Economic Commentaries


In late 2009 we conducted an in-depth study of the fiscal condition of the United States. We found it rather terrifying and we concluded that the country was about to end an era of twelve digit budget deficits (multi billions) and begin an era of thirteen digit budget deficits (trillions). The consequences of this would be to severely limit the government's options to fight the business cycle and ultimately to severely constrain its preeminence as a world power.

Since that analysis the U.S. economy has embarked on an economic recovery that has been sub-par by the standards of post World War II business cycles. Indeed growth was only about 2% in 2010-2011 and worse, nominal growth was below 4%. To some observers this record is akin to a depression, exposing the impotence of monetary and fiscal policy to revive the economy. To others it is a failure of fiscal stimulus to be sufficiently large to lift the economy out of its funk.

In either case the result is that through 2012 the federal government will have run a fourth consecutive year in which the budget deficit exceeds $1 trillion. In this period federal spending has climbed to roughly 25% of GDP versus its post war norm of about 20%. Federal revenue has fallen to about 15% of GDP versus its post war norm of about 18%. Despite this dismal record a recent CBS/N.Y. Times poll showed a drop in those surveyed expressing a concern about the federal budget deficit. Nevertheless the deficit is commanding the attention of aspirants for the Republican nomination, castigating its size and the recklessness of federal spending. So the budget deficit will undoubtedly be a topic for debate in the approaching election campaign. But in the meanwhile the President has seemingly responded to the most recent polls by offering a budget for fiscal 2013 and beyond that does little to address the structural ills that are imperiling the U.S. fiscal condition.

This report does not offer solutions to the budget deficit, but it offers several alternative realistic scenarios that suggest a fiscal train wreck could well be on the horizon. The point of departure is the baseline budget path developed by the Congressional Budget Office (CBO). The CBO conducts its analysis in the context of current law so its baseline scenario assumes that all the Bush era tax cuts expire at the end of this calendar year, the automatic sequester of federal spending mandated by the Congressional Super Committee goes into effect, Medicare payments to physicians are cut, military operations are wound down , payroll tax cuts expire, etc. From this budget we develop what we think is a more realistic budget path in which all the expirations assumed under the baseline are relaxed. In other words this is a scenario in which the legislative and executive branches abrogate all responsibility for fiscal discipline and it is business as usual in Washington.

These two budget outcomes are compared with the President's budget path which was published in mid February by the Office of Management and Budget (OMB). It assumes that only tax cuts for income earners above $250K are rescinded, that military operations are wound down and that the sequester order takes effect but with modifications. Like the CBO, the President's budget assumes the economy grows at an uninterrupted trend rate of about 2.7% annually, that inflation remains subdued, and that interest rates rise gradually with economic growth. For example, by 2022 both the CBO and OMB assume that short term interest rates will climb from nearly zero currently to about 4% by 2022 while rates on the ten year treasury note rise from about 2% currently to about 5% by 2022.

Critiquing The Assumptions

Importantly, the CBO baseline budget path assumes approximately $500 billion of fiscal drag in 2013. This is approximately 3% on GDP. Yet the CBO assumes only one quarter of modestly negative economic growth and then a quick restart to the trend line. Even if the U.S. and the global economy were experiencing a normal business cycle this scenario would be considered optimistic but not totally unreasonable. If we are experiencing a lengthy recession/depression the CBO forecast would be totally unreasonable and allowing it to unfold could result in a tragic blunder.

Interest rate assumptions are another matter as well. The assumption of a modest rate rise is not unreasonable for a global economy that has a lot of spare capacity. More specifically, though, Republican Presidential candidates are expressing dissatisfaction with the Federal Reserve's zero interest rate policy (ZIRP). The Fed Chairman would very likely resign or be replaced under a new administration. The new Chairman would presumably quickly lift short term rates to around 2%.

In our view there is a legitimate issue of the consequences that such an action would have on economic activity. Aside from the potential negative impact of higher interest rates on sectors such as housing and commercial real estate, there is the issue of the direct budgetary impact of higher interest rates on the net interest portion of federal outlays. For each one percentage point rise in the interest rate structure, such payments rise by about $100 billion per year over a ten year period. This is not inconsequential even in an era of trillion dollar deficits.

In consideration of these issues we examine three alternative budget paths which we think are the most likely or realistic outcomes. These key off the CBO adjusted or business as usual budget path. The first assumes that interest rates are 2 percentage points higher than under the CBO baseline but that everything else remains the same. The next scenario assumes that interest rates remain as originally forecast but that economic growth is 2 percentage points lower than forecast by the CBO and the OMB. A third and final alternative is that interest rates are two percentage points higher while growth is two percentage points lower than forecast by CBO and OMB.

These are not unrealistic alternatives. First off neither the executive nor the legislative branch has shown much backbone when it comes to budget reduction. Second, if the economy is mired in a long deleveraging process, growth could well remain weaker than trend for a lengthy period. Third, interest rates could rise for many reasons other than an explicit policy by the Federal Reserve or regardless of the policy being pursued by the Federal Reserve.

Thus, there are six alternative budget paths that are described and these are summarized in the accompanying charts and tables. Chart I is a summary of the alternative deficits that emanate from the CBO baseline budget path, the OMB, and our adjusted business as usual budget. Needless to say spending is higher, revenues are lower, and the deficit is wider under the adjusted business as usual scenario than under either the CBO baseline or the OMB. As shown on Table I, under the CBO baseline the economy makes giant strides toward fiscal discipline. Although the budget never goes into surplus in this scenario, the deficit shrinks to less than 3% of GDP by 2022 and as Table II shows, the debt to GDP ratio would drop from about 72% currently to about 62% by the end of the forecast period.

