Kevin L. Kliesen - Economist, Federal Reserve Bank of St. Louis
Published June 1, 2005 | June 2005 issue
By Laurence J. Kotlikoff and Scott Burns
As the debate over entitlement reform heats up, so does the partisan rhetoric. Everybody and their uncle, it seems, has a cure for Social Security and Medicare's long-term funding problem. To separate the wheat from the chaff, the layperson needs an unimpeachable resource that clearly explains the issues and the scope of the problem. The Coming Generational Storm, by Boston University professor Laurence Kotlikoff and Dallas Morning News columnist Scott Burns, is such a resource.
In careful detail, and attention-grabbing prose, Kotlikoff and Burns strive to give the reader a "fiscal and demographic reality check"—and the prognosis is grim. In their view, America's reality in the not-so-distant future will be one of confiscatory tax rates, much higher rates of inflation and Draconian reductions in government-funded future health and retirement income benefits. Absent major changes, they argue, America faces "the moral crisis of our age," which threatens the country with a "headlong plunge toward third world status." Laypersons might find the book's final two chapters especially useful, as they lay out a recommended set of financial investments to cope with the coming morass.
Kotlikoff and Burns spend the first two chapters discussing the demographic and fiscal dimensions of the coming generational storm that will buffet the United States, most of Europe, Japan and China. This storm, simply put, is the economic, political and social fallout stemming from a steady increase in the median age of the population, a trend that will greatly increase the ratio of retirees (age 65 and over) to workers (ages 20 to 64), known as the dependency ratio. Like a slow-building hurricane, the generational storm is being driven by two forces that have been increasing in intensity over time: First, the number years spent in retirement continues to rise (increased life expectancy); second, the number of children per family has been on the decline (falling fertility rates). As a result, between 1995 and 2080, the dependency ratio that underpins the Social Security Trustees' intermediate cost projections is expected to double, from 21.6 percent to 43.2 percent.
Kotlikoff and Burns suggest that these projections be viewed with suspicion, because they are based on questionable assumptions. First, they argue, the Trustees have underestimated both the rise in life expectancy rates and the decline in birth rates over time. The authors cite an article from Science which estimates that the life expectancy of women in the United States could be between 92 years and 102 years in 2070, far above the 85 years assumed in the Trustees' intermediate-cost estimates. Improvements in diet, healthcare and medicine, some scientists believe, will greatly lengthen life expectancy.
Second, fertility rates are unlikely to begin rising anytime soon because of numerous social factors that have greatly increased the labor force participation rates of women: increasing educational attainment, easy access to birth control, a greater acceptance of divorce and encouragement from spouses to boost household incomes. These and other factors, it is argued, have helped to greatly increase the median marrying age for women. As a result, more couples are having kids later, and they stop after one or two children.
Taken together, these trends imply that the ratio of elderly to
working-age population is likely to be far higher than the Trustees think. In Kotlikoff and Burns' view, the dependency ratio is likely to climb to roughly 60 percent by 2080, the level used by the Trustees only in their most extreme estimate.
But if the demographic tidal wave looks bad in the United States, Kotlikoff and Burns suggest that it is much worse in China, Europe, Japan and Russia, which face even lower birth rates, below population replacement in some countries. Between 2025 and 2050 population in Russia is projected to fall by 17 percent; in Europe and Japan, by 12 percent. (There is actually a fair range across Europe, as France's projected decline is just 1.5 percent, while Italy's is about 18 percent.) By contrast, the U.S. population is projected to rise by almost 15 percent over the same period. Since China, Europe, Japan and Russia also face lower birth rates than the United States, by 2050 the median age will be 53 years in Japan, about 50 years in Europe, but only 41 years in the United States.
After a fine job of running through the demographic sources of the storm, Kotlikoff and Burns then turn to the magnitude of the problem faced by fiscal (and, importantly, monetary) policymakers, and they explain why some of the proposed solutions are too simplistic to be worthy of further discussion.
