The inevitability of a U.S. government default.

AuthorHenderson, David R.
PositionEssay

Countries don't go bankrupt. --Walter Wriston, former head of Citibank, quoted in Benn Steil and

Robert Litan, Financial Statecraft

There is a myth that floated around the banking community not many years ago that governments do not go bankrupt. I cannot imagine who dreamed that one up.

--Gordon Tullock, "Thoughts on the National Debt"

There is a ticking time bomb in the U.S. government's fiscal structure: growing government spending, which, if unchanged by policy, will result in growing government debt. This is not the short-run problem that we hear so much about in the news when Congress gets to vote on increasing the ceiling for the U.S. federal debt. It is the long-run problem that economists such as Laurence Kotlikoff (Kotlikoff and Burns 2004; Kotlikoff 2011; Jagadeesh Gokhale and Kent Smetters 2006), among others, have been writing about for years.

The problem is this. Three components of the federal government budget--Social Security, Medicare, and Medicaid-are highly likely to take an increasing share of gross domestic product (GDP). Overall federal government spending, including interest on the debt, could exceed 40 percent of GDP by 2050. For more than sixty years, overall federal revenues as a percentage of GDP have almost always been within a narrow range. They have never gone over 21 percent of GDP and have almost never gone below 17 percent. Even during the crisis years of World War II, they never exceeded 22 percent of GDP (White House 2013). (1) The result, if the government does not change policy, will be annual deficits of approximately 20 percent of GDP. This is unsustainable.

The question then becomes: What will change? This is difficult to predict. But we give the following predictions in decreasing order of certainty.

First, federal government revenues are unlikely to be more than 22 percent of GDP for more than a few years.

Second, well before spending reaches 30 percent of GDP, the federal government will face a renewed, more serious fiscal crisis.

Third, likely cuts in the growth of Medicare and Medicaid spending would at best delay, but not prevent, this crisis.

Fourth, the probability is therefore fairly high that the federal government will be forced to default on some or all of its debt.

Fifth, outright default on the federal debt will occur despite any increasing inflation.

How We Got Where We Got on Spending

Federal government spending has been within a few percentage points of 20 percent of GDP since about the start of the Korean War in 1950. What has changed dramatically, though, is the composition of federal spending. To put it succinctly, federal government spending has moved dramatically away from guns toward "entitlements" and transfers.

In 1954, the first full year after the Korean War truce, defense spending was 13.89 percent of GDP, which made it 68 percent of all federal government spending. Defense spending as a percentage of GDP did not go under 10 percent until 1964 and then briefly went back above 10 percent in 1967 and 1968, the two most intense years of the Vietnam War. Defense spending then fell throughout the 1970s to a low of 5.61 percent of GDP in 1979. Then, in 1980, President Carter, competing with a fairly hawkish Republican field of candidates, raised defense spending to 6.02 percent of GDP in 1980, and in 1986 Ronald Reagan raised defense spending to a high of 7.06 percent of GDP. From then until 2001, defense spending as a percentage of GDP fell, reaching a low of 3.58 percent in 2001. By 2010, it was back up to 5.82 percent. Although defense spending has risen in real terms since 1950, it has declined substantially as a percentage of GDP. (2)

Instead, two other programs that began under President Johnson have accounted for a large part of the budget growth since his time in office. Those programs are Medicare and Medicaid. In fiscal year 2011, federal government spending on Medicare and Medicaid totaled $835 billion, which was 5.6 percent of fiscal year GDP.

Also, both President Johnson and President Nixon added substantially to Social Security spending by raising Social Security benefits. Between 1967 and 1972, Congress and the president raised Social Security benefits by 72 percent (37 percent after adjusting for inflation). When Wilbur Cohen, Johnson's secretary of health, education, and welfare, proposed a 10 percent hike in Social Security benefits, Johnson replied, "Come on, Wilbur, you can do better than that!" (3) President Nixon added to the problem by getting into a bidding war with Wilbur Mills, a powerful congressman who was jockeying for the 1972 Democratic presidential nomination. The net result under Nixon was a 20 percent increase in benefits.

Social Security spending as a percentage of GDP is rising due to demographics (the elderly are living longer, and the Baby Boomers are retiring) and to the fact that it has never been fully funded but instead is run on a pay-as-go basis. Rising Medicare spending is driven by one other factor: improved medical technology. We often hear it said that medical costs are rising. It is true that some medical costs are rising, but many medical costs are falling. The problem is not costs, but expenditures. The higher expenditures come about because medical professionals are able to do so much more to keep people alive, to cure or alleviate diseases, and to improve people's quality of life.

Health economist Burton Weisbrod puts it well: "Fifty years ago, physicians were little more than diagnosticians" (1991, 526). Now they can actually do something. Weisbrod cites many effective medical procedures, including kidney dialysis, organ transplants, arthroscopic surgical techniques, CT scanning, and nuclear magnetic resonator imaging. Projections of medical spending in the future are based, quite reasonably in our opinion, on the assumption that medical technology will improve and make many procedures and cures possible that are not possible today. (4)

Of course, the mere fact that improved medical care is possible does not mean that people will buy it. But Medicare is structured so that people bear very little of the cost of various procedures, so many people will opt for expensive treatments: to put it bluntly, they are spending other people's money.

Medicaid spending is rising for the same reason: improved technology and an increased number of things that medical care can accomplish. What brought this spending to such a high level in the 1980s and 1990s is that, in various budget deals from the mid- to late 1980s, President Reagan's staff, negotiating with southern California Democratic congressman Henry Waxman, accepted expanded eligibility for Medicaid in the future in return for modest tightening in the present. This reflected White House budget director David Stockman's desire for achieving short-run spending restraint at the expense of long-run profligacy.

Dan Morgan, writing about this negotiation for the Washington Post, states: A former Republican staffer recalled a 1984 meeting when 'Stockman came into a room with Waxman and agreed to give him stuff in the out [later] years' if Waxman would ease up on his demands for the year just ahead" (1994). The net effect was a massive increase in Medicaid spending. Morgan writes:

At the beginning of the 1980s, Medicaid was a no-frills government insurance program that mainly covered one-parent families and their children receiving Aid to Families with Dependent Children--welfare--and Supplemental Security Income (SSI) for the elderly and disabled. Those with a Medicaid card still had to find a doctor, health maintenance organization, hospital or pharmacy to serve them--not always easy because Medicaid generally paid less than private insurers or Medicare, the federal program that insured the non-poor elderly and the disabled. Today, Medicaid pays the medical bills of millions of children and women in working families, illegal immigrants seeking care in emergency rooms, single mothers making the transition from welfare rolls to work, AIDS sufferers and some elderly nursing home patients with middle-class spouses or children. It pays for more than four of 10 U.S. births, compared with one in six in 1981. In one state, Minnesota, the Medicaid program is so generous that it will pay the medical bills of young children in a family of four with an income of $39,462--almost three times the federal poverty ceiling. To put the $39,462 income figure in perspective, it was higher than the median income of $32,264 in 1994.

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