What can’t happen, won’t happen. If we can’t afford our direct debt, we surely can’t afford our unfunded obligations. The stroke of a pen can take these programs to “means testing.” If retirees cannot enjoy Social Security or Medicare reimbursal until their savings are drained, the unfunded obligations disappear. This still leaving us true, direct debt of 5½ times our income. It is a daunting figure. How many people do you know that have owed five times their annual income and suffered no adverse consequences?
So what are our choices? Repayment, reflation, or abrogation. To pay it off—or to pay it down to less threatening levels—requires the political will to make sacrifices today and will take decades; this path is a most assured way to not get elected. Alternatively, reflation is the debtor’s friend because it reduces the burden of our fixed-rate liabilities. Said another way, a 6% annual debt service and an eventual payment of principal are much more manageable when inflation runs at 5% rather than 2% (our real interest payments are only 1%, not 4%). The last alternative is to take the route of Russia in 1998 or Argentina in 2001—abrogate the debt. In our private debt—households and corporate debt—every default, foreclosure, and bankruptcy is a form of abrogation. However, for our public debt we would prefer not to explore the consequences of abrogation in the United States Treasury market, when our external debt is largely held by Russia, China, and the Middle East.
Our debt level will have to be brought down to a more reasonable level, through some combination of domestic abrogation, paydown, and reflation. Tax hikes are a near inevitability. Taxes are never a good thing for economic growth—the GDP multiplier for tax rates is approximately –3.0; that is, if tax rates rise by 1% of GDP, GDP can be expected to fall by 3%. Indeed, there’s look-ahead in this relationship. If tax rates are expected to rise by 1% of GDP, people change their behavior in anticipation of the higher tax rates. Has this been an important contributor to the current situation? Probably, but it would be difficult to prove.
The lion’s share of the debt reduction may well be accomplished through reflation. We can eliminate half of our debt in 15 years if our inflation runs 5% higher than our trading partners, and if our real GDP growth keeps pace despite the inflation. Thus, if our partners are running at 3%, then an 8% annual inflation rate would do the trick. To keep debt service costs, we need to persuade our creditors that we’re serious about a strong dollar, even as we work to weaken the dollar. For those of us who were unlucky enough to begin our careers in the 1960s and 1970s, we know this kind of inflation is not the foundation for solid real returns. This is not a smooth and comfortable road, but it is the only politically expedient path.
The final structural headwind to meaningful net-of-inflation returns is demographics. As the debt comes due, the people who accumulated and spent the debt will want to retire and let the next generation pay it down. Dependency ratios—the ratio of retirees to workers—are accelerating in the United States and are already very scary in Eastern Europe. The problem eventually becomes serious in China, as a delayed consequence of their one-child policy.
The game-changer that seems to have gone unnoticed is the first derivative, the relative change of the generational constituencies as evidenced in Figure 3. In 2002, the population was adding 10 new working age people—those age 20–64—for every single new potential retiree—those age 65 and up. By 2023, that literally flips to 10 new retiree wanna-bes for each new working age person. There’s essentially no wiggle-room in these figures: the people are already alive and can be counted.