Mereja

Author: David Walker

  • Trust Funds Con

    Social Security is in trouble. According to the Social Security Trustees Report, the Social Security program was in a $7.7 trillion hole as of January 1, 2009. That means Washington would have needed $7.7 trillion on that date, invested at prevailing rates, to deliver for the next seventy-five-years on the promises that the federal government has made. But we actually need much more than that to keep Social Security healthy, because it will experience larger and larger deficits both in the near future and beyond the seventy-five-year accounting horizon. As of January 1, 2009, that number – the amount we would need to invest to ensure the sustainability of the program for seventy-five years and beyond – was $15.1 trillion. How much of this huge sum do we have invested in real liquid and transferable assets today – that is, how much in actual money? Zero, zip, cero, nada, nothing!

    The truth is that the government’s Social Security guarantee is one huge unfunded promise. How can this be? I have mentioned the Social Security “trust funds,” where our payroll taxes go. All this money is transmitted to the federal government and credited to the Social Security trust funds. You would logically assume that these funds would have hard assets that have been saved and invested to cover the program’s future costs. However, rather than saving the money and investing it in a diversified pool of real and readily marketable assets, the government spends it and provides “special-issue” government securities in return.

    Just consider what actually goes into those funds. First there are the numbers reported in government financial statements. According to those numbers, Washington had issued approximately $2.4 trillion in special-issue US government securities that had been credited to the Social Security trust fund as of January 1, 2009. The computer records documenting these securities are held in a locked file cabinet in West Virginia. But there is a reason they are called special-issue securities, and it’s not good. Unlike regular government bonds, which people like us and the Chinese government can buy, these special-issue bonds cannot be sold; in other words, they are government IOUs that the government has issued to itself, to be paid back later – with interest. Imagine if you or I could sit around writing IOUs to ourselves that were worth something. Great way to make a living.

    Washington says that we can count on these bonds because they are backed by the full faith and credit of the United States government, which guarantees both principal and interest. But – believe it or not – under current federal accounting principles, the government does not consider these bonds to be liabilities – which is another way of saying the government doesn’t really think that it’s our money.

    Think about that for a minute. If you or I lend the government money by buying a bond, the government has to pay us back with interest. In other words, that bond is a government liability. But when it comes to the Social Security trust funds, the government is saying the special-issue securities it deposits are not a liability – in other words, they’re basically worth nothing at all. Now get this: The trust funds report these securities as assets on the annual reports that they provide to the public. Does that sound like wanting to have your cake and eat it too? Con artists of the world, I hope you’re taking notes.

    In my view, these bonds should be treated as liabilities, and their value should be counted as part of our debt-to-GDP ratio. After all, they are backed by the full faith and credit of the federal government, and I do not believe the federal government will default on them.

    Under the current scheme, the Social Security program has been running large surpluses since the reforms of 1983. But in actuality, Washington has spent those surpluses every year on other government activities. That is one way the government can reduce its public borrowing and keep interest rates down.

    To say the least, the federal government’s accounting for these funds understates both its total liabilities and its annual operating deficits. That brings us to another clever bit of Washington wordsmithing: the “unified deficit.” In public reporting, the government takes the real operating deficit, $638 billion in fiscal 2008, and subtracts the nonexistent amount credited to the Social Security trust funds, $183 billion in fiscal 2008. This “unified” figure – $455 billion – makes the federal budget deficit seem smaller than it actually is. And they have been doing this for many years.

    These accounting tricks would never be allowed in the real world, where trust funds are subject to stringent accounting rules and fiduciary standards. In essence, Washington is playing a massive con game – collecting your Social Security taxes, spending that money for its own purposes, and accounting for it in trust funds that are largely a fiction. A more proper description would be “trust-the-government funds.” Or as my boss, Pete Peterson, would say, “You can’t trust them, and they aren’t funded.” Just another example of how words used in Washington don’t have the same meaning they have in Webster’s dictionary.

