Tag Archives: Congressional Budget Office

Don’t like the fiscal cliff? You’ll hate the fiscal future.

Absent an eleventh-hour deal—which may yet be possible—the Federal government will cut spending and raise taxes in the New Year. In a town that famously can’t agree on anything, nearly everyone seems terrified by the prospect of going over this fiscal cliff.

Yet for all the gloom and dread, the fiscal cliff embodies a teachable moment. At the risk of mixing metaphors, we should think of the fiscal cliff as the Ghost of the Fiscal Future. It is a bleak lesson in what awaits us if we don’t get serious about changing course.

First, some background. Over the last four decades, Federal Government spending as a share of GDP has remained relatively constant at about 21 percent. This spending was financed with taxes that consumed about 18 percent of GDP and the government borrowed to make up the difference.

After a decade of government spending increases and anemic economic growth, federal spending is now about 24 percent of GDP (a post WWII high, exceeded only by last year’s number) and revenues are about 15 percent of GDP (the revenue decline can be attributed to both the Bush tax cuts and to the recession).

But the really telling numbers are yet to come.

The non-partisan Congressional Budget Office now projects that, absent policy change, when my two-year-old daughter reaches my age (32), revenue will be just a bit above its historical average at 19 percent of GDP while spending will be nearly twice its historical average at 39 percent of GDP. This is what economists mean when they say we have a spending problem and not a revenue problem: spending increases, not revenue decreases, account for the entirety of the projected growth in deficits and debt over the coming years.

Why is this so frightful? The Ghost of the Fiscal Future gives us 3 reasons:

1) As spending outstrips revenue, each year the government will have to borrow more and more to pay its bills. We have to pay interest on what we borrow and these interest payments, in turn, add to future government spending. So before my daughter hits college, the federal government will be spending more on interest payments than on Social Security.

2) When the government borrows to finance its spending, it will be competing with my daughter when she borrows to finance her first home or to start her own business. This means that she and other private borrowers will face higher interest rates, crowding-out private sector investment and depressing economic growth. This could affect my daughter’s wages, her consumption, and her standard of living. In a vicious cycle, it could also depress government revenue and place greater demands on the government safety net, exacerbating the underlying debt problem.

This is not just theory. Economists Carmen Reinhart and Kenneth Rogoff have examined 200-years’ worth of data from over 40 countries. They found that those nations with gross debt in excess of 90 percent of GDP tend to grow about 1 percentage point slower than otherwise (the U.S. gross debt-to-GDP ratio has been in excess of 90 percent since 2010)

If, starting in 1975, the U.S. had grown 1 percentage point slower than it actually did, the nation’s economy would be about 30 percent smaller than it actually is today. By comparison, the Federal Reserve estimates that the Great Recession has only shrunk the economy by about 6 percent relative to its potential size.

3) Things get worse. The CBO no longer projects out beyond 2042, the year my daughter turns 32. In other words, the CBO recognizes that the whole economic system becomes increasingly unsustainable beyond that point and that it is ludicrous to think that it can go on.

What’s more, if Congress waits until then to make the necessary changes, it will have to enact tax increases or spending cuts larger than anything we have ever undertaken in our nation’s history. As Vero explains:

By refusing to reform Social Security, lawmakers are guaranteeing automatic benefit cuts of about 20-something percent for everyone on the program in 2035 (the Social Security trust fund will be exhausted in 2035, the combined retirement and disability trust funds will run dry in 2033, and both will continue to deteriorate).

In other words, if we fail to reform, the fiscal future will make January’s fiscal cliff look like a fiscal step. I’ve never understood why some people think they are doing future retirees a favor in pretending that entitlements do not need significant reform.

You might think that we could tax our way out of this mess. But taxes, like debt, are also bad for economic growth.

But it is not too late. Like Scrooge, we can take ownership of the time before us. We can make big adjustments now so that we don’t have to make bigger adjustments in a few years. There is still time to adopt meaningful entitlement reform, to tell people my age to adjust our expectations and to plan on working a little longer, to incorporate market incentives into our health care system so that Medicare and Medicaid don’t swallow up more and more of the budget.

Some characterize these moves as stingy. In reality, these types of reforms would actually make our commitments more sustainable. And the longer we wait to make these inevitable changes, the more dramatic and painful they will have to be.

For all the gloom and dread, the Ghost of Christmas Yet to Come was Scrooge’s savior. In revealing the consequences of his actions—and, importantly, his inactions—the Ghost inspired the old man to take ownership of the “Time before him” and to change his ways.

Let us hope that Congress is so enlightened by the Ghost of the Fiscal Cliff.

Is Government the Solution?

