Thursday, January 8, 2009

Daschle on Health Care Reform: Will his proposals Change the Trajectory of Health Care Outlays?

I recently read Tom Daschle’s new book, “Critical: What We Can Do About the Health Care Crisis” (co-authored with Jeanne M. Lambrew and Scott S. Greenberger). This book has particular relevance since he will soon be the new czar of health care reform in the Obama administration. Arguing that it would be politically infeasible for the United States to move to a single payer, national health insurance scheme, Daschle and his colleagues argue for providing the option of an alternative health insurance scheme similar to that provided to Federal employees and the Congress. Such an approach would enhance competition with insurance provided by the private sector. They suggest that households unable to afford the purchase of federal insurance coverage might be made eligible for financial assistance through means-tested government subsidies. By extending the reach of the government beyond Medicaid, Medicare and the Veterans Administration, they believe that the combination of Federal insurance programs would also give the Federal government greater ability to influence how the private sector provides health care and its cost. (1)

The authors also call for the creation of a Federal Health Board (FHB) that would have direct authority over Federal health care programs, shaping the framework—as a “standard-setter”--for decisions on coverage and benefits, and introducing an evidence-based approach in considering the cost-effectiveness of drugs, devices, and medical procedures. They call for this agency to be accorded independence similar to that given to the Federal Reserve Board in the sphere of monetary policy (arguing that, as with monetary policy, Congress lacks the competence or flexibility to make micro decisions in the medical sector).

I have little doubt that adoption of Daschle’s proposals would be an important first step in reforming the provision and financing of health care in this country. Simply ensuring that individuals are able to obtain coverage at reasonable cost would be a dramatic step forward in ending the scandal of this rich country having so many of its citizens without medical insurance coverage. Competition will help to some extent in curbing the excessive administrative costs that characterize the private health insurance business in the United States. By moving closer towards universal coverage, the shifting of costs from uninsured to insured would be reduced, removing one source of the present pressure for rising costs. Daschle’s proposal also focuses on the potential for beneficial spillover effects from the Federal system on the approach taken by private insurers in terms of benefit coverage and in the application of cost-effectiveness standards in judging the efficacy or superiority of new drugs, sophisticated diagnostic tests, medical devices, and surgical procedures.

But any health care reform initiative in the U.S. must also address certain basic financial realities about the present situation (many of which are recognized by Daschle in his book), even before we consider an extension of coverage:

• The U.S. spends far more on medical care—by a factor of roughly 1.5:1—than any other industrial country, with health care costs now approaching 17% of GDP;
• All serious scholars suggest that it would be difficult to envisage containing spending at the current share of GDP; the most optimistic scenarios involve expenditures rising at a rate 1 percent faster than the growth of per capita GDP and the more realistic scenarios suggest an even faster rate of growth (see the recent forecast of the Center on Budget and Policy Priorities (CBPP), which largely echoes similar earlier forecasts by the Congressional Budget Office); (2) (3)
• Such a growth in Federal spending would simply not be affordable without dramatic increases in taxes or cuts in spending;
• Such growth in overall health care spending would also weaken the competitiveness of American business and further erode living standards of wage earners; and finally,
• Perhaps even more frightening, despite this high level of spending on medical care, a substantial share of our population is uninsured and our performance on indicators of health are below those of our peer countries.

So this means that any serious reform proposal must provide an answer to the following key questions:

• Will it ensure universal insurance coverage to all Americans?
• Will it contribute to an improvement in basic health indicators in this country?
• What would adoption of the proposal entail in terms of the growth of health care spending? Would it prevent the growth of spending as a share of GDP? Or would it continue to imply a rising share?
• Would there be full transparency as to how any further increases in spending would be paid for? By higher taxes? Cutbacks in other spending? Higher borrowing?

When I read Daschle’s book, I worried about whether his proposed initiative would be sufficient to address the last two questions posed above. I believe that much remains to be determined in judging whether the Daschle proposal will be able to contain the variety of cost pressures. But what gives me some hope is that Daschle’s discussion clearly recognizes most of the key challenges that will need to be addressed if these cost-constraining imperatives are to be tackled. In particular, he comments on the high administrative costs in the insurance industry; the substantial level of spending on pharmaceuticals and medical devices, the significant costs associated with malpractice insurance; the problematic duplication of high cost technologies in many parts of the country; the undesirable incentive of medical practitioners to shift costs to third-party insurers; the substantial proportion of medical expenditures concentrated in the last year of life; the weakness of America’s efforts at prevention (illustrated most starkly by the epidemic of obesity among young Americans); and the relatively high cost of medical manpower relative to that prevailing in other industrial countries.

