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Fiscal Overstretch that will Undermine an Empire
Financial Times ^ | July 14, 2003 | Niall Ferguson

Posted on 07/15/2003 4:48:41 PM PDT by Choose Ye This Day

The fiscal overstretch that will undermine an empire By Niall Ferguson and Laurence Kotlikoff Published: July 14 2003 20:05 | Last Updated: July 14 2003 20:05

Toppling three tyrannies within four years is no mean achievement. Since 1999, despotic rulers in Serbia, Afghanistan and Iraq have been ousted as a result of US military intervention. What makes this so remarkable is that it comes little more than a decade after a wave of anxiety about American "overstretch". Many former Cassandras now hail the country as the world's hyperpower - if not a new empire.

The irony is that the overstretch thesis is about to be vindicated just when conventional wisdom considers it discredited. But this overstretch has almost nothing to with the US's overseas military commitments. It is the result of its chronically unbalanced domestic finances.

In just five years' time, 77m "baby boomers" will start collecting Social Security benefits. In eight years they will start collecting Medicare benefits. By the time they are all retired in 2030, the US will have doubled the size of its elderly population but increased by only 18 per cent the number of workers able to pay for their benefits.

Economists regard the commitment to pay pension and medical benefits to the elderly now and in the future as part of the government's "implicit" liabilities. But these liabilities are no less real - indeed, are far larger - than the explicit obligation to pay back the principal plus the interest on government bonds. In fact their size is such as to render the US government in effect bankrupt.

The scale of this implicit insolvency was exposed this summer by Jagadeesh Gokhale, a senior economist at the Federal Reserve Bank of Cleveland, and Kent Smetters, former deputy assistant secretary of economic policy at the US Treasury. They compared the present value of all the revenue the government can expect to collect in future with the present value of all its future expenditure commitments, including debt service. The shortfall was a staggering $44,000bn. In comparison, the federal debt - $6,500bn - is small change.

The official reaction to this report was simply to bury it - a natural response given the awesome scale of the problem. But investors cannot afford simply to go into denial.

One possible inference might be that future federal deficits are likely to be larger than forecast and that this spells the end of the recent bond market "bubble". After all, a widening gap between revenues and expenditures is usually filled either by selling more bonds or by printing money. Either response implies a decline in bond prices and hence a rise in long-term interest rates.

Is that what is happening right now? In recent weeks, long-term bond yields have risen sharply while the yield curve - which had become more or less flat by the late 1990s - is now sloping more steeply upwards. The spread between yields on 10-year bonds and index-linked bonds with the same maturity has also widened slightly, suggesting a rise in inflationary expectations.

Yet the markets' reaction seems modest, given the size of the fiscal crisis facing the US. One possible reason why yields remain at levels not seen since the 1950s is that there are strong deflationary pressures at home and abroad. Overcapacity generated during the 1990s boom, investor pessimism in the wake of the bust, consumer anxiety about job losses - all mean there is a lot of slack in the US economy. Alan Greenspan, Federal Reserve chairman, has said deflation is a worry.

The truth is that we are in uncharted waters. Previous fiscal crises were not like this because most of a government's liabilities took the form of official bonds, not statutory pledges to pay benefits. Investors are used to a world in which governments in fiscal trouble can allow inflation to erode the real value of their debts. But even a significant jump in inflation would do little to solve America's fiscal crisis.

First, much of the government's tradable debt is of short maturity - indeed fully a third of it is due to mature within a year. That makes it harder to inflate away, because any increase in inflationary expectations will force the government to pay much higher interest rates when it seeks to renew these short-dated bonds. Second, Social Security benefits are protected against inflation via an annual inflation adjustment. Medicare benefits are also in effect inflation-proof because the government unquestioningly pays whatever bills it receives.

So what is going to happen? According to Profs Gokhale and Smetters, the only ways to eliminate the fiscal imbalance are to increase taxes or slash spending. But neither of these things will happen soon. On the one hand, the Bush administration is ideologically committed to tax cuts. On the other hand, Medicare and Social Security constitute the "third rail" of American politics: any candidate for office who touches them is guaranteed to receive a violent, possibly fatal, shock.

So the president faces a tough dilemma. Political expediency rules out fiscal reform; but if the bond markets foresee a spiral of deficit finance, sooner or later they will mark down the price of US treasuries with a vengeance. And rising yields will only increase the cost of rolling over the government's explicit debt.

No one can say for sure how the crisis of the US welfare system will be resolved. What is certain is that the harder it gets to pay for the most politically sensitive items of the federal budget, the more tempting it will be to cut the rest. What could be more "discretionary" than the cost of governing far away countries such as Kosovo, Afghanistan and Iraq?

