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Would a major financial incident like a downgrade in the triple-A rating for U.S. Treasury bonds prod Congress to finally fix the staggering long-term budget deficits facing entitlement programs? That question was asked yesterday by Kevin Hassett at a panel discussion regarding the SAFE Commission Act, which would establish a bipartisan group to formulate Social Security and Medicare reforms. Ratings agencies like Moody’s and Standard & Poor’s have warned that if Congress does not address future entitlement deficits soon, our best-in-the-world bond rating is at stake.

I would like to think that a major event like a Treasury downgrade would push Congress to act. But one technical issue regarding entitlement accounting makes me more pessimistic. The large numbers you read regarding Social Security and Medicare’s long-term deficits—around $40 trillion in total—are present values, which represent the discounted value of deficits that occur years or decades in the future. For instance, assuming an interest rate of 3 percent above inflation, a deficit of $100 billion that occurs 50 years from now has a present value of $23 billion. So far, so good–but why does this matter?

Well, consider what’s likely to happen in the case of a major crisis event like a bond downgrade or a dollar devaluation: in both cases, interest rates on government bonds are likely to skyrocket. Increasing these rates, which are used to discount future entitlement deficits, makes the present value of those future deficits smaller. For instance, if the real interest rate on government bonds went from 3 percent to 6 percent, that $100 billion deficit 50 years hence would have a present value of just $5 billion, less than one-quarter the size when the interest rates was 3 percent.

Now let’s translate this to Social Security: according to the 2008 Social Security Trustees Report , the program’s deficit over the next 75 years totals about 1.7 percent of payroll. But let’s consider if the interest rate rises from 2.9 percent above inflation—the rate assumed by Social Security’s Trustees—to 6 percent, a rate that might be plausible if credit markets get spooked about the government’s willingness to repay its debt. At a 6 percent discount rate, the 75-year shortfall would fall by around 1.74 percent–in other words, it would disappear!

It’s often said that “Doing nothing is not an option” with regard to entitlement reform. But Congress bases its perceptions of the size of entitlement shortfalls on the reports published by the government, and these reports may make it seem as if the easiest fix for Social Security and Medicare is in fact to do nothing, let interest rates skyrocket and “discount away” the programs’ massive future deficits. But what matters isn’t the “present value” of these deficits—it’s the size of the deficits to our kids and grandkids, and changes to technical measures like discount rates don’t do anything to help future generations pay the bills.

How we measure things has a great influence on what, if anything, we choose to do about them. The current measures, that make us look healthier in a crisis, are not working.

Tags: financial crisis, Medicare, SAFE Commission, Social Security