How is it that generally efficient markets can become irrational for years, setting up precipitous collapses? Asset bubbles are a fascinating manifestation of the human impulse toward concurrence-seeking leading to the suspension of reason.
Modern humans have been around 200,000 years, and for most of that time, “safety in numbers” was a matter of survival. As such, the wheels of Darwin tended to winnow out dissenters from the core group and genetically hard-wire consensus-building.
From the time children start school friendship and group acceptance is sought, and the instinct persists well into adulthood. Group rejection is mentally, emotionally and psychologically stressful, inherently so. The inability to find consensus around one’s own perspective can even produce behavioral pathology when normlessness and alienation lead to withdrawal from society’s broader values, morals and behavior.
The term “groupthink” was coined by Irving L. Janis in his 1972 book Victims of Groupthink: A Psychological Study of Foreign Policy Decisions and Fiascoes. Janis later described the symptoms of groupthink:
- Invulnerability – members exhibits unflappable certitude to the point of ignoring threats and risks.
- Rationale – members will stretch reason to debunk negative feedback and dissent.
- Morality – an almost religious faith in the righteousness of the group members and the cause.
- Stereotypes – those with different views are cast as nefariously motivated, ignorant or evil.
- Pressure – any sign of dissent by a member is quickly quelled by vigorous, forceful persuasion.
- Self-censorship – members withhold counter-arguments and concerns.
- Unanimity – a false perception of unanimity forms and is reinforced by the absence of dissent.
- Mindguards – certain members assume the roles of information flow gatekeepers to protect the leader and others from seeing or hearing anything that might disturb the group’s certitude.
Alternative courses of action are actively suppressed based not on the merits, but the desire to protect the consensus. Groupthink is an extreme manifestation of consensus-seeking. It can also convert an initial set of reasonable beliefs into extremes – e.g., when violence is used to silence someone with views considered objectionable by the group.
The same dynamic underlies asset bubble formation in markets. A compelling investment narrative morphs into irrationality, at least in terms of how it is being valued.
In 2000, legendary Fidelity portfolio manager George Vanderheiden, dispirited by two years of portfolio underperformance during a tech bubble he compared to the infamous tulip mania of the 17th century, retired at age 55. Vanderheiden’s non-consensus position had taken a toll, and an investing legend stepped aside in his prime. His funds were taken over by younger but already-proven Fidelity stars Bettina Doulton and Karen Firestone, who quickly reconfigured Vanderheiden’s two portfolios to participate in the so-called “new economy” tech narrative. The NASDAQ dropped 60% shortly thereafter and both left Fidelity by 2005 (and both went on to do just fine). All bubbles yield victims of dissent from the irrational consensus and participation in that same consensus.
There is a personal toll associated with dissent, but for Venderheiden, and financial markets generally, there can also be a financial price to pay if dissent does not pay off relatively fast.
Most forecasters extrapolate the recent trend. It is rare to find a strategist, analyst or investor arguing the trend will reverse imminently. Call it careerism. Variable compensation for mutual fund portfolio managers is largely driven by relative portfolio performance versus a benchmark. As such, there is substantial compensation and even job security risk when reducing exposure to one’s benchmark, regardless of how overvalued it might become. If the bubble expands, underperformance affects the bonus and job security.
In contrast, there is relatively less risk to staying invested along with one’s competitors. As long as the eventual correction, regardless of its magnitude, affects everyone more or less equally, the career risk is smaller. “No one saw this coming” is a common refrain in the wake of massive market drawdowns. But the losses themselves were certainly predictable, only the timing was elusive.
That is how bubbles are formed and persist. Reasonable narratives become irrational and last longer than tolerance for underperformance. As the irrational narrative persists without consequences, risk apathy and the bubble expand, along with the pain of the eventual reckoning.
Railroads, the Great Depression, biotech, tech, Japan, Russia, China – all bubbles beginning with compelling narratives that morphed into protracted irrational exuberance. All ended in tears. Are we in a credit bubble now? Is the US already bankrupt, but politicians and traders are subconsciously or willfully ignoring it owing to the psychological, emotional and financial inhibitions to dissent? Only a fool ignores clear danger because the crowd continues to shrug it off.