At its core, the middle of the book is an exercise in fiscal policy analysis using the generational accounting framework that Kotlikoff (among others) is noted for. Simply put, the GA approach is an effort to determine the size of the government's future fiscal obligations that today's generations are leaving to future generations. The Social Security Trustees use similar methodology, but they usually stop at a point 75 years in the future. Using calculations from a GA analysis that economists Kent Smetters and Jagadeesh Gokhale calculated for then-U.S. Treasury secretary Paul O'Neill in 2002, but which was subsequently scuttled for being "too politically dangerous," Kotlikoff and Burns show that the fiscal gap faced by the country is big—really big. The "big whammy," which is the net difference (in present value terms) between what the government expects to spend (outlays) and what it expects to take in (tax revenues), is $45 trillion (over an indefinite future). Medicare contributes about 80 percent of the total. Add in another $6 trillion or so for the prescription drug program, and the "menu of pain" required to close this $51 trillion gap—that is, the choices faced by today's policymakers—looks daunting. Kotlikoff and Burns present their menu with the percentage changes required in a given expenditure to close the gap if the change were enacted in 2003 or 2008. And they look at those changes as Option 1, when only one policy choice is available, or Option 2, when a combination of policy changes is made. The following table summarizes their data.
Clearly, choosing only one policy change (Option 1) leads to extreme (and highly unlikely) solutions—for instance, federal expenditures can't be cut by more than 100 percent. And regrettably, GA practitioners often seem to emphasize the doom-and-gloom single-policy changes, whereas the mixed approach that will likely underlie any serious reform effort is rarely discussed with the same fervor. Fortunately, Kotlikoff and Burns provide readers with a more realistic set of assumptions, which is a combined approach of higher taxes, reduced spending and cuts in benefits (Option 2). But whether the choice is Option 1 or Option 2, the main point Kotlikoff and Burns make is that the choices only get worse the longer policymakers wait.
Although most economists have some familiarity with the GA concept, it is unlikely that the average layperson or even the average policymaker in Congress or the administration does. And while Kotlikoff and Burns do an adequate job of explaining their complex models, it seems a bit of a stretch to assume that most readers will spend a lot of time on this section of the book—even though they might benefit from it.
At present, government policymakers, lobbyists and policy analysts seem fixated on reforming Social Security, even though, as the authors show, this is only about 20 percent of the overall fiscal problem. What, then, are some of the potential fixes, and what are the false leads?
First, some economists believe that the Social Security Trustees are much too pessimistic about future productivity growth rates. In their intermediate-cost assumptions, the Trustees project that labor productivity growth will average 1.6 percent per year from 2010 to 2080. However, since 1995, labor productivity has increased at a 3 percent annual rate. This prompts the question: Can we grow our way out of the mess? Alas, no, argue Kotlikoff and Burns, since entitlement benefits are indexed to wages and, thus, labor productivity. According to Kotlikoff and Burns, permanently raising the growth rate of labor productivity to 2.2 percent will indeed raise the wage base, allowing for higher tax revenues. But because benefits will also rise, the baseline fiscal gap (excluding the gap associated with the prescription drug benefit) will increase by almost 25 percent to $56 trillion. The revenue-expenditure gap will barely change.
Other options for closing the gap are just as fruitless, they argue. Here's a list of potential fixes and Kotlikoff and Burns' dismissal of them.
In their view, the most likely policy the government will initiate to deal with the coming crisis is probably the worst solution possible for a society whose population—or a large percentage of it—increasingly relies on a fixed income stream: Raise taxes and cut benefits only a bit, but then "print tons of money" to collect revenue from seigniorage.
For those who have forgotten the term, seigniorage is the difference between the face value of currency and coins and the cost of printing and distributing them; for example, if it costs a government 5 cents to produce a dollar bill, the seigniorage is 95 cents. Governments count seigniorage as revenue to finance spending without resorting to taxes or borrowing. To central bankers, the specter of raising money by seigniorage to pay for entitlement benefits is a scary prospect, but fiscal authorities starved for revenue may covet it. And indeed, Kotlikoff and Burns offer up one seigniorage scenario that could spark the coming storm. In this scenario, tucked away in the middle of the book, the Fed plays a central role.
