Entitlement Blues

The late economist Herbert Stein (Chairman of the Council of Economic Advisors under Nixon,  a founder of the American Enterprise Institute and an avowed Rockefeller Republican) once noted that something that is unsustainable cannot continue. It is asserted by those in the know of both right and left political persuasions that the current federal budget path is unsustainable and entitlements are the problem.

In particular the Medicare and Medicaid programs are on a long-run path to swallowing the whole budget. (Social Security also has a problem but it is modest by comparison.) The medical expenditures are driven by the nation’s demography and the medical sector’s increasing treatment costs. Both of these elements are outside of the formal budgeting process. Our population will continue to age. No one has made a convincing argument yet as to how to slow down the rate of medical inflation.

The Ryan/Republican approach is to shift the costs off budget by increasing the share of the costs paid for by the beneficiaries. The Obama Administration and the Democrats hope to shift some of the costs to the supply side of the medical market place. Neither approach directly deals with the demographic and cost inflation. The burdens are just redistributed. A real solution remains politically elusive.

This Ryan Won’t Fly-Part 1

Back in the days when economists had a sense of humor and irony Herbert Stein noted that something that is unsustainable will not continue. This unalterable fact is true of federal finances as currently constructed. The budget has a structural deficit of about 4%+ of GDP and this structural component will grow if the spending/taxing relationship is not changed. The Debt/GDP ratio will have to be reduced and stabilized. Empirical research indicates a ratio of around 60% is necessary for long-run economic stability. We are currently at 80% and moving towards a three digit level within the next few years. The recession is only partially responsible (about 60% of the current deficit can be attributed to the slow economy).

Currently there are three fully formed budgetary proposals designed to put federal finances on a sustainable path and reduce deficits and federal debt. They are : The Bowles-Simpson plan put forward by the President’s Commission on Fiscal Responsibility and Reform, the Rivlin-Domenici deficit reduction plan proposed by the Bipartisan Policy Center and the “Path to Prosperity” fiscal plan proposed by Congressman Ryan. And recently the Obama Late Entry Plan. I take it as a political truth that only bipartisan support will generate a plan that has any chance of legislative enactment, and bipartisan support indicates the public has the stomach for the plan’s distribution of pains and benefits.

This eliminates two extremes: A plan that claims to attack  the fiscal crisis by only cutting spending (The Ryan Plan )or a plan that solves the problem by only raising revenues (I’m speaking of both of these as a share of GDP). The current fiscal gap is roughly 10% of GDP.Under the current structure of taxes and expenditures. This gap would close to around 5% if the economy were operating at a full employment level of output. Any plan must reduce this structural gap to claim it will achieve fiscal sustainability.

The trick is to move toward a sustainable fiscal balance without jeopardizing the recovery. The adoption of a plan will not in itself immediately stimulate the recovery. It will improve the nation’s balance sheet overtime and provide a foundation for more economic stability. It accomplishes this by stabilizing and gradually reducing the Debt/GDP ratio at the 60% range, and reduces the potential “crowding out” effect of increasing federal debt held by the public. This does not assure balancing of the budget, at least not, annually. The ideal solution (I think) involves cyclical balancing of the budget with a virtual balance at around 5% unemployment and surpluses at output levels that generate unemployment a lower levels.

In the real world a politically acceptable solution will involve increased taxes, and program cuts (this will involve actual reductions in the growth rate of entitlement spending, actual reductions in Medicare and Medicaid. Pain for all is the politically acceptable solution.

A balanced plan also implies some growth in the federal share of the GDP. Demographic trends augur for an aging population and this means increased medical care per capita. Demography is destiny.There is no extant evidence that medical costs for the elderly will decline in absolute terms, or for that matter in relative terms. This means that the current and future generations will have to save more (either through increased personal savings or increased taxes) to cover growing medical expenses. Geriatric care is the elephant in the closet, and the elephant is growing. We can offset some of this burden through economic growth but growth is unlikely to offset all of it. We can try and offset the growth in medical federal medical liabilities trend by reducing government expenditures on other programs. That will buy some time but unless you can envision defense spending and non-defense discretionary spending trending to zero, the budget will increase. The interest on the debt is the other item that seems primed for inexorable growth absent serious fiscal discipline.

