What you should be worried about when politicians tell you they won't touch entitlements

A politician who promises never to cut Social Security or Medicare sounds like he’s protecting you. Take the promise at face value and follow it to the end, and it turns into a different promise, one no one campaigns on: inflation, sooner than you think.

Under current law, when the Social Security and Medicare Part A (hospital insurance) trust funds run dry in the early 2030s, benefits are supposed to be cut automatically so they match the revenue raised for the programs. That fiscal cliff doesn’t exist for other parts of Medicare. Parts B and D, which cover physician services and drugs, draw about three-quarters of their funding from general revenue rather than a trust fund, and they have no depletion date to force a conversation about reforms.

You wouldn’t know that the “do nothing approach” to Medicare and Social Security insolvency is a set of benefit cuts by reviewing CBO projections. Congress directed the scoring agency to ignore current law and instead assume that the gap between payroll taxes collected, and benefits will be borrowed to pay all benefits. Under that scenario, CBO tells us, debt to GDP will grow from 100.6 percent to 175.1 percent in 30 years. Brookings Institution’s Jessica Riedl calculated that this is $138 trillion in new debt interest included, through 2056. And it arrives just as debt held by the public passes its World War II record relative to the economy.

Yet, CBO projects that inflation stays at the Fed’s 2 percent target as debt explodes.

I don’t think that’s what happens. If Congress decides to borrow the entire difference between benefits and payroll tax revenue when the trust funds dry up, then Congress would be committing to piling on more borrowing on top of the already-large projected debt from Medicare Parts B and D. The reason I think this could be a fiscal inflection point is that if a number that large ($138 trillion in borrowing over 30 years) won’t move Congress to meet the fiscal cliff of 2032 with reform rather than borrowing, then Congress has made its choice clear to everyone: the surpluses needed to back the debt are not coming. That decision could trigger a repricing of the debt, with the price level rising so the real value of the debt matches the smaller stream of surpluses people now expect. It happens through inflation, and because it runs on expectations of the fiscal path, not on the act of borrowing, it can arrive very suddenly and long before the last dollar is borrowed.

Here is something to think about. When that happens, the Fed may not be able to help when inflation emerges. The textbook says higher rates cool inflation, but that rests on an assumption no one states: that fiscal policy tightens alongside. Absent that, every hike enlarges the government’s interest bill, and with no surpluses behind it, that larger bill is met with fresh borrowing, i.e., more nominal debt, feeding the inflation fire the hike was meant to put out.

That continues until the fiscal authorities implement austerity.

But what are the political incentives for that to happen? It’s unclear to me. On one hand, the fiscal cost of higher interest rates and higher interest payments is real. The political cost of inflation is real too. On the other hand, the same incentives that got us in this mess in the first place (politicians want to be reelected, and the sure way to get the most committed voters to vote for you is to promise not to touch Social Security and Medicare) are still in play. Also, seniors may be less affected by inflation than others because their benefits are adjusted for inflation. Finally, with a debt as high as ours and the maturity of our debt so short, the scale of the fiscal adjustments needs to be quite large, larger than I can expect any group of politicians on the right or the left to have the courage to implement. This is why I have a hard time seeing the mechanism that forces fiscal adjustments.

You see the same thing playing out in the fiscal consolidation literature. A study by AEI scholars back in the day showed that although we know which types of fiscal adjustments lower the debt-to-GDP ratio (mostly through spending), 80 percent of the adjustments implemented failed to reduce it. The same interest groups that got a country into a fiscal mess prevent the right type of adjustments from being implemented.

Some succeed obviously, and I am not saying the US won’t be one of these countries, but I am not holding my breath.

What about more Fed independence? There’s no historical case of a central bank forcing fiscal adjustment. Volcker is the closest example, and even Volcker repeatedly told Congress that monetary policy alone couldn’t control inflation. The fiscal adjustment came voluntarily, with Reagan-administration political support, not through monetary coercion. TEFRA, among other things, and the 1983 Social Security reform were instrumental in getting markets to treat the US regime as one that would eventually run surpluses to back its debt, and that belief did the work.

What about having a monetary rule to force fiscal discipline? Again, the mechanism assumes the fiscal side yields under monetary pressure. Not a given in my opinion. The scenario everyone’s worried about is one where the fiscal side won’t/can’t yield. Against a driver who’s removed his own steering wheel, tying your hands to yours doesn’t force a swerve; it commits you both to the crash. Remember that if the central bank raises rates sharply when inflation rises, accelerating debt growth, which drives inflation higher if no fiscal adjustments take place, prompting another hike.

All this is to say that when you hear politicians promise that they will not cut any entitlement benefits, remember that they could be making a promise no one will like: the promise to deliver inflation sooner than you think.