The Shadows of the Crisis: Past and Future

Should the Fed have intervened on LTCM?  My answer is no.  It set up the seeds of the present crisis, and encouraged the Fed to meddle in places where there is no significant legal basis to do so.  If they had let LTCM fail, the debts of the system would have shrunk more, and the system would not have failed, as it seems to be doing today.  It would have been a salutary check that would have brought us back to reality.  (Now, would that they had not loosened so much in 2002, 1995, and 1991, but that is another story….)

The failure of LTCM did have some positive effects on me.  It made me more skeptical about arbitrage, leverage, and illiquidity, at least to the degree that one has to be paid to take on these risks.  Also, that hedge funds as a group posed some systemic risk, even if none were as big as LTCM.

But now consider a problem in our future.  Is Social Security a Ponzi Scheme?  (I like Eddy and Jim, so this is not about either of them… I have been writing about this for 15 years.)  I don’t typically call it that, not because there aren’t some elements that resemble a Ponzi Scheme, but because it loses the writer credibility on the broader issues involved.  Rhetoric matters, and even tone of voice matters.

In analyzing Social Security and Medicare, the first thing one must do is unify them with the US Government, and consider them as a whole.  The US Government has moved two two plans off-budget and on-budget at their convenience in order to make the deficits look smaller.

When one looks at the system as a whole with current US Government borrowing, one sees the imbalance.  Many say, “The trust fund won’t run out of money until 2042,” or “Inflows will exceed outflows until 2022.”  The trouble is, we are at the peak now of inflows over outflows.  Starting four years from now, when Obama is a lame duck, that overage will shrink.  As the overage shrinks, taxes will have to be raised, or borrowing will have to rise.  And all of this is on top of what we have done in 2008, and will do in 2009, where the deficits are as aggressive as in wartime.  From an old CC post:

David Merkel
Every Little Help Creates a Great Big Hurt
8/23/2007 5:09 PM EDT

So there are some that want the US Government to bail out homeowners. Need I remind them that on an accrual basis, we are running near record deficits? Never mind. In another 5-10 years, it won’t matter anymore, because foreigners will no longer fund the gaping needs of the US Government as the Baby Boomers retire.

But so as not to be merely a critic, let me suggest an idea to aid the situation. Income tax futures. We could speculate on the amount the US Government takes in, and the IRS could use it for hedging purposes. One thing that I am reasonably sure of: tax rates will be higher ten years from now, and I would expect the futures to reflect that.

Position: long tax payments

I have focused on the latter half of the 2010s as my period for when the US will face a crisis, because then it will become obvious that the US can’t make good on all of its promises.  Well, the government is testing the boundaries of crisis now.

What everyone who relies on Social Security and Medicare should know is that those programs are subject to the will of Congress.  They could eliminate them tomorrow and no one could sue for damages.  “Wait, I paid into that for 40 years!”  Sorry, you paid extra taxes for 40 years, the law had no provision guaranteeing results for any individual.

All of that said, I am reminded about what former Senator William Proxmire said about Social Security.  (I met him at my High School when I was 16 — when I shook hands with him, there was no one else there, just me and him; I felt honored, particularly as he was a rare politician at that time who would not spend aggressively to win elections.)  He said that all Social Security benefits would be paid, but the purchasing power of those benefits would be limited.  That is a common sense warning from a man who knew that you can’t get something from nothing.

That brings us back to the present.  You can’t get something from nothing.  Why should you expect the government to rescue us from this crisis?  Who will lend us the the money/resources?  What return are they expecting?  What happens if we default?

I’m not specifically worried about Social Security anymore, because we are presently testing the boundaries of what the US Government can borrow at present.  I don’t precisely know where that limit is.  In implicit terms, we are past the debt limit if one includes that Social Security deficit.  But foreign powers, OPEC and China, can fund the US for their own reasons, even when US creditworthiness is scant.

If I were advising the governments of Saudi Arabia or China, I would tell them: sunk costs are sunk.  Do what maximizes value for your people from here.  That might break the current cycle where they support the US.

What I have written here outlines what we might expect over the next decade.  I hope and pray that matters prove better than what I expect.