Tag Archives: Monetization

Social Insurance, Trust Fund Runoff, and Federal Debt

28 Thursday Apr 2022

Posted by in Deficits, Social Security

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The Social Security and Medicare trust funds are starting to shrink, but as they shrink something else expands in tandem, roughly dollar-for-dollar: government debt. There is a widespread misconceptions about these entitlement programs and their trust funds. Many seem to think the trust funds are like “pots of gold” that will allow the government to meet its mandatory obligations to beneficiaries. But, in fact, the government will have to borrow the exact amounts of any “assets” that are “cashed out” of the trust funds, barring other reforms or legislative solutions. So how does that work? And why did I put the words “assets” and “cashed out” in quote marks?

The Trust Funds

First, I should note that there are two Social Security trust funds: one for old age and survivorship income (OASI) and one for disability income (DI). Occasionally, for summary purposes, the accounts for these funds are combined in presentations. There are also two Medicare trust funds: one for hospitalization insurance (HI – Part A) and one for Supplementary Medical Insurance (SMI – Parts B and D). The first three of these trust funds are represented in the chart at the top of this post, which is from the Summary of the 2021 Annual Reports by the Boards of Trustees. It plots a measure of financial adequacy: the ratio of trust fund assets at the start of each year to the annual cost. The funds are all projected to be depleted, HI and OASI much sooner than DI.

Fund Accumulation

The first step in understanding the trust funds requires a clearing up of another misconception: the payroll taxes that workers “contribute” to these systems are not invested specifically for each of those workers. These programs are strictly “pay-as-you-go”, meaning that the payroll taxes (and premiums in the case of Medicare) paid this year by you and/or your employer are generally distributed directly to current beneficiaries.

Back when demographics of the American population were more favorable for these programs, with a larger number of workers relative to retirees, payroll taxes (and premiums) exceeded benefits. The excess was essentially loaned by these programs to the U.S. Treasury to cover other forms of spending. So the trust funds accumulated U.S. Treasury IOUs for many years, and the Treasury pays interest to the trust funds on that debt. On the upside, that meant the Treasury had to borrow less from the public to cover its deficits during those years. So the government spent the excess payroll tax proceeds and wrote IOUs to the trust funds.

Draining the Funds

The demographic profile of the population is no longer favorable to these entitlement programs. The number of retirees has increased so that benefit levels have grown more quickly than program revenue. Benefits now exceed the payroll taxes and premiums collected, so the trust funds must be drawn down. Current estimates are that the Social Security Trust Fund will be depleted in 2034, while the Medicare Trust Fund will last only to 2026. These dates are reflected in the chart above. It is the mechanics of these draw-downs that get to the heart of the first “pot of gold” misconception cited above.

To pay for the excess of benefits over revenue collected, the trust funds must cash-in the IOUs issued to them by the Treasury. And where does the Treasury get the cash? It will almost certainly be borrowed from the public, but the government could hike other forms of taxes or reduce other forms of spending. So, while the earlier accumulation of trust fund assets meant less federal borrowing, the divestment of those assets generally means more federal borrowing and growth in federal debt held by the public.

Given these facts, can you spot the misconception in this quote from Fiscal Tiger? It’s easy to miss:

“In the cases of Social Security, Medicare, and Medicaid, payroll taxes provide some revenue. Social Security also has trust funds that cover some of the program costs. However, when the government is short on funds for these programs after getting the revenue from taxes and trust funds, it must borrow money, which contributes to the deficit.”

This kind of statement is all too common. The fact is the government has to borrow in order to pay off the IOUs as the trust funds are drawn down, roughly dollar-for-dollar.

A second mistake in the quote above is that federal borrowing to pay excess benefits after the trust funds are fully depleted is not really assured. At that time, the Anti-deficiency Act prohibits further payments of benefits in excess of payroll taxes (and premiums), and there is no authority allowing the trust funds to borrow from the general fund of the Treasury. Either benefits must be reduced, payroll taxes increased, premiums hiked (for Medicare), or more radical reforms will be necessary, any of which would require congressional action. In the case of Social Security (combining OASI and DI), the projected growth of “excess benefits” is such that the future, cumulative shortfall represents 25% of projected benefits!

Again, the mandatory entitlement spending programs are technically insolvent. Charles Blahous discusses the implications of closing the funding gap, both in terms of payroll tax increases or benefit cuts, either of which will be extremely unpopular:

“How likely is it that lawmakers would immediately cut benefits by 25% for everyone, rich and poor, retiring next year and beyond? More likely, lawmakers would phase in reforms gradually, necessitating much larger eventual benefit changes for those affected—perhaps 30% or 40%. And if we want to spare lower-income individuals from reductions, they’d need to be still greater for everyone else.”

It should be noted that Medicaid is also a budget drain, though the cost is shared with state governments.

