So we avoided the fiscal cliff. Forgive me if I am less than impressed with our political leaders.The temporary Bush tax cuts passed in 2001 and 2003 are now permanent for incomes less than $400,000 per year. The increase in taxes on incomes over this threshold is expected to net $617 billion over ten year. To be exact, that is $617 billion more in revenue than would have been collected had tax rates on higher incomes remained unchanged. On the spending side, automatic across-the-board cuts that would have gone into effect on January first will be delayed for two months.
Recently in public finance Category
Time to repost the most recent Deseret News article from yesterday.
As many observers expected the U.S. Federal Reserve began a new round of quantitative easing this fall in an attempt to stimulate the economy by increasing the supply of available money. As I discussed at the beginning of August, there is no fundamental difference between quantitative easing and the Fed's normal open market operations. In the latter case the Fed buys U.S. Treasury securities on the bond market and in the former case it buys other non-traditional financial assets. In both cases, however, it pays for these purchases by creating money.
The U.S Social Security system is in big trouble. While the trust fund balance today is just
over two and half trillion dollars, this amounts to about four years of
benefits payments. And while the balance
on the trust fund has been rising every year since the fund was created in
1987, it will not be long before demographics cause that trend to reverse. We need to reform Social Security and the
longer we wait, the bigger the burden of reform we become.
2008 was a bad year for anyone investing in the stock market. The Dow Jones Industrial Average lost almost 34 percent, and the S&P 500 lost 37 percent. Among those hit with big negative returns was the Utah Retirement Systems (URS), the agency that manages the state pension system. They reported a slightly less devastating loss of just under 25 percent on the pension portfolio.
Social Security is in trouble. While the system is currently generating tax
revenue that is approximately equal to the benefits payouts, this will not be
the case in the near future. Many state
and local pension funds are in a similar situation.
Taxes are in the news these days. Both Rick Santorum and Mitt Romney recently released tax plans as part of their campaigns for president. And the Obama administration released a new budget proposal for the coming fiscal year that alters some key tax rates.
Taxes are important for a variety of reasons. Few people enjoy paying them, but they are necessary if the government is going to, in the long run, pay for the goods and services it consumes along with the goods, services and transfer payments it provides to the public.
Several years ago I heard a joke about two macroeconomists who went hunting with a non-economist colleague. As they tracked a deer up a slope and over the crest of a hill, they noticed it edge into a clearing, making a perfect silhouette on the horizon. Within heartbeats of each other the two economists fired. One missed by ten feet to the right and the other missed by ten feet to the left. The deer ran off immediately, unharmed and the two men yelled in joy and began to hive five and slap each other on the back. Their colleague asked how they could be so excited when they had both missed by a substantial margin. They replied. "Yes, we missed. But on average we hit him right between the eyes!"
The Greek financial system is in big trouble right now. The fundamental problem is that the Greek government has been on a bit of spending bender over the past few years and has borrowed a lot of money to pay for this, all of it denominated in euros. It has become frighteningly clear that this level of debt is unsustainable and the Greek government needs truly radical fiscal reform to avoid defaulting on its outstanding debt. Much of that debt is held in the form of Greek government bonds by Greek banks, but a large amount is also held by various financial institutions outside of Greece.
By itself this is not really a very interesting or important situation. There are a large number of countries in the world and inevitably, some of them get into fiscal trouble. Some sort of financial crisis of this sort happens on a fairly regular basis. Greece is, however, a member of a monetary union. And its financial health could have an effect on the financial health of other members of that union.
The euro is a unique currency because it is issued by a collection of sovereign states, rather than by a single country as is usually the case. The currency was formally introduced into circulation in 2002 and replaced the national currencies of the participating countries. Control of the euro money was given to the European Central Bank (ECB), which was created with the sole purpose of managing the euro. When the euro was created it was very clear that all member countries would be using a single currency and would therefore be unified monetarily. It was not clear, however, how unified these countries would be in fiscal terms, however. There is no governmental equivalent to the ECB. There is a European parliament, but there is no central government with authority to tax and spend for the European Union as a whole. Fiscal matters are, in theory, left entirely to the individual member countries. This means there is no natural central source of funds to "bail out" the Greek government. The two bailout packages worked out so far have been hammered out via complex negotiations between Greece, the ECB, and other European governments.
Suppose Greece decides it is going to default on its government bonds. Does this necessarily mean that the euro as a currency is in trouble? Not necessarily. In fact, if there is no expectation that Europe is a fiscally united, then there should be no issue at all. Greek bonds, though denominated in the same currency as German bond, already pay higher interest rates due to their higher probability of default. If the Greek government decides to default, things could get really bad for Greece, but it need not affect other European countries. The fact that German and other European banks hold Greek government bonds could lead to increased stress on the banking sectors in those countries, but it need not lead to dissolution of the euro as a currency.
However, a problem does arise with one the way that Greece might choose to default on its debt. Rather than default outright, the Greek government could choose to drop out of the euro zone and reintroduce their previous national currency, the drachma. They could do this by initially trading all euro amounts in Greece one-for-one with drachma, for example, and legally rewriting all contracts in euro to contracts in drachma. Then the Greek central bank could drastically increase the number of drachma in circulation and repay its nominal debt with this new money. The result would be a devaluation of the drachma. Greek assets would be worth less on the world market, just like a default, but a formal default would be avoided. In effect, Greece would be solving its fiscal problems by imposing an inflation tax and at least some of the burden of that tax would fall on non-Greek holders of Greek government bonds.
Now suppose you had a time machine and knew for certain that this was going to happen on Dec. 31st 2011. What should you do today? You should sell any Greek assets you hold today to avoid the inevitable loss in their value when the drachma is devalued. If you are a savvy investor you might take profits by short-selling Greek debt. Even if you don't have the time machine and are uncertain what is going to happen, you might still find it prudent to sell. When all or most investors do this, the result is a worsening of the financial crisis.
If investors feel that Greek devaluation is becoming more and more likely, it is only natural that they begin to look at other European countries with similar fiscal problems. These countries include Ireland, Spain, Portugal, and perhaps even Italy & France. If enough countries choose to withdraw and devalue their currencies - particularly if either of the latter two do - then the euro as a multinational currency will effectively be dead.
Greek fiscal problems don't automatically mean the euro is doomed, but it is very easy to see why policy makers in Europe and elsewhere are worried that events are moving in exactly that direction.
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.
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.
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.
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.