A dozen or so years ago I heard Pete Peterson, former Secretary of Commerce and Senior Chairman of Blackstone Group, expound on the low savings, high balance of payments deficits, and frightening outlook for the fiscal affairs of the United States. He went on to found the Peter G. Peterson Foundation with $1 billion of the proceeds of his interest in Blackstone. The Foundation has the mission of raising the awareness of the necessity of fiscal responsibility.
At the time Peterson struck me as an alarmist. But no more.
Over the 15 years leading up to the current economic/financial problems, our high consumption economy, combined with a significantly undervalued Chinese currency and high oil prices, caused an immense explosion of foreign-owned U.S dollar assets…….negative saving here, by both consumers and government, and high savings abroad. Our deficits were financed in significant part by foreigners, notably China.
The long-term hope during this period was that we would see a reduced level of military spending, lower oil imports, and enough upward adjustment in the Chinese currency to start bringing things back into balance.
But China has made only token moves to revalue their currency, we have not made any meaningful progress in reducing oil imports, due primarily to price increases, and our federal deficits have exploded upward as the economy and financial system ran into serious trouble. So even as consumer savings began to rise, dissaving by government has increased rapidly. Remember that it’s aggregate savings that interest us, that is, savings of both the private and government sectors.
You’ve probably seen the numbers. Looking forward, federal deficits seem out of control. When realistc assumptions about economic growth are plugged into the calculations, the annual and cumulative deficits are truly staggering. And when Medicare and Social Security obligations are added, the numbers look impossible to manage. Something will have to give…..
Where does the money come from to finance these deficits? Will they have to be monetized, with treacherous implications for inflation? If so, to what extent?
These are very key questions. As to monetization, one is tempted to say that unless the Federal Reserve’s independence is compromised, it won’t happen. But there are several congressional camels trying to get their noses under the tent here. As now structured, I believe the Fed could avoid significant monetizing as long as the economy is growing and unemployment is not a serious problem. If the economy is not growing satisfactorily, and unemployment is uncomfortably high, some monetization might actually be desirable, but in any event the political pressures on the Fed to keep rates low would be immense.
Above all, beware of threats to the independence of the Fed. As I have pointed out in earlier Musings, hyperinflation has never occurred in a country with an independent central bank. Or saying it differently, as Niall Ferguson did in his recent book, The Ascent of Money, inflation is always a monetary phenomenon, but hyperinflation is always a political decision.
As to funding Medicare and Social Security entitlements, at this point in time I must say the problem looks almost too big to solve. Social Security and Medicare have promised $43 trillion more in benefits to senior and disabled workers than the programs will be able to pay. And that’s before any changes that might be wrought by the new healthcare legislation. The 2008 annual report of the trustees of the Social Security and Medicare trust funds concludes that both programs will require progressively larger transfers from general revenues to maintain projected levels of spending.
Medicare is the greater challenge. It seems very unlikely that our legislators will raise premiums sufficiently to cover the rising costs. If not, then benefits must be significantly reduced (also unlikely) or tax revenues must be increased. The latter looks like a shoo-in. One reputable estimate is that if financed by payroll tax, the Medicare tax would have to double to 5.7% by 2020 and triple to over 9% by 2030
Social Security will have positive cash inflow in until 2017 when it goes negative. But starting next year, 2010, the $80 billion or so of surplus Social Security annual cash inflow that has been borrowed by congress and used for other purposes begins to shrink and will have to be found elsewhere., thus further aggravating the task of finding financing for the federal deficit. By 2020 today’s $80 billion surplus will become a $75 billion shortfall. The shift of $155 billion will have to come from either general revenue or from a big jump in the payroll tax.
Meanwhile, back to the projected total deficit where we revert to talking about trillions of dollars instead of mere billions. No matter how you slice it, the federal government must find $12 to $15 trillion in cash over the next 10 years. From where? How?
If, for a variety of reasons, including lower net exports to the U.S., fear of a weak dollar, fear of U.S. inflation, and reluctance to add to already large dollar holdings, foreigners do not buy large hunks of dollar assets, including new federal debt, the money must come from either domestic savings or new money creation.
If domestic private savings are to be the primary source of funding, significantly higher interest rates will be required to attract those savings (which would also help to keep foreigners from abandoning us). If higher interest rates are deemed undesirable as a matter of economic policy, then higher taxes seem to be the only answer. But, of course, both high interest rates and higher taxes stunt economic growth, so we are looking at a vicious circle.
Hmmmmmm…… higher interest rates, higher taxes, higher domestic private savings…………not exactly a formula for a high growth economy is it? Is there a way out?
The ideal, of course, would be to have a high growth, low inflation, high savings economy, with a favorable trade balance and strong dollar. I don’t think that is a reasonable probability. Do you?