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Friday, May 25, 2007

The biggest challenge

The unfunded mandates facing this country are mind-numbing to contemplate. It is obviously very difficult for the folks in Washington to deal with the issues as well and they would rather debate other things.

The April Economic Letter from the Dallas Fed has some interesting comments concerning the unfunded mandates and their likely solution:
The infinite-horizon discounted present value of unfunded liabilities from Social Security and Medicare—the gap between what we take in and what we’ve promised to pay—is now $88.2 trillion. That’s six times the nation’s GDP.

The potent combination of lower birthrates, higher medical costs and longer life expectancies provides little reason for thinking the situation will improve...

Just how big is this unfunded liability on a per-person basis? Dividing the $88.2 trillion evenly among the 300 million people who live in the United States produces a per-person liability of about $290,000—more than five times the average household’s annual income. That’s what each U.S. resident would have to pay today to guarantee the solvency of Social Security and Medicare for future generations.

This is obviously not going to happen. Suppose we don’t act now to reduce the shortfall but instead use general government revenue to pay all promised benefits. Just how much of a burden would this pose for future taxpayers? Social Security and Medicare currently consume about 4 percent of general revenue (Chart 8). By 2030, we would need to devote 34.2 percent of general revenue to entitlements. By 2080, the figure rises to 64.8 percent. Every other government function—from defense to environmental protection and education—would have to shrink dramatically to fit into the remainder.

What about the possible solutions? The letter goes on:
A drastic, across-the-board reordering of government priorities doesn’t seem likely. To the extent people think about the unfunded liabilities at all, they assume we will eventually address the issue by spending less or raising new revenue. After all, that’s how any one of us would resolve a shortfall in our personal finances. But either approach is likely to reduce the economy’s growth rate.

The government has an additional resource unavailable to ordinary citizens: the Bureau of Engraving and Printing. And as policymakers debate the huge spending cuts or tax increases that will be needed to restore the solvency of the entitlement system, can we be sure they won’t come to view inflation as the least painful alternative?
The threat to monetize the unfunded liabilities may not seem real today, but in twenty years I would not be so sure.

The Letter goes on to suggest that the politicians are not likely to step up to the plate:

Any long-term solution to the entitlement quandary will require dramatic action, and the necessary response will be ever more drastic the longer it’s postponed.

If past is prologue, policymakers will forgo the opportunity to fundamentally reshape the U.S. entitlement system and will instead adjust the parameters of the current system, as the Greenspan Commission did in 1983.[6] Likely proposals are a higher retirement age, a lower cost-of-living adjustment and a more progressive payroll tax that could include elimination of the earnings cap.

While any of these measures would begin to address the unfunded liability issue, they have very different implications for future economic growth. For example, a higher retirement age would be expected to boost labor-force participation and thereby raise GDP growth. This has occurred in Europe over the past few years. However, some studies suggest that more progressive payroll taxes would reduce labor-force participation and thereby lower GDP growth.

Pres. Bush, for good or for ill, attempted to initiate a discussion about Social Security reform even while planning to implement the drug benefit which ultimately will cost more. Nevertheless, his attempt went over like a lead balloon and no one wanted to help even get a discussion started. The result is another four years lost on the ticking alarm clock which is the unfunded mandate.

It will be interesting to see how the current crop of presidential wannabes will deal with this problem - especially whether any single candidate is willing to provide a specific plan for any entitlement reform.

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