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The Next Four Years of Fiscal Conservatism: What Must Be Done to Sustain the Nation

Economics Tax & Budget

Yesterday the nation paused to celebrate the second inauguration of President Obama and to listen to his second-term plans as laid out in his inaugural address. At the same time, we at e21 believe this is the perfect time for fiscal conservatives to take stock of the challenges over the next four years and beyond facing those who favor lower taxes and spending. With another four years of Obama presidency ahead, the fiscal woes of our country appear to be on a continuing downward path that could result in disastrous financial consequences for the United States and perhaps the world if not addressed quickly. We checked in with three of e21’s best policy minds to get their takes on what issues fiscal conservatives should be worried about and how to address the next four years in order to keep the nation from another fiscal crisis.

Leadership on Social Security Desperately Needed

Charles Blahous

When President Obama was first inaugurated four years ago, the budget-related meme of the moment was that virtually all of our projected fiscal problems were due to health care, and Social Security represented a relatively small problem. After all, the previous year’s trustees’ report had shown twice as large a deficit in Medicare’s HI fund than was projected for all of Social Security.  The previous December Social Security was barely mentioned in a comprehensive memorandum on economic and fiscal issues provided to the president-elect by his advisors. The long-term deficit was said then to be “driven primarily by rising health care costs” alone.

What a difference four years make. Little of what was said then has turned out to be true. First Social Security was hit hard by the recession, depressing its payroll tax revenue and stimulating additional disability and early retirement benefit claims.  Social Security’s expenses began to exceed its tax income in 2010, earlier than projected in any prior trustees’ report.  The program began adding substantially to the federal deficit and is now projected to do so more with each passing year. The Social Security disability trust fund is now projected to be insolvent in 2016, just three short years away.

While Medicare remains the greater long-term threat to the general federal budget, in many respects the Social Security problem has surpassed it in near-term urgency. Over President Obama’s first term Social Security expenditures remained, as expected, higher than Medicare’s. But Social Security’s cost growth was greater as well – not only in aggregate dollars (annual costs grew by over $160 billion in Social Security vs. less than $120 billion in Medicare) but even in its rate of growth. Over the past four years, annual Social Security costs have risen by 26% (25% for Medicare).

Not only does Social Security disability face insolvency in 2016, but the overall program’s actuarial deficit is now roughly twice as large as Medicare’s. Of course, the actuarial imbalance is not the only meaningful indicator of the financial strains caused by the two programs. It does, however, mean that Social Security is the program for which stronger actions are now required to prevent insolvency.

We clearly cannot afford to wait until Social Security is nearing its projected insolvency date (2033 for its combined trust funds) to make the needed repairs. Well before then the choices will become so onerous that there is little practical likelihood they will be made. One reason is that lawmakers generally try to avoid cutting Social Security benefits for those already collecting them. By 2033, even eliminating all benefits for new retirees would be insufficient to close the program’s deficit, as would the largest payroll tax increase heretofore enacted. With so many baby boomers now entering the Social Security rolls each year, the window of opportunity for stabilizing its finances is shutting very soon.

As I have explained before, there is no precedent for completely closing a Social Security financing shortfall of the size we now face, meaning it may already be too late to get the job done. To save the program in 1983 lawmakers had to do a number of difficult things: delaying COLAs by six months, raising the retirement age, exposing benefits to income taxation, bringing federal employees and their payroll taxes into the program, and accelerating an increase in the payroll tax, among other things.  These changes were so controversial that they drew the spirited opposition of the AARP and almost didn’t happen even though an interruption of benefit checks was just months away.  Yet today we face a shortfall nearly twice as large in relative terms; to sustain the program now the political left must agree to twice as much in benefit restraints, and the right twice as much in tax increases. There is no assurance that this will happen. And with every year of further delay, the problem becomes even less likely to be solved.

Despite all this, White House Social Security rhetoric has thus far barely changed from four years ago. Some senior Administration officials have continued to downplay the Social Security shortfall as though the program’s financial downturn never even happened. Outside of the White House, it is impossible to know the reasons for this inattention. Without action, Social Security costs will grow to absorb fully one out of every six dollars workers earn within just twenty years, such that the program could only be sustained by merging it into the general fund, ending the perception of Social Security as an “earned benefit” and having income taxpayers subsidize payments as with other welfare programs. Many of us would regard this as a disastrous end to FDR’s Social Security legacy; one hopes President Obama would as well.

Social Security would warrant reform even if insolvency were not threatened. As currently structured it will ultimately fail to meet minimum standards of fairness and efficacy. Young workers now entering the Social Security system as taxpayers are projected to lose over 4% of their lifetime wages to the program, even if they receive all benefits now being promised.  The program also acts as a drag on employment, especially by seniors.  I have proposed reforms to repair the program’s severe work disincentives while also improving its finances.  We also need to change the benefit formula if for no other reason than that the cost of maintaining the current one forces workers to experience declining pre-retirement living standards.

