August 2011 Archives

Why Prices are Important

Runway Inflation in Hong Kong: Miners could teach infrastructure planners a thing or two
from the Wall Street Journal, July 14th, 2011

Should the Hong Kong airport be expanded to include a new 3rd runway at a cost of $17.5 billion?  Why not let the market decide?

"...we must figure out how much ... is "enough" over the long term as we also tailor our demand to resource availability at any given moment. This is easy, relatively speaking, for miners and nearly impossible for airport planners because miners have something the planners don't: a market price for their product and for their capital.

"In the airport context, putting a price on capacity would mean fully liberalizing the air traffic market and then auctioning off take-off and landing slots. Hong Kong could adopt a unilateral open-skies policy to welcome any and all comers, and also remove the remaining restrictions on so-called fifth-freedom traffic rights that would allow a carrier from Country A to fly between Hong Kong and Country C. Meanwhile, auction take-off and landing slots to the highest bidders, each slot being valid for some reasonable number of years.

"Then, let the airport operator figure it out. Privatize the Airport Authority (currently a government body), and see if the bond market thinks its expected income from slot sales will be sufficient to cover the capital expense of new capacity. Just like a mining firm."

The price mechanism could be implemented in lots of places that currently it is not.  This is just one good example.

What is a Currency?

What is Bitcoin? from CNBC, July 20, 2011

Currencies are normally issued by governments and are backed either by a commodity or by a legal mandate.  But Bitcoin is backed by neither.  In fact, it does away with a financial intermediary almost entirely.  Unlike Paypal or other online monies, Bitcoin is peer-to-peer exchange of "tokens."  The Bitcoin transfer protocol is the only intermediation that occurs.

"The process also lets people conduct transactions with virtual (but not complete) anonymity, perhaps the biggest key to its success so far. And as online transactions continue to grow and online data theft becomes a more common occurrence, bitcoin backers see an opening for the system."

"The bitcoin system is designed so there will never be more than 21 million bitcoins in existence.  Every four years, the number of new coins that will spring into existence--or be mined--will be cut in half, until the supply is exhausted in approximately 2030. After that, the only way to get bitcoins will be via exchanges. (At present, there are about 6.6 million in circulation.)."

"The value of bitcoins in real world dollars fluctuates wildly--often as much as 8 percent per day. As little as two months ago, the exchange rate was $1 USD per bitcoin. That was before the mainstream world learned about them, though--which sent their value through the roof.  Speculators quickly saw potential in this new currency and began buying them through Mt. Gox and other sites. Given the currency's instability, that led to rapid inflation and the currency value peaked at nearly $28 on June 9.  These days, you can expect to pay somewhere between $15 and $20 per bitcoin."
This article appeared in the Deseret News on Aug. 23, 2011

Switzerland is having currency problems. This may come as a surprise to many people, since unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the US has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.

The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50% more euro today that it was two years ago, and is worth almost 60% more dollars than it was in December of 2008.

For Swiss tourists and importers this is a huge gain; their relative wealth has surged with the exchange rate and foreign goods look much less expensive than the used to. For Swiss firms this is a disaster; for their customers the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.

As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.

This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically, gold) or they can let the value of their currency float on the market.

Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the US dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.

Some countries rigidly peg the value of their currency to another. Hong Kong, for example, pegs the value of the Hong Kong Dollar to the U.S. dollar at a rate of 7.8 HKD per USD. When a country pegs it ends up in the exact opposite position as above. The central bank can choose any value it wants for the exchange rate, but it loses control over its own money supply. It is forced to create an exact amount of new money each year that will keep the exchange rate fixed. If demand for the currency suddenly surges, the bank must create enough money to meet this demand. Central banks that peg the value of their currencies are forced to constantly buy and sell in the foreign exchange market to keep the price constant. When demand for their currency rises, they sell it and buy foreign currencies. When demand falls they buy their own currency and sell foreign reserves.

Most international financial crises over the past several decades have arisen because of central banks attempting to manipulate their money supplies while maintaining a fixed exchange rate. The collapse of the European Exchange Rate Mechanism in 1992, the Mexican peso crisis of 1994 and the Argentina currency board collapse in 2002 are three memorable examples. All were ultimately caused by countries attempting to hold exchange rates fixed, while at the same time engaging in independent monetary policies.