    Don’t worry, the reforms of the 1980s are still keeping the system above water. Monthly benefits should be paid in full for at least another three decades. However, the Social Security program will begin to pay out more than it takes in much sooner than that. The retirement and survivors income program expects its payments to exceed its revenues in 2010 and 2011. That will happen because revenue has declined during the recession – while at the same time, more people are retiring. When the federal government has to start cashing in the special-issue securities in the trust funds in order to pay benefits, it will have to raise taxes, cut benefits, and/or sell real bonds to the public in order to raise real money for retirees receiving benefits. If the government issues more public debt – in part to attract more foreign investors – that will likely increase our foreign dependency.

    Regards,

    David Walker
    for The Daily Reckoning Australia

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  • America Presents Unsettling Parallels With the Disintegration of Rome

    Perhaps because we are a young country, Americans tend not to pay much attention to the lessons of history. Well, we should start, because those lessons are brutal. Power, even great power, if not well tended, erodes over time. Nations, like corporations and people, can lose discipline and morale. Economic and political vulnerability go hand in hand. Remember, without a strong economy, a nation’s international standing, standard of living, national security, and even its domestic tranquility will suffer over time.

    Many of us think that a superpowerful, prosperous nation like America will be a permanent fixture dominating the world scene. We are too big to fail. But you don’t have to delve far into the history books to see what has happened to other once-dominant powers. Most of us have witnessed seismic political shifts in our lifetime. In 1985, Mikhail Gorbachev settled into his job as the Soviet Union’s young and charismatic new leader and began acting on his mandate to reenergize the socialist empire. Seven years later that empire collapsed and disappeared from the face of the Earth. Gorbachev runs a think tank in Moscow now.

    In a sense, the larger world is starting to resemble the nasty and brutish life that long has characterized the corporate world. Just ask Jeffrey Immelt, chairman and CEO of General Electric. Of the twelve giants that made up the first Dow Jones Industrial Average in 1896 – all of them once considered too big to fail – only GE remains. The other towering names of the era – the American Cotton Oil Company, the US Leather Company, the Chicago Gas Company, and the like – all have faded away. And as GE stands against the winds of today’s financial challenges, ask Immelt whether there is such thing as a company that is too big to fail.

    I love to read history books for the lessons they offer. After all, as the homily goes, if you don’t learn from history, you may be doomed to repeat it. Great powers rise and fall. None has a covenant to perpetuate itself without cost. The millennium of the Roman Empire – which included five hundred years as a republic – came to an end in the fifth century after scores of years of gradual decay. We Americans often study that Roman endgame with trepidation. We ask, as Cullen Murphy put it in the title of his provocative 2007 book, are we Rome?

    The trouble is not that we see ourselves as an empire with global swagger. But we do see ourselves as a superpower with global responsibilities – guardians if not enforcers of a Pax Americana. And as a global power, America presents unsettling parallels with the disintegration of Rome – a decline of moral values, a loss of political civility, an overextended military, an inability to control national borders, and a growth of fiscal irresponsibility by the central government. Do these sound familiar?

    Finally, there is what Murphy calls the “complexity parallel”: Mighty powers like America and Rome grow so big and sprawling that they become impossible to manage. In comparing the two, he writes, one should “think less about the ability of a superpower to influence everything on earth, and more about how everything on earth affects a superpower.”

    A superpower that is financially reliant on others can be vulnerable to foreign influence. The British Empire learned this in 1956, when Britain and France were contesting control of the Suez Canal with Egypt. The Soviet Union was threatening to intervene on Egypt’s side, turning the regional dispute into a global showdown between Moscow and Washington. The Eisenhower administration wanted to avoid that, and the United States also happened to control the bulk of Britain’s foreign debt. President Eisenhower demanded that the British and French withdraw. When they refused, the United States quietly threatened to sell off a significant amount of its holdings in the British pound, which would have effectively destroyed Britain’s currency. The British and French backed down and withdrew from Suez within weeks.

