David R. Henderson  

Default or High Inflation?

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I was on a discussion on Facebook yesterday with an economist about default and high inflation.

This economist and I agree that the U.S. federal government has an enormous deficit and debt problem in its future. What we disagreed about is whether there's much difference between the feds defaulting on their debt or creating high inflation. He saw not much difference. I see a lot.

That motivated me to go back to an article that San Jose State University economist Jeff Hummel and I had published in Independent Review back in 2014 that, for some reason, I don't seem to have posted about here. It's titled "The Inevitability of a
U.S. Government Default
." In it, we argue that the feds are likely to default, that money creation as an alternative is not likely to get them out of their fiscal fix, and that default is actually better economically than massively high inflation.

I recommend that you read the whole article if you want both to comment and to maximize the probability that I will pay attention to your comment.

Some highlights:

The problem is this. Three components of the federal government budget--Social Security, Medicare, and Medicaid--are highly likely to take an increasing share of gross domestic product (GDP). Overall federal government spending, including interest on the debt, could exceed 40 percent of GDP by 2050. For more than sixty years, overall federal revenues as a percentage of GDP have almost always been within a narrow range. They have never gone over 21 percent of GDP and have almost never gone below 17 percent. Even during the crisis years of World War II, they never exceeded 22 percent of GDP (White House 2013).1 The result, if the government does not change policy, will be annual deficits of approximately 20 percent of GDP. This is unsustainable.

The question then becomes: What will change? This is difficult to predict. But we give the following predictions in decreasing order of certainty.
First, federal government revenues are unlikely to be more than 22 percent of GDP for more than a few years.
Second, well before spending reaches 30 percent of GDP, the federal gov- ernment will face a renewed, more serious fiscal crisis.
Third, likely cuts in the growth of Medicare and Medicaid spending would at best delay, but not prevent, this crisis.
Fourth, the probability is therefore fairly high that the federal government will be forced to default on some or all of its debt.
Fifth, outright default on the federal debt will occur despite any increasing inflation.

Why Seigniorage Won't Do It
Assuming that revenues from explicit taxes remain capped at 20 percent of GDP, whether for structural or political reasons, and that politicians will have little incentive to cut spending, seigniorage would have to come up with the difference. Given that 10 percent inflation during the 1970s generated revenue amounting to 0.5 percent of GDP in the United States, a straight-line extrapolation suggests that covering the growing fiscal shortfall would require more than a tripling of the price level year after year after year. Within three years, the dollar would be worth only about 2.5 percent of its value just three years earlier. Such continual triple-digit inflation would be unprecedented, the highest the United States has ever experienced outside of its two hyperinflations. Moreover, seigniorage itself faces its own Laffer Curve (known as the Bailey Curve, after economist Martin Bailey). In order to avoid higher taxes on their real-cash balances, people spend money faster as inflation rises, thereby exacerbating the price increases. Higher rates of inflation thus generate proportionally ever-smaller revenue increases. Once we also acknowl- edge that the CBO's projections are probably too optimistic, we can see why our estimate that financing the explosion in Social Security, Medicare, and Medicaid payments will necessitate a 246 percent annual inflation is probably too low. How likely is it that governments in any developed country will be willing or even able to unleash such appalling currency depreciation? Recall how politically unpalatable the mere double-digit inflation of the 1970s was. The bottom line is that inflation's implicit tax on real-cash balances will not be much more able to resolve the escalating budgetary problems of the U.S. government than would an excise tax on chewing gum.

To be clear, we are not denying that a Treasury default might be accompanied by some inflation. Inflationary expectations, along with the fact that part of the monetary base is now de facto government debt, can link the fates of government debt and government money. This is all the more reason for the United States to try to break the link between U.S. currency and debt. We still may end up with the worst of both worlds: outright Treasury default coupled with serious inflation. We are simply denying that such inflation will forestall default.


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COMMENTS (24 to date)
Effem writes:

The Fed will likely own most government debt by then anyway.

Richard writes:

Why would the government have to rely on overall inflation? Couldn't it just print exactly the amount of money it needs to repay the debt and hand that over to creditors?