The path toward fiscal consolidation is less optimistic under the OMB forecast . Spending growth slows by less than the CBO baseline and revenues grow less rapidly because tax cuts are retained for all but the top most bracket. Under the OMB scenario Table I shows that the deficit falls steadily until 2018 when it bottoms at about 2.8% of GDP. Thereafter it begins rising again while Table II shows that the debt to GDP ratio is stabilized at about 75%. This is not a great outcome but at least it purports to put a tourniquet on the fiscal hemorrhage.

More Realistic and More Pessimistic.

The budget paths we have described thus far can be viewed as optimistic relative to what we think are more realistic scenarios. These are described next and they can be considered downright pessimistic. Indeed they lead us to conclude that a fiscal train wreck could be lurking in the foreseeable future.

The first alternative is the adjusted or business as usual CBO baseline. This presumes that all tax cuts are extended and the spending sequester is abandoned. Since this would merely be an extension of existing law there would not be any impact on economic growth. As Table I shows the deficit explodes relative to the baseline. To be sure the deficit is slightly shy of the magic one trillion mark from 2014 to 2018, but it rises above one trillion thereafter. As a percentage of GDP the deficit stabilizes around 5% or about double that measured under the baseline. Table II shows that under this business as usual scenario the debt to GDP ratio would rise gradually but persistently over the forecast period hitting over 90% in 2021-2022.

In the absence of demonstrable progress toward deficit reduction as shown in this scenario one would have to question the patience of the rating agencies and investors in government securities. Supposing U.S. debt were downgraded again as the rating agencies have already warned. Would financial markets react calmly again or would there be a negative interest rate effect. What would happen if the Chinese or other foreign investors responded by ceasing purchases of government securities or even beginning to dispose of their current holdings. A new President's vow to "get tough with China" policy carries a similar set of risks.

We attempt to address these possibilities in our next three scenarios. Using the CBO adjusted business as usual budget as our point of departure, table I shows the impact of a two percentage point increase in interest rates. The deficit is shown to remain above one trillion over the entire forecast period. Table II shows that under this scenario the debt to GDP ratio balloons to over 80% in 2014; over 90% by 2019; and to 100% in 2022. If interest rate assumptions are left as is by CBO and OMB, but growth is two percentage points lower, the result is even worse. Table II shows that the debt to GDP ratio would exceed 100% in 2017 and it would hit nearly 150% by 2022. Interest rates are increasingly important but economic growth remains the major determinant of the budget deficit.

Our final scenario is the most troubling. It uses the CBO adjusted budget path; it assumes that interest rates are two percentage points higher; and it assumes that economic growth is simultaneously two percentage points lower than forecast by either the CBO or the OMB. This is the scenario wherein structural impediments to growth are so severe that the economy is insensitive to monetary and fiscal stimulus. It is thus an extension of the environment that we have been mired in for the past three years but with higher interest rates.

As table I shows the deficit never falls below one trillion; it rises to above two trillion by 2019; and it goes above the three trillion threshold by the end of the forecast period. Table II shows that as a consequence the debt to GDP ratio exceeds 100%as early as 2015. It climbs steadily from there, reaching to nearly 200% of GDP by 2022. What is particularly frightening about this scenario is that it could easily be worse. For example, the U.S. recession ended in the spring of 2009 so it has been a full three years since the recovery began. The typical business cycle recovery only lasts about four years so one could argue that another recession is on the horizon. If so then our assumption of two per cent less growth would be too optimistic.

Another worry is the extent to which the Federal Reserve will continue buying assets and expanding its balance sheet. Were it to end this program interest rates could spike higher. A third concern is the potential for social unrest emanating from structurally high joblessness and depressed incomes and the possibility that this fosters a new round of tax and spend policies at the federal level.

Of course there is the optimistic possibility that the only time responsible action is undertaken in a democracy is in time of crisis. Perhaps the crisis environment that is spawned by some of our scenarios will bring about a new look at the size and role of government. Certainly the Republican budget that will soon be presented under the leadership of House Budget Committee Chairman Ryan will have the look and feel of a Simpson-Bowles program of tax reform and spending restraint. It will offer a different path but it also reminds us of the saying that there is no such thing as a free lunch. To get control of our fiscal situation will require pain. But some short run pain is a far better alternative than the fiscal train wreck that is headed our way.

There is also another option which is to continue policies which are designed to eventually inflate our way out of the deficit. Global monetary policy is now coordinated in an expansionary mode. The Federal Reserve is pursuing quantitative easing as is the Bank of England and the Bank of Japan. The European Central Bank has recently joined with its own form of quantitative easing and the Peoples Bank of China is now reducing reserve requirements. To date this coordination has had the effect of containing economic damage, if it has had any effect at all. Perhaps, irrespective of who leads Central Banks in the future quantitative easing would continue being pursued and Central Banks would in effect buy up all the accumulated debt in an attempt to avoid financial chaos and eventually inflate economic activity. This would have the unintended consequence of allowing fiscal authorities to avoid making tough decisions as has been the case in the United States to date. Thus. there is no question but that such a policy would be a dangerous course, but then again dangerous times may warrant dangerous actions.

Posted in: General

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