Going critical: American power and the consequences of fiscal overstretch.

• Author: Ferguson, Niall

... the interesting subject of the finances of the declining empire.

--Edward Gibbon, Decline and Fall of the Roman Empire, Book I, ch. XVII

TOPPLING THREE tyrannies--that of Slobodan Milosevic, the Taliban and now Saddam Hussein--within four years is no mean achievement by the standards of any past global empire. What makes this achievement so remarkable is that it comes little more than a decade after a wave of anxiety about American "overstretch" and decline. In The Rise and Fall of the Great Powers, Paul Kennedy warned that the United States was running "the risk ... of what might roughly be called 'imperial overstretch.'" America, he maintained, was spending too much on its overseas military commitments, to the detriment of the U.S. economy. Under such conditions, "The only answer to the question", as to whether the United States could remain a superpower, was "no."

As John Maynard Keynes once said, when the facts change, one ought to change one's opinion. Writing last September about America's subsequent ascent from superpower to "hyperpower", Kennedy invoked the deus ex machina of the "revolution in military affairs" to explain why his predictions of overstretch had not been fulfilled. All that investment in military research and development of which he had been so disapproving back in the 1980s had paid an unforeseen dividend. (1) Not only did the Soviet Union collapse as it strained to match the Reagan-Weinberger arms extravaganza; the United States also went on to collect a triple peace dividend in the 1990s: falling defense spending as a share of GDP, accelerating economic growth and a quantum leap in military capability that left all other states far behind.

The irony is that Kennedy's original thesis of fiscal overstretch is now about to be vindicated--but not as a result of America's overseas military commitments. Today's overstretch is the result of chronically unbalanced domestic finances, primarily the result of a mismatch between earlier social security legislation, some of it dating back to the New Deal, and the changing demographics of American society. In just five years' time, 77 million "baby boomers" will start collecting Social Security benefits. In eight years, they will start collecting Medicare benefits. By the time they are all retired in 2030, the United States will have doubled the number of its elderly population but increased by only 18 percent the number of workers able to pay for their benefits. Over time, a falling birthrate and lengthening life expectancy are indeed a potent combination.

A Menu of Pain

ECONOMISTS regard the commitment to pay pension and medical benefits to current and future elderly as part of the government's "implicit" liabilities. But these liabilities are no less real than the obligation to pay back the principal plus the interest on government bonds. Politically speaking, it may be easier to default on explicit debt than to stop paying Social Security and Medicare benefits. While no one can say for sure which liability the government would renege on first, one thing is clear: the implicit liabilities dwarf the explicit ones. Indeed, their size is so large as to render the U.S. government effectively bankrupt.

The scale of this implicit insolvency was laid bare this summer in an explosive paper by Jagadeesh Gokhale, a senior economist at the Federal Reserve Bank of Cleveland, and Kent Smetters, former Deputy Assistant Secretary of Economic Policy at the U.S. Treasury and now an economics professor at the University of Pennsylvania. (2) They asked the following question: Suppose the government could, today, get its hands on all the revenue it can expect to collect in the future, but had to use it, today, to pay off all its future expenditure commitments, including debt service. Would the present value (the discounted value today) of the future revenues cover the present value of the future expenditures? The answer was a decided no: according to their calculations, the shortfall amounts to $45 trillion. To put that figure into perspective, it is twelve times larger than the current official debt and roughly four times the size of the country's annual output.

Gokhale and Smetters also asked how much taxes would have to be raised, or expenditures cut, on an immediate and permanent basis to generate, in present value, $45 trillion? Their answer takes the form of a "menu of pain" with four unpalatable dishes to choose from. We could either, starting today, raise income taxes (individual and corporate) by 69 percent; or we could raise payroll taxes by 95 percent; or we could cut Social Security and Medicare benefits by 56 percent; or we could cut federal discretionary spending by more than 100 percent (which, of course, is impossible).

Another way of expressing the problem is to compare our own lifetime tax burden with that of the next generation if the government does not adopt one of the above policies. Hence the term often used to describe calculations like these: generational accounting. What such calculations imply is that anyone who has the bad luck to be born in America today, as opposed to back in the 1940s or 1950s, is going to be saddled throughout his working life with very high tax rates--potentially twice as high as those his parents or grandparents faced. Notwithstanding the Bush Administration's tax cuts, Americans are hardly under-taxed. So the idea of taxing our children at twice the current rates seems ludicrous.

It is not as if people are completely oblivious to the problem. It is common knowledge that we are living longer and that paying for the rising proportion of elderly people in the population is going to be expensive. What people do not yet realize, however, is just how expensive.

One common response is to say that the economists in question have a political axe to grind and have therefore made assumptions calculated to paint the blackest picture possible. But the reality is that the Gokhale-Smetters study was commissioned by then-Treasury Secretary Paul O'Neill and was meticulously prepared while Smetters was at the Treasury and Gokhale was on loan to the Treasury from the Federal Reserve. And, far from being a worst-case scenario, the Gokhale and Smetters figures are based on what are arguably optimistic official assumptions about future growth in Medicare costs, as well as about future increases in longevity.

Perhaps predictably, the Treasury now denies that it had anything to do with the Gokhale and Smetters study. It would rather we read the supposedly independent Congressional Budget Office's (CBO) ten-year budget forecasts, which are frequently cited in the press and are one of the principal reasons for the prevailing mood of complacency about fiscal policy. The credibility of the CBO's forecasts is a perfect illustration of the phenomenon known to students of drama as the suspension of disbelief. This also operates in the financial world. How does the CBO get us to suspend disbelief? The same way a good movie director does it--with good special effects.

During the Clinton Administration, the CBO routinely projected that, regardless of inflation or economic growth, the federal government would spend precisely the same number of dollars, year in and year out, on everything apart from Social Security, Medicare and other entitlements. At the same time, the CBO confidently assumed federal taxes would grow at roughly 6 percent each year. As a result, it was able to make dizzying forecasts of budget surpluses stretching as far as the CBO could see. (These phantom surpluses were the money Al Gore promised to spend on voters and George W. Bush promised to return to them during the 2000 election.)

With the election over, the CBO decided that not adjusting projected discretionary spending for inflation was no longer "useful or viable." Making this correction reduced the CBO's projected 2002-11 surplus from $6.8 trillion to $5.6 trillion. But that was nothing compared to the impact of subsequent...