Colossus (50 page)

Nobody can be surprised that in the American political system such unpleasant fiscal arithmetic gets marginalized. No sane presidential candidate would campaign with the slogan “Hike taxes by two-thirds.” Nor is any rational incumbent likely to cut Social Security and Medicare benefits by more than half. It is therefore safe to assume that in the short run almost nothing will be done to address the problem of generational imbalance. Unfortunately, this means the problem will get still worse. According to Gokhale and Smetters, if policy were left unchanged until 2008, income taxes would have to go up even higher—by 74 percent—to close the intergenerational gap. In other words, the arithmetic of generational accounting implies a distributive reckoning at some point in the future. The government sooner or later has to reduce its spending commitments or increase its tax revenues. Regrettably, the Bush administration’s approach to the latent federal fiscal crisis seems so far to have been a variation on Lenin’s old slogan: “The worse the better.” Faced with mounting deficits, the president and his men elected to push three major tax cuts through Congress. Administration officials have sometimes defended these measures as a stimulus to economic activity, a version of the “voodoo economics” once upon a time derided by the president’s father. There are good reasons to be skeptical about this, however, not least because the principal beneficiaries of these tax cuts are wealthy individuals.

One possible fiscal solution to the problem of generational imbalance has in fact already been implemented in Britain; that is simply to scrap the mechanism that allows welfare entitlements to rise ahead of general inflation. In 1979 the newly elected government of Margaret Thatcher discreetly reformed the long-established basic state pension, which was increased each year in line with the higher of two indices, the retail price index or the average earnings index. The first Thatcher budget amended the rule so that the pension would rise in line only with the retail price index, breaking
the link with average earnings.
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The short-run fiscal saving involved was substantial, since the growth of earnings was much higher than inflation after 1980. The long-run saving was greater still. The United Kingdom’s unfunded public pension liability today is a great deal smaller than those of most continental governments, as little as 5 percent of GDP for the period to 2050, compared with 70 percent for Italy, 105 percent for France and 110 percent for Germany.
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This and other Thatcher reforms are the reason the United Kingdom is one of the elite of developed economies that do not have major holes in their generational accounts.
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In the present American situation, the vital thing must be to bring Medicare spending under control, for it is in fact responsible for the lion’s share—82 percent—of the $45 trillion budget black hole. Just cutting the growth rate of payments per beneficiary by half a percentage point per year would shave $15 trillion off the $45 trillion long-term budget gap. There must be a way of capping the program’s growth without jeopardizing its ability to deliver medical services to the less well-off elderly. Unfortunately, by subsidizing the cost of prescriptions, the Medicare reform put forward by President Bush and enacted by Congress in 2003 will have the very opposite effect.
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A second policy option (now under serious consideration) would be to privatize Social Security.
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Will either of these policies be implemented? The answer is that it seems unlikely in view of the growing political organization and self-consciousness of the American elderly. Social Security is sometimes referred to as the third rail by American politicians, because politicians who touch it by suggesting any cut in benefits tend to receive a violent political shock from the American Association of Retired Persons (AARP). Mindful of the British experience in the 1980s, the AARP has already commissioned a study showing what the effect would be if an American government replaced the link between the state pension and wages with a link to inflation. It concludes that price indexation would cause the average replacement rate (benefit as a percentage of preretirement income) to drop by half over a period of seventy-five years, “fundamentally changing the relationship between workers’ contributions and the benefits they receive.”
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Quite why today’s elderly should worry about the level of pensions three-quarters of a century hence is not altogether clear. Nevertheless, such arguments resonate not only among the retired but also among the soon-to-retire. The
baby boomers are now so old that they have a bigger stake in preserving their future benefits than in lowering their current payroll taxes. Indeed, many have already joined the AARP, which sends Americans application forms on their fiftieth birthdays. So long as attitudes toward old age remain unchanged and so long as the retired and soon-to-be-retired remain so well organized, radical reform of the U.S. welfare state—and hence a balancing of federal finances—seems a distant prospect.

