# Inflation Is Not A Risk, It Is A Necessity

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by: Michael Blair

The United States economy seems stuck in first gear. There are some fundamental reasons why, and demographic trends comprise the most important of them.

It is useful to look back a few years. In 2000, the U.S. population was 281 million of whom about 75 million were either under fourteen or over 65 and the balance was 216 million. While it is not a perfect measure, I want to call this latter group the "working age" group, those between 15 and 65.

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I think it is rudimentary to assume that children under the age of 5 need adult supervision at all times. I will go further and make the simplifying assumption that at least one adult is needed to care for each two children under the age of five, and is otherwise not really available to be a member of the workforce. These are pretty crude definitions but they are useful for my purpose, which is to create a reference point. In 2010, in my view of the world, there were 206 million people in a position to be a member of the "core" working population. Taxes on those people as a group are needed to fund government. The amount of funding a government needs is highly correlated with retirement pensions, healthcare and education costs. Of course, there are other costs government incurs but with the exception of payments on the national debt, I want to ignore them for now. Again, the intent is simplicity.

In 2010, the 75 million people not in the "core" working group are the primary targets of government spending on pensions, healthcare and education. Call them the "recipient" group. Divide the "core" working group by the 75 million figure and you get a figure of about 2.75 people in the "core" group for everyone in the "recipient" group.

So what?

Let's just do the same arithmetic for 2010, a decade later. Now the population has grown to 309 million, with 81 million in the "recipient" group supported by a "core" group, which has grown to 218 million (309 less 81 less half of 20 million under 5). Now you get a figure of 2.69 people in the "core" group for everyone in the "recipient" group. Not really that big of a deal.

Suppose for the sake of argument that on average everyone in the "recipient" group required government support in one form or another totaling \$12,000 a year and that support was funded by current taxes.

 2000 2010 Number in "recipient" group 75 million 81 million Actual cost of entitlements \$2.1 trillion \$2.8 trillion Cost per "recipient" \$27,635 \$34,028 Number of people in "core" group 206 million 218 million Tax needed per member of "core" group \$10,061 \$12,646
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The definition of the "recipient" and "core" groups is somewhat arbitrary. A cross check on how well correlated it is to the reported entitlement cost per person, which in 2010 was \$31,950 according to a report by the Heritage Foundation. The demographic definition I have used is therefore not grossly wrong and is useful for my purpose and shows the entitlement cost per "recipient" growing just over 25% in a decade. While this change is not dramatic, it shows the effect of demographic changes on the needs of society in a simplistic model and how those demographic changes can affect national accounts.

Major demographic changes are ahead, however, and that may paint a more challenging picture. Between 2010 and 2030, there will be a sharp increase in the number of people over 65 reaching an estimated 73 million and continuing to grow through 2050.

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The table below sets out the hard data using the United States Census Bureau middle series. Click to enlarge

By 2030, the population will have grown to 370 million; 73 million will be over 65; and, 23 million under 5 years old. The "core" group in 2030 should be about 263 million (370 less 73 over 65, less 23 million under 5 and less 11 million looking after the under 5-year-olds). The "recipient" group has now swelled to 136 million (73 million over 65 and 63 million under 14). Moreover, the cost of entitlements has swelled to \$30,000 per recipient.

 2010 2030 Number in "recipient" group 81 million 136 million Cost of entitlements \$2.8 trillion \$4.6 trillion Number of people in "core" group 218 million 263 million Tax needed per member of "core" group \$12,646 \$17,596 Tax needed per employed person (see below) \$21,202 \$29,476
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In this simplistic model of the United States economy, the implications are clear and problematic. First, in this model taxes have to rise by about 40% in constant dollars to provide the same level of support to the "recipient" group by the end of the twenty-year period.

No one reading this should draw any conclusion from the definitions of the "core" and "recipient" groups except that they tend to capture the groups from whom taxes are collected and to whom transfer payments (entitlements like social security, Medicaid and so on) are paid. Moreover, it is unlikely that current entitlements can be held at roughly \$34,000 per person in 2010 dollars.

