By James C. Capretta, Michael D. Scott
Former Massachusetts Governor Mitt Romney spent many years at Bain Capital, which specializes in “turning around” failing businesses. Bain, and companies like it, invests in firms with broken business models and balance sheets to make them solvent and profitable again by cutting costs, shedding liabilities, reworking contracts, improving productivity and revenue, and focusing on core competencies. Once the business is profitable, it often monetizes some, or all, of its stake in the revitalized company.
The U.S. government exhibits all of the traits of a failing enterprise in need of a turnaround. Expenses are out of control, insolvency is a real possibility, and current management has no idea how to right the ship.
A big part of the problem is widespread misconceptions about the severity of the financial hole. Unlike private business, the federal government generally uses cash instead of accrual accounting to make decisions and report its financial condition. So, for the fiscal year that ended in September 2012, the federal government’s annual budget deficit was $1.1 trillion, total debt owed to the public was $11.3 trillion, and total U.S. government liabilities stood at about $18.6 trillion, according to official statements.
Those numbers are scary enough, especially in view of their deterioration in recent years. From 1789 to 2008, the federal government borrowed $5.8 trillion. Since then, the government’s debt has nearly doubled.
The reality, however, is far worse than even these numbers would indicate.
Each year, the U.S. government is taking on new, unfunded liabilities in the form of retirement and health care commitments which are not counted in the official U.S. government income statement or balance sheet. These are the equivalent of the pension and post-retirement health benefit promises that sank the airline, auto and steel industries and are threatening to sink the State of Illinois and other state and local governments.
For the federal government, these promises come in the form of benefits owed under laws governing federal employees, Social Security, Medicare, and now ObamaCare.
Officially, Social Security and Medicare are pay-as-you-go systems, with taxes collected today paying for benefits earned by current retirees when they were still working. That makes these public “social insurance” programs different from employer-based post-retirement health and pension benefit programs in two important ways. First, private companies are required under federal law to set aside assets to fund their pension promises. Second, in the early 1990’s, new accounting rules required firms to disclose post-retirement pension and health liabilities on their balance sheets. The requirement of disclosure alone was enough to force many companies to pare back their commitments. Some companies used the bankruptcy code to restructure their liabilities and restore the firm to solvency.
But even with “pay-as-you-go” accounting, these programs still have massive unfunded liabilities — and the trends are in the wrong direction. Earlier this year, the Social Security trustees reported the program has an unfunded liability of $20.5 trillion — an increase of $10 trillion since 2004. Medicare’s trustees reported the program has an unfunded liability of $42.8 trillion, up from $36.9 trillion two years ago. And unfunded commitments for federal workers have risen from $4.1 trillion in 2004 to $5.8 trillion in 2011.
On average, therefore, the government has accumulated new unfunded liabilities at an annual rate of about $4.5 trillion in recent years. If the same accounting logic that applies to publicly-traded companies applied to the federal government, the accrued and unfunded spending commitments for pension and health benefits would be reflected directly in the government’s spending, deficit and debt numbers. In 2012, “spending” would have exceeded $8 trillion — or over 50 percent of GDP — instead of the $3.5 trillion recorded under the cash accounting rules. This higher spending level would have also pushed the recorded deficit up to $5.6 trillion. All together, the U.S. government is now facing about $87 trillion (or 550 percent of GDP) in unfunded liabilities — $68 trillion of which are not reflected in official financial statements.
Job one for the next president must be to fix the U.S. government’s broken financial model. If a private business had such cash losses and accruing liabilities, the turnaround team would seek immediately to cut costs and renegotiate the contracts creating the problems. The same must be done with our general budget, Social Security, Medicare, Medicaid, and federal employee commitments. Current retirees and those near retirement can be protected. But benefit promises to future entrants must grow no faster than the revenue collected to pay for them. One option could include moving from today’s defined benefit commitments to defined contribution obligations, much like the shift from formula-driven pension payments to 401k’s in the private sector. This is especially important in Medicare, as defined contributions can foster the market discipline necessary to slow the pace of rising health care costs.
Beyond the entitlement programs, the federal government is in desperate need of a top-to-bottom review and reform. Unproductive programs must be shut down. Activities more appropriately handled by the states or by the private sector should be transferred or terminated. Duplicative federal activities must be consolidated. And federal agencies must be forced to deliver better value at less cost, just as every business must do to stay competitive.
The U.S. government is the most systemically important and inter-connected entity in the world; its financial solvency is critical for our citizens, businesses, and other governments. Because of its outsized importance to the global economy, the federal government cannot afford to sow seeds of doubt about its ongoing financial viability.
Critics have disparaged the business model of Bain and other turnaround firms because sometimes the medicine necessary for a return to profitability is bitter for the patient to swallow. Of course, that’s exactly why the federal government is rushing headlong toward a financial crisis; politicians have put off the tough choices for decades.
But delay is no longer an option. The actual bills are coming due and could be accelerated if Treasury investors reduce their demand for our securities. The only solution is to come clean with full and honest assessments of our expenses and liabilities along with plans to reduce them so that they do not impose unbearable burdens on future taxpayers.
A man uniquely qualified to take on this critical task is on the ballot next week, and there are signs that the electorate recognizes this. The nation certainly needs his skills.
Michael D. Scott is a former official at the Treasury Department and the Securities and Exchange Commission. James C. Capretta is a fellow at the Ethics and Public Policy Center and a former Associate Director at the White House Office of Management and Budget. He is fellow at American Enterprise Institute