GOING CRITICAL

Conventional wisdom predicts that if investors and traders in government bonds anticipate a growing imbalance in a government’s fiscal policy, they will sell that government’s bonds. There are good reasons for this. A widening gap between current revenues and expenditures is usually filled in two ways. The first is by selling more bonds to the public. The second is by printing money.
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Other things being equal, either response leads to a decline in bond prices and a rise in interest rates, the incentive people need to purchase bonds. That incentive has to be larger when the real return of principal plus interest on the bond is threatened by default or inflation. The higher the anticipated rate of inflation is, the higher interest rates will rise because nobody wants to lend money and be paid back in banknotes whose real value has been watered down by rising prices. The process whereby current fiscal policy influences expectations about future inflation is a dynamic one with powerful feedback effects. If financial markets decide a country is broke and is going to inflate, they act in ways that make that outcome more likely. By pushing up interest rates, they raise the cost of financing the government’s debt and hence worsen its fiscal position. Higher interest rates may also depress business activity. Firms stop borrowing and start laying off workers. The attendant recession lowers tax receipts and drives the government into a deeper fiscal hole. In desperation, the government starts printing money and lending it, via the banking system, to the private sector. The additional money leads to inflation, and the higher inflation rates assumed by the market turn into a self-fulfilling prophecy. Thus the private sector and the government find them
selves in a game of chicken. If the government can convince the private sector it can pay its bills without printing money, interest rates stay down. If it cannot, interest rates go up, and the government may be forced to print money sooner rather than later.

Figures like those produced by Gokhale and Smetters might therefore have been expected to precipitate a sharp drop in bond prices. But at the time their study appeared, financial markets barely reacted. Yields on ten-year treasuries have in fact been heading downward for twenty years. At their peak in 1981 they rose above 15 percent. As recently as 1994 they were above 8 percent. By mid-June 2003—two weeks after the $45 trillion fiscal imbalance figure had appeared on the front page of the
Financial Times
—they stood at 3.1 percent, the lowest they had been since 1958.
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Six months later they were just 1 percent higher.

One possible explanation for this apparent
non sequitur
is that bond traders found themselves in a similar predicament to that experienced by their colleagues trading equities just five years ago. At the time it was privately acknowledged by nearly everyone on Wall Street and publicly acknowledged by most economists that American stocks, especially those in the technology sector, were wildly overvalued. In 1996 Alan Greenspan famously declared that the stock market was suffering from “irrational exuberance.” Over the next three years a succession of economists sought to explain why the future profits of American companies could not possibly be high enough to justify their giddy stock market valuations. Still the markets rose. It was not until January 2000 that the bubble burst.
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Perhaps something similar subsequently happened in the bond market. Just as investors and traders knew that most Internet companies could never earn enough to justify their 1999 valuations, investors and traders in 2003 knew that future government revenues could not remotely cover both the interest on the federal debt and the transfers due on the government’s implicit liabilities. But just as participants in the stock market were the mental prisoners of a five-year bull market, so participants in the bond market last year were the mental prisoners of a twenty-year bond bull market that had seen the price of long-term treasuries rise by a factor of two and a half. Everyone knew there was going to be a “correction.” Yet nobody wanted to be the first player out of the market—for fear of having to sit and watch the bull run
continue for another year. Between January 2000 and October 2002 the Dow Jones Industrials index declined by almost exactly 38 percent as irrational exuberance gave way to rational gloom. In the middle of 2003 it was not difficult to imagine a similar correction to the bond market.
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When trying to make financial matters more vivid, writers often invoke imagery from the natural world. Bubbles burst. Bears chase bulls. So vast is America’s looming fiscal crisis that it is tempting to talk about the fiscal equivalent of the perfect storm—or the perfect earthquake, if you prefer; perhaps the perfect forest fire. In this case, however, nature offers more than mere literary color. For the dynamics of fiscal overstretch really do have much in common with the dynamics of natural disasters. We can know only that, like a really big earthquake, a big fiscal crisis will happen. What we cannot know is when it will strike, or the size of the shock. Adopting the language used by scientists who study the unpredictable pattern of natural disasters, we are condemned to wait and see when our fiscal system will enter “self-sustaining criticality”—in other words, when it will go critical, passing with dramatic speed and violence from one equilibrium to another.
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The simplest example of this phenomenon is what happens when you try to add to a pile of dry sand. If you drop more sand on top of the pile, one grain at a time, it keeps growing higher for a while. Then suddenly—and there is no way of knowing which grain will make it happen—the pile collapses. That collapse is when the pile of sand goes critical. Something not wholly dissimilar happens when one of the earth’s tectonic plates pushes once too often against another along a fault line, causing an earthquake. Now translate this into the world of mammals, which, unlike particles of sand, have consciousness. Imagine a herd of cattle quietly grazing while a man and his badly disciplined dog take a walk through a field. At first, one or two cows on the periphery spot him; then a couple more. They start to feel a little nervous. But it is only when the dog barks that the whole herd stampedes. A stampede is the self-sustaining criticality of mammals panicking.