Discretionary vs. Mandatory Budgets

When it comes to federal budget controversies, discretionary budget proposals receive most of the focus. The federal deficit reached unprecedented levels in 2020 and 2021 as pandemic support measures led to huge increases in spending. Even this year (2022), the projected deficit exceeds the 2019 level by over $160 billion. Joe Biden would like to spend much more, of course, though the loss of proceeds from his student loan forgiveness giveaway does not even appear in the Administration’s budget proposal. Biden proposes to pay for the spending with a corporate tax hike and a minimum tax on very high earners, including an unprecedented tax on unrealized capital gains. Those measures would be disappointing in terms of revenue collection, and they are probably worse for the economy and society than bigger deficits. None of that is likely to pass Congress, but we’ll still be running huge deficits indefinitely..

In a further complication, at this point no one really believes that the federal government will ever pay off the mounting public debt. More likely is that the Federal Reserve will make further waves of monetization, buying government bonds in exchange for monetary assets. (Of course, money is also government debt.) The conviction that ever increasing debt levels are permanent is what leads to fiscal inflation, which taxes the public by devaluing the public debt, including (or especially) monetary assets. The insolvency of the trust funds is contributing to this process and its impact is growing..

Again, the budget discussions we typically hear involve discretionary components of the federal budget. Mandatory outlays like Social Security, Medicare, and Medicaid are nearly three times larger. Here is a good primer on the mandatory spending components of the federal budget (which includes interest costs). Blahous notes elsewhere that the funding shortfall in these programs will ultimately dwarf discretionary sources of budgetary imbalance. The deficit will come to be dominated by the borrowing required to fund mandatory programs, along with the burgeoning cost of interest payments on the public debt, which could reach nearly 50% of federal revenues by 2050.

Conclusion

It would be less painful to address these funding shortfalls in mandatory programs immediately than to continue to ignore them. That would enable a more gradual approach to changes in benefits, payroll taxes, and premiums. Politicians would rather not discuss it, however. Any discussion of reforms will be controversial, but it’s only going to get worse over time.

Political incentives being what they are, current workers (future claimants) are likely to bear the brunt of any benefit cuts, rather than retirees already enrolled. Payroll tax hikes are perhaps a harder sell because they are more immediate than trimming benefits for future retirees. Other reforms like self-directed Social Security contributions would create better tradeoffs by allowing investment of contributions at competitive (but more risky) returns. Medicare has premiums as an extra lever, but there are other possible reforms.

Again, the time to act is now, but don’t expect it to happen until the crisis is upon us. By then, our opportunities will have become more hemmed in, and something bad is more likely to be promulgated in the rush to save the day.

Inflation Doomsayers and Downplayers

25 Friday Jun 2021

Posted by in Inflation, Monetary Policy

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There’s a big disconnect between recent news about escalating inflation and market expectations of inflation. In fact, there’s a big disconnect between market expectations and what we’re hearing from some conservative economists. The latter are predicting more inflation based on the recent spurt in prices and the expansionary policy of the Federal Reserve. Can these disparate views be reconciled?

Market Predictions

Market interest rates are considered pretty good predictors of inflation, at least relative to surveys and macroeconomic models. That’s because a fixed interest return is eroded by inflation, and fixed income investors will bid up interest rates to incorporate a premium to compensate for perceptions of increased inflation risk. This is known as the Fisher Effect, after the economist Irving Fisher. In fact, investors should bid rates up more than one-for-one with expected inflation, because the inflation premium will be taxed. A higher return must compensate for both higher expected inflation and taxes on the increased inflation premium.

After rising by about 1.2% from last summer through mid-March, interest rates on Treasury notes have declined slightly. The earlier run-up anticipated a strengthening economy, but if the increase was due to higher expected inflation, we could say it represented an added premium of about 1%, and that’s roughly in-line with changes in some other market-based gauges of expected inflation (ignoring pandemic lows).

Recent Inflation News

Meanwhile, measured inflation certainly has increased in 2021. I say “measured” because 1) “true” price changes are measured imperfectly, and 2) there is a difference between real inflation, which is a continuing process, and month-to-month changes in prices. Here, we’re really talking about the latter and hoping it doesn’t turn into a bad case of the former!

The green line in the chart below is the percent change in the consumer price index (CPI) from a year earlier. After declining during the pandemic, it rebounded sharply this year to almost 5% in May. The purple line is the increase in the CPI excluding food and energy prices, otherwise known as the “core” CPI. The jumps shown in the chart are well in excess of the market’s assessment of inflation trends.  

Both versions of the CPI have jumped in the past few months, but it turns out that durable goods like washing machines, TVs, and (probably) Pelotons have jumped the most sharply. Most of the weakness in prices during the pandemic was in non-durable goods, which stands to reason because so many activities away from home were curtailed. Also noteworthy about these price movements: when measured over a span of two years, prices excluding food and energy have risen at an annualized rate of only 2.6%. 