The recent discussion of possible changes to the Consumer Price Index (CPI) exemplifies the continuing lack of seriousness about Social Security. Correcting how we measure inflation is not a Social Security reform – it is merely a government-wide technical reform that happens to have a beneficial spillover effect on Social Security finances. For some to react to this as a severe Social Security “cut” is absurd. If we cannot even make a technical correction in CPI, pursuant to the clear intent of current law to accurately measure inflation, simply because it would slightly slow the growth of program costs, we are in big trouble: real Social Security reform will ultimately require adjustments roughly six times as large.

Given all this, is there hope for Social Security? There is, if the President leads. Remember that in his 2010 health reform effort he persuaded his own party’s legislators to support cuts in Medicare growth far greater even than what is now required to fix Social Security finances. His political base accepted enormous entitlement reductions they surely would have attacked had these been proposed from across the aisle. I thus have no doubt that if President Obama chooses to lead on Social Security, making an aggressive case for prompt action and pursuing specific reforms, it can be done. Without such leadership, however, Social Security’s days as a self-financing program are almost certainly numbered.

The Urgent Need for Genuine Health and Entitlement Reform

James Capretta

As President Obama begins his second term, the nation's strained fiscal policy remains front and center on the national agenda, and for good reason. Over the period 2009 to 2012, the federal government ran a cumulative deficit of $5.4 trillion -- nearly doubling the debt that had been accumulated from 1789 to 2008. The tax legislation passed at the beginning of this year will close projected future deficits modestly over the coming years compared to what would have occurred if the entire Bush-era tax policy had been permanently extended. Estimates produced by the White House Office of Management and Budget show ten-year deficit reduction of just $630 billion from the tax deal. The Congressional Budget Office (CBO) has yet to release its updated projections, but when it does those estimates will almost certainly show the gap between future projected spending and revenue remains far too wide and will never fall back again to historically benign levels.

At the heart of the nation’s fiscal challenges are the rising costs of the major health care entitlement programs -- Medicare, Medicaid, and the new subsidies provided by the 2010 health care law. In 1972, total federal spending on Medicare and Medicaid was just 1.1 percent of GDP. By 2010, the costs of these programs had risen to 5.5 percent of GDP, and CBO projections from last year show the costs rising to 9.1 percent in 2030 when the new entitlement spending from Obamacare is also added in and when plausible assumptions about on-going enforcement of arbitrary cost-cutting measures are used.

The prospects for seriously addressing the problem of health entitlement spending is not promising in the president's second term in large part because there is a sense in his administration and among congressional Democrats that Obamacare has already largely solved the problem. They argue that the provisions cutting future Medicare spending in the new law will work, and that numerous, government-initiated efforts to cut costs (such as the Accountable Care Organization program in Medicare) will fundamentally transform how health care is delivered in the United States.

But the actual results from Obamacare are likely to fall far short of the high expectations of the law’s supporters. For starters, the cuts in Medicare will almost certainly get undone in coming years because of the harm they will cause to seniors. Obamacare’s cuts to the Medicare Advantage (MA) program – the private insurance option in Medicare – is expected to push some 4 million seniors out of their MA plans by 2018. Moreover, the cuts in payment rates for hospitalizations and other services are so arbitrary and deep that the chief actuary for the program has stated they will force 15 percent of institutional providers to stop admitting Medicare patients.

At bottom, the disagreement over how to reform the health entitlement programs is a fundamental difference over how best to bring cost discipline to the wider health system. The president and his allies are firmly committed to a vision in which the federal government makes all of the important decisions about cost control. The disastrous byproduct of this approach is an erosion of the quality of American health care as federal price controls drive high quality providers out of the marketplace.

The alternative to full governmental control of the health system is a functioning marketplace with cost-conscious consumers. The president and his allies sometimes pay lip service to this approach when it is politically convenient, but their true beliefs are more accurately reflected in what they are touting in Obamacare. Their vision is for the federal government to become the enforcer of cost discipline, which will inevitably mean imposing Medicare-style price controls on the entire system.

It would of course be far better for the country if the president were to seek common bipartisan ground on health care over the next four years. Such an approach would increase the chances that real progress would be made and might even guarantee a lasting health care legacy for him. But it’s clear already that the president has no intention of following such a bipartisan course.

That leaves the law’s opponents with no choice but to continue to resist implementation of Obamacare and to continue pursuing their own vision. In other words, the intense clashes over health care that marked the president’s first term will almost certainly occur during his second term too.

Monetary Policy, QE4 and the next era of the Federal Reserve

David Malpass

The Federal Reserve’s fourth round of expansion, dubbed QE4, started in January.  It will quickly expand the Fed’s assets and liabilities to over $3 trillion, a tripling since President Obama’s first inauguration. 

