Entitlement Collapse is Worse Than it Looks 

Many argue that we need to get serious about reforming Social Security and Medicare because both trust funds will run dry. The implication is that this will be catastrophic, but this is not true. In reality, the entitlement problem may prove to be much worse.  

Both trust funds are filled with special issue bonds that are liabilities to the Treasury. Since the Treasury has no surplus upon which to draw, when these bonds are presented for redemption, Treasury must issue additional debt to retire them. But this is what would have happened if program benefit payouts exceeded tax collections in a system with no trust fund, so the trust fund might as well not even exist. The trust fund is filled with worthless paper, so emptying it out will have no effect.  

The true problem is the accumulation of ever more federal debt to provide revenue to allow the trust fund to redeem its claims on the Treasury. As total baby boomer benefits payments mount, the Treasury has had to issue bonds at an accelerating rate. This is why it only took 260 days to go from a national debt of $34 to $35 trillion a few weeks ago.  

In the absence of significant reform, growing shortfalls will have to be covered by evermore newly issued debt or monetized debt. In either case, the effect on long term interest rates will be the same: they will rise from either increased demand in the credit market arising from additional federal borrowing or, if the Fed decides to monetize these new debt instruments, decreased supply in the credit market arising from creditors requiring a premium for expected inflation. 

This latter effect arises because creditors will only buy a bond if its price is low enough to ensure a return that is high enough to protect the real purchasing power of their investment. This phenomenon is what economists call the Fisher effect.  

Many firms have taken on high levels of debt because very low interest rates made the cost of carrying debt artificially low. This allowed many firms to spend money on dubious things like DEI training for employees and initiatives aimed at drawing approval from ideologically driven investors. As can be seen in the chart below, the nonfinancial corporate debt-to-GDP ratio is now near all-time highs. 

With such high levels of debt, many firms are vulnerable to bankruptcy at even modest interest rates. The FED funds rate increase from .33 percent in April of 2022 to 5.33 percent in August of 2023 — where it remains today — is now hurting job growth and increasing the unemployment rate as corporate debt matures and must be financed at a higher rate of interest. 

Since firms are understandably reluctant to borrow more money with so much debt already on their books, banks have had to earn what they can from holding more securities like federal debt instruments than normal. This will compound the problem of entitlement generated increases to the deficit. Not only will higher interest rates imperil corporate firms through the increased cost of carrying debt, it will also produce a capital loss for banks, thereby putting them at risk of insolvency and therefore, in some cases, at risk for inducing a run on deposits not unlike what happened with SVB in March of 2023.  

As has been the case for Japan for over three decades, after a long period of very low interest rates the effect of even a modest increase will be exaggerated and will likely cause a recession. But unlike Japan in 1991 or the US in 2008, the underlying problem won’t be a specific bubble burst with a new start for economic growth. It will be an ongoing and growing unfunded liability problem.  

Although everyone is now obsessed with how much the Fed will reduce rates in September, the real story is this: no matter what the Fed does, without substantial entitlement program reform both nominal and real interest rates will inevitably rise in the future. The Fed can force rates down in the short-run, but over time the increase in inflation resulting from the actions taken to reduce real interest rates will cause the Fisher effect to increase nominal interest rates  

What voters should be worried about is that failure to address the entitlement problem might work the Fed into the kind of untenable debt situation that Japan had (and has), which in turn may induce the Fed to take drastic action to keep the economy out of a deep and prolonged recession.  

In the event of a recession triggered by increasing interest rates from continued deficit spending, the Fed may ask for Congressional approval to purchase private equities in an effort to avert the collapse of an entire generation’s 401Ks from widespread firm bankruptcies due to their inability to cover debt payments. This is hardly unprecedented. The Bank of Japan began purchasing stocks in 2010 and is now the largest owner of Japanese stocks in the world. This undoubtedly contributed to Japan’s stock-market plunge a few weeks ago since the bank is now trying to sell those assets.  

Voters need to understand that by not pressuring politicians to deal with entitlements now, we might end up with a substantial amount of the means of American production being owned by the government. This will harm our free-market society incalculably because, slowly but surely over time, it will rob the economy of its entrepreneurial zeal and strong property rights. It will make ESG and woke capitalism look like child’s play, delivering to central planners what they were unable to achieve in America on the battlefield or at the ballot box.