The Ryan approach throws all the burden of hunting elephants to the expenditure side of the budget. Over time discretionary spending declines by 91% as a share of the budget and Medicare and Medicaid spending are significantly reduced The burden of all these cuts falls on the majority of the population.

Nothing real has changed. The elephant is still growing demography and medical cost trends guarantee this result. The cost is shifted to the consumers of medical services. (Additionally, The Affordable Care Act is also repealed) Let me suggest that all of this is politically impossible, but the fight will slow down the search for real alternatives.

The federal budget deficit is not the real focus of the Ryan Plan. He wants to reduce the share of Federal spending to GDP to its post WW2 average of around 18% and just cuts spending growth to get there. The deficit is not eliminated until 2030 under his favorable economic growth assumptions. A discussion of these assumptions will follow in the next installment of the Ryan flight plan.

These spending cuts and medical cost redistributions will be combined with higher income earners sacrificing pre-Bush tax rates. This is the most regressive fiscal revision in US history.

Cliff Notes

The length of a recession is officially measured by the National Bureau of Economic Research (NBER) as the time from the previous peak in economic activity to the nadir (trough). This recession, known as The Great Recession, lasted 18 months according to the NBER, from December 2007 until June of 2009. Seems like forever. The recovery has been phlegmatic compared to typical post war recessions.  The cause(s) of this recession were not typical and were characterized by a severe financial crisis. Academic research indicates that the private deleveraging process required to recover from a crisis of this type typically takes several years (See Rienhart and Rogoff “This Time is Different: Eight Centuries of Financial Folly” 2009). We are doomed to a typical recovery. Our potential recovery is complicated by perceptions of the risks associated with our high level of public debt, particularly federal debt.

 It is obviously naïve to expect politicians to clarify issues surrounding the present state of the economy They have not disappointed.. The role of political philosophy colors the debate. Ideology prevents reasonable discussion and the weighing of evidence. The mavens of the left overstate the benefits of intervention and those of the right deny the possibility of benefits and see only negative consequences. How about a discussion based on logic and/or evidence rather than quasi-religious beliefs?

Simply put the “fiscal cliff” is a combination of tax increases and expenditure cuts designed to reduce the deficit by about 50% immediately. If this combination sounds like the European approach to their fiscal crisis, that’s because it is. We can observe how well it’s doing there. Why should we be different? There is no reason why. The Congressional Budget Office (CBO) estimates the effect of making the leap as a one-half percentage point reduction in the growth rate( or about $80 billion a year in GDP loss) with a high probability of a recession in 2013. So the price is lost output and increased unemployment. The economy returns normal growth (from a lower base) by 2015 according to projections. The gain is a lower cumulative deficit in the ensuing years. But the accumulated output loss adds insult to injury and insures that this accumulation will take years to overcome. The price is too damn high.

Larry Summers and Christina Romer have argued convincingly (April 2012) that more stimulus now with a real long-term plan for fiscal rectitude will achieve greater growth at less short-term cost. Makes sense to me. Sometime you have to strengthen the patient before performing the surgery.

More fiscal stimulus at this time with continued Quantitative Easing by the Federal Reserve has the possibility of giving the economy the jolt it needs to continue its revival even though global growth is slowing down. This prescription is the only game in town. Krugman and some other lefties have argued for a more aggressive monetary policy by the Fed. They would like the Fed to raise the target rate of inflation (currently 2% per year to 3 or 4%). They argue that raising the explicit target would encourage more consumer and business spending as there would be an expectation of more inflation, hence a fear of depreciating currency. I sympathize with this argument but it is not without risk. Once in place, inflationary expectations are hard to reverse, and there is a danger of overshooting the target. Let me just note at this time that the tighter monetary policy necessary to reduce inflation is not without significant costs.