In less than a year, Chairman Alan Greenspan's tenure as a Federal Reserve governor will end. What sort of economic and political response will Greenspan's exit elicit? According to the authors, Greenspan's departure will cause an inordinate amount of instability once financial market participants figure out that "the major American dilemma of the 21st Century"—looming increases in payroll taxes, cuts in benefits and/or increases in federal government debt the likes of which have never been seen—is just around the corner. But why will the light suddenly come on after the chairman leaves? Because "Greenspan has told the bond market what to think for so long that it's largely forgotten to think on its own."
More seriously, once the markets come to grips with their cognitive dissonance, uncertainty will cause the dollar to tank, leading to rising import prices and higher inflation. The Congressional Budget Office and the International Monetary Fund, surveying the looming fiscal train wreck initiated by the retirement of the baby boomers, will issue the kinds of warnings of fiscal irresponsibility that markets used to associate with corrupt (and bankrupt) Third World countries. The dollar falls some more, inflation continues to rise, the stock and bond markets tank, the economy grinds to a halt. Then the Fed shifts into recession-fighting mode, lowering interest rates—which only makes the problem worse. Eventually, inflation and long-term interest rates reach double digits, federal deficits mount because of additional tax cuts to stimulate spending and the deficit reaches 7 percent of gross domestic product (roughly twice what it now is.)
Over time, as the debt-to-GDP level climbs to 200 percent or more (according to some long-run scenarios issued by the CBO), Kotlikoff and Burns argue that the Fed will have no choice but to accommodate a significant amount of this new debt to cover checks written for Social Security, Medicare and prescription drug benefits. Even worse, similar scenarios unfold in Japan and Continental Europe, which face even deeper fiscal holes than does the United States. By this point, monetary accommodation, stagflation and seigniorage will have economists and policymakers reaching for their 1970s-era economic dictionaries.
Many economists, maybe even a majority of economists, probably would consider higher inflation to be a real possibility. Evidently, that does not include the economists who work for the Social Security Trustees. According to the assumptions that underlie the Trustees' latest 75-year intermediate-cost projection, inflation as measured by the consumer price index is expected to average only about 2.75 percent from 2015 to 2080. Even though today's central bankers have sworn a virtual death-oath to avoid a repeat of 1970s stagflation, accelerating inflation rates from today's relatively low-inflation environment remains one plausible scenario. After all, the Federal Reserve is a creature of Congress, and its independence is always somewhat qualified. Such a possibility should get Congress and the Federal Reserve to start thinking seriously about adopting an inflation-targeting regime to provide a stronger, institutionalized constraint on inflation.
Assuming the chips fall as Kotlikoff and Burns assume, much of the world thus faces the prospect of higher tax and inflation rates and, hence, considerably lower standards of living. Is there a way for the United States to avoid this? Not entirely, according to the authors; to a substantial degree the trends are inevitable. Still, they contend, policymakers can and should take several steps immediately to minimize the damage—battening the hatches, as it were, against the coming storm.
Their solution rests on three pillars. First, they would implement their own version of private accounts to replace the existing Social Security architecture. (They would, however, maintain the existing survivor and disability portions of the system.) These accounts, called personal security system accounts, would be mandatory for all citizens, employed or not, and they would be funded by the existing old-age insurance tax that employers and employees currently pay into the existing system (about 10.5 percentage points of the total 12.4 percent tax). Thus, for those 20 years into a 40-year career, half of their retirement benefit would come from the old system and half would come from the new PSS. To finance the accrued benefits for workers who have already paid into the OAI program, they would implement a national retail sales tax that would phase out at the rate that the accrued OAI benefits are paid off (about 45 years). However, the rate would not go to zero since PSS accounts for the disabled and unemployed need to be funded. Individual PSS accounts could only be invested in an index fund of stocks, bonds and real estate.
For an aging society, a shift toward a consumption-based tax holds great appeal as a means of boosting saving rates; retirees have a greater propensity to consume than workers do, so a consumption tax would curb that propensity. But the travel industry or any other industry that caters to the elderly isn't likely to be amused by this proposal. Moreover, people who do not currently pay the payroll tax on earnings above $90,000 (in 2005) would face a relatively large net tax increase initially.
