Why the US has a Deficit

Most of the popular press information I have read about the current US Deficit is at best incomplete and often is very inaccurate. First, let’s be clear about what the deficit is. The deficit is the annual excess of expenses over revenue. The US Debt is the accumulation of all previous deficits.

An important distinction regarding deficits is whether the deficit is “structural” or temporary. A structural deficit means that unless changes are made to increase revenue, reduce ongoing expenses or both, the government is expected to run a net deficit over an entire economic cycle.

A temporary deficit should disappear (or even correct itself) over a period of time. When the economy enters a recession a temporary deficit will arise when revenues decrease because of smaller personal and corporate income and expenses increase to cover (for example) additional unemployment insurance. This deficit is temporary because, when the recovery is complete, revenue is restored and the additional expenses are eliminated.

A good place to start looking for methods to “solve” the US deficit is to understand how it came about. The last time the US experienced a “surplus” was Fiscal Year 2001. Since then four significant changes have occurred: (1) Revenues decreased significantly because of the Bush tax cuts; (2) Congress passed and Bush and Obama signed legislation significantly increasing expenses; (3) Bush engaged in two wars (Afghanistan and Iraq) & Obama has not ended those engagements. Neither Congress nor the presidents chose to pay for those wars by increasing revenue or cutting other expenses; and (4) the US economy entered a major recession.

Items (1), (2) and the long-term aspects of (3) [for example, increased medical care for injured military] are structural in nature. The short-term costs of war (item 3) and the recession (item 4) are temporary. The growth in interest expense on the increased US Debt related to the short-term war and recession costs are structural.

In 2000, US Government revenue equaled about 20.6% of Gross Domestic Product (GDP). By 2009 this had declined to 14.8%. The average from 1970 through 2009 was about 18%. In years of boom, tax receipts are higher as a percentage of GDP than they are in recessions and so part of the difference is accountable solely to different economic times (the temporary aspect). However, most of the decline in revenues was introduced through the Bush tax cuts and is, therefore, permanent and structural. (If you don’t think they are structural, just ask any Republican and most laypersons if they would consider reverting to the pre-Bush tax rates as a tax increase. Of course, they do.)

At the same time Bush and Congress cut revenue, they increased spending. In 2000, Federal spending was about 18.2% of GDP. By 2008, it increased to 20.7% of GDP. This 2.5% increase in GDP was a combination of Iraq and Afghanistan war costs (item 3 above) on top of increased program costs (item 2). The Republicans trumped the previous spending increases of the Democrats under Clinton and literally and figuratively went hog wild.

In 2009 Federal spending as a percentage of GDP jumped to 24.7% in an effort to ameliorate the financial crisis. Only during World War II have Federal expenditures taken up a larger portion of GDP. However large this problem is, the recession portion should at least be a temporary problem. When people are out of work, they don’t pay taxes and they do need assistance. As a country we can argue how much assistance they need and for how long, but neither the argument nor its resolution touches the bigger issue, which is the structural deficit.

The Structural Problem in a Nutshell

If much of the recent problem is caused by the recession, won’t that portion self-correct as the economy continues to recover? Normally, yes, but this time, we’ve muddied the issue through political “hardball” positions.

As an aside, Americans shouldn’t worry about TARP and one-time bail-outs to GM or AIG. Other than increased interest costs, they are not a structural issue; they are more like unemployment compensation with the added advantage that much of it will be paid back. Besides, most nonpolitical economists agree that securing the financial system prevented a much deeper recession than the bad one we experienced.

I’m not an economist, so I am not developing my own estimates of the structural deficit. Those who do purport to have the answer frequently have political agendas that lead to over/under estimating the severity of our current situation. Many agree that in 2007 the structural deficit was around 3%. Estimates of our present structural deficit range from 6% to 10%—double or triple what it was shortly before the financial crisis.

Some spending that once might have been considered transient is now appropriately characterized as structural. Many member of Congress indicate that cuts to Defense spending are “off the table.” Those statements and recent actions in Afghanistan, Libya, etc. tend to give proof to the structuralization of what should have been temporary costs. Furthermore, applying an actuary’s understanding of the unfunded off-budget obligations we have accrued for Medicare, Medicaid, Social Security and Federal employee/Military pensions and post-retirement healthcare leads me to think we are understating our long-term structural deficit.

So whether the right number is 6% of GDP, or 8% or 10%, it is a really big problem. Even the low end estimate of 6% means to balance the budget requires changes in the order of $900 billion per year. At the high end we’re over $1.5 trillion a year. I’ll end this post with these sobering figures.

Next time we’ll look at the components of Federal revenue and expenses and start to develop a picture of what will be necessary to close this structural gap.

