Wall Street History

---

Wall Street History

10/06/2006

The Entitlement Debate

Federal Reserve Chairman Ben Bernanke has a reputation for
plainspeak that his predecessor, Alan Greenspan, was certainly
not known for. So on Wednesday, Oct. 4, Bernanke addressed
the topic of entitlements, the Baby Boomer generation, and the
coming crisis at a session of the Washington Economic Club in
Washington, D.C. Granted, this has not been a market-moving
subject over the years, and it’s never going to be one on any
given day, week or even month. But in the not-too-distant future
it is likely to begin eating away, bit by bit, and the Big Picture
outlook in terms of living standards, as Bernanke addresses, is
not a pretty one.

---

“The Coming Demographic Transition: Will We Treat Future
Generations Fairly?”

In coming decades, many forces will shape our economy and our
society, but in all likelihood no single factor will have as
pervasive an effect as the aging of our population. In 2008, as
the first members of the baby-boom generation reach the
minimum age for receiving Social Security benefits, there will be
about five working-age people (between the ages of twenty and
sixty-four) in the United States for each person aged sixty-five
and older, and those sixty-five and older will make up about 12
percent of the U.S. population. Those statistics are set to change
rapidly, at least relative to the speed with which one thinks of
demographic changes as usually taking place. For example,
according to the intermediate projections of the Social Security
Trustees, by 2030 – by which time most of the baby boomers
will have retired – the ratio of those of working age to those
sixty-five and older will have fallen from five to about three. By
that time, older Americans will constitute about 19 percent of the
U.S. population, a greater share than of the population of Florida
today.

This coming demographic transition is the result both of the
reduction in fertility that followed the post-World War II baby
boom and of ongoing increases in life expectancy. Although
demographers expect U.S. fertility rates to remain close to
current levels for the foreseeable future, life expectancy is
projected to continue rising. As a consequence, the anticipated
increase in the share of the population aged sixty-five or older is
not simply the result of the retirement of the baby bombers; the
“pig in a python” image often used to describe the effects of that
generation on U.S. demographics is misleading. Instead, over
the next few decades the U.S. population is expected to become
progressively older and remain so, even as the baby-boom
generation passes from the scene. As you may know, population
aging is also occurring in many other countries. Indeed, many of
these countries are further along than the United States in this
process and have already begun to experience more fully some of
its social and economic implications.

Even a practitioner of the dismal science like me would find it
difficult to describe increasing life expectancy as bad news.
Longer, healthier lives will provide many benefits for
individuals, families, and society as a whole. However, an aging
population also creates some important economic challenges.
For example, many observers have noted the difficult choices
that aging will create for fiscal policy makers in the years to
come, and I will briefly note some of those budgetary issues
today. But the implications of demographic change can also be
viewed from a broader economic perspective. As I will discuss,
the broader perspective shows clearly that adequate preparation
for the coming demographic transition may well involve
significant adjustments in our patterns of consumption, work
effort, and saving. Ultimately, the extent of these adjustments
depends on how we choose – either explicitly or implicitly – to
distribute the economic burdens of the aging of our population
across generations. Inherent in that choice are questions of
intergenerational equity and economic efficiency, questions that
are difficult to answer definitely but are nonetheless among the
most critical that we face as a nation ..

Although demographic change will affect many aspects of the
government’s budget, the most dramatic effects will be seen in
the Social Security and Medicare programs, which provide
income support and medical care for retirees and which have
until now been funded largely on a pay-as-you-go basis. Under
current law, spending on these two programs alone will increase
from about 7 percent of the U.S. gross domestic product (GDP)
today to almost 13 percent of GDP by 2030 and to more than 15
percent of the nation’s output by 2050. The outlook for Medicare
is particularly sobering because it reflects not only an increasing
number of retirees but also the expectation that Medicare
expenditures per beneficiary will continue to rise faster than per
capita GDP. For example, the Medicare trustees’ intermediate
projections have Medicare spending growing from about 3
percent of GDP today to about 9 percent in 2050 – a larger share
of national output than is currently devoted to Social Security
and Medicare together.

The fiscal consequences of these trends are large and
unavoidable. As the population ages, the nation will have to
choose among higher taxes, less non-entitlement spending, a
reduction in outlays for entitlement programs, a sharply higher
budget deficit, or some combination thereof. To get a sense of
the magnitudes involved, suppose that we tried to finance
projected entitlement spending entirely by revenue increases. In
that case, the taxes collected by the federal government would
have to rise from about 18 percent of GDP today to about 24
percent of GDP in 2030, an increase of one-third in the tax
burden over the next twenty-five years, with more increases to
follow. Alternatively, financing the projected increase in
entitlement spending entirely by reducing outlays in other areas
would require that spending for programs other than Medicare
and Social Security be cut by about half, relative to GDP, from
its current value of 12 percent of GDP today to about 6 percent
of GDP by 2030. In today’s terms, this action would be
equivalent to a budget cut of approximately $700 billion in non-
entitlement spending.

Besides tax increases, spending cuts, or reform of the major
entitlement programs, the fourth possible fiscal response to
population aging is to accommodate a portion of rising
entitlement obligations through increases in the federal budget
deficit .Consequently, the choices that fiscal policy makers
make with respect to these programs will be a crucial
determinant of the way the economic burden of an aging
population is distributed between the current generation and the
generations that will follow.

