Friday, February 5, 2010

The Deficit: On an Unsustainable Path?

The Administration published its budget this week.  I will leave others to play with the details of the budget.  (For example, this post on EconomistMom does a good job of examining the key details).  I like to look at the macro assumptions embedded in the budget. 

This administration, following the grand and old tradition of budget forecasting, makes economic assumptions that are possible but on the extreme edge of possible.  In other words, the Administration sticks to the broad outlines of the macro models but whenever there is a choice it errs in the favorable direction:  growth is a little higher, inflation a little faster, spending a little slower.  In addition, the Administration likes to cut programs in its budget that it knows Congress will reinstate.  An old favorite is threatened military programs.  A new favorite is sun setting tax provisions. 

I like to take the budget and tweak each of these assumptions back into the reasonable range.  Sometimes the result is a little worse; sometimes it is a lot worse.  In the current case, things end up a lot worse, because the jumping off point for the budget is so bad. 

I recalculate the budget forecast assuming 10 percent (not percentage points) lower nominal GDP growth, 18 percent faster expenditure growth (still faster growth than any time since the early 1990s), and 15 percent slower revenue growth. 

My forecast for government outlays as a percent of GDP is shown as the red line below.  Outlays as a percent of GDP start at a record 26 percent and grow steadily thereafter. 

The next picture shows my forecast for the deficit, using the same adjustments.  Notice, the assumptions in the OMB budget are exactly those that stabilize the deficit as a percent of GDP by 2014.  Using more reasonable assumptions, the deficit improves in the near term but then begins to explode as Social Security and Medicare expenditures rise sharply with the coming surge in retirements. 

What I have not considered is the cost of higher interest rates.  The Administration assumes almost no increase in interest rates despite the robust recovery and relatively rapid inflation path.  In itself, this is not realistic.  But it is especially not realistic if the markets come to believe the path I have written down.  If my path becomes the standard, the market will begin to demand a premium to hold U.S. debt.  (Of course, the good news is that the spread between corporate debt and U.S. Treasuries will narrow.  Oh wait …)

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