Mark Z writes:

Is your estimate the inflation that would be required to keep the debt the same in absolute terms? One might argue that a better definition of fiscal sustainability would be stable debt/GDP ratio, which may yield a somewhat less dire outcome. That said, too many commentators already make the questionable assumption of never ending >3% GDP growth to dismiss fiscal concerns out of hand.

David R Henderson writes:

@Mark Z,
Is your estimate the inflation that would be required to keep the debt the same in absolute terms?
No. If all we had to worry about was keeping debt constant, we would be in fat city.
One might argue that a better definition of fiscal sustainability would be stable debt/GDP ratio, which may yield a somewhat less dire outcome.
I'm breaking my rule here, but really, I strongly recommend that you read the article.
That said, too many commentators already make the questionable assumption of never ending >3% GDP growth to dismiss fiscal concerns out of hand.
True, and the growth would have to be well above 3%, not just above 3%.

Airman Spry Shark writes:

Presumably, there is some eldest percentile of the population for which Medicare & Social Security, at current levels & growth rates, could be sustainably provided; the percentage of the population above the current static eligibility age is almost certainly higher than that.

If the eligibility criterion was shifted to a percentile rather than a static age, could the new threshold be lowered to the sustainable level quickly enough to avoid default without anyone already older than the static age becoming too young to qualify at some point in the future?

Airman Spry Shark writes:

Addendum:

The percentile-criterion business is really just about political palatability. The limiting case is really this: is default inevitable if nobody who's not already getting benefits ever starts?

Mark Z writes:

Just read it, good article.

So, I can see one argument for why the total tax burden likely will rise above the historic threshold - that FICA tax revenue is not held down by the same forces of political economy as income or corporate taxes, in part because it is programs funded by them, Medicare and Social Security, that are largely driving cost increases. The politics of social security may tend to drive up payroll taxes because, while there may be general public resistance to tax increases, there is also strong public resistance to unmooring social security benefits from revenues and turning it into a welfare-type entitlement. Overturning the earned benefit model (what's left of it at least) may be a bigger political risk than raising the payroll tax. Looking at historical payroll tax revenue, it does indeed look like its fraction of US revenue has increased in recent decades even as corporate and personal income tax revenue have remained stable.

Of course that raises the other issue that, even if we balance expected SS revenues and benefits, we'll still run annual SS deficits (requiring funds from the general revenue) and surpluses, which aren't *really* saved by the government. So if payroll taxes are raised to a point where the SSA runs regular surpluses it doesn't necessarily improve our fiscal situation (in fact it may make it worse since a few studies contend that the government tends to respond to a social security surplus of X by increasing general spending by more than X).

Arnold Layne writes:

Are there any countries that don't have this ticking time bomb? Would be good to know if it's possible to start planning immigration.

David R Henderson writes:

@Airman Spry Shark,
Presumably, there is some eldest percentile of the population for which Medicare & Social Security, at current levels & growth rates, could be sustainably provided;
Yes.
the percentage of the population above the current static eligibility age is almost certainly higher than that.
I don't quite follow.
If the eligibility criterion was shifted to a percentile rather than a static age, could the new threshold be lowered to the sustainable level quickly enough to avoid default without anyone already older than the static age becoming too young to qualify at some point in the future?
I don't follow this either. What do you mean by "the new threshold?"

Pierre Lemieux writes:

Interesting analysis, David (and Jeff). Another, not rosier, outcome: the U.S. government will have become so powerful that it will be able to impose European level taxes. In this context, federal expenditures could easily double. Of course, it would not be America anymore.

David R Henderson writes:

@Airman Spry Shark,
The limiting case is really this: is default inevitable if nobody who's not already getting benefits ever starts?
No. If nobody not already getting Medicare and Social Security ever starts, then default is not inevitable. Not even close.
But think what that would mean. It would mean tens of millions of people currently between say, age 45 and 62, being told that they will see nothing for all those years of SS and HI taxes they paid.
A more-moderate solution that would likely avoid default would be to increase the age for both Medicare and Social Security in stages to, say, 70, and then have a more-realistic inflation index of say, 1 percentage point below CPI.

