Jeffrey Rogers Hummel’s article, “Why Default on U.S. Treasuries is Likely,” is troubling.

In it, he argues that inflation alone won’t be enough to compensate for the coming Social Security/Medicare budgetary shortfall and that Treasury will instead repudiate a large portion of its debt. I recommend reading the whole thing.

Defaulting on our debt would be bad.

Right now, U. S. treasury bills are traded as essentially “risk free” investments. They form the backbone of the global financial system.

He closes the article with this:

All the social democracies are facing similar fiscal dilemmas at almost the same time. Pay-as-you go social insurance is just not sustainable over the long run, despite the higher tax rates in other welfare States. Even though the United States initiated social insurance later than most of these other welfare States, it has caught up with them because of the Medicare subsidy. In other words, the social-democratic welfare State will come to end, just as the socialist State came to an end. Socialism was doomed by the calculation problem identified by Ludwig Mises and Friedrich Hayek. Mises also argued that the mixed economy was unstable and that the dynamics of intervention would inevitably drive it towards socialism or laissez faire. But in this case, he was mistaken; a century of experience has taught us that the client-oriented, power-broker State is the gravity well toward which public choice drives both command and market economies. What will ultimately kill the welfare State is that its centerpiece, government-provided social insurance, is simultaneously above reproach and beyond salvation. Fully-funded systems could have survived, but politicians had little incentive to enact them, and much less incentive to impose the huge costs of converting from pay-as-you-go. Whether this inevitable collapse of social democracies will ultimately be a good or bad thing depends on what replaces them.

Only four things can happen when the bills come due:

1)  We can raise taxes to cover the shortfall.

This is problematic for several reasons. Revenue does not increase linearly with tax rates and higher tax rates reduce growth rates which further reduces revenue. The target rates, as Hummel points out, would need to be in excess of 45%, a level that far exceeeds anything Americans have shown a willingness to put up with. I think this is a political non-starter. Taxe rates would have to climb across the board and I don’t see any politician in the next twenty years seriosuly campaigning to double the taxes on middle-class earners.

2) We can cut benefits and services, end Social Security and radically reduce Medicare commitments.

Political suicide. No politician will do it. Won’t happen.

3) We can radically inflate the money supply.

Hummel argues that we actually can’t do this because there’s so much private money in the world. I think he’s probably right, but I’ll offer another reason why we can’t do this, and it’s the same as the reasons we won’t do 1) or 2). It’s political suicide. Hyper-inflation affects everyone equally. Everyone’s wealth is reduced both here at home and abroad. Think this recession looks bad? Significant inflation would cripple the global economy.

4) We can repudiate some of our debt.

In other words, we’d just default on T-bills. But of course, we wouldn’t default on the T-bill rate, we’d default on particular T-bills. I’m guessing we’d default on debt obligations held by foreign banks and foreign governments. I’m also guessing that we’d be less likely to default on our debt obligations to Western Europe than we would be to default on our debt obligations to China.

The economic fallout of debt repudiation would be bad, very bad. We’d likely lose the dollar as the world’s reserve currency, some inflation would likely attend any debt default, and the global economy would take a significant hit. But the consequences would obviously be most dire for whoever holds the debt we choose to default on. How will our creditors respond?


Exit strategy?

The NYT has an interesting piece on the Madoff affair, “Hey Ponzi, What’s Your Exit Strategy, Exactly?

I have never understood why someone would ever start a Ponzi scheme when, by definition, there’s no way to end it.

The scam works by bringing in new unwitting investors to pay off the old unwitting ones. Since there’s no actual investment involved — just a transfer of money backward, with some portion presumably pocketed by the Ponzi schemer — keeping the scheme going requires an endless supply of new investors. The schemer’s liabilities only get bigger as time goes on, and there’s no way to end the ploy. Other than jail, that is. Or death. Or perhaps faking one’s own death.

The U.S. Social Security system is a Ponzi scheme. Benefits for existing retirees are paid out of payments made by current workers. Whatever excess there is in current revenue is “invested” in special Treasury bonds (special because they cannot be traded). When outgoing payments exceed incoming revenue, the bonds will be cashed in, and those bonds will have to paid with general tax revenue.