Could we see a similar currency crisis in the near future? Not with the U.S. dollar which freely floats. We could certainly see the value of the dollar drop if supplies expand or demand for the dollar drops, but we are unlikely to see the catastrophic overnight drops associated with a full-blown currency crisis. Europe, on the other hand, does have a fixed exchange rate system in that many different countries all use the same currency. Given the fiscal problems in Greece, Ireland, Portugal, Spain, and other countries in the Euro area, a currency crisis associate with a country dropping out of the euro pact is a real possibility.
This article was published on August 8, 2011 in the Deseret News under the title, "Debt deal didn't solve fiscal woes."

After months of wrangling and weeks of brinksmanship, the U.S. congress passed a bill raising the debt ceiling and President Obama signed it into law. The compromise calls for an immediate increase in the legal limit on federal borrowing by 2.4 trillion dollars and imposes reductions in federal spending by the same amount over the next 10 years.

It will be interesting to see how congress interprets the word "reduction." For most of us a reduction is an absolute drop. Congress, however, reduces spending by comparing the new forecast level of spending with the amount that was forecast before the agreement was reached, the so-called "baseline". There is no legal reason for using this baseline as opposed to some other measure. Some proponents of spending reform prefer a "zero baseline", where any change in policy is compared to a case where all future spending is assumed to remain at this year's levels. This latter baseline is a more accurate measure of how spending will actually change over time, but the former is a better reflection of the impact of a particular act of legislation.

If this was the only difference, baselines would not matter all that much. But when congress actually begins to implement the mandated spending cuts, the definition used will become very important. For example, if spending were forecast to rise by 10% per year over the next ten years, and we slowed that growth to only 5%, then (ignoring inflation) by the first definition we would have achieved a savings of just over 21%, but we would still have increased spending almost 26% from a zero baseline.

Credit agencies and financial markets are unimpressed by the debt-limit agreement. It is a good start; probably preferable to having the U.S. Treasury default on its debt payments. It may even be the best possible agreement one could hope for with a divided government. But it is only a start.
One of the more pithy, but accurate, descriptions of the deal came from Senator Rand Paul, who said, "The current deal to raise the debt ceiling doesn't stop us from going over the fiscal cliff. At best, it slows us from going over it at 80 m.p.h. to going over it at 60 m.p.h."
To the extent that the debt ceiling debate had focused the attention of the political class on the issue of spending it has done some good. But in a broader sense, the debt ceiling is a red herring. As I learned years ago from my college professor, Jim Kearl, the government has three fundamental ways of raising revenue: it can tax, borrow, or create money. And the effects of each of these, while not exactly identical, is roughly the same. In all cases the government extracts real resources from people in the economy which it then uses to buy goods and services and/or spend as transfer payments.

When it taxes the government uses the threat of force to extract resources. Failure to pay required taxes can result in imprisonment. When it borrows the government cajoles people into voluntarily surrendering resources by offering a sufficiently high repayment in the future. Of course, far enough in the future the government will be forced to raise taxes to pay for these interest payments, so the repayment is not as high as it may seem. Finally, when the government (via the Federal Reserve, in the case of the U.S.) creates money it taxes unilaterally without an explicit threat by reducing the real value of existing money holdings.
It is possible, by clever redefinition of terms to avoid a debt limit in the short run by turning debt into taxes. For example, suppose the government were to impose a surtax on households this year based upon estimated income from 2012. Tax revenue would rise, and the government debt would fall (or rise more slowly). But over time, everyone will end up paying the same amount as if the surtax had never been imposed.

The pressing problem with federal government finances is not the amount of money that is borrowed, but rather the size of the real resources the government extracts; in other words, the size of government. Right now there is no national consensus on how big the government should be. Until a consensus is reached and ultimately communicated to our political leaders, problems will continue to loom regardless what has happened or will happen to the debt limit.
A slightly edited version of this article was published July 25th, 2011,  in the Deseret News, under the title, "Term 'national debt' misleads country's finances."

On May 16th the US Treasury Department announced that the debt limit had been reached. Through accounting manipulations the federal government says it can manage to remain under that limit until early August. But what exactly is the national debt that is subject to this limit?

The statutory debt limit is a legal upper bound on the amount of debt the US government can issue through the Department of the Treasury. The actual amount of debt issued is often referred to as the "public debt" or the "national debt." The former term is more accurate, since this debt does not include amounts owed by private individuals or firms. Nonetheless, both terms are misleading.

So how much debt does the US government owe? The Treasury Bulletin reports that the outstanding US debt as of the end of September 2010 was $13,562 billion.

