July 25 2010
The spectre of Greek default continues to rattle global financial markets. Greek long-term government bond yields are running 700 basis points above comparable US Treasuries. The inference is that America is in far better fiscal shape than Greece. Nothing could be further from the truth.
Greek debt totals 120 per cent of gross domestic product, twice the US figure. But debt alone tells us little about a country’s fiscal condition. Economists call this the labelling problem, because governments can describe receipts and payments in any way they like. Payroll taxes to fund pensions and healthcare can, for instance, be labelled as borrowing, with the future benefits called repayment less a future tax. Measured thus, the US budget deficit is 15 per cent of GDP, not 9 per cent.
Chile’s pension reform of the early 1980s re-labelled that country’s deficits in this way. Receipts, which had previously been called taxes, were funnelled into private pension funds, from which the government then borrowed to cover the pensions themselves. Voilà. The same money was still flowing from workers to retirees but was now called borrowing. The economists’ change in language let them block spending, including on an aircraft carrier, claiming “the” deficit was too high. So Chile’s long-term fiscal position improved, despite reporting more debt.
Argentina subsequently “reformed” its pensions, albeit with no underlying fiscal tightening. Recently it nationalised its pension funds, calling the confiscated assets revenue, while keeping the future liabilities off the books. Thus Argentina sold IOUs for current cash. Greece did much same in selling anticipated fees from airports and proceeds from lotteries. But then so did France, when it confiscated France Télécom pension assets (while retaining the pension obligations) to meet the deficit criteria to join the euro.
But all these countries have something to learn from the real labelling master: Uncle Sam. During the past half-century, the US has sold tens of trillions of unofficial IOUs, leaving it with liabilities to pay Social Security, Medicare and Medicaid benefits that total 40 times official debt. So is US debt actually 40 times larger than reported? Is this year’s deficit 15 per cent of GDP or 9 per cent? It’s your pick, since we are in a fiscal wonderland of measurement without meaning.
In economics, as in physics, certain concepts are not well defined. In physics it is absolute time and distance, whose measurement depends on direction and speed through space. This frame of reference determines how we perceive the time of day or the length of a desk. In economics, every dollar a government takes in or pays out can be referenced with different words or labels, to produce almost any level of official debt one wishes to present. As a result, using debt levels to assess a country’s fiscal sustainability, as the Group of 20 nations just did, is like driving in Los Angeles with a map of New York.
Fortunately, theory suggests a label-free measure of fiscal status: the fiscal gap, or the present value difference between all future expenditures and receipts. The Greek fiscal gap is staggering. Calculations developed with my colleagues at Freiberg University put it at 11.5 per cent of the value of Greece’s future GDP. And this huge figure already incorporates Greece’s recently legislated fiscal policy retrenchment. But the US figure, based on the Congressional Budget Office’s just-released projections, is even larger: 12.2 per cent.
Clearly, Greece is in terrible fiscal shape. To get its books in order it would have to pull in its belt each year by another 11.5 per cent of GDP. This provides new meaning to the word draconian. But the US is in much worse shape, because the CBO’s projections that reveal the 12.2 per cent fiscal gap already assume a 7.2 per cent of GDP belt-tightening by 2020.
But the assumptions underlying this 7.2 per cent adjustment are highly speculative, including a substantial rise in the share of taxpayers facing the Alternative Minimum Tax, once called the “millionaires tax” for targeting only the rich. The CBO also assumes that real wage growth will push all workers into much higher tax brackets, and that Congress will slash discretionary spending as well as greatly limit growth in Medicare and Medicaid benefits. Each supposition runs counter to recent experience.
Wishing won’t fix America’s fiscal mess. The US is one foot away from a deep and permanent economic grave. It is far past time to do meaningful long-term fiscal planning, level with the public, and implement radical reforms that permanently put America’s fiscal house in order.
The writer is professor of economics at Boston University. The analysis underpinning this article was developed along with Christian Hagist, Stefan Moog and Bernd Raffelhüschen, all at Freiburg University