TCS Daily


The Great Race

By Arnold Kling - July 31, 2003 12:00 AM

The movie-going public is being treated to a depiction of the rivalry between two Depression-era horses -- War Admiral and Seabiscuit. One can view the future outlook for the United States economy as a similar contest, in this case between Moore's Law and Medicare.

Of all of the possible indicators that might be used to assess the success of the economy, I would select the ratio of government outlays to GDP. If this ratio gets to be too high, then the economy will collapse under the weight of the taxes needed to fund the government. The lower the ratio, the more confidence I have in the sustainability of the economy.

Some historical behavior of the ratio of government spending to GDP is shown in the following table.

Year

Federal Outlays as a percent of GDP

State and Local Expenditures as a percent of GDP

Total Government as a percent of GDP

1960

17.8

7.2

25.0

1970

19.3

10.3

29.6

1980

21.6

11.0

32.6

1990

21.8

11.4

33.2

2000

18.4

12.1

30.5

What I mean by the great race is the contest over which will grow faster -- the government or the economy. The ratio of government outlays to GDP rises when the government wins the race, and it falls when the economy wins the race.

In the 1960s, government won the race. Even though the economy grew substantially, government grew faster.

In the 1990s, the economy apparently won the race. Even though government grew substantially, the economy grew faster. Somewhat ominously, however, the economy did not grow faster than non-defense spending. Given that the decline in defense spending in the 1990s was not sustainable, the race was at best a draw.

War Admiral vs. Seabiscuit

For the next fifty years, I see two major factors at work. One factor makes me optimistic. The other factor makes me pessimistic.

The optimistic element in the outlook is technological progress, particularly in computing. The economy should grow faster than ever, because of Moore's Law. Increased computing power is going to fuel the economy in a number of ways.

·         The technology of the late 1990s has so far only been adopted and utilized effectively in a few industries. That means that we still have in front of us much of the gains from diffusion of current technology. Classic economic studies of hybrid corn and the dynamo support this view of gradual adoption of technology.

 

·         We are in the early stages of a revolution in wireless communications. At a recent conference, Microsoft's Maria Fernandez speculated on a future in which most of the devices connected to the Internet will be unmanned sensors and radios, acting autonomously. Along these lines, we have seen descriptions of potential uses for radio chips in passports, currency, keeping track of personal possessions, and numerous commercial applications.

 

·         Advances in computer processing are helping to drive advances in biotechnology. As Randall Parker put it, there are "signs that biotechnology is going to advance at rates which are analogous to the way electronics technology has been advancing for decades. If that is the case we should expect to see the costs for taking apart and manipulating biological systems to drop by orders of magnitude while the speed of doing so rises by orders of magnitude as well."

 

·         Nanotechnology, which is another beneficiary of improved computing, seems to be advancing even faster than was expected a few years ago.

But if Moore's Law is the economy's War Admiral, then Medicare is government's Seabiscuit. A new study by Jagadeesh Gokhale and Kent Smetters shows just how large Medicare looms in the future. They argue that the present value of the difference between future Medicare obligations and future Medicare tax receipts is a staggering $36.6 trillion. This swamps all other future budget issues, including the current national debt. The comparable fiscal imbalance in Social Security is only about $7 trillion in their estimate.

Gokhale and Smetters estimate that it would take a permanent tax increase of more than 6 percent of GDP to fund the fiscal imbalance in Medicare. If we take the structure of Medicare as given, and if economic growth fails to accelerate, then I believe that the liberals who argue for the repeal of the Bush tax cut are correct. The Gokhale-Smetters calculations show that what we need instead is a large tax increase, and the longer we wait to enact this tax increase, the larger it will have to be.

A Scenario Analysis

One way to summarize the possible outcomes of the great race is to consider four possible scenarios, based on different assumptions about the key drivers of Moore's Law and Medicare. This scenario analysis is presented in the following table.

Four Scenarios

Moore's Law Fails

Moore's Law Succeeds

Medicare is Reformed

Low Gear

Capitalist Utopia

Medicare is not Reformed

Economic Implosion

Affordable Welfare State

By Medicare reform, I mean something like my proposal to phase out Medicare. Reform means that health care decisions are made in the private sector, and it means that twenty years from now the cost of treating the elderly is not paid for by taxes on the young.

By Moore's Law succeeding, I mean more than just that the cost of computer processing continues to fall. I mean that the applications enabled by faster computing pan out and have a significant impact on increasing productivity. Although government policy can affect this somewhat, I believe that for the most part the success or failure of Moore's Law will depend on conditions in science, technology, and the private sector.

I believe that if we have both Medicare reform and success with Moore's Law, then the economy will win its race with government decisively, leading to what I call Capitalist Utopia. As individuals, we will enjoy high incomes, with the median household in thirty years living better than someone in the top 20 percent today. Those Baby Boomers who save prudently in response to the planned phase-out of Medicare will find health care affordable, thanks to a high rate of return on savings and new medical technologies that reduce treatment costs. However, Boomers who do not save for retirement will cry out for government support, and they will be filled with resentment for their "rich" (i.e., prudent-saving) counterparts.

At the other extreme, if Moore's Law fails and Medicare is not reformed, then the tax burden on the working population will increase beyond anything that has been seen in a viable economy, which means that we could see an Economic Implosion. Many of the most creative, hard-working people will be driven out of the mainstream economy. Some may go abroad, to take advantage of low-tax havens. Others will work underground, in a growing black-market sector. This in turn will force the government to raise tax rates further, driving more productive workers away, in a vicious downward spiral. Health care is rationed, and its quality deteriorates for everyone.

An intermediate scenario is one in which Medicare is reformed but Moore's Law fails. I call this "Low Gear," because the economy will still function, but economic growth will be slow. Even Baby Boomers who have saved prudently will find in their retirement years that after they pay for health insurance they have little discretionary income.

A better intermediate scenario is one in which Moore's Law succeeds but Medicare is not reformed. Paying for the Baby Boomers' health care requires a large increase in tax revenues, but the impact on tax rates is mitigated by the high level of GDP. Thus, I call this scenario "Affordable Welfare State."

Medicare Hedgehog?

In terms of Isaiah Berlin's famous metaphor, President Bush has been called a "hedgehog," meaning that he has a narrow focus. In foreign policy, his focus has been on defeating the forces of terror, and this strikes me as correct.

In domestic policy, the President's focus has been on tax cuts, which makes me nervous. Although the intent is to hold down government as a share of GDP, the tax cuts may fail to do so. For one thing, the size of the Bush tax cuts is overblown. More important, in the absence of Medicare reform, it is very doubtful that even those modest tax cuts can be sustained.

I wish that instead of remaining a tax-cut hedgehog, President Bush would become a Medicare-reform hedgehog. Otherwise, we had better hope that Moore's Law beats Medicare in the great horserace.

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