All Things Financial Planning Blog

Falling Off the Cliff

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I am reminded of Douglas Adams’ quote “It’s not the fall that kills you; it’s the sudden stop at the end.” The U.S. Government, as a way to help the economy out of the financial crisis, implemented financial measures designed to boost the economy through lower taxes, employee payroll tax reductions and unemployment compensation among others. While the U.S. economy was saved, the recovery has been tepid at best. The pressing issue facing the U.S. is that most of the measures that have provided financial life support are all due to expire at the end of 2012.

Ben Bernanke, Chairman of the Federal Reserve, dubbed the expiring stimulus measures a “fiscal cliff.” Chairman Bernanke urged Congress to put government debt on a long-term sustainable path, but should not do so at the expense of short-term growth. There is fear that Congress will be engaged in grid lock due to the upcoming elections and that the financial measures will expire at year-end. Should the U.S. economy fall over the fiscal cliff, the pain won’t be felt until the economy comes to a sudden stop.

The programs set to expire are the Bush Tax Cuts from 2001, 2003 and the more recent 2009, 2010 stimulus measures that created the Employee Payroll Tax Reduction and Emergency Unemployment Compensation programs. The estimate by Ned Davis Research on fiscal drag ranges from $72 billion to $388 billion in lost output. Should the loss be toward the higher end of the range, the sudden stop may come sooner than many of the pundits are predicting.

Congress may decide to “punt” like they did last year and extend the financial measures. The risk of this tactic is that while it may spare short-term growth, the long-term debt burden may become unbearable. The Congressional Budget Office projects that the ratio of government debt to Gross Domestic Product would increase to 93%. A larger debt burden may slow the economy by requiring the government to spend more on interest payments on the debt instead of spending on Social Security, Medicare, defense and other important areas. Over half of the interest payments could be going overseas as foreign investors currently hold more than half the U.S. debt.

The U.S. Government will also face increased funding pressures from the near depletion of the Social Security and Medicare Trust Funds. The 2012 Trustees report showed the Social Security Trust fund will be depleted in 2033, three years sooner than last year’s estimate. After 2033, the Trust will only be able to support 75% of benefits promised. Medicare is projected to face the same fate in 2024 with revenues sufficient to cover only 87% of costs.

Social Security and Medicare outlays currently account for a combined 34.5% of government spending, the largest combined spending of any other government program. These entitlements are going to become more burdensome as the Congressional Budget Office estimates that Social Security and Medicare will account for 43% of all U.S. government expenditures in just ten short years.

The burden of these programs will also be felt as entitlements become a larger percentage of the United State’s Gross Domestic Product (GDP). In 1970, Social Security and Medicare were approximately 3.9% of GDP where today it is nearly 9% of GDP. In 2022 the Social Security Administration estimates that the two programs will be nearly 10% of GDP and upwards of 12% in 2033. While these appear to be small incremental gains in terms of percentages, perspective must be kept on the sheer dollar size of the U.S. GDP.

Gross domestic product (GDP) refers to the market value of all officially recognized final goods and services produced within a country in a given period. The U.S. Nominal Gross Domestic Product as of March 31, 2012 was nearly $15.5 trillion dollars. Over a 20-year period, the rise in Social Security and Medicare spending as a percent of GDP will equate to approximately $465 billion dollars. The ability for the United State to avoid a “Greek Tragedy” is to keep our debts and entitlements to a manageable percentage of GDP. As the percentages continue their unabated rise, our Nation’s capacity to shoulder these burdens becomes more and more strained.

There is a definite “fiscal cliff” ahead. The challenge is we don’t know if it is 12 months or 12 years in front of us. The job of the Federal Reserve and our elected officials is to minimize the height of the fall from the top of the cliff. We can sustain a slow down, not a sudden stop.

Ed GjertsenEdward Gjertsen II, CFP®
Vice President
Mack Investment Securities, Inc.
Glenview, IL

Author: Edward W. Gjertsen II, CFP®

Edward W. Gjertsen II, CFP®, currently serves on the board of directors for the 24,000-member Financial Planning Association® (FPA®). He is vice president of Mack Investment Securities, Inc. in Glenview, Ill. and founder of The Mutual Bond Group, an organization dedicated to guide surviving spouses to financial independence. Gjertsen has been a member of FPA and its predecessor organization (International Association for Financial Planning) since 1996. Gjertsen served as FPA of Illinois chapter president and director of technology, and was awarded the FPA of Illinois's 2008 Heart of Financial Planning Distinguished Service Award. Gjertsen served as co-chair of the president/president-elect track for FPA Chapter Leaders Conference 2008, is a co-founder of the FPA diversity committee and will serve as 2010 diversity committee chair. Gjertsen holds a Bachelor of Science in economics from Illinois State University.

3 thoughts on “Falling Off the Cliff

  1. It means that in order to properly decide what amount of money one should save and how to invest so that its returns can be used in the old age for one’s benefits. These are difficult things and by joining the social security relieve one from these issues but still problem with government program remains that it will not satisfy the choices of many people. In the same manner, the supply side has to deal with the issues of moral hazard, adverse selection and for this purpose they want a lot of information on life expectancies in order to determine annuities. Annuities also have to pay to the sales people high commissions. But making compulsory to join for everyone in a program saves all these costs.

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