When the Trust Funds Run Dry: The Price Level May Do the Adjusting If Congress Doesn’t
What happens when the Social Security and Medicare Trust Funds run out, currently projected for the early 2030s?
Background. Background: Social Security and Medicare are funded by payroll taxes. When payroll tax revenues exceed payments, these programs “invest” the proceeds in Treasury debt. The Treasury issues that debt to finance other spending, so in effect payroll taxes pay for other spending. The trust funds are not an economic investment, like stocks or bonds. When the payroll taxes are less than payments, as is already happening, the programs redeem Treasury debt. To get the money, the Treasury uses income tax revenue or additional borrowing, to be paid by future income taxes. So, income taxes pay for program spending.
Trust funds are not an economic investment like stocks or bonds. They are just an accounting entry that says whether payroll taxes or income taxes pay for program vs. other spending.
When the trust funds run out, under current law, the government can no longer use income taxes or additional treasury debt to finance the programs. Under current law, benefits must be cut across the board to what payroll taxes alone provide.
At that point, Congress will face six options:
Let benefits fall automatically, as the law now requires.
Raise payroll taxes to fill the gap.
Use income taxes to pay for the spending; raise income tax rates to do so.
Borrow to keep benefits whole.
Reform the programs to cut spending thoughtfully and improve their incentives.
Mix of some or all of the above.
Among longtime Washington hands, the conventional wisdom is that legislators will take the easy route: preserve every benefit, avoid serious tax hikes, and finance the gap entirely with new debt. Benefit cuts are politically unthinkable, and so are large tax increases.
To do this, Congress would have to change the law and amend the Social Security and Medicare statutes to allow transfers from general revenues. According to the Congressional Budget Office, maintaining all Social Security and Medicare benefits by borrowing would add roughly $115 trillion to the deficit over the next thirty years. That’s $70 trillion in shortfalls and the rest in interest payments. On a real basis, using a 2% real discount rate, the present value of that $70 trillion is on the order of $40 trillion—greater than the current $38 trillion national debt. That is also the same amount by which income taxes would have to rise in order to avoid borrowing, and the same present value of the later, larger income taxes that would be needed to eventually repay added debt.
The danger, of course, is that Congress will borrow and then be unable or unwilling to repay such a massive amount of debt. A debt crisis will eventually erupt, leading to default or inflation. History has no shortage of examples of other countries unsustainable social spending causing debt collapses. It can happen here. And when people see that event coming, we will see a flight from Treasury debt and inflation in its anticipation.
So far, markets do not appear to believe that Congress will simply borrow everything, enact no reforms, and fail to restore fiscal order. If markets did, we would already see the repricing—rising yields, a weaker dollar, or inflation expectations, and inflation itself drifting upward. Surely, as the saying goes, America will do the right thing, even if after trying everything else.
Who is right? We will find out soon enough. But markets are not irrational to hope that Congress will act “responsibly.” By that, I don’t mean sweeping entitlement reform or aggressive means-testing but at least steps to avoid the outright fiscal free-for-all of borrowing everything with no hope of repayment.
History gives investors some justification for this hope. When major fiscal cliffs have approached—the debt-ceiling standoffs, government shutdowns, or the Social Security shortfall of the early 1980s—Congress has ultimately pulled back. In 1983, it forged a bipartisan deal to stabilize Social Security. In repeated debt-limit fights, it has always avoided default. Each time, legislators have done just enough to avert a genuine fiscal rupture. That record could explain why markets, for now, remain calm. It is not naïveté but a rational expectation that, at the eleventh hour, Congress will again choose some blend of tax and spending adjustments over fiscal abandonment.
But the depletion of the trust funds could mark a critical inflection point, even though the trust funds themselves are not genuine assets in any economic sense. Their exhaustion is when fiscal illusion meets legal reality. For the public, it will be the moment the comforting fiction of “self-financed” entitlements gives way to the truth that there must be large benefit cuts, large new taxes (payroll or income), or large new debt that itself must be paid for by even larger later new taxes or spending cuts. For markets, it will be the moment of revelation: they will finally see whether Congress intends to act responsibly or, instead, to cover the gap with borrowing.
Now, suppose that Congress, facing depleted trust funds, chooses to borrow every dollar needed to preserve full benefits, with no credible plan to repay. That’s the scenario embedded in every long-term CBO projection. In those baselines, the government simply issues new debt to cover the Social Security and Medicare shortfalls—and yet inflation and interest rates remain low, as if markets will calmly absorb tens of trillions in new borrowing without changing their expectations. Though the CBO makes these projections, with debt rising forever to the stratosphere, it clearly labels them “unsustainable.” We know this will not happen, the only question is how.
