| |  | | | | What if we don’t fix entitlements? |
| The deficit spending that took place in response to the pandemic created a tremendous debt burden for the federal government. But emergencies, like war and plague, do happen from time to time. Just as a family might sometimes need to take out a loan to get through a rough patch, a country might legitimately need to spend more than it has from time to time as well.
The problem with the pandemic debt binge is that it took place in the context of structural financial imbalances that pre-existed the arrival of the virus. In other words, we were already staring down the barrel of an unsustainable long-term fiscal outlook. The 30+% increase in federal debt since 2019 has only accelerated the day of reckoning.
On May 6, 2024, the Board that oversees the Social Security program published its 84th Annual Report. As was widely reported, they noted the so-called Social Security “trust fund” is expected to begin to go into the red starting in 2035. |
| | Under the intermediate assumptions, the projected hypothetical combined OASI and DI Trust Fund asset reserves become depleted and unable to pay scheduled benefits in full on a timely basis in 2035… The 2024 Trustees Reports indicate a need for substantial changes to address Social Security’s and Medicare’s financial challenges. The Trustees recommend that lawmakers address the projected trust fund shortfalls in a timely way in order to phase in necessary changes gradually and give workers and beneficiaries time to adjust their expectations and behavior. - Social Security and Medicare Boards of Trustees, 2024 Annual Reports |
| | It’s important to understand what the Social Security trust fund actually is. The trust fund is basically just an accounting construct. As workers contribute to the Social Security system via payroll taxes, their money does not get placed into an actual fund or investment vehicle but is simply used to pay for the current operations of the federal government.
In return, the federal government issues special IOU’s to the trust fund, which are effectively Treasury bonds. Through its ownership of these Treasury obligations, the trust fund collects interest from the federal government to pay out its obligations to senior citizens and other citizens who qualify for payments.
Due to demographic patterns, in particularly the aging of the baby boomer cohort, the trust fund stopped growing, and started shrinking, in 2021. While the first boomer was born in 1946, approximately 78 years ago, the peak of boomer births in the United States did really not occur until the early-1960s. |
|  | The last members of the baby boom wave (born in 1964) will turn 66 years old in 2030, which is the standard age of eligibility for social security retirement benefits. The tide has rapidly turned. According to government projections, by 2035, there will not be sufficient funds in the Social Security trust fund to cover required payments.
As many have noted, this does not mean Social Security payments will stop or even get cut. It will simply require a modification of the accounting structures the government uses. But this will require political action and will necessitate a broader rethinking of the Social Security program.
To the extent the trust fund was always an accounting fiction, with one entity of the federal government borrowing from another, this problem is also fictional. But the demographic trends that are sending these accounting arrangements to the point of insolvency are very real.
The key thing to focus on is the extent to which all of the entitlement programs will drive a massive increase in federal debt in decades to come. The Congressional Budget Office presentation from February 2024 speaks to this issue. |
| | Debt held by the public rises each year in relation to the size of the economy, reaching 116 percent of GDP in 2034—an amount greater than at any point in the nation’s history. From 2024 to 2034, increases in mandatory spending and interest costs outpace declines in discretionary spending and growth in revenues and the economy, driving up debt. That trend persists, pushing federal debt to 172 percent of GDP in 2054. - The Budget and Economic Outlook: 2024 to 2034 |
| | Thanks to a combination of growing entitlement spending commitments and growing interest on our national debt, the U.S. is facing what by all accounts appears to be unsustainable future debt burdens.
The CBO calculates debt owned by the public (which excludes Social Security IOU’s and other inter-governmental debt) at $28 trillion as of 2024, which is roughly 99% of Gross Domestic Product (GDP). Over the next decade, in the absence of entitlement reform, the U.S. will surpass World War II peaks in terms of debt-to-GDP. |
|  | | There are in fact relatively simple solutions to the entitlement problem. The country can dial back its anticipated spending on Social Security and Medicare. We can do this in any number of ways: adjusting retirement ages, reducing benefits, disqualifying certain citizens from participation. We can also raise taxes.
The real issue is, does the political will exist? Are voters even capable of understanding the long-term economic implications of our failure to get this problem under control? Are the politicians themselves capable of understanding it?
Even if a political candidate did grasp and chose to emphasize the long-term need to contain entitlement spending, would he or she have any shot of getting elected?
There was a time when the Republican Party was motivated to reduce the footprint of the federal government. But during the 2023 Republican primary campaign, Florida Governor Ron DeSantis was actually attacked for his earlier efforts to bring entitlements under control.
A key obstacle to entitlement reform is that older people have a much higher propensity to vote. According to some data, members of the oldest cohort of the population are twice as likely to vote versus the youngest cohort. |
|  | Source: Brookings Institution |
| While the Republican Party of Jack Kemp may have had the political will to fight for fiscal responsibility, the Republican Party of today seems to want to tread lightly on issues that directly affect older citizens. According to Pew Research, Trump won a majority of baby boomer and older voters, while losing significantly among younger voters. Old people are the Republican base.
