The real risks of deficits

Robert J. Shiller Professor of Economics Yale University Project Syndicate

Deficits are back -- with a vengeance. America's government budget deficit now stands at US$455 billion, 4.1 percent of GDP. Two years ago, the U.S. predicted budget surpluses as far as the eye could see.

Although marginally less bloated than the U.S. deficit, other rich countries are drowning in red ink. The European Commission predicts that the French government deficit will reach 3.7 percent of GDP this year, with Germany's widening to 3.4 percent -- both figures well beyond the deficit cap (3 percent of GDP) set by the Euro-zone's Stability and Growth Pact.

By running a deficit, a country increases its national debt and imposes burdens on future generations. Politicians naturally prefer to hide how wealth is shifted between generations. Their priority is paying for immediate problems, and for today's promised benefits.

The accountants who compute government deficits try to keep politicians from fooling us into accepting the benefits they offer without understanding something of the future cost. But what these accountants do not provide is a way to judge when deficits are justifiable and when they are not.

Deficits raise not only immediate political issues, but also issues of distributive justice between generations, and of intergenerational risk sharing. No generation should be forced to accept unnecessary economic risks imposed by another generation. Whether or not deficits treat future generations properly depends on how a government's systems for taxation and expenditure are designed.

Those who advocate running deficits often portray them as necessary to fix an economy in which confidence is draining away. Following Keynes, they argue that running deficits will restore confidence before a recession or depression can take hold. But this is like putting a patient on Prozac before he becomes suicidal.

Such arguments, although valid at times, have their limits. Japan's public deficits spawned a national debt of 140 percent of annual GDP, without producing any economic resurgence. Indeed, today's budget deficits reflect long-term problems that are not what Keynesian theory envisions. So discussions about deficits should be recast in terms of the really long-term intergenerational issues that matter.

The issues are subtle, because they hinge on what future governments may do. In the past, some governments, when faced with large national debts, effectively "inflated them away." They thus shifted the debt burden away from the next generation and onto investors who did not bail out of the bond market at the first sign of rising prices, or who postponed buying a house when inflation would have wiped out the real value of their mortgage debt.

Governments could decide to act this way again, especially if national debts grow bigger. A resurgence of substantial inflation may seem unthinkable in today's environment, but remember that even a relatively modest 6 percent annual inflation rate cuts the real value of a nation's debt in half in just 11 years. Continued public opposition to a gradual increase in inflation is not guaranteed. Some future politicians may succeed again in planting the idea that inflation, being stimulative, is good for the economy.

But in addition to today's officially measured government deficits, there are also other looming obligations caused by a demographic change (declining birth rates) and the prospect of huge social-welfare payments in the future. The scale of these obligations is monumental.

In their 2003 report, the Trustees of the U.S. Social Security Administration Trust Funds estimate that maintaining the Social Security System's solvency for the next 75 years will require an amount whose present value is $3.5 trillion, nearly equal to today's total U.S. government debt ($3.9 trillion). The Trustees of the U.S. Medicare Trust Funds (providing medical services to the retired) estimate that their unfunded obligations have a present value of $5.9 trillion -- 50 percent larger than America's official publicly-held national debt. The potential for budgetary shortfall with social security and health care is even worse in Europe and Japan, due to their more troublesome demographics.

Moreover, unlike official national debt, social-welfare obligations are not fixed in currency. Instead, they are promises of a certain standard of living (including the value of medical services), corrected for inflation. No government can thus "inflate them away."

But this does not mean that pensions and other welfare obligations are entirely fixed. What it does mean is that the problem is political. Pensioners are among the most powerful lobbies in a democracy, and politicians are loath to confront them on so fundamental an issue.

Still, we need to face squarely the intergenerational issues at the core of today's economic dilemmas. Our pension systems and our national budgets must be based on a "generational accounting" that assures that economic risk is spread systematically across generations.

What this means is that pension and tax institutions must be designed to take better account of the changing circumstances facing different generations, rather than make fixed promises -- which most likely cannot be kept, anyway -- of a certain payout in the future. For example, when demographic trends or persistent economic hardships impose undue social-welfare burdens on working people, benefits to pensioners should be automatically modified by raising the retirement age and/or adjusting benefits.

Such adjustments will probably happen anyway in the coming decades, but only after a long lag and with many inequities in the process. What we need is the right system from the beginning, so that we can rationally manage risks that span several generations.

Can these issues be addressed now, when the economic slowdown in most advanced countries makes most politicians focus on short- term fixes? Hard times, like the Great Depression, have been occasions for fundamental changes. With proper leadership (which unfortunately seems in short supply), today's milder hardships could provide an opportunity for public discussion of better ways of intergenerational risk sharing.

The author also writes the book "The New Financial Order: Risk in the 21st Century," Princeton, 2003.