The US is already bankrupt
In addition to the widely cited $19.8 trillion in US federal debt, total unfunded obligations are over 10X this headline figure. Government data found deep in the appendices of reports published by Trustees of Social Security and Medicare indicate the net present value ("NPV") of actual unfunded US obligations just related to these programs less dedicated revenues, is $87.7 trillion. That brings current debt to $112 trillion (see table below). But under the government accounting system, known deficits are not recorded as “debt” until the respective years they are incurred – dramatically understating the country’s current actual debt levels. When all government net cash flows are included, US debt is estimated to exceed $200 trillion. The US is currently bankrupt. The levers for redress are already painful but become more Draconian with delay. Capital markets and wealth preservers should take heed of this staggering component of systematic risk.
In addition to future net costs of Social Security and Medicare, critical budget line items like Defense, Medicaid, CHIP, and the Affordable Care Act subsidies, never mind the need for massive infrastructure spending, net of all revenue sources, add up to deficits in perpetuity. The present value of those deficits – the infinite horizon fiscal gap – is the only relevant metric for making policy decisions. Reporting based on this unassailable approach has gained little traction among financial journalists, politicians or capital markets, despite common sense and endorsement by a diverse group of 19 Nobel laureates in economics. Instead, labels like “transfers” are used to hide what really is, by any economic and mathematical definition, debt. The estimated "$200 to $205 trillion" in current debt, so calculated by economist Larry Kotlikoff, is not in dispute by anyone serious. Kotlikoff was once described by Paul Krugman as “… a fine economist, one of the world’s leading experts on long-run fiscal issues.” Debt of $205 trillion is roughly 9% of the net present value of GDP into the infinite horizon.
US Debt on Largest Programs Only
- $19.8 trillion of outstanding debt (0.9% of GDP over infinite time horizon $2,294.4 trillion)
- $8.5 trillion in balance sheet obligations (mostly Federal employee pensions; 0.4% of GDP)
- $32.1 trillion in Social Security obligations less projected revenues and other transfers (1.4% of GDP)
- $55.6 trillion Medicare participant costs above projected payroll taxes, benefit taxes, premium payments, and assets of the Medicare trust fund (2.4% of GDP)
- Less approximately $4.5 trillion in value of Federal assets
- $111.5 trillion (4.9% of $2,274 trillion present value of GDP over infinite time horizon)
Deficits and Debt Using Arbitrary Government Accounting
The CBO’s 2015 Alternative Fiscal Scenario (“AFS”) – by CBO’s own reckoning a more realistic forecast than the EBL fantasy routinely cited by politicians and financial media – projected deficit spending to reach 15% of GDP by 2040 compared to 2.9% in 2016. The AFS projections eschew the mindless use of current-law prescriptions driving the EBL forecast, implementation of which have and will continue to be waived. It incorporates estimates of economic feedback from higher deficits, higher payroll taxes, lower spending on R&D, infrastructure and education, and does not include the ruinous Medicare reimbursement cuts and other improbable healthcare cost reductions. But even the AFS reporting concession to reality, buried deep in CBO report, fails to account for the fact that hard financial obligations, like Social Security and Medicare, are known today, and are indistinguishable from debt.
Alas, the CBO’s wholly inadequate faint toward basic economic fundamentals and transparency by way of the AFS presentation was too much for the fiscally feckless profligates controlling the US purse in Congress, as it was abandoned after 2015.
Deficits have historically averaged 3% of GDP and not exceeded 9.8% (except during the two world wars), observed briefly in the aftermath of the financial crisis. A deficit equal to 15% of 2016 GDP would be $2.5 trillion, compared to the pedestrian 3.2% actually observed in 2016. An annual deficit of that magnitude increases debt by the value of total GDP every 5 years.
The CBO pegged net public debt as a percentage of GDP (“DGDP”) at 175% by 2040 under the AFS, compared to 77% currently. DGDP averaged just under 40% for the last 50 years, but rarely exceeded 20% prior to WWI. It peaked at just over 110% after WWII and then steadily declined to below 30%, where it remained until the Reagan administration opted to rebuild the US military. Rising defense spending coupled with increasing entitlement costs pushed DGDP from 25% to 40% during Reagan’s presidency. The ratio reached 48% in 1993 before welfare reform and the “peace dividend” from lower defense budgets following the collapse of the Soviet Union ushered in a new era of federal thrift. DGDP fell to 31% by 2001. The Financial Crisis prompted unprecedented government fiscal intervention, pushing DGDP to current levels. Research suggests GDP growth slows meaningfully once sovereign debt to GDP ratios reach 90%.
