BULLS & BEARS: Market may be at high, but big challenges loom

November 6, 2006

The other day, as investors basked in the glow of new stock market highs, an eyecatching headline traveled across newswires. The article, which seemed out of place with the record highs on the Dow Jones industrial average, was titled "GAO chief warns economic disaster looms."

The Government Accountability Office, or GAO, is an investigative arm of Congress that audits and evaluates the performance of the federal government. The head of the GAO can be thought of as the nation's chief accountant and government watchdog. That person is David Walker, and he believes it is time to tell Washington to steer the nation off the path of economic ruin.

Walker and a group of economists and budget analysts are on a traveling road show called the Fiscal Wake-up Tour. The nonpartisan group is making stops throughout the country to make its case to anyone who will listen. As Walker puts it, "This is about the future of our country, our kids and grandkids."

What is the cause for this feared economic crisis? Well, it is the problems we have heard before-the budget deficit and the three-headed entitlement monster: Social Security, Medicaid and Medicare. Walker points to the "demographic tsunami" that will come as the baby boom generation begins to retire. A recent GAO report notes that, in 2008, the first boomers will be eligible to draw "early retirement" Social Security benefits and, in 2011, the first boomers will become eligible for Medicare.

Although Social Security usually attracts the most attention, the most onerous of the three programs is Medicare. Medicare already consumes 13 percent of federal spending and, by 2030, the Congressional Budget Office projects, it will hog nearly one-quarter of the budget.

Why is Walker sounding the alarm now? Because postponing the need to deal with these fiscal challenges is not an option-waiting makes the problem worse. The GAO report contains a graph showing how the magic of compounding will work against us if the gap between revenue and spending is allowed to continue to grow.

Under the GAO's "optimistic simulation," waiting until 2040 to address the gap means that as a share of the economy, either taxes would need to be increased almost 60 percent or total spending reduced by a third in order to balance the budget in that year. Such drastic changes in policy have never occurred in post-World War II history.

At present, the low level of interest rates and the generosity of foreigners, who continue to lend us huge amounts of money, have masked the depth of our problems. Yet as the deficit grows larger, interest payments are increasingly going overseas rather than to U.S. investors. And if foreign lenders were to become hesitant in lending us more money to fund the budget gap, interest rates would rise. Analysts note that a modest rise in rates might actually be helpful by encouraging saving, but a big jump in rates would be disastrous.

Since these are issues that still sort of hang out there in the future, no politician wants to be the one to deliver the hard medicine to begin to fix them today. There are no easy solutions and anyone who wanted to deal with them would have to talk about raising taxes and cutting benefits, not the recipe for an election win.

Not to throw cold water on record stock prices, but our children deserve our immediate attention to these matters.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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