I wrote yesterday about the World Economic Forum’s Global Risks 2010 report, and how its top risk is unsustainable debt levels among several nations, notably the United States. The WEF report referred to the article, “Is the United States Bankrupt?” written by Laurence J. Kotlikoff for the July/August 2006 issue of the Federal Reserve Bank of St. Louis Review, pages 235-249. Today, I’ll review with you that article’s key points. You’ll find it in its entirety here.
Before we begin, note that the article’s publication three-and-a-half years ago proves what I mentioned yesterday about long-term crises taking their time to show up. Prior to Kotlikoff’s article, many other people warned of impending national bankruptcy in the early 2000s, the 1990s, and at the end of the Reagan administration. It’s not a new subject, but it has also not disappeared. The risk of the answer to the article’s title being “yes” is greater than ever, which is why we need to keep an eye on it.
Let’s dive in. Here’s the article’s opening summary:
Is the United States bankrupt? Many would scoff at this notion. Others would argue that financial implosion is just around the corner. This paper explores these views from both partial and general equilibrium perspectives. It concludes that countries can go broke, that the United States is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of US fiscal institutions is essential to secure the nation’s economic future. The paper offers three policies to eliminate the nation’s enormous fiscal gap and avert bankruptcy: a retail sales tax, personalized Social Security, and a globally budgeted universal healthcare system.
Kotlikoff believes that the right way to consider a country’s solvency is by looking at the life-time fiscal burdens facing current and future generations. If the burdens are bigger than the resources created by the generations, bankruptcy looms. Put simply, if people demand benefits costing more than the tax revenue they supply, the government goes broke. Well, guess what? That’s our current situation.
Kotlikoff asked, “Does the United States fit this bill? No one knows for sure, but there are strong reasons to believe the United States may be going broke.” He referenced a 2005 study by Gokhale and Smetters that looked at the gap between future government spending obligations and future government tax receipts, which is where the $66 trillion figure mentioned yesterday first emerged. Pause a moment to consider just how astounding a shortfall that represents. It’s $10,200 for every human being on the planet, or $220,000 for every American.
It’s a testament to government inefficiency that it has managed to owe every American more than a fifth of a million dollars, an amount more than twice the median net worth for 50-year-old citizens. In Kotlikoff’s words, the $66 trillion gap “is more than five times US GDP and almost twice the size of national wealth.”
He goes on: “One way to wrap one’s head around $65.9 trillion is to ask what fiscal adjustments are needed to eliminate this red hole. The answers are terrifying. One solution is an immediate and permanent doubling of personal and corporate income taxes. Another is an immediate and permanent two-thirds cut in Social Security and Medicare benefits. A third alternative, were it feasible, would be to immediately and permanently cut all federal discretionary spending by 143%.” As I covered yesterday, none of that is politically possible.
Plus, believe it or not, the $66 trillion gap is the most optimistic figure! Its calculations omit the value of contingent government liabilities and employ rosy assumptions about longevity and health care expenditures. The best thing most citizens can do for their country appears to be kicking off early before they cost too much. Lovely.
One example of how the assumptions behind the $66 trillion horror story are actually too optimistic comes from Medicare and Medicaid spending. The study assumed that the growth rate in the programs’ benefit levels would be just 1% higher than the growth rate of worker wages. Too bad in recent years wages haven’t been growing at all, and for many have disappeared entirely as jobs went up in smoke. Meanwhile, Medicare and Medicaid benefits per beneficiary have been cooking along at 3% rates of growth.
Kotlikoff lamented the inability of either major political party to deal with the growing gap and its parallel growing risk of national bankruptcy. The Clinton administration failed to make any headway and went so far as to censor an Office of Management and Budget accounting study that would have blown the whistle. The Bush administration was even worse, cranking up expenditures while shrinking receipts, and then firing former Treasury Secretary Paul O’Neill for producing an inconveniently honest report. Needless to say, the already bad trajectory went parabolically awful under the Obama administration.
Both parties and all presidents become irrelevant in the face of corporate control over government. Voters forever choose only between kettles and pots, getting excited about issues of the day, when the primary issue of national solvency never comes front and center and continues to worsen year by year.
Kotlikoff: “The fiscal irresponsibility of both political parties has ominous implications for our children and grandchildren. Leaving our $65.9 trillion bill for today’s and tomorrow’s children to pay will roughly double their average lifetime net tax rates.”
The deteriorating situation caught the attention of some economists years ago, and the specter of inflation has been on their lips ever since. We’ve covered its risk numerous times in The Kelly Letter, and the recent popularity of gold shows that more and more people are aware that the most likely solution will be money printing that kills the value of the dollar and introduces hyperinflation to the streets of America.
On that subject, here’s Kotlikoff:
Given the reluctance of our politicians to raise taxes, cut benefits, or even limit the growth in benefits, the most likely scenario is that the government will start printing money to pay its bills. This could arise in the context of the Federal Reserve “being forced” to buy Treasury bills and bonds to reduce interest rates.
Specifically, once the financial markets begin to understand the depth and extent of the country’s financial insolvency, they will start worrying about inflation and about being paid back in watered-down dollars. This concern will lead them to start dumping their holdings of US Treasuries. In so doing, they’ll drive up interest rates, which will lead the Fed to print money to buy up those bonds. The consequence will be more money creation — exactly what the bond traders will have come to fear. This could lead to spiraling expectations of higher inflation, with the process eventuating in hyperinflation.
Yes, this does sound like an extreme scenario given the Fed’s supposed independence, our recent history of low inflation, and the fact that the dollar is the world’s principal reserve currency. But the United States has experienced high rates of inflation in the past and appears to be running the same type of fiscal policies that engendered hyperinflations in 20 countries over the past century.
It can happen in America, too.
In upcoming issues, we’ll explore defending against it by owning assets that appreciate in an inflationary environment, including commodities such as precious metals, businesses that sell non-discretionary goods, and real assets like land and art. The trick will be finding ones most likely to perform well during the potentially long wait to d-day.
