The U.S. Budget and Economic Outlook: A Cautionary Tale

Each year, the Congressional Budget Office prepares a report for the U.S. Congress to provide an objective and impartial analysis on the state of the budget and the U.S. economy over a ten-year planning horizon to provide lawmakers an economic foundation for fiscal policy decisions.  The 2012 report, The Budget and Economic Outlook: Fiscal Years 2012 to 2022, was issued in the midst of a sluggish economic recovery from the greatest economic downturn since the Great Depression, known as the Great Recession or the Global Financial Crisis.  The report comes at a time of historic budget deficits and government debt, attempting to inform lawmakers the implications of current and likely fiscal and monetary policy on the U.S. economy and budget over the next ten years.  Unfortunately, the economic situation can only be characterized as grim, as the national debt crowds out investment required for long-run growth and considerable slack remains in the economy for the foreseeable future (Congressional Budget Office, 2012).  In addition, projected slow economic growth will likely exacerbate already historic budget deficits as tax revenues are projected to grow at a slower rate than entitlement spending; a situation that the CBO considers unsustainable (Congressional Budget Office, 2012).  The growth of entitlement spending in the Social Security, Medicare, and Medicaid programs are projected to rise at a considerably higher rate than the Gross Domestic Product, given an aging of the population and rising healthcare costs.  The implications for the future of the U.S. economy is quite serious, given that policymakers must choose between a fiscal policy that improves short-run economic growth through lower taxation and increased debt loads at the cost of long-run economic growth, or long-run economic growth through higher taxation, debt reduction, and lower entitlement spending at the cost of short-run economic performance.  Although unfortunate, it is likely that policymakers will choose to focus on short-run economic problems, given the polarization in Congress and election year politics.  Therefore, U.S. households need to prepare minimally for sluggish growth and the likelihood of additional recessionary periods, brought on by the short-run mentality of the U.S. political system.

Summary of CBO Budget Outlook

The CBO has differentiated their budget and economic outlook based upon two distinct scenarios, a baseline scenario based on current law and an alternative fiscal scenario based on possible changes to the law (Congressional Budget Office, 2012).  The CBO’s (2012) baseline scenario estimates federal revenues and spending “under the assumption that current laws generally remain unchanged” (p. 1); including the expiration of Bush-era tax cuts, the expiration of limits on the Alternative Minimum Tax, and the scheduled drop of Medicare payment rates by 27%.  In contrast, the alternative fiscal scenario assumes the extension of the tax cuts, an Alternative Minimum tax that is indexed to inflation after 2011, and Medicare payments to physicians that remain at current levels (Congressional Budget Office, 2012).  The two scenarios intend to help lawmakers assess the economic and budgetary implications of either maintaining or altering the provisions of current law.

In the CBO’s (2012) baseline scenario, the federal deficit declines from $1.1 trillion in fiscal year 2012 down to $196 billion in 2018, before rising up to $339 billion in 2022.  The decline in deficit through 2018 is because the revenues shoot up by 30%, as the scheduled or recent expirations of tax provisions take effect and taxpayer’s real income increases, moving them into higher tax brackets (Congressional Budget Office, 2012).  In addition, outlays are projected to rise from $3.6 trillion in 2012 to more than $5.5 trillion in 2022.  While discretionary spending is projected to decline, spending for mandatory programs like Social Security, Medicare, and Medicaid are projected to rise significantly; while the accumulation of rising debt and rising interest rates increase the cost of servicing federal debt (Congressional Budget Office, 2012).

Under the alternative fiscal scenario, the budget situation is far worse with lower revenues and higher spending, and a resulting rise in deficits (Congressional Budget Office, 2012).  Although not stated specifically in the report, the higher spending is a likely outcome of higher costs to service accumulated federal debt.  Figure 1 highlights the impact of each scenario on annual deficits:

Figure 1 – CBO annual budget deficit projection comparison between baseline and alternative fiscal policy scenarios from 2012 and 2022.  Adapted from “The Budget and Economic Outlook: Fiscal Years 2012 To 2022,” by the Congressional Budget Office, 2012, p.22.

Another useful way to compare the budgetary impact of the two scenarios is based on the debt-GDP ratio, or the debt of the U.S. federal government expressed as a function of GDP (Mankiw, 2012).  As noted in Figure 2, in the baseline scenario, the federal debt goes from 72% of GDP in 2012, down to 62% of GDP in 2022, whereas under the alternative fiscal scenario, the debt balloons to more that 94% of the GDP by 2022.