The national debt is held by a variety of individuals and institutions, and some of them really shouldn't count a part of the debt. For example, $5,656 billion was owed by one branch of the federal government to another. The US Federal Reserve System is included in this category because, while it is legally independent of the US government, it must refund its earnings on the US securities it holds to the Treasury. Subtracting this sum leaves a remaining balance that was privately held of $8,369 billion; still a substantial number, but more than a third smaller than the original.

This remainder was held as follows:
• $189 billion held by individuals in the form of savings bonds.
• $337 billion held by banks.
• $608 billion held by mutual funds.
• $1,030 billion held by pension funds and insurance companies
• $509 billion held by US state & local governments.
• $1,282 billion held by miscellaneous other investors.
• $4,257 billion held by foreign entities (firms, banks, governments, individuals, etc.)

It is not appropriate to think of the full amount as the debt of the nation. For one thing much of it is money owed by US citizens to US citizens. Just as I would not count $100 that I owe to my wife as part of our overall family debt, we should not count money owed by the government to its citizens as part of the overall national debt. It is in this sense that the term "national debt" is misleading.

Still that leaves over four billion dollars that the US government owes to foreigners. And if we include the net amount that private individuals and firms owe to foreigners the total is likely even greater. The national debt is only weakly related to the net amount of money we as residents of the US collectively owe to foreigners.

Another reason why the debt figures are misleading, however, is that they only show one side of the balance sheet. In addition to the debt it has issued the government also holds assets. These include some obvious things like the gold in Fort Knox, and money seized from criminals. But they also include physical goods (like the strategic petroleum reserve or stocks of grain bought to support farm prices), property (like the thousands of U.S. government buildings), machinery (like its fleet of automobiles, or its military hardware), and real estate (BLM lands, National Forests, and National Parks, for example).

We might argue that some or most of these assets should not be sold (perhaps never) even if they could be. But when we think of our personal net worth we often include such just goods as assets in our calculations. If a family owns a million dollar home, but owes debts of $250,000 we would not think of them as being broke and in the hole by a quarter of a million dollars; even if they really loved the house and had no intention of ever selling it and moving out. Still, we would also not think it wise of them to continue running up debt. In the long run, if they want to keep their nice house they can't continue to spend more than they earn.

Similarly, the government should not continue to run up its debt or it too may be forced to sell off some of the valuable assets it holds. (The government has done this before; for example, when it sold land to citizens prior to the Homestead Act. However, the primary purpose of these sales was not to raise revenue.)

The national debt is misleading as a measure of our nation's total net worth or even as a measure of the government's net worth. But that doesn't mean it's not important to monitor it and hold our government responsible for how it is managed.
This article was published July 8th, 2011, at KSL.com and published in the Deseret News on July 12th.

Republicans in the House and Senate are preparing constitutional amendments that would require the government to run a balanced budget every year. Politically, the lines are already drawn, with Republicans generally in favor and Democrats generally opposed. But does balancing the federal budget each year make economic sense? Like many issues in economics, the answer is, "it depends." Specifically, it depends on the time horizon over which we balance.

One way to gain some insight into how the government should act is to imagine the parallel with your own household budget. The parallel is not perfect, because the government is big enough to affect the whole economy while your household (even if you are Bill Gates) is not. Nonetheless, the analogy is useful.

So, should you run a balanced budget as a household? The obvious answer is, of course you should. In fact, you really aren't given much of a choice in the matter, at least in the long run. If you spend more than you earn over a long period of time you will go into debt. And if you fail to pay that debt, your creditors will start seizing your assets. You might get out of paying back the full amount by declaring bankruptcy, but that's not a good choice when making a personal financial plan.

A more subtle question is, over what time horizon should you balance your budget? Should it be a year? Clearly you don't balance it over short periods of time, like a day. Most of us get paid relatively infrequently. If we adopted a strict balanced budget rule, we would spend our paycheck in full each payday. On days when we didn't get paid we would not be able to spend anything. Clearly a day-to-day balanced budget is silly for most of us. In practice, we set aside most of our paycheck on payday and gradually spend this balance down until the next one arrives.

Financial planners tell us to set some of our income aside each payday and save. One reason for saving is to be prepared for an unexpected expense. In many cases we can't really avoid running a household deficit. If the transmission goes out on the car, it is usually necessary to repair it or replace the car, even if this exceeds the planned budget for the month. We can dip into savings do to this or borrow money, but either way we are running a budget deficit.