What you should conclude, because it is inescapable, is that the cost of entitlements held to today's level in constant dollars could rise as much as 65% over the next 20 years solely as a result of the aging population. Despite population growth, the amount that will have to be funded by taxes or borrowing will be something like 40% higher for every person in the "core" group. Since the United States does not have full employment of every person in the "core" group nor is such a goal even possible given the need to care for pre-school children, the cost per taxpayer will be higher. It is useful to roughly estimate how much higher.

In 2013, there are about 135 million people employed in the United States, up from about 130 million in 2010. I am going to assume all are taxpayers. The 2010 entitlement cost amounts to \$21,202 per employed person.

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In 2030, the "core" group will have grown to 263 million. If the same ratio of employed persons to the total group is maintained, there will be 157 million people employed in 2030 and the entitlement cost per person employed will rise to \$29,476.

If the entitlements were all funded by taxes, every taxpayer would have to ante up a bit more than \$21,000 to pay for the 2010 entitlements, an amount which would rise to something like \$29,500 by 2030 (in constant 2010 dollars). The average household income in the United States today is \$53,046. Since there are 115 million households, you can infer that average income per employed person is \$45,187 (115/135 x \$53,046).

Taxing \$45,000 annual income to pay for \$21,000 in entitlements (as of 2010) requires an average 47% income tax rate. Assuming incomes grow in real terms by 3% a year through 2030 the average income in 2030 will be about \$49,300. A tax rate of 60% would be needed in that year to fund entitlements.

Entitlements in constant dollars are unlikely to cut it in any event. With the shifting age mix in the population will come a much higher number of people in their 80s and 90s. The cost of caring for this group will grow in real terms. Canadian data are that 18% of one's lifetime health costs are incurred in the last year of life.

Older people require more care. It is really that simple.

If you think the current budget wrangling in Washington is acrimonious and unproductive just wait a while. Today's issues will look like a cakewalk in ten or twenty years.

Of course taxpayers have more than entitlements to pay for. Entitlements comprise the bulk of so-called mandatory spending which made up just 55% of government spending in 2010.

Interest on the national debt is a looming problem. While this outlay represented only 6% of government spending in 2010, it is growing very rapidly. Left unchecked, the Congressional Budget Office projections suggest interest on the public debt could consume all government spending within 40 years.

In this context, the stand off between Republicans and Democrats in Washington is easier to understand. Neither side can see a solution. Both need public support. It is almost a rule of debate - if you have nothing positive to add, criticize the other side's point of view. There is a lot of that going on. On the one hand, higher taxes will lead to slower growth and the Republicans understand that slower growth cannot be the answer. The Democrats understand that entitlements are a social necessity in a world where income inequality is becoming increasingly an issue, and they can see that higher taxes are needed to fund those entitlements. This is a Mexican stand off.

The solution to the dilemma lies in the markets. It is not possible to tax a way out nor is it realistic to expect to borrow a way out. Entitlements are vital social programs that are difficult to retract. The answer is inflation - hopefully controlled inflation. By implementing policies that create inflation governments achieve key goals. The cost of entitlements declines in real terms. The debt declines in real terms and becomes a lower burden on nominal GDP.

There are consequences. Savers are decimated as the value of their savings is eroded. Prices for hard assets like real estate and resources rise in nominal terms. Eventually, everything comes back into balance and as it does the demographic bulge of people my age die out and the age distribution curve is restored to a more productive ratio of "core" to "recipient" groups. The process takes decades, is hard to control and is fraught with risk.

For investors, the issue is important. Markets will have periods of very high volatility. If you rely on government for your retirement and post retirement healthcare, you might be disappointed. Plan your investments around the prospect of living longer and with limited support from Uncle Sam. Make sure your portfolio has a reasonable weighting of hard asset based equities. Avoid longer-term bonds. Keep a reasonable cash reserve to be able to benefit from severe market drops. And keep your head.

Best of luck in 2014 and beyond.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.