By Karl Smith
The news of the day, yesterday, was that the U.S. budget deficit was declining faster than the consensus expectation. Of course regular readers will be shocked, shocked to discover that deficit fears were over hyped.
This latest adjustment is primarily due to a stronger than ‘expected’ economic recovery and to the peculiar way in which public-private finances are accounted for. There was ample evidence that the economy was growing faster than official statistics showed. This is no fault of the statisticians — they have to abide by their methodological guidelines. However, those of us on the outside can and should be aware of the limits of those guidelines. In particular, they were likely to underestimate the crisis in real time and underestimate the recovery in real time. We shouldn’t be surprised when that turns out to be the case.
Fannie Mae and Freddie Mac were also always likely to be in better shape than their official statistics showed, and for exactly the same reason their balance sheets collapsed so suddenly. A recovering housing market means higher prices, faster sales and thus a better cure-rate. That is, more people go from delinquent to current than current-to-delinquent. It also means that REO properties sell faster and for a better price. And, of course that burgeoning demand will tend to increase the spread of lending rates over funding rates. All of these things serve to shore-up the mortgage giants.
More important, however, are two longer-term factors.
First, while revenue and spending decision matter at the margin, the real action in government finances is between asset and liability payments. The government’s primary asset is its taxing power over the U.S. economy. As the economy grows – in nominal terms – so do the payments from this asset. The government’s most important liability payment – from a dynamical point of view - is interest on the national debt. The current recession opened up an enormous spread between the two. The U.S. economy was growing at a nominal rate of roughly 4%, yet the government was funding itself at roughly 1%. This gives the U.S. government a 300 bps spread on its position. I would, almost reflexively refer to that position as “the monopoly provider of violence,” but I know that offends people and makes it sound like I have something against the government. As I see it, the monopolization of violence is a valuable service and if you do it well, it pays a handsome return. Nonetheless, however you want to define the role, the U.S. government’s fundamental finances improved dramatically as this spread broke open.
Moreover, a cursory look at the issuance decisions of the Treasury and the buying decisions of the Federal Reserve make it appear as if they are attempting to expand this spread. They are not moving all out to maximize it, as they clearly have the power to “corner markets” to use an old phrase. However, the Treasury is ever so slightly shifting its issuance towards longer-term debt, which is currently cheap, while the Federal Reserve is buying up high-coupon debt issued in the ’80s and ’90s. Together, this implies that the cost of rolling over U.S. debt is being nudged down and the tail-risk that a huge shift in the bond markets could leave the U.S. government with large bond payments is being eliminated.
Second, the largest non-interest driver of future deficits was projected to be healthcare. These projections were wildly naive and biased towards showing large deficits. Again, I wouldn’t blame the CBO for doing it this way. It seems completely appropriate given the task they were assigned. Nonetheless, we should be aware that things which can’t go on forever, stop. So, it was with healthcare.
Baring some really, really deep theory on why healthcare was going to run so far above trend one should be skeptical simply based on the argument from queerness. Things don’t usually increase in price way out of line with the rest of the economy, so it seems unlikely that healthcare will usually do this. It might from time-to-time, but not usually.
In addition, as healthcare grew mechanical and quasi-mechanical effects were likely to slow its growth. The mechanical effect is that as healthcare costs grow, healthcare becomes the economy. You can’t grow faster than the economy when you are the economy. So, that was always going to be nudging costs down. The first quasi-mechanical effect is that during a sector growth period there are going to be adjustment costs. Altering the economy, so that healthcare can take a larger share, will itself be costly. Doctors and nurses will be scarcer. Hospitals will be small. Technology will be new and confusing. Once these bugs are worked out adjustment costs will fall and so will the growth rate of costs.
The second quasi-mechanical fact is that as healthcare costs grow folks will become more cognizant of them. When costs are low, the head of surgery thinks mostly about how much good she can do with a new super matron. As the news media is dominated by stories about the rising cost of healthcare, she is also going to be nettled by doubts that this expense is really worth it. Her incentives per se may not have changed, but her attention set has. As her industry becomes a major economic player, the state of the economy will loom larger in her deliberations.
Lastly, there is an economic dimension. As more and more resources are poured into healthcare, the returns to arbitrage grow. Devoting yourself to a business that shaves .01% off of total health costs doesn’t make much sense when health costs are low. As they grow larger it becomes a game changer. As healthcare grows, more and more businesses will say “what’s the healthcare play here.” Sure, you are an auto repair shop, but doesn’t getting tires realigned reduce the risk of chronic bone damage? I don’t know, but as these costs grow it sure will pay to find out.
All of those things will tend to bring down the growth of healthcare costs. Hence, a naive extrapolation of average cost growth out into the future is likely to overestimate the total cost. The future is uncertain and little can be said about when and nothing can be said definitively about whether these changes in trend will occur, but it should come as no surprise if they do.