From the September 2007 issue of Wealth Manager Web • Subscribe!

The $64 Trillion Question

A national debt, Alexander Hamilton advised a young republic struggling with finances, will be a "national blessing." By that standard, the United States is free of fiscal sin in the 21st century. But even Hamiltonian notions of economic absolution have limits. For all his faith in debt as a tool for nation building, America's first Treasury secretary was careful to qualify his counsel, explaining that a "blessing" would come only if the liabilities were "not excessive."

The proviso leaves more than a little room for debate today about America's mounting financial promises. The current sum of red ink, according to one estimate, rises to a monumental $64 trillion. Yes, that's trillion with a "t." Washington's future pledges exceed the country's long-run capacity to pay by a cool $64 trillion. For comparison, U.S. gross domestic product in 2006 was $13.2 trillion.

The $64 trillion shortfall is calculated as the total long-run claim on federal coffers less the anticipated tax revenues if--a big "if"--corporate-style accounting is applied to the government's balance sheet over the infinite future. By that measure, the annual gap works out to $2.4 trillion, reports "Do the Markets Care about the $2.4 trillion U.S. Deficit?" in the March/April 2007 Financial Analysts Journal. The authors are Jagadeesh Gokhale (senior fellow, CATO Institute) and Kent Smetters (associate professor, Wharton School), a duo with a paper trail of studying government debt and drawing rather dark conclusions.

No one necessarily disputes the $64 trillion figure, which is to say that the underlying calculation is more or less accurate as far as it goes. The dispute centers on the accounting assumption that informs the math. Indeed, the Congressional Budget Office reported a budget deficit of $248 billion for fiscal year (FY) 2006, or just 10 percent of Gokhale and Smetters' estimate of the annual imbalance.

What's more, CBO's baseline budget outlook predicts that the negative gap between receipts and expenditures will narrow, rising to a $155 billion surplus in 2012. Gokhale and Smetters project the opposite, warning that America's deficit will deepen over time without a dramatic change in policy.

Why the difference in deficit estimates? Some of it comes from the choice of time frame. Tax revenues of late have surprised on the upside, boosting CBO's numbers. "Revenues tend to bounce around a lot," especially from one year to the next, says Robert Bixby, executive director of the Concord Coalition, a nonpartisan think tank focused on the federal budget. "But the long-term outlook doesn't change much."

There's also the political factor to consider. "The CBO is constricted by rules set by Congress," explains Bixby. For example, the 2001 and 2003 tax cuts are set to expire in 2010 and the CBO assumes as much, which implies a short-term revenue boost for the government down the road. But the expectation assumes too much, says Bixby. He predicts that Congress won't passively watch taxes rise in 2010. "That truly would be the biggest tax increase in American history, and Congress wouldn't let that happen," he says.

The point is that there's more than one way to forecast budgets. Even among those who generally agree with Gokhale and Smetters--that the deficit is fated to deepen--there's a debate over how much red ink is coming. Concord Coalition, for instance, expects the deficit to worsen, but by far less than what Gokhale and Smetters project (see chart below).

That leads to a third reason why forecasts can differ: accounting assumptions. Gokhale and Smetters' estimate is driven by a view that the government's financial commitments should be measured like pension fund-type liabilities. In fact, the idea has some appeal. The Federal Accounting Standards Advisory Board--the group that sets federal accounting guidelines--last year floated the idea of using corporate-style rules for the government's budgets.

No matter your choice of accounting templates, some aspects of the future budgetary challenges are beyond debate. Consider that Medicare accounts for the bulk of the government's future budget imbalance. The price tag for the program continues rising vigorously for reasons that won't soon be derailed--including an aging population and the relatively high level of health care inflation.

"The nation's long-term fiscal balance will be determined primarily by the future rate of health care cost growth," Peter Orszag, CBO's director, told the Senate's Budget Committee in June. "If health care costs continued growing at the same rate over the next four decades as they did over the past four decades," he explained, "federal spending on Medicare and Medicaid alone would rise to about 20 percent of gross domestic product (GDP) by 2050--roughly the share of the economy now accounted for by the entire federal budget."

It's tempting to dismiss it all as little more than the continuation of a debate that's as old as the Republic. Hamilton's mercantilism was bitterly opposed by Thomas Jefferson, who embraced an agrarian future for America. "The principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale," Jefferson complained in 1812.

Despite dire predictions from Jefferson and his philosophical heirs, the country survived and even prospered as Hamilton's view prevailed. Inspired by history, some dismiss the current budget warnings as driven more by a political than a fiscal agenda.

The Century Foundation, a public policy group in Washington, calls the unfunded liabilities issue a "ruse" in a 2004 essay. "Imagine if in 1950, someone had calculated the costs of educating the baby boomers in public institutions through their college years." No money had been set aside. "Yet nobody ever claimed in the 1950s and 1960s that the education of the baby boomers was an excessive burden...." Instead of alarmist warnings, "We need to strengthen social insurance for old people, and we will be able to afford it," the group asserts.

Still, the opposing school of thought says this time it's different. Really different. The United States faces a range of fiscal and social ills if the current course of spending (current and promised) isn't altered soon, warns a 2004 book ominously titled The Coming Generational Storm, co-authored by Laurence Kotlikoff, an economics professor at Boston University and research associate at the National Bureau of Economic Research. "Economic growth is not going to bail us out," the book predicts. "Nor will our parents, our trading partners, our immigration policy, our bosses, our technology, or our retirement behavior." What's the answer? According to the book: "Our only hope lies in immediately and radically reforming the Social Security and Medicare systems...."