US Net Public Debt as a Percentage of GDP
Source: Congressional Budget Office
The Trustees’ estimated aggregate unfunded liability for Medicare (Hospital Insurance, Part B and Part D) into the infinite horizon has risen from $42.9 trillion as of 2013 to $55.6 trillion in the 2016 report.
Lest anyone feel comforted by shrinkage in the deficit’s size in recent years owing to sequestration, thought to be so dire that it would force a compromise before coming to pass, here’s what the CBO said about its long-term outlook in the last two reports:
The CBO’s The 2016 Long-Term Budget Outlook states (bold emphasis is ours):
The previous edition of this volume, The 2015 Long-Term Budget Outlook, was published in June 2015 and showed projections through 2040. CBO now projects debt in 2040 that, measured as a share of GDP, is 15 percentage points higher than it projected last year, mostly because of changes in tax law.
In the March 2017 update, the CBO states:
CBO now projects debt in 2046 that, measured as a share of GDP, is 5 percentage points higher than it projected last year.
These are not trivial changes on top of a $41 trillion debt increase already projected in the earlier forecast.
Interest Rate Normalization
If interest rates today were at historically normal levels – roughly 3 points higher – interest expense would be $1.2 trillion, $750 billion/year higher (see chart below). The entire discretionary spending budget proposed for 2018 is $1.2 trillion. Using the last AFS projection in conjunction with more recent CBO GDP projections, we can estimate current debt of $19.8 trillion – excluding off-balance sheet debt of over $180 trillion, of course – will reach $115 trillion by 2046! Interest payments represented around 2.5% of GDP in 2016 but will account for 12% of GDP by 2046 if rates move back to the historical median.
What Would US Government Interest Expense be Today Under Historical Median Rates?
Outlays, Revenues, Deficits and Debt as a Percentage of GDP 2016 - 2046
The retirement of 78 million baby boomers born between 1946 and 1964 began in 2011. The present value of lifetime Social Security and Medicare benefits for individual 2015 retirees is estimated to exceed taxes they paid into the programs (all cash flows discounted at 2%/year, real) by a median ratio of 160%, depending on wages and participant demographics. This structural imbalance was less worrisome when the ratios of workers to beneficiaries for the programs were much higher.
In 1945, 41.9 workers were paying Social Security taxes for every 1 beneficiary, and the ratio was still 4.0 in 1965.
For Medicare, the ratio was 4.0 from 1980 to 2008.
In addition to the large baby boomer population, increasing life expectancy and declining fertility rates continue to push this ratio lower into the 2080s. The present values of remaining-life benefits per retiree in these programs are projected to rise roughly 50% each by 2030, and the net-present-value of outlays less revenues dedicated to the programs, into the infinite time horizon are $32.1 trillion for Social Security (1.4% of GDP NPV) and $55.6 trillion for Medicare (2.4% of GDP NPV.)
Net-Present-Value of All Outlays Less All Revenues - $205 trillion
All the government projections discussed to this point represent a fractional subset of the known obligations. The known shortfalls are only recorded as actual obligations on the government’s balance sheet in the years the unfunded obligations actually manifest as deficits. Known are the population, ages, mortality rates, benefits guaranteed by Social Security and Medicare, the current costs of all federal programs and the revenue sources under existing programs and tax law. Assumptions must be made on interest rates, appropriate discounts rates on future cash flows, GDP growth and labor force participation rates. These inputs tell us today what the deficits are going to be in perpetuity under existing law, and are easily recalculated under alternate policies.
The infinite horizon fiscal gap (“IHFG”) has been estimated to be $205 trillion, 9% of the NPV of US GDP into the infinite time horizon. That figure represents the actual debt outstanding of the US today. According to Kotlikoff, the US is in the worst shape of any developed country on this basis. The worst countries in the EU are Slovakia at 6.8%, Malta at 4.6%, the Netherlands at 4.5% and Romania at 4.4%. Recent EU problem-countries, Italy -0.9% (a surplus), Portugal 0.7% and Greece -0.8%, are in far better long-term fiscal shape than the US. Of course, we cannot say to methodology used for the EU countries matches that of the US. Luxembourg went from 9.7% to 4.2% between the 2012 and 2015 EU reports. The biggest problem for Luxembourg is a long-term spike in the pension and healthcare costs of an aging population. There were no major policy actions taken to explain an improvement of this magnitude, raising methodology questions.
Bringing a perpetual 9% IHFG into balance would require an immediate and permanent 50% increase in all taxes ($3.3 trillion in 2016), including individual income, payroll and corporate income taxes, an immediate and permanent 40% cut to federal spending ($3.9 trillion in 2016) or a new tax (e.g., wealth or consumption). Measures would actually have to be more severe, as these figures do not account for significant GDP feedback effects.
