Demographics, Deleveraging, and Debt –17 June 2012

President Obama and Mitt Romney both made speeches about the economy last week, dueling each other from opposite sides of battleground state Ohio.  While the economy is likely to be the premier issue in this year’s presidential election, neither camp is squaring with the American people about the situation we’re in and what we can expect.

In a word, the US economy is facing such severe structural headwinds that it is unlikely that we will see robust, job-creating growth no matter who’s in charge.  There are three intractable reasons for this: demographics, deleveraging, and debt.

Our demographic dilemma is well-known.  As the Baby Boom generation begins to retire, our government-sponsored income support programs will undergo tremendous stress; it is, as Wisconsin Rep. Paul Ryan has called it, the most predictable crisis in our history.

Indeed, the Social Security trust fund (Al Gore’s famous “lock box”) went cash-flow negative last year, meaning that the money coming in from FICA payments was insufficient to pay for current benefits.  Up until this point there had been a surplus, which was supposed to have been saved for future retiree payments.  Now that there is a deficit, the system is digging into its investment account and finding nothing but government iou’s.  It’s been spent.

But it’s worse than that.  One of the reasons this generation has so little saved up for retirement is this: back in the 1950’s, the payroll tax rate was only 3%; by 1990 it had risen to 15.3%.  So the money that the Baby Boomers might have socked away in savings was going to the government for Social Security.  Then, of course, by the time they are of an age to collect their share of the contributions, the money is gone.

That is what happens when you entrust government – at any level – with your retirement.  They find ways to raid the pension plan to fund their current needs because there is always – always – more demand for money than there is money.  And the big pot of pension dollars is too tempting to leave alone.

The Boomers’ retirement will of necessity create a drag on consumption, as retirees leave the work force and have to live on their savings.  As described in a paper by Ben Bernanke in 2007, this means that each worker’s output has to be shared by more people, which means less consumption per capita.  And since consumption is 70% of the economy, this will represent a significant economic headwind, totally apart from the stresses on the government’s budget.

The second structural impediment is the continuing deleveraging that the economy is enduring.  Back in the 1980’s, the ratio of household debt to disposable income was only about 60%.  It grew steadily through the 1990’s and then rocketed during the Bush years to a peak of nearly 140%.  This was when many people were using their homes as ATM’s, loading up on debt that the Fed was pricing too cheaply, and refinancing to cash out of their homes’ inflating values.  The ratio collapsed with the crisis, but still stands at about 110%.  It has much further to go before American households are in a position to increase their consumption as they have done in the past.

One of the implications of this is that Ronald Reagan himself could not spark the economic growth in the years ahead that he was able to do in the ’80’s.  Then, the level of debt was low enough to enable it to be part of the economic expansion and to contribute to it in a meaningful way.  Today, households are restraining consumption to bring their personal balance sheets into line, and as long as they do the economy’s ability to flourish will be limited.

The third issue is government debt.  Actors throughout the economy, business owners to consumers, are alarmed at the rapidly escalating levels of debt at various levels of government.  And with good reason.  Government debt is a signal of future taxes, and if not that then inflation, which throughout history has been governments’ ignoble response to unmanageable debts.  Either one will undermine economic prospects, leading to worsening business conditions and loss of jobs.

There is evidence in every direction: state governments that are tens of billions – even hundreds of billions – in debt, once pension liabilities and the like are factored in.  The Federal debt has grown by half since Barack Obama took office, and current budget projections call for trillion-dollar deficits well into the future.  And this doesn’t even count the unfunded liabilities for Medicare, Medicaid, and Social Security, which if properly accounted for would yield a total Federal debt that is a multiple of national GDP, not merely a large proportion of it.  In Europe we see the catastrophic results of unrestrained borrowing, as peripheral countries such as Greece impoverish their people as a price for maintaining access to funding.

The debt in this country is so large that working it down will take a long-term plan of steady improvement sustained by steely discipline, a virtue not well-rehearsed in Washington.  The near-hopelessness of the task makes this third economic headwind particularly troublesome.

Given all these impediments to stronger growth, one might ask, is Obama then justified when he maintains that the current meager expansion is not his fault?  I would argue, not in the least.

If there is one cure for these ills, it is economic growth, and particularly productivity growth.  Our free market economy is a marvelous engine for creating wealth and innovation, and it can make progress even in the most unpromising conditions.  Indeed, we have been in an expansion for the last three years, although it has not felt much like it.

What the economy needs, especially when the background circumstances are so unfavorable, is as much free rein as possible to experiment, to innovate, to engage in creative destruction.  Instead, what Obama has given us is smothering regulation, crony capitalism, more expensive energy, more expensive health care, and the constant promise of higher taxes and wealth redistribution.

Mitt Romney is right to challenge Obama on his economic record, and to maintain without apology that the way forward is to give people their freedom to find new ways to make a buck.  I think voters would find it refreshing if he leveled with them about the above structural problems in our economy, and emphasized that when the headwinds are strong, the last thing you want to do is throw out a drag anchor.

This economy may not be capable of a Reagan-style boom at this point, and Romney should be careful about over-promising.  But we are surely capable of doing more than we have been doing.  Tens of millions of people have suffered because of Obama’s wish to be a transformative president.  It’s time to give the free market a chance again.

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