Some would of course close the circle by saying that Hummers are needed in Iraq in order to keep Hummers in California supplied with cheap gasoline. But this once again exaggerates the importance of oil in the decision for war against Saddam Hussein. For the paradox of the empire of guns and butter can also be illustrated by comparing the contrasting economic fortunes of two American companies since the election of President Bush. Anyone who invested in the oil field engineering company Halliburton in late 2000 in the expectation that the company would benefit from a Republican election victory has been disappointed. In the three years to November 2003 the company’s shares declined by more than a third and did not benefit significantly from the more aggressive Middle Eastern policy supported by its friends in high places. An investor who put his money in Wal-Mart shares in late 2000 would, by contrast, have made a capital gain of a fifth. From a strictly economic point of view, investment in the quintessential consumer sector company has proved much more profitable than investment in the firm supposedly at the heart of the military-petroleum complex.
The growing importance of personal consumption in American economic growth has been one of the most striking developments of the past four decades. As a percentage of GDP it has risen from around 62 percent in the 1960s to nearly 70 percent in 2002. The corollary of this has been a decline in savings: the personal savings rate has dropped from an average of 9 percent from 1959 until 1992 to just over 4 percent in the subsequent eleven years. Indeed, Americans have financed a substantial part of their increased consumption by borrowing. Household sector credit market debt rose from 44 percent of GDP in the 1960s and 1970s to 78 percent in 2002.
Nor is it only ordinary Americans who are relying on credit to cover their rising expenditures on consumption. The federal government admitted in July 2003 that the budget surplus of $334 billion that it forecast two years before had—thanks to a combination of recession, war and tax cuts—become a deficit of at least $475 billion.31 This figure came as a shock to many Americans. During the Clinton administration, after all, the Congressional Budget Office projected budget surpluses stretching as far as the eye could see. However, these projections were based on the assumption that regardless of inflation or economic growth, the federal government would spend precisely the same number of dollars, year in and year out, on everything apart from Social Security, Medicare and other entitlements. At the same time, the CBO confidently assumed that federal tax revenues would grow at roughly 6 percent per year. In 2001 the CBO decided that failing to adjust projected discretionary spending for inflation (but not economic growth) was no longer “useful or viable.” Making this adjustment reduced the projected 2002–11 surplus from $6.8 trillion to $5.6 trillion. But that was nothing compared with the impact of subsequent unforeseen events. Two years later, after a recession, a huge tax cut and 9/11, the CBO’s projected ten-year surplus had fallen to $20 billion. Nevertheless, the CBO was still able to predict a medium-term decline in the federal debt in public hands from 35.5 percent of GDP to 16.8 percent over ten years.32 To generate this result, the CBO assumed, conveniently, that discretionary spending would remain fixed over the next decade even as the economy grew. In fact, these purchases, which include the additional military and security costs since September 2001, have risen more than twice as fast as economic output over the last three years. At the time of writing, the CBO has revised its projections again. It now predicts a deficit for 2004 of close to half a trillion dollars, and for the ten-year period from 2002 to 2011 the erstwhile surplus has become a $2.7 trillion deficit. That is $9.5 trillion more new debt than the CBO was anticipating before the last presidential election, less than four years ago.
Yet even the CBO’s latest projections still grossly understate the true size of the federal government’s liabilities because its “bottom line” is only that part of the liabilities that takes the form of bonds.
Americans like security. But they like Social Security more than national security. It is their preoccupation with the hazards of old age and ill health that will prove to be the real cause of their country’s fiscal overstretch, not their preoccupation with the hazards of terrorism and the “axis of evil.” Today’s latent fiscal crisis is the result not of excessive overseas military burdens but of a chronic mismatch between earlier Social Security legislation, some of it dating back to the New Deal, and the changing demographics of American society.
In just three years, the first of around seventy-seven million baby boomers will start collecting Social Security benefits. In six years they will start collecting Medicare benefits. By the time they all are retired, an official estimates, the United States will have doubled the size of its elderly population but increased by barely 15 percent the number of taxpaying workers able to pay for their benefits. Economists refer to the government’s commitment to pay pension and medical benefits to current and future elderly as part of the government’s “implicit” liabilities. But these liabilities are no less real than the obligation to pay back the principal plus the interest on government bonds. Indeed, politically, it may be easier to default on explicit debt than to stop paying Social Security and Medicare benefits. While no one can say for sure which liability the government would renege on first, one thing is clear: the implicit liabilities dwarf the explicit ones.
The scale of these implicit liabilities was laid bare in 2003 in a paper by Jagadeesh Gokhale, a senior economist at the Federal Reserve Bank of Cleveland, and Kent Smetters, the former deputy assistant secretary of economic policy at the U.S. Treasury. They asked the following question: Suppose that today the government could get its hands on all the revenue it can expect to collect in the future, but had to use it, also today, to pay off all its future expenditure commitments, including debt service. Would the discounted present value of all its future revenues suffice to cover the discounted present value of all its future expenditures? The answer is a decided no. According to their calculations, the shortfall amounts to $45 trillion.33 To put that figure into perspective, it is twelve times larger than the current official debt held by the public and roughly four times the country’s annual output. Gokhale and Smetters also asked by how much taxes would have to be raised or expenditures cut—on an immediate and permanent basis—to generate, in present value, $45 trillion. They offer four alternative answers (see table 14). The government could, starting today, raise income taxes (individual and corporate) by 69 percent, or it could raise payroll taxes by 95 percent, or it could cut Social Security and Medicare benefits by 56 percent, or it could cut federal discretionary spending altogether—to zero.
