It is essential that we come to grips with structural budget deficits but not because such deficits will cause inflation. It’s because large, sustained structural deficits vacuum up savings that could be put to more productive uses. Once the economy is back on track these deficits will make capital more expensive for private borrowers, crowding out the investments that are essential to boost productivity and fuel growth in real wages and living standards.

I am pleased to see that the new administration has embraced what was hitherto perceived as the third rail of American politics and brought the issue of unfunded entitlement liabilities to the fore. For the sake of our grandchildren, I hope that the administration and the Congress will take this vexing beast of a problem by the horns and tame it.

[S]cenarios that project large deficits also project rapid growth in the outstanding government debt.  The higher levels of debt in turn imply increased expenditures on interest payments to bondholders, which exacerbate the deficit problem still further.  Thus, a vicious cycle may develop in which large deficits lead to rapid growth in debt and interest payments, which in turn adds to subsequent deficits.  According to the CBO projection that I have been discussing, interest payments on the government's debt will reach 4-1/2 percent of GDP in 2030, nearly three times their current size relative to national output.  Under this scenario, the ratio of federal debt held by the public to GDP would climb from 37 percent currently to roughly 100 percent in 2030 and would continue to grow exponentially after that.  The only time in U.S. history that the debt-to-GDP ratio has been in the neighborhood of 100 percent was during World War II.  People at that time understood the situation to be temporary and expected deficits and the debt-to-GDP ratio to fall rapidly after the war, as in fact they did.  In contrast, under the scenario I have been discussing, the debt-to-GDP ratio would rise far into the future at an accelerating rate.  Ultimately, this expansion of debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts or tax increases, or both. 

Official projections suggest that the unified budget deficit may stabilize or moderate further over the next few years. Unfortunately, we are experiencing what seems likely to be the calm before the storm. In particular, spending on entitlement programs will begin to climb quickly during the next decade. In fiscal 2006, federal spending for Social Security, Medicare, and Medicaid together totaled about 40 percent of federal expenditures, or roughly 8-1/2 percent of GDP.² In the most recent long-term projections prepared by the Congressional Budget Office (CBO), these outlays are projected to increase to 10-1/2 percent of GDP by 2015, an increase of about 2 percentage points of GDP in less than a decade. By 2030, according to the CBO, they will reach about 15 percent of GDP.

Although demographic change will affect many aspects of the government’s budget, the most dramatic effects will be seen in the Social Security and Medicare programs, which provide income support and medical care for retirees and which have until now been funded largely on a pay-as-you-go basis.  Under current law, spending on these two programs alone will increase from about 7 percent of the U.S. gross domestic product (GDP) today to almost 13 percent of GDP by 2030 and to more than 15 percent of the nation’s output by 2050.  The outlook for Medicare is particularly sobering because it reflects not only an increasing number of retirees but also the expectation that Medicare expenditures per beneficiary will continue to rise faster than per capita GDP.  For example, the Medicare trustees’ intermediate projections have Medicare spending growing from about 3 percent of GDP today to about 9 percent in 2050--a larger share of national output than is currently devoted to Social Security and Medicare together. 

By 2030, almost one in five U.S. residents will be 65 years or older.  Well before then, beginning in about 2018, Social Security will start to pay out more in ben­efits than it receives from payroll taxes.  Even before that, -- in the neighborhood of 2010 -- Social Security will start exerting upward pressure on the unified federal budget deficit as its surplus diminishes, with a consequent reduction in net public saving, absent changes in the program itself, increased taxes, or reduced spending on other government programs.  

The situation for Medicare is similar and, potentially even more serious.  Payroll taxes to cover Medicare expenditures are currently in surplus.  Over time, however, Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to deal with than that associated with Social Security.   Thus, despite the relatively benign federal deficit we currently see, it is clear the situation will worsen dramatically over the next decade.  And, unlike the late '80s when deficits became a national concern, there seems to be no political consensus on the nature of this problem or its resolution -- a fact that should be a concern to all of us.

The Center for Retirement Research (CRR) has developed a National Retirement Risk Index to measure the share of working-age households that are in danger of being financially unprepared for retirement. Their findings are sobering.  They report that almost 45 percent of all such households are “at risk” of falling well short of the amount estimated to be necessary to maintain the household’s pre-retirement standard of living.  Younger households are particularly vulnerable, as are low-income households and those with neither a defined benefit pension nor a 401(k) plan. 

Several factors make today’s fiscal situation much more serious than indicated by the current ratio of the deficit to GDP. First, the deficit would be much larger, 4.1 percent for fiscal 2005, if it were not for a sizable surplus in Social Security ...The situation for Medicare is similar and, potentially, even more serious. Although payroll taxes to cover Medicare expenditures are also currently in surplus, over time Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to control than that associated with Social Security.

Currently, 3-1/4 workers contribute to the Social Security system for each beneficiary. Under the intermediate assumptions of the program's trustees, the number of beneficiaries will have roughly doubled by 2030, and the ratio of covered workers to beneficiaries will be down to about 2. The pressures on the budget from this dramatic demographic change will be exacerbated by the anticipated steep upward trend in spending per Medicare beneficiary. The soaring cost of medical care for an aging population is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate.

Excessive fiscal spending tends to boost output in the short run but eventually adds risks to our economy and restricts the effectiveness of monetary policy. The fundamental issues of how to deal with Social Security and rising retiree health care costs only serve to complicate our challenges with fiscal policy.

A permanent correction to the spending imbalances must involve the restoration of fiscal discipline and long-run solutions to the financing problems of Social Security, Medicare, and Medicaid.

While the present situation of the United States may not be alarming, the outlook comes closer to being so. Outlays are projected to rise slightly more than program revenues for Social Security and much more than program revenues for Medicare. The recent annual report of the trustees of Social Security and Medicare projected rapid deterioration in the trust funds financing both programs, with the Medicare fund being exhausted in fifteen years.

The combination of an aging population and the soaring costs of its medical care is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate.

So long as health-care costs continue to grow faster than the economy as a whole, the additional resources needed for such programs will exert pressure on the federal budget that seems increasingly likely to make current fiscal policy unsustainable. The likelihood of escalating unified budget deficits is of especially great concern because they would drain an inexorably growing volume of real resources away from private capital formation over time and cast an ever-larger shadow over the growth of living standards.

The uncertainty about future medical spending is daunting. We know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending.