For taxpayers in America, today is the deadline to pay their federal income taxes for 2008. With that chore behind them, they might now like to think about their future taxes — the ones that will pay for the $787 billion stimulus package, the $2 trillion commitment to prop up collapsing financial firms, and other programs that promise to deepen our $11 trillion national debt. Of course, that doesn’t count the $80 trillion to $100 trillion shortfall in funding for Medicare and Social Security. According to Wharton insurance and risk management professor Kent Smetters, a former deputy assistant Treasury secretary and economist for the Congressional Budget Office, most Americans should not be worrying about having to pay higher taxes. Why? Because even the biggest tax hikes will not raise enough money to pay off the debt and meet coming obligations. Accomplishing the latter would require politicians to do something they fear even more than raising taxes: Cut back on Medicare and Social Security benefits. Smetters described the coming crisis in an interview with Knowledge at Wharton.
An edited transcript of the interview follows:
Knowledge at Wharton: Assuming China continues to invest in our Treasury bonds, when do we have to start backfilling the deep debt hole that we’ve dug for ourselves, not even counting the much bigger shortfall for Medicare and Social Security that’s heading our way?
Kent Smetters: [China is] very nervous right now and… they’ve thought about floating an international reserve that’s no longer U.S. based. But even given the assumption that under the Safe Haven hypothesis [that United States Treasury bonds are the safest investments], U.S. debt is still viewed as the safe place [for investors] to go. And we continue to get the ability to float debt at these very low rates, which is almost a topic unto itself because these rates are so unbelievably low. But we face a very… significant short-term problem… because all this [U.S. government] debt is going to crowd out lots of private investment, and [the stimulus package it is funding] assumes that the government can do a better job at picking… the winners and [losers with its] investments.
Economists don’t have a hard and fast rule that says, “Here’s your maximum debt ceiling. And here is the most that you can go.” But given where we are in terms of paper debt — we’re adding another $2.1 trillion just this coming fiscal year and we’re going to be close to $11 trillion to $12 trillion in total, and on top of that … Social Security and Medicare — we really do face a very dire situation right now. The U.S. economy has never faced this type of challenge in the past, even in World War II when our paper debt was high. We just never faced the type of fiscal challenges that we face right now.
Knowledge at Wharton: Do we have to dig ourselves out of the national debt before we can address Social Security or Medicare?
Smetters: No. In fact, ideally, it would be in some ways just the opposite. Social Security and Medicare are much bigger problems, and the longer that we delay those, the more those problems [will] snowball. In particular, every year that we delay reform on either of those programs it adds about another $2 trillion to the present value shortfalls of both programs. So just a one-year cost of delay is about the size of the record deficit that we’re going to have this year….
Knowledge at Wharton: So, whatever we do for Social Security, the bottom line is that it has to cost a lot less than it does now.
Smetters: Yes. You can certainly raise some tax revenue in some places. People have talked about increasing the maximum taxable wage cap [currently $106,800]…. That’s not going to… help a lot in present value, because those people will eventually collect more benefits. They’re not going to collect as much… as they paid into the system, but it’s still not going to be super-effective…. People have [also] talked about taxing fringe benefits like health care and so forth. But the fact of the matter is that these benefits are growing faster than inflation. We have to bring Social Security benefit growth rate closer to [the rate of] inflation for it to be a sustainable system. And that’s the easy problem.
Medicare is the tough one.
Knowledge at Wharton: Medicare is tougher, why? Because … people [are reluctant] to give up benefits that have to do with their health care?
Smetters: Medicare is tough for two reasons. One, the shortfall in Medicare is six to seven times larger than in Social Security. Social Security is a major problem; Medicare is a crisis. You add both of those… shortfalls together and you’re getting something that’s … between $80 and $120 trillion in total present value shortfalls. … People can’t even imagine how big that number is. If you took the total value of the United States, except for the people (all the land, houses, buildings, everything that’s non-perishable, your washer and dryer, cars, and so forth), it has about a value of about $50 trillion. So we’re talking about a shortfall of twice the value of the value of the U.S. except for the people. Now, the value of the people is about three times that. We’re just talking about biblically large shortfalls. We’ve never seen this type of problem.
Eighty percent of that is driven by Medicare. And a lot of that is because of the way Medicare benefits are provided. It’s not a dollar benefit, it’s an “in kind” benefit. That is, they pay for operations. And so how do you scale that back? A dollar benefit like Social Security is easier to scale back. An operation, what do you do there? Do you say, “Okay, we’ll pay for half of it and you pay for the other half of it?” People have talked about this, but it’s more likely that we’ll move to some type of rationing system unless we take kind of a long [term] approach and get people to save for their future medical costs.
Knowledge at Wharton: The Obama administration asserts that reforming health care overall for all Americans the best way to address Medicare. Do you agree?