~ Jim

Dumbing Down Insurance Licensing Exams

The Wall Street Journal reported on April 25, 2011 that Primerica is pushing to make state insurance licensing exams easier so more of their potential agents can pass.

I have limited experience with state insurance licensing exams. In the mid-1980s the company I worked for brokered annuities for its small pension clients as a way to mitigate mortality risk. Since I was responsible for the folks who made those sales, I decided to become licensed myself.

I had to go to required classes—not exactly onerous—although it was a long Saturday because the class was B-O-R-I-N-G. I had to pass both the state licensing exam and a couple of NASD licensing exams since I was to sell annuities. I did read the suggested material for the state exam since many of the questions related to specific New Jersey requirements (including all the stuff about what happens to you if you don’t follow the rules). My study for the NASD exams consisted of taking one sample exam. I don’t recall my scores, but I had absolutely no problem passing and thought at the time that the minimal requirements New Jersey imposed didn’t make me feel comfortable that a state-qualified broker could give the best advice to the Aunt Bessies and Uncle Jakes of the world.

And now Primerica wants to make the tests easier? Insurance products have not become more straightforward in the last 25 years. If people can’t pass the tests, Primerica should change its recruiting so it attracts people who can. Primerica carps about an unsatisfied need because of the lack of brokers. The public, they say, is not being well-served.

If Primerica can’t attract people who can qualify under the current system, they need to change their ways. Perhaps they should look at their unique compensation structure that pays agents for bringing in other agents in addition to actually selling insurance products. Maybe if agent compensation was aligned with public needs, they would find qualified individuals, as their competitors do.

Oh, did I mention that if you want to join Primerica’s agent training program, it will cost you $99?

~ Jim

Paul Ryan’s Medicare Proposals

First the kudos to Paul Ryan. He is correct that unless we address Medicare we have little hope of addressing the Federal Government’s long-term structural deficits. Now the slam on two fronts:

1. His plan is a wolf in sheep’s clothing regarding the long-term viability of Medicare, and

2. He puts the primary burden of the fix on future generations of retirees.

Wolf in Sheep’s Clothing

In essence Ryan’s plan is to change Medicare from providing benefits to providing a subsidy for health insurance. Today’s Medicare offers an array of benefits eligible participants receive, subject to deductibles and co-pays. Participants pay no premiums for Medicare Part A, and pay highly subsidized premiums for Medicare Parts B and D. Only about 5% of participants pay increased Part B and Part D premiums because of their higher income levels.

Ryan’s proposal seems innocent enough. To understand how it would work, let’s say benefits cost $1,000 a year and are provided “free” by the government. Step one is to credit each participant with $1,000 and let them buy the equivalent benefit from a private insurance company. This will “get the government out of the medical insurance business.” Right?

Not so much. Government will still need to develop a whole set of regulations because it will cost a lot more to insure my parents than to insure me. Credits will need to be age-adjusted and perhaps, health-adjusted, to be fair. But let’s ignore that little issue. Let’s say they manage to get the credits and regulations right.

Why would an insurance company want to take on these plans? To make a profit—a profit not extant under the current system. Who will pay for that? The plan’s participants—unless the insurance companies are more efficient than the government in administering the plan. From your experience in dealing with insurance companies, what do you think? I’m not convinced. I think the approach will add Insurance Company profit to Medicare costs and will exacerbate the cost structure.

Additionally, the government does not need to charge a risk premium because if benefits are greater than expected, the government is on the hook. Not so with an insurance carrier. If its actuaries guess (oh, I mean misestimate) wrong about the level of costs, the insurance company is on the hook. They will want compensation to accept that risk. More added costs.

Now for a history lesson, which I think should be remembered in order to understand how Ryan’s plan will likely work in practice.

Let’s revisit the corporate world of medical plans during the 70s, 80s & 90s when I was consulting on plan design. The 70s began with employer-pay all plans (or plans with very modest employee contributions). Enter HMOs (Health Maintenance Organizations), which corporations first fought because it meant lack of control and then embraced because they promised lower costs.

For a fixed fee these entities would cover employees for all the basic medical services, but you had to receive care “in network” or be charged a premium. For a short period, medical costs stabilized before rocketing again. Then came insurance-company-sponsored PPOs (Preferred Provider Organizations). Same thing: an initial decline in the rate of cost increases before reverting to continued acceleration. (Note: there was never a decline in costs, just in the rate of increases.)

Corporations gave employees the choice to maintain their current plan, but with increased contributions, or take a lesser plan at little or no increase in their costs. Healthy employees took the new plan; those more likely to use benefits stayed with their dinosaur plan. This adverse selection drove traditional plan costs through the roof until no employees could afford them and employers dropped that choice.

