Someone recently remarked that “Washington D.C. does not work anymore.” That’s not entirely true: Congress and the Administration recently passed a dividend tax cut and there’s been progress on immigration reform. But regarding the critically important question of entitlement reform that remark appears to be correct.
The divide on what liberals and conservatives consider to be appropriate ways of addressing the looming fiscal crisis has never been wider. As the baby-boomers age, spending on entitlements — Social Security and Medicare — is projected to take ever-larger bite out of federal revenues, with less available for other needs such as defense, homeland security, infrastructure, and diplomacy.
The entitlement reform debate appears to be in equilibrium — between irresistible force and immovable object. Democrats insist that without a rollback of recent tax cuts no progress would be possible on scaling back entitlements for their poor and middle-class clients. But Republicans, having successfully passed several tax cuts during the last 5 years, are loath to retreat from their pledge to prevent their reversal.
Most economic analysts agree that a continued impasse on entitlement reform will worsen the economy. Without policy changes, imminent baby-boomer retirements will generate larger federal debt, adding fuel to the fire of already gigantic global imbalances in trade and capital flows. Growing federal debt will erode confidence in the government’s ability to repay it and prompt investors to shift their portfolios toward non-dollar assets. This could trigger sudden dollar depreciation, rapid inflation, and sharp interest rate spikes — with negative effects on U.S. domestic investment, productivity, and output.
Waiting to make a decision makes sense in the face of considerable uncertainty. Shortfalls in entitlement programs, however, are predictable with a high degree of certainty because they are driven by demographic changes that can be forecast accurately over long periods. The latest estimates of Social Security and Medicare Trustees’ places those programs’ unfunded obligations at $84 trillion. What is not easily predictable is when growing fiscal imbalances will trigger a coordinated financial reaction and cause an economic meltdown. Hence, many analysts are wondering when and how a “grand bargain” will emerge on entitlement reform.
But the logjam on entitlement reform indicates that both sides believe they would gain by sticking to their respective positions. This situation appears similar to the famous prisoner’s dilemma: If one side gives up its position on entitlement reforms, it could lose a lot — political base and electoral prospects — and the other would gain those advantages. If neither side gives in, the likelihood of a financial meltdown increases - whereby everyone’s losses would be huge. However, if both sides could comprise involving moderate sacrifices all around - that so-called “grand bargain” — both sides (and future generations) would benefit by avoiding an economic catastrophe.
In laboratory-like settings, outcomes in repeated prisoner’s dilemma trials have shown that many players adopt cooperative strategies for long-periods. Sustaining equilibrium at the “grand bargain” level, however, requires building trust through prior actions. One player can build goodwill (or political capital) with the other by risking early losses through cooperative actions. The long-term gains from achieving and sustaining payoffs at the “grand bargain” level may make those losses worthwhile.
The perception that Washington D.C. “doesn’t work” for entitlement reforms means that such political capital is scarce, with both sides are unwilling to compromise. And the bad equilibrium — of gradually making a potential economic calamity more likely — continues.
Under such conditions, reaching agreement would require a special type of political entrepreneur — one who can convince both sides to accept moderate sacrifices. One possibility is to target appeals to those among current voters who would eventually benefit from making short-term sacrifices — baby-boomers and recent retirees — many of whom will survive for another 30-40 years and wish to enjoy living standards similar to or better than those of today. These generations have a considerable stake in avoiding a serious economic setback. Only time will tell whether voters and their representatives can be convinced that giving up the bird in hand may be the best way of capturing the two in the bush.