When we look at the economics of the Social Security System, which went into deficit mode in 2010, we can see that we are facing what I have called Retirement Armageddon. But that's not the whole story. Default by the Federal government is not the same thing as the collapse of the United States.
It is easy to make a case for east Asia's economic success, but only over the next two decades. East Asia's economies are growing because their economies are being freed by decisions by politicians to reduce government regulations. But they all have two major problems: (1) the extreme boy/girl birth ratio of at least 120 to 100; (2) the threat of a rapidly aging population after 2025 or 2030. Economist Nick Eberstadt has been writing about this for a decade.
Japan will hit the demographic brick wall first. It probably has already hit it. South Korea faces the threat, but it has a developed economy. The largest Asian nations — China, India, Indonesia, and Pakistan — are not yet first world nations. Even at high economic growth rates, they will have trouble becoming first world nations by the time their ageing populations force a social crisis: the care and feeding of oldsters, especially old men who never married and who have no sons to support them.
The United States does not face a demographic crisis anything like what Asia is facing. It is also not facing what Western Europe is facing: extremely low birth rates, well below the replacement rate of 2.1 children per family. The USA is at replacement rate. Part of this is because of net immigration.
This is positive in another way. Immigrants come here because of economic opportunities. Second, there is sufficient optimism about the future to keep families reproducing. The recent economic setback may cause a decline of births, but we have not seen this yet. There is a future-orientation in the United States that has sustained population growth. We should not dismiss this as a liability, as the zero population growth movement has.
Because of the rapid growth in Federal debt since 2008, free market critics have become more pessimistic about the economic future of the nation. It is easy for non-Keynesian economists to see that the Keynesian policies of deficit spending and Federal Reserve credit expansion will harm this economy. These policies will indeed hamper the economy. They will not cripple it.
Why not? Because there is going to be a Great Default by the U.S. government. The old line by economist Herb Stein will come true: "When things cannot continue, they have a tendency to stop."
THE GREAT DEFAULT
The Federal government will default. This is not a matter of intellectual speculation. It is a matter of financial speculation. There is no question that Medicare will break the bank in Washington. There will have to be cutbacks in spending. The promises will not come true.
The same is true for Social Security. FICA taxes today are not sufficient to cover the expenses of Social Security, which went into default at the end of fiscal 2010.
Then there are the projected on-budget deficits of $1 trillion a year between now and 2020, at which time the government forecasters cease to offer forecasts. But we also know, as Bernanke reminded us on October 4, that these deficits are unsustainable. He also quoted Herb Stein. The planners know that what the forecasters predict will not come true. There will be a default, or else there will be rising interest rates. If there are rising rates, then fewer of the promises by government will come true. The Federal budget will have to be reallocated to pay the interest expenses.
State and local budgets are facing the same problem. The pension and medical care promises to retired government workers will be impossible to pay. This is finally becoming obvious. Yet politicians refuse to face this reality. They are still in the clutches of the state employee unions, especially the National Education Association. But the unions cannot tell the politicians how to persuade voters to consent to the tax hikes that will be required to fulfill the promises. The tax revolt has begun.
People think the Tea Party is a short-lived phenomenon. It isn't. That is because the taxes required to eliminate the deficits are long-term issues. There is nothing but deficits ahead of us — on paper. The promises have been made. The tax base sufficient to meet these promises is now a thing of the past.
The voters are going to stiff the retirees. Those retired state or local employees who think they will still be collecting their money in 2020 are living in a fantasy world. Their children will have to pick up part of the tab. This may be a large part.
Default will not take any single form. The killer is Medicare. The government spends about $11,000 a year per Medicare beneficiary. The boomers are going to come on board in 2011. They were born in 1946 to 1958. By law, the first wave of them become eligible in 2011. They will automatically lose their private health insurance coverage. They have no choice but to enroll if they want coverage. Everyone wants it, especially when it is mostly free. They fear being without coverage.
The decision to hike the retirement age to receive full benefits for Social Security was made in 1983. There is no way that there will be a similar decision in today's political environment. There are too many oldsters coming on board. The boomers vote. No politician is going to get elected who says "cut Medicare." Not yet, anyway. Ten years from now, yes. But it will take a crisis in Federal funding to make such a proposal politically acceptable to enough younger voters to push up the age of eligibility to anything like high enough to save the system until 2030.
If things can't go on, they have a tendency to stop. But the political setting of that "end of the line" decision is not yet clear.
If the default comes through Federal Reserve inflation, the entire economy will suffer. Anyone seeking health care will line up. This will be everyone who does not have enough money to buy a high-fee private physician who opted out of Medicare, or else buy the services of an Asian or Latin American physician outside the United States.
The default will come. It may come piecemeal: hiking the age of eligibility, or imposing means testing (sticking it to the rich), or reducing benefits, or inflating. It may come through an open default by Congress: a refusal to pay foreign holders of Treasury debt. This will be the preferred approach of Tea Party voters, whose ranks will swell as the deficits swell. Central bankers in Japan and China do not have large, well-organized constituencies in the United States.
The politicians dare not publicly identify which special-interest voting groups will have their benefits cut. The politicians will delay the day of reckoning. That's what most voters want them to do: lie and delay, lie and delay. They get re-elected for kicking the can. They know what they must do to get re-elected, and they will do it until voters finally decide to throw them out. But voters are not willing to identify which constituencies must be the first to lay their heads on the fiscal chopping block. That is why nothing will be done to solve the problem until the can is too large for Congress to kick.
Think of the United States without any of the following:
1. Medicare debt
2. Social Security debt
3. Federal employee pension debt
4. On-budget debt to foreigners
5. On-budget debt to domestic investors
6. State or local pension obligations
7. Interest expenses
Think of how the United States' political order would have to be run if all potential lenders would refuse to lend to any government because of the Great Default that had just stripped previous lenders of 100% of their investments.