Running this kind of deficit is not such a bad idea if we have the self-discipline to run surpluses later. That is, we either repay our loan or rebuild our savings account to its original level by spending less than our income.

When most of us manage our household expenses, we pay attention to the budget. We are aware of whether we have spent more or less than we intended and whether this is more or less than our income. However, we do not insist on a hard constraint that spending always be less than income. Instead, we keep an eye on our savings and borrowing. When savings falls or borrowing rises, we readjust our budget plans, realizing we need to spend less or do something to earn more.

Almost everyone in the U.S. realizes the government budget is seriously out of whack. We need major adjustments to spending if we are going to avoid bankruptcy. A balanced budget amendment is one way to force fiscal balance. Just as a financial planner might recommend a strict budget for a household that is heavily in debt, a balanced budget may be one part of a responsible plan to reform government spending and taxes. In this case, a strictly-enforced budget is a temporary tool that should be used to bring overall debt down. In fact, a good financial planner would recommend a budget surplus so that spending is significantly less than income and the large outstanding debt is reduced as quickly as is reasonably feasible. However, once the debt is reduced there is much to be gained from allowing borrowing in the face of unexpected events.

A balanced budget amendment is permanent and will bind all future congresses. Therefore, the short run gains in fiscal balance need to be weighed against the long-run losses in ability to respond to economic shocks. A better policy would be to impose spending restrictions until the level of debt reaches a much lower level. The best policy would be to elect a congress that is willing to spend within its means in the long run.

UPDATE July 25, 2011

Alex Tabarrok at Marginal Revolution has a proposal that brings together the good points of the balanced budget amendment, without the drawbacks I discuss above.  He calls it an "Unbalanced Budget Amendment," and it requires the government to run a surplus in good times, so that it has some savings to draw upon in bad times.
This article appeared in the Deseret News on June 28th, 2011.

In May, former Minnesota governor, Tim Pawlenty, declared his candidacy for the presidency of the United States. He also released a plan that is intended to lead to a revival of the US economy, which is in the middle of an anemic recovery. One of the key assumptions of this plan is that the economy can be coaxed and prodded into growing at an annual rate of five percent for a decade or more. As economist Donald Marron has pointed out, the US economy has grown at an average rate of 5% for ten years exactly once since the end of World War II. That was the period from mid-1958 to mid-1968. As he puts it, "Getting up to 5% over the next decade thus seems not merely ambitious, but almost unthinkable."

However, Stanford macroeconomist, John B. Taylor, argues that 5% is quite doable. One percent growth per year can come from growth of the population. Taylor argues another one percent can come from having a greater percentage of the population employed as workers. The remaining growth needs to come from increases in the productivity of capital and workers - what economists call total factor productivity or TFP for short. Since 1996 TFP has grown at an average rate of 2.7%, so the remaining three percent needed is not that hard to imagine.

When discussing growth it is important to distinguish between two different effects. The first is a levels effect. This occurs when something happens to permanently raise or lower the long-run productive capacity of the economy. For example, a one-time increase in the population due to a baby boom, or a relaxation of immigration constraints would give us a larger workforce and increase the amount of goods and services we could produce. Levels effects will cause the economy to grow in the short run as it adjusts slowly to incorporate these new resources. In the long run, however, the economy reaches a new higher level and then stays there without any further growth.

A second effect is a growth effect. This is a change that does not necessarily change the productive capacity of the economy immediately, but rather causes it to grow more rapidly over time. An increase in the rate at which new knowledge is discovered and turned into useful products would cause the economy to grow more rapidly over time, and these increases would continue for a long time without gradually petering out as level effects must necessarily do.

Pawlenty's plan calls for reductions in tax rates, balancing the federal budget, easing government regulation, and encouraging sound monetary policy. All of these are laudable goals, but they are also examples of levels effects. Eliminating burdensome regulation, for example, would allow firms to produce more efficiently and lead to increased production. It would also cause firms to hire more workers and invest in greater amounts of capital and machinery. However, once the firms have fully adjusted, there will be no additional economic growth.

If economic policies focus solely on these types of levels effects, then it might be possible to generate a decade's worth of growth in the neighborhood of five percent, but growth would not be sustainable at that level for much longer than that. To have long-lasting high growth rates, policy makers will need to focus on growth effects.

