Is the U.S. going the way of G.M.?

My first Deficit Task Force meeting took place at the American Farm Bureau headquarters in Washington, D.C. last December 17th — the day I turned 65 and became eligible for Medicare. I was the oldest Task Force member and the only one close to actually experiencing Social Security and Medicare.

Our first presentation was from the “Fiscal Wake-up Tour” — three experts on the federal deficit representing the Concord Coalition (non-partisan) , the Heritage Foundation (conservative) and the Brookings Institution (liberal). They were unanimous in their message — without major changes, the federal deficit would explode and bankrupt our country over the next thirty years (or less). They certainly got our attention.

As I mentioned in the previous post, I came to the meeting with the mistaken belief that the looming retirement of the baby-boomers and the resulting increase in Social Security payments were primarily responsible for the deficits.

Social Security

The Social Security Trust Fund is projected to run out of money in 2043. However, Social Security payments are currently equal to 4.4% of GDP and it is taking in payroll tax receipts equal to 4.8% of GDP — so the Trust Fund is growing and will be for the next decade. If nothing is done, SS payments are projected to grow to 6.1% of GDP in 2033 and then stabilize. A .5% of GDP increase in revenue or a cut in expenditures now would bring SS back into actuarial balance. This could be done by increasing the payroll tax from the current 12.4% to 13.7%. The required increase in the payroll tax would be less if combined with an increase in the “full retirement age” (the Task Force favored automatically increasing the “full retirement age” as longevity increases) and/or a increase in the cap on earnings subject to SS tax ($106,800 in 2009).

Social Security has a serious long-term funding problem that must be faced soon. However, since Congress controls both the revenue and expenditure sides of the Trust Fund, many options exist that will bring SS back to solvency. Only the political will is lacking.

Medicare and Medicaid

The government now pays directly or indirectly for well over half of U.S. healthcare. The biggest contributors to government costs are the Medicare and Medicaid programs and the tax revenue lost by not taxing employer-provided health insurance. Government costs are rising rapidly because healthcare costs are rising much faster than inflation in the rest of the economy. I’ll have much more to say about this in future posts.

Unless dramatic action is taken, steadily rising healthcare costs are projected to bankrupt the federal government. The Congressional Budget Office (CBO) has projected that the combined cost of Medicare and Medicaid will increase from 4.9% of GDP in 2010 to 10.6% in 2040 (an increase three times bigger than the increase in SS). During the initial meetings of the Task Force, we saw two graphs from the CBO that dramatically illustrate this point.

Notice that the top graph excludes interest payments on the national debt. If nothing is done and interest payments are added, the federal budget is projected to grow to 43% of GDP in 2050 with interest payments on the skyrocketing national debt alone costing 16% of GDP (and these estimates were done before the current recession). Federal tax revenue has averaged about 18% of GDP for the last 30 years. Hence, without a very large increase in taxes, the federal deficit in projected to explode in the near future — mainly due to rising healthcare costs.

Why worry about the federal deficit?

We’ve been hearing dire warnings about federal deficits at least since the 1980’s when the Reagan tax cuts caused the yearly federal deficit to jump to unprecedented levels. However, none of the predicted bad effects has materialized yet. Interest rates have stayed low. Buyers have lined up to eagerly buy our Treasury bonds. Interest payments as a share of federal outlays have actually fallen from 14% in 1985 to a projected 7% in 2009. Why is action so urgent now?

I believe the situation we currently face is different in two fundamental ways. First, the size the projected long-term deficits is much larger than we have ever experienced in peacetime. See the graphs on page 4 and the title page of the CBO’s most recent “Long-Term Budget Outlook.”

Second, our government is now selling most of its debt to foreigners. After the waves of currency crises that swept around the world between 1996 and 2001, many countries decided they needed to increase their reserves of U.S. dollar assets. By purchasing U.S. bonds, foreign governments caused the U.S. dollar to rise in value relative to their currencies and this promoted a rapid growth in their exports. Maintaining an undervalued exchange rate turned out to be a spectacularly successful development strategy — one that China and other other developing countries have been reluctant to give up. China now has accumulated over $1.5 trillion in U.S. debt and knows it will suffer large capital losses on this debt as soon as it stop buying dollars and lets the Yuan appreciate.

During the last decade, the U.S. has not experienced rising interest rates and the other negative consequences of its large federal deficits because foreigners have willingly accumulated U.S. dollars. They now have more dollars than they want and may soon start selling rather than buying. Interest rates will soon rise dramatically.

Because more than half of U.S. Treasury debt is now foreign-owned, foreigners have also gained a powerful foreign policy tool they can use against us. Sudden large sales of foreign-owned U.S. Treasury bonds would dramatically raise U.S. interest rates and disrupt our financial system. The U.S. threatened this financial weapon against the British an French governments and forced them to withdraw from the Suez Canal in the 1950’s. The Chinese could now do the same in a conflict with us.

Are we going the way of G.M.?

For sixty years, G.M. was the largest and strongest car company in the world. Because it was so powerful, G.M. could delay facing up to its mounting losses during the last decade. Neither management nor the unions stepped up to make the painful changes necessary to confront G.M.‘s problems and save the company. G.M. ended up bankrupt. Unfortunately, the U.S. faces a similar situation.

A final complication

A federal budget deficit for a year or two is not necessarily bad. During our current severe recession, the federal deficit has ballooned to an unprecedented $1.5 trillion. This deficit is due partly to the additional spending from the stimulus package, but mostly to a decline in tax collections. Both lower taxes and increased government spending are stimulating our economy at a time that stimulus is sorely needed. There is no doubt that the debt we are accumulating is adding to our long-term problem. However, large deficits are necessary until the recession ends. As soon as the economy gets back on it feet, the federal budget must be balanced.