Road to Fiscal Folly Is Paved with Good Intentions

In their path-breaking 2009 book "This Time Is Different: Eight Centuries of Financial Folly" economists Carmen Reinhart and Kenneth Rogoff conclude it never is.

Total U.S. government spending at all levels is currently about $6 trillion, the total deficit is almost $1.5 trillion, the gross recorded public debt almost $20 trillion and unrecorded contingent liabilities are many multiples of that. Moreover, fiscal deficits under the Obama budget for 2013 are projected to accelerate, and even the Ryan budget doesn't project bringing the budget into balance for almost another three decades.

This surely qualifies as financial folly. According to a recent McKinsey study, only significant fiscal austerity measures, deep spending cuts and higher taxes, have worked in similar circumstances to either avoid or recover from the resulting banking crisis and economic distress.

Some argue to postpone austerity measures until the economy recovers from the last recession, but Greece and other euro zone countries waited too long and, along with Britain, have slipped back into recession. Global bond market fear of the alternatives bought the U.S. additional time, lulling politicians into a false sense of security, but when the Fed stops buying over 60% of the Treasury auctions we can expect the same pattern: U.S. banks will then be stuffed with "riskless" government debt.

This time certainly doesn't look to be any different. Combined federal, state and local spending in the U..S — currently 40% of GDP — could reach European levels of 50% if the public sector continues to grow as projected and private sector productivity doesn't rebound. It could be different if public policy doesn't undermine the incentives to work, spend, save and invest productively. Spending on war — especially a lost cause — isn't productive. The looming fiscal crisis reflects the cost of the social welfare state, which can be financed productively but that's much easier said than done, as evidenced by the fiscal state of European practitioners.

About 35% of the federal budget reflects transfers to the elderly for Social Security (20%) and Medicaid (15%). This is a relatively minor contributor to the current federal deficit but a primary contributor to long run deficit projections, especially Medicaid. Social Security and Medicare both substituted a pay-as-you-go funding scheme for individual retirement and precautionary health care savings. Beginning in 1983 Social Security purportedly replaced private savings with public savings to be deposited in the so-called Social Secuity Trust Fund, but politicians spent the revenue without recording the liability, an unrecorded contingent liability approaching $3 trillion.

The payroll tax is mandatory because both programs transfer income between generations, a favor not returned when demographics inevitably invert the pyramid as the old beneficiaries on top outnumber the young (16-24 year old) entrants. The day of reckoning, already here for Europe, has been advancing in the U.S. Social Security required general tax revenues to pay benefits starting in 2010, as Medicare has always done, due to falling youth labor force participation and productivity as well as rising costs.

Youth unemployment in the U.S. is almost 20% and overall youth participation in the labor force declined by 20 % from 1985 to 2010 due to employment laws discouraging hiring. Youth productivity in the U.S. is also impeded by the public education system. In spite of annual public spending on primary and secondary education of about $10,000 per student — double the private sector norm — public high schools graduate only about 70% of entrants, and even many graduates lack basic employment skills.

Direct public spending for public higher education is about the same, but these expenditures are generally not targeted to improving labor market productivity as 50% of recent college graduates are un-or-under employed.

Actuarial projections of the trust fund deficits are a charade perpetuating the political myth that Social Security is a self-funded retirement system and Medicaid a self-funded insurance system — hence an entitlement. ObamaCare adds another mandatory tax — insurance premium — to be collected by private insurers (or the IRS) to fund other new unfunded government entitlements.

The fiscal problem with Medicare and ObamaCare isn't the additional cost of providing health care to those currently not getting it — a relatively small and affordable amount. It is that, unlike private insurance, such public entitlement schemes inevitably undermine individual incentives to work, spend and save productively.

The folly in the Obama 2013 budget isn't the amount spent on the elderly and poor, especially for necessities such as food, housing and health care, and it would be a mistake to focus on making these "systems" actuarially sound and/or eliminating the reported fiscal deficit by raising payroll and income taxes. The folly is thinking that public political re-direction of "investment" to people and business — think Solyndra — increases productivity.

This time can be different only with pro-growth reforms that fix the numerous tax, expenditure and regulatory policies that undermine individual incentives, both within and outside these social welfare systems.

For example, the household saving rate has been trending down since about 1970 — through the peak baby boom earning years — recently turning negative, and it is reasonable to attribute this partly to the politically nurtured illusions and myths as well as federal lending programs — pervasive for housing and education — that eliminate the need to save. The government sector will remain in deficit for decades to come and foreign lenders have already headed for the exits. Working households are currently "de-leveraging" not by saving but by defaulting, an unsustainable trend. An increase in net household saving will likely come from the top half of the income distribution that currently and prospectively pays all income taxes as well.

Tax reform that encourages savings is needed; doubling the capital gains tax and raising dividend taxes as recently proposed will do the opposite.

Social expenditures on education, housing and health account for almost half of all government spending. Vouchers provide a comparable benefit to public delivery at about half the cost by relying on individual choice and private sector competition and efficiency.

Regulations purporting to protect the public interests often end up benefiting politically powerful interests at the public’s expense. The cost of unnecessary torts is estimated at $300 billion annually, mainly for health care, and other examples abound.

The good news is that policymakers aren't faced with a Hobson's choice — throw grandma from the train or derail the economy. The bad news is that this time is different only if the public interest prevails over politics. Winston Churchill's quip that "Americans can always be counted on to do the right thing…after they have exhausted all other possibilities" applies to European politicians who are only now discussing politically painful "pro-growth" reforms.

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is an economic and financial consultant and a principal of University Financial Associates LLC.