Wealth Manager

The proviso leaves more than a little
room for debate today about America’s
mounting financial promises. The current
sum of red ink, according to one estimate,
rises to a monumental $64 trillion. Yes,
that’s trillion with a “t.” Washington’s future
pledges exceed the country’s long-run
capacity to pay by a cool $64 trillion. For
comparison, U.S. gross domestic product
in 2006 was $13.2 trillion.

The $64 trillion shortfall is calculated
as the total long-run claim on federal
coffers less the anticipated tax revenues
if—a big “if”—corporate-style accounting
is applied to the government’s balance
sheet over the infinite future. By that
measure, the annual gap works out to
$2.4 trillion, reports “Do the Markets Care
about the $2.4 trillion U.S. Deficit?” in the
March/April 2007 Financial Analysts Journal.
The authors are Jagadeesh Gokhale
(senior fellow, CATO Institute) and Kent
Smetters (associate professor, Wharton
School), a duo with a paper trail of studying
government debt and drawing rather
dark conclusions.

No one necessarily disputes the $64 trillion
figure, which is to say that the underlying
calculation is more or less accurate
as far as it goes. The dispute centers on
the accounting assumption that informs
the math. Indeed, the Congressional Budget
Office reported a budget deficit of $248
billion for fiscal year (FY) 2006, or just 10
percent of Gokhale and Smetters’ estimate
of the annual imbalance.

What’s more, CBO’s baseline budget
outlook predicts that the negative gap
between receipts and expenditures will
narrow, rising to a $155 billion surplus in
2012. Gokhale and Smetters project the
opposite, warning that America’s deficit
will deepen over time without a dramatic
change in policy.

Why the difference in deficit estimates?
Some of it comes from the choice of time
frame. Tax revenues of late have surprised
on the upside, boosting CBO’s numbers.
“Revenues tend to bounce around a lot,”
especially from one year to the next, says
Robert Bixby, executive director of the
Concord Coalition, a nonpartisan think
tank focused on the federal budget. “But
the long-term outlook doesn’t change
much.”

There’s also the political factor to consider.
“The CBO is constricted by rules set
by Congress,” explains Bixby. For example,
the 2001 and 2003 tax cuts are set to expire
in 2010 and the CBO assumes as much,
which implies a short-term revenue boost
for the government down the road. But
the expectation assumes too much, says
Bixby. He predicts that Congress won’t
passively watch taxes rise in 2010. “That
truly would be the biggest tax increase in
American history, and Congress wouldn’t
let that happen,” he says.

The point is that there’s more than one
way to forecast budgets. Even among
those who generally agree with Gokhale
and Smetters—that the deficit is fated to
deepen—there’s a debate over how much
red ink is coming. Concord Coalition, for
instance, expects the deficit to worsen, but
by far less than what Gokhale and Smetters
project (see chart below).

That leads to a third reason why forecasts
can differ: accounting assumptions.
Gokhale and Smetters’ estimate is driven
by a view that the government’s financial
commitments should be measured
like pension fund-type liabilities. In fact,
the idea has some appeal. The Federal Accounting
Standards Advisory Board—the
group that sets federal accounting guidelines—
last year floated the idea of using
corporate-style rules for the government’s
budgets.

No matter your choice of accounting
templates, some aspects of the future
budgetary challenges are beyond debate.
Consider that Medicare accounts for the
bulk of the government’s future budget
imbalance. The price tag for the program
continues rising vigorously for reasons
that won’t soon be derailed—including an
aging population and the relatively high
level of health care inflation.

“The nation’s long-term fiscal balance
will be determined primarily by the future
rate of health care cost growth,”
Peter Orszag, CBO’s director, told the
Senate’s Budget Committee in June. “If
health care costs continued growing at
the same rate over the next four decades
as they did over the past four decades,”
he explained, “federal spending on Medicare
and Medicaid alone would rise to
about 20 percent of gross domestic product
(GDP) by 2050—roughly the share of
the economy now accounted for by the
entire federal budget.”

It’s tempting to dismiss it all as little
more than the continuation of a debate
that’s as old as the Republic. Hamilton’s
mercantilism was bitterly opposed by
Thomas Jefferson, who embraced an agrarian
future for America. “The principle of
spending money to be paid by posterity
under the name of funding is but swindling
futurity on a large scale,” Jefferson
complained in 1812.

Despite dire predictions from Jefferson
and his philosophical heirs, the country
survived and even prospered as Hamilton’s
view prevailed. Inspired by history,
some dismiss the current budget warnings
as driven more by a political than a
fiscal agenda.

The Century Foundation, a public policy
group in Washington, calls the unfunded
liabilities issue a “ruse” in a 2004 essay.
“Imagine if in 1950, someone had calculated
the costs of educating the baby
boomers in public institutions through
their college years.” No money had been
set aside. “Yet nobody ever claimed in the
1950s and 1960s that the education of the
baby boomers was an excessive burden....”
Instead of alarmist warnings, “We need to
strengthen social insurance for old people,
and we will be able to afford it,” the group
asserts.

Still, the opposing school of thought
says this time it’s different. Really different.
The United States faces a range of fiscal
and social ills if the current course of
spending (current and promised) isn’t altered
soon, warns a 2004 book ominously
titled The Coming Generational Storm, co-authored
by Laurence Kotlikoff, an economics
professor at Boston University and
research associate at the National Bureau
of Economic Research. “Economic growth
is not going to bail us out,” the book
predicts. “Nor will our parents, our trading
partners, our immigration policy, our
bosses, our technology, or our retirement
behavior.” What’s the answer? According
to the book: “Our only hope lies in immediately
and radically reforming the Social
Security and Medicare systems....”
But time’s running out. Gokhale and
Smetters say that the longer the imbalance
is left unsolved, the bigger the problem.

