The $44 Trillion Abyss
The baby-boomers are about to retire, and it's going to cost us —
BIG. Here's what the government doesn't want you to know.
FORTUNE ~ 11/10/03
By Anna Bernasek
Last fall Paul O'Neill, then Secretary of the Treasury, wanted a simple answer to a thorny question: How
prepared was the nation today to pay all its future bills? Two government experts worked for months to
calculate the answer. Their findings, which shocked even them, were never published—the Bush
administration made sure of that. The reason for the silence was that by the time the two researchers had
completed their study, O'Neill had been thrown out of the Treasury and replaced by the more politically astute
John Snow. No savvy administration power player would dare point out, right in the middle of tax-cut season,
that there was a huge hole in the country's finances—a $44 trillion hole.
That's the kind of Washington tactic that makes Larry Kotlikoff angry. So angry, in fact, that the normally
composed and carefully spoken academic starts ranting about a government conspiracy to keep us all in the
dark. He even refers to this particular episode as "the great Treasury cover-up." And once you start Kotlikoff
on the subject, it's hard to stop him. "I hate politicians," he says, without pausing for breath. "These people are
so focused on the next election, they don't care about the next generation. The thing that really turns my
stomach is that they have the opportunity to do good, and they know they're doing bad, and it's okay. It's
Kotlikoff isn't some soft-headed, liberal, ivory-tower type. It's true his Boston office does resemble a tower, or
at least a turret, with rounded windows overlooking the Charles River and with a view across it to those two
bastions of economic thought, Harvard and MIT. But Kotlikoff is a mathematically minded, mainstream
economist who heads the economics department at Boston University. He has also taken on the role of fiscal
crusader. (At last count, he'd written some 11 books, 66 chapters, 80 journal articles, and 37 op-ed pieces
about our financial mess.)
The first massive wave of baby-boomer retirees will hit five years from now. That
will leave fewer workers to pay for ballooning Social Security and Medicare bills.

How the expected budget shortfall of $44.2 trillion* breaks down
Social Security
$7 trillion
$36.6 trillion
$0.6 trillion
*Based on current government revenue and spending.
Sources: Census bureau; Smetters and Gokhale
Two decades ago Kotlikoff, who's now 52, pondered the impact the baby-boomer generation would have
once it retired. He realized the government had a looming financial crisis on its hands because, in calculating
its budget, it considered only current-year Medicare and Social Security payouts—and ignored its massive
future obligations. That means, absurd as it sounds, that the government doesn't know what it really owes. And
a government that doesn't know what it owes has no way to judge whether it can pay up.
So in the mid-1980s Kotlikoff pioneered a new way of accounting that could do the math, and it quickly won
the approval of his profession. (Jargon-loving economists call it "generational accounting.") Kotlikoff's work
revealed the sheer enormousness of the financial hole the government would face. Back then it all seemed a
long way off, but today, with the first boomers reaching retirement age in five years, his message has taken on
new urgency. In the intervening years he's been writing books, testifying before Congress, and doing
everything he can to get the message out, but still nothing has been done to resolve the problem. In fact, the
way Kotlikoff sees it, we're making matters worse.
Before you dismiss Kotlikoff as a lonely prophet of doom, let's get back to that government report that never
saw the light of day. The authors of the report, Kent Smetters and Jagadeesh Gokhale, had intimate
knowledge of Kotlikoff's work. (Smetters had collaborated with Kotlikoff on several research projects over the
years; Gokhale had been one of Kotlikoff's graduate students.) Both economists were excited by the chance
to combine Kotlikoff's cutting-edge economic thinking with government policy. If President Bush published
their findings in his 2004 budget, it would be the first time an administration acknowledged how big the fiscal
problem facing the nation really was. It would also be the first step toward a solution.
Using the basic principles of Kotlikoff's generational accounting, they added up everything the government
expects to spend—Social Security benefits, debt-service payments, salaries, and so forth—far into the future
and put it in today's dollars. Then they added up all the income the government expects to earn—taxes,
income from government assets—in the future in today's dollars. To perform the calculations, Smetters and
Gokhale had to make certain key assumptions about the rate of growth in government spending, taxes,
medical costs, and hundreds of other things. Since they wanted to be as conservative as possible, they took
their numbers from the government's own budget. In one particular case—medical costs—they chose a much
more optimistic number, opting for 1% growth above GDP rather than the historical rate of 3%.
The gap between payments and income came in at $44.2 trillion. Think about $44 trillion for a moment. It's
probably the biggest thing you've never heard of—and certainly the biggest number FORTUNE will publish in
its pages this year. It's more than four times the size of our GDP, and 1 1/2 times the size of the entire world's
GDP. If we had a fire sale of all our nation's assets today—stocks, bonds, and real estate—we could just
about pull in $44 trillion.
