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A Misleading Financial Outlook

e21 | 2/11/2013

In Saturday’s weekly radio address, President Obama repeated the assertion that the federal government is “more than halfway” to the required cumulative deficit reduction to stabilize debt ratios. He then proceeded to argue that the policies undertaken to achieve this objective should be partially undone and replaced with a “balanced approach” – a vacuous rhetorical concept often used in place of “tax increases.” The notion that the federal government is “more than halfway” to fiscal stability is complete nonsense that can only be justified by defining the problem as narrowly as possible and relying on excessively optimistic forecasts for growth and interest rates.

The recent Congressional Budget Office (CBO) Outlook provides cover for those seeking to exaggerate the amount of progress made to-date and minimize the scale of the problem. Specifically, the CBO estimates that annual deficits will decline to a manageable 2.4% of GDP in 2015 ($430 billion) and federal debt as a percentage of GDP will stop rising and actually decline steadily between 2014 and 2018 to the current level of about 73% of GDP. The report clearly notes that current policies are unsustainable, as debt ratios continue to rise after 2018. But for someone seeking to minimize the problem – as the President certainly is – the report is an important piece of evidence to support the contention that significant progress has been made.

Unfortunately, the CBO report is highly misleading on this score for three main reasons: (1) the report assumes the real GDP growth magically accelerates to a 4.4% annual rate in 2015 and averages 3.8% for the four years between 2014 and 2017; (2) the report assumes that interest expense remains historically low despite the acceleration in growth, which makes debt fall relative to the size of the economy; and (3) since costs of mandatory spending continue to accelerate throughout the budget window, a 10-year snapshot artificially reduces the scale of the required adjustment since policies necessary to stabilize debt ratios in 2023 are insufficient to stabilize debt ratios in 2025, let alone 2035.

The first point is the most significant. As shown in Figure 1, CBO assumes that GDP will eventually converge with “potential GDP” – the total amount of output that could be produced if capital and labor were fully utilized. Since the growth rate of potential GDP has significantly exceeded the growth of real GDP during the recession and tepid recovery, an “output gap” has opened that represents the amount of “slack” in the economy, as depicted graphically in Figure 1. The only way for this gap to be closed would be for prior trends to reverse with the growth of real GDP to significantly outpace potential GDP growth over a sustained period.

As shown in Figure 2, this is what CBO assumes: in spite of the fact that growth has averaged just 1.8% since 2010, CBO expects growth rates to more than double to an annual average of 3.8% for 16 consecutive quarters between the end of 2013 and the middle of 2017. This result has absolutely no basis in any factual analysis about the prospective economic outlook; it is simply an outgrowth of a modeling assumption. In fact, given that the recovery is soon to enter its fifth year, it seems more likely that the economy will actually fall into recession during this period rather than enjoy startlingly-fast growth.

Figure 1: CBO’s Economic Outlook

CBOs Economic Outlook

Figure 2: Growth Rates of Real and Potential GDP

Figure 2: Growth Rates of Real and Potential GDP

Interestingly, even as CBO expects significantly faster 2013–2017 growth, it expects interest rates to remain historically low. The result is a huge gap between the cost of servicing the existing debt (the interest rate) and the growth of the economy, which would push the debt-to-GDP ratio down even as the government continues to run large deficits. It is hardly clear rates would remain so low even as growth rates double; and if this assumption doesn’t hold, the decline in debt-to-GDP would prove illusory.

The $620 billion in tax increases from the fiscal cliff deal helped to modestly reduce deficit projections from last year’s alternative scenario. Unfortunately, this tax increase came in as economically counterproductive a manner possible, as it focused on rate increases instead of limitations on deductions. The resulting convergence between real and potential GDP could therefore come through a slowdown in potential GDP resulting from a decline in the supply of labor and capital rather than the assumed acceleration in real GDP. Of course, this interpretation is entirely missing from the CBO analysis.

Dig deeper into the CBO Outlook and it becomes clear that the fiscal problems in the U.S. are acute as ever. Of course, the upcoming OMB assumptions are likely to be even more aggressive, which would further solidify impressions of fiscal improvement and redound to the benefit of those seeking to emphasize progress and emphasize the “balance” of future deficit reduction rather than its size.