Indeed, framing the issue in generational terms highlights the
fact that the economic implications of the coming demographic
transition go well beyond standard considerations of fiscal policy
and government finance, important as those are. For reasons that
I will explain in a moment, the aging of the population is likely
to lead to lower average living standards than those that would
have been experienced without this demographic change. How
that burden of lower living standards is divided between the
present and the future has important implications for both
intergenerational fairness and economic efficiency.

Why will the coming demographic transition carry a cost in
terms of long-run living standards? Assuming it unfolds as
expected, the projected aging of the population implies a decline
over time in the share of the overall population that is of working
age and thus, presumably, in the share of the population that is
employed. For any given level of output ‘per worker’ that might
be attained at some future date, this decline in the share of people
working implies that the level of output ‘per person’ must be
lower than it otherwise would have been. In a sense, each
worker’s output will have to be shared among more people.
Thus, all else being the same, the expected decline in labor force
participation will reduce per capita real GDP and thus per capita
consumption relative to what they would have been without
population aging. These reductions in output and consumption
per person represent an economic burden created by the
demographic transition .

[Ed. Bernanke then talks about solutions, including finding ways
to increase the national saving rate.]

However, as any economist will tell you, there is no such thing
as a free lunch. Saving more requires that we consume less (to
free up the needed resources) or work more (to increase the
amount of output available to dedicate to such activities). Either
case entails some sacrifice on the part of the current generation.
Consequently, a tradeoff exists: We can mitigate the adverse
effect of the aging population on future generations but only by
foregoing consumption or leisure today. This analysis is simple,
but it shows why the coming demographic transition has
economic implications that go well beyond the effect of aging on
the federal budget .

If we don’t begin soon to provide for the coming demographic
transition, the relative burden on future generations may be
significantly greater than it otherwise could have been .

The choice of which generations should bear the burden of
population aging has consequences for economic efficiency as
well as for intergenerational equity. If we decide to pass the
burden on to future generations – that is, if we neither increase
saving now nor reduce the benefits to be paid in the future by
Social Security and Medicare – then the children and
grandchildren of the baby boomers are likely to face much higher
tax rates. A large increase in tax rates would surely have adverse
effects on a wide range of economic incentives, including the
incentives to work and save, which would hamper economic
performance. Alternatively, to avoid large tax increases, the
government could decide to sharply reduce non-entitlement
spending in the future. However, such actions might also have
important social costs that need to be taken into consideration.

[Ed. Back to the topic of saving ]

Unfortunately, many years of concentrated attention on this issue
by policymakers and economists have failed to uncover a silver
bullet for increasing household saving. One promising area that
deserves more attention is financial education. The Federal
Reserve has actively supported such efforts, which may be useful
in helping people understand the importance of saving and to
learn about alternative saving vehicles. Psychologists have also
studied how the framing of alternatives affects people’s saving
decisions. For example, studies suggest that employees are much
more likely to participate in 401(k) retirement plans at work if
they are enrolled automatically – with a choice to opt out – rather
than being required to actively choose to join. The pension bill
recently passed by Congress and signed by the President
included provisions to increase employers’ incentives to adopt
such opt-out rules; it will be interesting to see whether such rules
are adopted and, if so, how effective they are in promoting
employee saving .

Another response to population aging is to adopt measures that
encourage participation in the labor force, particularly among
older workers. In the near term, increases in labor force
participation would raise income; some of this income would be
saved and would thus be available to augment the capital stock.
In the long run, higher rates of labor force participation,
particularly by those who would otherwise be in retirement,
could help to offset the negative effect of population aging on the
share of the population that is working .

Reform of our unsustainable entitlement programs should also be
a priority. The nature and timing of those reforms will be
determined, of course, by our elected representatives. However,
the intergenerational perspective does provide a few insights that
might be helpful to policymakers as they undertake the needed
reforms. First, restructuring the finances of our entitlement
programs to minimize their reliance on deficit spending will
enhance national saving and reduce the burden on future
generations. Second, changes in the structure of entitlement
programs should preserve or enhance the incentives to work and
to save; for example, we should take care that benefits rules do
not penalize those who may wish to work part-time after
retirement. Finally, the imperative to undertake reform earlier
rather than later is great. As illustrated by the simulation I
discussed earlier, the longer the delay in putting our entitlement
programs on a sound fiscal footing, the heavier the burden that
will be passed on to future generations. Moreover, the sooner
any restructuring of entitlement programs takes place, the easier
it will be for people now in their working years to prepare, for
example, by saving more today. However, if reform is delayed
and fiscal exigencies ultimately force changes in these programs
with little notice to potential retirees, their ability to adjust their
behavior appropriately could be much reduced .

(The) coming demographic transition will create severe fiscal
challenges, as the cost of entitlement programs rises sharply. I
hope to have persuaded you today, however, that the economic
implications of this transition go well beyond fiscal policy. From
a broader economic perspective, the question is how the burden
of an aging population is to be shared between our generation
and the generations that will follow us. A failure on our part to
prepare for demographic change will have substantial adverse
effects on the economic welfare of our children and
grandchildren and on the long-run productive potential of the
U.S. economy.


---

I will have some comments on the above in my Oct. 7 “Week in
Review” column.

Source: federalreserve.gov

Wall Street History returns next week the European Union.

Brian Trumbore

---