To give greater confidence that Daschle’s proposals would address the problem of rising medical outlays, I would make the following suggestion. In formulating the role and policy responsibilities of the Federal Health Board, I recommend that its explicit policy mandate should include—in addition to the objectives of universal coverage and a good standard of medical provision—the goal of constraining the trajectory of overall US medical outlays (as a share of GDP) to a given target path. This path would reflect both the dangers to fiscal solvency posed by the current health expenditure trajectory as well as the opportunity costs and competitiveness challenges posed by a rising share of medical outlays in GDP. Adoption of such an explicit policy mandate for the FHB would parallel the recognized need for a policy mandate to guide the difficult monetary policy tradeoffs faced by the Federal Reserve Board (viz., “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”).

Note, I argue that the FHB’s target would not simply be limited to constraining the growth of Federal spending. I share the conviction of the CBPP that reform that does not address the fundamental cost-increasing pressures in the entire medical care sector would be insufficient. The recent CBPP report cites both David Walker (former head of the GAO) and Peter Orszag (the incoming head of the OMB) making this argument. What would be important is that the FHB is in a position, over time, to take the requisite actions in its decisions on coverage and standards to influence the various pressure points underlying the current forecast cost trajectory. Note, I also do not rule out the possibility of some modest rise in the share of total medical spending in GDP. Such an increase might reflect the conscious choice of the American people that the gains afforded in better health would be worth the cost ( a point that has been made by David Cutler of Harvard University), as long as the burden of bearing this cost is equitably and transparently borne. (4)

I should also underscore what I believe should be a final important part of the task of the FHB. Specifically, it should help develop a greater understanding of how other industrial countries—faced with exactly the same set of pressures in terms of the availability of new and more sophisticated technologies in the context of aging populations—have made decisions to keep medical outlays within bounds. It should also work with other US government and private agencies to ensure that there is full transparency to the American people as to how the costs of delivering results in terms of medical care are being borne by different groups within the society. We continue to need a more transparent discussion of what medical care costs, what results and benefits we are getting for our high spending, and what are the difficult decisions that we must confront as we examine the costs and benefits of the ever-improving availability of new technologies of medical care.

(1) They suggest that a government-run insurance program modeled after Medicare could give such a program the “clout to bargain for the lowest prices from providers and push them to improve the quality of care.”
(2) Richard Kogan et all, The Long Term Fiscal Outlook is Bleak: Restoring Fiscal Sustainability Will Require Major Changes to Programs, Revenues, and the Nation’s Health Care System (Center on Budget and Policy Priorities, December 16, 2008)(see They note that for the past 30 years, costs per beneficiary throughout the health care system have been growing approximately 2 percentage points faster per year than per capita GDP.
(3) It is also important to emphasize that the very little of this growth would reflect the aging of America’s population.
(4) David Cutler, Your Money or Your Life (2005).

Saturday, January 3, 2009

(Not Thoughts on Fiscal Policy): Puzzling the meaning of W reading on the ranch

Friends and colleagues. These are not thoughts about fiscal policy. No, this is a short and puzzled musing. Like others of my bent, I have felt anger at the many bad decisions of President Bush and the enormous cost and wasted opportunities of his administration. I have been equally appalled knowing that throughout his Presidency, he spent an inordinate amount of time away from the White House, engaged in the clearing brush or mountain biking. But now I discover that the President has troubled me further with highly conflicted feelings. This discovery was triggered by the recent Wall Street Journal column of Karl Rove that described his competition with the President as to who could read more books in a year.* I should note that unlike John Aloysius Farrell (in his recent blog), I am not bothered that most of the books he read were ones that seemed to justify his self-image as a lonely and embattled President facing up to hard decisions.

No, my difficulties are different. I am a lover of books. My tastes are diverse, ranging from economics to history to natural sciences to fiction. My friends are always asking me what I have read recently. One of the hardest things about having a serious job (I was a senior official at the International Monetary Fund) and a full family life was that I never seemed to have the time to read even a quarter of the books I bought or wanted to read. After I retired from the Fund, I thought I would have more time to dive into my library and read all my wonderful books. Instead, life as a consultant and as a professor still finds me, reading policy briefs, reports, and journal articles relevant to my profession. And now I discover that our President, to whom we have entrusted the responsibility of addressing the most serious challenges facing our country (and world), has found the time to read something like 95 books a year!