Smetters: It will address some of it. It is interesting that the Obama team is starting to lean more toward the [Hillary] Clinton proposal, [raised] during the [Democratic primary] campaign, for… mandatory coverage. There’s nothing I’ve seen so far, however, that will fundamentally address the core issue, and that is that medical care costs are simply going up. Increasing access is great for various social reasons, but it’s not going to have a big impact on increasing costs unless we actually start making some hard choices. Some of those hard choices are going to be very unpopular, especially when you start to ration care. You basically say, “You’ve hit a certain age [after which] we’re no longer going to do those triple bypasses,” or something like that. And that’s obviously a tough choice. I hope we don’t get to that.
But the second approach is more of a long term approach, where you have to make people sensitive to how much… they spend on health care. That’s the core problem: People always want the very best, even if the marginal benefit is much less than the marginal costs, because they don’t bear the cost. In Medicare, the government bears the cost. And so people don’t have any type of trade off between spending and benefits. They always want the very best. And… the innovators always come up with the better pill even though its efficacy may be just marginally better than the generic drug; or the better operation, even though its efficacy will be just marginally better than the cheaper operation.
Knowledge at Wharton: Is there a way to bring more sensitivity about marginal benefits and marginal costs?
Smetters: There are only really two things you can do. The first is you say, “Well, people still aren’t sensitized to cost and benefits. We’ll keep on paying for it.” And in that case the government then has to say, “You know what, we’ll keep on paying but for only some stuff.” And now the government is the one in charge of deciding who gets what. The second approach is to actually make people directly sensitized to it. And you do that with things like health savings accounts in which people have to pre-fund some of their future medical care. They have to pay out the first several dollars of that care, and the government’s only a back stop on a catastrophic case.
The problem with the health savings accounts, people say, is there’s an equity issue — some people can’t accumulate a large savings account. And so then how do you address that issue? Whatever you do to address that issue de-links people from being sensitized to benefits and cost. So there’s no silver bullet here. Ultimately, the best package is some type of hybrid where you have people being sensitized to health care costs for routine care. For catastrophic care you probably have a government back stop, but more of minimal back stop than we now have. It’s not always wise to pay for the best device that’s out there. It’s really about taking into account cost benefits.
Medicare, by the way, will claim that it take costs and benefits into account. But in effect they do not. They will approve almost anything that has some type of marginal benefit and not really think very hard about the costs.
Knowledge at Wharton: How does the government go about preparing people for this? Given the psychology that you just discussed, how does the government go about preparing people for those difficult choices?
Smetters: That’s an interesting question because elected officials really have no incentive to do that. The chance of them being around 20 to 30 years or even 10 years from now is pretty low. So they have an incentive to always keep things going along. History has shown that it takes a crisis before you get any type of reform. And obviously that [last minute] reform is never the best possible reform. So, we could talk about what things the government will do. But we know the government won’t.
It’s going to require a lot more action by citizen groups. The Peter G. Peterson Foundation, for example, tries to educate people about some of these fiscal problems. Certainly there are some “blue dog” Democrats and some Republicans who want to talk about this issue. But for the most part this is an issue that [causes] you to lose re-election. So, trying to have a sustainable, reasonable conversation is difficult. And it’s only becoming more difficult as the baby boomers start to age even more and they become even more sensitive to this issue.
Knowledge at Wharton: So then what does the result of the crisis — when the crisis arrives, what does it look like in terms of taxes? If we have to raise them to some extent, along with cutting back benefits, what does the tax bill look like for Americans?
Smetters: We currently have a present value shortfall that’s twice the value of the entire country, except for the human beings. So, obviously, we can’t tax our way out. So the real issue is, what type of hit are we going to give do to benefits? You’re going to see benefits reduced, especially for higher income earners. We got a hint of that in Medicare Part D, the newest part of Medicare that gave us our prescription drug bill. They explicitly have some means testing in there, which basically says higher income people get a smaller benefit. Social Security benefits are now taxed. And in fact, they’ve been taxed since 1983. But it’s taxed on a progressive basis. Higher income workers get more of their benefits taxed. I think you’ll start to see a lot of more of that.
And so what will happen is Medicare and Social Security will become more of a flat system, [with] fewer benefits to higher income people even though they paid in more. But on the [revenue] side, I don’t see a lot of room for continuously increasing taxes. We’ll see, I think, more taxes on higher income individuals. And that will have long run implications because they’re also the ones who create jobs and invest and innovate. We already have the second highest corporate income tax rate in the world, even after you net in things like expensing and so forth. So for us to remain competitive, I just don’t see how… we can really do a lot on the tax side. But I do think we will see taxes go up. The thing I fear the most — and I think it is the most likely outcome — is that the government will print a lot of debt to pay off a lot of these shortfalls. And then the international markets, in particular the fixed income markets, will figure it out.
They will realize the government is basically monetizing that debt through higher inflation. And if you have an inflation rate that’s 25, 3% more per year than the historic average, you can really eat away a lot of debt just through the law of compounding. And so the market should figure that out and adjust the interest rates accordingly. That’s one reason why I believe that 30 year yields right now on Treasury [bonds], especially to non inflation protected Treasuries, is really too low. I believe Treasuries are in a bubble right now because everybody’s flocked to the safety. And there’s just no way that those low yields of 3.5% are going to cover the inflation rate over the next 30 years.
Knowledge at Wharton: Why doesn’t the rate respond to the reality of what’s going on in the market?
