from Follow the Money

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March 8, 2005

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I suspect Warren Buffet would agree with Bill Gross.

There is one easy way to make it easier for the US to deal with its own aging population: Stop promising so much of our future income to support the aging populations of Europe, Japan, Korea, Taiwan, Singapore, Hong Kong and Russa!

Whether the US privatizes Social Security or not, over time, a higher fraction of US income will go to support the elderly. US government bonds (Treasuries), corporate bonds and equities are all claims on future US income. To quote Mr. Gross:

... it matters little whether the system is pre-refunded with Treasury bonds or privately held stocks. The fact is that both of these financial assets represent a call on future production. If that production could possibly be saved, like squirrels ferreting away nuts for a long winter, then Treasury IOUs or corporate stocks might make some sense. But they can’t. [Future healthcare, food, transportation, and entertainment for boomer seniors] ... must be provided by the existing generation of workers for those who have retired and are presumably incapable of working.

Right now, though, the income of future US workers will have to support not just not an aging US population, but also to support an aging Japan, an aging Europe and aging China. That is what happens when the US finances its current consumption by borrowing from abroad, and adding to its external debt. The US gets a bill for its current consumption, the rest of the world gets an asset -- a claim on future US income.

In 2005, the countries of the world collectively are likely to save $800 billion out of their current income, and lend those funds to the United States to cover the United States’ current account deficit. That is not a small sum. In the future, they will expect to use the interest and dividend income on their investment in the US to support their population.

The only way the US can stop relying on the rest of the world to finance its current (not particularly high) level of investment is to save more. And one way to do that is for the US government to borrow less.

Again, let me turn to Mr. Gross.

By reducing budget deficits now, and especially that portion of the deficit owed to foreign governments, we would be able to keep more of our domestic production within our borders and therefore available to senior citizens, a thought that presumably Pete Peterson of the Blackstone Group and a serious thinker on Social Security would agree with. ... Common sense would inform even the most inexperienced Washington bureaucrat that Social Security (and Medicare) imbalances are curses of demographics and not financial funding. Keeping the "size" of our future IOUs low and out of foreign hands would minimize inflationary pressures and the transfer of goods and services overseas in future decades. It would also make it possible in future decades to borrow more overseas production than we could have with an excessive debt load.

(an aside: the overall impact of reducing the fiscal deficit on national savings depends on whether a reduced deficit is offset by rising investment and/ or falls in private savings, there is not a one to one correlation)

The US traditionally has earned more on its overseas assets than it has paid on its external liabilities, but that positive affairs is about to change. The growth in US external debt recently has been masked by very low interest rates -- and as US interest rates and US external debt levels rise, the "investment income" line of the US will clearly turn increasingly negative.

The potential drain on US national income from rising external debt is significant. Nouriel Roubini and I have calculated that even if the US starts to adjust now, and the trade deficit gradually falls to zero between 2005 and 2015 (think a fall of about 0.5% of GDP a year), the US external debt would still rise to over 50% of US GDP before it stabilizes. If foreigners earn a 5% (average) return on their investment, that involves a future net transfer out of the US of roughly 2.5% of GDP a year.

For the sake of comparison, the unfunded liability in Social Security stems from a roughly 1.5% of GDP gap between promised benefits and expected revenues after 2052, per the CBO. And Bush’s private accounts might imply setting aside a bit more than 1.5% of GDP in private accounts. But that will provide less future income than it seems, since the investments in private accounts will be offset by the issuance of an equal amount of debt -- debt that future US taxpayers will have to pay back. The rest of the world is investing far more than that in the US to fund its future retirement, and it is not borrowing to do so!

There is a case that Japan and Europe, both with older and less rapidly growing populations than the US, should be building up claims on the rest of the world. The US is among the youngest of the industrial countries and its growing population probably has a greater need for capital that Europe or Japan. But the US, Europe and Japan are not the entire world - far from it. To me, it makes more sense for Europe and Japan to be investing in the capital-scarce emerging world to build up assets to finance their retirement rather than financing the United States’current consumption boom. Not all of the emerging world is young. China, for example, is aging fairly rapidly. But most of the emerging world is younger than China, let alone the US. Moreover, China is growing very rapidly, far more rapidly than the US, and has an enornmous need for capital to finance its rapid development. If Japan and Europe met some of China’s need for investment, China could spend more of its current income and still invest at something close to its current pace. That, to me, makes more sense than Japan investing in China -- but then having China use the inflow from Japan to finance the US (through its reserve build-up).

The US may not need to build up its external assets by running a current account surplus - something that would let the US draw on the rest of the world for income in the future. But the US also would be well served, in my view, if it did not pledge too much of its future income to support the rest of the world either.

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