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The Social Security System went into red ink mode this year. I predicted last January that this would happen. My video is here.

More money is now flowing out of the Social Security Administration to recipients than is flowing in through FICA taxes and interest payments to the SSA Trust Fund from the U.S. Treasury’s general fund.

The old deception is no longer working: counting FICA revenues as income for the on-budget Federal budget, while not counting the IOUs issued by the Federal government to the SSA Trust Fund as a liability. Today, there is not even the traditional phony surplus.

I went public with this story in 1977, when Jimmy Carter hiked FICA taxes, promising that this would defer the crisis until the turn of the century. It deferred it six years. The crisis was deferred again in 1983, when the SSA technically went bankrupt, and the government changed the law again. Another day of reckoning is here again. We can expect another change in plans.

But what will be the government’s strategy? It can raise the retirement age again, but that is politically risky. Will Congress go along with the Obama Administration, should Obama make this a legislative priority? If the new congress is Republican, or even just the House, I doubt that Obama would risk this. He wants to be re-elected in 2012. The House will have the votes to block this, and Republicans would pillory Obama if he tries to ram through such a disguised default. I doubt that he would propose such a thing under any conditions.

Another strategy: extend the salary base on which FICA taxes are due, which caps out today at about $107,000. Most Democrats would vote for this. I doubt that many Republicans would. Again, it’s politically risky for Obama. It would be perceived as a tax hike, and the voters seem reluctant to accept more taxes. In any case, to muster the votes, Obama would have to admit that the system is in trouble. The Republicans could counter with this:

Yes, the Social Security System is in trouble. That’s because there are so many Americans out of work. Obama forced through an $800 billion stimulus deficit in 2009. Republicans voted against this, but we did not have the votes to block it. We said that the stimulus would not work, and we were correct. We warn you: this is not the time to hike taxes. That will increase unemployment even more.

All this is true. The fact that Congress voted for Hank Paulson’s $780 billion bailout of the financial industry two years ago will be conveniently allowed to remain in the bipartisan Congressional memory hole.

What can the government do? It cannot easily raise FICA income. It cannot cut expenses by raising the date of eligibility for partial benefits (age 62) or full benefits (age 67, maximum). It can borrow from the general fund. That is what it is presently doing. There is no indication that this will cease until interest rates climb substantially.

This gives the government time. It must come up with a politically acceptable way to defer the bankruptcy of Social Security.

It also does count the liabilities of the states. The estimate here is $4.4 trillion, with assets of under $2 trillion. That’s a shortfall of about $2.5 trillion.

If these assets are in part U.S. government debt, the problem gets even worse, faster.

Then there are municipal government pension liabilities: cities and counties.

None of this solves the Medicare problem, which is five times worse than Social Security in terms of the unfunded future liabilities, and is less subject to accounting tricks. The boomers are eligible at age 65. They begin to hit the Medicare rolls next year. Their numbers will increase annually for the next 12 years thereafter. Their generation was born from 1946 to 1958.

PRIVATE PENSIONS: THE PIGGY BANK

There are approximately $5.5 trillion in private pension fund accounts in the United States.

These assets constitute the largest potential piggy bank for the government to tap into, either year by year or in one overnight raid.

If the government taps into this capital on a piecemeal basis, there is a real possibility that half of investors in tax-deferred retirement programs will stop making any further investments in these funds. The percentage might be larger.

What would be the justification for such a raid on the national piggy bank? The need to safeguard the future of retired Americans. What is needed, the President could tell us, is a government guarantee. Your retirement is safe from the ups and downs of the private capital markets. So, the government is going to issue guaranteed retirement bonds that will pay a guaranteed interest rate. What rate? Whatever the 30-year bond rate is.

The 30-year bond rate is at an historically low level. It can be kept at this rate for as long as the Federal Reserve System buys the bonds.

Is this politically feasible today? I don’t think so. The hostility to major government programs is high. It is likely that the Democrats will lose their majority in the House of Representatives in the November election. Unless the President and a lame-duck Congress were to ram through a confiscation/swap before January 2011, there will be no confiscation. The next two years will be marked by gridlock. I don’t think Obama would have the votes.

If this is the case, could it be done by the President in an emergency decree in an executive order? Yes, but this decree would face the possibility of a Congressional override within 15 days. I think there would be an override.

What about the economics of such a declaration? What good would it do the government to confiscate the pension money?

That would depend on the reaction by investors. If investors decide that the government will not sell the stocks and bonds immediately, they might buy more. After all, the assets are in “strong hands.” The new owner is a “buy and hold” investor.

On the other hand, investors might conclude that this confiscation is an act of a President in panic mode. The government needs the money. Therefore, it will sell the assets. This could cause a crash: a rush for liquidity, as investors get out while the getting is good. This would keep getting out from being good.

Here were see the dilemma of the President — any President. The stocks and bonds are not money. To get access to money, the government must sell the assets. That would create a financial panic.

The government would face this problem: “Sell!” “To whom?”