TABLE 14: PERCENTAGE INCREASES IN TAXATION OR CUTS IN EXPENDITURE REQUIRED TODAY TO ACHIEVE GENERATIONAL BALANCE IN U.S. FISCAL POLICY
Policy
Percentage Change
Increase federal income taxes
+ 69
Increase payroll taxes
+ 95
Cut federal purchases
-100
Cut Social Security and Medicare
-56
Source: Jagadeesh Gokhale and Kent Smetters, “Fiscal and Generational Imbalances.”
Another way of expressing the problem is to compare our own lifetime tax burden with the lifetime tax burden the next generation will have to shoulder if the government does not do one of the above—hence the term often used to describe calculations like these: generational accounting. What such accounts imply is that anyone who has the bad luck to be born in America today, as opposed to back in the 1940s or 1950s, is going to be saddled throughout his working life with very high tax rates, potentially twice as high as those his parents or grandparents faced. Notwithstanding the Bush administration’s tax cuts, Americans today are scarcely undertaxed. So the idea of taxing the next generation at twice the current rate seems, to say the least, fanciful.
There is, however, one serious problem with these figures, not with the calculations that underlie them but with their acceptance. To put it bluntly, this news is so bad that scarc
ely anyone believes it. It is not that people are completely oblivious of the problem. It is common knowledge that Americans are living longer and that paying for the rising proportion of elderly people in the population is going to be expensive. What people do not yet realize is just how expensive. One common response is to say that the economists in question have a political ax to grind and have therefore made assumptions calculated to paint the blackest picture possible. But the reality is that the Gokhale-Smetters study was commissioned by Paul O’Neill when he was treasury secretary and was prepared while Smetters was at the Treasury and Gokhale at the Federal Reserve. Moreover, far from being a worst-case scenario, the Gokhale and Smetters figures are based on what are arguably optimistic official assumptions about growth in future Medicare costs and longevity. Historically, the annual growth rate in real Medicare benefits per beneficiary has exceeded that of labor productivity by 2.5 percentage points. But official projections assume only a 1 percentage point differential in the future. (They also assume, optimistically, that it will take fifty years for Americans to achieve current Japanese life expectancy.) Under somewhat different assumptions the total fiscal imbalance could be even larger than $45 trillion.
Nobody can be surprised that in the American political system such unpleasant fiscal arithmetic gets marginalized. No sane presidential candidate would campaign with the slogan “Hike taxes by two-thirds.” Nor is any rational incumbent likely to cut Social Security and Medicare benefits by more than half. It is therefore safe to assume that in the short run almost nothing will be done to address the problem of generational imbalance. Unfortunately, this means the problem will get still worse. According to Gokhale and Smetters, if policy were left unchanged until 2008, income taxes would have to go up even higher—by 74 percent—to close the intergenerational gap. In other words, the arithmetic of generational accounting implies a distributive reckoning at some point in the future. The government sooner or later has to reduce its spending commitments or increase its tax revenues. Regrettably, the Bush administration’s approach to the latent federal fiscal crisis seems so far to have been a variation on Lenin’s old slogan: “The worse the better.” Faced with mounting deficits, the president and his men elected to push three major tax cuts through Congress. Administration officials have sometimes defended these measures as a stimulus to economic activity, a version of the “voodoo economics” once upon a time derided by the president’s father. There are good reasons to be skeptical about this, however, not least because the principal beneficiaries of these tax cuts are wealthy individuals.