Potential to Increase Revenues – Burden Has to be Shared by Lower Earners
The Social Security tax is 12.4% on the first $127,000 of income (adjusted by average wage increases), with employers paying half. The Medicare tax is 2.9% on all income, half paid by employers, and an additional 0.9% for individuals on earnings or investment income above $200,000.
What if Social Security taxes were applied to 100% of income, rather than just the first $127,000? Ignoring the negative feedback effects on GDP attending higher marginal taxes (actual reduced hours worked, capital flight, reduced capital investment plus delayed and otherwise reduced income recognition), the static math on this action implies $190 billion in additional revenues (see table below), almost all from the top 10% of earners. Corporate matching of this additional taxation is unlikely as it would increase the tax burden on US corporations by over 60%.
US Outlays and Revenues 2016
What about increasing taxes on wealthier Americans and corporations? The top-1% of US earners (earnings above $465,626 in 2014 – see table below) accounted for $1.997 trillion or 21% of total gross income in 2014 (latest data) and $543 billion or 39% of total taxes. For reference, the earnings threshold for inclusion in top-10% of earners in 2014 was over $133,000 and top-5% was under $189,000. US corporations, under the highest tax rates in the OECD (worse when state and local taxes included), paid $321 billion in taxes ($300 billion in 2016) and accounted for almost 11% of total revenues in 2014 (not counting the individual taxes paid by their employees, of course).
Concentration of Income and Taxes (2014)
If twice as much revenue had been extracted from corporations and the one-percenters in 2016, roughly $880 billion of additional revenue is theoretically raised before accounting for the substantial declines in GDP that would accompany such a massive tax hike.
In summary, the total additional revenue, measured on a static-GDP and earnings basis, from expanding individual Social Security taxes to 100% of income for individuals and doubling taxes on the top-1% of earners and corporations, would reduce the $1.7 trillion per year objective by $1.07 trillion, still leaving almost $700 billion of deficit reduction needed per year, before accounting for lower GDP. The point of these static hypotheticals is to demonstrate the necessity of entitlement reform and higher taxation of lower income earners as part of any solution. The research on the economic feedback (GDP reduction in this case) associated with significant tax increases is copious. Net revenue generation from significant tax increases would be much smaller than these static calculations suggest.
Sales taxes similar to value-added-tax (“VAT”) in Europe are thought to be regressive, but consumption patterns closely track income, albeit with some meaningful variation in what is consumed. Consumption taxes also tend to discourage consumption in favor of savings/investment, a tradeoff between demand-side and supply-side theories of economics, respectively, and certainly a shift toward longer-term value creation over nearer-term gratification. It is a popular myth that consumption is the primary driver of economic activity rather than investment. But make no mistake, a meaningful consumption tax will have negative economic feedback effects as well.
Arguments Against the Need for Action
“A lot can change in the future.” The trajectory of crippling deficits even in the context of a significant degree of variability in actual outcomes is known, and budget surprises are rarely to the upside.
AFS projections “only occur if the cuts under current law are not implemented.” The CBO and Medicare Trustees consider certain cost cuts called for under current law unlikely to be achieved because either they require improbable, unidentified technological breakthroughs to significantly reduce costs of healthcare delivery, or they involve arbitrary price controls like the 24.7% Medicare reimbursement cut (“delayed” every year by Congress) that would result in doctors losing money on Medicare patients and thus withdrawing from the program in large numbers.
“The Social Security Trust Fund is a major mitigating factor” No, it is not. The “Fund” has already been spent making it just another government obligation – and a major contributor to the core problem.
“Japan has managed to get by with 200% debt to GDP, why can’t the US?” Japan has staved off financial crisis largely because almost all of its debt is held by Japanese institutions and private citizens willing to purchase and hold sovereign debt at near-zero real yields for a generation. Roughly half of publicly held US debt is in foreign hands, 10% each by China and Japan (around $1.1 trillion each). Relative to the US, Japan has meaningfully more consumption taxation, a better handle on its pension and healthcare costs, and is much further along in its demographic problem (26% of population over 65 compared to less than 14% in US). Moreover, Japan’s economy has experienced secular deflation and grown at below 2% for 30 years.