Dubbed “the third rail” of American politics by Tip O’Neill, Social Security, and senior citizen entitlements generally, are dangerous subjects. Even if a politician claims he or she just wants to make reforms that will affect younger generations, it can be toxic. Always wary of the old bait-and-switch, seniors don’t want it touched.
With the average American’s propensity to vote increasing as he or she gets closer to retirement age, reforming entitlements is as much a structural political problem as it is a structural financial problem.
The path of least resistance is to kick the can. In other words, maintain our spending on entitlement programs as they are currently designed, fund it with revenue and borrowing from the general treasury, and allow the debt-to-GDP ratio to grow to unprecedented levels. |
| What happens if we do nothing? |
| Doing nothing is an option, and often a popular one in Congress. Take, for example, the federal gas tax. At 18.4 cents per gallon of gasoline, it was last raised in 1993 and has not been indexed for inflation. Yet this excise tax is the chief funding mechanism of the Highway Trust Fund.
When we complain about our crumbling infrastructure, one of the main reasons is that the Highway Trust Fund has been chronically underfunded as the excise tax that supports it has been declining in real terms. Why has the tax not simply been adjusted for inflation? Because no politician wants to campaign on a platform of “I will make it more expensive for you to fill up your tank.”
If we do not make material adjustments to entitlement programs, our national debt will steadily grow as a percentage of GDP. So what happens next?
Fiscal dominance |
| If the United States chooses to let its public debt reach extremely high levels relative to the size of the economy, it would not be the first country that has gone down this path. Many smaller, developing countries have starred in this movie.
Economists who examine the monetary implications of high public debt loads refer to the phenomenon as fiscal dominance. This is a scenario where a country’s fiscal situation dominates central bank decision making.
When there is fiscal dominance, a central bank has a diminished ability to engage in restrictive monetary policy because the national government, loaded with debt, cannot afford high interest rates. The government also requires nominal growth in private sector incomes and assets to generate tax revenues needed to fund its debt obligations.
Historically, emerging market countries, especially in Latin America, have found themselves caught in this cycle. High inflation becomes embedded within the economy, along with high interest rates. We addressed the growing similarity between the U.S. and many emerging market economies in a recent video discussion. |
|  | An excellent article that explores the risk of the United States encountering a fiscal dominance problem was published in October 2023 by Columbia Business School professor emeritus Charles Calomiris. Calomiris believes our trajectory on entitlement spending, paired with potential growth in military spending, has sent us clearly down the fiscal dominance path. |
| | As a country gets close to the ceiling, the interest rates creditors demand rise (as they demand an inflation risk premium) in anticipation of the risk of hitting the ceiling. That means that the perceived risk of hitting the ceiling (once you are close to it) can become self-fulfilling. - Charles Calomiris |
| | Just as Mike in Hemingway’s The Sun Also Rises described the process of his own personal bankruptcy—“gradually, then suddenly,” fiscal dominance occurs when public debt reaches a tipping point. Private capital may at some point lose faith in the ability of the Federal Reserve to restore inflation rates to low levels. The math no longer works.
Re-imagining monetary policy
The insolvency of the Social Security trust fund and the looming entitlement crisis set the stage for a wholesale revisitation of our national finances. The development of digital currencies adds another layer to this debate.
Proponents of Modern Monetary Theory (MMT) seem ready to pounce. As we described in our Investing for Inflation Protection investment guide, MMT calls for direct financing of government operations through money creation.
Anyone with a fleeting understanding of economic history or monetary policy understands that if a government pays for itself with money that it prints, this is a recipe for hyperinflation and the fall of the regime. MMT advocates understand this risk as well—but claim that the inflation problem can be solved through taxation.
According to MMT, after printing and then spending/distributing the money, the government can tax the private sector as needed to withdraw money from the economy and bring inflation under control.
An MMT-based framework would completely rearrange the power structure of American society, which is likely its real purpose. The “power over the purse” is among the most important powers that citizens provide to their elected officials. Congress decides how much to spend, what to spend it on, and how to pay for it. |
| | This power over the purse may, in fact, be regarded as the most complete and effectual weapon with which any constitution can arm the immediate representatives of the people, for obtaining a redress of every grievance, and for carrying into effect every just and salutary measure. - James Madison, Federalist No. 58 |
| | MMT is highly theoretical and has never truly been implemented. But it appears to relocate spending and taxation decisions into the hands of technocrats within the federal government. It also eliminates any separation of power between those who make these decisions and those who control our banking system.
The political implications of MMT are extreme and potentially get overlooked as people struggle with the complexity of the terminology and concepts. As our debt-to-GDP levels get worse and worse every year, and potentially give rise to an economic crisis, the stage is becoming set for a radical overhaul of our monetary system. This could certainly include proposals for a centralization of economic power along the lines of Modern Monetary Theory.
Investing take-aways
In an environment in which paper money becomes degraded, the best thing to own are real assets in the broadest sense of the term. Not just real estate and commodities but assets and businesses that will keep up with or outpace nominal growth in the economy.
Structural inflation risk is one of several good reasons to maintain a long-term allocation to stocks. Our Inflation Protection Model Portfolio emphasizes stocks that we think will perform particularly well in an environment of sustained inflation. |
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