Figure 2 – CBO annual total federal debt projection comparison between baseline and alternative fiscal policy scenarios from 2012 and 2022.  Adapted from “The Budget and Economic Outlook: Fiscal Years 2012 To 2022,” by the Congressional Budget Office, 2012, p.22.

Under both scenarios, an aging population and rising healthcare costs push entitlement spending higher, resulting in large deficits and levels of federal debt that are considered unsupportable (Congressional Budget Office, 2012).

Summary of CBO Economic Outlook

In the baseline scenario, the CBO forecasts slow growth of the real Gross Domestic Product, forecasted at 2% for 2012 and 1.1% for 2013 (Congressional Budget Office, 2012).  GDP “is the market value of all final goods and services provided within a country in a given period of time” (Mankiw, 2012, p. 200); whereas the real GDP is “the production of goods and services valued at constant prices” (Mankiw, 2012, p. 205).  Real GDP is an important measure because it only measures growth from production output, rather than growth resulting from inflation.  Moreover, GDP is an identity used to understand how the economy is using resources and include the components of consumption, investment, government purchases, and net exports (Mankiw, 2012).  According to the CBO baseline scenario projections, the economy will grow sluggishly through 2013, experience higher real GDP growth of 4% between the years 2014 and 2017, and growing at 2.5% from 2018 to 2022 (Congressional Budget Office, 2012).

The CBO alternative fiscal scenario illustrates how changes to current law could affect the economy (Congressional Budget Office, 2012).  Under the alternative fiscal scenario, economic outcomes could be quite different, as the GDP would improve slight in the short-run, increasing to 2.2% to 2.8% in 2012 and 1.6% to 4.8% in 2013 (Congressional Budget Office, 2012).  However, GDP projections for the alternative fiscal scenario in the long-run reflects two opposing forces, lower marginal tax rates that will increase incentive to work and save, while higher deficits that will “crowd out” private investment (Congressional Budget Office, 2012).  Mankiw (2012) describes “crowding out” as “a decrease in investment that results from government borrowing” (p. 274).  Crowding out occurs as government borrowing decreases the supply of loanable funds that fund private investment, “the purchase of goods that will be used in the future to produce more goods and services” (Mankiw, 2012, p. 201).

While the lower tax rates of the alternative fiscal scenario will encourage work, saving, and aggregate demand in the short-run, the increased debt will crowd out long-run productivity and economic growth sacrificing roughly 2% of growth by 2022 and beyond, where “the projected impact on GDP would tend to become more negative” (Congressional Budget Office, 2012, p. 29).  Both the baseline and alternative fiscal scenarios highlight Mankiw’s (2012) first principle, that “people face trade-offs” (p. 4).  In this case, the trade-offs are based on government fiscal policy under the baseline scenario that promotes long-run economic health while sacrificing short-run growth, or the alternative fiscal scenario that promotes short-run economic growth while sacrificing long-run economic health.

Another important trade-off noted in the CBO’s economic outlook is the short-run trade-off between inflation and unemployment, echoing Mankiw’s (2012) tenth economic principle. While the labor market has shown signs of recent improvements (Lange, 2012), the unemployment rate remains stubbornly high, a situation the CBO attributes to continuing weakness in aggregate demand (Congressional Budget Office, 2012).  According to the Bureau of Labor Statistics (2012), “persons are classified as unemployed if they do not have a job, have actively looked for work in the prior 4 weeks, and are currently available for work” (p. 1). Mankiw (2012) describes the relationship between inflation and unemployment, noting that higher aggregate demand results in higher prices, which in turn causes firms to hire more employees, reducing unemployment, resulting in an inverse relationship between inflation and unemployment.  Because of continued short-run weakness in aggregate demand, the CBO (2012) expects the unemployment rate to remain above 8% through 2013, followed by a gradual decline to within the 5%-6% natural rate of unemployment by 2017 as the economy gains strength.

During the next several years of continued high unemployment, the CBO (2012) expects prices will rise at a subdued pace, noting “the price index for Personal Consumption Expenditures will increase by 1.2% in 2012 and by 1.3% in 2013” (p. 37).  While after 2012, the CBO’s (2012) expectations are that the inflation rate will rise to 2% as measured by PCE, inline with the Federal Reserve’s long-run goal.

