Posner lays out clearly many of the present and future solvency and default risks to the United States federal government. He bases some of the analysis on a valuable recent Morgan Stanley report with the provocative title “Ask Not Whether Governments Will Default, but How”. Default on some of their debt by countries like Greece and Italy are real possibilities, and default by leading countries like the US and Germany is surely possible. But I do not believe their default is at all inevitable.
The report first presents the usual measure of default risk- the ratio of government debt (not held by other government agencies) to GDP in 2009- for the federal government of the US and for eight European nations: France, Germany, Greece, Ireland, Italy, Portugal, Spain and the United Kingdom. On this criterion, Greece and Italy look in trouble, with ratios of about 1.15, and the US looks in reasonable good shape, with a ratio of about ½, which is much lower than that for most of the other nations in their comparison set. For example, Germany’s debt/GDP ratio is 0.73, while the United Kingdom’s ratio is 0. 68.
Morgan Stanley’s report argues debt/GDP is not a good measure of default risk, and suggests instead the ratio of debt to government revenues. On this measure, the US looks terrible, with a ratio of 3.58. This ratio is much higher than that of the eight European nations because they tax a much larger fraction of GDP than the federal government of the US does. Yet it is not obvious to me that using tax revenue rather than GDP in the denominator is a better measure of solvency risk. Countries that already collect a sizeable fraction of GDP as tax revenue have less room to raise taxes than do countries like the US that tax a much smaller fraction. This argument suggests that the high GDP/tax revenue ratio for the US makes its solvency risk lower rather than higher compared to Europe. On the other hand, that the American federal government raises so much less may be a sign of greater resistance to higher taxes in the United States than in Europe.
On balance I believe it is better to use the debt/GDP measure, although the discussion that follows would be the same with either measure. Two main factors will determine the size of the default risk for the US as well as Europe. As both Posner and the report emphasize, a frightening prospect is the expected growth in entitlements over time, especially the growth in medical care spending. This is partly due to the continuing aging of populations in developed countries since older persons take a greatly disproportionate share of spending on medical care. Even more important than aging itself is that spending on each older age group has risen at a fast rate over time with the development of expensive new drugs and surgeries.
In the Affordable Care Act that became law in March of 2010, Congress and the president tried to address the high and growing spending by the US on healthcare. The US ratio of spending to GDP is approaching 17%, which is essentially the highest ratio in the world. Unfortunately, in many ways this law worsens America’s approach to health care rather than improves it. One main defect is the failure of this Act to increase the quite small ratio of out of pocket spending by older sick individuals on their own healthcare compared to their spending out of tax dollars. Obviously, individuals have much less incentive to economize on unnecessary health spending, such as the removal of the prostate for 85 year old men with prostate cancer, when the great majority of their spending comes from tax dollars rather than from their own income and wealth. Another serious defect of the law is that it extends rather than contracts the American reliance on employer provided health care. My post on the new law on March 28th discusses other defects.
The Morgan Stanley report does not give much weight to the potential of faster economic growth to reduce the likelihood of sovereign default risk. If the rate of growth in GDP were speeded up, the debt/GDP ratio might be kept under control even without governments collecting a much larger share of GDP in tax revenue, as long as the growth in government spending did not adjust upward to the faster growth in the economy. For example, if the economy grew in the long run by 2% per capita per year rather than 1.5% per capita per year, GDP per capita would double in about 36 years rather than in 48 years. This difference in the level of GDP achieved over time would greatly improve the ability of governments to handle their debt.
In recent months I have argued in several posts on this blog that governments should be concentrating on trying to speed up longer-term economic growth rather than promoting further stimulus packages and other short run palliatives. Faster long term growth in per capita incomes and real reform in the looming health and retirement entitlement are the only truly effective and efficient ways to greatly reduce the risk of eventual default on sovereign debt by the US, Europe, and other nations.