Debt and Deficits in the face of Baby Boom Retirement

1. Debt and Deficitsin the face ofBaby Boom Retirement Winter 2006 Economics 102

2. Core issues • Current large fiscal deficits • Modest national debt levels • Large demographic changes • How do they add up?

3. deficits

4. Intl debt-to-GDP

5. Debt to GDP

6. Sustainable? • Yes, if debt/GDP doesn’t rise much • If GDP increases at (1+g) then debt needs to increase by less • Deficit including interest must be less than g or about 4% [2% real plus 2% inflation] • With debt of 80% of GDP and 5% interest that component is 4% of GDP • Thus on average need balanced budget • Note that this includes social security

7. First glance • US doesn’t look so bad • Need to close 4% of GDP gap • Some small portion cyclical, 0.5% of GDP? • Hence reduce expenditures • Not much “fluff” outside of defense • If can cut defense by 1% of GDP… • Else must raise taxes • Must undue much of Bush tax cuts • Net around 1.5%, assuming we end the “war on terror” [that is, creating more terrorists?]

8. aging

9. Share of 65+ in population

10. Old-age dependency

11. Baby boomers • Retirees per worker shifting • Since pensions are pay-go, either taxes or savings must rise • Given the past 2 decades in the US, we shouldn’t be optimistic about the latter • Hence “saving” social security is critical • Pension related numbers are not huge • Health care costs are

13. US Social Security Costs

14. Spending projections

15. The big issue is health care reform

16. Future shifts • Social security perhaps +2% of GDP • Combination of • modest cuts to benefits • Modest increases in taxes • Gradual boost in retirement age • Health care • +4% of GDP in optimistic case • Present value is 5x social security

17. So how add up? • Current structure is large international imbalances • Result of low domestic savings and high government dissavings • (S-I) + (T-G) = (X-M) • 0/- - -- in magnitude • So what changes with retirement?

18. need • +2.5% of GDP to correct deficits • +2.0% of GDP to fund pensions • +5.0% of GDP to cover health care • +10% of GDP as order of magnitude • Absent effective health care reform

20. Back to S-I savings invesment balance • (S-I) + (T-G) = (X-M) • Need boost T gradually • Not a crisis, multiplier impact if do too quickly • Flash point: crowding out • Can we run larger trade deficits • Permitting more workers to shift to health care • Will we squeeze investment? • Ditto, but resulting in lower long-term growth?

21. What happens if we annoy OPEC? • Money fungible: global savings flows matter, not whether Dubai buys US bonds • Could have significant short-term impact • Slow rise in interest rates • Accompanied by depreciation of dollar • My prediction: pain both at home and internationally • High interest rates squeeze growth • High prices (weak dollar) squeezes consumption

22. Politics • Open questions: not my specialty • Econ majors required to take politics! • Little sense that proactive policy likely • Bankruptcies due to “legacy” costs • Force more onto Federal budget and force reform? • Health care crisis • Force interventions to keep hospitals open and doctors in practices? • Interest rate erosion • Market forces will keep gradual but stimulate politics? • High debt to GDP will potentially make it hit deficits in short run

23. The good side • US productivity growth robust • But need to improve education! • US demographics strong • Especially if we don’t clamp off immigration • Our debt all in dollars • Foreign exchange crisis impossible • So can inflate away what you owe to the rest of the world • But not on Bernanke’s watch!