Last week I wrote that total US debt was approximately $53 trillion, excluding the government’s unfunded liabilities like Social Security and Medicare. Let’s take a look at Social Security and Medicare and their imminent impact on the government’s deficit.

The Federal Budget is an entirely fictitious and unimportant concept: it can be in surplus or deficit depending on how it is defined and on political objectives. But the government cannot hide its actual deficit, which is called the fiscal deficit. If the government’s expenditures exceed its tax receipts it must borrow an amount equal to the shortfall. We can find out what that shortfall is by looking at the Balance of Payments (BOP) accounts published by the Bureau of Economic Analysis: for 2007 the preliminary BOP deficit is $739 billion.

Social Security and Medicare payroll taxes are included in the general tax receipts of the government and until last year these entitlement programs collected more in taxes than they paid out in benefits. This year is the first year in which Baby Boomers who chose early retirement at age 62 become eligible for Social Security and in three years the first wave of Baby Boomers will be eligible for Medicare. But this year the Hospital Insurance Fund, which is part of Medicare, is projected to fall short by $8 billion for the first time, adding to the government’s deficit instead of financing its expenditures. This is before Baby Boomers are even eligible for Medicare. Social Security is expected to be in the red in less than ten years.

When Social Security was first conceived, the idea was that payroll taxes would be paid into a trust fund that would invest the money and pay out benefits at a later date. The accumulation of assets in the trust fund, and the investment income on those assets, would allow Social Security to be self-financing. But in 1968 President Lyndon Johnson “unified” the federal budget by including Social Security taxes with other tax receipts.

Social Security Funds’ (there are two funds) assets were used to pay for the government’s expenditures and their assets were replaced with non-marketable special issues of government debt. These special issues of debt are not included in the government’s debt (even the government engages in exotic off-balance sheet antics) and because there are no other assets left in the funds other than these special obligations of the Federal Government, all Social Security and Medicare obligations are now part of the general obligations of the Federal Government. When entitlement payments start exceeding tax receipts for the respective programs it will increase the deficit instead of reducing it, as has been the case until now.

The government can default on Social Security and Medicare, but that would not be politically convenient. It is more likely that they will continue to erode the real (inflation adjusted) value of Social Security payments by understating price inflation and ignoring monetary inflation.

The government will have to pay Social Security and Medicare and the impact that these payments are going to have on the fiscal deficit ten years from now is enormous. The more people retire, the less the government will collect in tax receipts and the more it will have to pay out simultaneously.

Expecting the government’s deficit to explode when the Baby Boomers start retiring, President Bush signed a law in 1990 prohibiting the President or Congress from including Social Security trust funds in the Federal Budget. But President Clinton reversed that law three years later and effectively used Social Security receipts to help “balance the budget”.

Social Security costs are currently substantially higher than Medicare costs but Medicare costs are increasing faster than Social Security, and are expected to exceed Social Security payments in less than 15 years. There is much debate about all this, especially the fact that Medicare costs are rising at a faster rate than the economy is growing, faster than payroll taxes and faster than the Consumer Price Index.

The blame for this was assigned to pharmaceutical companies, hospitals and health care organizations for gouging consumers. It has also been suggested that the increase in demand for medicines and medical care has put upward pressure on prices. Medicare costs are rising to keep pace with inflation, if we understand that inflation is measured by the increase in the money supply, which is currently increasing at an annual rate of over 17%.

So the sad fact is that Medicare costs are not out of control; rather, Social Security payments are grossly lagging monetary inflation. The government can control Social Security payments by manipulating the Consumer Price Index, which they overtly do, but they cannot control Medicare costs. It is not medical costs that are out of control; inflation is out of control.

The government will deal with this problem by creating more inflation to meet its CPI linked obligations with dollars that will be worth less when the payments are made. As long as people believe the CPI numbers, Social Security costs can then be contained in real terms. Expect massive inflation of the dollar that will reduce the value of dollars in order to mitigate the real impact of Social Security payments. A side advantage of this is that by inflating and devaluing the dollar the government also reduces the real value of the national debt.

The implication for us is that prices will continue to rise much faster than the Consumer Price Index, the dollar will continue to be under pressure on foreign exchange markets (barring short rallies) and eventually medium to long-term interest rates are going to soar. In order to have a positive real rate of return on debt we would need to see interest rates of almost 20%. It happened in the 1970s when monetary inflation was less than it is today.

But inflation will not contain Medicare. In order to help with those payments the government will increase tax rates. Expect payroll taxes, which fund Social Security and Medicare, to increase. And then there will be numerous new ways to tax the “rich”: any household with an income of over $100,000. According to the most recent Census data median household income in 2006 was $48,201 and only 19.1% of households had income of over $100,000. That means the “rich”, with household income of more than $100,000 are going to be aggressively targeted to help fund the government’s already large, and growing, fiscal deficit.

David Walker, the former Comptroller General of the Government Accountability Office is so concerned about Social Security and Medicare that he began touring across the country to give seminars about the dire condition of the government’s finances: http://www.youtube.com/watch?v=D6Q14HOBThM.

According to Mr. Walker, Americans’ living standards are unsustainable and the impending explosion of Social Security and Medicare costs is the most serious threat to America – forget terrorism, he says. Beginning this year, and for the next twenty years, approximately 78 million Americans will start retiring and become eligible for Social Security and, by 2011, for Medicare. Social Security and Medicare payments already account for more than 40% of the government’s expenditures, twice as much as the second biggest line item, military spending. Both Henry Paulson, the Secretary of the Treasury and Ben Bernanke, the Federal Reserve Chairman, echo David Walker’s concerns.

Keep in mind that David Walker is the man tasked with auditing the government’s books. In his opinion government accounting procedures and controls are so lacking that it is impossible for his office to conduct the required audit of the government’s affairs, and he became so frustrated with the lack of response to the looming Social Security and Medicare crisis that he quit his job.

If the auditor of any large public company came out and announced that the company’s books were so inadequate that he could not perform an audit, that the company’s response to his concerns was to ignore him, and that he therefore could no longer act as auditor for this company, the company’s stock would enter free-fall and any outstanding debt would immediately be called. The company would be bankrupt in a day.