The graying budget

Posted by on February 24, 2010 @ 11:06 am in Economy & markets

Several years ago at a speech in New York, I warned that “a future President Clinton or McCain would face a daunting budget challenge from population aging.” My political forecast was off, but my economic and demographic forecast is unchanged.

It is a well-known demographic fact that societies around the world are aging. It is not just a U.S. phenomenon (the impact is somewhat muted here by immigration) or a developed-world phenomenon. Even countries like Mexico and China are facing rapidly graying populations. Some demographers have suggested that the global population will reach an historic first in the current century: The proportion who are elderly is expected to exceed the proportion who are young.

Global aging has a fiscal impact, and there is no better demonstration of that than in the current U.S. budget outlook (see table below). Over the next 10 years, the federal government’s revenue is expected to grow by an additional $2 trillion. That growth in revenue will be entirely offset by additional Social Security and Medicare expenses (an increase of a half-trillion dollars each), growth in Medicaid (a material portion of which will pay for long-term nursing-home costs for older Americans), and interest on the debt.

The federal budget

Source: White House Office of Management and Budget.

As a percent of the aggregate economy, the deficit will fall from 10.6% to 4.2% over the period. Yet the economic policy goal should be to balance huge deficit spending today—necessary to counteract the financial crisis and “Depression 2.0″—with budget surpluses in the future. This is impossible given the inexorable rise of spending on old-age programs. As you can see from the numbers, if there were no material growth in aging programs over the coming decade, the collective budget would be in surplus by 2020 (lower benefits growth would also reduce interest costs).

In the current budget debate, the deficit issue has been conflated with the financial crisis. If the financial crisis had occurred 20 or 30 years ago, it would likely have meant a onetime surge in deficits and debt, and a relatively minor aberration in the long-term growth path of the U.S. But the banking crisis came at precisely the worst time—just on the threshold of a large wave in government spending on old-age programs. Hence the stream of red ink.

The good news, I suppose, is that the U.S. is better off than other countries. In Europe, public pensions are higher and immigration rates lower. Birth rates in both regions for non-immigrants are roughly the same: at replacement rates; the main difference is that in the U.S., (mostly Hispanic) immigrants are having more children, easing the aging burden. (That is a quite different perspective on the merits of immigration: Young immigrants pay Social Security and Medicare taxes!) Intertwined with this, of course, is the secular increase in health care costs, in the U.S. and around the world.

The Obama administration has created a new commission to tackle the long-term budget issue. The options have been known for several decades and are clear: higher taxes, which of course weigh heavily on working-age families and hinder economic growth, or reduced benefits, which means a transfer of resources away from older Americans and an increase in economic insecurity in old age.

In the end, the debate will be over how many public resources should be devoted to the old-age population—a debate over how gray the budget should be as the population ages.

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