I write this post as a warning for those in Congress who will be tempted to put all future Social Security and Medicare shortfalls on Uncle Sam’s credit card. They may think that the consequences of their decisions will be felt only many years down the road. However, there is a good chance that these consequences won’t be delayed. Here is what could happen instead: the moment Congress confirms such a path, expectations could shift instantly. Investors would recognize that the long-standing pattern of last-minute responsibility has broken down, that fiscal discipline is no longer forthcoming. That realization alone could trigger an immediate repricing of government debt. The real value of outstanding bonds would fall, prices would rise, and inflation would emerge not gradually over decades but at once, when markets absorb the fact that Washington has chosen the politically easy way out and is incapable of reform.
There is little the Fed could do to stop such an inflation. To avoid inflation, the Fed would have to allow unrestrained interest rate rises, that forces the government to undertake the reform it refuses at the peril of an immediate default. It would have to ignore “turmoil” in the government bond market rather than buy Treasurys en masse, and it would have to raise short term rates, until it wins a game of chicken with Congress, and Congress so thoroughly reforms as to bring Treasury investors back. The Fed is, to put it mildly, not likely to do that, or to be allowed to do that.
A Very Short History of the Fiscal Theory of the Price Level
This scenario is illuminated by the Fiscal Theory of the Price Level (FTPL). This theory emerged from several generations of economic thought. Its roots lie in Thomas Sargent’s work of the early 1980s, which showed that inflation ends only when governments restore fiscal balance. In Unpleasant Monetarist Arithmetic (with Neil Wallace, 1981), Sargent demonstrated that even a disciplined central bank cannot control inflation if fiscal policy is unsustainable—an early statement of fiscal dominance. His later research on postwar European inflations showed that prices are stabilized by fiscal and economic reforms that created credible structural budget surpluses, not by tighter money. Indeed, in several cases, once the fiscal reforms were enacted, inflation dropped precipitously, while interest rates dropped, money supply expanded, and governments were able, in the short run, to borrow even more!
Eric Leeper’s 1991 paper (“Equilibria under ‘Active’ and ‘Passive’ Monetary and Fiscal Policies”) provided the foundation for what became the modern Fiscal Theory of the Price Level (FTPL) by formalizing how the interaction of fiscal and monetary regimes determines price-level outcomes. Leeper showed how fiscal theory works when central banks follow an interest rate target, as they do, rather than control money supplies, which is nice in theory but our central banks don’t do it. Later, John Cochrane significantly developed, extended, and popularized the theory, culminating in his 2023 book The Fiscal Theory of the Price Level. Together with other scholars, they built a complete general-equilibrium model in which the price level adjusts so that the real value of government debt equals the expected present value of future primary surpluses, i.e. tax revenues minus non-interest spending. Inflation is always too much money chasing too few goods, but this theory emphasizes that less money and more bonds will not help. In the end money and bonds together are too much when they are more than the government will credibly soak up by taxes in excess of spending. Money and bonds together are like stock in the government, and fall inexorably when people lose faith in their backing, just as stock prices fall when people lose faith in a company’s earnings and dividends. Inflation, in this view, is the market’s way of ensuring that government promises and resources remain consistent, by marking down the value of the promises when the resources are not in sight.
The Arithmetic That Never Blinks
The logic behind the fiscal theory of the price level is visible in the government’s basic valuation identity. The real value of its outstanding debt must equal the expected present value of future primary surpluses. This equality exists in all economic theories. If debt is not sustainable, inflation or default must happen. The only minor quibble among economists is the mechanism.
If Congress issues new debt to finance benefits without credible future surpluses—through entitlement reform, spending restraint, or tax changes—the identity must still hold. People will not surrender their savings if they don’t believe they will be repaid. If the government tries to do it, equilibrium is achieved through adjustments of the price level: the real value of government debt falls until it matches its expected fiscal backing.
In practice, price stability depends not on the central bank alone but on fiscal expectations. Inflation in this framework is not only a monetary policy choice but the outcome of inconsistent promises: when markets no longer expect future surpluses sufficient to support today’s debt, they try to dump debt and buy goods and services instead. The price level rises to make the numbers add up.
The Expectations Channel
Inflation is not a mechanical consequence of borrowing; it reflects expectations about fiscal credibility. If investors believe credible future surpluses will emerge through entitlement reform, spending restraint, or tax-based expansion, to eventually match the new debt, the price level need not change. Government borrowing to meet transitory spending needs, and backed by credible expectations of a return to normal small surpluses that pay down debt, is a good and great thing. But if markets conclude that political constraints make those surpluses unlikely, that excess spending is permanent, the adjustment must occur through a revaluation of nominal debt.
Markets need not wait for monetary expansion. They reprice government liabilities the moment they doubt that sufficient future surpluses will appear. The first signs might be higher long-term yields or a weaker dollar. Governments typically move to issuing short-term debt to avoid higher rates. For a while, lower long-term bond prices spread the burden to those unfortunate bondholders. Then the inflation breaks out. The underlying adjustment is the same: the price level rises until the real value of government obligations matches their expected fiscal backing.