    The US dollar has never come under a direct foreign attack (though its vulnerability is growing). A direct foreign attack would result in a dramatic move away from the dollar. That would lead to a significant decline in its value, as well as higher interest rates. This is often referred to by economists as a “hard landing.” In lay terms, it’s more like a crash landing. Still, Americans have become intimately acquainted with the shocks of financial instability. Americans of a certain age still vividly recall the depths of the Depression in the 1930s and the chaos of inflation and long gasoline lines during the oil shock of the 1970s. We will also remember the financial collapse that began in 2008, and we pray for nothing worse. Some of our smartest financial thinkers are praying right along with us. “I do think that piling up more and more and more external debt and having the rest of the world own more and more of the United States may create real political instability down the line,” investor Warren Buffett has said, “and increases the possibility that demagogues [will] come along and do some very foolish things.”

    Regards,

    David Walker
    for The Daily Reckoning Australia

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  • Cleaning Up America’s Fiscal Policy

    Those of you who are parents (and I’m a parent) may want to reject out of hand the idea that we are in effect stealing from our children’s future and bequeathing to them a far less prosperous life. But if we don’t begin to address our fiscal challenges soon, it’s only a matter of time before the consequences begin to show up, most likely starting with higher interest rates. As things get worse, our children will slowly see their living standards decline. We can still prevent these things from happening. The ultimate goal of cleaning up our fiscal policy is not to avoid a recession or even to balance the budget per se – it’s to pass on the kind of healthy, vibrant nation that we inherited.

    It’s easy to fall back on generalities – that America is a great country, and that we always rise to great challenges and will do so again. True, but we can only succeed by taking action, and we have a lot of action to take. Let’s say we do take only small steps to address our fiscal crisis. Let’s say we stop cutting taxes, but we don’t increase them radically either. Let’s say our government continues to take in about the same level of historical revenues, but we hold discretionary spending to 2008 levels as a percentage of the economy, and we don’t expand health care or other entitlements any further. That sounds pretty benign, but it’s actually a disaster scenario for our children.

    Let’s take the example of kids born in early 2000, when our national budget was in balance and the technology-powered future seemed bright.

    During the first eight years of their lives, we have learned, the nation’s financial hole grew by 176 percent to $56.4 trillion. And the number is not standing still. That was its size as of September 30, 2008 – before the official declaration of a recession, before the significant market declines of October 2008, and before the big stimulus and bailout bills designed to jump-start the economy and address our immediate financial crisis. In fiscal 2007, recall, our budget deficit was $161 billion, or 1.2 percent of the economy. By 2009, the deficit soared to $1.42 trillion, which is about 9.9 percent of the economy. Just think about that for a second. Our federal deficit grew by almost nine times in the past two fiscal years!

    Given our scenario – no benefit cuts, no tax hikes – the government would have to finance this gaping hole mainly by borrowing money from domestic and foreign investors, with interest. Don’t forget, according to the GAO’s latest long-range budget simulation, even without an increase in overall interest rates, our interest payments would become the largest single expenditure in the federal budget in about twelve years. And what do we get for that interest?

    Nothing!

    Of course, something will have to give before we get to that point. However, the government has overpromised and underdelivered for far too long. How can we fix things? Will we cut benefits, those mandatory payments that are chiseled into law? Or will we raise taxes to onerous levels? We will probably have to do some combination of both. That is, we will have to renegotiate the social contract with our fellow citizens and raise taxes. However we do that, our kids will pay the price. And the bigger the bill we pass on to them, the bleaker the future we will bequeath to them.

    Let’s assume that Washington policy makers continue to punt on making tough spending choices and ultimately raise taxes to address the growing deficits. Nobody will reach in our kids’ pockets and take their money because the government will take it before it even reaches their pockets. What will that mean for their after-tax income? Right now, on average, Americans pay about 21percent of their income in federal taxes and another 10 percent to state and local governments. By 2030, to pay our rising bills, that amount could be at least 45 percent – higher even than the average 42 percent that most Europeans pay. By 2040, it would be at least 53 percent and climbing. In reality, total taxes in 2030 and 2040 would be even higher than these estimates because of the fiscal challenges facing state and local governments – such as Medicaid costs, unfunded retiree health care promises, underfunded pension plans, deferred maintenance and other critical infrastructure needs, and higher education funding.