“Our nation’s failure to adjust fiscal policies
is like attempting to roll over debt,”
they write. “With accruing interest costs,
the debt simply snowballs.”

The government, with the power to
print currency and service debt indefinitely,
can always borrow more. But that
luxury may come at a price if abused, including
the so-called crowding-out effect.
If the government runs afoul of Hamilton’s
“excessive” counsel, the result may
push private borrowers out of the market
as borrowing costs rise. Supply and
demand, in other words, can’t be denied
indefinitely.

That, at least, is the theory. But nothing’s
quite so cut and dried when it comes
to the interaction of the government and
the capital markets. The budget deficit
during the Reagan administration, for
example, dipped into then uncharted red
ink territory in the 1980s. Yet interest rates
generally fell as the decade progressed.

Recent history too offers something
less than full clarity on the relationship
between interest rates and deficits. Consider
the rare surplus of $236 billion for
FY2000, as per CBO. By FY2006, it was
gone—replaced by a deficit of $248 billion.
Yet from 2000 on, the yield on the 10-year
Treasury bond has trended lower. Underscoring
the drift, in FY2003 when the deficit
touched a record depth of -$376 billion
in June 2003, the 10-year’s yield swooned—
touching a generational trough of 3.07
percent.

Of course, if one looks at the deficit as
a percentage of the economy, there was
more red ink in the 1980s. Meanwhile,
an examination of the full sweep of history
suggests that the crowding-out effect
isn’t easy to prove—or disprove. There are
times when deepening deficits are
accompanied by higher interest rates, but there
are also periods when the opposite holds.
The implication is that the crowding-out
effect may or may not be relevant, depending
on the circumstances.

Yet one could argue that the anticipated
deficits (in absolute and relative terms)
loom so large that the upward pressure on
rates is virtually assured. If so, why hasn’t
the bond market already priced in the future
now, today, this minute?

The capital markets are forward-looking
machines, and the budget challenges
are widely debated and dissected. Yet the
recent deepening of federal debt has cast,
at most, a slight impact on the price of
money. Yes, the 10-year yield in June 2007
moved above 5 percent for the first time
in a year. Nonetheless, it’s hard to make
the case that the bond market is becoming
increasingly worried about fiscal troubles.
Even if the 10-year yield jumped to 6 percent,
that would still be lower compared
to rates that prevailed for much of 1999
and early 2000, when the budget was in
the black.

Investors can debate whether or not
the capital markets are adequately discounting
the future and the timing of the
likely solutions: raising taxes or cutting
benefits. One or both may be inevitable,
but recent political history suggests that
neither is imminent. All the more so
given the onset of the presidential election
cycle, which isn’t likely to spawn a
rush of politicians vowing painful policy
prescriptions.

In fact, there may be a third way out: inflation.
A government assuming ever larger
piles of debt runs the risk of debasing
the currency for easing the financial pain
of swelling liabilities. Then again, the particulars
of the future burdens don’t lend
themselves to overt inflationary therapy,
says Gokhale. In an interview with Wealth
Manager, he explained that the main drivers
of the government’s red ink—Social
Security and Medicare—are largely immune
to inflationary schemes.

“Social Security benefits are indexed
to inflation so you can’t use inflation to
erode the benefits,” Gokhale says. “Medicare
benefits are also indexed because
they’re in-kind benefits.” The cost of heart
surgery and cholesterol drugs may rise,
but if the government promises to deliver
said service, the inflation burden is born
by the state, at least initially.

True, although the inflationary fallout
may eventually spill over into the money
market. If the government’s delivery of
health care requires debt-based financing,
as it almost surely will, higher inflation is
a risk—in which case the investment outlook
for bonds is suspect.

But the government’s budget prospects
may be more complicated than straight
accounting implies. Concord Coalition’s
Bixby expects the deficit to deepen, but
he makes a distinction between his outlook
and the darker scenario painted by
Gokhale and Smetters.

“I agree that the impending liabilities of
Social Security and Medicare, and frankly
the whole budget apparatus is thoroughly
unsustainable over time,” admits Bixby.
“But to translate that into saying that this
year’s true deficit is $2 trillion isn’t very
realistic. What are we going to do? Raise
taxes by $2 trillion? It doesn’t give you a
guide for any rational policy action.”

Still, Bixby says that Gokhale and Smetters
should be commended for reminding
us that the fiscal challenges are huge.
“But the government isn’t a corporation,
and [its programs] aren’t private pension
plans he adds. “These are legislative
entitlements; they’re not contracts.
That’s why they’re not, strictly speaking,
liabilities. Congress has changed these
programs in the past; it will change them
in the future.”

Maybe that’s why Wall Street doesn’t appear
overly concerned with the country’s
destiny with debt—at least not yet. “One of
the problems with issues like this—the really
big issues-—is that it’s as if they never
really materialize,” muses Quincy Crosby,
strategist at The Hartford. “There never
seems to be a denouement.”

At Payden & Rygel, a money manager
in Los Angeles, chief economist Tom Higgins
admits that the budget deficit has
relevance for the long run. “But for an investment
manager, we’re focused on the
next six to 12 months. In that time frame,
it doesn’t have a whole lot of implications
for Treasury yields, the equity markets or
the crowding-out effect,” he adds.

Some optimists go so far as to say that
the issue may not be all that relevant in
the long run, either. In the dynamic market
economy that is the United States, the
private sector is likely to come up with
solutions—solutions that aren’t necessarily
obvious in 2007. Meanwhile, the government
will eventually do what it needs
to do. It may not be easy, and it may take
time, but according to this line of thinking,
financial doomsday will be avoided
once again.

The bond market seems inclined to
agree. Deciding whether the wishful thinking
has legs is the $64 trillion question,
and one that will be answered one day at
a time.