Finally, some, including Paul Krugman, have argued NPV of future unfunded liabilities into the infinite time horizon is a “misleadingly big number” meant to scare impressionable policymakers into cutting entitlement benefits. In the context of the much bigger NPV of future GDP into the infinite time horizon, numbers are far less scary, goes this particular bromide. The numbers were presented here in that context, and anyone thinking the permanent spending cuts and tax increases necessary to yield 9% of GDP is not a crisis has not done the simple math.
The self-perpetuating cycle of accelerating entitlement spending, interest expense and debt produces increasingly massive amounts of unproductive capital allocation in the economy, further undermining already-anemic economic growth and, eventually, pushing inflation higher as well as the interest rates necessary to attract and retain buyers of US debt. The longer remedial action is delayed, the more painful the necessary policy changes will be. Policy options include default, massive tax increases including implementation of a wealth tax or a consumption tax, similarly painful spending cuts or much higher inflation to devalue legacy debt. The last will have limited value as entitlements rise with cost of living. Income tax increases on the wealthiest earners, alone, cannot begin to fix the problem.
If painful policy changes are made sooner, affected seniors have more years to prepare for unavoidably-smaller benefits by altering savings and consumption patterns or delaying retirement. Delay means fewer options and less lead-time to deal with likely steeper benefit cuts.
Approximately 95%-99% of the working population not effectively self-insured through existing or ongoing wealth accumulation will be most affected by the austerity to come. Annual deficits are scheduled for a precipitous spike by the mid-2020s and, absent revenue-generation and spending changes, there is no relief thereafter barring a dramatic and entirely unlikely shift in demographic trends or productivity.
No meaningful remedial action is under consideration in Congress. A bi-partisan bill introduced in 2013 (the Intergenerational Financial Obligations Reform Act or INFORM Act, S.1351 & H.R. 2967) simply requiring generational accounting to at least improve the transparency of the true fiscal trajectory, from which better-informed policy might be implemented, died in the Senate Budget Committee.
So, why aren’t markets treating sovereign debt of countries with significant IFHGs like the bonds of insolvent companies? Deficit spending has been accepted by markets for some time, without significant penalty in the cost of capital, begetting more deficit spending. Moreover, the neo-Keynesian “multiplier effect” has been dogmatically sold by progressive ideologues in both parties, including arguments historically higher deficits were inadequate! Keynes argued for deficit spending to jump start a stagnant economy and paying down the extra debt incurred once the economy actually recovered.
Massive market corrections always follow bubbles, but irrational exuberance can stubbornly persist. Seemingly modest catalysts invariably burst the bubble. The relative calm accompanying decades of deficit spending is being extrapolated while the mathematical certainty of a painful reckoning is ignored. Avoiding full downside participation in predictable, major market drawdowns can add more to long-term returns than full participation in the ups and downs with a static buy-and-hold approach.
 “The Financial Report of the US Government for Fiscal Year 2016,” Department of the Treasury, p. 58.
 “The 2016 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Fund,” p. 202.
 “2016 Annual Report of the Board of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds,” pp. 217, 219, 221.
 International Monetary Fund, World Economic Outlook Database, October 2016 (difference between gross and net US debt).
 “The Financial Report of the US Government for Fiscal Year 2015,” Department of the Treasury, p. 81.
 C. Eugene Steuerle and Caleb Quakenbush, Urban Institute, “Social Security and Medicare Taxes and Benefits over a Lifetime – 2015 Update.”
 “The 2016 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Fund,” p 63 and “2016 Annual Report of the Board of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds,” p 67.
 Steuerle and Quakenbush, op. cit.
 Fed. Old-Age and Survivors Insurance and Fed. Disability Insurance Trust Fund,” op. cit. p 192.
 Fed. Hospital Insur. and Fed. Supplement. Med. Insur. Trust Funds,” op. cit. pp. 232, 234, 236.
 Glenn Springstead and Andrew G. Biggs, “Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income,” Social Security Bulletin, 68, no. 2 (2008).
 Jeffrey Liebman and Emmanuel Saez, “Earnings Responses to Increases in Payroll Taxes” (working paper, University of California–Berkeley, 2006).
 Karel Martens, Marginal Tax Rates and Income: New Time Series Evidence,” Cornell University, NBER, CEPR, August, 2013.
 Eric J. Bartelsman and Roel M. W. J. Beetsma, “Why Pay More? Corporate Tax Avoidance Through Transfer Pricing in OECD Countries,” Journal of Public Economics, Vol. 87, 2003.
Disclosure: I/we 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.