    With reductions in disposable income like that, the children of 2000 will inherit a much different kind of America in 2030. That’s when they will be turning thirty, entering their most productive years.

    So much of their money will be devoted to keeping the government afloat that they’ll have relatively little for everything else in life. Their homes will be smaller and drabber. There will be less to spend for cars, vacations, dinners out, and big TV sets, all of which their parents took for granted. They’ll still read about the consumer society and conspicuous consumption, but mainly in history texts. Maybe it’s a good idea for America to become less materialistic – but the idea should be to give our children that choice, not to impoverish them.

    Regards,

    David Walker
    for The Daily Reckoning Australia

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  • The US Federal Budget

    The recession and attendant financial shock appear to be easing as I write this. But in Washington, financial imprudence is part of the fabric of government. You can see that in a single document that gets updated every year: the US budget. In putting together the budget, the president and Congress set our national priorities and allocate resources among them. The results have been pretty consistent. Over the forty years ending in 2008, revenues have averaged about 18.3 percent of our economy and spending has averaged over 20.6 percent, resulting in an average deficit of about 2.4 percent.

    But that gap began to widen under Bush 43, who cut taxes while starting two wars, bolstering homeland security, adding an expensive prescription drug benefit to Medicare, and increasing other spending. In 2007, the federal deficit stood at $161 billion, or 1.2 percent of our economy. In 2008 it was $455 billion, or 3.2 percent. In 2009, figuring in the billions spent to pull our economy out of recession and on various bailout efforts, the deficit rocketed to about $1.42 trillion, 9.9 percent of our economy.

    In Washington, they speak of our “fiscal exposure” – the sum of all the benefits, programs, debt payments, and other expenses that will cost us big bucks in the future whether or not we want to cut spending. The term I’ve used for all of that is our “federal financial hole.” In the first eight years of this century it has grown from $20.4 trillion to $56.4 trillion – a 176 percent increase.

    Maybe you have a few bills – mortgage payment, auto loan, cable TV, phone – deducted automatically from your checking account. How would you feel if those expenses had risen 176 percent in eight years while your income remained steady?

    The hole is getting deeper because we are doing little to bring our income into line with our spending. And until now I haven’t even talked about the interest payments on our federal debt. Suppose our government fails to increase federal revenues above the current rate. Based on the GAO’s latest long-range alternative budget simulation, within about twelve years, our interest payments will become the largest single expenditure in the federal budget. By 2040, all of our federal tax revenues will add up to enough to cover only our two biggest expenses: interest on our debt and Medicare and Medicaid. Everything else – Social Security, defense, education, road building, you name it – will fail to be funded.

    As you know, benefits payments are the biggest chunk of the government’s massive obligation. Since the 1960s, the growth of these mandatory payments has overtaken what we spend on defense as a share of our national output – and what we spend on everything else in our federal budget, from law enforcement to border protection, children’s programs to national parks, highways to foreign aid.

    Although defense has declined dramatically as a percentage of the overall federal budget over the past forty years, we have actually increased total defense spending. In recent years, we have added resources to fight terrorism abroad. That means that other discretionary programs are much more susceptible to cutting. These include education, research, transportation, infrastructure, and other programs that, if properly designed and effectively executed, can promote economic growth and development. How will squeezing those areas serve to keep America great?

    All of this puts us in a major-league quandary. Our nation has to bring what we earn into line with what we spend at a time when our spending literally is out of control. One option – cutting investments in America’s future in order to finance our large and growing mandatory spending programs – is another way of cheating the next generation. Unfortunately, today we are both cutting our investments in the future and handing our descendants a mountain of debt. That is a double whammy for young people and the unborn. It’s not just irresponsible, it’s immoral and downright un-American.

    David Walker
    for The Daily Reckoning Australia

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