So what bothers me? I guess it is my inability to clarify my various emotions concerning this discovery? Should I resent that the President, with all else on his plate, managed to read more than I? Should I be angry at his irresponsibility for devoting so much time to reading as well as other avocations, that he short-changed us in terms of his focus on the job for which he was elected? Or should I feel relief that he was reading, since this time off the job spared us from further bad decisions? But then I reflect that perhaps how he spent his time would not have mattered much: Jane’s Mayer’s recent book suggested that most of his decisions were largely predetermined anyway, being formulated by the Vice President and his staff. I guess all I am left with is the feeling that we are all be better off knowing that any future competitions between Karl Rove and George W. Bush will no longer be our concern.

Also see John A. Farrell’s blog on the competition in US News and World Report,

Tuesday, December 30, 2008

The Obama Stimulus Plan: We need Policy Reforms as well as a Fiscal Stimulus

In his op-ed piece of last Sunday’s Washington Post, Larry Summers underscored that the Obama administration’s fiscal stimulus package is being designed not only to create “jobs and incomes essential for recovery,” but also to make “a down payment on our nation’s long-term financial health.” He illustrates this point by noting the importance of investments to build classrooms, laboratories, and libraries, spur renewable energy initiatives, modernize our health-care system, and rebuild our public infrastructure. Importantly, he notes “we must measure progress not by the agendas of interest groups, but by whether the American people experience results.*

As someone who has written on the importance of addressing long-term fiscal challenges, how can I be unhappy with this approach? Summers has correctly focused on one important element of long-term financial health, namely, the sources of our competitiveness and of long-term growth And yet a holiday of reading on the challenges facing us in the spheres of health care, energy, food, education, the environment, and infrastructure, convinces me that alone, this strategy might nevertheless be an enormously important, missed opportunity.

Don’t get me wrong. The thrust of the spending priorities that Summers has outlined are all sensible, and his emphasis on ensuring adequate returns appropriate. But what is missing from this characterization of the strategy is recognition that these are all sectors where the government’s role is already extensive and often misdirected, and where we will need a fundamental change in government policy if we are to address our major fiscal weaknesses as well as foster higher growth. Particularly in the spheres of health, agriculture, energy, and infrastructure, government lobbyists and interest groups have heavily influenced government policies. These policies have created enormous rents for particular industries and groups in the economy. Some of these rents have arisen from public spending decisions. Others have arisen from regulatory decisions that have sheltered certain industries, prevented the market from internalizing important negative externalities, or incentivised questionable production activities. Others have arisen by the deliberate underfunding of some important and legitimate and “formally recognized” government activities (see my blog of November 27).**

This is not the place to itemize all the ways, in these different sectors, where reforms in the whole approach to government policy might be needed. A few examples may suffice. Start by reading Eugene Steuerle’s recent blog on the “Breadth of Brokenness ***, where he lists the ways in which policies in a number of sectors are costly, inefficient, and not serving the public interest. Then read Michael Pollan’s brilliant op-ed of October 12, 2008 “Farmer in Chief, ”**** which underscores both the misdirection of government policy in the food sector and the damage such policies are causing in terms of poor health, energy dependence, and climate change. Certainly, you should also read the many recent op-eds by Tom Friedman as relates to the energy sector, and his call for the introduction of some form of carbon tax. In health care, Tom Daschle’s recent book, Critical: What We Can Do About the Health Care Crisis, outlines important first steps toward health care reform, though (as I will argue in a forthcoming blog) his proposals appear insufficient to reduce spiraling long-term health care costs, tackle the ways in which current government policies misdirect resources, or provide distorted incentives to the pharmaceutical industry.

In many of the vital spheres where a fundamental change in government policy is required, it will be far more difficult politically to execute a change in policy than to simply increase spending on meritorious investments. The latter are likely to be of the win-win variety. The former would inevitably involve “losses” to politically powerful groups in these sectors. But also, because the role of government has so shaped the market incentives in these sectors, many others in the economy would also feel the costs of reform (e.g., investors who have relied on government policies in considering their investment strategies across sectors).

I thus see the current financial crisis and the need for an ambitious fiscal stimulus package as an opportunity because there may be value in directing some of the fiscal stimulus to “grease the wheels” of policy reform, in effect, facilitating the transition to a more sensible set of policies. Pollan’s piece certainly suggests that the food sector is one where it might be necessary to provide financial assistance to redirect incentives away from the excessive focus on corn and soy-based products. Again, linking financial support for the auto industry to a program for its retooling for the production of more energy-efficient cars is another example of where fiscal grease might facilitate policy reform.

