Tuesday, August 25, 2009

Six ways the U.S. won't escape its national debt. 

The US national debt -- including its "implicit debt", unfunded liabilities for promised Medicare, Social Security, and Medicaid benefits and federal employee/military pensions -- is staggeringly, unsustainably large: $64 trillion at the end of 2008. And since then it's grown to about $69 trillion (after adding the 2009 fiscal deficit of near $2 trillion and a year's interest to the implicit debt.)

How unsustainable it? Even if never paid off the government still will have to pay interest on it. At the 6% long-term rate estimated by the Trustees of Social Security, interest on $ 69 trillion is $4.14 trillion a year. Interest on US debt is financed with income taxes. There are 80 million payers of income tax in the US. Dividing $4.14 trillion by 80 million taxpayers gives $51,750 per taxpayer annually. Meanwhile, average household income in the US is about $50,000.

An average tax bill per taxpayer larger than median household income, just for interest on the debt, seems a pretty good working definition of "unsustainable".

Of course, taxpayers aren't paying all this yet. At this writing the "debt held by the public" upon which cash interest is paid (the "explicit debt") is $7.4 trillion. But over coming years it is going to grow fast as the "baby boomers" sail into retirement and the implicit debt turns explicit to pay for it.

During the next 10 years the debt held by the public is projected to grow by another $9 trillion -- 20% more than the total accumulated since George Washington's inauguration in 1789 until today. After that it is "off to the races." Standard and Poor's projected in 2005 that on then current policy the credit rating of the United States would be "junk" by 2027 -- and Obama's policies and the recession have since accelerated that debt accumulation by a good half dozen years ... but enough of the bad news.

There's an old saying in economics that "if something is unsustainable it will not be sustained". So in the end the U.S. will escape the unsustainable portion of its debt, one way or another. The question is "how?"

Arnold Kling has suggested seven possibilities. In my opinion there is only one. His possibilities are in italics below, my opinion on each follows.

1. Muddle through. No major change in policy...

Zero chance by arithmetic. As more than $50 trillion of "implicit debt" is converted to cash-interest paying explicit debt, the government is not going to be able to pay the interest owed on $50 trillion with "no change in policy".

2. Technology to the rescue. Some major technologies, probably either wet or dry nanotech, produce so much economic growth that the ratio of debt to GDP stays under control ...

Dreams are nice. But when per capita GDP has been increasing 2% a year for near 200 years at a remarkably steady rate, why would it explode upward now? Why not 50 years ago? Or 50 years from now, when it will be far too late?

Moreover, even a surge in the growth rate large enough to be deemed "huge, unprecedented" by historical standards still won't work, because Social Security benefits are tied to wages which rise with the growth rate, and demand for health benefits rises faster than income, which rises with the growth rate.

This possibility has been considered here in more depth with real numbers previously.

3. Policy changes. Congress increases taxes ... and/or takes steps to rein in Medicare and Social Security spending.

Nothing else is possible by process of elimination. There's an easy way (Congress responsibly does this in advance to head off calamity) and a hard way (Congress irresponsibly delays until calamity arrives and then does it to avoid worse calamity) and I certainly more expect the latter. But this is going to happen, because in the end there are no other options.

And to paraphrase Sherlock, when you eliminate everything that won't work...

4. Inflate away the debt with moderate inflation (between 5 and 10 percent per year)...

Zero chance. Impossible for two reasons:

First, it won't work even for the explicit Treasury debt because "inflating away" debt only works if the debt is actually paid off.

Lenders aren't dummies. If a government continues running deficits and thus has to roll over its debt after it starts inflating, lenders charge it enough interest to cover the inflation and more (an "inflation premium" in case the government inflates further). The government gets clobbered with skyrocketing interest rates, is still borrowing, and has more problems than ever.

Nations "inflating away debt" as some sort of easy way out of it is largely an economic urban legend. To eliminate debt (even with inflated dollars) the government must stop borrowing, which requires a massive change in real fiscal policy -- it has to push revenue above spending. Which gets us back to the only option, "policy changes".

Second, inflation very clearly can't eliminate the >$50 trillion of "implicit debt" because Social Security benefits and federal/military pensions are inflation-indexed, while Medicare and Medicaid are paid in "real service" terms, the cost of which rises even faster than inflation.

5. Wealth tax. The government takes, say, 5 percent of everyone's personal assets above $100,000...

Zero chance. A one-time fix won't work. Future expenditures rise above revenues forever at an accelerating rate -- literally exponentially as interest on the debt compounds. No one-time fix will do. There's just not enough wealth to seize to pay down the bulk of $69 trillion.

6. Hyperinflation....

Won't work for the same reason as "inflation". That's the "beauty" of owing all your big debts in inflation-adjusted and real terms, regardless of nominal dollar cost.

7. Default. The U.S. simply refuses to pay some or all of its debt...

Even if it happens it doesn't give the funds needed to pay Medicare, Social Security, Medicaid, and unfunded federal-military pension obligations. So it is no solution.

Remember, the fiscal killer is not the $7.4 trillion of Treasury debt or whatever amount the Treasury debt is projected to reach in the next few years, but the >$50 trillion present value liability for Medicare, Social Security, Medicaid, & unfunded federal and military pensions. Walking away from $7.4 trillion you owe now doesn't give you the money to pay >$50 trillion you'll owe soon.

The ONLY solution for financing this >$50 trillion is increasing taxes to pay promised benefits or cutting the amount of them that gets paid, or -- in reality -- both. It must happen, by arithmetic nothing else is possible, so it will happen. Though the politics of it happening is going to be interesting to watch (in the sense of the old Chinese saying, "May you live in interesting times.")

To see the rough size of tax increases/benefit cuts needed to keep the government solvent, and for perspective on them compared to past budget events (such as World War II) here are some numbers.