For this reason, the latest Department of Defense green paper - which projects a levelling off of the total US defence budget at 3.5 per cent of gross domestic product - may prove optimistic. Over the past 20 years, the Medicare budget has risen five times faster than the defence budget and that trend seems likely to continue.

In short, the colossus that bestrides the world has feet of clay. The latent fiscal crisis of the US welfare state implies at best an empire run on a shoestring; at worst a retreat from nation-building as swift as the original advance towards it. Niall Ferguson is Herzog professor of financial history at the Stern School of Business, New York University. Laurence Kotlikoff is professor of economics at Boston University. A longer version of this article will appear in the autumn issue of The National Interest

TOPICS: Business/Economy; Culture/Society; Editorial; Government; News/Current Events
KEYWORDS: boomers; budget; fiscalcrisis; overspending; socialsecurity; taxes; welfare
The biggest single threat looming over our country's horizon, and the press is worried about 16 words in a speech.

And, yes, I feel this IS a larger threat to us than Islamic terrorism. Terror IS a serios issue, and one we must confront and defeat. However, terrorism is ultimately unpredictable. We've made good progress, but there's much more that we still need to do (i.e., secure borders and ports). But terrorist attacks may or may not happen, regardless of our best efforts. We won't know until they do.

Our fiscal meltdown is a foregone conclusion, if we don't change our ways. We can't keep spending as if there is no consequence. We can't give all things to all people. Some Boomers and all Gen-X'ers are going to be hit with the high, hard reality that there IS no Social Security. Period. "Too bad, we were wrong. You paid all those years for nothing."

I don't know what it will take to wake up our spoiled, complacent populace.

1 posted on 07/15/2003 4:48:41 PM PDT by Choose Ye This Day
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2 posted on 07/15/2003 4:50:14 PM PDT by Support Free Republic (Your support keeps Free Republic going strong!)
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BTW, if my math skills don't deceive me...and they may... "The shortfall was a staggering $44,000bn"

44 thousand billion in the U.K. = $44 QUADRILLION dollars.

That's a heckuvalotta money.
3 posted on 07/15/2003 4:55:15 PM PDT by Choose Ye This Day (
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and hardware.


4 posted on 07/15/2003 5:14:49 PM PDT by LasVegasMac
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"The biggest single threat looming over our country's horizon, and the press is worried about 16 words in a speech."

Well stated. I just wonder how the welfare rolls will look if 20 million more new applicants suddenly appear in the next two years....
5 posted on 07/15/2003 5:16:23 PM PDT by Beck_isright (Remember the Blue Ridge Corporation!!!! Damn the torpedoes and SEC, full speed ahead!)
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To: arete
Ping for your comments...
6 posted on 07/15/2003 5:17:06 PM PDT by Beck_isright (Remember the Blue Ridge Corporation!!!! Damn the torpedoes and SEC, full speed ahead!)
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I think that means 44 trillion...which would be plenty bad enough...we need more tax & spending cuts
7 posted on 07/15/2003 5:23:31 PM PDT by citizen (Praise the Lord and pass the ammunition!)
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To: citizen
Well, that's what I thought at first, $44 Trillion. But then I started looking around on the net, and found a couple sites that explained that the British use different terminology than we use here, and that in the UK a thousand billion is what we call a Quadrillion. Again, I don't know, and I'm only trusting what I've seen on the web (never a smart proposition).]

But you're absolutely right. It's WAY too much money.
8 posted on 07/15/2003 6:15:43 PM PDT by Choose Ye This Day (
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To: citizen
You're right. It IS $44 trillion, not quadrillion. My bad.

An eye-opening website, if you haven't watched the national debt calculator lately, is at:

Any ideas on how to get ALL our elected officials (President Bush included) to start paying attention and DO something about this?
9 posted on 07/15/2003 6:22:52 PM PDT by Choose Ye This Day (
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The biggest single threat looming over our country's horizon,

We need a space based resource extracting, nanotech economy in a big way.

10 posted on 07/15/2003 6:27:05 PM PDT by Centurion2000 (We are crushing our enemies, seeing him driven before us and hearing the lamentations of the liberal)
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Yes, the US will have a problem. But it will be much more tame compared to the impending disaster in the EU member states. At least US population growth is high enough to maintain the status quo for a while. It seems odd that the Financial Times wouldn't mention this fact - the collapse will come much sooner in its own backyard.
11 posted on 07/15/2003 6:27:17 PM PDT by July 4th
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Comment #12 Removed by Moderator

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