In this book, the authors defend with brio the thesis that “[t]he United States is bankrupt” (italics in original). Their light style and flashy formulas have all the advantages and drawbacks of the genre: they make for engaging and easy reading, but with shortcuts that sometimes make the point more, not less, difficult to understand.
Fiscal gap | The problem, they explain, is not the annual deficits. The annual deficit is not a significant figure: it can be misleading as it changes depending on how the government labels expenditures and revenues—what the authors call “the labeling problem.” Accounting manipulations hide expenditures by shifting them into the future and disguise future taxes by leaving inflation to increase them stealthily. Instead of taxation without representation, we now have “taxation without cognition” (emphasis in original). The result is that most of the liabilities “have been carefully kept off the government’s books in a system of duplicitous accounting that goes far beyond Enron’s and Bernie Madoff’s wildest dreams.”
The authors argue that what matters is the “fiscal gap,” that is, the difference between the government’s promises and future obligations on the one hand, and all its expected revenues on the other hand. Calculated in discounted dollars over an infinite horizon, the fiscal gap cannot hide expenditures nor lie on revenues. It is the only true measure of whether a government is financially sound or bankrupt.
Kotlikoff has done much academic work to quantify this statistical and actuarial construct. His latest estimates (as of June 2011), reported in The Clash of Generations, show the federal fiscal gap at $211 trillion dollars, about 20 times the amount of the official debt. It is equivalent to 14 times current gross domestic product. “[O]n a fiscal gap basis,” the authors write, “the United States is in worse fiscal shape than Greece.”
In order to close that gap, the government would have to immediately and permanently increase all federal taxes by 64 percent. Alternatively, the government could immediately and permanently cut primary federal expenditures (all expenditures excluding reimbursement of the interest and principal on the official debt) by 40 percent. If action is delayed, even more dramatic tax increases and/or budget cuts would be needed. We are close to the point where nothing could realistically prevent a federal bankruptcy.
The main culprits for the fiscal gap are Social Security and Medicare. Created by Franklin D. Roosevelt in 1935 (and complemented by Medicare since 1965), Social Security is “a six-decade-and-counting Ponzi scheme.” The system is based on the obligation of current workers to pay for current retirees’ retirement, with the promise that the former will get similar subsidies when they grow old. This promise has become impossible to honor because the old are taking too much and the young are not able to pay.
In parallel with longer life expectancy, the state “has been turning retirement into a well-paid, long-term occupation.” Retirees get on average more than $30,000 per year in Social Security, Medicare, and Medicaid benefits, which amounts to three-fourths of annual per capita income, “far beyond our children’s capacity to pay” and “far beyond our own capacity—and will—to pay.” In 2030—less than 20 years from now—these expenditures would eat two-thirds of federal revenues. According to official figures (which are less pessimistic than Kotlikoff and Scott’s), putting the Social Security system on a sound financial basis would require an immediate and permanent increase of 29 percent in the Social Security tax rate (from 12.4 percent to 16 percent), or an immediate and permanent 22 percent cut in benefits. The welfare state that has been built for the old is “a generational time bomb, which will explode as a terrible clash of generations.”
The old have voted themselves retirement incomes that are not supported by savings. The national savings rate has been decreasing for six decades, from 16 percent of GDP to essentially zero, while consumption, and especially consumption by the old, has increased. In order to pay what has been promised to older Americans, working adults will have to pay enormous taxes, which will depress the economy and make their tax burden even heavier. Until now, people have received more in benefits than they have paid in Social Security and Medicare taxes, but that is ending: young people will have to pay more in taxes than they will get in benefits. This is nothing less than the exploitation of the young by the old, “fiscal child abuse,” and a “war on our children.”
Kotlikoff and Burns argue that Ricardo equivalence (whereby the current generation would save in order to help the future one pay its higher taxes) does not work because, empirically, the old don’t care that much for their children. Either the working young will have to pay twice—once for today’s retirees and a second time for their own old age—or else the system will crumble.
The authors also examine the fiscal policies of state and local governments. To close their own fiscal gaps of $38 trillion (to be added to the $211 trillion federal fiscal gap), state and local governments would have to increase their own taxes by 12 percent or reduce expenditures equivalently. “We are, in short, totally screwed,” conclude Kotlikoff and Burns. They fear that “major social strife could occur at any time.”
‘Purple Plan’ | The Clash of Generations is three books in one, with the fiscal gap section being followed by a section outlining the authors’ proposed policy solution and another section offering financial advice for individuals. Unfortunately, the second and third sections are not as interesting as the first one.
The second section explains the authors’ so-called “Purple Plan” to save America from government bankruptcy. They call their plan “purple” “because both Red Republicans and Blue Democrats will like what they see.”
What are the solutions? A repudiation of the federal debt would only solve part of the problem. What is needed is to question the welfare state. But Kotlikoff and Burns don’t want to travel that road.
The first component of their Purple Plan is a big attempt at social engineering of the financial sector. They want banks to be stripped of their limited liability if they don’t become mutual fund companies that simply pass their depositors’ money to mutual funds. This intriguing idea may be an exploitable entrepreneurial idea. Perhaps our authors should continue to build businesses around their ideas and create a Purple Bank (assuming actual regulations do not make the venture too costly). The problem with their proposal is that it would impose a single banking model on everybody. They must be very sure of their idea, to want to impose it on 300 million Americans! Would they be willing to assume personal liability for the results?
