Rational gloom

by on March 3, 2004 at 8:10 am in Economics | Permalink

Tyler is not as pessimistic as I am (see my earlier posts here and here) regarding our long-term budget problems. Unfortunately, he should be. Consider Tyler’s most gut-level response:

The United States remains a strong and prosperous country. Our infrastructure, national culture of innovation, human capital, and economic dynamism are unparalleled in world history.

Of course. Who would deny this? The problem is that the budget projections of Kotlikoff et al. already take these factors into account. Their projections assume that the economy will continue to grow, they assume that a nuclear weapon will not go off in Washington, they assume that we will not become bogged down at increasing expense in the Middle East for the next 50 years etc.

A doctor tells a man that he has just 6 months to live. The man replies but doctor I’m only 25, I’m in great shape and I’ve never been seriously sick before. Yes, the doctor says that’s why I gave you 6 months.

Tyler’s next comment reveals a misunderstanding. He says, “The Bush fiscal policies, whatever their irresponsibilities, costs, and drawbacks, haven’t changed those core facts.” But the Bush policies are not the major problem. The major problem is that we are about to be hit by a tidal wave of old people (contra Tyler demographics are the problem not the solution). The baby boom generation, born beginning in 1946, will begin to retire in 2008 and as they do so the demands on social security and Medicare are going to explode. By 2030 there will be 18.2 million people in the United States 85 years of age and older! In 2000, the 65 years and older crowd made up 12.4 percent of the population. By 2030 they will be 19.4 percent of the population.

Critically, combine baby boomers with rising life-expectancy and declining fertility and we have that by 2030 there will be only 2 workers per retiree (down from 16.5 workers per retiree in 1950).

Comparing today’s US budget deficit with that of Brazil or any other country misses the point. It’s the present value calculation over the future that is important. Put simply: Kotlikoff is applying Milton Friedman’s permanent income hypothesis to government accounting. (Kotlikoff is to Stone as Friedman is to Keynes).

Tyler’s most technical point, that g may be greater than r, also misses the mark. If g is greater than r then we can continually roll over our debt and eventually grow our way out of it. But this calculation is only relevant for a fixed debt – the problem is that our debt is rising very rapidly. If the debt were to stand still we could pay it but it ain’t standing still.

Tyler challenges me to put my money where my mouth is. In fact, I have. First, I got a job as a tenured professor! Second, I borrowed a lot of money at the lowest interest rate I expect to see in my lifetime and bought housing. The key problem in the future is going to be inflation and rising tax rates so you want to borrow at a fixed rate and put your wealth in hard to tax assets (Tyler, art may be an even better investment! You can always take it with you over the border.) I also own an internationally diversified portfolio (yes, even some in Brazil).

No, I’m not yet stocking up on cans of spam. We could get lucky. Kotlikoff could be wrong. The obvious facts of demography make me think that he is right enough, however, to warrant taking serious actions now rather than later. But like Kotlikoff, I don’t think our political system is ready.

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