The President-elect ran on a campaign for a “change that we could believe in.” His policy proposals in many areas clearly underscore his recognition that a fundamental change in policy direction is required. The urgency of addressing the financial crisis argues for a strong and stimulative fiscal policy. But if the long-run financial health of the country is to be addressed and long-term growth reenergized, the focus on “change,” and importantly, the misdirected character of government policies in many sectors, must be tackled in the process. In closing, I recognize that perhaps much of the transformational policies that I hope will be forthcoming may already be on the agendas of the incoming Cabinet and its various transition teams. But what is critical is that such policy reforms are not seen as of secondary importance relative to the fiscal stimulus package.

* (
**** Pollan&st=cse

Wednesday, December 24, 2008

The Madoff Ponzi—Where did all the money go (and what does this have to do with our fiscal deficit)?

It is difficult not to wonder about this. When I discuss the matter with my friends, the inevitable point is made that it is really hard to spend $50 billion dollars, even over a 10-15 year period. So where did it all go and what does this have to do with our fiscal deficit? My son Nate, who is an MBA student at Yale, and I were recently discussing these questions and the following is our fairly arbitrary guess. Our estimates are, of course, just conjectures. At some point, investigators will probably be able to come up with a far better estimate, and it will be intriguing to really disentangle this complex scheme.

Several observations on the mechanics of such a scheme can be imagined. First, one must assume that some of the capital simply went to support Mr. Madoff and his life style of an apartment in Manhattan, fancy houses in Montauk and Palm Beach, and if I recollect from the news, a house or apartment in Europe. I also seem to recall yachts with the name of “Bull,” as well as country club memberships in Palm Beach and the Hamptons. All of this does not come cheap, and one may assume that Mr. Madoff pocketed and spent, after tax, at least $25 million a year—or $35 million pretax-- (my ignorance of this standard of living may mean that I have underestimated what such a life style costs by a factor of two or three even). But there is also significant overhead to the production of Ponzi income of this magnitude. Add three floors of rent in the so-called Lipstick building of Manhattan, as well as the overhead costs of the employees and other running costs of his legitimate securities transactions business (presumably including at least two well-paid sons and other relatives), and we can potentially account for another $40 million in expenses (again, my numbers are completely arbitrary). So this would imply that Madoff would have had to have annual inflows of capital to his operation of at least $75 million to cover these costs. Even over 10-15 years, this would have amounted to no more than $1-1.2 billion. But when the scheme collapsed, Madoff estimated that something like $50 billion was the amount of lost capital, leaving us with approximately $49 billion unaccounted for.

So what happened to the rest of the money? Let’s look at how the scheme would have worked in a given year. Let us imagine 2008, this last year of the scheme before it collapsed. At the roughly 10 percent rate that Madoff was offering investors, he would have had to pay out about $5 billion in “dividends and interest” in order for his investors to continue as happy campers. Simply as a guess, let us assume that 60% of the

$5 billion, or $3 billion, stayed with Madoff as a reinvestment and 40% was paid out and spent by his investors. For the latter, this would have included the charitable foundations that paid their employees and made grants with the income; the universities that used this endowment income to pay their teachers and staff; and of course those who lived on their income from Madoff to support their retirement or their life style of consumption. Assuming that Madoff was running the operation with no liquid reserves, this implies that Madoff would have needed roughly $2 billion in capital inflows plus at least another $75 million, as noted above, to cover the payout to investors as well as his own “expenses.”[1]

Including the inflows from new investors (which were added, on paper, to Madoff’s principal even though he was actually using the money to pay off existing investors) to the $3 billion Madoff was supposedly reinvesting, the capital value of the Madoff scheme would have risen by the full $5 billion in 2008, even with zero increase in actual value ($2.1bn in from new investors, $2.1bn out for expenses and payouts, $3bn of fictitious returns). It is also worth noting that Madoff’s reported earnings attributable to investors would have been subject to taxes by their recipients.

