This is the season when Frank Capra's "It's a Wonderful Life" is replayed more than any another movie. Younger viewers may be surprised to learn that people once actually made deposits – as small as a nickel or dime – to fund their down payments for mortgages, health care and retirement.
Starting in the 1970s, long-term savings moved from banks (and at that time thrifts) to capital markets, and mortgage lending followed. In the 1980s people started saving less for health care and retirement because the government promised to do that for them. And starting in the late 1990s the government also started to reduce and eventually eliminate the need to save for a down payment on a house.
Loans with little or no down payment were the root cause of the recent financial crisis. The failure to save for health care and retirement is the root cause of the next financial crisis.
The "fiscal cliff" – an automatic rise and federal taxes and cut in expenditures – will undoubtedly make a bad economy worse and could throw the economy back into recession. Just as George Bailey survived his plunge in the movie, so too will the U.S. economy. But it won't survive the policy that half the population shouldn't pay income taxes while most households should be entitled to mortgages, health care and retirement benefits without saving for them.
Social Security was introduced and administered as a pay-as-you-go welfare scheme in 1935 using language usually associated with retirement plans, a ruse that continues to this day. Life-cycle retirement spending schemes are funded in advance with savings, and because people require a lot more care in old age when their income is lowest health care expense is also inextricably linked to life-cycle savings.
Private retirement systems in the U.S. are required by law to be essentially fully funded. The amount of savings required depends primarily on the retirement age relative to life expectancy, the promised benefit and the return on investment. Public retirement funds are also generally expected to be fully funded but are exempt from assuming a realistic rate of return, resulting in underfunding by about $5 trillion.
Politics expanded the federal entitlement promises of the purportedly self-funding pay-as-you-go pyramid system to the point where the cumulative difference between the future revenues under the current tax structure and the future benefits is now an estimated $100 trillion, the current "unfunded" federal liability. Had the same funding laws been applied to these entitlements, the current required fund would be about $50 trillion discounted at the Treasury yield used for Social Security (and about half that amount at the much higher discount rate used by state and local government retirement funds).
To put that figure in perspective, U.S. household wealth is currently about $65 trillion. This additional funding would have just about offset the dramatic decline of household savings over the last three decades.
Policymakers now face a Catch-22. The past saving shortfall obviously reduced investment and economic growth well below potential, water over the dam at this point. Now compound interest works in reverse: the consequence of past underfunding is reduced future household consumption, in this case by the estimated $100 trillion.
That leaves three possible solutions: announce the "fraud" and default on entitlements; redistribute income from others by increasing taxes; or continue to borrow the money from foreigners and subsequently default through inflation to reduce foreign household consumption.
Trying to shrink entitlements and the public sector while raising taxes has led to social unrest in Europe and there is no reason to believe that will be different here. While the southern European countries are dependent on a German bailout, U.S. politicians think we can "grow" out of the problem. But current policies are anti-growth and all of these proposed solutions are likely to be so as well, discouraging savings. Cuts in entitlements will cause the elderly to draw down their own personal savings faster and reduce bequests to and depend more on their children, who are already in bad shape as a result of the last financial crisis.
A Federal Reserve report released in June 2012 showed a 38% decline in the median net worth of U.S. households from 2007 through 2010 from $126,000 to only $77,300, a level last seen in real terms in 1992, but the median household's share of existing federal liabilities is $140,000, almost $50,000 of which is owed to foreigners.
There isn't much time. Carmen Reinhart and Ken Rogoff, in their 2011 study "Growth in a Time of Debt," found that from 1790 to 2009, once a developed or developing country – including the U.S. – exceeded a 90% debt-to-GDP ratio, economic growth slowed by nearly 2% annually for nearly a decade with accelerating inflation. The U.S. ratio is already above 100%. Robert Gordon believes that the low trend rate of private sector productivity growth in the U.S. since the 1960's will inevitably worsen, resulting in a century of stagnation.
Even the most ambitious pro-growth policies will fail without sufficient savings. The threshold for not paying taxes should be dropped from the current median income household to the bottom quintile. In return, liberal tax credits should be provided for down-payment savings accounts, health savings accounts and individual retirement savings accounts while phasing the younger generation out of the unfunded federal entitlement pyramid scheme altogether.
The biggest systemic threat currently facing the country is the inevitable rise in interest rates and collapse in long term bond prices, reflecting the dearth of domestic savings. The Financial Stability Oversight Council, chaired by the Treasury secretary with the Fed's chief as vice chairman, hasn't yet sounded this alarm. As with housing policy, it will likely be up to the financial markets to deliver the truth. And take the political blame!
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.