Default, Inflation, Higher Taxes — Choose One

When I look at the present economic environment, I am not encouraged.? But if you really want me to be discouraged, talk to me about politics.

For the last 40-80 years we have been borrowing, whether implicitly (pensions, retiree healthcare) or explicitly, deferring problems into the future, where they will be compounded with interest and survivorship (lifespans have lengthened, Kaiser, and sadly for those who pay, they want a high quality of life in their dotage).

So, at present, legislators are more partisan, whether in the states or at the federal level.? Why?? There is less slack.? Let’s start at the state level, because most of them have to balance their budgets, and can’t print money to help out.

Many states are screaming in pain.? As such, they tell their legislators in the Federal Congress to send back money.? But that toughens the debate on the Federal level.

With almost all state budgets fighting against a deficit, and some in deep trouble, it makes for interesting and ugly politics.? Much of this was created by optimistic assumptions of what could be earned from equities over the long run, much of which is now being slowly repudiated, as markets fail to live up to expectations.

The Federal budget is hopelessly out-of-whack, with 4-5% of GDP deficits out as far as the eye can see.? So, what do we do about it?

1) Raise Taxes.? I don’t like this idea, because the US Government has entered many areas where it should not be.? I would rather see the discretionary government shrink considerably.? Also, remember, Social Security and Medicare are not guaranteed.? Congress could wipe out all benefits tomorrow, and face a political firestorm.? But remember, in the Great Depression, that is just what they did.? This is why I don’t insist that rates must head higher.? It depends on society as a whole.

Raising taxes has the perverse result of slowing economic growth, which affects future taxes.

2) Inflate the currency.? Ugh.? Oppress the elderly, who cannot work to make up the difference?? Create a new inflation mindset that has all of us focusing on the short-term.? Inflationary economies by their nature become more and more short term.

3) Default on obligations.? There are several forms of this:

a) Total default: anyone with a Treasury Note is a sucker.? Global depression ensues.

b) External default: we do not honor external obligations, but honor internal ones.? Global depression ensues, but the US does relatively well.

c) Internal default: what, are you joking?? Why do we pay off the losers who lent to us?

As we look at Greece, Spain, and Portugal, we chuckle over the foolishness of the EU thinking that they could have monetary union without full political union.? It didn’t work under the Confederation, why should it work elsewhere?

But we should not chuckle.? After all, we have California, Illinois, and New York, and more waiting in the wings.? There is no bankruptcy code for the states.? I am not sure what happens if one state does not pay, aside from being shut out of the municipal bond market.

So, my point remains — what are we going to do?? Raise taxes, inflate the currency, or default?? Perhaps in a real crisis, we would slim down the government.? We might also decrease Social Security and Medicare benefits.? We might also amend ERISA, to allow for reductions in pension payments.? In a real crisis, nothing is fixed.

Or, we might tax a lot more — the depression was an example of that.? That is a reason that I am not a total bear on Treasuries.

The government has choices to make.? What should they do?? Offer your answers as best you can.

34 thoughts on “Default, Inflation, Higher Taxes — Choose One

  1. Given the choices you set forth and political realities as well, I’d venture that external default is the most likely outcome. Maybe with some inflation tossed in.

  2. c) Internal default: You mean “internal, but not external default”, correct? Sounds like your preferred choice would be b) – United States of Argentina?

  3. I think we’ll get a combination of higher taxes (most likely in the form of a hefty VAT), higher but stable inflation (maybe 3-4% targeting after our debt-binge to bring the debt-GDP ratio back from the stratosphere), and some reduction in promised outlays, such as delay in receipts (pushing Social Security and Medicare eligibility back until, say, 70 or so) or means-testing or growth-rate-freezes.

    The bottom line is that our descendants will be charged a higher percentage of their wages, face higher nominal interest rates, be less able to rely on the purchasing power of their currency savings, and get less government actions and benefits on their behalf.

    They will pay more and get less than their forebears because of the profligacy of their parents’ generation. What a shame on us all.

