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...Federal expenditure commitments on account of massive government entitlement programs are growing larger and becoming less reversible. The traditional perspective on how significant inconsistencies between outstanding government liabilities and the government's future expected budget balances are resolved suggests that higher inflation could be the mechanism by which those two items are realigned with each other.
There is ongoing debate about whether faster inflation would occur because the Federal Reserve would eventually be forced to support the government's future debt-financed expenditures through monetary accommodation or whether a sudden realignment of prices could occur even without an independent or fiscally induced monetary expansion--following the predictions of the so-called fiscal theory of the price level (FTPL).
This article first outlines the scope of the prospective U.S. federal budget crunch by reporting the federal "fiscal imbalance" and its components. The fiscal imbalance measure compares, in present value terms, outstanding debt plus the government's aggregate non-interest spending commitments with its future revenues under current policies. Latest available calculations suggest that the federal fiscal imbalance equals $63.7 trillion. The Social Security program contributes $7.7 trillion to that amount. Assuming that annual general revenue transfers to Medicare are not dedicated to it, Medicare contributes $65.2 trillion, and the rest of the federal government, which includes Medicaid, contributes $89.2 trillion. (1)
An overall fiscal imbalance of $63.7 trillion suggests that expected future primary budget surpluses--government receipts minus non-interest expenditures--may (or should) be considerably out of line with the real value of outstanding government debt. Although the FTPL would predict an immediate price level adjustment, such an adjustment has not yet been observed. (2) And, although economists have attempted to garner evidence in support of the FTPL by analyzing evidence from other countries (most notably Loyo 1999), there is as yet a lack of broad consensus about the empirical validity of the FTPL. Because the FTPL essentially bypasses all concerns about the conduct of monetary policy, this article says little about the FTPL beyond noting it as a theoretically valid possibility. It devotes more attention to the traditional monetary-policy-supported inflationary mechanism as analyzed by Sargent and Wallace (1981).
Sargent and Wallace's "unpleasant monetarist arithmetic" provides the theoretical framework for analyzing how U.S. fiscal and monetary policymakers could be interacting. Although their framework is based on special assumptions about how fiscal and monetary policies are made, it reveals the tradeoffs involved depending on which of those two policymaking authorities acts as the "leader" and which acts as the "follower." Most common is to assume that the fiscal authority leads. But when it sets a permanent path for taxes and spending involving excessive debt creation, the monetary authority must coordinate its policies to accommodate that path by monetizing government debt.
On the basis of more realistic assumptions about fiscal and monetary authorities' policymaking horizons, however, this article suggests that current world market forces and the actions of both a "not-so-independent" Federal Reserve and shortsighted fiscal policymakers are worsening an already severe federal budget crunch by maintaining a severely out-of-balance fiscal policy. Continuing such a fiscal stance over many years implies redistributing resources from younger and future generations toward older ones. (3) That means future generations must pay by accepting either steep benefit cuts or permanently higher taxes, the latter possibly involving more rapid inflation.
Plumbing the Depths of the U.S. Fiscal Hole
The seeds of the looming economic difficulties were sown many decades ago by a combination of social insurance policies and a protracted boom-bust sequence in fertility rates that was completed by the mid-1960s. The consequence of that temporary fertility surge--a 76-million-strong baby-boom generation--is now approaching retirement with expectations of substantial Social Security, Medicare, and other entitlement transfers--roughly consistent with current benefit rules. (4) Fulfilling those expectations for a cohort equaling one-quarter of the total U.S. population would require steep increases in future taxes--not least because U.S. labor force and federal revenue growth are projected to slow just as the boomers begin retiring en masse toward the end of the current decade. One way of raising those larger revenues may be via faster inflation.
Table 1 shows an estimate of the U.S. fiscal imbalance with budget projections extended without a time limit. It shows that the United States faces a federal budget shortfall equivalent to $63.7 trillion as of 2006 calculated under the Office of Management and Budget's baseline economic and demographic assumptions (Gokhale and Smetters 2007). That means continuing current policies under those assumptions involves government debt plus the excess of projected outlays over receipts totaling $63.7 trillion in present discounted value. (5) Social Security contributes $7.7 trillion and the Medicare program contributes $65.2 trillion to the total federal imbalance. The rest of the federal government's contribution to the fiscal imbalance (which includes Medicaid) equals -$9.2 trillion. (6)
These fiscal imbalance figures have a simple interpretation: For example, Social Security's imbalance of $7.7 trillion shows the amount of additional resources that the government must have on hand, invested at interest, in order to forever avoid changing Social Security's current payroll tax and benefit policies. The same interpretation applies to Medicare's fiscal imbalance estimate. (7) Because the rest of the federal government account shows a negative fiscal imbalance, that federal sector could reduce taxes or increases outlays by as much as $9.2 trillion in present value. Of course, overall, the federal government is short by $63.7 trillion and must raise those resources by enacting future policy changes--reductions in scheduled expenditures or increases in scheduled taxes or some combination of the two. Tax increases are unlikely to be effective because of their likely negative economic impact. Nevertheless, if the Congress does not explicitly adopt either one of these two fiscal approaches in the not-too-distant future, faster inflation could emerge as a default adjustment mechanism.
Table 1 also shows that the fiscal imbalance will grow larger over time as long as no corrective policy adjustments are undertaken. For example, the imbalance as of 2007 amounts to $66.1 trillion since no policy changes were enacted in 2006 to reduce its size. The accrual of an additional $2.4 trillion to the fiscal imbalance arises because the dates when revenue shortfalls are projected to occur move nearer to the present with the passage of time. An alternative way to state this outcome is that the fiscal imbalance as of 2006 accrues interest. The current annual cost of postponing fiscal adjustments ($2.4 trillion) is about 10 times larger than the officially reported annual deficit for fiscal year 2006 (U.S. Treasury 2006).
If the fiscal imbalance under current policies is resolved largely by tax-side adjustments, how high must taxes be increased? Panel C of Table 1 shows that taxes on total payrolls would have to be increased immediately and permanently by 14.4 percentage points--a more than doubling of the existing payroll tax of 15.3 percent, most of which is levied on capped payrolls. (8)
Alternatively, if the fiscal imbalance were resolved largely through entitlement benefit cuts, those benefits (Social Security plus Medicare) would have to be reduced by 47.4 percent immediately and permanently. Yet another alternative would be to permanently cut all outlays except those on Social Security and Medicare by 65.5 percent.
Table 2 shows...
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