One viable fiscal solution to generational imbalance has already been implemented in Britain: that is, simply to break the link between the state pension and wages. In 1979, the newly elected government of Margaret Thatcher discreetly reformed the long-established basic state pension, which was increased each year in line with the higher of two indices: the retail price index or the average earnings index. In her first budget, Thatcher amended the rule for increasing the basic pension so that it would rise in line with the retail price index only, breaking the link with average earnings. The short-run fiscal saving involved was substantial, since the growth of earnings was much higher than inflation after 1980 (around 180 percent to 1995, compared with a consumer price inflation rate of 120 percent). The long-run saving was greater still: the United Kingdom's unfunded public pension liability today is a great deal smaller than those of most continental governments-as little as 5 percent for the period to 2050, compared with 70 percent for Italy, 105 percent for France and 110 percent for Germany. This and other Thatcher reforms are the reason the United Kingdom is one of the elite developed economies not currently facing a major hole in their generational accounts. (Interestingly, the others are nearly all ex-British colonies: Australia, Canada, Ireland and New Zealand. According to international comparisons done in 1998, each of these countries could have achieved generational balance with tax increases of less than 5 percent.)

Could it happen in the United States? In view of the growing political organization and self-consciousness of elderly Americans, it seems unlikely. If you spend some time in Florida, you are bound to see scores of bumper stickers that read: "I'm Spending My Kids' Inheritance." Fifty years ago, such sentiments were seldom uttered, but attitudes and behavior have changed. Economic research shows conclusively that the elderly as a group are indeed consuming with next to no regard for their adult children. The federal government has spent half a century taking ever larger sums from workers and handing them to retirees in the form of Social Security, Medicare and Medicaid benefits. The result has been a doubling of consumption per retiree relative to consumption per worker. Thus, the absence of voluntary transfers of wealth between the old and the young helps explain why Social Security is sometimes referred to as the "third rail": any politician who suggests a cut in benefits will receive a violent political shock from the American Association of Retired Persons (AARP) and related interest groups.

The Return to Fiscal Sanity

So are there any policies an American president can adopt without risking electoral oblivion? The first goal must be to discipline Medicare spending, which is responsible for the lion's share-82 percent-of the $45 trillion budget black hole. Since 1970, the rate of growth of real Medicare benefits per beneficiary has exceeded that of labor productivity by 2.4 percentage points. The $45 trillion figure assumes, optimistically, that in the future the growth rate of Medicare benefits per beneficiary will exceed productivity growth by only 1 percentage point. Just cutting the growth rate of Medicare benefits per beneficiary by half a percentage point per year would shave $15 trillion off the $45 trillion long-term budget gap. There must be a way to cap the program's growth without jeopardizing its ability to deliver critically important health insurance protection to the elderly.

Unfortunately, the President's new policy-which effectively bribes the elderly with a drug benefit to join HMOs-has three flaws. First, the benefit he proposes is fabulously expensive: between $400 billion and $1 trillion over ten years. Second, his scheme retains the traditional and very expensive fee-for-service Medicare system and permits the elderly to switch back to it whenever they like. Unfortunately, they are likely to switch back just when they are becoming expensive to treat. Finally, the HMOs are free to shut down and ship their customers back to the traditional plan whenever their clients become too expensive.

The key, then, to meaningful Medicare reform is to eliminate entirely the traditional fee-for-service option and give all Medicare participants a voucher to purchase private health insurance. But would this not leave them at the mercy of the market, which favors insuring only the healthiest among them? The answer is no, provided the vouchers handed to the elderly are weighted according to their health status. Thus an 80-year-old with pancreatic cancer might get a $100,000 voucher, while an 80-year-old who is in perfect shape might get only a $5,000 voucher. The vouchers would be determined each year in light of the participant's health status at the end of that year. Having set a rigid cap on total Medicare expenditures, the government can readily determine the amount of each voucher. (The major objection to this proposal is the loss of each participant's privacy, since he will have to reveal his medical history to a government-appointed doctor. But this seems a small price to pay to regain some measure of fiscal sanity.)

The second key policy is to privatize Social Security, but in such a way that the current elderly help rather than hinder reform. One way to do this would be to close down the old system at the margin and enact a federal retail sales tax to pay off, through time, its accrued liabilities. What workers would otherwise have paid in payroll taxes would now be invested in special private retirement accounts, to be split fifty-fifty between spouses. The government would make matching contributions for poor workers. And it would contribute fully on behalf of the disabled and the unemployed. Finally, all account balances would be invested in a global, market-weighted index of stocks, bonds and real estate.

Will either of these policies be implemented? We are not optimistic, since each would entail sacrifices by retired Americans, as the AARP would no doubt hasten to point out. Social Security reform appears likely to remain a taboo subject on the presidential campaign trail. And with the enactment of the drug benefit, Medicare has supposedly been dealt with.

There is, however, one other, more drastic possibility. It is usually assumed that outright default on the government's implicit liabilities is unlikely. Is it? Suppose a major change in expectations about America's fiscal future is looming on the horizon. If the bond market does "go critical"--if, in other words, investors suddenly start to fear an inflationary outcome of the federal fiscal crisis--then a president like this one, who is as attracted to reductions in Social Security as he is to reductions in taxation, might seize the moment of national emergency. And it would indeed be a national emergency. A government facing a steep increase in its borrowing costs would confront a large and powerful social group determined to defend their entitlements.

Such a scenario has one obvious historical precedent. In ancien regime France, the biggest burden on royal finances did not take the form of bonds but of salaries due to tens of thousands of officeholders, men who had simply bought a government sinecure and expected in return to be paid a salary for life. All attempts to reduce these implicit liabilities within the existing political system simply failed. It was only after the outbreak of the Revolution, arguably a direct consequence of the monarchy's fiscal crisis, that the offices were abolished. The officeholders were compensated by cash payments in a new currency, the assignats, which were rendered worthless within a few years by the revolutionary printing presses. This parallel has two implications: first, there can be big political consequences when fiscal systems go critical; and second, vested interests that resist necessary fiscal reforms can end up losing much more heavily from a revolutionary solution.

PERHAPS, then, Paul Kennedy was not so wrong after all to draw parallels between modern America and pre-revolutionary France. Bourbon France, like America today, had pretensions to imperial grandeur but was ultimately wrecked by a curious kind of overstretch. It was not overseas adventures that did in the Bourbons. Indeed, Louis XVI's last foreign war, in support of the rebellious American colonists, was a huge strategic success. Rather, the overstretch was internal, and at its very heart was a black hole of implicit liabilities.

In the same way, the decline and fall of America's undeclared empire will be due not to terrorists at our gates nor to the rogue regimes that sponsor them, but to a fiscal crisis of the welfare state. The government finds itself between the falling rock of market sentiment and the hard place of vested interests. Political expediency rules out fiscal reform; but if the bond markets foresee a spiral of deficit finance, sooner or later they will mark down the price of U.S Treasuries even further. And rising yields will only increase the cost of rolling over the government's explicit debt.

This fiscal crisis is not, of course, a problem unique to America. It afflicts the world's second and third largest economies even more seriously, since neither Japan nor Germany can compensate for the senescence of their populations with American-style immigration. But neither Japan nor Germany has pretensions to be a global hegemon or hyperpower. Their decline into economic old age has minimal strategic implications. That is not true in the American case.