  4. you forgot 4) issue more debt to pay back the old debt – all in on the Ponzi Scheme. And under no circumstances admit that there may be a limit to how much the US of A can borrow: just assume that number is limitless – that China will continue to fund us.

    oh – if/when that fails, crank up the printing press!

  5. I think Indy has it. Rather than a VAT, however, I would be in favor of higher taxes on the more prosperous–a more “progressive” progressive income tax. I do recognize it would have some adverse impact on private investment, but sustaining our federal government comes first in my mind.

    Hell, I’ll settle for CONTROLLING outlays, but I expect our Congressmen & women can’t pass up a chance to send some more money back to their district/state. I’d really like to see this waste of taxpayer money ended.

  6. There are four areas of the economy that are bloated as a percentage of GDP: corporate profits, income/wealth of the top 1-5%, health care spending and defense spending.

    Cutting discretionary spending gets you almost nowhere. And remember, things like the IRS and DoJ are considered discretionary and cutting those would probably be counter productive.

    I don’t see how inflation works as an out. Wouldn’t inflation of ca. 4-5% send interest rates, and debt costs, much higher? And the CPI will almost certainly rise faster than wages, so entitlements would rise faster than taxes.

    We spend twice the OECD average on health care and probably 5-10 times the average on defense. Normalize those two areas, return to a more progressive income tax and motivate corporations to either distribute or invest their profits and the problem is solved.

  7. I think what our country needs is an adult conversation about reality – which is there is not solution. The best we can do now is figure out the relatively winners and losers as the pain is distributed.

    Is there a “solution” to detox from heroine? No – only things that create other problems. I believe the best route going forward is about as likely as me being appointed dictator, but I’ll share my opinion anyway.

    We need to let individuals compete to decide their own fate now that we are in the detox mode of the generational credit bubble. The government should move to make our currency convertible into a basket of currencies to create an intrinsic worth. This would be deflationary, but then that is the natural outcome from credit addiction. All of the other “solutions” like inflating and higher taxes are just like methadone or subutex – they may make the acute symptoms of detox less painful but make things worse long term.

    There are always winners and losers in a zero sum game and morally I believe that it should be left to the individual to have self determination in this regard. The major issue policy makers continue to ignore is the REALITY of the global wealth disparity that de facto means that western standards of living must fall as the developing world continue to emerge from the end of the cold war.

    To date we’ve masked this decline in living standard via credit growth and shoddy government statistics. However, it is a reality and will continue until “we” meet them somewhere in the middle. My personal preference would be for a painful deflationary contraction that would be horrible for a couple/few years, but at least we would retain our currency and lay a solid foundation once that process plays out.

    Ironically, the best real world example of this played out in southeast asia followign the 1997-1998 crisis as the west+Japan blackmailed the nations in crisis into doing exactly this. They suffered terribly for a couple of years, the system cleared, and that region of the world has grown in a solid fashion based on good fundamentals since.

    Like I said, I have zero confidence this path will be taken – there isn’t anyone able to blackmail the west into following it. However, sometimes the least bad option in the long term is the most painful in the short/intermediate term. I suspect that we will continue down the path of some horrendous mix of methadone and subutex via political cronyism that could impoverish our average citizen for generations. Many forget that Argentina was one of the world’s wealthiest nation’s prior to WWI….

  8. That’s what a get for posting before drinking coffee on a Sunday – forgetting to proof read and horrible spelling! My apologies…

  9. I hate the idea of a VAT, but it has certain qualities that will make it irresistible to the political class. It can start off low and then go up when people get used to it, it’s a stealth tax, since it’s levied upstream in the distribution chain and consumers don’t notice it, it’s regressive, which means the rich will like it, it can be pitched as a consumption tax, which sounds virtuous (but isn’t), and they’ve had it in Europe and the UK forever, which means it has a track record that can be marshalled in its favor. It’s inevitable, and will be here sooner than you think. In fact there are already rumblings for it in the Democratic think tanks.

