Means of deficit reduction: Medicare and Social Security

Yesterday, I argued that the United States faced a policy dilemma in avoiding debt deflationary forces while maintaining fiscal prudence. The reality is that President Obama faces political constraints in Washington right now regarding budget deficits. He is not likely to get another stimulus package through the Congress unless he can credibly demonstrate a longer-term deficit reduction outlook. In my view, this necessarily means changes to Social Security and/or Medicare.

Last June and July, I presented five charts from Ross Perot’s website which demonstrate the future budgetary problem:

Fiscal Year 2007: before the bubble burst

What becomes apparent if you look at these charts is that the United States faces a very large fiscal problem under present tax and spend scenarios given likely future growth outcomes. In plain English: there is a gigantic hole in the U.S. Government’s balance sheet under normal GAAP accounting. Let’s look at the balance sheet for 2007 because John Williams at has already done the analysis and this was a budget that was created before the housing bust was apparent.

On December 17th, The U.S. Treasury released the annual Financial Statements of the United States Government for fiscal year 2007 (year-ended September 30th), prepared using generally accepted accounting principles (GAAP), audited by the General Accountability Office (GAO) and signed off on by Treasury Secretary Paulson.

The statements still show that the federal government’s fiscal woes continue to careen wildly out of control. Based on my estimate of the 2007 GAAP-based deficit exceeding $4.0 trillion (see discussion below), the term "out of control" is not used loosely. If the government were to raise taxes so as to seize 100% of all wages, salaries and corporate profits, it still would be showing an annual deficit using GAAP accounting on a consistent basis.

The number $4 trillion is the number you would see if the U.S. Government reported its accounts as businesses do on an accrual basis using Generally Accepted Accounting Principles (GAAP). GAAP accounting means that all promises i.e. future pension and healthcare spending must be accounted for on today’s financial statement. If we did not do accounts on an accrual basis, then many companies would go bankrupt when the unaccounted for future liabilities not addressed on their balance sheet came due. In the case of General Motors, future liabilities for pensions and healthcare are a large part of their financial problem.

The U.S. government reports its accounts on a cash basis. That means it matches the cash that comes in the door against bills it must pay in that current year. This is how small businesses run their accounts. Under this methodology, the accounting looks very different. Here is how George W. Bush summed up his 2007 budget deficit (Fiscal Year 2007 Overview).

For 2007, the Budget forecasts a decline in the deficit to 2.6 percent of GDP, or $354 billion. By 2009, the deficit is projected to be cut by more than half from its projected peak to just 1.4 percent of GDP, which is well below the 40-year historical average deficit.

As last year’s dramatic increase in receipts demonstrates, the most important factor in reducing the deficit is a strong economy.

His last words are well-placed because we know that the course of events was quite a bit different than was predicted in this budget. In sum, there is a large hole in the government’s accounts that an order of magnitude larger when you use GAAP. This was true even before the housing bubble and makes plain that the U.S. government’s budgetary problems are structural. (Also see Wikipedia’s entry on the 2007 Budget. It gives a good overview)

Honing in on the problem: Medicare and Social Security

The problem, of course, is Medicare and Social Security. Looking again at 2007 and the composition of spending (Chart of the day: US federal spending and receipts), one can see that 40 percent of the budget went to spending on Medicare/Medicaid and Social Security. This percentage will rise inexorably as the Baby Boom generation retires starting in 2011. If you look at the government’s own accounts (PDF), they tell the story. Notice the over $40 trillion in unfunded liabilities associated with Medicare/Medicaid and Social Security

Social Security and Medicare

How this fits in to today’s debate

These unfunded liabilities fit into today’s policy debate in that reducing Social Security and Medicare benefits would not only eliminate structural budgetary problems, it would also allow Obama to demonstrate fiscal prudence – even while the present deficit balloons. I guarantee you that Summers, Geithner, Orszag and Romer are on to this and that this is a debate of huge importance inside the Administration. I anticipate we will see a Social Security/Medicare change under Obama. The question is how would this change be achieved. There are four possible ways:

  1. Raise Taxes. To satisfy liberals, who have become more and more worried about Obama, one could see the Administration allowing Congress to eliminate the payroll tax exemption on some of the income earned above $100,000. If you listened to Joe Biden on Meet the Press on Sunday, it was clear that the President is going to make pragmatic decisions on budget issues and will not veto bills unless their totality is “wrong for America.” Translation: he would not necessarily add in a payroll tax increase himself, but he would sign a bill that has one if he could tout this as a tax increase for the rich and stress the fact that the middle class would see no rise in the income tax.
  2. Reduce Benefits. Another way to reduce entitlement liabilities is to reduce the net benefits. Obviously raising tax on benefits for those earning a specific threshold outside income would be the taxation way of achieving net benefit reduction. Again, this would be touted as a tax on the rich. Cutting benefits outright is a non-starter and political suicide. On Meet the Press, Biden was unwilling to dismiss the potential that the President would sign a Universal Health Care bill that taxed health care benefits. I think this is a crucial statement regarding both UHC and entitlement programs.
  3. Reduce Coverage. Because medical care has advanced hugely over the last decades, we are now able to keep patients alive (and often healthy) who would have died years ago. As a result, medical costs have skyrocketed. The simple fact is that using all available medical science to treat patients costs a lot of money. This makes attractive the potential cut of Medicare coverage i.e. reducing which procedures and care will be paid for. I expect, this is another option that is going to be explored.
  4. Delay Benefits. This is my preferred option. The average lifespan of Americans has increased tremendously particularly since Social Security was enacted. As a result, retirees today receive many more benefits than they did in the 1940s. (“The 2000 U.S. census revealed that the number of Americans over 65 years old has more than doubled since 1950 and increased from 31.1 million to 34.91 million from 1990 to 2000, largely because of continuing advances in medical science and nutrition.” – MSN Encarta Encyclopedia). These demographics are killing the U.S. and they are going to get worse. Given relatively low fecundity rates among young American women, they will get worse still. Therefore, the U.S. government is going to have to raise the age at which Americans are eligible for Social Security.

In sum, while I prefer a delay of benefits, all of these ways of reducing entitlement benefits are going to be researched and suggested. The Obama Administration does seem willing to address these issues, potentially as a quid pro quo for another round of stimulus.

An alternative view

I would be remiss if I didn’t present you with links to the other side of this argument. This is handled capably by Dean Baker of the Center for Economic and Policy Research, one of the few economists to have spotted the housing bubble early (see his 2002 article here). In April, he penned a piece at Andrew Cockburn’s site called “Hands off Social Security.” I suggest you read this for an alternative view. In addition, I would also recommend his book with CEPR colleague Mark Weisbrot “Social Security: The Phony Crisis.”

One reason Baker is so vehement in his arguments is that he knows ideologues are orchestrating a battle against Social Security in order to deprive you of your retirement benefits. Remember the 2004 Bush plan to privatize Social Security? What lies underneath this is a desire to give the financial services industry even greater power by allowing it to control the funds for Social Security. So, be forewarned.

In the end, while I have great respect for Baker – and agree with many of his arguments, I disagree with his conclusions (summarized here in his opposition to the film I.O.U.S.A.). Social Security and Medicare must be changed.


In the end, if you are looking for ways to increase stimulus to prevent a double dip or debt deflation while remaining fiscally prudent, a cut to entitlement programs is going to be necessary. As I see it, you can’t have your cake and eat it too.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.