America is bankrupt
THE US has a fiscal gap—the present value of all its future spending (including servicing its official debt) less all its future taxes of $202 trillion—almost 14 times GDP. Greece, by comparison, has a fiscal gap of about 11 times GDP. To close the US fiscal gap would require raising all federal taxes, immediately and permanently by almost two thirds!
The Economist as well as all other financial media as well as virtually all economists (academic and business) and policymakers are focusing on the official debt. For the US, the official debt is $9 trillion. This is minor compared to the fiscal gap, which includes all liabilities, official and unofficial. The fiscal gap is huge compare to the official debt because Uncle Sam has spent six decades accumulating massive obligations to make social insurance payments, which it carefully kept off the books.
My paper with Jerry Green makes clear that, from the perspective of economic theory, the deficit is a number in search of a concept—that what we report as official versus unofficial debt is purely a matter of the words we choose; i.e., the debt measures/reflects our fiscal language, not our fiscal policy.
This labeling problem—that current taxes can just as well be labeled "current government borrowing coupled with future taxes" and current transfer payments can just as well be labeled "current government lending coupled with future transfer payments", means that "the" deficit is up for grabs. Each of the billions of people on this planet is free to use different words to differently, but consistently, re-characterise past US government receipts and payments and arrive at whatever size current US debt he or she wishes to report.
As a simple example, if we classify this year's FICA contributions as "government borrowing" rather than "taxes" and call the future promised benefits "repayment of the borrowing less a future tax", the same amount of money will move from the public to the government this year and the same amount of money will move from the government to the public in the future, but we'll increase this year's reported official deficit from 9% to 15% of GDP.
Time is not well defined in physics. The debt is not well defined in economics. Both are functions of frames of reference, i.e., language. Neither tells us about reality.
Focusing on the debt, as virtually everyone is doing, is straight out of "The Emperor's New Clothes". If everyone continues to do so, there will be no crisis, at least not for a while. But if enough people start looking at the only measure of fiscal solvency that is label-invariant, namely the infinite horizon fiscal gap (finite horizon fiscal gaps suffer fully from the labeling problem), they will realise that the US is bankrupt—not in 30 years, not in 10 years, not in 5 years, but today. When that happens, the crisis will follow immediately.
As for how to fix the fiscal mess, we need immediate and radical reform. On this score, please read " Jimmy Stewart Is Dead", particularly the Afterword, which lays out in a few pages how to fix the healthcare system, the Social Security system, and the tax system. Alternatively, read my op eds on these topics posted at www.kotlikoff.net.
Gradual steps should be taken to avert an abrupt crisis
IT IS clear that America cannot just "count on" growth going forward. While growth-enhancing strategies may work, and corporations may invest more as jobs and demand pick up, creating a virtual cycle, the scale of efforts and mixed results over the past two years suggest that any counting on growth must also prudentially count on associated risks. The risk of a fiscal stimulus that does not deliver on growth is an added government debt burden. While there is perhaps no immediate fiscal crisis and the woes of European countries only strengthen the role of the dollar as international reserve currency, there are three issue to worry about:
1. An American debt crisis is unlikely to be a smooth outcome; it will more likely be a trigger strategy at which its risks start looking worse than another group of countries and investors switch to a more diversified base of international currencies for their reserve holdings. This will likely erode the liquidity premiums built into different ends of the Treasury curve and raise the borrowing costs steeply and abruptly.
2. When an American debt crisis looms large, any current government would hate to be the one that takes tough measures to rein them in as the end game approaches. They would all want to borrow, even at exorbitant costs, to roll on the debt and pass on the cost to the next cycle of politicians. This political economy consideration implies that there is a prudential need to manage fiscal issues ahead of time, rather than by reacting at the end. It is quite possible that some of what we are seeing now is in fact an outcome of such political economy considerations—borrow now to "count on" growth and pass on risks to the future.
3. Spending cuts, tax increases and lengthening of debt maturity in spite of greater borrowing costs may all be needed to achieve lower liabilities, a better asset base and reduced rollover risk. These policies, if implemented abruptly, would also be dangerous, both from a triggering-a-debt-crisis standpoint as well as from the political instability or stalemate they may bring about. Again, a prudential strategy would be to work on these gradually. Of course, tax increases may be needed to affect the transfers essential for better provision of safety net employment insurance and health care.
