Why budget fixes can't wait

After another year of failed reform, America's preferred plan to pay for Social Security and Medicare seems clear: Wait and see if we can muddle through.

President Bush's all-out White House effort to sell Social Security reform fizzled. The program that began in 1935 is now projected to be unable to meet all its financial obligations by 2041.

Congress did make some cuts to Medicare last month. But it's a drop in the bucket compared with the costs of a new prescription-drug benefit. Medicare trustees say the program could face shortfalls starting in 2015, with the trust fund dry by 2020.

On some policy matters, muddling through can work. But is it a viable way to contain the surging cost of entitlements that some experts say threatens US prosperity? Can a mighty domestic economy and willing foreign lenders keep the United States financially sound without major policy reform?

It's true that the forecasts rest on a multitude of assumptions that may prove too optimistic - or pessimistic. Factors such as the changing lifestyles of older citizens, the rate of healthcare inflation, the pace of economic growth, and even the savings habits of people in China could alter projected outcomes significantly.

Moreover, Social Security's liabilities - a focus of fierce political debate - are actually far less challenging than those of Medicare and Medicaid.

But entitlement experts say the magnitude of this fiscal time bomb is such that "wait and see" won't work. Major tax hikes and benefit cuts may be needed.

"We have a big problem," says Laurence Kotlikoff, a Boston University economist. "The biggest [economic] risk we face is a major financial meltdown, leading to high interest rates.... Why? Because the country is broke" - or, at least, it would be if all its future obligations were counted and tax rates didn't rise.

"Everyone who gets into this boat has to print money," Dr. Kotlikoff says, from the Roman emperor Diocletian to perhaps a future chairman of the US Federal Reserve.

While much attention is focused on the baby boomers, who began to turn 60 this month, the problem isn't really their looming retirement.

The nub of the challenge is the confluence of three long-term trends: People are living longer, healthcare costs keep rising, and government has promised to pay much of the tab for retirees. Prescription-drug coverage is the latest example of promises rising faster than funding.

"With the stroke of a pen [President Bush] creates a liability that's actually twice the size of Social Security problem," in terms of its future shortfall, says Kent Smetters, a professor of risk management at the University of Pennsylvania.

These trends take the US government - and the nation's economy - into uncharted waters.

How bad is it? Dr. Smetters and Jagadeesh Gokhale of the Cato Institute have calculated the present value of the government's "fiscal imbalance," based on all projected future spending and income.

The unfunded tab: about $65 trillion dollars.

To pay for that shortfall, Smetters says, Social Security and Medicare taxes deducted from paychecks would need to double immediately.

The nonpartisan Congressional Budget Office puts the numbers in a slightly different way. In its gloomiest long-term forecast, the combination of Medicare, Medicaid, Social Security, and interest on the national debt could eat up half of gross domestic product, the nation's total output of goods and services, by 2050.

But forecasting is an inexact science. Many factors will influence the fiscal situation over coming decades, from birth rates to the health of older Americans. A positive trend, for example, is a steady decline in disability rates among seniors. That may mean that demand for healthcare doesn't grow as fast as longevity.

Other wild cards relate to the global economy. The US is far from the only nation with an aging population. But even as Europe, Japan, and others face their own entitlement challenges, some experts point to possible solutions.

A recent assessment by the investment house Goldman Sachs figured that by raising the eligibility age for retirement benefits, more people would stay in the workforce, boosting economic growth.

Over the next 20 years, this could boost incomes above current forecasts by 12 percent in major European countries, 11 percent in the US, and 7 percent in Japan. Anything that boosts economic growth would help nations meet their growing bills.

That's where China's saving habits could come in. Boston University's Kotlikoff and two German economists recently studied how the Chinese propensity to save a large share of income might affect the global economy - and entitlement burden - in this century.

Their paper had a whimsical but provocative title: "Will China eat our lunch or take us out to dinner?"

Its conclusion: China could very well provide a pool of capital that helps fuel not just its own growth but the global economy - helping to prevent economic stagnation in developed nations for decades into the future.

"They're saving at these incredibly high rates," says Kotlikoff. "If they keep that up they can't help but generate lots of capital for the rest of the world to use."

Even with China's help, US tax rates would have to rise to cover the spending that Kotlikoff's model predicts.

"We spend far more on healthcare than other industrialized countries, but it's not at all clear that we are ... more satisfied" with our care, or healthier, as a result, says Jim Horney, an analyst at the Center on Budget and Policy Priorities, a Washington think tank.

But it's not clear that other nations, with nationalized care, have created systems that satisfy their citizens or contain costs either, experts say.

The goal of cost-containment leads quickly into controversial subjects such as rationing or means testing.

"It's going to take a real comprehensive approach," Mr. Horney says. "We face a long-term problem, and we need to do something about it."