Focussing on the Debt Molehill

As I noted in an earlier posting, the recent agreement that averted a debt default crisis is, in the grand scheme of Washington's fiscal future, completely meaningless.  Dr. Laurence Kotlikoff, an esteemed Professor of Economics from Boston University has shown that the debt situation in the United States is far worse than the $16 trillion plus headline figure and that, unless extreme measures are taken, the situation is unsolvable.

Dr. Kotlikoff uses what is termed "generational accounting" to identify the size of the unfunded future liabilities of the federal government.  This method of accounting, developed in the early 1990s, provides economists (and anyone else who cares to listen) a means of estimating prospective per capita lifetime net tax burdens after receipt of government-sourced income and benefits.  Prospective means that the fiscal tax burden is evaluated over the entire lifetime of a given cohort, net tax means that government transfers (i.e. entitlements) are subtracted from taxes and lifetime means that future dollar flows are discounted back to the present.  Using this method of accounting, economists can estimate how much future entitlements will cost and how much funding (i.e. tax revenue) will be required to fulfill those obligations in the future.  The difference between the two is termed the "fiscal gap" or the gap between revenues and expenditures over a long time frame.  In simpler terms, generational accounting measures the debt burden that is left by one generation for a future generation.  Obviously, all policy decisions made by governments today have an impact on generations to come; for example, here are three of the larger obligations that we will leave to future generations of Americans:

1.) The current debt net of assets plus interest owing on that debt.

2.) The cost of government benefits that have been promised to the elderly and the ill now and in the future.

3.) The present value of all future government purchases (discretionary spending).

The gap between these three obligations and the amount of revenue in taxes that Washington collects from current and future taxpayers is the dreaded fiscal gap.  Currently, the present value of the burden being passed along to future generations is far larger than the present value of their future labour income, suggesting that future generations will face twice the tax burden that those of us who are alive today are facing just to cover the fiscal gap.  What makes the situation dire is the fact that the number of Americans who will collect an average of $40,000 annually in entitlement benefits is expected to grow enormously over the next three decades as baby boomers reach their sunset years.

How big is this fiscal gap?  In 2011, Dr. Kotlikoff estimated that the fiscal gap was $222 trillion, nearly 12 times the current official intragovernment and external government debt.  It is also 12 times the nation's entire gross domestic product.  Here is a bar graph showing how the fiscal gap has grown over the past decade:

Here's a look at one of the key repercussions of the current fiscal situation on younger Americans.  A study by the IMF from 2010 looks at how severe this problem will be, a problem that, again, is exacerbated by the rapid growth in the older population, a group that utilizes more of the social safety net.  The study shows that those Americans that are currently older will receive far more in benefits than they paid in taxes as shown in this chart:

For example, the real net income (lifetime benefits received minus lifetime taxes paid) of a person who was 70 years old in 2010 was 305 (i.e. they receive far more in benefits than what they paid into the system in taxes over their lifetime) compared to only 19.6 for someone who was 25 in 2010 (i.e. they receive far less in benefits than what they paid into the system in taxes over their lifetime). 

Clearly, future generations of Americans will have painful choices to make.  They will have three choices, none of which is without pain (except the last which pretty much sums up what we're doing now):

1.) Pay more for their entitlements in the form of much higher taxes.

2.) Reform the size of government benefits (likely reducing them).

3.) Pass the burden along to future generations.

The generational imbalance between future revenue and future benefits is magnified by the recent drop in government revenues as taxation levels have dropped since 2001.  Because the drop in revenue is not being matched by a drop in spending, the cost will be redistributed from current to future generations.

Out of a sense of alarm, Dr. Kotlikoff and a host of Nobel Prize-winning economists created the INFORM or Intergenerational Financial Obligations Reform Act, a bipartisan piece of legislation that was designed to incorporate the concept of generational accounting and the fiscal gap into future laws.  By implementing this act, legislators would be forced to look at the impact of any legislation on the long-term fiscal imbalance, that is, think beyond the two/four year election cycle rather than kicking the can down the road as they are prone to do now.  Unfortunately, after being introduced as House Resolution 2976 on August 1, 2013, this is where the INFORM Act now lies:

I'd call that Dead On Arrival, wouldn't you?  According to Govtrack.us, there is a 23 percent chance that this breath of fiscal fresh air will get past the House Budget Committee stage and a measly 7 percent chance that it will actually be enacted.

Lastly and to put all things into perspective, here's a chart showing the size of spending cuts or revenue increases that will be required to eliminate the current fiscal gap:

You'll notice that the longer Congress waits to solve the country's fiscal illness, the more painful the cure becomes.  How would any taxpayer feel about a 55 percent increase in taxes now and forever?

When we hear about the never-ending debt and deficit negotiations in Washington, it's important that we put the whole situation into longer term context.  As you can see from this posting, the entirety of Congress and the President are tied up in knots, trying to flatten a fiscal molehill when, in fact, it is a fiscal mountain that is going to come back to haunt us all.  