But time's running out. Gokhale and Smetters say that the longer the imbalance is left unsolved, the bigger the problem. "Our nation's failure to adjust fiscal policies is like attempting to roll over debt," they write. "With accruing interest costs, the debt simply snowballs."

The government, with the power to print currency and service debt indefinitely, can always borrow more. But that luxury may come at a price if abused, including the so-called crowding-out effect. If the government runs afoul of Hamilton's "excessive" counsel, the result may push private borrowers out of the market as borrowing costs rise. Supply and demand, in other words, can't be denied indefinitely.

That, at least, is the theory. But nothing's quite so cut and dried when it comes to the interaction of the government and the capital markets. The budget deficit during the Reagan administration, for example, dipped into then uncharted red ink territory in the 1980s. Yet interest rates generally fell as the decade progressed.

Recent history too offers something less than full clarity on the relationship between interest rates and deficits. Consider the rare surplus of $236 billion for FY2000, as per CBO. By FY2006, it was gone--replaced by a deficit of $248 billion. Yet from 2000 on, the yield on the 10-year Treasury bond has trended lower. Underscoring the drift, in FY2003 when the deficit touched a record depth of -$376 billion in June 2003, the 10-year's yield swooned--touching a generational trough of 3.07 percent.

Of course, if one looks at the deficit as a percentage of the economy, there was more red ink in the 1980s. Meanwhile, an examination of the full sweep of history suggests that the crowding-out effect isn't easy to prove--or disprove. There are times when deepening deficits are accompanied by higher interest rates, but there are also periods when the opposite holds. The implication is that the crowding-out effect may or may not be relevant, depending on the circumstances.

Yet one could argue that the anticipated deficits (in absolute and relative terms) loom so large that the upward pressure on rates is virtually assured. If so, why hasn't the bond market already priced in the future now, today, this minute?

The capital markets are forward-looking machines, and the budget challenges are widely debated and dissected. Yet the recent deepening of federal debt has cast, at most, a slight impact on the price of money. Yes, the 10-year yield in June 2007 moved above 5 percent for the first time in a year. Nonetheless, it's hard to make the case that the bond market is becoming increasingly worried about fiscal troubles. Even if the 10-year yield jumped to 6 percent, that would still be lower compared to rates that prevailed for much of 1999 and early 2000, when the budget was in the black.

Investors can debate whether or not the capital markets are adequately discounting the future and the timing of the likely solutions: raising taxes or cutting benefits. One or both may be inevitable, but recent political history suggests that neither is imminent. All the more so given the onset of the presidential election cycle, which isn't likely to spawn a rush of politicians vowing painful policy prescriptions.

In fact, there may be a third way out: inflation. A government assuming ever larger piles of debt runs the risk of debasing the currency for easing the financial pain of swelling liabilities. Then again, the particulars of the future burdens don't lend themselves to overt inflationary therapy, says Gokhale. In an interview with Wealth Manager, he explained that the main drivers of the government's red ink--Social Security and Medicare--are largely immune to inflationary schemes.

"Social Security benefits are indexed to inflation so you can't use inflation to erode the benefits," Gokhale says. "Medicare benefits are also indexed because they're in-kind benefits." The cost of heart surgery and cholesterol drugs may rise, but if the government promises to deliver said service, the inflation burden is born by the state, at least initially.

True, although the inflationary fallout may eventually spill over into the money market. If the government's delivery of health care requires debt-based financing, as it almost surely will, higher inflation is a risk--in which case the investment outlook for bonds is suspect.

But the government's budget prospects may be more complicated than straight accounting implies. Concord Coalition's Bixby expects the deficit to deepen, but he makes a distinction between his outlook and the darker scenario painted by Gokhale and Smetters.

"I agree that the impending liabilities of Social Security and Medicare, and frankly the whole budget apparatus is thoroughly unsustainable over time," admits Bixby. "But to translate that into saying that this year's true deficit is $2 trillion isn't very realistic. What are we going to do? Raise taxes by $2 trillion? It doesn't give you a guide for any rational policy action."

Still, Bixby says that Gokhale and Smetters should be commended for reminding us that the fiscal challenges are huge. "But the government isn't a corporation, and [its programs] aren't private pension plans," he adds. "These are legislative entitlements; they're not contracts. That's why they're not, strictly speaking, liabilities. Congress has changed these programs in the past; it will change them in the future."

Maybe that's why Wall Street doesn't appear overly concerned with the country's destiny with debt--at least not yet. "One of the problems with issues like this--the really big issues---is that it's as if they never really materialize," muses Quincy Crosby, strategist at The Hartford. "There never seems to be a denouement."

At Payden & Rygel, a money manager in Los Angeles, chief economist Tom Higgins admits that the budget deficit has relevance for the long run. "But for an investment manager, we're focused on the next six to 12 months. In that time frame, it doesn't have a whole lot of implications for Treasury yields, the equity markets or the crowding-out effect," he adds.

Some optimists go so far as to say that the issue may not be all that relevant in the long run, either. In the dynamic market economy that is the United States, the private sector is likely to come up with solutions--solutions that aren't necessarily obvious in 2007. Meanwhile, the government will eventually do what it needs to do. It may not be easy, and it may take time, but according to this line of thinking, financial doomsday will be avoided once again.

The bond market seems inclined to agree. Deciding whether the wishful thinking has legs is the $64 trillion question, and one that will be answered one day at a time.

JAMES PICERNO ( is senior writer at Wealth Manager.

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