Since there’s no actual investment involved — just a transfer of money backward, with some portion presumably pocketed by the Ponzi schemer — keeping the scheme going requires an endless supply of new investors.

The transfer of money backward is from current workers to current retirees. The portion pocketed by the Ponzi schemer (the Federal Government) is whatever current excess revenue exists.

Some people, of course, just pretend that Social Security is fine. Like Richard C. Leone of the Century Foundation,

Simply put, Congress is bound to pay the interest and principal on Social Security’s trust fund, which means that the system will be able to continue paying promised benefits in full until sometime between 2042 and 2052, depending on the forecast. There should simply be no misunderstanding about that.

He’s right. The bonds held by Social Security represent a claim that Congress has to pay. Out of general tax revenue. So, when payments begin to exceed income (sometime around 2014-2017), Congress will have to make up the difference by either a) raising taxes, or b) cutting benefits. Which would, you know, be radically different than if the Social Security Administration had to make up the shortfall by either a) raising taxes, or b) cutting benefits — A difference without a distinction if ever there was.

But maybe, the Social Security problem isn’t really that big a problem? Paul Krugman makes this argument,

Now it’s true that rising benefit costs will be a drag on the federal budget. So will rising Medicare costs. So will the ongoing drain from tax cuts. So will whatever wars we get into. I can’t find a story under which Social Security payments, as opposed to other things, become a crucial budgetary problem in 2018.

What we really have is a looming crisis in the General Fund. Social Security, with its own dedicated tax, has been run responsibly; the rest of the government has not. So why are we talking about a Social Security crisis?

Because existing Social Security/Medicaid shortfall is $40.8 trillion dollars, or four times greater than all other outstanding federal debt, that’s why.

Defense accounts for 20% of the budget. SS/Medicare/Medicaid account for 42%, interest and other mandatory spending (like congressional salaries) account for another 20%. Discretionary domestic spending accounts for 18%. So, say we trim defense back by 20% (which I’m not advocating), and we slash domestic programs by 50%. That gets us 13% of federal revenue, or enough money to pay the interest on about a quarter of the Social Security/Medicaid debt.

The schemer’s liabilities only get bigger as time goes on, and there’s no way to end the ploy. Other than jail, that is. Or death. Or perhaps faking one’s own death.

So, what’s our exit strategy? Exactly?

$700 Billion? Chump change.

From Investor’s Business Daily:

In an analysis prepared for Republican Rep. Paul Ryan, the Congressional Budget Office outlined the ghastly details:

“The tax rate for the lowest tax bracket,” the CBO told Ryan, “would have to be increased from 10% to 25% (or 150%), the tax rate on incomes in the current 25% bracket would have to be increased to 63% (or 152%); and the tax rate of the highest bracket would have to be raised from 35% to 88% (or 151%).”

What could require a 150% across-the board increase in taxes? Unfunded entitlement obligations to Social Security and Medicaid. What’s the amount? $53,000,000,000,000. That’s right. $53 trillion dollars. Did I say unfunded? I did.

From Eric Raymond:

Raising taxes can delay this, but not prevent it. And might, actually, trigger it sooner; the historical evidence suggests that current tax rates may already be at above the minimum level where, by suppressing and unhealthily redirecting economic activity, they actually reduce total revenue. …

The only alternative to raising taxes (or deliberately inflating the currency, which in this context has similar effects) is to buy debt and pay entitlements out of that, pushing the unsustainability problem into the future. …

At some point, the U.S. government is going to lose both the ability to increase revenues and the ability to sell bonds. At that point the entitlements system will crash. Transfer checks will either stop issuing or become meaningless because the government has, like some banana republic, hyperinflated the currency in order to get out from under its debt obligations.

This bill is coming due. In 2014, expenditures will exceed revenue. The only solution is to cut benefits for future recipients and to cut them radically.

Obama’s “plan” is to raise the FICA cap. It’s a stop-gap measure that would put the collapse off until after he left office, but it wouldn’t do anything to solve the crisis.

McCain’s position is slightly better, but only slightly. McCain’s plan is to create a bipartisan commission, a la Reagan. (Which is just another way of not answering the question.)

Obama has explicitly rejected the idea of a commission, mostly because any bipartisan commission would almost certainly cut benefits, which he is adamantly opposed to doing.