Hard Choices

In his most recent Quarterly Letter, Jeremy Grantham sums up the demographic tsunami staring much of the developed world in the face:

The populations of the developed world are getting older and, as they age, they need more medical attention. The march of medical science means that an increasing number of expensive helpful treatments are available. The problem is that they are mostly very expensive and only a little bit helpful. Yet it is hard to limit or ration their use. A symptom of this is that almost 25% of total medical expenses occur in the last year of life, while equivalent spending in prenatal and child care would yield multiples of the payoff to society. The result is that total medical costs rise rapidly, and in the U.S. are handsomely in first place globally, with the percentage of GDP going to medical care at one-third more than the average developed country. With progress in the study of the human genome, we will soon see breathtakingly expensive ways to reduce the incidence of very rare diseases and much more that will be hard to ration or resist. And a great leap in life extension drugs although desirable (where can I buy it?) would result in a terrible extension of the age profile problem.

The plain truth is becoming more obvious by the minute. Almost all developed countries are overcommitted to retirement benefits, especially health care. Even without severe aging problems, health costs alone would be a major economic challenge. With an aging population, though, health costs and retirement costs balloon and put an intolerable burden on younger workers. We in developed countries are on a collision course with budgetary integrity: given our current policies on health costs we simply cannot afford the commitments we have made.

In the developed world, which choice is made will depend on the country’s history and on the strength of its concept of the social contract: how much personal disadvantage is the individual willing to accept in the interest of the social good?  Under current stresses, the Europeans seem ready to extend the retirement age (never waste a good crisis!), which can fairly be seen as involving a degree of reneging, received with varying degrees of kicking and screaming.  Here the possibility of rationing health benefits to the level society is willing to pay is so anathema that it cannot be talked about sensibly and, if at all, the language must be tortured in order to talk around the point. Our culture demands the best that money can buy, combined with unlimited legal liability (courtesy of the legal lobby and all those lovely lawyers in Congress), and friendly conditions for the drug and insurance industries (courtesy also of their effective lobbies). Nobody gets treated badly except, of course, the ordinary user. That is to say, the ordinary taxpayer, who pays a third more for mediocre or worse aggregate health results, lower life expectancy, etc., etc., etc.

Our cost-laden health system is perhaps fine if you are willing to pay for it. But the same people who scream “death panels” at the concept of sensible rationing also reach for their revolvers, of which they insist on having plenty, at the prospect of having a tax structure nearer the average of the rest of the rich world. Now, this is a non-compute. It has to be one or the other, either rationing or taxes. Presumably we will hunker down, wait for a crisis, and then respond. In my opinion, this refusal to make painful choices puts the U.S. fairly high up the list of countries with longer-term financial problems.

Unfortunately, it is difficult for us to visualize today’s administration proactively addressing this issue until they are forced to.  Cutting healthcare benefits for largest constituency is not exactly a roadmap to reelection, which is why we continue to kick the can down the road.  Much easier to let the next guy worry about it I suppose.  Reading GMO’s letter reminded us of a recent BIS Working Paper which further put our unfunded liabilities into perspective.  The authors, Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, conclude that:

Fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning. 

It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly.

The chart below illustrates the extent of the problem at home.  The authors examine three scenarios, all of which are built upon the wildly optimistic projections that real interest rates remain constant at their long term average (not a chance), and real GDP growth is set to the “post-crisis rate” (estimated using the OECD’s stimulus-driven, recovery in 2009).  The results are disastrous in every scenario, even using cheery assumptions.  In the base case (red line) Debt/GDP ratios rocket beyond 150% in just the next decade.  The second scenario (green line) examines the long-run implications of fiscal adjustments similar to the policies being proposed today.  Although debt accumulation slows, we are still faced with substantial increasing debt ratios.  The blue line shows the consequences of a third scenario that combines gradual fiscal adjustment with a freezing of age-related spending at 2011 levels.  While the consequences of such a draconian policy result in a reversal of debt ratios in several economies, the US is not one of them.  Even this policy is not sufficient to bring rising debt under control.

