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Economics: Are we mired in debt?
New York: September 09, 2004
By John R. Stephenson

If you examine the official debt statistics and compare them to those of other nations, the U.S. appears to be on pretty firm footing. The gross U.S. official federal debt now stands at $4.4 trillion which is roughly 40 percent of the gross domestic product (GDP). While that is a huge number (about $31,000 per American worker), it seems positively miniscule when compared to other countries on a debt-to-GDP ratio basis. Japan, with the second largest economy in the world, has a debt-to-GDP ratio of 164 percent whereas Italy's gross debt is 118 percent of GDP and Belgium clocks in at 98 percent debt-to-GDP ratio. But do the official debt statistics paint an accurate picture of the true fiscal position of the U.S.? No.

The reason is simple. Governments around the world have free reign to report the "official" statistics any way and over any time frame that they choose. Most often, they choose to ignore the effects of government benefit programs over time. In the case of the U.S., the effects of the future obligations of Medicare, Medicaid and Social Security are not included in the official federal debt numbers. Why? The numbers, if reported, would be truly shocking and the fiscal situation of the U.S. would look dramatically different. Not only are the true obligations of the government far worse than the official debt numbers presented by the government, but as our population ages, the costs associated with these social programs and the burdens on workers are going to skyrocket. In 1970, Medicare benefit payments were .74 percent of GDP but today, they account for 2.6 percent of GDP and by 2030, they are projected to equal 4.7 percent of GDP. For Medicaid, the growth projections appear to be the same.

But just how much could the official debt numbers differ from an independent projection of the U.S. government's obligations? Lots. In the fall of 2002, Dr. Kent Smetters (an economics professor at the University of Pennsylvannia) who spent two years at the U.S. Treasury as deputy assistant secretary for economic policy and Dr. Gokhale a senior economic advisor to the Federal Reserve Bank of Cleveland at the behest of then U.S. treasury secretary, Paul O'Neill, undertook to determine the fiscal gap that would exist between the projected future tax receipts and the future expenditures assuming that tax rates stayed constant. Of course, if the present value of future tax receipts outstripped the present value of future government expenditures (on Social Security, Medicare and Medicaid etc.), then the government would have a fiscal surplus (notwithstanding the cumulative effect of budget deficits) and if there was a shortfall, then the government would face a larger than "official" level of indebtedness. Their findings? The fiscal gap they calculated was $45 trillion which is eleven times larger than the current official debt and roughly four times the size of the country's annual economic output (GDP). In 2002, when these calculations were being tabulated, the total net worth of America, as measured by the Federal Reserve Consumer Balance Sheet figures, was a little less than $40 trillion. The conclusion? If we had to pay our obligations (including the promised future benefits) today we would technically have to declare bankruptcy.

To close this enormous fiscal gap, the two researchers examined possible alternatives that the government could implement immediately and permanently to eliminate this $45 trillion of red ink. They summarized their findings in a so-called "menu of pain" which outlined some policy responses the government could take.

Figure 1: Smetters and Gokhale's Menu of Pain

Source: The Coming Generational Storm - Kotl i koff and Burns

Of course, alternatives such as cutting immediately and permanently federal discretionary spending by 106 percent is impossible and a more palatable solution might be to implement a combination the "Menu of Pain" alternatives to alleviate the fiscal gap. Needless to say, the longer the menu of pain is postponed, the more severe the ultimate remedy will be.

But why hasn't anything been done to close the fiscal gap? In large part because politicians are elected to tell us what we want to hear not what the truth is. As well, these burdens are going to fall on someone else's watch and on other people's shoulders (namely those of our children and of future generations). By effectively transferring the promises and excessive governmental spending of today to future generations, we have created the potential for massive inter-generational conflicts. Are our children going to exist on some 40 percent less take home pay than we did? Are we going to renege on the promises we made to the boomers and the elderly to provide for them in retirement? I think not. The most likely monetary response is to try and inflate the problem away by printing more money. Of course, a policy of turning on the printing press is a recipe for disaster as countries such as Argentina have discovered but it may be the only alternative that the government will be willing to implement to close the fiscal gap. It is only a matter of time until savvy bond traders figure out the current state of fiscal affairs and decide to dump the U.S. currency accordingly.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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