Another Perspective

Disconnected From Fiscal Reality

Why are financial markets not taking looming entitlement shortfalls into account?

By 8.6.07

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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.

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About the Author

Jagadeesh Gokhale is a senior fellow at the Cato Institute and a former senior advisor to the Federal Reserve Bank of Cleveland.