Why default is inevitable


franklin-delano-roosevelt-laughing-photo-1[1]We seem to be living in perilous times. Parts of the United States government are shut down because the House and Senate can’t agree to either fund or defund Obamacare, whose rollout this month has been an unmitigated disaster. This impasse now threatens the looming deadline to raise the debt limit before the Treasury supposedly runs out of money sometime in the next 48 hours.

Many people around the world fear that the United States might default on its debt if Congress fails to raise the debt limit. The consequences of default would be far-reaching and hard to predict because so much of the world economy is based on the US dollar and the “full faith and credit” of the US government to honor its debts.

In recent days several friends have asked what I think about this situation. My position is that default is inevitable, but I’d be very surprised if it happened this week. Here’s why:

Most of the Federal budget, nearly 60% of it, is taken up by entitlement programs. People who qualify for these programs, like Social Security and Medicare, are legally entitled to their benefits. The government cannot reduce these benefits without changing the law. About 30% of Federal spending is discretionary, meaning that the government can choose to cut it without violating any laws. And interest on the national debt accounts for less than 7% of the Federal budget.

The problem is that current Federal spending is about 24% of GDP (gross domestic product, i.e. the total value of all goods and services produced by our economy each year), whereas the Federal revenue (taxes) are only about 15% of GDP. So for every dollar the Government collects in taxes, it’s borrowing and spending an additional 60 cents.

That borrowing represents 38% of the Federal government’s funding, which is greater than the 30% of the budget taken up by discretionary spending. So even if we slash discretionary spending to zero, we can’t fund both our current entitlement spending and our interest payments without additional borrowing.

This means we’re in pretty bad shape today, but it’s only the beginning of the story.

In the days before Obamacare became law, the non-partisan National Taxpayers Union issued a report on the unfunded liabilities of then-current entitlement programs. In other words, understanding that we’re going to have greater numbers of older, sicker people in the future and fewer workers funding Medicare and Social Security, how much extra money would the Federal government need to have on hand today in order to deliver all the benefits it has promised under these programs for the next 75 years without raising taxes?

The answer: About $46 trillion. That’s about three times the current United States GDP. And that’s before factoring in the Obamacare subsidies that will theoretically help defray the cost of health insurance for lower-income Americans once the websites stop crashing.

The National Center for Policy Analysis published a similar study 10 years ago, before the Medicare prescription drug benefit (Part D) became law, and the numbers were similar. Authors Jagadeesh Gokhale and Kent Smetters predicted that the fiscal funding gap would be around $50 trillion including Medicare Part D. They calculate that the gap could be closed by a permanent increase in payroll taxes by about 15%, or by raising income tax revenues permanently by about 60%.

This entitlement funding gap is frighteningly large, much larger than the value of the national debt that causes so much political hand-wringing. Each year we’re spending more than 8 times as much on entitlement programs as we are on those interest payments that we’re supposedly going to miss if we don’t raise the debt limit. But we don’t have a meaningful national discussion about entitlement reform.

For all this talk about defaulting on our debt obligations, why aren’t we talking instead about the inevitable default on our unsustainable entitlement spending?

Part of the problem is that this conversation necessarily involves math, and a recent study suggests that less than 10% of US adults are likely proficient enough to understand a question of this complexity.

Beyond ignorance, the obvious answer as to why we don’t talk about entitlement reform is that these programs are untouchable. Any attempt to alter them in a meaningful way is political suicide. This feature was admittedly designed into the programs in the form of payroll taxes. As FDR said:

We put those pay roll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program. Those taxes aren’t a matter of economics, they’re straight politics.

Well done, then. 78 years later and still working as designed.

vice-president-lyndon-b-johnson-everett[1]Congress and LBJ amended FDR’s Social Security Act in 1965, adding two amendments that created Medicare and Medicaid.

Medicare, like FDR’s Social Security, is funded through payroll taxes.

Incidentally, some policymakers wanted health insurance as part of the original Social Security Act of 1935, though they feared that including health insurance would jeopardize the entire bill, so it was left out.

In piggybacking Medicare on top of Social Security and using payroll taxes to fund this new entitlement, LBJ guaranteed that Medicare would be just as politically sacrosanct as its forerunner. And 48 years later, Medicare is still as untouchable as ever. It has been amended several times but has always grown in size and scope.

In spite of their shared political knack for creating these fiscal black holes, FDR and LBJ are not the worst villains in this story. That distinction belongs to LBJ’s successor, a man whose infamy seems to have denied him the privilege of a three-letter sobriquet.

nixon-victory-sign[1]Richard Milhous Nixon did not create Social Security or Medicare, but the magnificently reckless monetary policy maneuvers that he undertook to boost his chances of re-election effectively forced central banks around the world to hold the US dollar as their primary reserve asset, making them complicit in anesthetizing the United States to the fiscal pressures of these two entitlement monsters plus profligate discretionary spending, thereby lulling us into a false belief that our government can be exceedingly generous to all without anyone ever having to pick up the check.

When Nixon unilaterally defaulted on our obligations under the Bretton Woods system back in August of 1971, he set us up to run chronic fiscal deficits with no real consequences. And but for a period of fiscal sanity in the late 1990s, we have done just that:

So we find ourselves in the present crisis, stuck between a fiscal rock and a monetary hard place, with massive unfunded entitlement liabilities on one hand and an endlessly-growing national debt on the other. There is no way out but through some kind of default:

  • We could default on our bondholders. One of my professors once said that when sovereign debt reaches unsustainable levels, default is inevitable. And a nation can either default quickly through a restructuring, which is a euphemism for “we aren’t going to pay you back” (see Argentina), or do it slowly through deliberate inflation, i.e. paying off an unsustainable debt with cheaper dollars in the future (arguably the Fed’s present and future course of action). A restructuring of US debt is unfathomable at present as we can (at least for now) easily afford our interest payments. And in spite of what seems like partisan gridlock, the Treasury still has a few tricks up its sleeve before it throws in the towel.
  • We could default on the old, the poor, and the sick. Restructuring Social Security and Medicare seems like a good idea given more than $46 trillion in unfunded liabilities tied to these programs, in addition to the still-unknown cost of the Obamacare subsidies. But by design any of these reforms will entail a steep political cost, and the proverbial chickens likely won’t come home to roost until today’s politicians have retired or died. It may take a threat of (or even an actual) default on our debt in order to compel the government to undertake meaningful entitlement reform. Some low-risk options for restructuring these programs include significant phased increases in the age of eligibility and financial incentives for families to complete end-of-life planning (advanced directive, living will, medical power of attorney, etc.)
  • We could default on taxpayers. Granted, there is no prohibition against raising taxes in the future, but a social contract most definitely exists between taxpayers and the government wherein the government promises fair services in exchange for a fair tax rate. We will likely need some type of tax increase in order to close the entitlement funding gap, and any tax increase will be politically risky. We could theoretically minimize political fallout by increasing taxes on only the so-called “rich”, though this type of default cuts both ways in the tax game and is therefore of limited utility in practice.

We’re in a tough spot, and there is no easy way out. We’re ultimately going to have to restructure both our tax code and our entitlement programs if we want to regain the kind of fiscal and monetary discipline that will allow future security and prosperity. These entitlement and tax defaults will be painful, but they will be much more manageable than a disorderly default on our debt.

The most immediate question, then: Who is in a position to lead us through this transition?

2 thoughts on “Why default is inevitable

    1. Glad to see that you called that part out. I believe that good intentions coupled with gross ignorance are a significant root cause of the present crisis.

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