The state of New Jersey just reported a $58 billion liability to
its current and past employees on account of post-retirement health
care benefits. States like California, Maryland, New York, and
North Carolina have estimated such liabilities running into tens of
billions of dollars. In Texas, lawmakers are fearful of the
pressure to cut retiree health benefits immediately, so they’re
attempting to reject the Governmental Accounting Standards Board’s
new reporting requirements on state and local post-employment
benefits. But thousands of state and local jurisdictions across the
U.S. have outstanding retirement health benefits promises to
current and past employees, totaling in the low trillions in
today’s dollars.
That’s on top of federal shortfalls in Social Security and
Medicare, estimated by those programs’ trustees at about $40
trillion through the next 75 years. Closing this fiscal imbalance
will require nearly doubling today’s payroll tax rate of 15.3
percent, or imposing a similarly draconian benefit cut. Given how
large government imbalances are overall, policy changes to close
them will likely become imperative when the Baby Boomers begin
retiring in droves in another decade.
So it’s a puzzle why the prospect of a negative economic impact
from unavoidable fiscal policy changes in the not too distant
future aren’t already reflected in financial markets. Some people
suggest that investors are ill informed about the financial
imbalances plaguing U.S. government entities. The information is
usually buried deep inside official reports of Social Security’s
and Medicare’s finances. And the policy requirements for closing
long-term fiscal imbalances, leave alone their likely economic
impacts, are never discussed in the reports. But participants in
financial markets are supposed to be among the most highly educated
and knowledgeable people, and they should be able to put two and
two together.
Another possibility is that the economic impact of these fiscal
developments would occur too far into the future for current
investors to incorporate into their trading strategies. It’s
doubtful that those who understand the economic implications of
existing government imbalances would be sanguine about charging
only 4.5 percent interest on 10-year non-inflation indexed Treasury
bonds. This suggests that most market actors don’t believe that big
tax hikes or steep increases in government debt will occur within a
decade.
A third possibility is that financial markets are flush with
savings from foreign, especially East Asian, countries. The primary
sources of these funds are trade surpluses that those countries
have been running with developed countries such as the U.S.
Although these funds are good for U.S. financial markets, the fact
that they are largely controlled by a few foreign governments
rather than a great many individual investors makes them
riskier.
Those governments could more easily coordinate an exit from U.S.
capital markets if fiscal imbalances started taking a toll, hitting
the U.S. economy even harder. But this prospect means that
investors — mainly the foreign governments themselves — may be
severely mispricing the risks associated with investing in U.S.
capital markets.
Other possibilities are that market actors are aware of U.S.
fiscal pressures but believe relatively painless solutions will be
implemented soon; that the problems will turn out to be smaller
than expected; or that they can unwind their long portfolio
positions in U.S. securities just before policy reforms threaten a
market downdraft.
But projected fiscal shortfalls arise from demographic forces
that are irreversible and entitlement policies with strong
political support. Whether at a time of impending budget crisis the
U.S. Congress adopts mainly tax increases or benefits cuts — or
splits the difference between the two — both types of policies
would hurt the economy. Retirees will react to unanticipated
benefit cuts by cutting spending, and workers will react to tax
increases by working less. The decline in output, productivity and
profits could provoke capital flight and both demand- and
supply-side forces will promote a downward economic spiral.
Although some investors may get out just in time, most of us
won’t.
The only policy with fewer negative macroeconomic implications
would be to cut scheduled entitlement benefits with a long lead
time, perhaps by increasing the age at which full retirement
benefits become payable. Such a policy would induce people to
revise their expected retirement dates forward in time, generate
additional output, and improve entitlement programs’ finances.
However, retiree lobbies, Baby Boomers and minorities would
fiercely resist such a policy, for they stand to lose the most from
it.
The old political practice of promising generous retirement
benefits with no regard to their future fiscal implications, and
without forward-looking accounting or budget controls, was (only)
possible when the Baby Boomers were working and revenues were
booming. Now the costs of these practices will have to be paid
through policy reform, but no one wants to take the lead in
proposing early, cost-saving solutions.
U.S. entitlement programs were established to protect American
workers and retirees from uncontrollable economic shocks. It is
ironic that after seven decades of mismanagement of Social Security
and four decades of Medicare, these programs now constitute the
greatest risk to future American prosperity.
