Happy Birthday Social Security! A Refresher Course in Macroeconomics For Laurence Kotlikoff

By Yeva Nersisyan

No day goes by without some deficit hawk trying to spread fear among ordinary Americans about the looming fiscal crisis. One gets the impression that the hawks are competing with one another to see who can come up with the scariest scenario. And it seems to be working. A recent USA Today/Gallup poll found that 64% of those surveyed in the poll disapprove of president Obama’s handling of the federal budget deficit. But Obama’s discretionary stimulus has been very small relative to the magnitude of the crisis we are in, and as discussed here most of the deficit was due to automatic stabilizers. Hence Obama’s policies have little to do with the rising deficit, and public disapproval of his policy demonstrates how misinformed the public is on the issues of federal deficit and debt.

A recent piece from one Boston University Economics professor, Laurence Kotlikoff, published in Bloomberg, was too outrageous to leave uncommented. Most of the deficit hawks seem to be united around the same agenda: getting rid of the very modest safety net that the U.S. government provides to its population. After making a bold claim that the U.S. is bankrupt here is what he has to say:

The authority that he uses to support his claim that the U.S. is bankrupt is nothing other than the I.M.F (and you thought that the I.M.F is rethinking its position on economic policy!). But what exactly does he mean by “simplifying” the tax, health-care and retirement systems? The only thing that comes to mind is downsizing – cut, cut and cut. How else would you achieve the 14% permanent fiscal adjustment that he thinks is needed? According to Kotlikoff, not only will this help put the fiscal house in order but it will also “revitalize the economy”. Moreover, these programs could still be able to achieve their “legitimate purposes at much lower cost”. What could be better?

This is the most extreme deficit hawk position that one encounters. There is a legitimate concern about a double-dip recession in the U.S. Household balance sheets are no better than they were before the crisis. Household debt stands at 122% of personal disposable income. The unemployment rate is high and is expected to stay high for the foreseeable future. In this situation the U.S. consumer can by no means be expected to pull the economy out of the hole. U.S. corporations, facing uncertainty about the strength of consumer demand, aren’t hiring despite sitting on huge piles of cash. Just what exactly will fill the aggregate spending gap when the government withdraws its spending and how cutting entitlements will “revitalize the economy” is a mystery to me. And probably to Kotlikoff too, since he makes no attempt to offer explanation in this article.

According to the IMF closing the fiscal gap will require a “permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.” (“The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years.”) This is the preferred definition of the fiscal gap promulgated by infinite horizon deficit warriors like Kotlikoff. In their world, an adjustment in the government’s fiscal balance from a 9% deficit to a 5% surplus (i.e. 14% adjustment) will take place without any negative effects on the rest of the economy. In the real world, however, we cannot have an adjustment in government’s financial balance without simultaneously having an adjustment in the non-government sector’s financial balance. A 14% of GDP fiscal adjustment means that the non-government sector’s financial balance will also adjust by the same amount, only in the other direction. For example, households could adjust their budgets to run huge deficits to allow the government to tighten its fiscal stance.

So what are our options according to Kotlikoff? To achieve this fiscal adjustment we will need nothing less than doubling of all of our taxes. “Such a tax hike would leave the U.S. running a surplus equal to 5 percent of GDP this year, rather than a 9 percent deficit”. (Of course doubling taxes is not something that he seems to be in favor of. This is just used to demonstrate how enormous the “hole” is). But one year will not do it. The U.S government will need to run a 5% surplus for many years to come to pay for scheduled expenses down the road.

Since the official deficit and debt numbers don’t look scary enough Kotlikoff offers us his own calculations. You see, the federal debt held by the public stands only at 53% of GDP and is expected to climb up to only about 68% in 2011. Compared to other developed nations this is a relatively low number. One could look at Japan and say: “Well, they have managed not to go bankrupt with a 200% Debt-to-GDP ratio so why would the U.S. be in trouble with a much lower level of debt?” Kotlikoff will then tell you that the fiscal gap is “more than 15 times the official debt”, a whopping $202 trillion. When baby boomers fully retire and collect all of their oversized benefits we will have an annual bill of $4 Trillion in today’s dollars. And if after all of this you still have any doubts then Kotlikoff will point you to the direction of Greece (I won’t go into that in this blog but you can read here on why the U.S. is not like Greece). Who wouldn’t be scared?