This is utopia. It will never happen. Why not? Because lenders always return to the scene of the crime. "This time, it's different." European kings defaulted for centuries, over and over. The suckers just kept coming back. Latin American nations have repeatedly defaulted since about 1810. The lenders always come back.
So, politicians know that a default is not going to close off the flow of future funds. If the default is open and total, the restoration of credit is rapid. "Look: they are debt-free. They will not default for another 20 or 30 years. Let's lend!"
The way to default on all debts is hyperinflation. But this is devastating for commercial banks. They get paid off by creditors without mercy. This is why hyperinflation does not come to large modern nations that have not suffered a military defeat. It has happened to no Western nation since 1945. Bankers run the central banks. They do not allow central banks to hyperinflate. They allow them to bail out failed banks, or swap assets at face value to keep big banks solvent. But hyperinflation is the debtor class's friend and the bankers' enemy. Bankers simply do not allow central banks to hyperinflate. Hyperinflation is not in their self-interest.
Large commercial bankers will promote inflation by central banks in order to keep governments solvent. They want to maintain the illusion of solvency. They hold government debt. But they will unload these obligations on central banks before the day of default comes. Then they will pressure central bankers not to inflate any more. They will take steps to protect themselves from the coming open default by governments. Then Great Depression 2 — the product of central bank stable money policies — will not take them down. It will take down local banks that do not have protection from the central bank and national politicians.
The system is run for the largest banks. It is not run for local banks. Hyperinflation will ruin all commercial banks. So, the central banks will selectively save their nations' biggest banks.
There are limits to the expansion of government debt. Voters will not allow these debts to threaten their way of life. We know that American voters will not tolerate a ratio of more than 25% spending to GDP by the Federal government. We are now at that limit. So, those who lend the Federal government more money will find themselves left holding the bag.
The Great Default will not come in one massive bankruptcy. It would be easier if it did. But it will come. There will be a battle over who gets his piece of the action cut, but there will be losers.
THE CASE FOR OPTIMISM
There will be a default. The expansion of the state will not continue much more. Americans are at their limit of tolerance. We are not headed for national disintegration. We are headed for a restoration of localism. Some sacred cows will be slaughtered along the way, but not the entire nation.
Think of these four words: "When Washington's checks bounce." That day is coming. It will restructure the allocation of political power.
The United States has some very great advantages. Here are a few:
1. A tradition of entrepreneurship
2. Ease of starting a business
3. Geographical mobility
4. Occupational mobility
6. Educated labor force
7. Dying trade unions
8. Widespread literacy
9. Freedom of the press
10. Internet replacing the press
11. Widespread gun ownership
12. Growing skepticism regarding Congress
13. 50 separate states
14. Independent county governments
16. Politicians who are on the defensive
17. Political gridlock in Washington
18. Talk radio
19. An escape hatch: bankruptcy laws
20. High charitable giving
Americans can declare bankruptcy and start over. This is an important tradition. The Bible had this system (Deut. 15:1-2). That which Americans have retained as a fundamental right as individuals is going to be applied at some point to all levels of civil government. The United States government is going to stiff the Asian central banks. It will stiff all of its creditors.
Those who are economically dependent on politicians' promises are going to take a hit. There will be lots of maneuvering on this. Each special-interest group will try to keep from getting cut off. But they will all be cut off, step by step.
Younger voters are going to escape. The American electorate can be suckered by politicians promising security. But when those promises threaten the lifestyles of the voters, they will mandate selective defaults.
I think that day has arrived. We will see it in November. It will not go away. From this point forward, those who want to expand state spending will face a wall of political resistance. The era of the tax-funded free ride is coming to an end in the United States.
AN ERA OF STAGNATION
An era of economic stagnation is upon the United States. This will make us look bad in comparison to Asia. I see Asian growth continuing, though there will be a crash at some point — sooner than most Asians think. Central banks will have to stop inflating, and that will end the boom. But, over the next two decades, Asia will surge ahead. They started in poverty. Fast growth from a small base is likely. Equally fast growth from a large base is not possible.
There will be a slow strangulation of the U.S. economy until such time as the Great Default begins. When it does begin, the state will be hampered at every level. The era of expansion of the state will end. The tax-funded gravy train will not end overnight, but it will be slowed to a crawl.
Governments in the USA have hit the brick wall of taxation. The Federal government is using massive debt to get around this brick wall. This can go on for a time, but its end is sure. Herb Stein was right.
There will be great political battles ahead over whose oxen will be gored by the tax revolt. Oldsters will probably be the last to have their budgets cut. But it is sure that this will happen — not just in the United States, but all over the world. He who drops out of the labor force will live to regret it.
I do not see a dark future for America as a nation. I do see dark days ahead for those who have planned their lives on the assumption that Uncle Sam is Uncle Sugar. He who has extended credit to any level of government is now skating on thin ice.
When the Great Default sets back the lenders who trusted government promises, the United States' economy will recover. There is a long tradition of American entrepreneurship and a commitment to education which, when combined, are greater than any other society.
I hope Asia will match this and even extend it. Liberty is universally a benefit.
The Great Default will add to liberty, even though it sets back those who have trusted politicians' promises.
Liberty will receive a shot in the arm when this phrase provokes universal laughter: "The full faith and credit of the United States." That day is fast approaching. The credit rating of the United States government will be marked down from AAA to AA. It will then be marked down to A. For every notch down that it falls, the national day of deliverance draws closer. American liberty is measured inversely to the credit rating of the United States government.
October 14, 2010
Copyright © 2010 Gary North