Just to be clear, that number is not a bill that comes due on a certain date. What it shows is the debt that would
accumulate over years of deficits if we continue as we are. It is an honest measure of the inexorable pressure
on the government's future ability to spend. This amounts to a massive weight on the economy.
Worse than that, it's getting bigger. Every year the government sits on its hands, that $44 trillion grows by
about $1.6 trillion. Remember, Kotlikoff's generational-accounting technique estimates the present value of
our future needs. It's exactly like saving for retirement—the later you start, the more you have to save each
year. So if nothing is done this year, the gap will widen to nearly $46 trillion next year.
Worse still, Smetters's and Gokhale's numbers may be on the low side. Take another look at how important
the assumption about medical costs is. What Smetters and Gokhale discovered was that the two biggest
factors making up the $44 trillion black hole were Medicare and Social Security. If they assumed a growth rate
above GDP for medical costs of 1.5% instead of the 1% they used in their calculations, that $44 trillion gap
would become $65 trillion.
After O'Neill was fired, Smetters and Gokhale were left holding a controversial report that they had thought
was supported at the highest level of government. And once it was clear their work would never go anywhere
in Treasury, they published their findings in a conservative journal put out by the American Enterprise Institute,
and returned to their pre-Treasury employers. Smetters is back at the University of Pennsylvania; Gokhale, at
the Cleveland Fed.
There is rare consensus among economists regarding the wisdom of generational accounting. But some,
notably Harvard economist Martin Feldstein, see the problem as just that—a problem, not an apocalypse.
Feldstein was Kotlikoff's dissertation advisor and remains a close friend. He wields considerable influence
with the current administration and has seen many of his ideas incorporated into its fiscal policy. "What Larry
has done is to say what happens if we don't do anything to fill the gap," Feldstein explains. "That's not what will
happen. Either we'll raise taxes, cut benefits, or change the way we finance the system. Or it will be some
combination of all three." Feldstein points to President Bush's policy proposal to privatize Social Security as
evidence that the government is committed to dealing with the problem.
That may be, but it will require a great deal more courage than any politician has shown so far. In their report,
Smetters and Gokhale calculate it would take a 69% hike in all federal taxes or a 95% hike in payroll taxes to
close the $44 trillion gap. Or, if you prefer spending cuts, a 100%-plus cut across all discretionary federal
spending (which, of course, is impossible) or a 45% cut to Social Security and Medicare. Solving this problem
will hurt like hell.
What about economic growth? Can't that help reduce our debt? Kotlikoff shakes his head again. Growth, in
fact, makes this particular problem worse, because when the economy grows faster, so do Social Security
and Medicare. Kotlikoff reels off a long list of "painless" solutions he has considered: technological progress,
asset sales, greater use of capital, foreign investment, inheritance, employer-based retirement plans, delaying
the retirement age, increasing immigration, eliminating government waste, and on and on. He explains how
each one is a drop in the bucket or counterproductive or just plain unpredictable.
One aspect of this problem that everyone agrees on is that it is so huge that no single segment of society can
bear it alone. It's going to be felt across the board by all Americans. Seventy-seven million baby-boomers are
going to start retiring in five years' time. As they do, the number of retirees in America will double. At the same
time the workforce supporting them will grow by a mere 15%.
The longer you talk to Kotlikoff about this subject, the more dramatic his rhetoric becomes. "We're setting our
kids up for a great fall," Kotlikoff says bitterly. "We were left with a much better situation than our parents and
their parents before them—it's the American dream. But instead, we're leaving our kids with a fiscal crisis."
He's particularly critical of the Bush administration and believes it has made matters worse by cutting taxes by
so much and increasing spending so sharply. For instance, he points to President Bush's proposed
prescription-drug benefit (the Democrats also back it), which could cost between $400 billion and $1 trillion
over ten years. By his reckoning, that raises the $44 trillion fiscal gap by another $6 trillion.
The way Kotlikoff sees it, we're heading for a crisis with no escape. He believes that one day financial
markets will wake up to the size of the problem and send interest rates through the roof. When that happens,
the government will be forced to get its house in order—i.e., raise taxes and cut benefits. It will also rely on
higher inflation to help reduce the debt problem. If that all sounds bad for the economy, well, it will be. "I'm
scared," says Kotlikoff, "but I don't know what to tell my 13-year-old son. All I can do is try and save more. But
what can you leave your children that won't be eaten up by taxes and inflation?"
It's clear nobody can solve a $44 trillion-sized problem overnight. Yet in Washington, generational accounting
is as popular as a skunk at a garden party. The real question is, Do we continue an Eyes Wide Shut fiscal
policy or—and this is a huge "or"—admit there's something really big and ugly staring us in the face?