RUNNING ON EMPTY
How the Democratic
and Republican Parties
Are Bankrupting Our Future
And What Americans
Can Do About It
By Peter G. Peterson
Farrar, Straus and Giroux -- 242pp -- $24
THE COMING GENERATIONAL STORM
What You Need to Know about
America's Economic Future
By Laurence J. Kotlikoff and Scott Burns
MIT Press -- 274pp -- $27.95
According to the Congressional Budget Office, the budget deficit for fiscal year 2004 will be $422 billion, with the red ink over the next 10 years totaling in the trillions. Meanwhile, the Democrats and Republicans -- and their associated economists -- spar over who is to blame for the deficits, whether they are hurting the economy, and what can be done about them.
Against this political backdrop come two important but flawed books that focus on the long-term budget picture over the next 75 years. One is Running on Empty by Peter G. Peterson, an investment banker who is chairman of the Council on Foreign Relations. Then there's The Coming Generational Storm by Laurence J. Kotlikoff, a respected economist at Boston University, and Scott Burns, personal finance columnist for The Dallas Morning News. Both tell an exceedingly, perhaps excessively, gloomy story.
The two books make the same point: that an aging U.S. population, combined with out-of-control entitlement payments to the elderly, is leading to budget deficits of almost unimaginable size, imposing a heavy economic burden on future generations. Indeed, the authors use similar language. "There is no economic or demographic magic wand we can wave to make everything right," say Kotlikoff and Burns. "We are heading into one God-awful fiscal storm." Peterson, too, sees the coming decades as the "fiscal equivalent of a perfect storm."
Both books assemble projections that show Medicare and Social Security costs taking up a soaring share of national output for the coming 75 years. The result, they argue, will be either huge tax increases for the young, even more enormous government borrowing, or big cuts in benefits for the elderly.
None of these options is attractive, and all of them can potentially lead to disaster. For example, if the government tries to get out of trouble by borrowing more, or by printing more money, Kotlikoff and Burns note, investors "will quickly dump their holdings of U.S. Treasury and other bonds," leading to soaring interest rates and a falling dollar. This could subject the U.S. to the sort of financial crises seen in countries such as Argentina. In such a crisis, "a seemingly small factor can flip the switch on the economic electric chair," write the authors. "When that happens, the transformation from economic health to economic death is swift and merciless."
This pessimistic perspective, while a bit overwrought, can certainly not be dismissed out of hand, either by policymakers or voters. Both books provide readable expositions of their arguments. The big difference is that Kotlikoff and Burns provide more specific policy suggestions than Peterson does -- especially for reforming Medicare -- as well as fairly good insights into how an individual can prepare financially for a world with a fiscal catastrophe. Peterson, by contrast, is more concerned with the moral failings of America's economic policy, ladling equal blame on both Republicans and Democrats: "Both political parties have formed an unholy alliance -- an undeclared war on the future." he writes. "An undeclared war, that is, on our children."
Yet the authors of both books can be taken to task for the same failing: They are obsessed with demographic changes and the growing gap between government spending and revenues, but they utterly dismiss the effects of growth. Thus, in the words of Kotlikoff and Burns, "economic growth is not going to bail us out." And Peterson calls one section of his book "The 'Grow the Economy' Fantasy."
Moreover, both books express extreme distrust of technology and warn the reader not to count on it to solve our problems. "The lesson here is that we can't be sure about technology and future economic growth," write Kotlikoff and Burns, who then go on to suggest that the 1990s boom was overstated. Adds Peterson: "This is not the first time self-appointed prophets have proclaimed the arrival of a new era of endless prosperity, only to be proved laughably wrong."
Yet in reality, the rate of productivity growth over the next century will be the key factor determining whether adjusting to an aging population is easy or difficult. Consider the "dependency ratio" -- the ratio of Americans 65 and older to those 20 to 64. The number of elderly for each working-age person more than doubles from 2005 to 2080, according to Social Security Administration (SSA) projections cited by Kotlikoff and Burns. That sounds mighty scary.
In fact, the change in demographics is a slow-moving process that can easily be overcome by decent productivity gains. Since the mid-1990s, productivity growth for the whole economy has averaged 2.3% or so, according to the SSA. If that performance is continued into the future, then output per person goes up six times over the next 75 years. With additional improvement, to 3% annual productivity growth, each working person will be able to produce nine times more than today. (By comparison, in its own forecasts the SSA assumes average productivity gains of only 1.6% per year). Thus it becomes a lot easier to see how we could have sufficient resources for an aging population.
Ah, but the authors of both books have already provided an answer to that. They argue that faster productivity growth would just lead to higher spending on retirement and medical benefits. "A robust economy," writes Peterson, "would by itself cause Social Security benefits, which are tied to wages, to become more generous, while also further inflating health care costs." Kotlikoff and Burns reinforce this point by citing approvingly from a 2003 study that estimated "the long-term fiscal gap" -- the present value of the difference between the government's future expenditures and future receipts. The resulting number, $45 trillion in today's dollars, was astronomical enough. But the study also reported that higher productivity growth would lead to a bigger fiscal gap, not a smaller one, as benefits rose faster than revenues.
However, Peterson, Kotlikoff, and Burns miss a crucial factor: A fast-growth economy makes it much easier to find a politically and economically palatable solution to the fiscal-gap problem. Consider that under current projections, Medicare is expected to rise to almost 14% of gross domestic product over that span, up from 2.6% in 2003. That's based on the SSA's relatively pessimistic forecasts for future productivity and GDP growth.
Now let's assume instead that the U.S. has a fast-growth economy that can expand at 3% a year for the next 75 years -- with the extra growth coming from new technologies, perhaps. It turns out that in 2080, just 7% of the fast-growth economy would provide as much real resources for Medicare as 14% of the slow-growth economy. Thus, in a fast-growth economy we could put a cap on Medicare expenditures as a share of GDP and still spend as much on health care, in real terms, as in today's slow-growth projections.
Still, even if growth can lift some of the long-term gloom from the forecasts, the fiscal structure of both Medicare and Social Security still has to be revamped to be able to take advantage of the growth. Peterson favors a fairly conventional list of fixes: He would cut "the abundance of fraud and waste" in Medicare, promote public health, and "face hard choices," by putting caps on spending.
By contrast, the policy solutions of Kotlikoff and Burns are specific and ingenious. For example, they would freeze benefits from Social Security at their current levels and fund them with a federal retail sales tax. Kotlikoff and Burns argue that would be a much broader and less regressive tax than the current payroll tax, which is not applied to incomes over a certain amount ($87,900 in 2004). At the same time, workers would make compulsory contributions to a "Personal Security System" that invests in a single market-weighted global index fund of stocks, bonds, and real estate. When people retire, they would get an inflation-protected pension, based on the value of their investments -- and with the real principal of their contributions guaranteed.
Moreover, one of the real strengths of the Kotlikoff and Burns book is that it gives some fairly good insights about how individuals can prepare themselves for a future economy in which tax rates and inflation rise and social benefits become smaller. They warn against depending too heavily on 401(k)s, noting that "even a modest inflation rate may negate the benefit of 401(k) and IRA saving for many workers." Instead, they lay out a portfolio for savings, including mutual funds that specialize in gold and other precious metals, energy mutual funds, inflation-protected bonds, and international equity funds, especially those focused on China.
Peterson, Kotlikoff, and Burns are far too gloomy about the future prospects of the baby-boomer generation and its children. Nevertheless, the real import of their argument is that even with growth, the financing of the current entitlement system will eventually have to be dramatically rebuilt -- and that's a message that should be heard.
By Michael J. Mandel