The Infinite Horizons of American Faith

Tyler Cowen recently linked to Larry Kotlikoff on the correlation between growth and debt. I want to keep this a short post, without passing judgement on the actual question RR set to answer. Now let’s be clear, Kotlikoff’s post actually had nothing to do with the correlation on growth and debt, but with his decade-long position that “official debt” is a legal anachronism and what we ought to worry about is our fiscal gap. Indeed the article barely discusses the causal levers in the debt-GDP ratio, and primarily rehashes a thesis he has made over and over. (There is nothing wrong with this, but it’s important to understand the context of the conversation).

There may be merit to that claim, but his conclusions are far less empirically-founded than RR or Dube. Take this:

Domestic saving is the main determinate of domestic investment, so it’s no surprise that take as you go has also wiped out most of domestic investment. And less domestic investment has meant slower economic growth. In sum, Reinhart and Rogoff are right. They just aren’t using the right numbers to show they’re right.

You have to wonder on what basis Kotlikoff thinks RR “are right”. Has he compared – for all countries across the rich world – the correlation between growth rates and the discounted future value of all liabilities? What is the regression, I wonder? And on what confidence?

But the bigger point is, even if he had, it would not matter. Kotlikoff explains there’s no “economic theory” behind excluding our Social Security and Medicare liabilities from official debt. Actually there is: and it’s not going to sound pretty for the American taxpayer or pensioner.

If America seems likely to default on its “official debt” (here forward referred to as “debt”), international capital markets will reward us with a punishing increase in bond yields, and depreciation of dollar-denominated debt. Here’s what’s going to happen if America updates its promises to the sick and elderly: nothing.

Bond markets won’t break with adoption of chained CPI and Moody’s won’t downgrade us if we pass the Ryan Budget. In fact, we have multiple times amended our promises to these trusts. Imagine if one day Congress decides that paying creditors face-value isn’t politically savvy? People will never trust us again. And it will be worse than Argentina or whatever, because we do not even face a serious fiscal crisis. Capital markets will see an America that falls to political whims even when debt service is still eminently possible.

That’s the “economic” difference between liabilities to creditors and Social Security. Now, don’t get me wrong: left-wing commenters make the same comparison. When economists cringe at the idea of a debt ceiling crisis, but then suggest a “long run” entitlement reform, they ask “why default on your promises to the elderly”?

The answer is: they are political. On the left, I believe our safety net programs have strong economic value. But I cede that there is a fair argument that they do not, and are simply political artifacts. However, the financial position of American securities is an unimpeachable reality left, center, or right. Conflating the two is a significant mistake.

And why is this important to Kotlikoff’s claim? Well, there’s nothing in stone about the so-scary “$222 trillion”. The idea that CBO can compute our fiscal gap on an infinite horizon based on current law is absurd. Because “current law” has this uncanny habit of changing.

There’s another point as well: our social security and Medicare shortfalls are financed through the sale of government debt. That’s right – the argument that debt doesn’t mean much becomes even weaker when you consider our liabilities to entitlement programs are reflected in official debt figures, which are at least a better gauge of contemporary law.

Folks, I’m not telling you to ignore our fiscal position (though I think there’s a good case for agnosticism). But not all liabilities are created equal, I don’t know which “economic theory” textbook teaches you that. American debt is the most important source of liquidity in international capital markets. “Bonds” held by social security and Medicare pensioners are useless. They can’t even be traded.

That doesn’t mean Kotlikoff is wrong, in fact he’s dead right – just in the wrong debate. His argument makes an incredibly strong case that we must amend our law. That is the definition of a “$222 trillion” fiscal gap. There are no other ways to look at the picture. But the idea that theoretical dynamics behind growth and debt do not discriminate between mode of liability is insane.

The only social security vigilantes are political, backed in full confidence by the AARP.