I wrote this as part of a inter-department debate on fiscal policy. Thought it might be interesting to a wider audience


My Colleague Maureen Berner points the following video on the debt

The video, which is well done, is convenient in that it collects every misunderstanding about fiscal policy in one place. I’ll try to address a few of the issues


Paul Krugman is found of saying that there is no such program as SocialSecurityMedicareandMedicaid. His point, and he is largely correct, that the challenges facing Social Security are orders of magnitude less significant than the challenges facing Medicare and Medicaid. The IOUSA film, however, lumps them all together under the heading of entitlements.

The essential “problem” with Social Security is that the population is living longer. Thus people are collecting Social Security for a larger and larger fraction of their lives. Add to this a slowing birth rate and you quickly get to a situation where the current population of workers cannot support the current population of retirees at the current benefit levels on the current tax rate.

To solve this problem you have to change one of those four “currents.”  We have to either:

1) Grow the workforce

2) Shrink the retiree population

3) Reduce Benefits

4) Raise Taxes

Luckily, however, it wouldn’t take much in any of those four categories to solve the problem. For example, a payroll tax hike of 1.45 percentage points for both employers and employees should do it.

Alternatively, we could simply reduce the rate at which Social Security benefits increase. Currently, benefit levels are increased each year based on the average increase in wages. This means when the average American gets a raise, Social Security beneficiaries get a raise.

However, we could simply index Social Security to inflation instead of wages. In this way beneficiaries get enough increases to keep them at their current standard of living but the standard does not improve.

I suspect the second option is less likely than the first. I think the first is pretty much a done deal. Its just a matter of waiting until the problem is pressing enough that a tax increase can be passed.

Medicare and Medicaid are a different beast.  Expenditures on those two programs are expected to double every 8 – 9 years. So that by 2037 we’ll be spending eight times as much as we are today. Indeed, this pattern is expected to continue indefinitely. Its Medicare and Medicaid that are driving the $53 Trillion in unfunded liabilities the video speaks of.

This sounds like a major problem but I argue that its not. There are basically two reasons

First, these represent promises some of which have been made to people who haven’t been born yet, to make payments sometime in the distant future, for services many of which do not even exist yet.

That’s right. The driver behind that cost growth estimate is the assumption that over time medical science will develop newer, better, and more costly treatments and that then we will want to buy those treatments and give them to people many of whom, in the case of Medicaid, have not even been born yet.

This is not one of the more ironclad commitments that have been made throughout history.

My essential position is that if we decide in the future that we want to devote the bulk of our national resources to providing incredibly advanced medical treatment to anyone who might want or need it, then fine. That is a choice we are entitled to make. But, if we don’t want to do it, then we just don’t do it. From a 30,000 foot perspective its really that simple.

Moreover, worrying a lot about the problem now doesn’t help anyone. The core problem is that science is thinking up really expensive ways to treat people. Thus if we want to treat people in the future with the most advanced medicine possible its going to be really expensive. There is no way around this. Either we pay a bunch of money or we don’t. No amount of planning or saving or serious self-reflection is going to change that basic reality.

Economics is not a morality play where if you’re really good and responsible everything works out. There is no solution here where everything works out.

Second, doing nothing will likely “solve” this problem for us as well as any other solution. As medical costs continue to grow health insurance will become less and less affordable. Either, people are going to have to accept falling take home pay, opt for less coverage, or expand government subsidies for health care.

I am not sure which will be chosen but I tend to think the political process will opt for more government subsidies.  Eventually, this will put most of the medical care under the control of the federal government, at which point it will choke off high-priced innovation. I think this is behind some of the fear of an increasing government role in health care.

The government’s role, however, is not really material to the outcome. If there are no government subsidies then more and more people will drop out of the insurance market. Fewer people will have coverage and the demand for health care services will drop.  Expensive technology depends on economies of scale. That is, a large base of consumers who share the burden of R&D costs. As that base shrinks R&D will become unaffordable and the high-priced innovation will grind to a halt.

The result is the same because we are working with the same fundamental forces. The growth in technology spending is outstripping the ability of people to afford it.

Growing Federal Debt

For some reason the debt really captures people’s attention. There are basically three ways that you can pay for government spending: taxes, printing money and debt.

All three transfer resources from the private sector to the public sector. With taxes its obvious how that happens. You give up some of your paycheck to the government.

When the government prints money, it induces inflation. Inflation lowers the value of the money in your pocket. In this way everyone holding money gives up some of their purchasing power to the government. The printing of money and the ensuing inflation are simply a tax on holding cash.

Lastly, the government can issue bonds or debt. When investors buy the debt they transfer resources to the government. Had they not loaned their money to the government the investors would have loaned it to someone else in the economy. In this way debt acts in somewhat  like a tax on borrowing money.

However, at the macro-scale resources have to be transferred out of the economy at the time they are used. There is no way to teleport resources from the future to now. Therefore, the argument that we are borrowing against our future is largely an accounting fiction. Resources that are used to today must be produced today and must detract from consumption or investment that occurs today.

You might be worried that its investment that is taking the beating. However, that doesn’t seem to be the case. The relationship between investment spending and government borrowing is weak. This is because the relationship between government borrowing and gross domestic savings is weak. The share a cyclical component but their secular trends are unrelated.

That is, when the economy is bad gross savings falls and government savings falls. Government savings is the inverse of government borrowing. However, over the longer term gross savings is rising while government savings is falling.

FRED Graph

The Trade Deficit

This is a perennial source of worry and on an international scale there are concerns about long run stability. However, this has largely to do with complex concerns about currency stability.

The important upshot is that little of this effects the US directly. We have dollar denominated debt. That is, we have borrowed money from the rest of the world in dollars and promised to repay that money in dollars. If the value of the dollar crashes then that’s just too bad for them. That get paid back in a currency that is worth less than what they lent in.

This is different from many Third-World countries which borrow in dollars or euros but use their own currency. If their currency crashes they still have to pay back dollars or euros which are now really expensive for them.

There is also the issue that the US will be owned by the rest of the world. The problem with this perspective is that the US is paid more interest in most years than it pays out in interest payments. We have borrowed from the world but we have also lent to the world. In total we have borrowed way more than we have lent. However, the interest payments on what we borrowed are much lower than on what we lent.

This is sometimes called the dark-matter hypothesis of international trade but its basic concepts are not mysterious. The US acts as the venture capitalist for the world. It borrows cheaply because we are big and safe and then loans out to start-up nations who pay back large sums in return for us taking a chance on them.

The Leadership Deficit

IOUSA argues that our most serious deficit is a deficit of leadership. The commentators, including some senators,  say a lot crazy things  such as, our looming fiscal crisis is the second biggest worst thing that could happen to America besides terrorists setting off a nuclear bomb.

This is worrisome only in that it shows the severe lack of imagination possessed by members of Congress. There are many many worse things that could happen than either a nuclear bomb or a fiscal crisis. Indeed, it is probable that before the century is out, one of them will happen. (See Nick Bostrom’s Global Catastrophic Risk)

Of all the things to worry about fiscal crisis is fairly low on the totem poll. Most importantly there are ways to fix the situation quickly. The most direct is simply a large tax increase. That wouldn’t be pleasant but it would be disastrous. After all, the government is still subtracting all of the resources it spends from the economy. Its just doing it through the bond market rather than direct taxes.

Raising taxes would make the pain explicit but it wouldn’t make the total burden any greater. My guess is that as future issues mount taxes will simply rise to close the gap.