  10. print the money and payoff all debt is better choice than default. if external default, then you can bet USA becomes second Argentina. and personally, why would i want to lend or trade with you if you defaulted? until you settle the old debt (means payoff), i will not lend or trade with you. That is motto that should be followed by all lenders. if you defaulted once, then it doesn’t matter if you offer higher rate, i will not lend to you again because of old debt to settle and i simply will not trust you to do any business, trade, or lending with you. a trust is last you want to break, gain this motto should be followed by all lenders.

  11. A brief word in favor of a VAT. It is high time to use tax policy to level the incredibly uneven playing field that US workers are playing on.

    One of the major problems facing the US is off-shoring of production to China – in part to the low value of the RMB. There is a strong lobbying constituency from retailers and other platform companies to keep things as they are due to the profits from marking up cheap Chinese goods to US levels, and damn the consequences to the country.

    A VAT would at least tax the value add from Chinese labor. As tax policy currently stands, we tax US based production of businesses with FICA payroll taxes, among many others. Foreign production isn’t burdened by these taxes, and we wonder why US workers are uncompetitive!

  12. All these ideas are foolish and guaranteed to fail — unless there is a meaningful control on spending.

    If we must have higher taxes, it should come with a restriction that government spending (on and off balance sheet) cannot grow faster than GDP — as it has for decades

    Get government spending as a percent of GDP back down to the levels it was when JFK was president (which would mean cutting spending in half, or doubling GDP).

    No spending programs, no more “entitlements” — nothing until debt is paid down. Then restrict spending growth to GDP growth.

    Oh — and educate these silly class warfare people that insist on babbling on your blog. Its “We the People” against the political elite who don’t listen and don’t care what we think.

  13. Why doesn’t cutting spending even make it onto your list of possibilities? What exactly is the downside of cutting a third or a half of government spending? How about spending cuts right across the board? Let the government figure out how to do more with less – or better yet prioritize for a change and make some tough choices. That’s what everyone else has to do, far past time for them to do so too. I can think of plenty of departments that could be eliminated altogether with no loss that I can see.

    Or how about dramatically cutting salaries and benefits for federal employees? Salaries for federal workers are significantly higher than salaries for persons doing comparable work in private companies, around 1/3 higher from recent estimates. And their benefits are far superior to the benefits of the average non-governmental employee.

    How about cutting defense spending in half? We currently are spending 700 Billion dollars a year on defense spending. That’s about 20% of total government spending – and as much as the rest of the world spends COMBINED. We have troops and bases in 126 countries around the world – including Japan, South Korea, Germany, Bulgaria, Greece, Spain among many others. Other countries manage to limp along with a 1/10th or 1/20th of our level of defense spending, and so should we.

    Here’s another one. Pass a balanced budget amendment, and an amendment that any bill raising taxes from their current levels must receive a 2/3rds majority in both the House and the Senate.

    I would be perfectly willing to do some serious cutting social security and medicare along with all the other government programs. For instance: Increase the ‘normal retirement age’, and the age people are eligible for social security and medicare to 70. Or 75. And then index the retirement age to average life expectancy. It is something like 78 right now. It was 62 back when social security was established. Average life expectancy is going up by about 1/2 year per year.

  14. David,

    You say, “Congress could wipe out all benefits tomorrow, and face a political firestorm. But remember, in the Great Depression, that is just what they did.” Could you say a little more about the parallel between then and now? What was the scale of benefits that were wiped out? What was the political clout of those who lost?

    Entitlements are the main reason I worry about inflation. I don’t know that we will, but I think it is a serious risk. And if we are going to have serious inflation, that is a major shaper of portfolio choices.

    I would have though Japan in the last 20 years was the main example to study, for a case where government over-committment did *not* lead to inflation. But if the US in the 1930’s is an important example, I’d like to understand it better.

    Thanks,

    Jim Fickett
    ClearOnMoney.com

  15. IMHO we’ll probably head into an Argentina / Venezuela type situation:

    1. Large and strong special interest groups (seniors, public employees) will come out in force to support plans that try to issue more debt and raise taxes.