In our Q4-09 Broyhill Letter, we stated: “We are not yet at the end of the road, although we can hear the fat lady singing more clearly today. Our problems are not insurmountable, but they require immediate attention. Simply hoping that we will grow our way out of the remnants of crisis will cost us dearly. The key conclusion policymakers should learn from the work of Reinhart and Rogoff is that seldom in history have countries grown their way out of deep debt burdens. Reversing a crisis of confidence and strengthening sovereign balance sheets requires smart policies from strong leaders. Sadly, we have neither. Perhaps Paul Broyhill was on to something when he suggested it would take a “one-term” president willing to make unpopular short-term decisions to restore the long term health of our great nation. I’d still like to believe that America would appreciate such character when they saw it and re-elect him for a second term, but I recognize that this is wishful thinking, particularly as we have yet to find him.”

Smart policies from strong leaders.  The best advice we’ve heard to date was eloquently stated as, “Stimulus in the front . . . austerity in the rear.”  In other words, our economy is badly in need of smart, productive investments today.  Without appropriately directed stimulus (which we’ve seen little as of yet), the probability of Dancing towards Depression increases each day.  We’d hate to see what the state of the economy looked like without government intervention, although we may find out if those in DC don’t learn to play nice.  Since we can’t spend to infinity (we realize some disagree), today’s spending must be accompanied by tomorrow’s austerity.  Someone must address the 800 pound healthcare and social security gorilla.  Preferably, before a crisis as it will be too late otherwise.  And if you are looking for an example of a smart, productive investment, see Grantham’s thoughts below from the same letter.  Needless to say, Cash for Clunkers (or appliances for that matter) does not qualify.

The amount of carbon dioxide (CO2) in the atmosphere, after at least several thousand years of being quite constant, started to rise with the advent of the Industrial Revolution. It has increased by 40% and is rising each year. This is certain and straightforward. One of the properties of CO2 is that it creates a greenhouse effect and, other things being equal, causes the temperature to rise. This is just physics. Skeptics argue that this wide range of uncertainty lowers the need to act: “Why spend money when you’re not certain?” But since the penalties rise hyperbolically at the tail, a wider range implies a greater risk (and a greater expected value of the costs). This is logically and mathematically rigorous and yet is still argued.

Pascal asks the question: What is the expected value of a very small chance of an infinite loss? And, he answers, “Infinite.” In this example, what is the cost of lowering CO2 output and having the long-term effect of increasing CO2 turn out to be nominal? The cost appears to be equal to foregoing, once in your life, six months’ to one year’s global growth – 2% to 4%, or less. The benefits, even with no warming, include: energy independence from the Middle East; more jobs, since wind and solar power and increased efficiency are more labor-intensive than another coal-fired power plant; less pollution of streams and air; and an early leadership role for the U.S. in industries that will inevitably become important. Conversely, what are the costs of not acting on prevention when the results turn out to be serious: costs that may dwarf those for prevention; and probable political destabilization from droughts, famine, mass migrations, and even war. And, to Pascal’s real point, what might be the cost at the very extreme end of the distribution: definitely life changing, possibly life threatening. The biggest cost of all from global warming is likely to be the accumulated loss of biodiversity. This features nowhere in economic cost-benefit analysis because, not surprisingly, it is hard to put a price on that which is priceless.

A special word on the right-leaning think tanks: As libertarians, they abhor the need for government spending or even governmental leadership, which in their opinion is best left to private enterprise. In general, this may be an excellent idea. But global warming is a classic tragedy of the commons – seeking your own individual advantage, for once, does not lead to the common good, and the problem desperately needs government leadership and regulation. Sensing this, these think tanks have allowed their drive for desirable policy to trump science. Not a good idea.