During any of these changes did you notice your recordkeeping or dealing with insurance companies became easier? Me neither and I’ve been very fortunate to be healthy.

Now let’s peer into the future. In year two, what happens under Ryan’s proposal? From the sketchy details I’ve read, it will work like this: Your voucher grows with CPI, which let’s say increased 3%. Your new voucher is $1030. Good deal, until the insurance company mentions that medical inflation ran at, say, 15%. Now, the same benefits will cost you $1150. You can personally pay the $120 difference, or you can enroll in a less generous plan that just happens to cost $1030. It provides almost as good benefits—you’ll hardly notice the difference—or so they say.

The poor have no choice and must migrate to the reduced plan unless they know they are going to need the better benefits of the original plan, in which case they find some way to pay up. The rich pay the extra $120.

After a few years of this, an interesting trend arises. Three kinds of plans emerge. The lesser plan annually cuts benefits to match what the voucher provides. The well-off pay for benefits similar to those originally provided by Medicare except they are purchasing those benefits through voluntary associations. To participate, you had to be a professional of some sort, or earn a PhD or be a member of some other affinity that insurance company underwriters can use as a proxy for well off. In the meantime a third group has arisen. These people need the better benefits because they use them. They don’t qualify for the affinity plans and their costs escalate out of sight.

Ultimately this third group cannot afford the coverage because of pre-existing conditions, although they are never denied coverage because of that. They are the last ones in the original pool. Everyone else swam away.

Nothing in this process I have described addressed spiraling medical costs. The medical system is privatized (a Libertarian goal), but the voucher covers fewer and fewer benefits each year. Benefit cuts are implemented through the mechanism of having vouchers that do not keep up with the cost of benefits.

The system quickly bifurcates into haves and have nots. The haves can still get liver transplants; the have nots will not be covered and will die.

Ryan would undoubtedly object and state that because he has put consumers in charge, they will be able to change the trajectory of medical costs. Consumers with skin in the game will decide to go to cost-efficient providers, etc. etc. and the cost of delivering medical care will decline because of the competition.

Let me ask this: if the largest US employers with all of their bargaining power have been unable to put a dent in long-term medical cost increases, why should we think 300 million individual consumers each scrambling on his own will succeed?

They will not succeed. If anyone has a chance to put a lid on cost increases it would be the Federal Government IF and ONLY IF Congress did not fetter it as it currently does by refusing to allow the government to negotiate deals directly with medical providers, drug manufacturers, etc.

Ryan’s plan will not solve the problem, because it does not address the causes of the problem.

The Burden on future generations

Anyone currently over fifty-five is exempt from the structural changes Ryan requires for those younger. I am in this protected class and I object on several counts. First, we citizens of the United States must be required to make shared sacrifices to solve our problems. Seniors vote; seniors are generally more conservative. Ryan’s cynical approach of not asking anyone close to Medicare eligibility to make sacrifices exacerbates the "us versus them" schisms politicians utilize to get elected.

Second, this approach of grandfathering seniors does not address the question of which cohort of taxpayers caused the Medicare problem. My children did not cause the imbalances in the system. Medicare came into existence in 1965. When I first started working full-time in 1972, I paid 0.6% of wages up to $9,000 toward Medicare. It wasn’t until 1986 that the current 1.45% rate went into effect and only in 1994 was the income limit removed.

Increases in medical costs have been significantly greater than increases in wages, which means if 1.45% was the correct rate in 1986, it is guaranteed to be woefully inadequate now. My father paid Medicare taxes for about 20 years, almost all before the 1.45% rate went into effect. My parents have both benefited from Medicare for over twenty years and (thankfully) appear to have many more years ahead of them. During their retirement, Medicare benefits continued to expand. Only in the last few years have those with higher incomes (over $85,000 for an individual) paid greater Part B premiums than the standard 25% of the cost of the benefits charged other participants.

This has been a great deal for my parents, and while not quite as great a bargain for me, I expect a financial analysis would show it will take me very few years to “earn” back my contributions into the system.

Medicare’s problem doesn’t start in 2021 when the first people currently under age 55 will start to receive Medicare. It is a current problem and to solve it means a shared sacrifice by those presently receiving benefits, those soon to receive benefits and those much farther away from receiving benefits.

The solution is to deal with the underlying cost structure of our medical system (everyone agrees it is broken) and the terms and conditions for receiving benefits under Medicare. That means we need to honestly move away from thinking it is government’s responsibility to give everyone over age 65 an almost unlimited right to whatever care might extend their life.

That’s a harder issue for us Americans, but if we don’t have that honest discussion, we will never address the underlying cost structure of our broken medical system in these United States.

~ Jim