Given these risks but also the emerging signs of a fledgling recovery, a slow but definitive fiscal policy commitment would be the best road forward. Policy uncertainty could exacerbate any risks the American economy faces in case growth does not pick up.
No crisis is imminent, but fiscal reform is necessary
THE US does not face an imminent fiscal crisis. The US government will not default on its debts, and it’s even unlikely that the Fed will be forced to monetise federal debts. However our fiscal regime is becoming increasingly dysfunctional, thus radical reform would be quite helpful. I’ll sketch out what I view as ideal, with the understanding that political constraints will make actual reforms much more modest.
Despite 9% unemployment, a rapid move toward fiscal austerity in the US would be highly desirable. Before doing so, however, Congress and the Fed need to get on the same page regarding stabilisation policy. The government should give the Fed a desired trajectory for nominal GDP growth over the next 10 years, and instruct them to engage in level targeting, which involves making up for any near-term overshoots or shortfalls. This would anchor NGDP growth expectations, allowing Congress to sharply reduce the deficit without endangering the recovery.
The next step is to reduce expenditures. Obviously this is a political decision, but I’d favor much lower spending on the military, homeland defense, and agriculture. Programmes such as highways and K-12 education should be shifted back to the states. In the medium term we should gradually shift from an insurance-based system of medical expenditure (public and private) to a system where most medical expenditures are made out of health saving accounts, with catastrophic insurance plans covering the most expensive procedures. This could help restrain the growth of Medicare. Over the very long term we need to shift to a system of fully-funded private retirement accounts, on top of a basic annuity provided by the government. All fiscal reforms should be aimed at moving the US toward the low-tax, high-saving Singapore model.
Our tax system also requires radical restructuring. We need new consumption and environmental taxes, but adding them to our current tax regime would invite even greater distortions and inefficiencies. Instead I’d eliminate both the personal and corporate income taxes and replace them with a progressive consumption tax regime, comprised of three parts:
- A progressive payroll tax, with an earned-income tax credit for low income workers.
- A progressive value-added tax, with much higher rates on luxury goods.
- A relatively steep carbon tax.
Obviously this sort of radical restructuring is not politically feasible, but some reform is likely over the next decade, due to the increasing inefficiencies of our current tax system. For instance, the US corporate income tax is now the highest among developed countries, but is also riddled with loopholes.
The tax plan I outlined has features that are attractive to both the left and the right, and thus provides a road map for future compromises. Republicans should insist that no new broad-based tax is added without first eliminating at least one of the existing (income) tax systems.
Democrats should insist that any new consumption taxes be progressive. Because reducing complexity and eliminating taxes on capital are both huge net gains for the economy, there are win-win compromises available if both sides are willing to deal.
A "stealthy default" may punish foreign creditors
IT'S abundantly clear that America's fiscal arithmetic simply does not add up. The implication is a continued increase in its government debt-to-GDP ratio over the medium term. But will this lead to crisis? And, if so, what kind of crisis?
One option is to "do a Japan" which, despite all its difficulties, has almost miraculously managed to live with persistent increases in government debt while enjoying an extraordinarily low cost of borrowing. Japan, however, is special. Its creditors are almost entirely Japanese, suggesting that both creditors and debtors have a strong "national interest" in resolving any fiscal difficulties. And Japan's stagnation—associated with persistent corporate sector de-leveraging—has released savings which the government has been able to tap into very cheaply.
The US is hardly in the same position. Its creditors are increasingly foreign, not domestic, and it has a paucity of savings. Politically, it would surely struggle to cope with ongoing Japan-style stagnation associated with continued de-leveraging. Under these circumstances, the escape route will be a "stealthy default".
The Treasury Department isn't in the business of delivering an outright default, but monetary trickery can nevertheless shift the burden from US debtors to foreign creditors. The best way to do this is to print money, not so much to raise domestic inflation (that would hit domestic creditors, including many in the baby boomer generation who vote in elections) but, instead, to devalue the dollar. Because foreign creditors have mostly lent to the US in dollars, the renminbi or rouble value of their US investments would then be worth a lot less.
Admittedly, faced with this risk, bond yields might still rise. Much then depends on whether the Federal Reserve would then extend its unconventional stimulus programmes in a bid to keep yields at low levels. If it does so, the risk of a major dollar collapse will surely increase.
The Chinese, Russians and other don't vote in US elections. When political expediency dominates economic reality, foreign creditors become an easy target: because they are, the risks of a financial crisis will escalate, ultimately undermining the dollar's reserve currency status.
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