It’s doubtful that the government’s policy of near-zero interest rates and massive leveraging of its balance sheet through bond purchases is stimulative under current regulatory policies.  The money multiplier that connects the Fed’s creation of bank reserves to private sector credit growth has simply stopped functioning under current regulatory policy. The Fed’s balance sheet has been expanding without any corresponding expansion in private sector credit much less the multiple expansion assumed in monetary theory.  The weakness of the recovery during the Fed’s extreme monetary policy is an indication that the policy may have been contractionary, not stimulative.

During his December 12 press conference, Fed Chairman Ben Bernanke was asked how he thinks QE works, an interesting question given the length of time the policy experiment has been underway.  In his response, Bernanke drew on a theory that he had laid out in his August 27, 2010 Jackson Hole speech: “What matters primarily is the mix of assets on the Fed’s balance sheet.  The Fed is acquiring Treasuries and MBS, forcing investors into other closely-related assets.”

In the 2010 speech, Bernanke explained in detail how he envisioned Fed asset purchases might add to economic growth: “Such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public… For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.”

The problem with this transmission theory is that it assumes an expansion of private sector credit as banks or other investors buy corporate bonds, but that hasn’t been happening.  The Fed’s balance sheet has been expanding, but not private sector credit.  Regulatory policy and capital requirements limit bank leverage, resulting in very slow growth in total private sector credit.

In effect, the Fed is borrowing from banks to guide capital into Treasuries, government MBS and corporate bonds.  This huge Fed-engineered departure from a market-based allocation of capital harms bank lending to other sectors of the economy that would be more likely to create private sector jobs, helping explain the weakness in U.S. GDP growth.

The more bonds the Fed buys in a limited credit environment, the more contractionary the impact since it comes at the expense of other lending. Investment in long-term fixed assets (such as structures) has been weak, and productive short-term assets (such as a loans for inventory, accounts receivable and new business creation) have been harder to finance.

The result is that Fed policy distorts markets, hurts savers, and favors the government at the expense of the private sector.  Recent years have seen a massive shift in the sources of income in the U.S. economy, with government transfers and corporate profits growing much faster than the income of small businesses, sole proprietors, dividends and interest. This distortion in income growth is a major departure from historical norms and is consistent with the Fed’s flow of funds data showing the similar distortion in credit growth described above.

Under QE4, the Fed will buy $45 billion per month in Treasuries to replace Operation Twist, with no limit in terms of time or amount of these purchases.  The Fed added the concept that it anticipates that the “exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent.”  In addition to the contractary impact, there are several negatives in this approach:

The Fed is asserting the legal authority to make unlimited “large-scale asset purchases” on its sole discretion even when there’s no systemic crisis.  That has huge implications for the future, when each slowdown will cause the markets to believe the Fed might buy more assets.

By using short-term financing to buy back long-term bonds, the Fed is shortening the effective maturity of the national debt.   The Wall Street Journal carried a long article on December 12 called “Inside the Risky Bets Made by Central Banks” examining some of the implications.

By setting a target for the unemployment rate, the Fed is expanding its role in the economy, in effect making itself accountable for unemployment. The Fed should be focused on setting interest rates properly and assuring price stability to meet its mandate of maximizing the nation’s employment.

Finally, by promising low rates for a long period, the Fed undercuts the normal impetus to borrow to lock in low rates before they go up.

The Fed is expected to maintain an aggressive monetary policy in 2013 as long as economic growth remains weak. The slow growth is most likely due to bad tax policy, too much government spending, poor regulatory policy and the Fed itself, creating a circular process that forces continues rounds of QE.

The next FOMC statement is due January 30, followed by a press conference.  The voting members in 2013 are expected to be slightly more dovish than in 2012, with frequent dissenter Jeff Lacker leaving the voting rotation. All members in the incoming FOMC voting rotation were Federal Reserve Bank staffers before taking the presidencies of their regional Fed banks – Eric Rosengren (Boston Fed since 1985), Charles Evans (Chicago Fed since 1991), James Bullard (St. Louis Fed since 1990) and Esther George (Kansas City Fed since 1982).  This brings to the voting rotation a combined 91 years of work experience inside the Federal Reserve system, creating the expectation that Fed’s 2013 policy will remain expansionary in terms of its balance sheet and probably contractionary in terms of its economic impact.

In sum, the pattern of QE3, QE2 and Operation Twist saw steady declines in the Fed’s own growth expectations as the policies were implemented.  Under QE4 and the aspiration for a 6.5% unemployment rate, the impact may be even more pronounced as the Fed’s liabilities surpass $4 trillion and grow as a percent of the economy and private sector credit outstanding. 

Charles Blahous is a research fellow with the Hoover Institution, a senior research fellow with the Mercatus Center, and the author of Social Security: The Unfinished Work.

James C. Capretta is a visiting fellow at the American Enterprise Institute, a fellow at the Ethics and Public Policy Center, and project director of

David Malpass is President of Encima Global and Chairman of’s Stop the Fed campaign.