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This is the fifth of a series of articles that I've called "7 Deadly Sins of the Government Debt Debate." You don't need to read the other four to follow this one, but if you were to go here, here, here or here, you'd find that we're playing word games. In the diagram below, see if you can match the "sins" on the right to the topics on the left. The earlier articles matched the first four topics to the sin that fit best. The discussion here covers topic #5: Net Government Debt.

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The Net Debt Paradox

Imagine you could create a fake world that's close to the real world but not identical. The only difference is that Social Security and Medicare don't exist in your fake world. The Social Security Act wasn't passed in 1935, nor could it be expanded in 1965 to include Medicare. But all other historical events are the same, including wars, election results, recessions and financial crises. The goal is to demonstrate one of the problems with the debt debate, which I'll call the Net Debt Paradox. The paradox is this: if we only rely on the most commonly reported figures, government debt would be higher in your fake world than in the real world.

But hold on, you say: How could debt be higher without entitlement programs? Isn't the debt crisis mostly about the costs of these programs? The social spending that's projected to grow faster than the rest of the budget? If you remove the social spending, wouldn't debt be lower, not higher?

No, the paradox is that it wouldn't, because of the way the government presents its finances. Nine times out of ten, debt is defined as the amount that the government borrows from "the public" - also known as "net debt." Whether you're reading something from the Treasury Department, the Office of Management and Budget (OMB), or the Congressional Budget Office (CBO), you'll find that net debt takes center stage. The trick that explains the paradox is that net debt excludes borrowing from the Social Security and Medicare Trust Funds. The IOUs that the government awards to the Trust Funds, whenever it drains their excess capital to pay for other types of spending, are assigned to a separate category of borrowing that's commonly swept under the carpet.

To explore the Net Debt Paradox further, I'll add a little more detail to your fake world. Imagine that people compensated for the lack of government retirement insurance by increasing their savings. In your fake world, the amounts that would otherwise be deducted for Social Security and Medicare are instead invested in Treasury bonds. Coupons and principal payments on those bonds are then reinvested in more Treasury bonds, at least until retirement. With this additional detail, your fake world is almost economically equivalent to the real world.[1] In each case, people loan a portion of their accumulating wealth to the government, but on the promise that it'll be paid back to them in retirement. The main difference is that there's no "middle men" in the fake world. By this, I mean the Trust Funds, which act as middle men by standing in between the government and the private savers who lend it their assets (see diagram).

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The diagram highlights the problem with excluding Trust Fund borrowing from reported debt. And if you identify with the private savers on the left side, you'll call foul. The government's obligations to you shouldn't be any less sacrosanct for mandatory pay deductions than for voluntary Treasury bond purchases. And they shouldn't be netted out of total borrowing.

Note that I'm not generalizing to all types of netting, but making a distinction for trust fund borrowing because it represents public savings. Netting of assets and liabilities makes sense for the relatively small amounts of Treasury securities that government agencies hold in their general accounts because they need a place to park their cash. In this case, it's reasonable to isolate the government's borrowing from "the public" and report this figure as our total public debt. But Treasury holdings that are more or less economically equivalent to investments by the public are a completely different animal.

So how much does the government reduce its reported debt by deducting Trust Fund borrowing? As of December 2012, the answer is $4.4 trillion.[2] That's 28% of the nation's annual economic output and about two-and-a-half times federal tax revenues. It allows the government to report a debt-to-GDP ratio of 74% instead of the more accurate figure of 102%. As you can see, this is a meaningful difference. And everyone should be aware that the government's debt projections - from both the White House (through the OMB) and Congress (through the CBO) - begin with the lower, bogus number. Which then gets repeated countless times in the media and creates the impression that our debt trajectory is much better than it actually is.

From baby boom to debt boom

But the figures alone don't tell the whole story. The large gap between reported debt and total borrowing isn't only convenient for politicians, it's also a gift of demographics. The unusually populous baby boomer generation (those born between 1946 and 1964) dominated the labor force over the past three decades or so. Which means the Trust Funds have enjoyed a favorable ratio between the number of people making contributions and the number receiving benefits. There were ample excess contributions for the government to borrow and apply to other purposes.

But the demographics are changing. Assuming a retirement age of 65, baby boomers began to leave the labor force in 2011 and will continue to do so until 2029. They'll increasingly take benefits instead of making contributions, and the Trust Funds will no longer produce excess cash for the government to spend. On the contrary, they'll force the government to raise capital to cover redemptions on the IOUs that they've accumulated.

The implication is that the borrowing that's been swept under the carpet will be gradually uncovered. Like losing trade tickets hidden away in a drawer by a rogue trader, Trust Fund borrowing can't be ignored forever. The new debt that the government will need to issue - to replace the amounts currently provided by the Trust Funds - will be classified as held by "the public." In other words, it'll finally count. It'll push reported fiscal deficits well above what they would have been if borrowing from the Trust Funds had never been excluded from reported totals. Call it payback. And as for the creative approach to reporting debt, call it chicanery.

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[1] It's not exactly the same since Treasury bonds and social insurance benefits pay out differently, but it's easy to invent a slightly more complicated fake world that's even more economically equivalent to the real world. Just imagine that people could invest in special Treasury securities with annuity and insurance features that mimic Social Security and Medicare payouts.

[2] This figure comes from the "Monthly Treasury Statement" for December 2012, published by the Treasury Department's Financial Management Service. The figure includes the federal government's borrowing from all government trust funds (Social Security and Medicare comprising nearly two-thirds of the total).

Source: The Debt Paradox That Everyone Should Be Aware Of