sachs or a Morgan Stanley they would go to a startup - now what the large financial firms will say is that instead of going to them they're looking for private equity or they're looking for a hedge fund.

I am very worried right now that we are at the end or certainly somewhere after midway in a cycle of a huge amount of money going into this sector. And as a consequence of that I would predict that the expected returns are not going to be there. They're just not going to be there.

HUBBARD: I agree that MBA students are a great lagging indicator. But that doesn't mean that they're fooled. I think that the amount of student interest you see here is much greater than the available spots. The typical way into a top private equity firm is to have years of operations experience or consulting. Very few MBA students go into private equity.

We all tell them that, I think they understand that. There is too much money sloshing in and it does mean the average returns will fall. But there are also, I think, some firms that are extraordinarily talented and will continue to do well.

TYSON: One other thing on entrepreneurship because I really want to support what Glenn says. You want to find a way to integrate across a number of disciplinary perspectives and give students more of a holistic view of what it means to run an operation. Traditional ways of doing that through studying operations, they didn't work. It was very divorced from finance and marketing and organizational behavior and so you just had these silo perspectives.

What the entrepreneurship courses do is they actually do bring together a lot of strands of thinking about what it means to run a business venture. By studying entrepreneurship, you're actually learning something about running something large or something small.

HUBBARD: This is actually at the core of our joint program. Both of us have said to students that we want them to think like entrepreneurs. I don't think either one of us means that we think or hope even that most students are going to go out and start a business.

The classic economic definition of an entrepreneur is somebody who puts pieces together in a different way. To me that's what financial engineering is, that's what better risk management is, that's what the private equity is.

TYSON: That's branding, it's everything ...

HUBBARD: Rather than saying, 'I'm a marketing guy' or 'I'm an operations guy' or 'I'm a finance guy,' all of us want to believe and hope that we are producing people who run things and are innovators. And I think our chance of doing that is a lot greater if you get them to think like an entrepreneur.

FORTUNE: Do you think that we are in a period of permanently low real interest rates and risk premia?

HUBBARD: I think it's relatively obvious that risk premia are quite low. Particularly when I think about emerging market products, and when I think about even some sub-segments of the high yield market in this country. You should trust people who play with real money more than an academic, but I don't think that those risk premia are accurate going forward. I also don't think that we've got a permanently new low level of real interest rate.

TYSON: Why would we?

HUBBARD: I think any economist that tells you there are permanent changes...

TYSON: Don't believe them!

HUBBARD:...you should be highly suspicious.

TYSON: So we just hope the unwinding occurs gradually, that's all. I agree completely and I hope the unwinding is gradual.

HUBBARD: So far it has. We have tightened monetary policy quite significantly and we have not had the usual collateral damage of that level of tightening.

FORTUNE: But we also still only have a 2 percent real interest rate, and the average is closer to 3 percent. That's a 50 percent rise in the real interest rate to get back to the norm.

HUBBARD: I don't dispute anything you say, but there is another piece of the puzzle - which is that the nominal interest rate is a risk premium for the variability of inflation. There is a very good argument to be made that over a period of time investors might [come to] believe that inflation is low and stable in a way it might have been in the 1950s.

The only issue I have with that argument is our battle against inflation was won a while ago. So I just question why it took investors this long

TYSON: It took a long time.

HUBBARD: But maybe it took investors a long time to really believe that the Federal Reserve...

TYSON: They didn't believe in the mid-1990s.

HUBBARD: Even though we had a Fed chairman that was quite credible, mind you, that whole period ...

TYSON: It took a very long time.

FORTUNE: When Laura was going though her list of 'buts,' one of the things she mentioned was the trade deficit. Big 'but,' right?

TYSON: A concern.

FORTUNE: A big concern, you haven't really talked about that.

HUBBARD: Certainly, the current account deficit is very large. Certainly it's almost outside of experience. I would caution [against] a run to panic simply because, and I hate to sound parochial, but the U.S. is special. Don't go to a sample of countries that were never the reserve currency country and extrapolate the [current situation of the] United States.

To me the reason I think financial market participants are calm is that the scenario they're pricing is one in which there is gradual increase in saving in the United States, and there is a gradual recovering of the financial system issues that we've been talking about.

TYSON: My worry about the trade deficit is that to the extent it has been driven by a set of policy choices in the U.S., we've put ourselves in an unnecessarily risky situation.

We didn't have to get this far. We got this far in terms of depending upon the rest of the world to provide us with savings. They have been quite wiling to do it so far. But you put yourself in a situation of greater risk. The larger the imbalance, the greater the risk that you don't get the nice gradual scenario.

The other thing that I wanted to say about trade deficit gets back to the politics. Glenn and I would certainly agree that a very disturbing development both in the U.S. and Europe is the increasing spread of anti-globalization sentiments. When you have a trade deficit as large as we have, it just becomes a trigger for unleashing those kinds of sentiments.

HUBBARD: The issue in fighting those protectionist sentiments is to go at something we started talking about at the beginning of the conversation: How do you address ordinary people's fears of job loss. You're never going to win the protectionism battle quoting academic treatises.

On the policy, I'd be careful because a Fed study concluded there was very little link between the budget deficit run recently and the current account deficit. And the one policy that was linked to the rising current account deficit was the Federal Reserve's deliberate attempt to reflate the housing market. That was a deliberate policy gambit that I would argue has paid off pretty well. So yes, policy had something to do with it but it wasn't a mistake.

FORTUNE: What are the consequences of a rising protectionist tide to the global economy?

HUBBARD: Part of the reason I am a big supporter of free trade isn't just the standard economist's homily that free trade increases the consumption possibilities of everybody - although that's true and it's important.

There is increasing evidence that this productivity growth that we all started the conversation celebrating is driven in part by great foreign competition that forces a search for the most efficient technologies and investment. We run the risk of losing that and losing the dynamism that frankly is creating a lot of new jobs.

Remember, in the past quarter century, the U.S. isn't just the high-growth economy, it's actually the high-job-creator economy as well. So productivity growth and job creation don't have to be the enemy of one another. What I would say to people is one thing that's uncomfortable and I wish I knew how to say it better and another that I know how to say well but no politician seems interested in hearing.

The first is, we economists can't tell what the next big thing is, but we can say the American economy has come up with it again and again. If we encourage that, and step out of the way of barriers to it, I think we will see substantial innovation that creates jobs.

The more comforting thing has to do with the message of more individually directed training and support for new careers. That I think many economists, conservative or liberal, would agree on.

TYSON: I agree with the notion that international competition fosters innovation and productivity. I think the problem for us is that technology and global competition has played out in a way that's encouraged the returns to go towards the very top. I don't see that changing and I do worry a lot about that. Not that I necessarily have a set of policies to propose but I do worry about that because I think when you go and talk to these people you don't really have anything much to offer.

We've shifted the global labor supply situation significantly in the past 20 years, particularly in the past ten. And that is working to the disadvantage of a significant number of workers in advanced industrial countries, who essentially were earning a premium because of the market power of the advanced industrial countries.

HUBBARD: Part of the problem here is that there were many workers getting supra-competitive wages. They may have grown to believe that that really was their marginal product. But now with a competitive world it really isn't.

TYSON: Glenn, that's easy for us to say. Maybe it's not affecting our marginal revenue product but if it's affecting most people's, there's the politics, that's the situation. People don't want to hear it. They'll say, 'So what you are saying is that competition from China and India is driving down my wages: See I told you so.'

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