What might panic the mammals who buy and sell long-term U.S. bonds for a living? Here the sand pile is composed of the
expectations
of
millions of individuals. Like grains of sand, little bits of bad news are dropped on us, day after day, week after week. Like the sand pile, we can hold steady for some time before the cumulative weight of these grains of bad news causes us to alter our fundamental expectations. But one day something happens—maybe just one extra grain of bad news—that triggers the shift from equilibrium into self-sustaining criticality. Everything therefore depends on what traders and investors expect the government to do about the $45 trillion black hole and what might happen to change the expectations they currently hold. Here, then, is one possible scenario. Bondholders will start to sell off as soon as a critical mass of them recognize that the government’s implicit and explicit liabilities are too much for it to handle with conventional fiscal policy and conclude that the only way the government will be able to pay its bills is by printing money, leading to higher inflation. What commonly triggers such shifts in expectations is an item of bad financial news.
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One reason this scenario has superficial plausibility is that it echoes past events. Although few bond traders have history degrees, they recollect that the high bond yields of the early 1980s were in large measure a consequence of the inflationary fiscal and monetary policies of the previous decade. Nor do the 1970s furnish the only historical precedent for inflationary outcomes of fiscal crises. Governments in fiscal difficulties have often resorted to printing money because doing so helps in three ways. First, they get to exchange intrinsically worthless pieces of paper for real goods and services. Secondly, inflation waters down the real value of official debt. Thirdly, if the salaries of government workers are paid with a lag or are only partially adjusted for inflation, inflation will lower their real incomes. The same holds true for other government transfer payments.

Yet there are reasons to be skeptical about the idea of a new inflation. For one thing, there are strong deflationary pressures at work in the United States today. Overcapacity generated during the 1990s boom, investor hesitancy in the wake of the bust, consumer anxiety about job losses—all these things meant that virtually the only sector of the U.S. economy still buoyant in mid-2003 was housing, for the simple reason that mortgage rates were at their lowest in two generations. In April 2003 one of the lead stories on Bloomberg described deflation as the “great bugaboo menacing the markets and the economy in the early 2000s.”
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A month later the chairman
of the Federal Reserve, Alan Greenspan, acknowledged that there was a “possibility” of deflation in his testimony before the Joint Economic Committee of Congress.
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A second argument against the higher inflation scenario is more pragmatic: only a modest proportion of the federal government’s $45 trillion fiscal imbalance would in fact be reduced through a jump in inflation in the ways described above. First, much of the government’s tradable debt is of short maturity; indeed, fully a third of it has a maturity of one year or less.
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That makes it much harder to inflate away because any increase in inflationary expectations forces the government to pay higher interest rates when it seeks to renew these short-dated bonds. Secondly, Social Security benefits are protected against inflation through an annual inflation adjustment. Medicare benefits are also effectively inflation-proof because the government unquestioningly pays whatever bills it receives. Thirdly, government workers are not likely to sit idly and watch prices outpace their wages. For all these reasons, a rerun of the 1970s would not in fact solve the federal government’s fiscal problems.