It was thus salutary that Douglas Elmendorf, the widely respected director of the Congressional Budget Office, told a congressional hearing last week that 80 percent of economic experts surveyed by the University of Chicago’s Booth School of Business agreed that the stimulus got the unemployment rate lower at the end of 2010 than it would have been otherwise.

That’s E.J. Dionne writing in today’s Washington Post. This sort of statement is all too common: “There is consensus on stimulus. All economists agree it is unquestionably beneficial. If anything, the 2009 stimulus was too small. Case closed. Move along.” This is not a fair representation of the scientific view of stimulus.

Let’s start with the Booth School survey. Every week, the Booth School’s Initiative on Global Markets polls an ideologically diverse group of about 40 economists on a particular issue. The surveys are fascinating; I read them every week. On February 15, they put two statements to the panel and asked them to respond. The first statement reads:

Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.

It is true that, of those surveyed, 51 percent agreed and 29 percent strongly agreed with this statement. Some of the comments from those who agreed with this statement are telling. Anil Kashyap of Chicago for example wrote, “But this is an incredibly low bar.” And Darrell Duffie of Stanford wrote, “Subsidizing employment leads employment to go up, other things equal. Adverse impacts through growth incentives might take time.” These statements (and others) suggest that perhaps the question was overly-narrow.

Thankfully, IGM probed further. They asked the economists to weigh in on a second statement:

Taking into account all of the ARRA’s economic consequences — including the economic costs of raising taxes to pay for the spending, its effects on future spending, and any other likely future effects — the benefits of the stimulus will end up exceeding its costs.

This time, when the economists were asked about the longer-run, total effects of stimulus, they were much more equivocal. Less than half agreed or strongly agreed with the statement, 27 percent were uncertain, and the rest either disagreed or had no opinion. A number of respondents noted the uncertainties involved. Nancy Stokey of Chicago summed it up nicely, writing, “How can anyone imagine this question is answerable, given the current state of economic science?”

Amen. In my testimony last February before the House Education and Workforce Committee, I wrote:

There are many things on which economists agree (e.g., few dispute the merits of free trade or the long-run fiscal problems with our largest entitlement programs). Unfortunately, there is very little consensus among economists on government’s ability to jumpstart a sick economy.

The degree of disagreement over stimulus is evident when you look at the literature on the “government purchases multiplier.” The multiplier measures the amount by which an economy expands when the government increases its purchases of goods and services by $1.00. If the multiplier is larger than 1, it means that government purchases multiply or stimulate private sector economic activity. If it is between 0 and 1, it means that purchases displace or crowd out private sector economic activity. And if it is less than 0, it means that government purchases crowd out enough private sector economic activity to offset any increase in public sector activity.

In my testimony, I showed the following sample of recent estimates. Each bar shows the high and low-end estimate of a particular study.

As I wrote in February:

Note that there is a wide range in the estimates both across and within studies. If the optimistic scenarios are correct, an additional $1.00 in deficit-financed government spending spurs $2.70 in new private sector economic activity. But if the less-optimistic scenarios are correct, then an additional $1.00 in spending destroys $3.80 in private sector activity.

This misses some of the recent data. In a recent paper Valerie Ramey of UCSD, for example, uses: “a variety of identification methods and samples,” and finds that “in most cases private spending falls significantly in response to an increase in government spending.” She finds that while government spending does bring down the unemployment rate, “virtually all of the effect is through an increase in government employment.” Note that this is entirely consistent with the first IGM statement. In other words, one can believe that stimulus harms the private sector and is costly in the long run, but still think that it might have boosted (government) employment for a time. This is hardly a ringing endorsement of stimulus.

For more on this topic, see Garett Jones’s excellent (February) post here or Veronique’s post here.


Addendum: Vero responds to Dionne’s column, adding links to lots more research on when multipliers might be large or small. And Russ weighs in here, calling for more humility. Read and bookmark both posts.

There is Nothing So Permanent as Temporary Stimulus

It is interesting to note that not even the most-ardent Keynesians are willing to claim that permanent fiscal stimulus makes any sense whatsoever. That is, the stimulative effects of debt-financed spending—whatever they may be—are only fleeting. Hence, the perennial Keynesian calls for ”temporary, targeted and timely” stimulus spending. But is that the way it happens? 

Last summer, the Congressional Budget Office issued a report showing federal spending as a share of GDP skyrocketing well above its 40-year average. At the time, the CBO projection seemed to indicate that the spending would, indeed, be temporary. By 2013, the report claimed, spending as a share of GDP would be within a few percentage points of the 40-year average (though still above it).

One year later, CBO has issued another report. This one shows spending as a share of GDP remaining will above its 40-year average for the foreseeable future. Note, however, that they still show spending as a share of GDP declining somewhat in the coming years. Below, I show both projections on the same graph (click on the graph to make it larger). I plan to update this graph next summer.