Demographic conditions profoundly affect the U.S. federal budget. Roughly one half of spending outside of interest on the debt and defense goes to people age 65 and over. In 2006, combined Social Security, Medicare, and Medicaid spending averaged over $30,000 per capita for the older population. The first baby boomer will apply for Social Security in 2008 and for Medicare in 2011, and shortly after, spending pressures will soar.

Just as spending pressures will accumulate rapidly, tax revenue growth will decline because of a slowing in the growth of the working population. The slowdown will be the result of baby boomer retirements and a scarcity of younger entrants into the labor force. Simply put, the boomers did not have enough children to support them comfortably in their old age.

The combination of accelerating spending and decelerating revenue growth will place enormous upward pressures on budget deficits unless spending programs for the elderly are reformed, tax burdens are raised far above historically normal levels, or other government programs are cut to almost nothing. If deficits are allowed to drift upward continually, international financial markets will eventually become concerned about the future of the U.S. economy. At best, international and U.S. domestic investors will then demand higher interest rates and higher returns on U.S. equities before they are willing to buy U.S. bonds and stocks. At worst, investor concerns could cause a financial panic and do grave harm to the U.S. economy.

It is important to differentiate two very different types of economic cost imposed by deficits. Mild deficits erode a nation's wealth and therefore its standard of living in the long run. That is because deficits are financed by selling debt to either Americans or foreigners. If Americans did not use their savings to buy this debt, they probably would invest in housing or in business equipment and buildings in the United States and that would add to American wealth and productivity in the long run. Added productivity results in higher wages and therefore higher U.S. living standards.

To the extent that foreigners buy the debt, the United States will have to pay them interest in the future. The U.S.-generated income used for this purpose will not be available to Americans, and again, U.S. living standards will suffer. The erosion of U.S. living standards caused by mild deficits occurs slowly and is barely noticeable in the short run. But over the long run, it slowly accumulates and eventually becomes quite significant.

However, the negative effect on living standards is not the main concern raised by growing deficits. As deficits grow, the nation's debt will eventually start to grow faster than its income. Then interest on the debt will also grow faster than income. If a nation starts to borrow to cover a growing interest bill as well as a portion of its noninterest spending, it can quickly get into very serious trouble. An ordinary household would too under similar circumstances. The interest bill begins to explode, and at some point, a household declares bankruptcy. A nation has another recourse. It can print money. But then inflation explodes and can easily reach 10,000 percent per year, or even more than 1,000,000 percent, as it did in the case of the Weimar Republic in the 1920s.

At what point should investors become worried about a debt explosion leading to hyperinflation? The ratio of the government's debt to the nation's gross domestic product (GDP) is an important indicator. If a government borrows enough every year to cause its debt to grow faster than the nation's total income, there is some reason to worry. Of course, this need not be an intense worry if the nation starts with a very low ratio of debt to GDP, and the United States' ratio is quite low relative to that of most other developed nations. Nevertheless, if the United States does nothing to reform its programs for the elderly or to raise taxes dramatically, the ratio will begin to rise at a very rapid rate after about 2015.

At what point do deficits raise the national debt faster than income? Economists focus on something called the primary surplus or deficit, which is noninterest spending minus revenues. Why is interest spending ignored in this calculation? In the long run, the interest rate on the public debt gravitates toward the growth rate of the economy. Let us assume that both the interest rate and the economic growth rate equal 5 percent. If the government borrows just enough to cover the interest bill on the debt, the debt will grow 5 percent. With the economy also growing at 5 percent, the ratio of debt to GDP will be constant. If the government borrows less than the interest bill, that is to say, runs a primary surplus, the ratio of debt to GDP is likely to fall in the longer run. Thus, it is considered prudent to always strive for a primary surplus.

That does not mean that government should never allow the debt-to-GDP ratio to rise over limited time periods. It would be very wasteful to raise and lower tax rates with every wiggle in expenditures. If a country is confronted by a temporary surge of spending because of a war or a major investment project, it makes sense to borrow temporarily even if the ratio of debt to GDP rises for a time. The same is true when a recession temporarily reduces revenue. Raising taxes could worsen the recession, although that theory is more controversial than it once was.

The budget duress caused by the aging of the population is not temporary. The problem will persist and worsen rapidly if there is no significant change in policy. It would be better to implement the necessary policy changes gradually and deliberatively rather than hastily when frightened by a panic in financial markets.

Bibliography:

1) Kotlikoff, Laurence J. and Scott Burns. 2005. The Coming Generational Storm. Cambridge, MA: MIT Press.

2) Penner, Rudolph G. and C. Eugene Steuerle. 2003. The Budget Crisis at the Door. Washington, DC: Urban Institute.

3) Rivlin, Alice M. and Isabel Sawhill, eds. 2005. Restoring Fiscal Sanity 2005. Washington, DC: Brookings Institution Press.

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