Of course these are the figures at the end of the scheme. During all of the previous years, a similar type of operation was occurring, with some of the money being paid out and actually used for real purposes by Madoff’s clientele, and with an important part of the capital growing fictitiously. So in trying to guess where the money went, one might hazard the fairly arbitrary guess that a significant part (perhaps 65 percent) never went anywhere! It represented earnings on capital, reinvested, that never actually existed. It was as if the original money of investors had not been invested but spent, but nevertheless the original sum was kept on the books and a 10 percent return kept being added to it.[2] (Note that if you were to invest $100,000 and earn a 10 percent return that you reinvested every year, you would have roughly $260,000 accumulated at the end of 10 years). So one can easily imagine that if many investors had left their money in the investment scheme for many years, quite a significant fraction of the amount they supposedly held would have simply been the result of smoke and mirrors.

Another significant sum, let us say roughly 30-35 percent, was actually was paid out and used by legitimate people for presumably legitimate purposes. A small share, probably 1 percent, was earned as fees by the feeder funds that took a 1.5 percent management fee on the amounts that they channeled to the Madoff funds. Madoff and his enterprise probably skimmed off about 1-2 percent of the total over the years. As is inevitable with Ponzi schemes, those who invested late in the game were probably the largest losers, never having had the opportunity to avail themselves of the income that Madoff so regularly paid out.

And how does the fiscal deficit enter in? Well, as I noted above, for each $1000 reportedly earned by Madoff for his clientele, at least $150 was presumably paid to the Federal government in taxes (assuming all of it was declared as dividends and subject to the 15 percent tax rate on dividends). However, in many cases, even more was probably paid, since some earnings would have been declared as interest and taxed at the recipient’s marginal tax rate. Most likely, the Federal government received, on average, about 20 percent of Madoff’s fictitious reported earnings for his clients. So most likely, if roughly $47-50 billion was “earned” over the time frame of the Madoff scheme, and this was all declared as taxable income, the Federal Government was probably the beneficiary of about $10 billion. So one could say that this was Madoff’s implicit contribution to preventing the Federal deficit from being even higher over the period. Of course, now that the losses are revealed, it is likely that many of the losers will now be able to write off some of their losses, recouping some of their previous payments in lower tax liabilities in 2008 and 2009, and thus adding to the already high fiscal deficit!

None of this is very pretty as we begin the holiday season.

[1] Most likely, during some years of the operation, Madoff did have liquid reserves which he invested and actually earned some income from; in this last year, one might imagine that capital withdrawals exhausted these reserves and that he was frantically seeking new inflows to cover withdrawals as well as his normal payout to investors at the time the operation collapsed.

[2] One should also note that from the perspective of these investors, the real loss in return is what they would have earned if they had invested in legitimate securities, with the rest of the loss wholly fictional, representing an unreal, above-market return.

Thursday, December 18, 2008

Getting off Square One on America’s Long-Term Fiscal Deficit

As the United States Government seeks to dig the economy out of a recession through a massive fiscal stimulus package, many voices continue to remind us that the larger challenge to be faced is the large and growing long-term fiscal debt. For example, the Center on Budget and Policy Priorities (CPBB) has just issued budgetary forecasts through 2050 ( These highlight that under current policies and with historically reasonable assumptions, the federal debt will reach 279 percent of GDP in 2050. “The average amount of program reductions or revenue increases that would be needed over the next four decades to stabilize the debt at its 2009 level…equals 4.2 percent of projected GDP”, “the equivalent of an immediate and permanent 24 percent increase in tax revenues.” These warnings are not new. They follow similar alerts from the Congressional Budget Office, academics, and journalists over the last several years. The Peter G Peterson Foundation is also ramping up for a major initiative to raise the alarm, starting with the airing of its film on the long-term fiscal crisis, I.O.U.S.A (see, early next year.

Perhaps the more challenging question is why there has been so little traction on this issue, particularly given that these facts are undisputed among America’s political leaders as well as by most economic analysts. There are two simple answers. The first is the most obvious. Addressing the long-term fiscal deficit will be politically painful, requiring significant increases in taxes or cuts in expenditure programs, and the political system does not do pain very well. The second is the difficulty of coming to grips with how to tame the major elephant in the room, that is the largest source of the looming fiscal gap—the rising costs of medical care.

What has been missing in this litany of fiscal warnings, and which perhaps best explains why there has been so little political groundswell for action (including in the recent Presidential campaign), is any significant discussion of how this fiscal mess will be resolved, and who will bear the burden of its resolution. And here the CBPP’s note does highlight one important observation, which was first made in a joint op-ed by former Treasury Secretary Robert Rubin, incoming OMB head Peter Orszag, and economist Allen Sinai. Long before we get to 2050, it is likely that the edifice will crumble—that the capacity of the US government to continue to run large fiscal deficits and to service its growing debt will implode. Interest rates will begin to rise, further aggravating the debt service burden, and foreign buyers of US debt obligations will begin to be wary of too large a portfolio exposure to the US government.