That is the short-run problem with any open confiscation of pension fund assets. The government still would face the huge obligations of Social Security and Medicare. My guess is that most investors who have been saving money in the IRAs and 401(k) programs would cease to add to them. Why would they? The funds are in the hands of the government.

At that point, the government would face the end of the Ponzi scheme for the confiscated funds.

My assessment of the problem is that the government will not confiscate the funds for the sake of getting their hands on money for Social Security. But there is another motivation.

THE NEW OWNER

If the government confiscates pension fund assets, it becomes the owner of American capitalism. Common stocks have voting rights. The government would overnight become the legal owner of the American economy. It would have controlling interest on the boards.

The government officially says that it wants American free enterprise . . . except for the mortgage market, of course, which is America’s largest single capital market. The government insisted that it did not want control over Chrysler and General Motors. Then the government pressured the president of GM to retire. If that is not ownership, what is?

The Federal government is in a legal position to buy controlling interest in American industry. It has already shown a willingness to do this. Paulson nationalized the mortgage industry without consulting Congress. Congress rolled over. It passed a $786 billion bailout within a month. “Nice doggy. Good doggy.”

All it will take is another crash to create the motivation for a raid on the piggy bank. I don’t think the Administration will risk this otherwise.

The fact that Americans are happy with the nationalization of the mortgage market indicates that there is no strong opposition to the idea of socialism. Paulson did not use the word “nationalization.” If the Administration calls it something else, voters will accept it. But they have to be persuaded that the alternative is a fall in their net worth. If it is perceived as confiscation of their retirement funds, they will rebel.

The retirement portfolios fill the biggest piggy bank on earth. These funds are very tempting for political leaders. The U.S. government and all the other levels of governments have enormous pension fund obligations that they cannot possibly meet without the Federal Reserve buying the debts of these governments, or else a Federal agency that passes the money through to state and local governments.

There will have to be mass inflation to pay off these obligations: default by price inflation. This will be possible only if the government also imposes price and wage controls. Otherwise, inflation by the FED will hike wages and prices, which will then activate the pension programs’ COLAs: cost-of-living adjustments. That would cause massive shortages.

Why would the government raid the assets? To re-liquefy the declining capital stock markets — to prevent panic. It could create a GSE like Fannie or Freddie, but for pension fund assets. Then it could sell the assets to the Federal Reserve. Would the FED buy these bonds? Probably, at least up until the time that price inflation rises above 20% per annum.

The goal here would be to keep the capital markets solvent. This would serve as a floor for investors. This would extend moral hazard, but with a new owner: the U.S. government. What enrages voters is that the bailouts favor big banks. But if the bailouts favored the national pension fund program, it probably would be accepted in the face of panic.

WILL THE GOVERNMENT DO THIS?

I think this would be a panic measure comparable to September and October 2008. I do not see this as likely under the new Congress. There will be Republican resistance to any major programs suggested by the Obama Administration. The new faces in the House will not back down short of a major breakdown of the capital markets. They will want to preserve their reputations as hard-nosed opponents of flim-flammery by the Administration until 2012. They will fight anything as large as a $5.5 trillion heist of pension fund assets.

I think there are good reasons for investing in assets that do not leave obvious paper trails. I also expect existing government policies to create new conditions of panic in the capital markets. So, I generally think it is unwise to have money tied up in income tax-deferred retirement funds that must be allocated in terms of the general rules for market safety: “widows and orphans.” The widows and orphans are going to be skinned by the combined policies of the Federal Reserve System and the Federal government.

I think the most likely scenario will be default disguised by mass inflation, though not hyperinflation in the high double-digit range. The path of least resistance for the FED and the Feds is to create money and add to the deficit. I don’t think the government will risk anything more radical than this, short of a collapse of the capital markets.

Their motivation then will be to defer the day of reckoning. To do this, the government will want control over the capital markets comparable to its control over the mortgage markets. It will want to be perceived as the healer, not the raider. It must keep the investment money flowing into the system, just as the present system keeps mortgage money flowing.

So, I do not expect an overnight confiscation of pension fund assets except during a major crisis.

CONCLUSION

Make your decision about where to invest, what to invest in, and which fund to use to manage your money, if any. Make it in terms of the principle of government deferral of a day of reckoning. Anything that defers that day will be adopted.

Which crisis do you think will come first? That is where to concentrate your effort to stay ahead of the government.

I think the Social Security crisis can be deferred longer than the banking crisis. I think maintaining the solvency of the banking system is always at the top of the list at the Federal Reserve.

When you think about the next shoe to fall, think “banking.” That is the shoe you want to avoid being under when it falls.

The bankruptcies of Medicare and then Social Security are coming. But they can be deferred longer. Concentrate on one crisis at a time.

This is why I think hedging against the confiscation of pension fund assets is not our top priority. The government will try other measures before it risks that one. It would gain control over business, but the economic problem of converting these assets into money is very big. It might create a wave of selling. I see this threat as a response to a wave of selling, not a problem of the red ink in Social Security and Medicare.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2010 Gary North