Latest CBO Budget Projections Underline Need for Goldilocks Budget Deal
The latest analysis from the Congressional Budget Office (CBO) shows a sharp divergence between a baseline projection and an alternative fiscal scenario for the U.S. economy. To put it in language a child could understand, the baseline projection is too cold while the alternative scenario is too hot. It is clear from the report that we need a Goldilocks budget deal to get things just right.
The CBO’s baseline assumes no changes in current law. Paradoxically, no change in the law would mean big changes in policy. That is because we are facing the so-called fiscal cliff–a set of measures that include allowing the Bush tax cuts to expire as scheduled, making sharp cuts in Medicare payments to doctors, ending extended unemployment benefits, and allowing mandatory cuts to defense and nondefense spending to come into force. The CBO projects that those changes would shrink the budget deficit to about 4.0 percent of GDP, compared with a projected 7.3 percent for 2012. The deficit would decline to 1 percent of GDP by 2016.
The alternative fiscal scenario assumes that Congress will make the kinds of changes to current law that it has regularly made in the past. Tax cuts will not be allowed to expire (except for the temporary reduction in payroll taxes); Medicare cuts will be postponed (the so-called “docfix”); and mandatory spending cuts will be cancelled or postponed. Under those projections, the deficit for 2013 would be 6.5 percent of GDP, never falling below 4.2 percent of GDP.
The alternative fiscal scenario—business as usual—is “too hot” in the sense that it keeps the deficit and debt on unsustainable paths. The following chart shows that under business as usual, the debt will reach nearly 90 percent of GDP in ten years; after that it would grow indefinitely. By contrast, the fiscal tightening in the baseline projection is sufficient to begin bringing the debt ratio down almost immediately.
On the other hand, the baseline projection—running the economy off the cliff—is “too cold” in the sense that it is predicted to put the economy back in recession in 2013, with an estimated 0.5 percent decrease in real GDP. That result shows up in the following chart as a temporary widening of the output gap (the gap between actual and potential real GDP) before the gap begins to narrow again.
Clearly, neither path is optimal for the economy. Pursuing the alternative fiscal scenario would mean driving the economy toward eventual default or inflationary monetization of the deficit. Those outcomes could be avoided only by undertaking fiscal consolidation measures that, because of the delay, would be even more painful than those of the dreaded fiscal cliff. On the other hand, an optimal fiscal consolidation undertaken immediately would not be so strongly front-loaded as to drive the economy into recession.
The Goldilocks outcome of fiscal consolidation that begins immediately but is phased in gradually as the economy recovers will require political compromise. The components of compromise are known to everyone:
- Tax reform that increases revenues while broadening the base and reducing the disincentives inherent in high marginal rates.
- Discipline regarding both defense and nondefense components of discretionary spending without compromising growth-enhancing expenditures like education and infrastructure.
- Reform of social security and Medicare that recognizes both budgetary and demographic realities.
Where are we headed? Will our political system deliver us a bowl of porridge that is just right, or will it, like the Mama Bear in this cartoon, throw us into the pot as Goldilocks stew?
6 Responses to “Latest CBO Budget Projections Underline Need for Goldilocks Budget Deal”
I have to ask where you get the "too hot" prognosis from. The crux seems to be ".. the debt will reach nearly 90 percent of GDP in ten years; after that it would grow indefinitely."
Surely, if we have no brains or responsiveness to conditions, "indefinitely" doesn't sound good. But 90% of GDP is not by itself a problem. Japan has twice that, and no problem. What is wrong with low-cost, no-risk savings vehicles offered to the population that wishes to save in large amounts?
Right now, the deficits are the only thing keeping employment in semi-civilized territory. In the far-off future when spending eventually meets potential output, unemployment is low, and government can take its foot off the accelerator, that would be a good time to talk about cutting spending and reducing deficits, as part of a larger program of responsible macro-economics.
But the idea that some level of debt is self-evidently bad doesn't carry any water. We can carry exactly as much as it takes to return to a balance of savings and consumption.
"I have to ask where you get the 'too hot' prognosis from."
I get it directly from the CBO report, which says "Ultimately, the policies assumed in the alternative fiscal scenario would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective." There is a footnote with detailed explanation of that prognosis.
"What is wrong with low-cost, no-risk savings vehicles offered to the population that wishes to save in large amounts?" Nothing, really, if you're Japan, where the population does want to save in large amounts and interest rates seem to be permanently near zero. The US population does not save nearly as much. That means that, unlike Japan, we have to borrow mostly from abroad to finance the deficit. It makes a difference. Also, our interest rates won't stay Japanese-low forever. The CBO projects a real interest rate of 5.4 percent on 10 year Treasury notes by 2022 (5.4 percent nominal), and that starts to add up when debt is at 90 percent of GDP.
" In the far-off future . . . that would be a good time to talk about cutting spending and reducing deficits" I agree with you on the concept that deficit reduction should not be too front loaded, but we can't wait until the "far-off future." The window for acting is getting shorter and shorter. Most importantly, we can't wait to "talk about" fiscal consolidation. We have to start talking right now. The only path to a healthy budget is to talk about, and commit to, a properly phased fiscal consolidation plan now.
There is a growing empirical literature indicating that excessive debt relative to GDP reduces the rate of economic growth. It was inspired by the historical work of Reinhart and Rogoff and the most recent paper (July 2012) is by Baum, Chercherita-Westphal and Rother of the European Central Bank. I also co-authored a paper with Caner and Kohler-Geib with similar results. The cross-country studies all measue debt by gross debt (all bonds issued by governments) without subtracting debt held within governments. Data availability does not allow the use of net debt (held by the public) as used by the CBO. Currently US gross debt is over 100% of GDP, and the general result of these papers is that gross debt over in excess of the threshold of 70-90% of GDP reduces real economic growth. Debt can be "too hot".
A cynical speculation…
In a political economy full of various kinds of rent seeking, mis-incentives and even perverse incentives, with demographics like ours, AND
With the unstoppable effects of worldwide integration into labor markets AND
The pretty much unstoppable effects of automation
Only two macro states are really possible:
a. Growing debt and other "political narcotics" to keep things staggering along.
b. A crises of some sort, on a large scale (serious depression, violent or non-violent revolution, default, or very slow motion disaster ala Japan.)
I think this is the same as claiming there is no "just right", the choices are "too hot" (more political narcotics of one kind or another) or "very much too cold" – but there is no "happy medium".
Let us all hope I am wrong.
You are right to point to the importance of gross debt. For some purposes, like calculating current interest expense, net debt is the right measure, but for long term sustainability, gross debt can be more relevant. For example, debt held by the social security trust fund has no interest expense, but it is a real liability in the sense that the government is committed, as the trust fund is drawn down, either to replacing it with debt held by the public, raising taxes, or defaulting on promised benefits.
The Cliff is beginning to look good to me.