Is the US in a fiscal crisis?

Over at the WSJ, James Freeman reports on an interview with "legendary investor" Stanley Druckenmiller about the US's fiscal problems. Mr. Druckenmiller, via Freeman, argues that a postponement of payments on US debt as a result of the current budget impasse would not be a catastrophe, but failure to solve our fiscal crisis would be. Hence he supports the Republican strategy of brinkmanship over the debt limit to achieve the goal of long-term deficit reduction.

But how serious is our fiscal problem anyway? Is it a "crisis"? We often hear that the Social Security or Medicare system has a long-run funding shortfall measured in the trillions of dollars, but what does this mean? Bruce Bartlett puts everything into perspective here. According to his figures the total shortfall in Social Security and Medicare - that is, the present value of the gap between what the government promises to spend on these programs and what it takes in in tax revenues dedicated to them, over the infinite horizon - is $56.4 trillion. That seems like a lot of money, but (a) it's small relative to the present value of US GDP, that is the resources our society has at its disposal to fund these programs, over the infinite horizon, and (b) it's really an accounting fiction since if the tax revenues dedicated to these programs are insufficient we can always fund them from other sources.

As an illustration of (b), consider another program that has a serious unfunded liability problem: national defense. We as a society have decided we need to have the world's strongest military, requiring us to spend as much on defense as the next 19 highest spending nations combined. We want to be able to wage war simultaneously in Iraq, Afghanistan and Libya, while maintaining a troop presence in countries like Germany and Korea, and also defending our homeland. That defense posture costs us about $700 billion, or 5% of GDP, every year. Yet we have no revenue dedicated to support it. That means, assuming 2.5% real GDP growth, 2.5% inflation, and a real interest rate of 4.5%, the present discounted value of the shortfall in defense funding is... hmm, let me see, ... $37.45 trillion. Yikes! Surely only a massive overhaul of defense spending, beginning right now, can save us from certain disaster! No? Well, then that's my point.

A more meaningful measure of the shortfall in Medicare and Social Security is the amount taxes would have to be raised every year to cover the financing gap. According to Bartlett, this is 3.8 percent of GDP (every year), i.e. we'd need the current economy equivalent of about $550 billion in new tax revenues every year. That's a lot. But it could be achieved by increasing the federal income tax from the current 6.2 percent of GDP to 10 percent of GDP (about what it was at the peak of the stock market boom in 2000 and in the year before the Reagan tax cuts). It could be achieved by making large cuts in defense spending, or a combination of the two. The need to raise that much money could be reduced by imposing cost controls like those in the health reform law passed last year and those proposed by Obama in his latest budget address. Bartlett says we can go a long way simply by not implementing the "doc fix" every year as has been Congress's wont since reimbursement rates were lowered in 1997.

So Medicare and Social Security face some big problems, but it's not not a crisis. And bond market participants seem to agree. As Paul Krugman notes today, despite fears of "invisible bond market vigilantes" warning us of fiscal ruination, the yield on ten-year US Treasury securities is now at a near record low of 3.11 percent. Nonsense, says Druckenmiller - the Treasury bond market is not a free market because the Federal Reserve has been intervening to stabilize prices. "The market isn't saying anything about the future. It's saying there's a phony buyer of $19 billion of Treasurys a week." Excuse me, $19 billion? Daily trading volume in the US bond market is in the area of $400 billion, so $19 billion a week is less than one percent of the total. Most estimates of the cumulative effects of the Fed's quantitative easing programs put the effect on yields between 50 and 100 basis points - even Treasury yields of 4 percent would not signal any kind of concern about a crisis. So no, the bond markets are indeed telling us that the people managing the world's wealth are not concerned about default risk on US government debt. Not that they've never been wrong, mind you, but there's certainly no evidence to support the alarmist claims of the Freemans and Druckenmillers among us.