In effect, markets will force action sometime in the next decade or so—this might occur through tax increases, draconian cutbacks in government programs, or by cutbacks in coverage or benefit eligibility. It also might occur through inflation, if the government were to erode the real value of its debt by printing money (though it is doubtful that in today’s globalized financial markets that this can be a successful strategy for very long). But action will take place because there will be little alternative. This will be painful and will have real consequences. The need for action, when pushed by markets, will not occur at a time of our choosing; indeed, one could imagine scenarios where the timing is simply awful in terms of the global economy or national security interests.

The current financial crisis is illuminating in this regard. We have just experienced (during a Republican Administration no less) an enormous unexpected and untargeted wealth “tax” of roughly 20 percent, borne largely by homeowners and by those with portfolio wealth (that has sunk in value). Unlike a tax increase, where at least the government would receive the associated revenues, few (and certainly not the government) have benefited from this current loss of wealth. Others are feeling or will feel the ripple effects of this loss in the form of lost wage earnings, lower benefits at the State level, higher taxes and fees, and lower interest incomes. A year ago, few would have imagined the starkness of the crisis that we now face.

Who will bear the financial burden of how this larger long-term fiscal debt problem will be resolved remains to be determined. One can imagine a number of equally plausible scenarios. The most desirable would be one that arose from a well-thought out strategy entailing many “politically difficult” measures sequenced over time: with some increases in tax rates and revisions in the tax code (e.g., reducing some present tax subsidies), significant efforts at rationalizing how and what medical services are provided, adjustments in coverage and eligibility for medical benefits, cutbacks in inefficient or less meritorious government programs, adjustments in the social security system in the form of higher payroll taxes or delayed ages for benefit eligibility (see Eugene Steuerle’s recent blog for some obvious candidates for reform ttp:// Another scenario might entail a far more comprehensive revision of the way in which medical care is delivered and financed, coupled with some less dramatic revisions to taxes and expenditures. Still another might reflect a far less strategic approach, involving ad hoc tax increases, brutal expenditure cuts, and ad hoc adjustments in the Medicaid or Medicare system. And finally, of course, using inflation to reduce the real value of a government’s debt is an approach many governments have used in the past, with large and long-term harm, both to individual households and to the government’s financial credibility. Regrettably, these latter solutions have been the outcome too often in the past.

How individual American households—of different income groups, from different generations, and from different sectors—would be affected by these very different ways in which the problem might be resolved would need to be analyzed carefully. A major part of these effects would be reflected in higher taxes, lower benefit incomes, a higher cost of public services, and a need to defray some costs that had been previously been financed by the government. But another important part of the effect would be reflected, say, in diminished access to real and useful government services or reduced availability of some medical care that had heretofore been provided by the government. Some groups in society might be affected far more than others—for example, if there were a major restructuring of the medical care system. Equally, some approaches—such as an increase in inflation--would certainly affect creditors and, as we have long known, would disproportionately affect those with a more limited ability to adjust their assets to an inflationary environment. What is important to acknowledge and clarify is that different approaches would affect different households in different ways, but the effects would be real and substantial.

Perhaps the best way to motivate political action would be to explore a few alternative scenarios and to illustrate specifically and transparently who would bear what part of the burden. Let the American public come to grips with the stark reality of the possible consequences of a well-thought-out strategy as opposed to an ad hoc, unplanned approach or recourse to inflation. The chips will fall, but they do not have to fall in an unintended way. Equally, some policy solutions will involve far less harm to America’s long-run interests. Others will not only be costly, but inefficient and damaging to America’s security and long-term interests.

Thursday, November 27, 2008

What Will the Obama Administration Administer?

These first few weeks since the election have been enormously heartening. The Obama administration’s cabinet is beginning to take shape with nominees of high quality—well trained, pragmatic, with enormous experience, and good judgment. This signal that a sensible economic policy strategy will be put in place in the coming months is reassuring, given the extraordinarily important role that the government will play in the coming months, both in providing a stimulative boost to the economy and as a regulator (and even owner of parts) of the financial sector.