MIT economist Robert Solow won the Nobel Prize in 1987 for his pioneering work in economic growth. One his most important contributions was to show that much observable growth comes from increases in hard-to-measure intangibles that economists lump together and term "technology." Technological progress is now regarded as the primary engine of long-run, sustained growth. To raise the long-run growth of the economy, policy will need to focus on encouraging the expansion of technology.

Some countries, particularly developing ones, try to increase technology by government industrial policy. While this may be somewhat effective for economies that are catching up with the world technology leaders, it does not work well with economies that are already technologically advanced.

For countries like the US a much better approach is to put incentives into place that encourage the production of new ideas and technologies. Tax deductions or tax credits for research and development are one way to do this. Better enforcement of patents and other intellectual property would encourage firms and entrepreneurs to engage in more research and development as well.

Five percent growth for a decade is not an impossible goal for the US economy, but if it is to come about it will require careful consideration and implementation of policies that encourage investment in new ideas and technologies. A focus on policies like balancing the budget and reducing government inefficiency will make us better off, but by themselves are unlikely to yield the five percent growth that Mr. Pawlenty has in mind.
This article appeared in the Deseret News on June 14th, 2011

Last month the managing director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, was arrested in New York. The extensive coverage of that case has led to increased scrutiny of the IMF as an institution. The IMF is an important institution in international banking and finance, but few people realize what the IMF does and why it matters.

The IMF was created near the end of World War II. In July 1944, delegates from the Allied nations met at the Mount Washington Hotel near Bretton Woods, N.H.. The conference was called to set up an international financial system that would stabilize the world economy once the war was over. The need for stability had been clear as early as World War I, when most major nations abandoned the gold standard. The successive turmoils of the Great Depression and World War II made reestablishment of a gold-based system impossible. The Bretton Woods agreement put the world back on an international gold standard.

Three major international institutions were created as a result of the Bretton Woods Agreement. The World Bank was established to aid in the reconstruction of countries in Europe and Asia that were severely damaged by the war. The General Agreement on Tariffs and Trade (GATT), now known as the World Trade Organization (WTO), was set up to negotiate reductions in high tariff barriers that had been erected during the 1930s. Finally, the IMF was established to help maintain the stability of the fixed exchange rate system.

Most fixed exchange rate systems are subject to speculative instability that is very similar to a bank run. When a run occurs on a bank it is because of widespread beliefs on the part of depositors that the bank lacks sufficient cash on hand to pay out the small number of depositors who would normally withdraw their money in the short-run. As George Bailey explained so well in "It's a Wonderful Life," the deposits in a bank are backed mostly by loans and only a small amount of cash is kept on hand. When depositors fear the cash is going to run out, they all run to the bank and withdraw. This quickly depletes the cash on hand and the bank can become insolvent. Historically, to reduce the likelihood of bank runs, we have instituted deposit insurance and created lenders of last resort, i.e. central banks. They provide cash that the bank does not have on hand during a run and allow depositors to be paid off if they wish. Knowing that the lender of last resort exists and will act if needed is often sufficient to stop a bank run from happening in the first place.

Similarly, when countries fix the value of their currencies they can be subject to speculative attacks. Central banks that fix their exchange rates must constantly buy or sell foreign currency reserves to smooth out fluctuations in the supply and demand for their own currency. Suppose holders of Thai baht believe the Thai central bank will soon run out of U.S. dollars. They also realize the value of the baht will fall. To avoid this loss they attempt to convert their baht to dollars now -- just like a run on bank deposits. The IMF was created to be an international lender of last resort; a sort of central bank for central bankers. When a speculative attack occurred the IMF was supposed to step in and provide needed foreign reserves from its fund (hence the name).

The fixed exchange regime set up at Bretton Woods was abandoned in the early 1970s. And the main purpose for the IMF's existence disappeared at the same time. With floating exchange rates, central banks need never run out of foreign currencies, because they don't really need to buy or sell them.

So what does the IMF do under our current international system? Despite abandoning fixed exchange rates in general, many countries still fix the value of their domestic currencies to others. Sometimes this pegging is formal -- as in the case of Hong Kong -- and sometimes it is informal. The IMF played an important role in supplying needed foreign reserves to Asian countries in 1997, for example. Sometimes countries experience financial turmoil unrelated to exchange rates, and the IMF is increasingly involved in restructuring sovereign debt. The most recent example of this is the crisis in Greece, and looming crises in Spain, Ireland, Portugal and elsewhere.