There are two other lines in the chart above that demonstrate much less alarming changes in prices: the orange line is so-called “median” inflation, which is the price change in the median component of the CPI. That is, half of all price components included in the CPI rose faster and half rose slower than the median. It has barely accelerated this year and stood at only about 2.1% higher in May than a year earlier. The blue line is the so-called “trimmed” CPI, or the average price change of the middle 84% of all CPI components. While it has accelerated in 2021, the year-over-year increase was only 2.6% in May. 

Thus, the breadth of the jump in prices was limited. The Federal Reserve and a lot of market participants insist that the uptick is narrow and temporary — a transitional phenomenon related to the sluggish recovery of supplies in the post-pandemic environment.

But again, the accuracy of price measures is always in question. For example, the housing cost component of the CPI was up only 2.2% in May from a year ago, but it is calibrated to actual survey data only twice a year, the survey is a weak data source, and we know home prices and rents have risen aggressively. Quality and quantity adjustments are always in question as well. An old approach for businesses dealing with rising costs is to reduce package size, which has been called “shrinkflation”. It seems to be back in vogue.

Inflation Drivers

It’s not yet clear how much wage pressure is occurring now. The economy-wide average hourly earnings data has been distorted over the past 15 months by the changing mix of employment, first shifting toward greater concentration in high-wage (work-at-home) occupations and now shifting back toward lower-wage jobs as the economy reopens. But we know many employers are facing a labor shortage, due in large part to extended unemployment benefits and other pandemic-related aid, so this puts upward pressure on wages. In 2021, minimum wage rates are undergoing substantial increases in 17 states, and a number of large employers such as Amazon have increased their minimum pay rates. That creates competitive pressure for smaller employers to boost pay as well.

The fundamental cause of an “honest-to-goodness” inflation is “too much money chasing too few goods”. The Federal Reserve has certainly given us enough to worry about in that regard. The basic money stock (M1) increased by four-fold in the late winter and early spring of 2020, just as the pandemic was spreading. Today, it is almost five times greater than in early 2020, so growth in the money stock remains quite fast even as the recovery proceeds. No wonder: the U.S. Treasury is issuing about $1 trillion of new debt every four-to-six weeks, and the Fed is essentially monetizing these deficits by purchasing a huge chunk of that debt.

That’s a lot of “helicopter” money… new money! But are there too few goods for it to chase? Or is it really chasing anything? Is it just sitting idle? First, GDP is likely to exceed its pre-pandemic level in the second quarter, despite the fact that private payrolls are still down by about 7 million employees. Of course, that doesn’t eliminate the ostensible imbalance between money and goods, and one might expect a veritable explosion in price inflation under these circumstances.

So far that seems unlikely. The so-called velocity of money (its rate of turnover) has plunged since the start of the pandemic, with no discernible rebound through the first quarter of 2021. That means a lot of the cash is not being used in transactions for real goods, but financial transaction volume has been quite strong in 2020-21. Daily stock trading volume was up by more than 50% in 2020 from 2019, and in the first quarter of 2021 it stood another 34% higher than the 2020 average (though volume tapered in April). This is to say nothing of the increased frenzy in cryptocurrency trading. So, while some money is turning over, the expansion of the money stock remains daunting and pressure might well spill-over into goods prices.

Caution Is a Virtue

So long as the Fed keeps printing money, and assuring investors that it will keep printing money, the equity markets are likely to remain strong. There are mixed signals coming from Fed officials, but the over-riding message is that the recent uptick in prices is largely temporary and limited in scope. That is, they assert that certain prices are being squeezed temporarily by rebounding demand for goods while suppliers play catch-up. 

Market expectations of inflation seem to agree with that view, but I have strong trepidations. There are cash reserves held in the private sector to support more aggressive spending. Large companies, consumers, and banks are still holding significant amounts of cash. The Biden Administration is doing its best to spend hand-over-fist. This administration’s energy policy is causing fuel bills to escalate. Home prices and rents are strong. The dollar is down somewhat from pre-pandemic levels, which increases import prices. Finally, the Fed is reluctant to reverse the huge increase in the money supply it engineered during the pandemic. If the recent surge in prices continues, and if higher inflation embeds itself into expectations, it will be all the more difficult for the Fed to correct. 

The market and the Fed might be correct in predicting that the spike in measured inflation is temporary. The recent data show that these worrisome price trends have not been broad. Just the same, I don’t want to hold fixed income investments right now: if higher expectations of inflation cause market interest rates to rise, the value of those assets will fall. Stock values should generally keep pace with inflation barring stronger signals of tightening by the Fed. Unfortunately, however, many would suffer in an inflationary environment as wages, fixed assets, and benefits are devalued by rising prices.