Economic Rundown: Volume 66, Number 6

As the sequester approaches, the rhetoric is getting more heated as both politicians and industry leaders are beginning to preach the Armageddon of their choice that will surely occur if policy is not adjusted to their taste.  So far only Wall Street appears unconcerned about the growing reality that roughly $100 billion in government spending (about 0.6% of GDP) will come to an end on March 1st — and that there appears to be little political will to stop it.  Only on Friday, with the announcement from WalMart that all is not well in the world of low end retailing, has there been any reaction to the fact that the solution to the fiscal cliff was largely to allow it to happen.  True taxes did not go up on the middle class – but they did go up $120 billion on wage earners and $60 billion on the wealthy.  The wealthy saw a huge offset in the payment of $300 billion in special dividends late in 2012.  The wage earner has seen no such offset – and if they work in defense or for the federal government or any number of related industries they are fearful of the sequester which might cut deeply into their spending power in coming weeks. There are estimates that roughly one million workers could lose their jobs (assume $100,000 per worker) if the full brunt of the cuts came in the second quarter.  That would more than offset the expected 500,000 new jobs that were expected during that period.


Without a negative reaction from the populous or Wall Street, Washington is unlikely to act.  They pretty much did the minimum on the fiscal cliff and we expect the minimum here as well – which likely means letting the sequester hit and then dealing with the fallout in the continuing resolution and the 2014 budget negotiations depending on whose ox is gored the most.  Coming off the soft fourth quarter, consensus estimates for the first quarter are for roughly 2.5% real GDP growth.  Much of that is just a bounce from Sandy, and the 0.1% gain in January retail sales should send a warning signal that the outlook for 2% growth being sustained into the second quarter is not so good.  The just released CBO mid-session review predicts 2013 growth at 1.4% as strong private sector growth is damped by the considerable headwinds of the fiscal cliff and sequester.  Bottom line, the private sector needs to remain upbeat in their economic outlook to keep hiring 200,000 a month or the headwinds will swamp the boat.  The 0.4% drop in manufacturing industrial production for January comes after two elevated months, but sets a poor tone for the start to the quarter if consumers are fading.  The consequences of the fiscal cliff will intensify as we move deeper into the year and consumers are less able to temporarily offset the permanent cut in their spending power by increasing borrowing.  Add a sequester, which will also start slow but intensify as cuts in budget authority translate into actual cuts in spending, and the CBO outlook is quite realistic.  Note that their forecast is based on current law.  That law already incorporates the reality of the amended fiscal cliff and anticipates the full consequences of the sequester.


We were very optimistic back in September when all looked dark specifically because all looked dark – so it seemed highly likely politicians around the world would act to avoid the worst, and they did.  Now we are concerned that the financial markets are whistling past the grave yard and that Washington will remain divided until the pain from the fiscal cliff and sequester has a deeper impact on the economic outlook.


Myths and Legends on Health Care Spending

Two numbers caught our eye this week that bear directly on the sequester and budget debate.  The first was that retail sales at health care stores for the past three months were negative compared with a year ago, versus a 4.5% rise for all retail activity.  Indeed, health care stores show weaker growth than every category except general merchandise sales.  The second number was that the CBO’s latest estimate for Medicare spending in 2020 is now $200 billion lower when it estimated the number in 2010, a reduction of 15%, showing the gross inaccuracy of long term forecasts.  The CBO cut down its estimate for two reasons.  First, as noted above, health care spending is already on a much slower track than anyone has expected.  This is the fourth straight year of slow growth in health care outlays – and CBO and industry experts are quite divided on the explanation.  The reality is medical care expenditures rise during recession as other spending is cutback, and then tend to trend in line with other spending awaiting the next recession. From 1992 to 2008, health care consumption barely budged as a share of total consumption despite great gnashing of teeth about larger federal programs – all of which are government transfers to consumers and reflected in health care PCE.




The second reason was that the fiscal cliff deal reduced tax rates for incomes below $450,000 from what they would have been if Bush tax laws had expired as planned.  As a result, the benefit of tax deductions for health care was reduced so some 3 million more workers are now expected to lose coverage from employers when Obamacare kicks in.  The interesting fact is not how many people will lose coverage, but rather the realization that tax rates matter in hiring, wage and benefits decisions.  We are constantly surprised when analysts act as if tax benefits like mortgage deductions, the expensing of equipment, or the increased advantage of writing off wages or benefits at a higher tax rate would not affect behavior.  One cannot apply the rules of economics selectively – prices matter even when they are less obvious prices like interest rates (the price of moving money through time) and tax rates (the cost of government services).  Wages are likely to grow faster than benefits now that tax rates are rising – increasing the taxable part of the fiscal pie.  Unfortunately, this reality is not reflected in the CBO’s own long run forecasts on wages share of GDP.