One possible fiscal solution to the problem of generational imbalance has in fact already been implemented in Britain; that is simply to scrap the mechanism that allows welfare entitlements to rise ahead of general inflation. In 1979 the newly elected government of Margaret Thatcher discreetly reformed the long-established basic state pension, which was increased each year in line with the higher of two indices, the retail price index or the average earnings index. The first Thatcher budget amended the rule so that the pension would rise in line only with the retail price index, breaking the link with average earnings.34 The short-run fiscal saving involved was substantial, since the growth of earnings was much higher than inflation after 1980. The long-run saving was greater still. The United Kingdom’s unfunded public pension liability today is a great deal smaller than those of most continental governments, as little as 5 percent of GDP for the period to 2050, compared with 70 percent for Italy, 105 percent for France and 110 percent for Germany.35 This and other Thatcher reforms are the reason the United Kingdom is one of the elite of developed economies that do not have major holes in their generational accounts.36
In the present American situation, the vital thing must be to bring Medicare spending under control, for it is in fact responsible for the lion’s share—82 percent—of the $45 trillion budget black hole. Just cutting the growth rate of payments per beneficiary by half a percentage point per year would shave $15 trillion off the $45 trillion long-term budget gap. There must be a way of capping the program’s growth without jeopardizing its ability to deliver medical services to the less well-off elderly. Unfortunately, by subsidizing the cost of prescriptions, the Medicare reform put forward by President Bush and enacted by Congress in 2003 will have the very opposite effect.37 A second policy option (now under serious consideration) would be to privatize Social Security.38
Will either of these policies be implemented? The answer is that it seems unlikely in view of the growing political organization and self-consciousness of the American elderly. Social Security is sometimes referred to as the third rail by American politicians, because politicians who touch it by suggesting any cut in benefits tend to receive a violent political shock from the American Association of Retired Persons (AARP). Mindful of the British experience in the 1980s, the AARP has already commissioned a study showing what the effect would be if an American government replaced the link between the state pension and wages with a link to inflation. It concludes that price indexation would cause the average replacement rate (benefit as a percentage of preretirement income) to drop by half over a period of seventy-five years, “fundamentally changing the relationship between workers’ contributions and the benefits they receive.”39 Quite why today’s elderly should worry about the level of pensions three-quarters of a century hence is not altogether clear. Nevertheless, such arguments resonate not only among the retired but also among the soon-to-retire. The baby boomers are now so old that they have a bigger stake in preserving their future benefits than in lowering their current payroll taxes. Indeed, many have already joined the AARP, which sends Americans application forms on their fiftieth birthdays. So long as attitudes toward old age remain unchanged and so long as the retired and soon-to-be-retired remain so well organized, radical reform of the U.S. welfare state—and hence a balancing of federal finances—seems a distant prospect.
GOING CRITICAL
Conventional wisdom predicts that if investors and traders in government bonds anticipate a growing imbalance in a government’s fiscal policy, they will sell that government’s bonds. There are good reasons for this. A widening gap between current revenues and expenditures is usually filled in two ways. The first is by selling more bonds to the public. The second is by printing money.40 Other things being equal, either response leads to a decline in bond prices and a rise in interest rates, the incentive people need to purchase bonds. That incentive has to be larger when the real return of principal plus interest on the bond is threatened by default or inflation. The higher the anticipated rate of inflation is, the higher interest rates will rise because nobody wants to lend money and be paid back in banknotes whose real value has been watered down by rising prices. The process whereby current fiscal policy influences expectations about future inflation is a dynamic one with powerful feedback effects. If financial markets decide a country is broke and is going to inflate, they act in ways that make that outcome more likely. By pushing up interest rates, they raise the cost of financing the government’s debt and hence worsen its fiscal position. Higher interest rates may also depress business activity. Firms stop borrowing and start laying off workers. The attendant recession lowers tax receipts and drives the government into a deeper fiscal hole. In desperation, the government starts printing money and lending it, via the banking system, to the private sector. The additional money leads to inflation, and the higher inflation rates assumed by the market turn into a self-fulfilling prophecy. Thus the private sector and the government find themselves in a game of chicken. If the government can convince the private sector it can pay its bills without printing money, interest rates stay down. If it cannot, interest rates go up, and the government may be forced to print money sooner rather than later.
Figures like those produced by Gokhale and Smetters might therefore have been expected to precipitate a sharp drop in bond prices. But at the time their study appeared, financial markets barely reacted. Yields on ten-year treasuries have in fac
t been heading downward for twenty years. At their peak in 1981 they rose above 15 percent. As recently as 1994 they were above 8 percent. By mid-June 2003—two weeks after the $45 trillion fiscal imbalance figure had appeared on the front page of the Financial Times—they stood at 3.1 percent, the lowest they had been since 1958.41 Six months later they were just 1 percent higher.
One possible explanation for this apparent non sequitur is that bond traders found themselves in a similar predicament to that experienced by their colleagues trading equities just five years ago. At the time it was privately acknowledged by nearly everyone on Wall Street and publicly acknowledged by most economists that American stocks, especially those in the technology sector, were wildly overvalued. In 1996 Alan Greenspan famously declared that the stock market was suffering from “irrational exuberance.” Over the next three years a succession of economists sought to explain why the future profits of American companies could not possibly be high enough to justify their giddy stock market valuations. Still the markets rose. It was not until January 2000 that the bubble burst.42 Perhaps something similar subsequently happened in the bond market. Just as investors and traders knew that most Internet companies could never earn enough to justify their 1999 valuations, investors and traders in 2003 knew that future government revenues could not remotely cover both the interest on the federal debt and the transfers due on the government’s implicit liabilities. But just as participants in the stock market were the mental prisoners of a five-year bull market, so participants in the bond market last year were the mental prisoners of a twenty-year bond bull market that had seen the price of long-term treasuries rise by a factor of two and a half. Everyone knew there was going to be a “correction.” Yet nobody wanted to be the first player out of the market—for fear of having to sit and watch the bull run continue for another year. Between January 2000 and October 2002 the Dow Jones Industrials index declined by almost exactly 38 percent as irrational exuberance gave way to rational gloom. In the middle of 2003 it was not difficult to imagine a similar correction to the bond market.43
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