So while the PSS plan makes a lot of economic sense, it will inevitably face a political firestorm. It may also cause a sharp slowdown in economic growth, at least temporarily, as consumers find an extra 12 percent tacked on to the prices of the goods and services they purchase.
The second pillar of the Kotlikoff-Burns plan focuses on the much larger fiscal gap that arises from the Medicare program. For this they propose a medical security system (MSS), a voucher-based plan to replace the existing fee-for-service system that they argue is the root of the current Medicare funding problem. Over time, the per-person voucher limits would grow at the rate of real wages. Want a Cadillac healthcare system? Then create a Cadillac economy. (However, it's hard to imagine an economy of high inflation, high interest rates and high tax rates being described as a Cadillac economy.)
These two fixes, though, would eliminate only about half of the $51 trillion fiscal gap. The authors would close the other half with three additional steps. First, extend the MSS to Medicaid, which would save about $10 trillion. Second, reverse the Bush tax cuts, which would result in another $9 trillion; simply reversing the Bush tax cuts would not solve the entitlement funding problem, despite some claims to the contrary. Third, hold federal discretionary spending to 6 percent of GDP, which would close up the remainder. The authors don't mention it, but readers should be aware that the latter two proposals would exert another sizable drag on the economy, at least in the short term.
In the last two chapters of the book, the authors lay out some pretty solid investment advice, most of which is predicated on their predictions of increasing inflation and tax rates and declining dollar value. Their two key suggestions: (1) invest in real estate, Treasury inflation-indexed securities, low-fee index funds and other assets that will protect against higher inflation and a falling dollar; and (2) pay taxes now (Roth IRAs or mutual funds) rather than later (401(k) or 403(b) accounts). They also provide an excellent explanation of how high mutual fund fees can eviscerate retirement income over time.
This review does not do the book justice. Kotlikoff and Burns provide a powerful and convincing prediction of an impending political and economic crisis and a cogent proposal for addressing the problem at a national level. They also provide individuals with a surprisingly thorough guide to retirement investing—in a sense, how to prepare for the storm at a personal level. In that regard, the book is chock-full of penetrating statistics, implications from existing tax laws that influence retirement benefits of nonworking spouses relative to working spouses, explanations of why homeownership will be "the canonical
tax-benefited investment" and why many people are seriously underestimating their longevity and, therefore, how much more savings they actually will need to provide income during their retirement years. The informed layperson or financial planner would undoubtedly benefit from many of the insights the authors discuss in the last few chapters of the book.
On the other hand, the book does have two significant flaws, one of which greatly diminishes the effectiveness of the authors' message. First, while I'm sympathetic to the GA approach that Kotlikoff and Burns use, their model—like any model used to derive long-term projections—is highly sensitive to the set of assumptions on which it's based (for example, the discount rate or the exogenous productivity growth rate). Ultimately, this is why any long-term projection will inevitably be wide of the mark.
This is not a reason to ignore the model's projections, of course, but it is reason enough to not get too attached to point estimates that are projected to occur at a future date when we and our children have gone to a place that neither knows nor cares about fiscal gaps or sustainable productivity growth. The CBO and the Social Security Trustees both run multiple simulations to inform policymakers of a range of possible outcomes and the probabilities one should attach to one scenario versus another. It would have been useful if Kotlikoff and Burns had done more of that as well.
A more serious criticism is of the intemperate language the authors sometimes use to belittle many of those who toil in politics, the policy establishment and the private sector. Much of this writing is their attempt at light humor—perhaps comic relief in the face of impending disaster. But if the authors are hoping to influence the political process, which is where the reforms must ultimately flow from, they probably shouldn't accuse the political establishment of nefarious work. Here's one example: "Whatever the route chosen, only one thing is certain. The changes will be well oiled and slippery. Members of both parties will still be swearing they have 'saved' Social Security when its recipients eat more cat food than the nation's cats" (p. 177). Such rhetoric threatens to undermine what is otherwise a serious and forceful call to action about the storm that awaits us.