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Friday, August 28, 2009

$3 to $7 trillion CBO Underestimate of the deficit

I am no expert on the budget, but my pundit record is a documented 100% accurate. When I was revising my introductory economics text in 2000, I spent about one hour examining the CBO’s budget projection of a $4 trillion surplus by 2010. I concluded that there would be no surplus to speak of (Paul Gregory, Essentials of Economics, 5th edition, p.166). This conclusion was easy. The surplus disappeared if we dismissed the improbable assumption that nominal government spending would increase 2.3 percent a year (versus the historical rate of 7.6%) and recognized that the peace dividend of 1998-2000 was a one time event. The CBO projection also assumed that there would be no recession between 2000 and 2010.

I just repeated the same hour-long exercise with the CBO’s August 2009 projections, which estimate that the cumulated deficit will grow by $7 trillion between 2008 and 2019. Without even looking at the revenue side of the equation (which looks too optimistic to me), I conclude that the CBO projection underestimates the cumulated deficit by $3 to $7 trillion. The deficit grows by $3 trillion if we use the growth rate of government spending over the previous eleven years. It grows by $7 trillion, if we use the historical rate of growth of government spending since 1970. The CBO projection also assumes there will be no recession over the next eleven years. A recurrence of recession would raise the cumulated deficit by a considerable amount depending on its severity.

Even if we accept the CBO’s optimistic revenue projections, I doubt that the growth of spending can be reduced below rates of the last decade or the longer term rates. If I am correct, gross federal debt will be between 110 to 130 percent of GDP in 2019. Federal debt held by the public will be between 80 to 100 percent. These figures do not include the potential impact of an expensive federal government health care reform. These national debt ratios will make the United States look like Italy and Spain.

I therefore have to join the chorus that such deficits are not sustainable and conclude that the alarming deficit projections we have seen are underestimates of the true situation unfolding.