Laurence Kotlikoff’s latest article in the Federal Reserve Bank of St. Louis Review has instigated a flurry of commentary on the state of domestic policies. Kotlikoff poses the question, “Is the United States Bankrupt?” Despite the colorful language with which he describes the state of affairs, his answer is “no.” In Kotlikoff’s view, the United States is not yet in bankruptcy, but it’s headed that way.
Almost all of the ensuing media discussion of Kotlikoff’s argument has failed to focus on his central point. The Wall Street Journal recently provided a lot of mumbo-jumbo about how our national “balance sheet” is healthy and national wealth rising rapidly — a transparent effort to dispel any doubts that the economy’s condition, and by implication Bush policy, is sound. But, again, Dr. Kotlikoff’s thesis is about the economy’s future condition, not its current one.
Kotlikoff’s claim is supported by several carefully calibrated computer analyses that show how the promise to provide many trillions of dollars to today’s citizens — of which $67 trillion are unfunded — would spell disaster in years to come. Over the next 20 years, 76 million people — fully one-fourth of the total population — will transition into retirement, compounding the problem dramatically.
Because we believe that the government would somehow secure our retirements, we are saving and investing less of our earnings. Personal saving, which has trended lower since the early 1980s, recently entered negative territory. And the longer the government maintains its unfunded benefit promises, the longer our under-saving behavior is likely to persist.
The impact of public policies on private economic behavior could result in a vicious downward spiral. Two dynamic and mutually reinforcing forces are operating today: First, currently unfunded federal obligations are accruing interest and growing larger over time, making it more difficult to raise the resources to pay for them. Second, the growth of worker productivity is declining and will continue to decline as a result of lower prior saving and capital formation. The pick-up in productivity since the mid-1990s appears to be reversing its course: growth in U.S. output per hour declined from 4.1 percent per year in 2002 to 2.3 percent in 2005. If this slide persists, resources to pay for growing obligations will have to be raised from a smaller future economic pie.
The outcome of these two forces would be higher future tax rates, which would not only further dampen productivity, but also reduce the amount worked — following the same pattern as Europe since the 1980s. That implies progression toward reduced living standards, if not national bankruptcy.
Scary as this outlook is, the reaction of some pundits is yet scarier: Many have blithely dismissed the analysis as based on unrealistic assumptions. The Wall Street Journal, for example, suggests that Kotlikoff’s prognosis rests on the “false assumption that the current level of [entitlement] benefits will ever be paid.” That view, however, just replaces one false assumption with another. If one-fourth of Americans join the ranks of retirees, they would gain strong incentives to crush any attempt at scaling back the growth of entitlements.
Nor can the traditional method of cutting federal obligations — allowing inflation to do it for us — be employed in the case of Social Security and Medicare entitlements. Social Security is indexed to inflation and Medicare provides “in kind” benefits — whereby the government pays cash not to retirees but to medical providers for services rendered to retirees. With inflation-linked defaults inoperative and explicit defaults politically infeasible, the only — temporary and self-defeating — way to stave off bankruptcy would be to increase taxes on workers. The simple lesson here is that the longer we procrastinate in reforming entitlements — under faint hopes that faster economic growth will solve our fiscal problems — the larger future tax hikes will have to be.
There is a yet deeper point that many commentators appear to miss: that well crafted, direct, and immediate fiscal adjustments to curb the current overextension of entitlements would themselves prove to be pro-growth policies. They would reduce the misdirection of private resources into current consumption rather than saving and investment.
Most observers appear to interpret the phrase “faster economic growth” to mean growth at rates faster than today’s. Instead, they should compare future growth rates under reformed entitlement policies with those that would result if today’s policies were maintained. As Kotlikoff shows, future growth would be much slower unless we scale back promised benefits and establish a stable and credible tax structure. These reforms are crucial to the continued health of the economy.