David R Henderson writes:

@Mark Z,
Just read it, good article.
Thanks.
I think you're right that revenues could run well above historic levels. But notice that we said they could go to 22 percent of GDP, which is almost 5 percentage points above their historic levels.
Interesting analysis, David (and Jeff).
Thanks.
Another, not rosier, outcome: the U.S. government will have become so powerful that it will be able to impose European level taxes. In this context, federal expenditures could easily double. Of course, it would not be America anymore.
True. We think that's unlikely. As long, that is, as we avoid a VAT.

Khodge writes:

The two problems I have with the article are (1) treating federal, state, and local as one entity with a shared problem (you might as well throw personal debt in the hopper); (2) the pretense of a trust fund, especially in the context of inflation i.e. cash released into the economy by the government is not value-increasing.

Airman Spry Spark's observations mirror some of my thinking, First, if things can be forestalled for about 20 years the demographics do change. Second, while we boomers may feel entitled to cadillac care in our twilight years, future lawmakers are not legally bound.

The most obvious problems in my scenario is that many current aspiring politicians are tending socialist, countered by the most fertile members of society are conservative. As a laboratory we have a current battle being waged by the teachers.

Thaomas writes:

So long as there are taxes with low dead-weight losses such as progressive consumption taxes or even progressive income taxes, the current levels of projected debt is not a problem. Of course if we can identify low benefit expenditures (those with benefits less than the dead wight losses) reducing these would be desirable.

Pigou taxation of negative externalites such as a tax on CO2 emissions will also help the long run fiscal outlook

Airman Spry Shark writes:
@Airman Spry Shark, Presumably, there is some eldest percentile of the population for which Medicare & Social Security, at current levels & growth rates, could be sustainably provided;

Yes.

OK, so let's say the eldest X% can be sustainably supported.
the percentage of the population above the current static eligibility age is almost certainly higher than that.

I don't quite follow.

Let's say that Y% of the population is over 67; Y% > X%.
If the eligibility criterion was shifted to a percentile rather than a static age, could the new threshold be lowered to the sustainable level quickly enough to avoid default without anyone already older than the static age becoming too young to qualify at some point in the future?

I don't follow this either. What do you mean by "the new threshold?"

Step 1 would be to change the criterion from 67 years old to being in the eldest Y%. Step 2 would be to gradually adjust the percentage (Y% -> X%); that would be the new threshold I was referring to.

Since cutting off new beneficiaries would ensure solvency, there is necessarily some threshold transition rate fast enough to avoid default without throwing any existing beneficiaries off the rolls; the remaining question would then be how slowly can the threshold be sustainably shifted.

mariorossi writes:

I am not really convinced by the arguments.

Under the assumption that taxes cannot increase and benefits cannot be reduced, neither default nor inflation would solve the problem. You are making the case that the future deficit and not the debt are the real issue.

Clearly the starting debt is more or less immaterial if you are running an hyper-inflation regime. And clearly default cannot permanently finance a massive deficit (assuming that you are not arguing you could default serially). Are you also assuming that a bond default would discharge entitelments at the same time (which seems like an unlikely assumption to me)?

I don't actually agree that the US government will find itself in such dire financial circumstances, but if it does, monetary financing seems very likely anyway and outright default would seem unnecessary at that point.

The crisis would likely start during a normal recession, with the Fed forced to return to QE. Would the Fed truely not monetize the debt in such a situation? I doubt they'd have the courage to plunge the US in a new depression.

I see inflation (and not hyperinflation) plus taxes and benefit cuts as a much more likely outcome.

Justin D writes:

My expectation is, that for a long time, the U.S. will be able to get away with a Japan-style scenario, in which interest rates are so low that the debt burden doesn't matter even if it's very high and, likewise, the deficit can be relatively high forever.

Say that NGDP growth averages 2.5%. As long as you maintain a deficit at 5% of GDP, debt will never rises beyond about 200% of GDP.

Even if debt is 200% of GDP, if the average rate paid on debt is just 1% (which is higher than even the 30Y Japanese government bond yield today), that's a very manageable 2% of GDP going to debt service. The experience of Japan suggests that very high debt loads are sustainable in fiat money economies, and the Fed would always be there to nip any severe sell off of treasuries in the bud.

So if the government takes in, say, 22% of GDP via taxation to fund 27% of GDP spending, that will essentially be sustainable forever, without default or high inflation.

robc writes:

David,

A more-moderate solution that would likely avoid default would be to increase the age for both Medicare and Social Security in stages to, say, 70

This was already done to increase the SS full retirement age from 65 to 67.