The second component of the Purple Plan aims at reengineering health care. The authors of The Clash of Generations propose a national health insurance scheme that would subsidize a basic health insurance plan for every American. The private insurance companies that would offer such plans would be prohibited from discriminating against existing conditions. As anybody would be allowed to supplement his basic insurance plan if he wished and could afford it, the proposed system appears to be non-monopolistic, much like Obamacare. Why, then, do the authors claim that their proposal would have “much in common” with the Canadian health care system? I don’t know.
The Purple Health Plan is marred by other problems. This sort of initiative should be left to the states. Indeed, Massachusetts, Vermont, and Maine have similar schemes, and have had them for a long time in the last two cases. People who want some form of public health insurance just have to move to those states. Moreover, Kotlikoff and Burns are quite certainly mistaken to think that their system would reduce the cost of public health care. They do propose liability and malpractice reform, but they fail to mention (and perhaps don’t realize) that simply restoring freedom of contract, with the parties assuming the price/risk ratio they want, would do the trick.
A deep tax reform provides the third component of the Purple Plan. The main idea is to replace the personal and corporate income tax system with a consumption tax of 17.5 percent. The authors argue that their system would still be progressive given the compensating grants and credits given to poor consumers. Through increases in other taxes, the whole proposal would “generate substantially more revenue.” Contra Kotlikoff and Burns, this is a drawback, not an advantage, of the reform.
As for Social Security, the Purple Plan would phase it out and replace it with another compulsory scheme, the “Personal Security Plan.” This new public pension scheme would invest all contributions in an international index of securities and be fully funded, except for a government guarantee of the participants’ invested money. Kotlikoff and Burns argue that forcing people to save for their old age is justified because the state would otherwise have to help the improvident ones. They don’t seem to understand that there is a difference between ad hoc assistance and entitlements. Can’t ordinary taxes be considered a sort of insurance savings, so that an entitlement scheme becomes unnecessary? The authors are strangely silent about who would bear the cost of phasing out the actual scheme. And they don’t consider the government’s temptation, at some point in time and for some good reason, to expropriate such a large accumulation of assets or to boss around the corporations in which the scheme would own shares.
More generally, what Kotlikoff and Burns do not seem to realize is the irremediable inconsistency between the American ideal of liberty on the one hand and, on the other hand, the welfare Leviathan and the high taxes and pervasive controls it requires. They don’t raise the essential question of the role of the state. They just want to save the present system in a sustainable form. Their proposals show how complicated that is.
The book’s last few chapters provide financial advice to those who want to save enough for their retirement. The authors discuss such topics as how to invest and where to live—in other words, how individuals can try to escape the hole in which government policies have put them. This section is not uninteresting. For example, by emphasizing index funds, it silently rehabilitates the Efficient Market Hypothesis. It is, however, not totally consistent with the first part of the book. It discusses at length how to maximize one’s returns from Social Security and how to use Treasury Inflation Protected Securities (TIPS) in the context of a diversified portfolio. But hadn’t we learned, just a few chapters before, that Social Security will not be able to pay the promised benefits and that the federal government is totally bankrupt?
Trusting the state | The main fault of The Clash of Generations is its unbounded trust in the capacity of the state to do good. This is strange for a book that provides a devastating criticism of everything government has done wrong thus far and continues to do wrong now, including the “impending, gigantic, and virtually inescapable failure that will change our lives.”
The authors want a new, all-encompassing financial service regulator similar to the Federal Drug Administration (no joke: that’s the example they themselves use) to weed out bad financial instruments. They wish for an omniscient government. All information in individual mortgage applications should be available on the web. The federal government would know everything about any individual’s health status in order to determine the size of the voucher that each person would receive toward purchasing health insurance. About your finances and your health, the state would know everything and, of course, use that information efficiently for your own good. No more asymmetry of information: Leviathan has it all!
To trust government with information is surprising under the pen of authors who have documented so many ways in which the government uses its control of information to cheat its subjects. For example, they brilliantly illustrate how nobody understands tax law and other legislation. They argue that modeling a certain decision that beneficiaries of Social Security should make requires, under reasonable hypotheses, going through 10105 alternative possibilities, a number greater than the number of atoms in the universe. No computer can make such calculations.
In parallel to their irrational trust of government, the authors continuously attack “predatory” finance, “Wall Street,” and private greed, apparently oblivious to the fact that financiers work under regulations established by “our government” (as they repeat endlessly and fondly). If the magical “we” and “our” don’t occur a hundred times in the book, then I am Bernie Madoff. What’s more dangerous, political or financial greed? As John Maynard Keynes perceptively noted, “It is better that a man should tyrannise over his bank balance than over his fellow-citizens.”
Kotlikoff and Burns sometimes see ghosts, such as the “rising individualism, increasing personal freedom” since the 1970s. Except for the abolition of the draft, some marginal increase in sexual freedom, and the reaffirmation of the Second Amendment, it is not easy to see where that increase in personal freedom has happened. And despite their generally sound economics, the authors seem to claim that saving would prevent people from being “reliable consumers” à la Galbraith or Keynes. They espouse redistributionist values, but just don’t like the current redistribution package from the non-rich young to the non-poor old. Ah, they seem to cry, bring in our ideal state! Bring us a Madoff we can trust!
This being said, The Clash of Generations presents many worthwhile observations and ideas that run against conventional wisdom. Even if its solutions fall short, the book does explain a large part of the reason why the American state (mainly the federal government, but also state and local governments) is bankrupt.