America's Looming Unsolvable Debt Crisis

Updated October 30, 2013

With the debt ceiling crisis "behind us", at least for the time being, I'd like to present a few graphs that show how America's federal debt compares to other nations and how the situation is likely to worsen as the years pass despite the political platitudes that politicians are so prone to offer us.

Let's start with two graphs from the Congressional Research Service showing how the level of the U.S. sovereign debt compares to other advanced nations as a percentage of GDP.  First up, gross debt as a percentage of GDP:

In this measure, the United States comes in sixth place with gross government debt of just over 100 percent of GDP, behind Japan, Greece, Italy, Portugal and Ireland, four of the five PIIGS nations that were of such a concern a couple of years back.

Here's a graph showing net debt as a percentage of GDP for the same advanced nations:

Net debt subtracts the government's total financial assets from its total financial liabilities or debts.  Once again, the United States comes in sixth place with a net debt-to-GDP ratio of 80 percent, behind Greece, Japan, Portugal, Italy and Ireland.

Unfortunately, as though it's not bad enough now, the debt situation is only going to get worse for all developed economies.  In most cases, there will be a sharp rise in the ratio of old-age population to working-age population; this will push up costs for health care and other entitlement programs, unfunded and underfunded liabilities that will arise from an aging population.

Let's start this section by looking at United States net federal government outlays as a percentage of GDP:

Currently, net outlays for Washington are just under 22 percent of GDP, just off the post-World War II highs of 24.4 percent in 2009 as the economy circled the white porcelain bowl.  Federal government net spending as a percentage of GDP has risen steadily from between 10 and 15 percent of GDP since the late 1940s a situation that will continue as the population ages.

Now, let's go to a 2010 paper by Stephen Cecchetti et al from the Bank for International Settlements entitled "The future of public debt: prospects and implications".  Here is a graph from the paper showing the ratio of old-age population to working-age population for some of the world's larger economies between 1960 and 2050:

Currently in the United States, the ratio between the old-age population and the working-age population is around 0.20.  By 2050, this is estimated to rise to around 0.38 meaning that there will be twice as many seniors per worker as there are now.  That means that age-related government expenditures will rise for the United States as well as other advanced economies as shown here:

In order to cover these additional age-related costs, the United States will have to improve its budgetary balance (excluding interest payments) by 6.9 percent of GDP, the highest level among the key nations in the study, excluding Greece.

You will notice that the authors' calculations exclude interest owing on the debt.  Here's what happens to projected interest payments as a percentage of GDP (United States in purple):

Interest payments will rise from under 5 percent of GDP now to about 23 percent of GDP by 2040.  Remember, this is on top of rising age-related costs as I noted above.  What we end up with is a worst case scenario where interest owing on the debt is rising at the same time as age-related expenditures are increasing.

To stabilize the U.S. debt-to-GDP level at the level last seen in 2007 (the pre-crisis level), over the next five years, the federal government will have to run a primary surplus of 8.1 percent of GDP, over the next 10 years, the primary surplus will have to be 4.3 percent of GDP and over the next 20 years, the primary surplus will have to be 2.4 percent of GDP.

To put these numbers into perspective and just in case you were curious, the "fiscal gap" described by Lawrence Kotlikoff is nothing short of sphincter puckering.  In a recent interview, Dr. Kotlikoff defines the difference between the governments outlays (liabilities) and its receipts (assets) as the "fiscal gap" which currently amounts to about 10 percent of the present value of the future GDP.  About 60 percent of this gap is related to spending on Medicare, Medicaid, health exchanges and employer-paid, tax exempt healthcare premiums.  Dr. Kotlikoff estimates that, generational accounting suggests that the fiscal gap is a stunning $200 trillion rather than the oft-cited $16.4 trillion in current debt.  To come up with $200 trillion in present value, a combination of tax hikes and spending cuts amounting to 10 percent of GDP would have to be implemented immediately and indefinitely.  If spending cuts alone were used, a permanent 36 percent cut in all non-interest spending would have to take place.  If tax hikes alone were used, a permanent 55 percent increase in all federal taxes would have to take place.

To summarize, it's obvious that the current situation in the Senate and Congress is, at most, going to put a temporary bandaid on a long-term nightmarish debt problem that is likely not fixable by anyone from any political party unless someone is willing to inflict a great deal of pain on voters and voters find themselves willing to make huge personal sacrifices.    When you look at these numbers and see that decades worth of surpluses are necessary to meet the long-term shortfall related to aging and interest payments, it is quite apparent that the situation is futile because we can't even get agreement on a single year's budget.   Unfortunately, there are very, very few in Washington that spend even one second of their day thinking about anything beyond the next election cycle.  

On the other hand, perhaps we are better off believing in the illusion that a debt-ceiling agreement will actually accomplish something meaningful rather than facing the painful reality of the looming fiscal gap.  In any case, it's quite apparent that any debt ceiling deal that is reached by the Republicans and Democrats is just putting a bandaid on a fiscal hemorrhage.