Smetters: In theory it should. I think what you have is a flight to safety going on right now, where people are basically saying, “Where else do I hold my money? And I’m nervous about the markets.” It’s obvious that people are worried about even corporate fixed income, given the very high yield that those are earning right now. So people are panicked. And so they’re moving toward was viewed as historically safe, and that’s U.S. Treasuries. The irony is that a whole herd of people moving into one security because they’re scared creates a problem for those people because prices of those securities get bid up. You’re going to have a lot of people holding long duration, fixed income, government securities who are going to see pretty significant price declines over the next decade.
Knowledge at Wharton: And it’s not just China that is holding those bonds. It’s also American retirees or future retirees.
Knowledge at Wharton: What is it that’s keeping the Chinese government in that market?
Smetters: China, Japan and the UK have over half of our debt…. Traditionally the view was that U.S. debt is safe and there were some regulations, especially for Japanese pension funds, requiring investments in safe areas, and U.S. Treasuries qualified because of their safe reputation. China is starting to question that now, as are other investors. The question becomes, when does it kind of snap? What we know from fixed income markets and foreign exchange markets internationally is that things don’t just gradually change. Investor sentiment suddenly snaps and people start to panic. We saw that in Asia and Latin. One reason U.S. may face a different situation is that, in the case of previous crises such as in , South Korea or Thailand or Argentina, it was easy just to yank your money and put it elsewhere. When you yank your money from the U.S., you are not 100% clear about where you put it. And so that may create more of a gradual scenario for the U.S..
But, you know, we’re seeing growth in the BRIC countries [Brazil, Russia, India and China]. It would not be surprising that you could see — not an Asian style currency crisis or anything of that magnitude — but certainly our own currency crisis in which investors would suddenly get nervous and start to pull out of U.S. Treasuries. We could see yields increase quite a bit, and rates and prices decline.
Knowledge at Wharton: Would it mean an absence of cash for the government to do what it does?
Smetters: It would mean that they would have to pay much higher interest rates to float the same debt. That just makes it more difficult for them to continue to roll over the debt. One reason why the Treasury can get away with holding so much debt is that at current yields, it’s pretty cheap for them. Japan during the 1990’s was facing yields of close to 0%. It’s shocking that they, in some sense, weren’t floating even more debt than they were. And they were floating quite a bit.
But the real lesson is not so much the cost of debt, because what Japan did during the 1990’s showed us is that the Japanese government was able to float debt for dirt cheap. The real problem is that they diverted a lot of investments away from new, nimble financial institutions [and propped] up the very inefficient, old school finance institutions. We’re basically doing the same thing in the United States. We’re trying to prop up institutions that were too large to begin with, AIG and lots of the investment banks. They were just too big to begin with. That’s why corporate risk management was never possible, because… they were just too big, too unwieldy to think about corporate risk management very seriously.
Somewhat ironically, [the major banks] actually lost more money buying some of the safer [subprime-based] collateralized debt obligations, than they did with their investments in hedge funds, which bought some of the higher risk stuff… These old institutions, these investment banks and large insurers like AIG, they’re just old, inefficient and too large. And we’re trying to prop them up. We’re trying to keep them alive. And that’s exactly what Japan did and that’s why Japan had a recession that lasted a good decade. I see that scenario playing out over the next five years in the United States. Unless we’re willing to allow for a good train wreck, to have some pain in the short run, we’re going to have this train wreck screech out over many, many years. And, as a result, we won’t clear the tracks very quickly.
I’ve said it before and I’ll say it again: The one nice thing about a good train wreck is you clear the tracks quickly and you start over — but we just refuse to let that happen. That’s what Japan did.
Knowledge at Wharton: Would clearing the tracks quickly mean allowing some pain to occur sooner rather than later?
Smetters: Yes. There are a couple of dimensions. One is what’s going on in the subprime market and the banking market. There, clearing the tracks quickly basically means creating the most transparent fiscal institution possible. And [procedure for doing] that is called bankruptcy. Everybody says we want to clean up the balance sheets of these institutions y quickly, and we want to do it in a cheap and efficient way. Well there’s a process already out there, it’s called bankruptcy. That’s exact what it does. It cleans it up very quickly. And in terms of the entitlement programs [Medicare and Social Security], there’s no real equivalency of bankruptcy per se, rather we need to have this long discussion about exactly how we’re going to scale back benefits — because we can’t raise taxes enough.
Social Security is the easier problem. Again, it’s a cash benefit and all you need to do is slow the benefit growth to something closer to inflation toward, closer toward inflation. And that in particular means hitting higher income people a little bit harder in terms of their eventual benefits. I wouldn’t tax them a lot more, but I would certainly decrease their benefits. Do that and you can pretty much fix Social Security.
Medicare is much harder, obviously because it’s a much bigger problem and because of the nature of its benefits. So again, there your choices are, either have people pay for a lot of it themselves and therefore be sensitized to this tradeoff between benefits and costs, or the government takes a much more draconian approach and basically says, “We’ll still pay for it, but now we’re just going to start rationing who we pay for and what we pay.”
Knowledge at Wharton: Thanks very much.