While these services are useful, they could be provided by other international institutions or governments, even by private parties in some cases. The IMF's main purpose for existing vanished 35 years ago, but the IMF is likely to remain an important international institution for the foreseeable future.

Social Security isn't bankrupt ... yet

This article appeared in the Deseret News on May 31st, 2011.

In mid-May the trustees of the U.S. Social Security system issued their annual report. The conclusion of the report is stated clearly and succinctly: "Projected long-run program costs for both Medicare and Social Security are not sustainable under currently scheduled financing and will require legislative corrections if disruptive consequences for beneficiaries and taxpayers are to be avoided."

One bit of information from the report that got some attention was that the total payouts in benefits have finally surpassed the collection of revenue from payroll taxes. This was not unexpected; we have known for a long time that the retirement of the baby boomers would eventually cause this to happen. What was surprising is that it happened this year and that it is projected to remain this way for the foreseeable future. Last year's report projected this flipping point would occur in 2015.

The Social Security system is a pay-as-you-go system. Revenue collected from workers is used primarily to pay for the benefits of retirees. Only a small fraction of revenue (about 8.5 percent this year) goes into the trust fund. This is in contrast to most other retirement plans, where most or all of the revenue collected goes into holdings of financial assets earmarked specifically for future benefits.

Social Security is still generating net surpluses today because it earns interest on the $2.7 trillion held in the trust fund. The system is expected to start generating net deficits starting in 2022. From that point on, the balance in the trust fund will begin to fall until it drops to zero in the year 2035.

Once this milestone is reached, the system faces a conundrum. Since the Social Security trustees do not have the legal authority on their own to raise taxes or lower promised benefits and cannot issue debt obligations, they will have no choice but to pay only some portion of promised benefits. That will initially be about 80 percent.

The scenario laid out above is true as far as it goes, but it also misrepresents how our fiscal system actually works.

The Social Security trust fund holds all its assets in the form of U.S. Treasury securities. Since these are normally very safe assets, this might actually be prudent, but it also means that the trust fund is effectively a fiction. The trust fund is a set of government assets that is backed by the same government's debt. This means the public debt is not as big as reported, and it also means there is no nest egg tucked away in a secure vault somewhere. In truth, the trust fund is backed by the government's ability to tax its citizens in the future. Workers today who are interested in receiving their promised benefits when they retire should therefore be very concerned about the size of the public debt and the U.S. budget deficit.

The trustees' report assumes that in 2035 they will need to reduce benefits so that total benefits outflows equal the total inflow of tax revenues. Politically, this seems highly unlikely. Rather, Congress would likely borrow more money to pay the full promised amounts to retirees. This accumulation of debt could conceivably go on for a very long time, but eventually the government would be unable to issue any more debt. No one knows for certain what the limit is, but we do know there is one. In fact, the limit may appear unexpectedly -- just ask the Greek government.

To avoid long-run bankruptcy, we need to realign the mismatch between promised benefits and expected tax revenues. The Social Security Administration is well aware of this problem. There are many viable options that would move us in the right direction. For example, there is talk of changing the way Social Security benefits are calculated so that future benefits are not so large a proportion of lifetime earnings. But change cannot occur unless Congress enacts it.

Since Social Security is pay-as-you-go, and workers pay the benefits of retirees, one way to make the system more sound is to increase the ratio of workers to retirees. In the past a high ratio was maintained by a high birthrate. But birthrates have fallen dramatically in the U.S. in the past few decades, and life expectancy has risen at the same time. We are transitioning from a retirement age of 65 to 67 in an attempt to adjust this ratio, but it is unlikely to be sufficient. Increases in legal immigration are one way to correct the imbalance. For fiscal purposes it doesn't matter if the birthrate rises and we have more young workers, or if they immigrate from other countries. More workers supporting the existing retirees reduces the tendency to draw down the trust fund balance.

Still, the fundamental problem with the system is that the benefits levels are too high relative to the taxes. Lawrence Kotlikoff of Boston University recently calculated the gap between the net present value of promised benefits from all government programs (which are dominated by Social Security and Medicare in the long run) and the net present value of all taxes likely to be collected. He calls this figure the "fiscal gap" and comes up with a number of $202 trillion! This means that in order to meet the promised obligations from our current fiscal system, we need to find the equivalent of more than a decade's production of all the goods and services in the entire U.S. economy.

Clearly, unless we can reduce promised benefits relative to taxes imposed, the system will go bankrupt. It is not too late to fix the Social Security system, but the longer we wait, the more difficult the fix will be.