    2. Raised taxes will bring in less and less revenue.

    3. Demagoguery begins.

    The really interesting question is who will be the scapegoat for the administration that comes into a failing US Gvt? Maybe Jews, China, bankers. (Jewish Chineese Bankers)? Mexicans? The IMF?

  16. @maynardGkeynes – Agree on the VAT tax. The beauty of a consumption-side tax is that it can go after all that darned tax-free Roth IRA money people are keeping from the IRS without breaking any explicit promises.

  17. Whoa. Reading this post and the follow-on comments has really brightened my day. The scary part to me, especially as a young Gen Xer (35) is that I think the pessimists have this one right.

    James Dailey, I think you’ve got it exactly right. So where does that leave one at the individual level trying to plan out the next couple of decades from a economic/financial perspective. You are right, we all can’t be winners, and there will probably be many losers especially compared to present living standards.

    What are some of you doing? I’m just curious. I’m trying to save as much of my income as humanly possible. I’ve made big life decisions based on the economic future I see. One is the decision to not have children to boost my savings rate and not add to my fixed expenses over the next 20-25 years. What about investments to maintain and grow purchasing power in this upside-down economic world with funny debt-money?

  18. @dlr — Amen!

    First, let me qualify what I am about to write by saying I have lots of respect for David Merkel as an investment “expert”, which is why I make it a point to always read his blog.

    With that caveat, I fear Mr Merkel represents a rather large group of people with antiquated thinking. The boomers (like dlr, I am also GenX) grew up in an era of ever expanding government.

    The answer to every problem, according to boomers, is raise taxes, raise government spending, and create new regulations without repealing any of the existing regulations that don’t work (or eliminating the bureaucrat jobs that enforce the failed regulations).

    But the boomers are cowards. Yes, I said it and I stand by it. The new president (who is too much like all the old presidents) isn’t even bothering to go through the motions of lying that his generation will pay its own bills. Debt will increase for ever more — and stick younger generations with the bill. Its shameful.

    Mr Merkel and his entire generation need to wake up and accept that spending cuts are required if the USA is going to remain.

    I would love to have a more optimistic view of the future — but I see the US government collapsing during my lifetime.

    History shows us (without exception) that countries that cannot control spending always collapse, and there is no reason to believe this time will be different.

    Mr Merkel lives too close to Washington DC, and is stuck in 1960s thinking — which is why he didn’t mention spending cuts on his list.

    At this stage of indebtedness, it no longer matters whether some programs are “good ideas” or not — as a country we cannot afford them.

    Cut everything across the board.

    And the first tax that should be passed is a tax on lobbyist and “think tanks” in Washington. Their “free speech” rights are no more important than ours, which are being summarily ignored at the moment.

  19. whoops — I meant to write: (like Mike C, I am GenX)… I don’t know what generation dlr is

  20. To all — I am very much in favor of cutting spending and eliminating whole Cabinet agencies. I am in favor of cutting Defense spending dramatically. I have not been in favor of our wars. Anyone who has read me for a long time knows that I am a small government advocate. I believe the only legitimate functions of government are defense, internal security, justice, and public health.

    But cutting spending can only take us so far without reworking entitlements, and reworking municipal and state pensions. That’s why I emphasized those. Would anyone seriously think that if I suggested cuts to things that would be exceptionally tough to do, that I would not recommend the easier cuts too?

    I look at the political situation and I see chaos. I don’t see any coalition available to cut spending. That is another reason why I wrote about it the way that I did. I was trying to deal with the inevitability of a major negative consequence if we don’t cut spending. One of those consequences would be higher taxes, as after the Great Depression.

    I don’t see the government cutting spending until their ability to borrow at any reasonable rate in dollars fails. They should cut spending, but they will not.

    On another note, I would be reluctant to trust the US Government with a VAT. Too powerful.

    And, to Mike C, if I didn’t have my eight kids, I would have a lot more money, but I would be poor internally. You have your own calculus, and that’s fine. Each one of us has to ask what we are living for.