But these challenges come at a difficult time. The last eight years have seen a dramatic expansion of the government’s debt and future budgetary commitments, both explicit and implicit. Congressional Budget Office projections highlight the impact that this has had in undermining the nation’s long-term budget sustainability. The Peter G Peterson Foundation’s recent film, I.O.U.S.A, graphically illustrates the depth of the fiscal hole that we are in. Knowledgeable fiscal economists of all political stripes recognize the necessity to move swiftly to increase government revenues, reduce government expenditure commitments (particularly in the health care sector), and start the arduous process of restoring some degree of balance to the U.S. government’s long-term budget. Now the recession of 2008 and the implosion of both the financial and housing sectors has, within the space of a few months, further aggravated these long-term fiscal prospects and forced the incoming administration to consider a dramatic increase in fiscal spending in order to pull the US (and perhaps the global) economy out of recession. While there is little doubt that this fiscal stimulus is necessary if economic growth is to be restored, it will not make the challenge of addressing the fiscal challenges of the long-term any easier.

However, there is another element to this situation that has received far less attention, but which is relevant to any solution to both current and future problems. Even as the recession and financial crisis have forced the government to become a far more involved player in the US economy, and despite the large fiscal deficits previously created by the Bush Administration, many knowledgeable observers question the capacity of the US government to carry out its functions effectively!

Specifically, while military and entitlement spending commitments have soared and tax rates have been cut, the Bush administration (and to a lesser extent the Clinton administration) has sought to rein in other areas of spending through a slow starvation diet of those Federal agencies that deliver the real bread and butter of government goods and services. Across the board, operating budgets have been slashed, important offices delivering critical services have been eliminated or starved for funds, while contracting-out and privatization has become the norm. This has been coupled with an aggressive policy in recent years to infiltrate the senior layers of the civil service with many whose reigning ideology is to minimize the role and importance of government. The result has been a weakened federal bureaucracy that lacks the capacity to be adequately responsive in providing the basic stuff of public services required in this increasingly complex 21st century world. Of course, this also raises doubts as to whether the government has the operational capacity to deliver on the current pressing fiscal and regulatory policy agenda.

These are not random conjectures. The reduced ability of the government to regulate the financial sector is now well recognized. But informed observers and reports emanating from the policy literature and newspaper articles highlight that there has also been a systemic weakening in the government’s capacity to deliver on its mandate in many other spheres. For example, in recent lectures, Francis Fukuyama of The Johns Hopkins University’s School of Advanced International Studies* <#_ftn1> has highlighted the dramatic decline in the operating effectiveness of the US government’s aid agency, USAID. The politicization of the Justice Department has reached the status of front-page headlines. In the environmental community, concern has grown over the dramatic scaling back of EPA’s expertise and the turning over of the agency to those in the mining and energy industries who were supposed to be the regulated rather than the regulators. Witness the closure for lack of funds of the already small office in EPA responsible for providing critical data to poor countries around the world on indicators of the manifestations of climate change. Equally witness the cutbacks in the climate-change budget of NASA’s Earth Sciences program.

Even in those agencies responsible for disbursing entitlements, there has been deterioration in the capacity to disburse. One example would be the long delays by the Social Security Administration in determining eligibility for disability payments. The Bush administration’s efforts at financial starvation and ideological undercutting of the role of Federal agencies has been abetted by demographic trends. Many experienced senior servants of the baby boom generation are now retiring as they reach the required years of service for a pension.

So let me restate the difficulty of the situation. The incoming Obama administration finds itself with a need to expand the government’s role. It will be involved in regulating and even owning parts of the financial sector. It will be charged with acquiring financial assets derived from the housing and even the consumer finance sectors. It may be drawn into providing guidance or subsidies to the automobile sector. It will need to design policies that not only add to aggregate demand, notably in the infrastructure sector but which also energize the long-term growth potential of the U.S. economy. Additionally, it will be engaged in developing and implementing important but complex policy initiatives—for reduced energy dependence, a strengthened education system, and expanded coverage of health insurance. Yet it will take the reins of a government civil service that is short on the skills and administrative capacity to meet these challenges. And all this comes at a time when there is a continuing long-term fiscal imperative to move towards a restoration of fiscal sustainability in the government’s financial operations.

