The Social Security and Medicare Burden
(October 25, 2007)
Dear Subscribers and Readers,
In a recent issue of the Financial Analysts Journal (a CFA Institute publication), two of the authors discussed the topic of the Social Security and Medicare liabilities, and how that is going to impact the government's deficit going forward. The article, entitled “Do the Markets Care about the $2.4 Trillion U.S. Deficit?” begins by criticizing the government's form of accounting and its knack of “pulling the wool” over the population's eyes. Quoting the article:
The U.S. federal government's current method of accounting makes that of former Enron Corporation look almost pristine. The long-term imbalances in the nation's entitlement programs, including Social Security and Medicare, are not integrated with the rest of the budget, although in the private sector, ignoring retiree health and pension programs would be illegal. If the federal government properly accounted for its explicit and promised liabilities, it would record a national debt of $63.7 trillion in 2006 and a national [annual] deficit of $2.4 trillion.
This article would explore two things. First of all, how is the $63.7 trillion deficit derived? Second of all, is the market rational? That is, is it ignoring the Social Security and Medicare liabilities or has it already discounted these potential “twin burdens” going forward?
First of all, it is interesting to note that this is not the first time this has been discussed – either in the mainstream financial media or on the MarketThoughts.com website. Various calculations of the present value of the sum of Social Security and Medicare liabilities have been bandied about over the last few years. While not all of them were in the same “ballpark,” they usually lie in the range of US$40 trillion to US$80 trillion. In calculating the $63.7 trillion number, the authors used the following assumptions:
- An annual labor productivity growth rate (change in hourly labor compensation) of 2.0% a year
- A CPI of 2.5% a year
- A real discount rate of 3.65% a year, which is a little bit high by today's standards (thus lowering the liability number) but is consistent with the long-term average of the 30-year Treasury rate
- A gradual increase in the health care cost as a percentage of GDP, with Medicare Parts A and B costs growing by one percentage point faster than GDP per capita from 2009 to 2016, while Medicare Part D is assumed to grow five percentage points faster than GDP per capital during the same period. From 2017 to 2020, Part A is assumed to grow faster than GDP by 2.8%, Part B 2.8%, and Part D 5.5%. From 2020 to 2041, total health care costs are expected to only grow 1.5% faster than GDP, and after 2041, this is expected to grow at the same level as GDP growth. This is consistent with the Office of Management and Budget's projections. By far, this is the most important assumption in the authors' projections.
The authors argued that these assumptions are very optimistic relative to historical standards. For example, total health care expenditures in the US rose from 9.1% of GDP in 1980 to 16.0% by 2004. Moreover, it is unreasonable to expect any substantial Medicare reform anytime soon, given that this hasn't occurred with Social Security yet – a problem which has been discussed and acknowledged extensively but which is still facing political Gridlock in Washington. By comparison, Medicare will require a much more lengthy and “painful” debate about which drugs and procedures the program will cover. Moreover, the authors are actually using more optimistic assumptions compared to the Social Security and Medicare trustees, a group that is composed of the Office of the Actuary at the Social Security Administration and the Centers for Medicare and Medicaid Services. The latter's liability projection is actually more than $10 trillion higher!
To put this in perspective, $63.7 trillion is greater than the entire net capital stock of the US – that is, greater than the market value of all property, land, buildings, infrastructure, automobiles, financial assets, and consumer durables combined – by as much as $20 trillion. While this does not include the value of human capital or other intellectual capital such as patents (although one can argue that the value of patents are already reflected in the share prices of public companies), this point is relatively moot since human capital cannot be readily converted to cash by selling out to foreigners (as an aside, the authors contend that the value of human capital in the US is approximately $130 trillion).
Put another way, the $63.7 trillion shortfall is equivalent to a “confiscation” of about 6.6% per year , and the fiscal imbalance is expected to increase by $2.4 trillion (hence the $2.4 trillion national deficit number in the title of the article) each year that the law remains unreformed. Instead of the $200 billion or so that the government reports as its official budget deficit, the authors contend that – under US GAAP accounting – the government should be reporting a deficit that is closer to $2.4 trillion for 2006. In order to make up this deficit going forward, an additional (perpetual) 14.4% tax on wages and salaries will need to be implemented immediately.
In a rational world, the capital markets would already have discounted the above deficit. But given the current low interest rate environment (the decline of the U.S. Dollar over the last five years doesn't really count, as the Euro Zone has bigger fiscal problems down the road than the US), one can safely say that the capital markets have, so far, brushed off these concerns. The authors came up with four hypotheses as to why the capital markets are unconcerned:
- Unfunded liabilities such as Social Security and Medicare are not real – they are merely a projection of an uncertain future. The authors contend that there are great political and technical obstacles for reducing or removing this liability, as increasing taxes or monetizing the liabilities through inflation can only do so much (in fact, one can even argue that higher inflation would compound the problem, as it usually results in less real economic growth).
- Stein's Law: “That which cannot go on forever won't.” Policymakers and investors alike have great faith that future policymakers will figure out how to “fix this problem.” Of course, there is no question that this will be fixed, but the question is “How?” Again, the authors contend that there isn't enough “willpower” in either the White House or the Congress to eliminate this projected imbalance by cutting back healthcare spending significantly. As a result, the only alternative is for higher taxes and higher inflation.
- An uncertain future. That is, 30 years from now, the world would look very different, resulting in many secular trends such as: a) people being more productive and working much longer, 2) improvement in medical technology that will greatly reduce costs, 3) people may have a greater willingness to pay taxes going forward, and perhaps even work harder as well. However, the authors contend that any information we have available to date does not justify this very optimistic outlook, and that their projections are actually optimistic relative to other forecasts.
- Foreigners will bail us out by buying out assets, but this argument has a flaw: It ignores the US fiscal sector altogether, along with its projected shortfalls and taxing power. Moreover, many of the US creditors, such as Europe, Japan, and even China are also going to be facing great fiscal burdens down the road given their own aging populations. Rather than bailing us out, many foreign countries will be more concerned about their own financial problems instead.
Given their study and their conversations with fixed income investors and traders, the authors concluded that: Conversations with fixed-income investors reveal an enormous myopia about the implications of the financial problems facing the federal government. Even worse, these informal discussions reveal a high degree of herding, reinforced by the view that capital markets are always efficient: Because capital market participants exhibit close to zero concern about the long-term financial problems facing the government, those problems must not really be important. The general belief that capital markets cannot be wrong is exactly why they can, however, and why an Argentina-type disaster can happen in the United States. The financial shortfalls that the federal government faces are unprecedented, as investors will eventually figure out. Hopefully, policymakers will have the wits and political will to address these shortfalls soon and avoid a situation in which investors suddenly realize the shortfalls' implications and attempt to exit the fixed-income market all at once.
As I have discussed before, market participants periodically tend to swing towards extreme optimism or pessimism. At any point in time, there is usually a good balance of good news and bad news – market prices tend to just depend on what investors would like to focus on at any particular point in time. For example, just six months ago, one can argue that risk aversion in the financial markets was virtually zero, as both high yield and emerging market (and of course, subprime) spreads closed at their lowest levels EVER, which as I had pointed out, did not reflect a realistic view of what these asset classes would and can do going forward. Today, we are seeing a quite different story, especially in structured finance products that involve subprime securities or leveraged loans. At some point, the financial markets will choose to focus on the Social Security and Medicare burdens, even if the necessary medical technology does come along 20 years from now and wipe out this liability. The $64 billion question is, as always, “When?”
Henry To, CFA