    PS — I was born on the dividing line between the Baby Boomers and GenX — I see elements of both in my life.

    Now, did I fail to cover any concerns over my post? It feels really weird for me to be accused of not mentioning cutting government spending. That would be my #1 idea, but the politicians have ruled it out in both parties.

  21. David, I don’t know why your position was misunderstood. Cutting defense is not an option for a super power that wants to keep issuing the reserve currency. And domestic spending is a mess, don’t see politicians with a spine saying “enough”. Inflation hits old people, deflation the young. We shall see where the domestic power struggle goes. And for those stacks of papers in Beijing? Trade it for Taiwan, add Korea if it is not enough.

  22. David,

    Re the wiping out of benefits in the great depression — are you referring to Hoover’s decision to disperse the “Bonus Army”? It seems the veterans wanted to borrow something on the order of $2-$4 billion against their bonus certificates. The federal budget was already about $2 billion in the red, out of a total of about $12 billion, so this was a largish amount at the time. But if this is the incident you are referring to, it seems to me that there is a very big difference from today: the veterans were a much smaller political block than all those today who stand to benefit from social security and medicare.

    Jim

  23. “But the boomers are cowards. Yes, I said it and I stand by it.” (Greg)

    @Greg: Up against the wall, MF!

  24. I am likely one of the younger commenters on this subject, being in my late 20’s. I have owned my own company for three and a half years. My generation is furious. Friends and associates of similar economic position and age are livid with the mismanagement of OUR future being perpetrated day in and day out. I can’t say with any certainty how this will play out (I don’t think anyone can), but I will say that the only appropriate steps from where I sit appear to be:

    1. Pension reform. This means haircuts, and reduced benefits. Sorry guys, you don’t deserve $150,000 a year for the rest of your life because you worked in “public service” for 20 years. Public service benefit packages over the past 10 years have been far more substantial than their private sector counterparts, ex the FIRE industries.

    2. Wholesale efficiency audit of the Fed Gov. The redundancy, waste and pure theft is enough to make one’s blood boil. Has anyone contemplated the effects to our deficit afforded by a top-down re-evaluation of every job and department in the FedGov? This will never happen – but a boy can wish.

    3. Soc Sec and Medicare must be addressed within the next five years. Nobody – NOBODY – my age believes we’ll ever see a dollar from either program, and yet we pay into the programs every year. This is a legalized ponzi at its apex; nothing more, nothing less. Some generation is going to have to bite the bullet on this one, and it sure as hell won’t be my kids. So whether these reforms take place now or 20 years down the road, the only difference will be the amount of pain and the generation that bears it. This is one issue that my generation is not afraid to take a hard line on, and rightfully so.

    4. Cut taxes. Cut them deep, and cut them permanently. Perhaps this Obamanation has finally turned the corner and begun to realize that the answer is NOT a larger government and expanded taxation. Perhaps it took his election and bungling of everything he touches to make people understand that smaller is better. Smaller equals less taxes. Less taxes equals more freedom. The math – although I’m sure many will disagree with me – frankly isn’t that complicated. The explosion in production, investment, and growth that would follow a wholesale reduction of income taxes and elimination of capital gains taxes would be like nothing this country has ever seen. The deficit would necessarily skyrocket for a year, followed by a similarly parabolic drop.

    My 2 cents. Thanks for listening. I’m pissed.

  25. @Cpj13: You strike me as a bright, sincere and genuinely concerned young person. Please consider, just consider, the possibility that you have been manipulated by a right wing, corporatist campaign that began before you were born, and that has become so ubiquitous that you don’t even recognize how it has polluted your every thought on what is happening in the world around you. Hint: Think about who got bailed out recently, who paid for it, and who lost their jobs.

  26. @maynardGkeynes: Greg: Up against the wall, MF!

    Kind of a foolish thing to say to someone half your age and twice your size, don’t you think?

    I stand by my comment. Baby boomers are selfish cowards.

