The Equal Sign Can Be a Real Bitch

On a long enough timeline, consumption equals production.

Guest post by Robert Gore at Straight Line Logic

If one had to choose a single symbol to represent the apex of human thought and achievement, a strong candidate would be the equal sign: =. That sign says that the symbols and mathematical operations to the left of it are equal to the symbols and mathematical operations to the right. Furthermore, to retain equality, anything done to the left side of the equation must be done to the right side. The equation is the heart of elementary arithmetic, the most complex principals of mathematics and science and their real world applications, and everything in between. Only logical challenge can disprove an asserted equality, and no amount of wishing will turn an inequality into an equality. The equal sign represents humanity’s capacity for ruthlessly pristine logic.

Many people shun mathematics, science, and logic, seeking refuge in their antitheses. A good part of human intellectual history has been attempts to either ignore equalities or turn inequalities into equalities. Forgiving, sloppy, delusional illogic is usually collective. Every age has its particular refuges. Our age has rejected the mathematics of debt. What can logically not occur, a perpetual inequality—consumption greater than production— has become the foundation of the global economy. As the tagline for Zero Hedge notes: “On a long enough timeline the survival rate for everyone drops to zero.” In the same vein, on a long enough timeline, consumption equals production. Understand that equality, and the future comes into stark relief.

Housing was the focal point of the last debt crisis. Old age funding—pensions and medical care programs—may well play that role during the next one. The math is straightforward: over time contributions and investment returns (if any) must equal promised benefits. The current reality is also straightforward: aggregate contributions, even if augmented by sterling investment returns, will be nowhere near enough to fund promised benefits. Current government and central bank policies exacerbate the predicament, making the achievement of even minimal investment returns problematic. The pay-as-you-go structure of many old age funds, such as Social Security and Medicare, does not allow for any investment returns at all.

It is easy for politicians to promise benefits and assume high investment returns. It is much harder to make the required contributions, whose benefits are long term and promise no immediate political payoff, and to actually realize the assumed investment returns. Underfunding of an old age fund can persist for years, especially if the fund borrows money. At any positive interest rate, borrowing further unbalances the equation; debt service will always outweigh the funds received. Debt only delays the day when promises are broken and the benefits paid out are realigned with what the fund actually has. Greece, Detroit, and Puerto Rico are the first chapters of what promises to be a very thick book.

Many of the governments facing actuarial imbalance do their best to make it worse. Contributions to old age funds come from the real economy, which is also where investment returns are generated. If there is a government on the planet that has improved the functioning of its economy over the last few decades, SLL is unaware of it. Dwindling growth (charitably defined as that benchmarked by official government figures) in the US, Europe, Japan, and China confirms that assertion. The ever-expanding Federal Register is emblematic of regulators gone wild, not just in the US, but around the world, and debt is a “gift” that keeps on taking. Most of the world’s $225 trillion pile of debt has paid for consumption or zero sum speculation. By definition these activities do not generate a return in excess of debt service, consequently their associated debt acts as an economic drag.

Central banks pushing down interest rates, in many cases to negative territory, kills old age funds dependent on investment returns. Most such funds are still assuming they can generate an annual 6 or 7 percent return, but if interest rates on safe debt are in the 2, 1, or -1 percent range, they have to take more risk to hit their targets. Taking more risk means investing more in equities and long-dated bonds. By most measures stocks are at the high end of their valuation ranges, and investing in them is especially dicey with governments and mounting debt gumming up economies. Long-dated bonds are most subject to interest rate risk should central banks find themselves unable to continue suppressing rates.

Such suppression encourages debt and discourages saving. Debt only makes sense when it is used to generate a return greater than the costs of debt service. Saving that funds productive investment is the true foundation of long term progress and economic growth. Dwindling savings further erodes the ability of the real economy to fund the contributions necessary to maintain old age funds’ solvency. If having children is thought of as “saving” for old age security, and in less developed countries that is often the literal case, then contributions are also facing a demographic “savings” deficit. In virtually every developed country, including China, over the next few decades the percentage of elderly will dramatically increase relative to the younger population that will supposedly support them (see links here and here).

Promised old age benefits are for income and medical care, and the funding gap for the latter is even greater than the former. In the US, decades of government intervention in medicine have produced almost complete separation of those receiving care from those paying for it, competition-destroying, cost-increasing concentration in the medical, drug, and insurance industries, and now Obamacare, which has exacerbated existing problems and created new ones. It relies on the healthy subsidizing the unhealthy and the more affluent subsidizing the less. Not surprisingly, the healthy and affluent are either shunning or subverting the system and insurance companies are fleeing unprofitable markets. Those who remain are seeking hefty premium increases. So add costly, convoluted, and inefficient medical and health insurance systems to the factors contributing to the unsustainable old age funding inequality.

That inequality propels mounting global debt, which has papered over shortfalls. That works until it doesn’t. Crashing commodity prices, sputtering economies, the frantic, counterproductive exertions of governments and central banks, and rising dependency ratios (the ratio of the dependent to those who support them) mean the reckoning is at hand. Whether or not anybody wants it or plans for it, benefits are going to align with the actual resources available to pay them, just as house prices aligned with economic reality during the last crisis. Unfortunately, this alignment will be far more severe than that one.

That equal sign can be a real bitch.