We believe a significant part of the solution to the sequester will be trading spending cuts beyond the next election for less stringent cuts in the next four years.  Health care is a critical part of this process.  In the State of the Union Address, President Obama opined that Congress has already cut deeply into the deficit and that they only needed $1.5 trillion more over ten years to reach the $4 trillion goal that will supposedly solve our debt problem.  The CBO’s mid-term outlook drew a much different picture, as it finds deficits and debt to GDP already under control during the next decade due to the higher revenues generated from the solution to the fiscal cliff.  Under the new “current law”, the deficit will decline to 2.4% of GDP in 2015 before rising to 4% by 2022.  Debt to GDP in 2014 will hit 76% and will still be just 77% in 2022.  The problem is in the following decade as retiring baby boomer drive up health care spending.  We do not believe politicians will take a recession, or very much pain at all, today to solve a problem that is still ten years away.


One of the reasons the CBO’s estimates are better than expected is the reduction in Medicare spending mentioned above.  Since the last budget estimates in August 2012, new technical estimates on major health care programs (that means wonky stuff on growth rates due to qualification standards and inflation estimates) have trimmed $473 billion out of the deficit for the next ten years – roughly one third of what the President said was needed.  Note that only $76 billion of these savings occur in the next four years before the next election.  Long range budget assumptions can result in huge changes in numbers in the out years.  One of the favorites for inclusion in future deficit negotiations is to alter the definition of CPI so that COLAs are less robust going forward for pensions and medical care.  From a little acorn does a mighty oak tree grow.  Note that Obamacare was neatly planned to begin after his first term was finished, in part because Congress felt they could adjust it if Congress, or the President, or health care costs changed.  Long run plans in Washington are for show as they can always be changed.


Though the vociferous debate about how health care and social security will bankrupt America has been going on since before I became a professional economist over thirty years ago – they have not.  Inflation got us in 1982, the S&L crisis hurt in 1990, and the NASDAQ bubble popping in 2000 was a problem, and the Big Kahuna was Lehman in 2008.  Financial services and monetary policy are a constant problem, but health care and social security have yet to cause a ripple.  Nor are they likely to for at least another decade since health care costs will not explode until the baby boom is well into their 70s.  Indeed, most of the growth in health care spending over the next decade is among work age beneficiaries of Obamacare, and those costs are predicted to level off after 2017 when enrollment has peaked.  Most of the rise in health care costs since Medicare started have been offset by slower growth in military spending – and that is what current law expects over the coming decade.  Major health care programs will grow by roughly 1.5% of GDP and discretionary defense spending will fall about the same.  We have historically shifted from defending ourselves against outsiders to defending ourselves against nature as the threats from outside have shifted from the Cold War with a Russian military superpower to terrorism by shadowy groups.  Both industries are primarily domestic in nature, with little import penetration, so both are huge government jobs machines – and politicians like jobs.  We do not see them cutting off the spending any time soon.


Nor are health care costs immune to budget constraints.  There was an episode of falling health care spending during the late 1990s when the budget was last under restraint.  Moreover, actual inflation in health care costs is far lower than the commonly talked about escalation in medical care CPI.  As with all industries, purchasers do not simply accept the price hikes from providers.  Rather, they shift to cheaper alternatives, with actual inflation being reflected in the PCE deflator for health care rather than the fixed basket for medical care CPI.  Over time about half of medical CPI growth is avoided – and since 2008, the PCE deflator for medical care has risen at the same pace as for all consumer inflation.  With medical care now so large a part of the federal budget, we can expect more price control as they can no longer hide price inflation in reductions in other programs.




Our long term view on health care is far more optimistic than the dire warnings of budget debacles as the baby boom ages.  Rather we expect that between now and thirty years from now when my own “middle of the baby boom” medical expenditures should peak in my mid-eighties medical technology – particularly directed at prevention – will have changed a lot.  Due to my fear of dying old and broke when Social Security, Medicaid and Medicare abandon me, I intend to work longer than my parents.  Thus, I must stay in better shape during my hopefully longer working years.  I will not be the only one.


Historically, federally paid for medical care is primarily for the aged via Medicare.  The faster growing program – Medicaid – is directed at lower income households, most of which are younger.  Medicaid’s traditional aid to the blind, disabled, and children now is being augmented by the Obamacare expansion to previously uninsured healthy low income workers.  Care for the working age and future working age population is a far better societal investment than in retirees.


We expect entrepreneurial medical care companies knowing there is a huge pie of government spending virtually guaranteed if they compete effectively will result in ongoing productivity enhancements.  We believe that with fifty states administering Medicaid funds there will be an active process in developing and adopting best practices. We do not know which industries will and which industries will not provide health care directly for their workers under Obamacare, but we do know it will be decided over the next three years as the program matures.  That still leaves lots of time before health care costs start to rise rapidly for future Presidents and Congresses to decide what additional changes need to be made.  We suspect that baby boomers, who already dominate voting and will vote in even greater percentages as they get older, will defend their medical care coverage (and social security income) so we do not see this debate going away – ever.  Well at least until after I am dead, which I hope is in the very long run.


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