The alarming situation we are in, according to the deficit hysteria crowd, is the result of the government running a Ponzi scheme for 6 decades as it has been taking resources from the young and giving them to the old. If their point is that we are taking real resources from the young and giving them to the old, then yes, that’s what we are doing. And that’s what every society is doing, has always done, and will always be doing unless you want to let the elderly population die of hunger. Ditto for infants—the lazy do-nothings expect us, the working age population, to take care of them! Why can’t those lazy infants and elderly people pull their own weight?

But if it is all about real resources, the debate shifts to a completely different dimension. Will we have enough resources so that baby boomers can get a decent standard of living when they retire? Will the economy be able to produce enough to sustain its non-working members—young and old? This is the real issue and it cannot be solved by cutting government spending nor by raising taxes today. Nor can it even be resolved by ramping up financial saving today—that would only lead to more dollars chasing scarce resources tomorrow.

What matters is our capacity to produce goods and services in the future. If we want to be able to produce more in the future we need to invest more in education, technologies and infrastructure today. But if Kotlikoff thinks that we are redistributing “financial resources” from the young to the old (and I suspect that’s what he believes) then this is a false concern as explained below.

First of all, as discussed in many posts on this blog, the government is the monopoly issuer of the country’s currency and hence it cannot go bankrupt. It doesn’t need tax or bond revenues to spend; it simply spends by crediting bank accounts which ultimately amounts to creating new currency (cash or deposits in commercial banks). It then sells government securities to drain any excess reserves that the banking system might receive as a result of government spending. This is done to help the Fed hit its interest rate target. And even if the government wanted to, it couldn’t spend your tax money. Why? Because just as government spending creates new money, taxing destroys money. Government cannot spend that which doesn’t exist.

Both government bonds and currency are liabilities of the Federal government (Treasury and Fed), its IOUs. There is only one difference between the two – bonds pay higher interest than reserves. The government pays interest on bonds to offer an interest earning alternative to reserves. To get us to accept the currency, it imposes taxes on us. If currency is government’s IOU why would government need to borrow its own IOUs in order to spend? Furthermore, there is no balance sheet operation that allows one to borrow one’s own IOUs. When the government sells bonds, it simply exchanges one type of IOU for the other – this is not borrowing. When you deliver government’s IOUs to it to pay your taxes, it simply extinguishes your tax liability, just like you deliver bank deposits (bank IOUs) to a bank to discharge your obligations (bank loans) to it. If you could issue IOUs that were as acceptable as government IOUs, i.e. if everything was for sale in your IOUs, what kind of crazy idea would it be for you to borrow them back in order to spend?

The second problem with Kotlikoff’s argument is his presumption that government can somehow run fiscal surpluses for years on end. As explained in many posts on this blog government’s fiscal surplus means that the non-government sector is running a deficit. In other words, the government is injecting less income into the private sector (through its spending) then it is draining out of it (through taxation). Assuming a 4% of GDP trade deficit (although it could shrink if the government cuts spending), the negative adjustment in private sector (firms and households) balances desired by Kotlikoff will be in the amount of 9% of GDP (5% government surplus + 4% current account deficit/foreign sector surplus). The private sector will be dissaving at a rate of 9% of GDP per year. Can this go on forever or for many years as the IMF says it should?

In Kotlikoff’s world, where this somehow will have only positive effects, it can. But in the real world this is operationally impossible. For one thing, the private sector cannot indefinitely run a deficit without facing solvency problems – it is a user of the currency not the issuer. More importantly, a persistent federal budget surplus is impossible for a sovereign currency issuer like the US because the funds used to pay taxes ultimately come from government spending. If it continuously withdraws more funds from the economy then it’s injecting into the economy then at some point the private sector’s previously accumulated hoards of government IOUs will be depleted. People will simply be unable to pay their taxes.

Deficit hawks such as Dr. Kotlikoff simply shift the public debate from pressing issues such as high unemployment to false concerns about fiscal solvency and debt sustainability. They devise numbers which are meaningless for a nation operating with a sovereign currency, and use these to misinform and scare ordinary people. They are the reason why the very people who benefit from successful government programs (such as Social Security) undermine their own economic well-being by electing deficit hawks to Congress.

The academic experts calling for deficit reduction are irresponsible to say the least. They feel they can say anything without being held accountable for the impact of their ideas on the lives of people. We should devise some standard of accountability for professional economists, maybe similar to what we have for doctors. This would definitely throw some water on the deficit hysteria fire.