The inflation rate, “the percentage change in the price index from the preceding period” (Mankiw, 2012), is often measured with both the Consumer Price Index and the PCE price index.  The CPI “measures the change in prices paid by urban consumers for a market basket of consumer goods and services [and] the PCE price index measures the change in prices paid for goods and services by the personal sector in the U.S. national income and product accounts” (McCully, Moyer, & Stewart, 2007, p. 1).  Where the CPI is used as an economic indicator, the PCE price index is used for macroeconomic analysis and forecasting (McCully, et al., 2007), hence the focus on PCE in the CBO’s outlook.

The CBO’s (2012) inflation projections are based in large part on the significant excess capacity in the economy for labor, capital resources, and housing. Because high unemployment continues to place downward pressure on wages in the labor market, it is less likely that businesses will need to raise prices to offset labor costs, once again highlighting the trade-off between inflation and unemployment.  The modest improvement in the unemployment rate between 2012 and 2022 will moderate inflationary pressure.  The CBO (2012) inflation outlook does note that there is concern by some economists that the Feds “extraordinary purchase of assets during the financial crisis will push inflation above 2 percent” (p. 37).  The concern is valid given that the Fed’s purchase equated to injecting enormous sums of money into the economy, which creates a new equilibrium price level for the supply and demand of money, lowering the value of money (Mankiw, 2012).  However, the CBO (2012) does not believe the increased money supply will lead to significant inflation because the money is largely in excess reserves, and the Fed has “several other policy tools for restraining borrowing, such as raising the federal funds rate and raising the interest rate paid on excess reserves” (p. 37).  It appears that the CBO has faith in the Feds ability to manage the inflation rate at the 2 percent target over the next ten years.

In short, the CBO (2012), in the baseline scenario, expects the U.S. economy to grow sluggishly over the next two years, with continued slack in the labor market and inflation below the two percent target.  While in the long-run, the economy is projected to grow as much as 4% annually, reach the natural rate of unemployment, and experience modest inflation at the 2% target (Congressional Budget Office, 2012).  Under the alternative fiscal scenario, the CBO (2012) expects very different outcomes for the economy, with higher short-run growth, a lower short-run unemployment rate, but higher interest rates as increase government debt decreases available loanable funds.  In addition, the alternative fiscal scenario could lead to lower long-run growth as businesses defer investment and government debt increase, where rising interest rates cause government interest payments to take up a larger percentage of the budget (Congressional Budget Office, 2012).

Observations

Recent economic news tends to reinforce the conclusion that the U.S. economy is gaining strength, as the number jobless claims remained at a four-year low (Lange, 2012), the GDP grew 3% in the final quarter of 2011, much higher than previously expected (Censky, 2012), and the Dow broke 13,000 for the first time since 2008 (Hauser, 2012).  As a result, many Americans perhaps consider the economic headwinds of the last several years to be in the rear view mirror.  However, the situation described in the CBO report tells a much different story highlighting the grim prospects for the U.S. economy.  The economy remains sluggish and the unemployment rate is projected to remain high for several years, while the 2012 budget deficit is $1.1 trillion (Congressional Budget Office, 2012).  Moreover, despite the Affordable Care Act, healthcare spending will remain the primary driver of federal debt over the next ten years.

What is clear from the CBO budgetary outlook is the simple fact that little has been done to address the growing problem of entitlement spending.  Auerbach and Gale (2012) suggests that the long-term budget outlook is unsustainable and recommends that policymakers address the imbalances soon to allow for gradual adjustments.

In a recent hearing, Bernanke (2012), recognized the economic progress of the last several years, but expressed frustration at modest pace of recovery.  More importantly, Bernanke provided policymakers guidance on the federal budget situation and its impact on the economy, noting that “even after economic conditions have returned to normal, the nation will still face a sizable structural budget gap is current budget policies continue” (Bernanke, 2012, p. 5).  Bernanke (2012) highlighted the economic consequences associated with the federal budget imbalance and the resulting government debt:

• Reduced productivity growth resulting from the crowding out of investment.
• A greater share of future income will be devoted to interest payments to foreign debt holders.
• Policymakers may be impaired in their ability to respond to future economic shocks.
• Interest rates could soar should investors lose confidence that the U.S. government can manage fiscal policy, spurring a financial crisis. (p. 6)

The economic implications of Bernanke’s warning are quite clear and play themselves out in the CBO’s alternative fiscal scenario.  Of most concern is the real possibility of future economic shocks that policymakers may few options to deal with, given the extent of federal debt obligations or the possibility of a response creating a fiscal crisis.  Both Bernanke (2012) and the CBO (2012) recognize that significant uncertainty exists in the economic and budget projections and suggest that the economy is quite fragile and open to future economic shocks, with the Eurozone crisis and rising gas prices tending to top the list.  There also remains a distinct possibility the U.S. may experience another recession in the short-run.