    I am fed up with you cowards spending money and sticking us with your debt.

    I agree with CPJ13, that no one under 45 will ever get their money back from Social Security — definitely not in real terms, and probably not at all. I would be happy to forfeit my future “benefits”, which I won’t see anyways. Cancel the whole foolish program tomorrow

    Medicare is already actuarily bankrupt, and will be cashflow bankrupt long before I am eligible. Its another empty promise from a selfish, cowardly generation.

    “Entitlements” are simply age discriminatory taxes, penalizing GenX and younger generations with a tax for an imaginary benefit we will never get.

    So there are some spending cuts that are simply “no brainers”. Both programs are expendable unless benefits are guaranteed for future generations.

    Raising Soc Sec taxes is EXACTLY the same thing as cutting our future benefits (assuming Congress doesn’t spend the money first, which is likely). Pay more for the same, or pay the same for less. Raising taxes is a coward’s answer.

    Municipal pensions? Eliminate them all. No one in my generation gets a pension, guaranteed or otherwise. We have to save money in an IRA and hope to God some corrupt politician doesn’t steal it before we reach retirement age.

    We have no skin in the pension game — so we will not care when (not if) they are eliminated. The Most Cowardly Generation has lived way beyond its means for decades, and now must live below its means during their twilight years.

    Endless tax increases are at least as controversial as spending cuts — and you should have acknowledged such in your post. Then commenters wouldn’t have been so angry at your post

  27. maynardGkeynes “Hint: Think about who got bailed out recently, who paid for it, and who lost their jobs”

    Yeah, lets think about that:

    Who got bailed out? A bunch of baby boomer aged bankers, by a baby boomer aged Treasury Secretary.

    Who paid for it? It was “paid for” 100% with debt that future generations will be stuck with

    Who lost their jobs? Because age discrimination laws only protect older workers, and most district attorneys are cowardly baby boomers — job losses were very concentrated in younger workers

    Oh, and the GM bailout of cowardly UAW retirees was orchestrated by a baby boomer president

    The “Greatest Generation” (to use Tom Brokaw’s self serving label) fought World War II — but then paid the money back!!!

    The selfish “flower power” generation took the largest creditor nation in the world and turned it into the biggest debtor the world has ever known. Some legacy you cowards are leaving

  28. @Greg: As you can imagine, the vast number of replies I get to each of my posts makes it impossible for me to answer each of them individually. However, I want you to know how deeply I appreciate your comments in support of my positions.

  29. We should study countries like Argentina. Given our political situation I cannot imagine too many difficult decisions being made openly and explicitly in Washington due to all the interests involved.

    Present claims on future economic output simply cannot be met – eventually interest rates, asset prices and currency values will adjust to this reality.

    One problem is that if much of the developed world adopts banana republic fiscal / monetary policies will there be many safe places to store wealth any more? (I guess gold in the basement might work)

  30. Does someone in the “government spending is out of control” camp wish to explain why spending is out of control now when total federal government spending as a percentage of GDP has not changed substantially in 50 years?

  31. The front page of the CBO website should be required reading before anyone comments on the federal budget.

    Notice that until the crisis spending was below the average for the period 1970-2009. Notice that the reason the deficit is so high is because revenues are at an all time low. Notice that this is because individual income tax and corporate income tax collections are also at an all-time low.

  32. F — it’s not just current spending, it is failing to accrue for promises made.

    Yes, taxes have come down in GDP terms somewhat. Spending was supposed to come down at the the same time. The zeitgeist was that we could have it all, and that debt didn’t matter.

    I’ve put my own proposals on the table for tax reform. I would be willing to see higher overall taxes if the code itself were fairer.

    http://alephblog.com/2008/04/12/problems-with-tax-reform/

    And, I would eliminate the estate tax (after all, we are being taxed as traders and the government has already gotten its cut), and taxation on dividends. I would pay for that by removing the deductibility of interest to individuals and corporations, grandfathering existing debts. Lower the leverage in the system.

    Dreaming, I know. It will never happen.

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