Economic Review
First Quarter 2006 

Social Security and Medicare: The Impending Fiscal Challenge - (PDF 263K)
By Craig S. Hakkio and Elisha J. Wiseman

Social Security—and the solvency of its Trust Fund—have increasingly become a focus of discussion in the media and policy circles. The basic problem is that promised benefits will soon exceed program revenues. Without changes in benefits or funding, the Trustees of Social Security project that assets in the Trust Fund will be depleted in 2041. While Social Security is a serious problem for taxpayers and beneficiaries, Medicare poses an even greater challenge. Together, the two programs’ benefits currently amount to about 6 percent of GDP. By 2080 they are projected to swell to 20 percent.

With spending on these two programs projected to grow faster than the nation’s GDP, the Board of Trustees of Social Security and Medicare have concluded that “We do not believe the currently projected long-run growth rates of Social Security and Medicare are sustainable under current financing arrangements.” To keep the programs solvent without slashing benefits or increasing tax revenues, the federal budget deficit would need to grow drastically. Thus changes will likely be needed to the structure of the two programs. In fact, any viable solution is likely to involve changes in government spending and taxes.

Hakkio and Wiseman provide a framework for understanding the nature of the fiscal challenges posed by Social Security and Medicare—a prerequisite for finding specific solutions.

The Trend Growth Rate of Employment: Past, Present, and Future - (PDF 258K)
By Todd E. Clark and Taisuke Nakata

Over the course of the recovery from the 2001 recession, many forecasters have revised downward their expectations for job growth in the United States. The often disappointing pace of employment growth has been attributed to various forces, such as the high health-care costs faced by employers, structural changes causing some industries to decline, outsourcing of jobs from the United States to other countries, and strong productivity growth. Many of these explanations imply the sluggish pace of job gains to be the result of weakness in aggregate demand and labor demand. However, some observers have suggested that broad demographic changes affecting labor supply – such as the aging of the population – could account for part of the sluggishness of job growth. The demographic changes may have slowed the trend growth rate of employment.

A change in trend would have important implications for fiscal and monetary policy. For fiscal policy, slower trend growth in employment will tend to result in slower long-term growth in tax revenues, with potentially important effects on government programs such as Social Security. For monetary policy, assessments of the state of labor markets and the overall economy compared to sustainable trends often figure prominently in monetary policy decisions. If trend job growth were to slow, actual growth in jobs that appears weak by historical standards could exceed the new trend rate. The course of monetary policy could differ substantially if job growth were correctly realized to be above trend rather than incorrectly assessed to be at or below trend. Therefore, accurate assessments of potentially changing trends are important to effective monetary policy.

Clark and Nakata examine employment and labor force indicators for evidence of a slowing of trend employment growth in the United States. They conclude that declines in the growth rates of population and labor force participation have caused the trend growth rate of employment to slow. Over the next ten years, a reasonable baseline projection for trend job growth is 1.1 percent per year, or about 120,000 jobs per month.

Interchange Fees in Credit and Debit Card Markets: What Role for Public Authorities? A Conference Summary - (PDF 219K)
By Barbara Pacheco and Richard Sullivan

Credit and especially debit card transactions are on the rise worldwide. Interchange fees are an integral part of the pricing structure of credit and debit card transactions. Indirectly paid by merchants to card issuers, interchange fees in most countries are set by credit and debit card networks. But in one country, Australia, the central bank is regulating interchange fees, and in several other countries and areas, including the European Union, Mexico, the Netherlands, Spain, and the United Kingdom, public officials are taking, or considering taking, a more hands-on regulatory stance. In the United States, it is largely the court system that is debating interchange issues.

The payments industry has a strong vested interest in interchange fees. They are a major portion of costs that merchants pay for processing debit and credit card payments and are a major source of revenue for banks that issue the cards. One reason for recent interest in interchange fees in the United States is a shift in retail payments away from checks. Research sponsored by the Federal Reserve documents a rise in electronic payments and a decline in the use of paper checks, with a milestone recently passed where the majority of noncash payments are now made using electronic instruments. This shift is also occurring in other countries. Since paper checks typically do not have an interchange fee while credit and debit payments do, the shift is a major reason why merchants face a rapidly rising cost of processing payments. Card issuers, on the other hand, rely on associated revenues to provide a return to their substantial investment in card payment networks.

Pacheco and Sullivan summarize the proceedings of a conference sponsored by the Federal Reserve Bank of Kansas City, held in Santa Fe, New Mexico, in May 2005, which explored issues surrounding interchange fees. The conference brought together a distinguished group of industry participants, antitrust authorities, central bankers, and academics.

Rethinking Federal Policy for Regional Economic Development - (PDF 195K)
By Mark Drabenstott

Economic development policy is a major priority of the federal government. Over the past century, Congress has created a panoply of programs aimed at economic development in communities and regions. These programs have sprung up at different times, with different goals, and with different ways of meeting those goals. Yet taken together they add up to a big priority and a lot of dollars. By one estimate, the federal economic development effort spanned 180 programs in 2004 and spent more than $180 billion.

This is a critical time to take stock of this federal effort. The current deficit makes every dollar count in Washington. But there is a far more compelling reason to rethink federal policy for economic development: The world has changed but federal policy has not. Globalization of markets for goods, services, capital, and currencies has fundamentally changed the rules of the game in economic development. The problem is quite simple: Most federal programs for economic development were written for the economy of the 20th century, not the 21st century.

Drabenstott examines how federal policy might shift to align with the new global economy. First, he summarizes the current federal role in economic development. Second, he describes the evolution in economic development thinking. Third, he explains why three shifts in federal policy will be important if the nation wants to help regions hone their competitive edge.

A Robust Rural Economy in 2006? - (PDF 182K)
By Jason Henderson

Rural America will remember 2005 as a year of drought, hurricanes, and surging gas prices. To be sure, some regions of the country faced devastating natural catastrophes. Yet, these catastrophes did not stop the farm sector from posting another banner income year—nor did they stop the nonfarm sectors from enjoying solid gains in employment and income. Overall, the rural economy was quite resilient in 2005.

Heading into 2006, the rural economy appears poised for another year of robust activity, especially if private sector forecasts hold true. Energy prices are the risk to the forecast. The higher oil and natural gas prices translate into higher production costs for factories, farms, and households. Yet, higher prices are also underpinning a new wave of investments and market opportunities in rural America’s emerging bio-based energy sector.

Henderson reviews the rural economy in 2005 and discusses the prospects for 2006. He also explores the potential impacts of high energy prices on the rural economy in the year ahead.

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