Recent history offers a powerful illustration of how inflation adjusts when Congress refuses to do so. During 2020–2022, the federal government ran roughly $5 trillion in debt-financed transfers with no credible plan to tighten the budget later. At the same time, the Federal Reserve absorbed a large share of that new debt, keeping yields low and reinforcing the perception that the expansion would not be offset by future surpluses. Households received cash, spent it, and saw no prospect of higher taxes or lower spending to repay it. Inflation followed because investors and consumers recognized that the new debt lacked fiscal backing. Prices rose until the real value of government liabilities matched the fiscal resources expected to support them. By the time inflation reached 7 to 9 percent, the real debt burden had fallen by roughly ten percentage points of GDP—the fiscal adjustment occurring through prices rather than legislation, exactly as the fiscal theory of the price level predicts.
Contrast that with the early 1980s. When Paul Volcker raised interest rates to break inflation, he was backed, however imperfectly, by a government moving toward fiscal discipline. The 1983 the Social Security Commission played a major role, as did the Reagan-era tax reforms, later spending restraint, and the Gramm–Rudman caps. Deregulation and tax reform led to strong economic growth, and nothing raises revenue like more taxable income. Together these steps signaled to markets that future fiscal surpluses were once again plausible. That change in fiscal expectations made Volcker’s policy credible: investors believed the government would honor its debt in real terms rather than inflate it away. As a result, inflation expectations collapsed, long-term interest rates fell, and credibility returned. And in the 1990s, the expected surpluses materialized, and paid back the fiscal costs of disinflation.
The lesson is clear: monetary policy alone can’t sustain price stability without fiscal backing. In the 1980s, Congress and the Fed moved together to restore balance. In the 2020s, Congress moved in the opposite direction, and inflation did the consolidating for it.
The Price Level as Verdict
This is the uncomfortable implication of the fiscal theory: inflation is not entirely a monetary-policy failure; it is the market’s verdict on fiscal solvency. It’s the price-level adjustment that restores consistency between government promises and real resources.
Economists will always acknowledge that “monetary and fiscal policy must be coordinated,” monetary policy requires fiscal solvency. Governments that print money to finance deficits will see inflation. But they tend to forget this age-old wisdom. And, perhaps with reason. When debts were small, deficits were small, and governments were small, fiscal policy could easily adapt to repay bondholders. But those days are gone. 100% debt to GDP ratios means that fiscal-monetary coordination will be the top issue going forward. The looming fight between Fed and Government will be interest costs on the debt and intervention to lower treasury yields, not goosing of the Phillips curve.
If, after the trust funds are depleted, Congress legislates that it will borrow everything necessary to preserve benefits without credible reform, the same fiscal logic applies. Markets need not wait for the Federal Reserve to expand the money supply; they will reprice government debt as soon as they doubt that future surpluses will appear. The first signs may be higher yields or a weaker dollar, but the underlying adjustment is the same: the price level rises until the real value of government obligations matches their expected fiscal backing.
One might hope that inflation will at least reduce Social Security and Medicare costs. Alas, Social Security is aggressively indexed, so inflation will make those payments more expensive in real terms. And health care costs also rise with inflation. Retirees will see losses in the value of their bond portfolios however, which will make any benefit reforms even harder to implement.
Everything must be paid for. If Social Security, Medicare and Medicaid are not paid by current taxes, they are paid by future taxes, if not those, they are paid by inflating away retiree’s asset portfolios and money holdings. What looks like a quiet “fiscal adjustment” in Washington shows up in daily life as higher grocery bills, rising rents, and savings that no longer stretch to the end of the month.
Conclusion:
Politicians weighing whether to kick the can down the road on entitlement reform when the trust funds run dry may take comfort in CBO projections showing debt climbing for decades with no apparent crisis or inflationary spiral. That complacency would be dangerously misplaced, as CBO reports themselves acknowledge. Financial markets will not wait for the debt to reach those distant levels; they will respond the moment it becomes clear that Congress intends to finance Social Security and Medicare shortfalls entirely with borrowed money and no chance of reform or eventual repayment. Once investors conclude that fiscal discipline has been abandoned, they will reprice U.S. debt quickly, and the adjustment will follow through falling bond values, higher prices, and rising inflation.
The way to prevent such a shock is not austerity for its own sake but precommitment and credibility. The United States can avoid fiscal inflation only by committing now to future surpluses through entitlement reform, spending restraint, and clear limits on debt finance. Central bank independence cannot anchor prices when Congress refuses to anchor expectations. If lawmakers will not deliver the surpluses needed to sustain fiscal balance, the price level will do it for them. Inflation, in that sense, is not a choice but the arithmetic of broken promises. The reckoning will not come decades from now; it will begin the moment expectations break—and that moment may arrive when Congress commits to financing the programs’ multi-trillion-dollar shortfalls with no credible fiscal plan to back them.
The good news: we do not need short run “austerity,” of sharply higher tax rates or instant spending cuts. We need decades of small surpluses, along with strong economic growth. The bad news: only such growth-oriented reform will do any good.