The new Congress faces an urgent need to reposition the big entitlement programs, Social Security and Medicare, on a sounder financial footing. With each passing year, these programs' massive fiscal imbalances grow larger, making it harder to solve the problem, but all the more necessary to do so.
As reported by its trustees, Social Security's total imbalance has increased from $10.4 trillion in 2004 to $13.4 trillion in 2006 - a jump of $3.0 trillion in just two years. And Medicare's imbalance has grown from $61.6 trillion in 2004 to $70.5 trillion today - an increase of $8.9 trillion in the same period.
That's $11.9 trillion in new debt in the past two years alone. Put another way, it's 85 percent of the $14 trillion of GDP that the United States will likely produce this year.
Some of this increase reflects changes in underlying economic assumptions, but a significant portion of it arises from accruing interest costs on the existing fiscal imbalance. At the current interest rate of 2.9 percent, for example, the combined imbalance of Social Security and Medicare - $83.9 trillion - will accrue added costs of $2.4 trillion this year. Next year's interest cost accrual will be even larger, as additional interest accrues on this year's interest costs as well. This situation is clearly not sustainable, because US economic growth cannot keep pace with such massive accruals in future government obligations.
There is considerable debate about whether and how to "recognize" on the government's books future Social Security and Medicare payment obligations. Members of the Federal Accounting Standards Advisory Board recently released preliminary views indicating a split between its members on the issue. FASAB was established by the Treasury, Office of Management and Budget, and The Comptroller General. Three of its members currently oppose recognizing any more than benefits currently "due and payable" as government "liabilities."
However, six other FASAB members favor earlier recognition of entitlement liabilities—as soon as workers meet every benefit-eligibility requirement except that of attaining retirement age. That means the present value of future benefits as earned to date by all benefit-eligible workers - even those far from retirement - would be recognized and reported as explicit government liabilities, not unlike outstanding government bonds.
Why is this debate important? There are two main concerns about broadening the definition of entitlement liabilities beyond the current "due and payable" standard. First, it might make future entitlement obligations more difficult to change. But those obligations are extremely difficult to alter even now - as we witnessed last year when the American Association of Retired Persons led voters opposed to entitlement changes to thwart the Social Security reform debate that President Bush was attempting to initiate. Broadening entitlement liability recognition would only render this reality more transparent.
Second, earlier recognition of entitlement liabilities would make the government's finances appear a lot shakier, and may make it more difficult for it to raise funds in capital markets. Whether and to what extent this would occur is difficult to foretell.
However, consider the flip side: Hiding the reality that the government must raise trillions more in future taxes to meet its benefit obligations - or forcibly cut those obligations when the costs of tax increases become unacceptably large - creates a seemingly benign economic outlook today. It provides a false sense of security to consumers and policymakers. As a result, consumers continue to save less, making them more vulnerable to future adjustments in taxes, entitlement benefits, or other public expenditures. And the lack of visibility and market discipline encourages relatively shortsighted politicians to postpone difficult reform decisions.
Lawmakers and Administration officials recently highlighted the Congressional Budget Office report of a $248 billion "deficit" for the just-completed 2006 fiscal year, and everyone applauded how much smaller the deficit had turned out to be than projections suggested two years ago. But this year's actual cost accrual in Social Security and Medicare alone amounts to $2.4 trillion - ten times as much - a reality that remains hidden under current budget accounting standards.
Historically - and irrespective of which political party is in power - government officials have opposed earlier recognition of entitlement obligations as explicit government liabilities. They usually justify their position by observing that such obligations would only relate to current entitlement laws, which are subject to future changes. Of course, future changes are inevitable given the programs' insolvency. But, ironically, that perspective appears to be the biggest hurdle preventing pro-active changes in entitlement policies.
Lawmakers should resume entitlement reform discussions soon. The policy debate would take on greater urgency, however, if the size of entitlement obligations were explicitly recognized on the government's books. And clear recognition that the government faces payment commitments much larger than its outstanding Treasury securities would impose greater discipline on lawmakers who might otherwise be inclined to spend public funds like there's no tomorrow.
Jagadeesh Gokhale is a senior fellow at the Cato Institute and a former senior economic advisor to the Federal Reserve Bank of Cleveland.