Conclusions

The future of the U.S. economy, although in the midst of a modest recovery, remains fragile because of policymaker’s divisions on government fiscal policy.  While the Federal Reserve continues to implement monetary policy designed to help the economy perform relative to its potential, government fiscal policy continues to undermine U.S. economic growth.  In particular, the CBO (2012) highlights the dilemma facing policymakers, given the must decide between the baseline scenario that could stifle short-run aggregate demand with the higher taxation required to reduce government debt, or the alternative fiscal scenario that stimulates aggregate demand in the short-run, but sacrifices long-run growth and increase government debt to unsustainable levels.  Policymakers appear divided on their approach to dealing with the long-term structural problems associated with the federal budget, with Republicans favoring lower taxes and moderate spending cuts and the Democrats favoring higher taxes and few spending cuts.  In addition, because of election year politics, neither party appears interested in actually solving the long-term budget problems, and as a result, may support the alternative fiscal policy for the short-run economic gains it promises.

Of most concern to this author is policymaker’s unwillingness to tackle the most significant problem in the federal budget, the unsustainable entitlement spending that is the primary cause of growing government debt.  The CBO (2012) warns policymakers that “if the  rising level of spending is coupled with revenues that are held close to the average share of GDP that they have represented for the past 40 years, the resulting deficits will increase federal debt to unsupportable levels” (p. xiii).  Indeed, Bernanke (2012) echoes the CBO, warning policymakers that a sustainable budget should be a top priority, arguing that “to achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time” (p. 7).  In this author’s opinion, it is unlikely that policymakers will be willing to tackle the structural problems of the federal budget given the short-run focus caused by the U.S. political system.  Rather, it is more likely that policymakers will remain focused on choosing between the two evils described by the CBO, the baseline scenario, or the alternative fiscal scenario.  Because of election year politics, it is likely that neither party has the patience or the appetite to both raise taxes and cut spending, likely resulting in the continuance of bad fiscal policy in the form of the alternative fiscal policy.  Therefore, U.S. households need to prepare minimally for sluggish growth and the likelihood of additional recessionary periods, brought on by the short-run mentality of the U.S. political system.

References

Auerback, A. J., & Gale, W. G. (2012). The federal budget outlook: No news is bad news (pp. 1-26). Cambridge, MA: National Bureau of Economic Research.

Bernanke, B. (2012). The economic outlook and the federal budget situation Committe on the Budget (pp. 1-7). Washington DC: Board of Governors of the Federal Reserve System.

Bureau of Labor Statistics, U. S. (2012). Current Population Survey Frequently Asked Questions  Retrieved January 11, 2012, from http://www.bls.gov/cps/faq.htm – Ques5

Censky, A. (2012, February 29, 2012). GDP: Economy grew faster at the end of 2011  Retrieved February 29, 2012, from http://money.cnn.com/2012/02/29/news/economy/gdp_growth/index.htm?iid=HP_River

Congressional Budget Office. (2012). The budget and economic outlook: Fiscal years 2012 to 2022.  Washington DC: Congressional Budget Office Retrieved from http://cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf.

Hauser, C. (2012, February 28, 2012). Dow Closes Above 13,000: First Time Since 2008  Retrieved February 29, 2012, from http://www.nytimes.com/2012/02/29/business/daily-stock-market-activity.html

Lange, J. (2012, February 23, 2012). Jobless claims hold steady at 4-year low  Retrieved February 29, 2012, from http://www.reuters.com/article/2012/02/23/us-usa-economy-idUSTRE7BM0AB20120223

Mankiw, N. G. (2012). Principles of macroeconomics (6th ed.). Mason, OH: South-Western Cengage Learning.

McCully, C. P., Moyer, B. C., & Stewart, K. J. (2007). Comparing the consumer price index and the personal consumption expenditures price index. Survey of Current Business  Retrieved February 28, 2012, from http://www.bea.gov/scb/pdf/2007/11 November/1107_cpipce.pdf