Thus, while the Obama transition team focuses on filling the roughly 6000 political appointments at the top of the US Government, it must also not lose sight of the need to develop a strategy to restore the capacity of the underlying bureaucracy to respond to the challenges ahead while delivering effectively the basic but critical public services of government. In a recent important blog, Gene Steuerle of the Peter G. Peterson Foundation has called for the new administration to address what he terms the “broken” nature of government. He calls for “a series of processes—actual proposals for quick enactment in some cases, commissions and white papers in others, and complete departmental reviews in yet others.”** <#_ftn2>

The process Steuerle recommends is indeed critical in order to ensure that the different programs and policies of the government are warranted in terms of their objectives, relevance, and their modalities. But it will also be important that the level of funding and the adequacy of staffing is appropriate for these programs to be effectively implemented and for government agencies to have the capacity to respond to the many new and difficult challenges they will face. For most major departments, this will require external program audits, with adequate participation from key client groups, OMB, and the US Government Accountability Office. Higher funding levels will be needed not only for the cost of operations but to ensure that salaries of civil servants are sufficient to attract high quality staff. Achieving these objectives will of course entail additional spending, but in relative terms, the amounts that would be required are far less than the amounts being contemplated in the current financial rescue package and in any case they are dwarfed by the spending cuts that will be necessary in entitlement spending over the long term. Rebuilding the civil service and adequately funding the operations of the federal government are of critical importance if it is to meet its challenges without having one hand tied behind its back.

Peter Heller’s blog “Thinking about Fiscal Policy” can be found at or .

* A recent book by Carol Lancaster of Georgetown University has also highlighted the deterioration in the capacity of USAID.

** See

Monday, November 10, 2008

The Current Financial Crisis is only the Tip of a Long-Term Financial Iceberg!

With financial markets in crisis worldwide, policy makers are rightly focused on actions to restore confidence and enable banks to feel comfortable in renewed lending. Without such actions, the risk of a recession spiraling into a depression would be great. While households worry about their jobs and their portfolios, they also are recognizing that their long-run financial plans have now been jeopardized.

For years, analysts have warned that the U.S. government’s fiscal future is bleak—that its long-run obligations to retirees in the form of social security and, even more, for Medicare and Medicaid, have far outstripped projected tax revenues. Current policy actions to shore up the financial system have only added to the US government’s debt burden, making the restoration of long-run fiscal solvency even more difficult. Other potential liabilities loom, for example, if the US might be on the hook for bankrupt private, municipal, or state pension schemes. But the issues involved in addressing this looming fiscal crisis have long been the third rail of American politics. The focus of both Republicans and Democrats has, if anything, been more on enlarging health coverage than on restoring solvency to government obligations for medical care or social security.

The current financial crisis highlights that the private pillar of financial support for America’s aging population is now also severely shaken. Workers are starting to understand the risks associated with relying on high returns from home and equity investments for the financing of their retirement. Wealth in the form of home equity and 401K-type investment nest eggs has plummeted. The retirement plans of aging baby-boomers are being reconsidered. Pensioners who have relied on their investment portfolios to supplement social security, are worrying about whether they might need to reenter the labor market. Employers, including many states and municipalities, are worried that their pension plans are now seriously underfunded. And the prospect that households can rely on the Federal government’s promises with respect to medical and social security is even more threatened as the government’s own debt rises in the current financial crisis.

What must be done? First, we need to address the major weaknesses in America’s long-run growth prospects—an educational system that ranks far behind its competitor nations, failing and outmoded infrastructure, excessive energy dependence, and falling outlays on research and development. Without buoyant economic growth, the size of America’s pie will be inadequate to provide for rising living standards and a comfortable retirement for its citizens. Second, we need to fundamentally rethink how the financial costs of retirement are to be shared as between the baby boomers and succeeding generations. All serious analysts recognize that there are limits to what can be expected in the form of higher taxes on future workers. The sooner a fair and equitable sharing of the burden of Social Security, Medicare, and Medicaid is resolved, the lower the pain that any solution will entail. Third, increased wealth cannot be bought on the cheap by an expectation of rising home or stock equity values. Households will need to work longer, consume less, and save more. Finally, once the crisis is over, we must move to restore fiscal solvency. This means a return to a balancing of the Federal budget deficit over the cycle.

America could benefit by looking at the experience of other countries in Europe and Japan. They appear to be addressing the challenge of an aging population and providing comprehensive health care in a fiscally responsible way. Some countries in Europe particularly appear to have constructed social insurance systems and fiscal policy rules that are more responsive to these challenges than those of the United States.

As a first step, the next President should convene a nonpartisan commission to develop, within a tight timetable, proposals for energizing growth and restoring both fiscal solvency and a balanced role for the private and government sectors in financing the longer life span of America’s workers.