For those born before 1937, it was 65. For those born after 1960, it is 67. It ramped up between at an increase of 2 months per birth year, except for a pause at 66 for those born 1943-54. As those born in 1960 are only 57 now, we could continue the trend without changing close retirement ages much.

1961 would be 67 and 2 months
1962 67 and 4 months
etc
1966 would be 68
1972 would be 69
1978 would be 70 which would get us to where you proposed.

Although I see no reason to stop, lets continue it on past that:

1984 would be 71
1990 would be 72
1996 would be 73
2002 would be 74
2008 would be 75
2014 would be 76
Kids born this year would get full SS retirement at 76 and 8 months.

We would need to do the same for medicare too, which is still at 65 for everyone, IIRC. We could start increasing it with the 1961 birth year also and keep it 2 years younger than the SS age.

Hazel Meade writes:

Question: What percentage of the debt is held by the Social Security Trust Fund? Is that the debt you are talking about defaulting on? (Because that wouldn't do anything to alter the situation really).

Alan Goldhammer writes:

@Hazel Meade - I think that US govt debt is the only thing the SS Trust Fund can invest in. I don't know what the % is of the entire US debt.

One thing that is constantly missed in the discussion of Social Security and Medicare is that these entitlements are already means tested to an extent (I have first hand knowledge here :-) ). If your income threshold is modestly high because of IRA disbursements and pension income, 85% of your Social Security payment is taxable at the Federal level. It would be interesting if such tax payments could go back into the trust fund.

Social Security trust fund problem can partially be solved by eliminating the current cap on income subject to Social Security with holding.

Medicare Part B premiums are adjusted for one's AGI in the most recent tax year and there are five levels of monthly premium payments. Again, a retiree with pension, investment, and IRA disbursement quickly finds him/her self in to one of the higher categories of premium payments. One also has a deductible and co-payments for doctor visits. Medicare Part A is the one that causes the problem as that one is totally funded out of Medicare taxes and there is no patient premium.

Hazel Meade writes:

@Alan,
That's correct, the trust fund is invested by law in government bonds. Defaulting on those bonds doesn't change the liability to provide future benefits. You would just have to get the money from current tax revenues (which is what you're going to do anyway).

Giving taxes on SS earning back to the trust fund wouldn't change the 20% limit on revenue as a percent of GDP, either. Money is fungible so it would make no difference to the deficit - it would just mean that the SS trust fund cashes a few fewer bonds and the tax money that would otherwise be spent on paying those bonds would be spent on something else. You still face the same choice of cutting benefits or cutting discretionary spending.

Alan Goldhammer writes:

@Hazel Meade - I wonder how much money accrues to the treasury from those people who are subject to tax of their SS earnings. I'm sure it must be a fair chunk of change.

For a couple who file jointly 85% of their SS earnings are taxable if the joint income > $44K which is a pretty low threshold if the have even modest outside income. If both had worked and waited to take maximum benefits it's not unrealistic that joint SS income would be $50K where $42.5K of that is taxable. this ends up surprising a lot of individuals (it did me the first year that we filed with SS earnings and neglected to have Federal with holding for estimated tax purposes).

I remember some years ago a financial planner who gave a lecture at our offices on retirement savings. He said the good thing about sheltering income in IRAs and 401(k) plans was a good thing because you are likely to be in a lower tax bracket during retirement. I'm laughing at this right now as it certainly is not proving true in our case. Our AGI is about 70% what it was when we were both working since we now are starting to take mandatory withdrawals from retirement accounts plus pension plus investment income. I'm not complaining about that; only that the Federal tax burden is not much different.

Hazel Meade writes:

@Alan, Ahh. I see where you are going here. It's a roundabout way of cutting benefits, which means those bonds don't get cashed quite as soon.

Alan Goldhammer writes:

@Hazel Meade - Correct!!!! Most people who write about SS and Medicare totally ignore that there is a sort of means testing associated with these programs right now. Part B Medicare premiums are paid into the Medicare program but as far as I can tell the taxed SS benefits just go to the general Treasury and not back into the Trust Fund.

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